Auditing is concerned with the verification of accounting data and with determining the accuracy and reliability of accounting statements and reports.
Verification does not mean seeking proof or absolute certainty in connection with the data and reports being audited. It means looking for sufficient evidence to satisfy oneself as auditor that the accounts show a true and fair view. What is sufficient evidence depends on what professional experience and knowledge tell one to be satisfactory. In this unit, you shall be considering the different aspects of audit evidence after making financial statements and assertions as the point of entry. Also, you shall be exposed to the relevant concepts – audit trail, circularisation of debtors, audit working papers and auditing procedures – that will help you in grasping some important elements in auditing.
At the end of this unit, you should be able to:
- verify the various assertions that are made in accounting statements
- enumerate the varieties of evidence
- describe the basic techniques for collecting evidence
- explain audit trail and circularisation of debtors
- demonstrate the activities involved in auditing procedures.
3.0 MAIN CONTENT
3.1 Financial Statements and Assertions
Directors produce or cause financial statements to be produced. In doing so, they are asserting as follows:
- The individual items are: (i) correctly described; (ii) show figures which are mathematically correct or fairly estimated;
- The accounts as a whole show a true and fair view. The idea to grasp is that the producer of a set of accounts is making assertions about items in the accounts when he puts them in the accounts.
The assertions he is making are as follows:
- Existence: an asset or liability exists at the Balance Sheet date. This is an obvious assertion with such items as land and buildings, stocks and others.
- Rights and obligations: an asset or liability pertains to the entity at the Balance Sheet date. This means that the enterprise has, for example, ownership of an asset. Ownership as an idea is not simple and there may be all sorts of rights and obligations connected with a given asset or liability.
- Occurrence: a transaction or event took place which pertains to the enterprise during the relevant period. It may be possible for false transactions (e.g. sales or purchases) to be recorded. The assertion is that all recorded transactions actually took place.
- Completeness: there are no unrecorded assets, liabilities, transactions or events or undisclosed items. This is important for all accounts items but is especially important for liabilities.
- Valuation: an asset or liability is recorded at an appropriate carrying value. Appropriate may mean in accordance with generally accepted accounting principles such as the Companies Act Rules and Accounting Standards requirements and also consistent with statements of accounting policies consistently applied.
- Measurement: a transaction or event is recorded at the proper amount and revenue or expense allocated to the proper period
- Presentation and disclosures: an item is disclosed, classified and described in accordance with applicable reporting framework.
As an example, let us look at an item in a balance sheet ‘bank overdraft N102, 500. 00’. In including this item in the balance sheet, the directors are making the following assertions.
- That there is a liability to the company’s bankers.
- That at the balance sheet date, this liability was N102,500.00
- That this amount is agreed by the bank.
- That the overdraft was repayable on demand. If this were not so, it would not appear amongst the current liabilities and terms would be stated;
- That the overdraft was not secured. If it were secured, this fact would need to be stated.
- That the company has the authority to borrow from its memorandum and articles.
- That a bank reconciliation statement can be prepared.
- That the bank is willing to let the overdraft continue.
If no item ‘bank overdraft’ appeared in the balance sheet, it would represent an assertion by the directors that no overdraft liability existed at the balance sheet date. The assertion will either be corroborated or refuted and any information that does this is referred to as evidential matter.
3.2 Audit Evidence
The auditor’s attitude to each item in the accounts will be as follows. (a) Identify the express and implied assertions made by the directors in including (or excluding) the item in the accounts;
- Evaluate each assertion for relative importance to assess the quality and quantity of evidence required;
- Collect information and evidence;
- Assess the evidence for: (i) appropriateness: appropriateness subsumes the ideas of quality and reliability of a particular piece of audit evidence and its relevance to a particular assertion; (ii) sufficiency.
Note that audit evidence tends to be persuasive rather than absolute and that auditors tend to seek evidence from different sources or of a different nature to support the same assertion. Note also that auditors seek to provide reasonable but not absolute assurance that the financial statements are free from misstatement. Auditors do not normally examine all the information available but reach their conclusions about financial statement assertions using a variety of means including sampling.
Having formulated judgement on each individual item in (or omitted from) the accounts, the auditor must formulate a judgement on the truth and fairness of the accounts as a whole. To do this, he will need other evidence in addition to the judgements he has made on the individual items. As an example, he may need evidence of the directors’ implied assertion that the accounts should be drawn up on the going concern principle.
The quality and quantity of evidence are constrained by the following.
(a) Absolute proof is impossible;
(b) Some assertions are not material;
(c) Time is limited. Accounts must be produced within a time scale and the auditor may have to cope with less than perfection to comply with the time scale;
(d) Money is limited. The ideal evidence may be too expensive to obtain;
(valuation of property in property companies, for example) or capable of greater variations (stock and work-in-progress).
3.2.2 Varieties of Evidence
The evidence an auditor collects can be divided into the following categories:
- Observation: (i) Examination of physical assets; (ii) Witnessing the internal control and book-keeping procedures; (iii) Observation of the records to ensure that book-keeping and internal control procedures have been carried out.
- Testimony from independent third parties. e.g. bank letters, debtors circularisation.
- Authoritative documents prepared outside the firm e.g. title deeds, share and loan certificates, leases, contracts, franchises, invoices.
- Authoritative documents prepared inside the firm, e.g. minutes, copy invoices.
- Testimony from directors and officers of the company. This may be formal, for example, the letter of representation, or informal, for example, in replies to Internal Control Questionnaire (ICQ) questions.
- Satisfactory internal control. For many items, this is the most useful evidence.
- Calculations performed by the auditors. Evidence of the correctness of many figures can be obtained this way.
- Subsequent events. The audit is usually performed well after the year end and many assertions can be verified by reference to subsequent events.
- Relationship evidence. Evidence confirming the truth about one item may tend to confirm the truth about another. For example, evidence confirming the correctness of investment income also confirms some aspects of the item of ‘investments’.
- Agreement with expectations. Verification can be assisted by the computation and comparison of ratios and absolute magnitudes with those achieved (a) in the past; (b) by other companies; and (c) budgeted. Conversely, inconsistencies and unusual or unexpected items will alert the auditor.
- External events. The client is not isolated from the world, and the auditor should use his knowledge of current events in his assessment.
3.2.3 Basic Techniques for Collecting Evidence
The basic techniques for collecting evidence are nine in number and they are as follows:
- Physical examination and count.
- Confirmation. This should be in writing, external sources being preferable to internal sources.
- Examination of original documents. Original documents should be compared with the entries in the books. The usual wording is vouching.
- Re-computation. Additions, calculations, balance extractions, etc.
- Retracing book-keeping procedures. Checking postings.
- Scanning. This is somewhat indefinite but is widely used, especially in seeking the unusual or the unlikely.
- Inquiry. Asking questions. This is a necessary and valid technique. However, auditors acquire a habit of always seeking confirmation of oral answers.
- Correlation. Seeking internal consistency in records and accounts
- Observation. Seeing for oneself is the best possible confirmation especially in connection with internal control systems.
3.2.4 Test Checking
It is not always necessary to obtain evidence about each individual transaction. The modern approach is to obtain evidence about each type of transaction by examining a representative sample of each type. This is called test checking and is applied as much to assets and liabilities as to routine transactions. The size of the sample to be tested depends on: (a) the strength of the internal control system;
(b) the materiality of the items;
(c) the number of items involved;
(d) the nature of the item;
(e) the audit risk attached.
3.2.5 Sources of Audit Evidence
Sources of audit evidence include form within (systems, books, documents, assets, management and staff) and from without (customers, suppliers, lenders, professional advisers etc.).
The sources and amount of evidence required will depend on, materiality, relevance, and reliability of the evidence available from a source, and the cost and time involved.
Relevance of audit evidence depends on whether it assists the auditor in forming an opinion on some aspects of the financial statements. For example, evidence that indicates that a recorded asset exists is relevant to audit objectives.
.2.6 Reliability of Audit Evidence
The reliability of audit evidence can be assessed to some extent on the following presumptions.
- Documentary evidence is more reliable than oral evidence;
- Evidence from outside the enterprise (e.g. bank letter) is more reliable than that secured solely from within the enterprise;
- Evidence originated by the auditor by such means as analysis and physical inspection is more reliable than evidence obtained from others (auditors always say ‘show me’ not ‘tell me’).
- Evidence for a figure in the accounts is usually obtained from several sources (e.g. for debtors – a good system with internal controls, debtors circularisation, ratio analysis, payment after date, etc). The cumulative effect of several evidential sources which give a consistent view is greater than that from a single source (i.e. 2 + 2 = 5);
- Original documents are more reliable than photocopies or facsimiles.
3.2.7 Sufficiency of Audit Evidence
Sufficiency is a great problem in auditing. The auditor’s judgement will be influenced as follows.
- His knowledge of the business and its industry;
- The degree of audit risk. Assessment of this is helped by considering the following points. (i) Nature and materiality of items of account (e.g. stock is material and difficult to measure); (ii) The auditor’s experience of the reliability of the management and staff and the records; (iii) The financial position of the enterprise (in a failing enterprise, directors may wish to bolster profits by over- valuing assets or suppressing liabilities); (iv) Possible management bias (as in (iii)), but also the management may wish to ‘even out’ profits for stock market image or taxation reasons;
- The persuasiveness of the evidence;
- The nature of the accounting and internal control systems and the control environment.
3.2.8 Procedures for Collecting Evidence
The procedures for collecting evidence include:
(a) substantive testing;
(b) analytical review.
These have been considered at some point in this course.
SELF-ASSESSMENT EXERCISE 1
- Highlight the various assertions that are made in financial statements.
- Enumerate and explain the varieties of audit evidence.