Understanding Audit Evidence: A Practical Guide for Accountants
Accountants are at the heart of financial reporting, tasked with preparing annual financial statements (AFS) that as per section 29 of the Companies Act, 2008:
“present fairly the state of affairs and business of the company, and explain the transactions and financial position of the business of the company”
Preparing financial statements extends to maintaining a supporting file filled with relevant evidence that can stand up to audit scrutiny. All accountants must understand the concept of audit evidence as it ensures that the financial statements are accurate and verifiable, meeting regulatory standards and auditors' expectations. Below is an explanation of what is audit evidence under ISA 500, providing practical insights to help accountants strengthen their financial reporting practices.
What is Audit Evidence?
Audit evidence is the information auditors use to decide if the financial statements are fair and accurate. According to International Standards on Auditing (ISA 500), this evidence must be both sufficient (enough in quantity) and appropriate (relevant and reliable) to support the auditor's conclusions.
Sufficient Evidence
Sufficiency refers to having enough audit evidence to support the auditor's opinion on the financial statements. Auditors decide how much evidence is needed based on their assessment of risk, i.e. more evidence is needed for higher-risk areas, while less may be enough for lower-risk areas. Accountants play a crucial role in this process by maintaining comprehensive supporting documents and records that support all parts of the financial statements and assisting auditors in collecting the required type and number of evidence for each area.
Appropriate Evidence
Appropriateness refers to the quality of audit evidence, focusing on relevance and reliability. Relevance means the evidence is directly related to what the auditor is trying to verify, while reliability concerns how trustworthy the evidence is.
Evidence can come from various sources, including a company’s accounting records, external documents like bank statements or customer confirmations and observations. The type and amount of evidence depend on the details and risks of each financial statement. Accountants should ensure that the evidence supporting information in the statements is persuasive by providing documentation that is both relevant to the audit objectives and reliable, supporting a strong and well-founded audit opinion on the financial statements.
Relevant and reliable evidence is more persuasive, giving auditors confidence in their conclusions. For example, evidence obtained directly by the auditor, such as through physical inspection or direct confirmation from a third party like a bank or customer, is generally more persuasive than evidence obtained from the client through inquiries.
Types of Audit Evidence: What is More Persuasive?
The different types of evidence and their persuasiveness is identified in the ISA 500 standards as follows.
1. Physical Evidence
This includes tangible evidence obtained through the auditor's physical inspection or observation, such as counting inventory or inspecting fixed assets. Physical evidence is often highly persuasive because it is directly observed by the auditor, reducing the risk of misrepresentation.
2. Confirmations
This involves obtaining direct confirmation from a third party, such as bank confirmations or receivable confirmations from customers. Confirmations are considered very persuasive due to their external origin, providing independent verification of the information.
3. Documentation
This includes internal and external documents, such as invoices, contracts, and meeting minutes. The persuasiveness of documentation depends on whether it is internally or externally generated. External documents, especially those from independent sources, are more reliable than internally generated ones.
4. Analytical Procedures
Analytical procedures involve plausible relationships among financial and non-financial data. While useful, analytical procedures are generally less persuasive than direct evidence because they involve inference rather than direct observation or confirmation.
5. Inquiries
This involves asking questions of knowledgeable persons within or outside the entity.
Inquiries are generally less persuasive due to their subjective nature and potential bias. However, when corroborated or supported with other evidence, they can provide valuable insights.
Examples
Below are some practical examples of how accountants can ensure that the evidence they provide when compiling financial statements is both sufficient and appropriate, aligning with audit requirements:
Inventory Valuation
When preparing financial statements, accountants must ensure the inventory is valued correctly. To support this, there must be detailed records, such as purchase invoices, inventory count sheets, and valuation reports on file. An auditor will often conduct a physical inspection to verify the existence of the inventory and might request external confirmations, like supplier statements, to verify ownership and purchase terms. By providing comprehensive documentation that aligns with these checks, accountants ensure that the evidence is sufficient (enough quantity) and appropriate (relevant and reliable) to support the inventory's valuation.
Receivables Confirmation
For receivables, accountants should ensure that customer balances are accurate and that supporting evidence, such as sales invoices, payment records, and aging analysis reports, is on file. Auditors may seek direct confirmations from customers to verify the existence and accuracy of receivables reported in the financial statements. Since these confirmations come from independent third parties, they are highly persuasive evidence. By ensuring that the initial records and reconciliations are accurate and complete, accountants help make the audit evidence both sufficient and appropriate.
Internal Controls Documentation
Accountants play a key role in documenting internal controls over financial reporting, such as segregation of duties, approval processes, and reconciliation procedures. Auditors will test these controls by reviewing the documentation, observing processes, and performing walkthroughs of transactions to understand how controls are implemented and operate in practice. By maintaining detailed and up-to-date documentation of these processes, accountants provide the basis for assessing the effectiveness of internal controls.
By proactively compiling thorough, well-organized, and relevant documentation, accountants can ensure that the evidence required for auditing purposes is both sufficient and persuasive, ultimately facilitating a smoother and more effective audit process.
