Chapter 7Audit Evidence Review Questions7-1In both a legal case and in an audit of financial statements, evidence is used by an unbiased person to draw conclusions. In addition, the consequences of an incorrect decision in both situations can be equally undesirable. For example, if a guilty person is set free, society may be in danger if the person repeats his or her illegal act. Similarly, if investors rely on materially misstated financial statements, they could lose significant amounts of money. Finally, the guilt of a defendant in a legal case must be proven beyond a reasonable doubt. This is similar to the concept of sufficient appropriate evidence in an audit situation. As with a judge or jury, an auditor cannot be completely convinced that his or her opinion is correct, but rather must obtain a high level of assurance.The nature of evidence in a legal case and in an audit of financial statements differs because a legal case relies heavily on testimony by witnesses and other parties involved. While inquiry is a form of evidence used by auditors, other more reliable types of evidence such as confirmation with third parties, physical examination, and documentation are also used extensively. A legal case also differs from an audit because of the nature of the conclusions made. In a legal case, a judge or jury decides the guilt or innocence of the defendant. In an audit, the auditor issues one of several audit opinions after evaluating the evidence.7-2The four major audit evidence decisions that must be made on every audit are:1. Which audit procedures to use.2. What sample size to select for a given procedure.3. Which items to select from the population.4. When to perform the procedure.7-3An audit procedure is the detailed instruction for the collection of a type of audit evidence that is to be obtained. Because audit procedures are the instructions to be followed in accumulating evidence, they must be worded carefully to make sure the instructions are clear.7-4An audit program for accounts receivable is a list of audit procedures that will be used to audit accounts receivable for a given client. The audit procedures, sample size, items to select, and timing should be included in the audit program.7-5The auditor must obtain sufficient appropriate evidence by performing audit procedures to afford a reasonable basis for an opinion regarding the financial statements under audit. There are three major phrases of the standard.7-5 (continued)PHRASEMEANING OF PHRASEObtain sufficient appropriate evidenceThe auditor must obtain evidence that is reliable and there must be a reasonable quantity of that evidence.By performing audit proceduresThe auditor performs audit procedures to meet audit objectives using the eight types of evidence.To afford a reasonable basis for an opinion regarding the financial statementsThe auditor cannot expect to be completely certain that the financial statements are fairly presented but there must be persuasive evidence. The collection of evidence gathered by the auditor provides the basis for the auditors opinion. 7-6There are two primary reasons why the auditor can only be persuaded with a reasonable level of assurance, rather than be convinced that the financial statements are correct:1. The cost of accumulating evidence. It would be extremely costly for the auditor to gather enough evidence to be completely convinced.2. Evidence is normally not sufficiently reliable to enable the auditor to be completely convinced. For example, confirmations from customers may come back with erroneous information, which is the fault of the customer rather than the client.7-7The two determinants of the persuasiveness of evidence are appropriateness and sufficiency. Appropriateness refers to the relevance and reliability of evidence, or the degree to which evidence can be considered believable or worthy of trust. Appropriateness relates to the audit procedures selected, including the timing of when those procedures are performed. Sufficiency refers to the quantity of evidence and it is related to sample size and items to select.7-8 Following are six characteristics that determine reliability and an example of each.FACTORDETERMINING RELIABILITY EXAMPLE OFRELIABLE EVIDENCEIndependence of providerConfirmation of a bank balanceEffectiveness of clients internal controlsUse of duplicate sales invoices for a large well-run companyAuditors direct knowledgePhysical examination of inventory by the auditorQualifications of providerLetter from an attorney dealing with the clients affairsDegree of objectivityCount of cash on hand by auditorTimelinessObserve inventory on the last day of the fiscal year7-9TYPES OF AUDIT EVIDENCEEXAMPLES1. Physical examination Count petty cash on hand Examine fixed asset additions2. Confirmation C