What it means
Two words carry the whole standard: sufficient and appropriate. Sufficiency is about how much evidence has been collected, which depends on how risky the area is and how much comfort the auditor already has.
Appropriateness is about quality, which breaks down further into relevance, meaning the evidence actually addresses the point at issue, and reliability, meaning it can be trusted. Reliability follows a fairly consistent hierarchy that is useful to know as a finance manager.
Evidence obtained directly by the auditor from an independent outside source, such as a bank confirmation, ranks highest, followed by internal documents produced under strong controls, then internal documents produced under weak controls. Verbal explanations from management sit at the bottom and can never carry an area on their own.
Auditors gather evidence through a defined set of procedures. Inspection means examining documents or physical assets, observation means watching a process being performed, external confirmation means writing to a third party, and recalculation and reperformance mean redoing the arithmetic or the control step.
Analytical procedures compare the numbers against expectations, and enquiry means asking questions, always to be corroborated by something else. Nobody tests everything, because that would cost more than the business is worth.
Auditors set a materiality threshold, identify the areas where a misstatement is most likely, and sample within those areas so that the work done is proportionate to the risk. This is why an auditor may examine forty invoices in one area and none at all in another.
For a finance team this is intensely practical, because the evidence the auditor needs is evidence you have to produce. Organisations that keep contracts filed against revenue entries, retain signed goods-received notes and document their own control checks get through an audit faster and cheaper.
Those that reconstruct the story during fieldwork pay for the auditor's time twice over. Two nuances catch people out.
First, evidence has to exist at the right time; a control that was documented after the auditor asked about it is much weaker than one evidenced throughout the year. Second, the auditor's working papers must show not just what was found but why the conclusion follows, because a regulator reviewing the file later will judge the reasoning as well as the result.
In practice
Real-world examples.
Example
A distribution business tells its auditor that cash at bank is $3,400,000, and the auditor writes directly to each bank rather than accepting the reconciliation. One reply shows a $220,000 overdraft on an account nobody had reported, which the finance team had assumed was closed. The confirmation letter, not the internal reconciliation, is what surfaced it.
Example
A wine merchant holds $2,800,000 of stock across three bonded warehouses. The auditor attends the year-end count at two of them, recounts a sample of high-value cases and traces them back to the stock records. Observation and inspection together provide better evidence than either the count sheets or management's explanation alone.
Example
A subscription software firm reports $11,000,000 of deferred revenue. The auditor selects 30 contracts, reads the term dates and recalculates the release schedule independently. Two contracts had been billed annually but recognised as though they were monthly, and the recalculation quantifies the correction at $340,000.
Formula
Calculation
Overall Materiality = Benchmark x Percentage
Performance Materiality = Overall Materiality x Reduction Factor
Sample Size = (Population Value / Tolerable Misstatement) x Confidence Factor
Projected Misstatement = (Errors Found / Value Tested) x Population Value
Worked example. Pemberton Instruments reports pre-tax profit of $4,000,000 and holds trade receivables of $6,000,000 spread across 900 customer balances. The auditor sets overall materiality at 5% of pre-tax profit and performance materiality at 75% of that figure.
Overall materiality = $4,000,000 x 5% = $200,000.
Performance materiality = $200,000 x 75% = $150,000.
Sample size = ($6,000,000 / $150,000) x 3 = 40 x 3 = 120 balances.
The 120 balances selected cover $1,500,000 of the total. Testing finds errors totalling $9,000, giving an error rate of $9,000 / $1,500,000 = 0.6%. Projected across the whole population, that is 0.6% x $6,000,000 = $36,000, comfortably below the $150,000 performance materiality, so the auditor concludes the receivables balance is not materially misstated.Case study
Seen in the real world.
Pemberton Instruments is an illustrative, fictional laboratory equipment maker used here to show how the quality of evidence, not just the quantity, decides an audit. In its first year under a new auditor, the fieldwork ran three weeks longer than planned and the fee came in $85,000 over the estimate. Management blamed the auditors for being difficult.
The audit partner's closing report told a different story. Roughly half the sampled sales required the team to reconstruct the paperwork because delivery notes were not filed against invoices, and the stock provision had been supported only by a verbal explanation from the operations manager rather than by ageing data. The team could not rely on internal evidence, so it fell back on more expensive external testing.
Before the next year end, this fictional company changed three things: delivery notes were scanned and attached to invoices automatically, the stock provision was rebuilt from an ageing report with a documented policy, and the finance team prepared a standing evidence pack. Fieldwork finished a week early and the fee fell back below the original estimate, which is the return on making evidence easy to find.
Watch out
Common mistakes.
- Believing that management's explanation is enough on its own. Enquiry is the weakest form of evidence and always has to be corroborated by a document, a recalculation or an external confirmation.
- Thinking more evidence always means better evidence. A hundred weak internal documents can be worth less than a single independent confirmation from a bank or a customer.
- Creating control documentation after the auditor asks for it. Evidence generated in response to the request says nothing about whether the control operated throughout the year.
Questions
People also ask.
Why does the auditor test only a sample?
Because testing every transaction would be prohibitively expensive, so procedures are targeted at the areas where a material misstatement is most likely.
What is the most reliable type of evidence?
Information the auditor obtains directly from an independent external source, such as a confirmation sent by the auditor to the client's bank and returned to the auditor.
What happens if evidence cannot be obtained?
The auditor treats it as a scope limitation, which can lead to a qualified opinion or, if the area is pervasive enough, a disclaimer of opinion.
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