Auditors use the term "physical examination" to describe a special type of evidence gathering activity usually performed in the substantive testing stage of the audit engagement. (Physical examination is different to inspection and observation.)
Physical examination refers to the examination by the auditor of a physical asset of the entity, such as machinery, equipment, and inventory.
When evidence of completeness of an asset is required, the auditor gathers evidence that the asset physically examined has been included in the accounting records. For example, if evidence of the completeness of inventory was required the auditor physically examines a quantity of inventory items and then ensures those items have been included in the accounting records.
When evidence of validity [existence] of an asset already included in the accounting records is required, the auditor physically examines that asset. For example, if evidence of the validity [existence] of the recorded quantity of inventory was required, the auditor selects a number of inventory items that are included in the accounting records, notes the quantity of the items that has been recorded, and then ensures that quantity of items actually exists by physically examining the items.
In the substantive testing stage, physical examination provides complete and highly reliable evidence as to the validity [existence] of physical assets and incomplete, although highly reliable evidence, of the completeness of physical assets. This assumes that the person making the physical examination is competent and appropriately experienced.
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