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Auditing- A Practical Approach

Chapter 6: SAMPLING AND OVERVIEW OF THE RISK RESPONSE PHASE OF THE AUDIT

FMGT 4310

Auditing 2

Chapter 6 Learning Objectives 1. Explain how audit sampling is used in an audit

2. Understand the difference between sampling and non-sampling risk

3. Differentiate between statistical and non- statistical sampling

4. Describe sampling methods and the factors to be considered when choosing a sample

5. Determine the factors that influence the sample size when testing controls

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Chapter 6 Learning Objectives 6. Determine the factors that influence the sample

size when substantive testing and consider techniques used to perform substantive tests

7. Outline how to evaluate the results of tests conducted on a sample

8. Understand the difference between tests of controls and substantive tests

9. Explain the factors that impact the nature, timing, and extent of audit testing

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What is “sampling” ?

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Importance of Sampling to Auditors

• The auditor doesn’t look at everything… just selected pieces.

• In some circumstances, the auditor CANNOT look at everything.

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Purpose of Sampling

Why?

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Reasonable assurance

Cost vs. Benefit

Auditors will take a sample when:

• A decision must be made about the balance or class of transactions.

• The nature and materiality of the balance or class of transactions does not demand a 100% audit.

• The time and cost to audit 100% of the population would be too great.

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Professional judgement

Sampling is Used to Conduct:

• “Walk through” tests (to understand internal controls)

• Tests of controls

• Tests of details

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The objective is to select a sample that is representative of the population as a whole.

i.e. representative

sampling 6-9

Representative sampling

Representative sampling

If the sample turns out to be different than the population as a whole, then it is NOT representative

Is this a problem?

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Non-representativeness can occur due to:

→ Sampling risk

→ Non-sampling risk

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Representative sampling

Table 6.1

6-12Copyright John Wiley & Sons Canada, Ltd.

Representative sampling → Sampling Risk Control Tests

Increased AR

Inefficient audit

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Representative sampling → Sampling Risk Detail Tests Sampling risk could result in: • auditor concludes financial

statements NOT misstated when there is one in the population

• sample contains more misstatements than population, auditor concludes financial statement misstated

Increased AR

Inefficient audit

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Representative sampling

Non-sampling risk could result in: • Application of ineffective

procedures • Reliance on poor evidence • Too little time testing high risk

accounts or critical controls

Statistical vs. Non-Statistical

Representative sampling

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Statistical sampling

• Sampling that uses the laws of probability for selecting and evaluating the validity of a sample from a population for the purposes of reaching a conclusion about the population

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Statistical sampling

– sample items selected at random – statistical calculations are used to

measure and express the results (e.g. standard deviation, confidence interval)

→ sample risk/error can be quantified using statistical calculations

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Statistical sampling

• Simple random sample selection • Systematic sample selection

–Interval

–Probability proportionate-to- size

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Sample Population- Revenue account Materiality= $25,000

Sampling Unit?

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Statistical sampling

Advantages –

Provides:

• quantitative evaluation of the sample results.

• a more defensible expression of the test results.

• provides objective recommendations for management.

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Statistical sampling

Disadvantages-

• generally more costly and time consuming to set up and run.

• may require additional training costs for staff members to use statistics or specialized software.

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Judgmental Sample Selection methods

• Directed sample selection • Block sample selection • Haphazard sample selection

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Judgmental Sampling

Advantages

• Allows the auditor to apply subjective judgment in determining the sample size and selection process.

→can achieve results equal to statistical sampling with less cost

• May be designed so that it is equally effective as statistical sampling while being less costly.

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Judgmental Sampling

Disadvantages

• Cannot draw objectively valid statistical inferences from the sample results.

• Cannot quantitatively measure and express sampling risk.

→INCORRECTLY regarded by some as being less effective for audit purposes.

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Summary Statistical vs. Judgemental

Similarities

• Both require a structured process involving planning, selection, conducting, evaluating

• Both can be applied to a stratified population

• Both require judgment

Differences

• Sampling risk can be quantified in statistical sampling using mathematical formulae

• Cannot quantify sampling risk in judgmental sampling

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Stratify the Population

• The auditor may choose to stratify the population before selecting a sample.

• i.e. the auditor splits the population into multiple smaller sets or layers, and each set has a similar characteristic.

• After the population is stratified, the sample will be selected using either a probabilistic or non- probabilistic sampling method.

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Sampling process

For both statistical and judgmental methods, the four main stages are:

1. Planning the sample

2. Selecting the sample

3. Performing the tests

4. Evaluating the results

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Planning 1. State the objectives of the test

Test of detail:

• Auditor wants to determine the maximum amount of monetary misstatement that could exist, based on the sample

Test of control:

• Are the identified internal controls that the auditor intends to rely upon effectively applied?

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Test of control:

• Some internal controls can be sampled

• While others cannot be

Test of detail:

• Decision to sample for test of details depends on the nature of the population, risk, etc.

• May choose to verify 100% instead

Planning 2. Decide IF Audit Sampling is appropriate

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Planning 3. Define Attributes and Exception/Error

Conditions Planning: Test of control

(e.g. attribute sample)

Test of detail (e.g. MUS sample)

Define the item of interest

Identify the characteristic or attribute of interest

Individual dollars

Define exceptions or errors

Define the control deviation (an exception)

Normally, any monetary difference (error)

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Planning 3. Define Attributes and Exception/Error

Conditions Planning: Test of control

Sales (Occurrence)

Test of detail

AR (Existence)

Define the item of interest

Control- Credit approval before shipment

Individual dollars

Define exceptions or errors

Sale released even though customer balance exceeds credit limit

Confirmed AR amount different from amount in customer account

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Planning 4. Define the Population

• Population can be defined in a way to suit the

audit tests

• Most populations can be stratified, if needed.

• Must draw sample from the entire sample

population as defined

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Planning 5. Define the Sampling Unit

Tests of control:

• Usually a physical unit, e.g. invoice, shipping document, purchase order

Test of detail:

• If MUS, would be the individual dollar

• For judgmental sampling, it is likely the unit making up the balance, e.g. an unpaid invoice

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Slide 19

Test of detail:

• Materiality is used to determine the acceptable misstatement amount for the audit of each account

These decisions require the use of professional judgment.

Test of control:

• TER is the exception rate the auditor will permit in the population and still be willing to use the assessed control risk

• As TER increases, the sample size decreases

Planning 6. Specify the Tolerable Error Rate (TER) or

Materiality

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• For judgmental sampling, professional

judgment is used to calculate the sample size

• For statistical sampling, mathematical

formulae or software are used

Planning Determine initial sample size

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When determining size of sample for control testing, CAS 530 requires auditor to consider:

–Amount of reliance on that control –TER for that control –Expected population error rate –Population size

Sample Size

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Factors that influence sample size

Table 6.3

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Risk drives the amount of work needed to be done

Risk?

When determining size of sample for substantive testing, CAS 530 requires auditor to consider:

–RMM –Other substantive testing –Materiality –Expected population error rate –Population size

Sample Size

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Factors that influence sample size

Table 6.4 6-39

Risk drives the amount of work needed to be done

Risk?

• Once the sample size has been

determined, choose the items from the

population using the sampling unit

defined in Step #5

Sample Selection 7. Select the sample

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• Stratification may result in a

combination of sample methods to be

used

Sample Selection 8. Select the sample

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Stratification Example:

AR Confirmation sample includes:

• Small number of High value accounts

• Accounts due from related parties

• Numerous low value accounts

Sample Selection 8. Select the sample

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• For test of controls, examine each item for the attribute defined in Step #3, recording all exceptions found

– Test for: Are all sales properly approved for credit?

Perform the Tests 9. Perform the audit procedures

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• For test of details, apply the audit procedures to each item to determine whether the BALANCE is correct or contains any misstatement

– Send and reconcile AR confirmations, conduct alternative procedures to verify AR account balance.

Perform the Tests 9. Perform the audit procedures

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• For test of controls sample error rate (SER) equals actual number of exceptions divided by actual sample size – But that is not necessarily equal to

the actual population error rate – a potential range of likely error must

be calculated

Evaluate Results 10. Generalize from the sample to the

population

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• In practice, auditors tend to test controls when they expect NO exceptions

• i.e. If the controls are effective, ANY exceptions are too many. If any exceptions are discovered, then it may be the case that no reliance on the controls is possible.

→We are trying to answer the question: Can we rely on the internal controls for a particular account assertion?

Evaluate Results 10. Generalize from the sample to the

population

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• When generalizing tests of details, auditors deal

with $$ amounts rather than with exceptions

• Misstatements found are projected from the

sample results to the population

→Are the accounts materially misstated?

Sample $ error → Population $ error

Evaluate Results 10. Generalize from the sample to the

population

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Test of controls:

• Was there a breakdown in internal controls that caused the exceptions? (Does it affect control risk?)

• Are there other compensating controls that can be tested/relied upon?

• Should additional substantive testing be conducted because of these results? (i.e. you are unable to rely on controls)

Evaluate Results 11. Analyze exceptions or misstatements

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Test of detail:

• Were the misstatements caused by serious control exceptions?

– (Do we need to reassess control risk?)

• Is additional substantive testing required?

– (to better identify magnitude of the error)

Evaluate Results 11. Analyze exceptions or misstatements

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Test of controls: • If SER >TER, we

will normally conclude that the control is NOT effective.

Test of detail: • Compare materiality to

total projected error.

• If total projected error is greater than materiality, we can conclude that the account balance is NOT acceptable.

Evaluate Results 12. Decide on the acceptability of the

population

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• What if the auditor decides the population is NOT acceptable?

What next?

Evaluate Results 12. Decide on the acceptability of the

population

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• What if the auditor decides the population is NOT acceptable?

1. Revise TER, materiality – not easily defensible

Evaluate Results 12. Decide on the acceptability of the

population

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• What if the auditor decides the population is NOT acceptable?

2. Expand the sample size. –May decrease the sample error

rate OR you could end up with the same result.

Evaluate Results 12. Decide on the acceptability of the

population

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• What if the auditor decides the population is NOT acceptable?

3. For compliance testing • Conclude that the control is

ineffective. For substantive testing • Conclude that the account is

misstated.

Evaluate Results 12. Decide on the acceptability of the

population

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• What if the auditor decides the population is NOT acceptable?

4. Revise assessed control risk. –Errors in account details could

be caused by weaknesses in internal controls.

–This will likely mean an increase in tests of detail.

Evaluate Results 12. Decide on the acceptability of the

population

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Table 6.5

As an auditor what would you conclude if the materiality was set at $3,500? What if the materiality was $7,500?

Evaluate Results 12. Decide on the acceptability of the

population

Adjustment?