Chapter Five: Audit Evidence

5.1 Introduction

5.2 Relationship Of Evidence To Audit

Risk
5.3 Financial Statement Assertions

5.4 Sufficient Competent Evidential Matter

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 5.1 Introduction
 During financial statement audits, the auditors gather and evaluate
evidence to form an opinion on whether financial statements
follow the appropriate criteria, usually generally accepted
accounting principles.
 Sufficient evidence must be gathered to provide an adequate basis
for the auditors' opinion on the financial statements.

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5.2 Relationship of Evidence to Audit Risk
 The term audit risk refers to the possibility that the auditors may unknowingly
fail to appropriately modify their opinion on financial statements that are
materially misstated.
 Audit risk is reduced by gathering evidence- the more competent evidence
gathered the less audit risk assumed.
 Obviously, one way to gather additional evidence is to increase the extent of the
audit procedures.
 However, additional evidence may also be obtained by selecting a more
effective audit procedure or by performing the procedures closer to the balance
sheet date.
 Those the auditors must gather sufficient evidence to reduce audit risk to a low
level in every audit. 3
 Cont’d …..
 This concept is reflected in the third standard of field work that
states:
 Sufficient competent evidential matter is to be obtained through
inspection, observation, inquiries, and confirmations to afford a
reasonable basis for an opinion regarding the financial statements
under audit. (Emphasis added.)

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 5.3 Financial Statement Assertions
 Audit procedures are designed to obtain evidence about the assertions of
management that are embodied in the financial statements.
 When the auditors have gathered sufficient audit evidence about each
material financial statement assertion, they have gathered sufficient
evidence to support their opinion.
 These financial statement assertions are summarized as:

 Existence or Occurrence:- assets, liabilities, and owners' equity reflected

in the financial statements exist; the recorded transactions have occurred.
 Completeness:- all transactions, assets, liabilities, and owners' equity that
should be presented in the financial statements are included.
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 Cont’d ….
 Rights and obligations:- the client has rights to assets and obligations to pay

liabilities that are included in the financial statements.

 Valuation or allocation:- assets, liabilities, owners' equity, revenues, and

expenses are presented at amounts that are determined in accordance with

generally accepted accounting principles.

 Presentation and disclosure:- accounts are described and classified in the

financial statements in accordance with generally accepted accounting

principles, and all material disclosures are provided.

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 Audit Risk at the Assertion Level
 For each financial statement account, audit risk consists of the
possibility that
 (1) a material misstatement in an assertion about the account has occurred,
and
 (2) the auditors do not detect the misstatement.

 The risk of occurrence of a material misstatement may be separated into

two components: 1) inherent risk and 2) control risk.

 The risk that auditors will not detect the misstatement is called detection risk.

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 Inherent Risk
 It refers to the possibility of a material misstatement of an assertion before
considering internal control.
 the following are indicative of high inherent risk for the assertions about
many accounts in the client's financial statements:
 Inconsistent profitability relative to the industry

 Operating results that are highly sensitive to economic factors

 Going concern problems

 Large known and likely misstatements detected in prior audits

 Substantial turnover, questionable reputation, or inadequate accounting skills

of management

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 Cont’d …..
Assertions with high inherent risk often involve:

• Difficult to audit transactions or balances,

• Complex calculations,

• Difficult accounting issues,

• Significant judgment, or

• Valuations that vary significantly based on economic factors.

 Auditors use their knowledge of the client's industry and nature of its
operations, including information obtained in prior year audits to assess inherent
risk.

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 Control Risk
 The risk that a material misstatement will not be prevented or detected on a timely basis
by the company's internal control structure is referred to as control risk.
 This risk is entirely based on the effectiveness of the internal control structure.
 To assess control risk auditors study the methods and procedures by which the company
controls its accounting processes.
 An effective internal control (IC) structure promotes reliability in the accounting data. .
 To obtain an understanding of the IC procedures and to determine whether they are
designed and operating effectively, the auditors use a combination of inquiry, inspection,
observation, and re performance procedures.
 If the auditors find that the client company has designed effective IC for a particular
account and consistently followed in day-to day operations, they will assess control risk
for the related assertions to be low, and thereby accept a higher level of detection risk.
 Thus, the effectiveness of the client's IC is a major factor in determining how much
evidence the auditors will gather to restrict detection risk.
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 Detection Risk

 The risk that the auditors will fail to detect the misstatement with their audit

procedures is called detection risk.

 That is, the risk that the auditors' procedures will lead them to conclude that

material misstatement does not exist in an account or assertion when in fact

such misstatement does exist.

 Detection risk is restricted by performing substantive tests.

 For each account, the scope of substantive tests, including their nature, timing,

and extent, determines the level of detection risk.

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 Measuring Audit Risk
 In practice the various components of audit risk are not typically quantified.

 Instead, the auditors usually use qualitative categories, such as low, medium,
and high risk.
 '' Audit Risk and Materiality in Conducting an Audit, '' allows either a
quantified or a no quantitative approach, but includes the following formula to
illustrate the relationship between audit risk, inherent risk, control risk, and
detection risk:
 AR= IR X CR X DR
Where:
 AR= Audit risk

 IR = Inherent risk

 CR= Control risk

 DR= Detection risk 12

 Cont’d ……
 To illustrate the measurement of audit risk, assume that the auditors
have assessed inherent risk for a particular assertion at 50 percent and
control risk at 40 percent. In addition, they have performed audit
procedures that they believe have a 20 percent risk of failing to detect a
material misstatement in the assertion. The audit risk for the assertion
may be computed as follows:
• AR= IR X CR X DR

= .50 X .40 X .20

= .04

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 Cont’d ….
 Thus, the auditors face a 4 percent audit risk that material misstatement has evaded

both the client's internal controls and the auditors' procedures.

 It is important to realize that while auditors gather evidence to assess IR and CR,

they gather evidence to restrict detection risk at the appropriate level.

 IR and CR are a function of the client and its operating environment. Regardless of

how much evidence the auditors gather, they cannot change these risks.
 Therefore, evidence gathered by auditors is used to assess the levels of IH and CR

 DR, on the other hand, is a function of the effectiveness of the audit procedures

performed. more evidence that is gathered, the lower the level of detection risk.
 As a result, DR is the only risk that is completes a function of the sufficiency of the

evidence gathered by the auditors' procedures.

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5.4 Sufficient Competent Evidential Matter

 What constitutes ''sufficient competent evidential matter''? This question arises

repeatedly when planning and performing every audit.

 When CPAs are accused of negligence in the performance of an audit, the

answer to this question will often determine their innocence or guilt.

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 Nature of Evidential Matter
 Evidential Matter is any information that corroborates or refutes an
assertion.
 Auditors use a variety of audit procedures to obtain corroborating
information.
the most common types of audit procedures.
 Physical examination means to view physical evidence of an asset.
 For example, the auditors might physically examine plant, equipment, or
inventory items to obtain evidence as to their existence or condition.

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 Cont’d ……
 Confirmation is the process of obtaining and evaluating a response from a
debtor, creditor, or other party in reply to a request for information about a
particular item affecting the financial statements.
 Most frequently, confirmation requests (and responses) are in a written form.

 Comparison is the process of agreeing or contrasting two-different sources of

information.
 Auditors often use comparison to test information at various stages of
processing within the accounting system.
 In describing this process, we between distinguish between tracing and
vouching.

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 Cont’d ….
 Tracing is the process of establishing the completeness of transaction processing

by following a transaction forward through the accounting records.

 For example, the auditors may trace from a source document to the subsequent

recorded transaction.
 Vouching is the process of establishing the occurrence or valuation of recorded

transactions by following a transaction back to supporting documents from a

subsequent processing step.

 For example, the auditors may select recorded purchase transactions in the
purchases journal and vouch them to supporting evidence such as invoices, paid
checks, and receiving reports.
 The direction of testing for vouching is the reverse of that used for tracing.
Vouching is also referred to as '' tracing back.'' 18
 Cont..
 Re-perfromance is the process of repeating a client activity. For example, the
auditors may recalculate depreciation, or re-perform bank account
reconciliation.
 Other examples of re-perfromance include: footing, cross-footing, and
extending.
 Footing is the process of proving the totals of a vertical column of figures, such
as the total of daily sales for the month from the sales journal.
 Cross footing, on the other hand, is the process of proving the total of a
horizontal row.
 An example of cross footing is determining that withholdings plus net pay is
equal to gross pay for an employee in the payroll journal.
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 Cont’d ….
 Extending is the process of recomputing by multiplication. To extend the client's
inventory listing is to multiplication. To extend the client's inventory listing is to
multiply the quantities in units by the cost per unit. The resultant product is the
extension.
 Observation is the process of viewing a client activity. For example, the auditors
may observe the application of internal control procedures such as the client's
inventory-taking procedures.
 The distinction between physical examination and observation is that for
observation to be performed an activity must be involved.
• Thus, while physical examination and observation both may involve inventory,
observation would require a client activity (e.g., counting) to be occurring.
• In practice, the term observation is sometimes used to refer to both types of procedures.
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 Cont…
• Inspection involves a reading or point-by-point review of a document or
record. For example, the auditors may inspect a loan agreement. The
terms examine, review, read, and scan are often used to describe
applications of the inspection technique.
• Reconciliation is used to establish agreement between two sets of
independently maintained but related records.

 Thus, the ledger account for Cash in Bank is reconciled with the bank
statement, and the home office record of shipments to a branch office is
reconciled with the record of receipts maintained by the branch.

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 Cont…
 Inquiries are questions directed toward appropriate client personnel.

• The responses to the questions may be oral or in writing.

• An example of the inquiry technique is the auditors' questioning of the client's

controller about the segregation of duties for cash receipts.
• The term inquiry is also sometimes used to refer to the technique of questioning
parties outside the organization. For example, a letter of audit inquiry may be
sent to the client's lawyer.
 Analytical procedures are evaluations of financial information made by a study
of expected relationships among financial and non-financial data.
• For example, analytical procedures might involve comparison of the client's
financial ratios for the year under audit with those of prior years.
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 Competence-- A Relative Term
• To be competent, evidence must be both relevant and valid. For evidence to be relevant, it must apply to
the audit objective being tested.
• The validity of evidence is dependent on the circumstances in which it is obtained.

While this makes generalizations difficult, the following factors generally affect the validity of evidential
matter:
 When auditors obtain evidence from independent sources outside of the client company, it provides
greater assurance of reliability than that secured solely within the company.
 The more effective the internal control, the greater the reliability of the accounting records and other
internally generated documents.
 Evidence obtained directly by the auditors through physical examination, observation, computation, and
inspection is more persuasive than information obtained indirectly, or secondhand.
• In addition, the competence of evidential matter is increased when the auditors are able to obtain
additional information to support the original evidence.
• Thus, several pieces of related evidence may form a package of evidence that has greater competence
than do any of the pieces viewed individually.
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 Sufficiency-- A Matter of Judgment
 The term sufficient relates to the quantity of evidence the auditors should obtain.
 The amount of evidential matter that is considered sufficient to support the auditors'
opinion is a matter of professional judgment. However, the following considerations
may be useful in evaluating the sufficiency of audit evidence.
 The amount of evidence that is sufficient in a specific situation varies inversely with the
competence of the evidence available.
 Thus, the more competent the more competent the evidential matter, the less the
amount of evidence that is needed to support the auditors' opinion.
 The need for evidential matter is closely related to the concept of materiality.
 The more material a financial statement amount, the greater the need for competent
evidential matter.
 Conversely, little or no evidence is needed to support items that are not material.
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 5.5 Types Of Audit Evidence
 When conducting audits, the auditors gather a combination of many types of evidence to

adequately restrict audit risk.

The major types of evidence that are gathered during an audit may be:

1. Physical evidence

2. Documentary evidence: (created outside the client organization and transmitted directly to the auditors;
created outside the client organization and held by the client; created and held within the client organization)

3. Accounting records as evidence.

4. Evidence from analytical procedures

5. Evidence form computations

6. Evidence provided by specialists

7. Oral evidence

8. Evidence from client representation letters.

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 1. Physical Evidence.

 Actual physical examination or observation provides

the best evidence of the existence of certain assets.
 The existence of property and equipment, such as
automobiles, buildings, office equipment, and factory
machinery, may be established by physical
examination.
 Similarly, the amount of cash on hand is verified by
counting; and inventory counts are observed.
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 Cont…
 There is also the possibility that one or more worthless checks may have been
created deliberately by a dishonest employee as a means of concealing from the
auditors the existence of a cash shortage.
 The observation of the client's count of inventory may also leave some
important questions unanswered.
 The quality and condition of merchandise or of goods in process are vital in
determining their salability.
 If the goods counted by the auditors contain hidden defects or are obsolete, a
mere counting of units does not substantiate their balance sheet valuation.

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 * ILLUSTRATIVE CASE*
• During the observation of the physical inventory of a company manufacturing
semiconductors- small chips of photographically etched silicon that channel
electricity along microscopic pathways-one of the auditors counted
semiconductors purportedly worth several hundred thousand dollars.
• He then asked why apparently identical appearing semiconductors on another
wall were not being counted.
• The client informed him that these semiconductors were defective and could not
be sold.
• To the auditor, the defective semiconductors were identical in appearance with
those included in the count. Shortly thereafter the auditor entered academics.

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 Cont..
• In the case of plant and equipment, the auditors' physical examination verifies
the existence of the asset, but gives no proof of ownership.
• A fleet of automobiles used by salespeople might be subject to a mortgage.

• Also, physical examination does not substantiate the cost of the plant assets.

• In summary, physical examination or observation provides evidence as to the

existence of certain assets, but generally needs to be supplemented by other
types of evidence to determine the ownership, proper valuation, and condition
of these assets.
• For some types of assets, such as accounts receivable or intangible assets, even
the existence of the asset cannot be verified through physical evidence.

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 2. Documentary Evidence.
 An important type of evidence relied upon by auditors consists of documents.
 The worth of a document as evidence depends in part upon whether it was created within
the company (e.g. a sales invoice) or came from outside the company (e.g., a vendor's
invoice).
 Some documents created within the company (Checks, for example) are sent outside the
organization for endorsement or processing; and are regarded as very reliable evidence.
 auditors should consider whether the document is of a type that could easily be forged or
created in its entirety by a dishonest employee.
 A stock certificate evidencing an investment in marketable securities is usually elaborately
engraved and would be most difficult to falsify.
 On other hand, a note receivable may be created by anyone in a moment merely by filling
in the blank spaces in one of the standard note forms available at any office supply store.

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 Cont…
Documentary Evidence Created outside the Client Organization and Transmitted Directly
to the Auditors.
• The most reliable documentary evidence consists of documents created by independent
parties outside the client's organization and transmitted directly to the auditors without
passing through the client's hands.
• For ex, in the verification of accounts receivable, the customer is requested by the client to
write directly to the auditors to confirm the amount owed to the auditor's client.
• However, they do not address all assertions of existence of the items, but less effective at
addressing completeness and the appropriate valuation of the amounts.
• For ex, while a returned account receivable confirmation provides reliable evidence about the
existence of an obligation, it does not address whether the debtor can pay the obligation.

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 Cont…
 To ensure the reliability of the confirmation process, the auditors should
carefully design the confirmation requests to seek the appropriate information
and make it easy for the recipient to provide a meaningful response.
 To make sure that the confirmation reply comes directly to the auditors and not
to the client, the auditors will enclose with the confirmation request a return
envelope addressed to the auditors' office.
 Another type of document created outside the client's organization and
transmitted directly to the auditors is a letter from the client's attorney
describing any pending litigation.
 Again, the client requests the attorney to furnish the information directly to the
auditors and the auditors mail the request.
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Documentary Evidence Created Outside the Client Orgn & Held by the Client

• Many of the externally created documents referred to by the auditors will be in the
client's possession.
• Examples include bank statements, vendors' invoices and statements, property tax bills,
notes receivable, contracts, customers' purchase orders, and stock and bond certificates.
• In deciding how much reliance to place upon this type of evidence, the auditors should
consider whether the document is a type that could be easily created / altered buy
someone in the client's employ.
• The auditors should be particularly cautious in accepting as evidence photocopies of
documents or documents that have been altered in any way.
• Some externally created documents in the client's possession might have been forged
• Externally created documents in the possession of the client are used extensively by
auditors and are considered, in general, as a stronger type of evidence than documents
created by the client.
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 Documentary Evidence Created and Held within the Client Organization

 No doubt the most dependable single piece of documentary evidence created

within the client's organization is a paid check.

 check bears the endorsement of payee & stamp indicating payment by the bank.

auditors look upon a paid check as a strong type of evidence.

 The paid check may be viewed as evidence hat an asset was acquired at a given

cost, or as a proof that a liability was paid or an expense incurred.

 Most documents created within the client organization represent a lower quality

of evidence than a paid check because they circulate only within the company

and do not receive critical review by an outsider.

 Ex- of internally created documents that do not leave the client's possession are sales

invoices, shipping notices, purchase orders, receiving reports, and credit memoranda.
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 Cont…
• The degree of reliance to be placed on documents created and used only within

the organization depends on the effectiveness of the internal control.

• If the accounting procedures are so designed that a document prepared by one

person must be critically reviewed by another, and if all documents are serially

numbered and all numbers in the series accounted for, these documents may

represent reasonably good evidence.

• Adequate internal control will also provide for extensive segregation of duties so

that no one employee handles a transaction from beginning to end.

• An employee who maintains records or creates documents, such as credit

memoranda, should not have access to cash.

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 Cont…
 On the other hand, if internal control is weak, the auditors cannot place as much
reliance on documentary evidence created within the organization and not
reviewed by outsiders.
 If an employee is authorized to create documents such as sales invoices and
credit memoranda and also has access to cash, an incentive exists to falsify
documents to conceal a theft.
 If documents are not controlled by serial numbers, the possibility arises that the
auditors are not being given access to all documents or that duplicates are being
used to support fictitious transactions.
 There is the danger not only of fictitious documents created to cover theft by an
employee, but also the possibility that mgnt is purposely presenting misleading
F/ statements and has prepared false supporting documents for the purpose of
deceiving the auditors. 36
 3. Accounting Records as Evidence.
 When auditors attempt to verify an amount in the financial statements by
tracing it back through the accounting records, they will ordinarily carry this
process through the ledgers to the journals and vouch the item to such basic
documentary evidence as a paid check, invoice, or other source documents.
 To some extent, however, the ledger accounts and the journals constitute
worthwhile evidence in themselves.
 The dependability of ledgers and journals as evidence is indicated by the
extent of internal control covering their preparation.
 Whenever possible, subsidiary ledgers for receivables, payables, and plant
equipment should be maintained by persons not responsible for the general
ledger.

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 Cont…
 All general journal entries should be approved in writing by the controller or

other official.
 If ledgers and journals are produced by a computer system, various computer

controls should be in effect.

 When controls of this type exist and the records appear to be well maintained,

the auditors may regard the ledgers and journals as affording some support for

the financial statements.

 In addition to journals and ledgers, other accounting records providing

evidential matter for independent auditors include sales summaries, trial

balances, interim financial statements, and operating and F/reports prepared for

management. 38
 4. Evidence from Analytical Procedures.
 Analytical procedures involve evaluation of financial statement information by
a study of relationships among financial and non-financial data.
• Analytical procedures,'' provides guidance and examples of applications of
these procedures.

the process of performing analytical procedures consists of four steps:

 Develop an expectation of an account balance.

 Determine the amount of difference from the expectation that can be accepted
without investigation.
 Compare the company's account balance with the expected account balance.

 Investigate significant deviations from the expected account balance.

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 Cont..
• Examples of analytical procedures include comparisons of revenue and expense amounts
for the current year to those of prior periods, to industry averages, to budgeted levels, and
to relevant non financial data, such as units produced or hours of direct labor.
• A more sophisticated analytical procedure might involve the development of a multiple
regression model to estimate the amount of sales for the year using economic and
industry data.
• In addition, analytical procedures may involve computations of percentage relationships
of various items in the financial statements, such as gross profit percentages.
• When the relationships turn out as expected, auditors are provided with evidence that the
data being reviewed are free from material error.
• On the other hand, unusual fluctuations in these relationships may indicate serious
problems in the financial statements and should be investigated fully by the auditors.

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 ILLUSTRATIVE CASE*

• In performing analytical procedures for a marine supply store, the

auditors noticed that uncollectible accounts expense, which normally
had been running about 1 percent of net sales for several years, had
increased in the current year to 4 percent of net sales.
• This significant variation caused the auditors to make a careful
investigation of all accounts written off during the year and those
presently past due.
• Most of the uncollectible accounts examined were found to be
fictitious, and the cashier-bookkeeper then admitted that he had
created those accounts to cover up his abstraction of cash receipts.

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 Comparisons with Industry Averages

• Average statistics for various industries are a viable through various Annual Statement
Studies.
• Such averages provide a potentially rich source of information for analytical procedures.
• Comparisons with industry statistics may alert auditors to classification errors, improper
applications of accounting principles, or other errors in specific items in the client's
financial statements.
• In addition, these comparisons may highlight the client's strengths and weaknesses
relative to similar companies, this providing the auditors with a basis for making
constructive recommendations to the client.
• Certain problems may be encountered when using industry averages for analytical
procedures because of a lack of comparability among companies and inability to obtain
current industry data.
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 Comparisons with Internal Client Data

• Every audit client generates internal information that may be used in performing
analytical procedures.
• Forecasts, production reports, and monthly performance reports are but a few data
sources that may be expected to bear predictable relationships to financial statement
amounts.
• In establishing these relationships, auditors may use dollar amounts, physical quantities,
ratios, or percentages, Separate relationships may be computed for each division or
product line.
• Trend analysis is a technique for identifying consistent patterns in the relationships of
data from successive time periods.
• For example, a review of the client's sales for the past three years might reveal a
consistent growth rate of about 7 percent.

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 5. Computations
• Another form of audit evidence consists of computations made independently by the
auditors to prove the arithmetical accuracy of the client's records.
• Computations differ from analytical procedures. Analytical procedures involve the
analysis of plausible relationships among financial data, whereas computations simply
verify mathematical processes.
• In its simplest form, an auditor's computation might consist of footing a column of
figures in a sales journal or in a ledger account to prove the column total.
• Independent computations may be used to prove the accuracy of such client calculations
as earnings per share, depreciation expense, allowance for unelectable accounts, revenue
recognized on a percentage of completion basis, and provisions for federal and state
income taxes.
• Therefore, auditors usually rely on the services of an actuary to compute this liability.

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 6. Evidence Provided By Specialists
 Auditors may not be experts in performing such technical tasks as judging the
value of highly specialized inventory, or making the actuarial computations to
verify liabilities for postretirement benefits.
 Audit evidence about such matters is best obtained from qualified specialists.

 Other examples of audit tasks that may require the use of a specialist include
valuations of works of art or restricted securities, and legal interpretations of
regulations or contracts.
 ASS 73 defines a specialist as a person possessing special skill or knowledge
in a field other than accounting and auditing, giving as examples actuaries,
appraisers, attorneys, engineers, environmental consultants, and geologists.
Regardless of whether the specialist is hired by client or by auditors, the
provisions of SAS 73 must be followed. 45
 Cont…
• It is desirable for the specialist consulted by the auditors to be unrelated to the client, but
it is acceptable for the specialist to have a relationship with the client.
• The specialist can even be employed by the client. However, the auditors should assess
the risk that the specialist's objectivity might be impaired because of the relationship with
the client.
• If the auditors believe that specialist's objectivity might be impaired, they should perform
additional procedures or engage another specialist.
• In any event, the auditors are responsible for performing procedures to ascertain the
adequacy of the professional qualifications and reputation of the specialist.
• This usually involves making inquiries about the specialist's credentials and experience.
• The auditors should never refer to the specialist in their audit report unless the specialist's
findings are not consistent with the representations in the financial statements, causing the
auditors to modify their opinion.
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 7. Oral Evidence
• Throughout their examination the auditors will ask a great many
questions of the officers and employees of the client's organization.
• These questions cover an endless range of topics:-the location of records
and documents, the reasons underlying an unusual accounting procedure,
the probabilities of collecting a long past due account receivable.
• The answers auditors receive to these questions constitute another type of
evidence.
• Generally, oral evidence is not sufficient in itself, but it may be useful in
disclosing situations that require investigation or in corroborating other
forms of evidence.
47
 Cont…
 For example, after making a careful analysis of all past due accounts

receivable, an auditor will normally discuss with the credit manager the

prospects for collection of accounts considered doubtful.

 If the opinions of the credit manger are in accordance with the estimates of

uncollectible accounts that have been made independently by the auditor, this

oral evidence will constitute significant support for the conclusions reached.

 In repeat audits of a business, the auditor will be in a better position to evaluate

the opinions of the credit manager based on the accuracy of the manager's

estimates in prior years.

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8. Evidence from Client Representation Letters
• At the conclusion of the audit, the CPAs obtain from the client a written representation
letter summarizing the most important oral representations made during the
engagement.
• For ex, management usually represents that all liabilities known to exist are reflected in
the F/ statements. Most of the representations fall into the following broad categories;
• All accounting records, financial data, and minutes of directors' meetings have been
made available to the auditors.
• The financial statements are complete and prepared in conformity with generally
accepted accounting principles.
• All items requiring disclosure (such as loss contingencies, illegal acts, and related party
transactions) have been properly disclosed.

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 Cont…
• SAS 19 (AU 333), '' Client Representations,'' requires auditors to obtain a

representation letter on every engagement and provides suggestions as to its

form and content.

• These letters are dated as of the last day of field work and usually are singed by

both the client's chief executive officer and chief financial officer.
• A client representation letter is a low grade of audit evidence and should never

be used as a substitute for performing other audit procedures.

• The financial statements already as a substitute for performing other audit

procedures.
• The financial statements already constitute written representations by the client;
hence, a representation letter does little more than assert that the original
representations were correct.
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 Evidence about Accounting Estimates
• The auditors must be especially careful in considering financial statement accounts that
are affected by estimates made by management (often referred to as accounting
estimates), particularly those for which a wide range of accounting methods are
considered acceptable.
• Examples of accounting estimates include allowances for loan losses and obsolete
inventory, and estimates of warranty liabilities.
• Making accounting estimates is management's responsibility, and such estimates are
generally more susceptible to material misstatement than financial statement amounts
which are more certain in amount. SAS 57 ( AU 342), '' auditing Accounting
Estimates,'' requires the auditors to determine that (a) necessary estimates have been
developed, (b) the accounting estimates are reasonable, and (c) the accounting
estimates are properly accounted for and disclosed.

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 Cont…
• Determining whether all necessary estimates have been developed and accounted
for properly (steps (a) and (c) requires a knowledge of the client's business and
the applicable generally accepted accounting principles. When evaluating the
reasonableness of accounting estimates (step (b)), the auditors may use one or
more of the following three basic approaches:
• Reviewing and testing management's process of developing the estimates-- this
will often involve evaluating the reasonableness of the steps performed by
management.
• Independently developing an estimate of the amount to compare to
management's estimate.
• Reviewing subsequent events or transactions bearing on the estimate, such as
actual payments of an estimated amount made subsequent to year-end.
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 Cont…
• The wide range of potential accounting methods complicates transactions
involving accounting estimates Pensions leases and long-term construction
contracts are just a few examples of transactions with complex accounting
methods that vary depending on the nature of the agreements and the specific
circumstances.
• It is the auditors' responsibility to evaluate whether the accounting rules
followed are appropriate in the circumstances.
• While it sounds so basic as to almost be trivial, it is essential that the auditors
understand the transactions in which their clients are involved.
• In practice, this requirement is onerous since the auditors may be involved in a
variety of audits, requiring knowledge of a host of different accounting
methods and estimates.
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 The Cost of Obtaining Evidence
• CPAs can no more disregard the cost of alternative auditing procedures than a store

manager can disregard a difference in the costs of competing brands of merchandise.

• Cost is not the primary factor influencing the auditors in deciding what evidence should be

obtained, but cost is always an important consideration.

• The cost factor may preclude gathering the strongest possible form of evidence and

necessitate the substitution of other forms of evidence that are of lesser quality, yet still

satisfactory.
• ex, assume that the auditors find that the client has a large note receivable from a customer.
• One option is for the auditors to correspond directly with the customer and obtain written

confirmation of the customer issued the note and regards it as a valid obligation.
• Second, the auditors might test the collectibles of the note by obtaining a credit report on

the customer from a local credit association.

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 Cont…
• They might also obtain copies of the customer's most recent financial

statements accompanied, if possible, by the opinion of an independent CPA. To

carry our illustration to an extreme, the auditors might obtain permission to

make an audit of the financial statements of the customer.

• The cost of conducting this separate audit could amount to more than the note

receivable the auditors wished to verify.

• The point of this illustration is that auditors do not always insist upon obtaining

the strongest possible evidence.

• They do insist upon obtaining evidence that is sufficient under the
circumstances.
• The greater the risk of material misstatement of the item to be verified, the
stronger the evidence required by the auditors, and the greater the cost they
may be willing to incur in obtaining it.
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