Taxmann’s Analysis | Bridging Audit Gaps – Strengthening Audit Evidence for Enhanced Financial Transparency

Audit Evidence is a Standard on Auditing (SA) issued by the Institute of Chartered Accountants of India (ICAI), which provides guidelines for auditors on obtaining and evaluating audit evidence to form an opinion on financial statements. To guide auditors in designing and performing audit procedures that provide sufficient and appropriate evidence to form an audit opinion, thereby ensuring the credibility and accuracy of financial statements. This standard is crucial in strengthening audit quality and enhancing financial transparency by reducing the risk of errors or fraud.

Table of Contents

1. Assessment of Reliance on Management’s Expert
2. Audit Procedures for Inventory Valuation and Third-Party Confirmations
3. Verification of Opening Balances in Initial Audit Engagements
4. Designing and Documenting Audit Samples for Effective Risk Assessment
5. Identification and Documentation of Subsequent Events in Audits
6. Conclusion

Auditing is not just a compliance requirement but a critical safeguard ensuring financial transparency and accountability. Yet, persistent gaps in audit practices continue to threaten the reliability of financial reporting. According to a 2023 global audit study, nearly 30% of audit deficiencies arise from inadequate documentation, improper reliance on management experts, and weak risk assessment methodologies.

Imagine an auditor relying blindly on an expert’s valuation, later finding that flawed assumptions led to a massive financial misstatement. Or consider an inventory audit where third-party stock verification is overlooked, leading to inflated asset values and regulatory penalties. These real-world challenges highlight the need for auditors to strengthen their approach to gathering and evaluating audit evidence.

This article dives deep into key observations from SA 500, Audit Evidence and associated standards, exploring where audits often fall short and how best practices can bridge these critical gaps. By adopting a meticulous and proactive approach, auditors can reinforce their role as financial gatekeepers, ensuring accuracy, credibility, and compliance.

1. Assessment of Reliance on Management’s Expert

1.1 Observation

Management often relies on experts for various financial estimations, such as depreciation, gratuity, and leave encashment liabilities. However, it was observed that auditors, in some cases, did not adequately evaluate these experts’ competence, capability, and objectivity. The reliance on such experts’ reports without due verification led to incomplete or unreliable audit evidence. Additionally, some expert reports lacked transparency regarding the basis of estimation, limitations, or assumptions, raising concerns over their credibility as audit evidence.

1.2 Relevant Provision

SA 500, Audit Evidence States:

“When information to be used as audit evidence has been prepared using the work of a management’s expert, the auditor shall, to the extent necessary, having regard to the significance of that expert’s work for the auditor’s purposes:

(a) Evaluate the competence, capabilities and objectivity of that expert;

(b) Obtain an understanding of the work of that expert; and

(c) Evaluate the appropriateness of that expert’s work as audit evidence for the relevant assertion.” (Para 8)

1.3 AASB Guidance

As per SA 500, when information is to be used as audit evidence and has been prepared using the work of a management expert, the auditor needs to evaluate that expert’s competence, capabilities, and objectivity. The auditor should obtain an understanding of the expert’s work and evaluate the appropriateness of that expert’s work as audit evidence for the relevant assertion. Preparing an entity’s financial statements may require expertise in a field other than accounting or auditing, such as actuarial calculations, valuations, or engineering data. Failure to assess these aspects increases the risk of material misstatements in the financial statements.

An extract from the ONGC Independent Auditor’s Report for the year ended 31^st March 2024 that reflects the scrutiny of the report on ‘IT audit and security’ of a third-party expert by the auditor is enclosed below:

2. Audit Procedures for Inventory Valuation and Third-Party Confirmations

2.1 Observation

There were instances where auditors did not obtain sufficient documentation for inventory held by third parties. The audit files lacked evidence of confirmations being sent to third parties or alternative procedures to verify the stock’s physical existence. In cases where inventory was material to the financial statements, this lack of confirmation increased the audit risk.

2.2 Relevant Provision

SA 501, Audit Evidence—Specific Considerations for Selected Items States:

“When inventory under the custody and control of a third party is material to the financial statements, the auditor shall obtain sufficient appropriate audit evidence regarding the existence and condition of that inventory by performing one or both of the following:

(a) Request confirmation from the third party as to the quantities and condition of inventory held on behalf of the entity or

(b) Perform inspection or other appropriate audit procedures.” (Para 8)

2.3 AASB Guidance

SA 501 requires the audit firm to confirm significant inventory held by third parties at the physical inventory date. In addition to confirmation, the audit firm may also consider performing additional procedures depending on the nature of the inventory and other circumstances. These procedures may include attending or arranging for another auditor to attend the third party’s physical counting of inventory, obtaining another auditor’s report on the adequacy of internal controls, inspecting documentation such as warehouse receipts, or requesting confirmation from third parties when inventory has been pledged as collateral.

An extract from the Titan Company Limited Independent Auditor’s Report for the year ended 31^st March 2024 that reflects the independent confirmation obtained of inventories held with a third party by the auditor is enclosed below:

3. Verification of Opening Balances in Initial Audit Engagements

3.1 Observation

In several cases, audit firms did not document procedures for verifying opening balances when appointed as new auditors. This raised concerns regarding the accuracy of financial data carried forward from prior periods. Additionally, there was inadequate evidence of reviewing previous audit work or assessing whether prior period misstatements had a continuing impact.

3.2 Relevant Provision

SA 510, Initial Audit Engagements – Opening Balances States:

“The auditor shall obtain sufficient appropriate audit evidence about whether the opening balances contain misstatements that materially affect the current period’s financial statements.” (Para 3)

“The auditor shall determine whether the prior period’s closing balances have been correctly brought forward to the current period or, when appropriate, any adjustments have been disclosed as prior period items in the current year’s Statement of Profit and Loss.” (Para 6(a))

3.3 AASB Guidance

SA 510 describes the additional procedures that an auditor should perform when engaged to audit an entity’s financial statements for the first time. In an initial audit engagement, the auditor should determine the appropriateness of the opening balances and assess whether accounting policies applied in prior periods have been consistently applied in the current period. The auditor must obtain sufficient appropriate audit evidence about whether the opening balances contain misstatements materially affecting the current period’s financial statements.

4. Designing and Documenting Audit Samples for Effective Risk Assessment

4.1 Observation

Audit documentation often lacked clarity on the rationale behind sample selection, the methodology used, and whether the selected sample size adequately addressed audit risks. In certain cases, auditors did not document considerations for determining sample sizes, nor did they justify why specific items were included or excluded from the sampling process.

4.2 Relevant Provision

SA 530, Audit Sampling States:

“The auditor shall determine a sample size sufficient to reduce sampling risk to an acceptably low level.” (Para 7)

“The auditor shall select items for the sample in such a way that each sampling unit in the population has a chance of selection.” (Para 8)

4.3 AASB Guidance

SA 530 requires the auditor to design an audit sample considering both the purpose of the audit procedure and the characteristics of the population from which the sample is drawn. The auditor should determine a sample size sufficient to reduce sampling risk to an acceptable level and ensure that items arto provideat provides a representative view of the population.

5. Identification and Documentation of Subsequent Events in Audits

5.1 Observation

Auditors failed to document procedures to identify subsequent events that may require adjustments or disclosures in the financial statements. This lack of documentation raises concerns about whether all subsequent events were properly accounted for.

5.2 Relevant Provision

SA 560, Subsequent Events States:

“The auditor shall perform audit procedures designed to obtain sufficient appropriate audit evidence that all events occurring between the financial statements and the date of the auditor’s report that require adjustment of, or disclosure in, the financial statements have been identified.” (Para 6)

5.3 AASB Guidance

SA 560 requires auditors to understand any procedures management has established to ensure that subsequent events are identified. Auditors should inquire with management and those charged with governance, review meeting minutes, and examine the entity’s latest subsequent interim financial statements. If a subsequent event requiring adjustment or disclosure is identified, the auditor should determine whether it is appropriately reflected in the financial statements.

6. Conclusion

Audit evidence is the cornerstone of financial statement credibility. The abovementioned observations underscore the need for auditors to adhere strictly to SA 500 and related auditing standards. By implementing proper verification procedures, ensuring expert evaluation, and maintaining robust documentation, auditors can enhance audit quality and mitigate financial misstatement risks. Ensuring compliance with SA 500 will improve financial transparency and reinforce trust in audit processes among stakeholders.