Lecture Video 1
LECTURE 1: ISA 500 AUDIT EVIDENCE
We are going to look at International Standard on Auditing number 500 today, which is the auditing standard that tells the auditor what is meant by this concept of audit evidence and gives the auditor the rules and the concepts that must be applied when we’re talking about audit evidence.
So when we mean evidence, we mean proof.
And when we’re speaking about audit evidence, what we’re wanting is the proof that we gathered during the audit process. And that is so that we have enough to go on as auditors to express our opinion at the end of the day on the financial statements.
This standard is the one that lays out the rules and regulations quite nicely and very simply. And gives us some really useful tools about how we are supposed to go about collecting the audit evidence, and what it needs to look at so that we get a professional product, and we get an opinion that is based on something reliable.
We are going to start at the beginning of the standard, which gives us a really great definition. All the standards give you a definition and an objective at the beginning of the standard, and it gives us an audit objective at the beginning of ISA 500. What is nice about this definition is that it is speaking to audit evidence, but actually captures really nicely the purpose of what we are trying to achieve with the audit at the end of the day as well.
THE AUDIT OBJECTIVE
“The objective of the auditor is to design and perform audit procedures to obtain sufficient appropriate audit evidence to be able to draw a reasonable conclusion on which to base the auditor’s opinion.”
This is the audit objective, and what we are going to start off with, is going through some of these key concepts quickly just so you know what the words mean, and why it’s put together like it is. And then we are going to have a look at quite a nice example to figure out how do we make this definition work in practice. After that, we will come back to the definition just to make sure that you understand and you’re quite comfortable with these terms when we read the sentence again.
The definition and what’s in front of you on the screen is taken directly from the standard. The keywords are underlined, and we’ll just emphasise them now.
The objective as far as the evidence standard is concerned, the rules that they’re giving us, is to assist the auditor to design and perform audit procedures (that’s what they do during the audit), in order to obtain (which is to gather or get) sufficient and appropriate (important words). That refers to the audit evidence to we’re trying to collect, and why. Because the auditor needs to express an opinion.
SO WHAT DO THESE WORDS REALLY MEAN?
When we speak about designing anything we are talking about making sure that we plan for something. So when you design a house, you actually draw up plans. When you design an outfit, or piece of clothing, you need to draw it out first. So when we’re talking about designing; we’re talking about planning the audit procedures - knowing what it is what we want to do, how we want to do it and when we want to do it, before we even go there.
When we talk about the word perform, we mean what extra information do we need to consider in order to be able to physically go and do the audit procedures that we are planning.
When we talk about sufficient, we are really saying, enough. Have we got enough evidence? We need to plan and perform these procedures so that we have enough evidence to support our audit opinion. And that evidence has got to be enough, and it’s also got to be the right type of audit evidence. That means that whatever it is that you are collecting as proof, must actually prove the thing that you are trying to test. It doesn’t help that you’re trying to test inventory for example, and you go, and you get proof on the assets of the company, or on the revenue, or even on the salaries.
And when those four things are put together – proper planning; the right instructions how to perform a procedure; and as long as you have enough of it and it’s the right type - then this standard says you should have enough to in order to be able to express an audit opinion. So that makes sense, but let’s see if we can have a look and see how it works in practice, and ask a few questions about it and enhance our understanding, and then we’ll come back to that definition again.
The example that I’d like to give you today is that of a manufacturing company. They have got a big factory, and at the year-end they have got boxes of inventory – boxes of stock – and it’s all lying on the floors in the factory warehouses, and that is going to, because it’s year-end, translate into an item on the balance sheet called inventory and that inventory is going to have a value.
Now, as an auditor, you are expected to express an opinion on that value of inventory. Is the value of inventory correct, does the inventory exist, can investors rely on the fact that the company says that they have this much stock? Now the big question for us is, “How are you going to get that proof; how are you going to gather evidence that all of these things that management is saying about the inventory is true?”
Before we can even go to the factory to see what we can see, and what’s available, we need to sit down and develop a bit of a plan. You can’t go in without a plan of action.
So let’s just say this is our client and we’ve got to gather evidence and proof about this inventory. We have a planning meeting at work, and we have a team sitting around the table, and there are four trainee auditors around that table and I ask each one of those trainees, without any other knowledge, “What would you do if I told you I want you to go and see if that inventory is correct or not”.
I haven’t given any further instructions; I’ve just said, “How would you do it?”
Trainee one is going to say, “I think the best way to figure out if that inventory amount is correct or not is to go and physically count it. I’ll go, and I’ll count the boxes.”
Fair enough, that’s certainly one way we could get some evidence over the inventory.
So the next trainee says, “You know, as far as I’m concerned, management was there the whole year and they were responsible for putting together the inventory balance anyway. So I’m going to ask management what they did, and I’m going to ask them if the amount is correct.”
Trainee three says, “Not much has changed in this business from last year to this year. They’re at the same level of activity, same size, same customers. So we had a look at the inventory last year, so all I’m going to do now is compare this year to last year, and if it is about the same, that’s what I am expecting. Then I’m going to accept it as correct.”
Then the last trainee, I say, “What would you do?” And this trainee says that he’s going to have a look at the purchases that the company made during the year. He’s not going to look at the inventory itself; he’s going to go from another angle and say, “Well, they should have on hand, more or less what they bought less maybe what they sold.” That’s how he’s going to work out whether the inventory is correct or not.
As you can see, just asking, “Is it right?” is not enough. There could be a number of different answers and a number of different sources of evidence. So the next question we now have to ask ourselves, is with these four sources here, “Do you think that that would all give us some form of audit evidence? Would they all be valid?”
They are quite different, and the temptation certainly would be to say one or two of them are questionable, but the answer is - they are all correct. They are all different forms of evidence that would give us something.
So if that’s the case, well then I have to make that question a little bit more of a burning question and say, “Fine, in that case, if I were to make this a bit of a bigger stakes game and your life depended on what you give me as an answer there, what would then go to for the best way to get the audit evidence?”
Chances are you would probably then say, “In that case, I’m actually going to go and count the stuff. I want to be a hundred percent sure that it is accurate.”
To take it a little bit further, if it was really that important, and your life really did depend on it, you might actually opt to do all four, or a combination of them as well.
The question then becomes, “What is the best way that I can get that evidence? What is the best form or procedure that I can perform? Is it only one or is it a combination? Is it various sources?”
The other thing that’s really important for us to then say is, “How do we know that what you’re doing is enough?”
The number of boxes that you look at - Are you’re going to look at all of them? Can you look at all of them? What if there are two million boxes there? You’ll never get through all of that, but you still got to give an opinion.
How are we going to determine what is enough evidence, and what is enough to satisfy you enough to put your word on a block about what that inventory is going to be?
As you can see from this picture, there is a lot more that goes into the audit evidence than what we initially thought of, but you can see the relation to the definition.
So again we’re coming back to - We’ve got to plan the audit procedure. In planning it properly, we have to understand the clients well enough to say:
What is the best approach that we can use?
How are we going to make sure that we select that?
What are our risks?
What do we need to make sure we are looking at particular detail? (Because that’s a bit of tricky area.)
How do we know that we have enough evidence?
If we plan that properly, then we can tell these four trainees exactly what it is that they need to do. And there we can take it back to the definition again – We have planned (i.e. we’ve designed) an audit procedure; we’ve been able to give the trainees and the team a better instruction as to how this is supposed to be done; and by knowing the inventory balance well, and knowing the client well, we have been able to determine how many needs to be looked at, and what is the best type of procedure that can be used.
And those four things together, as we said earlier, is then going to meet our objective of the audit opinion.
So that is how audit evidence comes back to the audit objective.
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