Chapter 11

1. Chapter 11 Audit Sampling Concepts

2. Discussion of Audit Procedures • Nature • Technique (eg. computation, observation, confirmation etc.) • Type of evidence (eg. Internal, external..) • Timing • when procedures are performed • Extent • the amount of work done when the procedures are performed. Many audit techniques are applied on a test basis (on only a sample of the population)

3. Sample Sampling Defined: SAS No 39 = application of an audit procedure to less than 100 percent of the items within an account balance or class of transactions for the purpose of evaluating some characteristic of the balance or class (AU 350.01). Population

4. Audit Sampling Does Not Include: • Tracing several transactions through the accounting system to gain an understanding internal control structure (walk-through); • Complete or 100% examination of population items • Examining all items exceeding some dollar amount, and testing the remaining items by analytical procedures or, in some cases, not at all because they are immaterial; and • Observing employees who are performing a control procedure that does not leave an audit trail, such as observing the physical inventory count. • Enquiry, written representations, and internal control questionnaires • Analytical Procedures

5. Two purposes for audit sampling Test of controls • Sample:Usually from a class of transactions (populations), such as: • Cash Receipts • Cash disbursements • Purchases (inventory additions) • Inventory issues • Sales on credit • Expense details • Purpose:Obtain evidence about client’s control objective compliance: • Occurrence • Authorization • Completeness • Accuracy (valuation) • Posting, Classification, Timing

6. Examples of tests of controls • For a sample of recorded sales invoices, compare to bill of lading, price list, quantity shipped, shipping date and recalculate amounts • Trace a sample of shipping documents to invoices • For a sample of cash receipts compare to deposit slips, check for approval, recalculate cash, trace to daily report, compare dates, trace postings • Trace daily reports to cash receipts

7. PurposeObtain evidence about assertions related to financial statement balances: Existence / Occurrence Completeness Valuation Ownership Presentation and disclosure Sample:Usually from items in an asset or liability balance (population) such as: Accounts Receivable Loans receivable Inventory Fixed assets Accounts payable Two purposes for audit sampling Test of Details

8. Tests of Details: Examples • Confirm a sample of the receivables, investigate exceptions and follow up non-respondents by vouching sales charges and cash receipts to supporting documents (evidence of existence, rights and valuation) • Obtain an aged trial balance of the receivables. Audit the aging accuracy on a sample basis. Calculate and analyze the age status of the accounts and the allowance for uncorrectable accounts in the light of current economic conditions and the company’s collection experience (evidence of valuation) • Vouch a sample of receivable balances to cash received after the cutoff data (evidence of existence, rights and valuation)

9. Audit Sampling: Key Decisions • Which population should be tested and for what (population)? • How many items should be included in the sample (sample size)? • Which items should be included (selection)? • What does the sample information tell about the population as a whole (evaluation)?

10. Non-sampling and Sampling Risk • An auditor can fail to reduce audit risk to an acceptably low level because of: • Non sampling Risk: • improper assessment of inherent and/or control risk • failed to apply audit procedures carefully, loss of control over audit evidence • Inappropriate procedures • Lack of professional skepticism • Sampling Risk: • the probability that an auditor’s conclusion based on a sample might be different from the conclusion based on an audit of the entire population.

11. Non-sampling Risk • Non-sampling risk cannot be quantified. It can only be guarded against. • Public accounting firms attempt to minimize non-sampling risk by : • Implementing good quality control practices of hiring, training, and supervising competent personnel, • Carefully designing audit program procedures, and • Assigning appropriately qualified auditors to each audit.

12. Sampling Terminology • How to select sample: • Random selection • All sampling units have equal chance of selection. Good, but time-consuming • Systematic random selection • Random starting point. Less timc-consuming. Beware of systematically recurring errors in popn. • Directed sample selection • Block sample selection • Haphazard selection

13. Sampling Terminology • Whether to subdivide population or not • Stratified vs. non-stratified sample • How to evaluate results • Statistical vs. non-statistical • How to define sampling unit /what item to select • Physical units • Dollar units (= proportionate to size sampling)

14. By Physical attribute: physical units are sampling units each unit has equal chance of selection may need to compensate for high variability eg. By stratification By Dollar Unit: dollars are sampling units larger $ units have greater chance of selection no need to compensate for high variability or stratify population by value Sampling Techniques

15. Sampling Terminology • What to look at once sample is identified • Attribute sampling (yes/no) • Variables sampling

16. Statistical vs. Non-statistical • Either either statistical or non-statistical methods are permitted under GAAS. • Objective of both is to enable the auditor to reach a conclusion about an entire set of data by examining only a part of it. • Statistical sampling methods allow the auditor to express sampling risk in mathematical terms. In non-statistical sampling, the auditor gives “thoughtful attention” to this risk

17. Statistical sampling • Statistical sampling = audit sampling that uses the laws of probability for selecting and evaluating a sample from a population for the purpose of reaching a conclusion about the population. • selected at random • statistical calculations used to measure and express the results • does not require that laws of probability be used to determine sample size

18. Statistical: -precise, definite, objective description of results -requires quantification of risk and materiality -requires a random sample -costly, training of staff Non-Statistical: Less rigid approach to unique problems Permits auditors to be vague about risk and materiality Permits auditors to be more subjective, consider outside factors Statistical vs. Non-statistical

19. Sampling Steps • 1. State the objectives of the audit test • TOC: To ensure key control is operating effectively, as documented, throughout period of reliance • TD: To determine amount of misstatements related to assertion being addressed • In both cases, must carefully specify procedure to be applied and popn that it applies to

20. Sampling Steps • 2. Define error or exception conditions • TOC: Normally an attribute. • define exceptions advance of test so that the auditors doing the test will know one when they see it. Should be related to the key control, and should be important enough that its exception could lead to material errors. • TD: Normally an error amount, or audited value which is compared to book value.

21. Sampling Steps • 3. Define the population • =The set of all elements in the account or class of transactions. • Consider objective (eg. Direction of test) • Ensure all items in population are subject to selection (timing, physical location, proper stratification if population is stratified) • 4. Define the sampling unit • Physical unit or dollar units?

22. Sampling Steps • 5. Specify your tolerances • TOC: Tolerable exception rate • Depends on significance of transactions, significance of control, and consequences of non-control • TD: Tolerable misstatement (related to materiality) These are your benchmarks: if your test results lead you to conclude that your “problems” (control deviations/exceptions in TOC, errors in TD) exceed these amounts, you will act accordingly.

23. Sampling Steps • 6. Specify your sampling risk • TOC: Acceptable risk of assessing control risk too low (ARACR) • The lower your control risk, the higher the reliance on internal controls, the lower this risk must be • TD: Acceptable risk of incorrect acceptance (ARIA) • From equation: AAR=IR*CR*DR • AAR=IR*CR*APR*ARIA

24. Sampling Steps • 7. Estimate rate of problems in population • TOC: Expected population exception rate • As this rate increases and approaches your tolerable exception rate, your sample size will have to increase • TD: Expected population error rate • Same as above

25. Sampling Steps • 7. Determine sample size • TOC: • TER • ARACR • EPER • Population size if less than 1000 • TD: • Tolerable misstatement (relates to materiality) • ARIA (relates to other components in risk model) • Expected errors in population • Population Size (book is incorrect!!) • Some methodologies adjust for popn. Variability: unncessary if DUS is used

26. Sampling Steps • 8. Select sample and perform audit procedures • 9. Generalize from sample to the population • TOC: • Compare sample exception rate to tolerable exception rate. Consider ARACR. • TD: • Compare errors in sample and extrapolate to population

27. Misstatements

28. By Physical attribute: each unit has equal chance of selection may need to compensate for high variability MLE = $ amount of error in sample / # of units in sample * # of units in popn. By Dollar Unit: larger $ units have greater chance of selection no need to compensate for high variability MLE = $ recorded amount of popn / # of units in sample * sum of proportionate amounts of error in dollar units in sample in error Sampling Techniques

29. Sampling Steps • 10.Analyze exceptions or misstatements • TOC: consider: • Pervasive ? • Deliberate? • Misunderstanding ? • Related to FS balances ? • TD: • misunderstanding of GAAP? • Isolated? • intentional irregularity • management override of controls

30. Sampling Steps • 11.Determine acceptabilty of population • TOC: if results are unsatisfactory: • Increase sample size (will decrease ARACR) • Set control risk higher, reduce reliance on internal control • TD: • Increase sample size (will decrease ARIA) • Have client correct (careful: just correcting known errors will not affect MLE) • Qualify audit report