Charteredaccountants.com.au/training Fundamentals of Auditing in 2007 ICAA Audit Training Series 2008 Module 4 – ASA 530 Sampling ASA 500 Audit Documentation.

charteredaccountants.com.au/training Fundamentals of Auditing in 2007 ICAA Audit Training Series 2008 Module 4 – ASA 530 Sampling ASA 500 Audit Documentation and Evidence charteredaccountants.com.au Michael Cain, FCA Audit & Accounting Technical Director Nexia International – Australia and New Zealand

Module 4 - Overview  ASA 530 - Sampling and Other Means of Testing  ASA 500 – Audit Evidence  ASA 230 – Audit Documentation  AGS 1038 – Access Audit Work Papers

charteredaccountants.com.au/training Fundamentals of Auditing in 2007 ICAA Training Series 2008 ASA 530 – Audit Sampling and Other Means of Testing charteredaccountants.com.au Michael Cain, FCA Audit & Accounting Technical Director Nexia International – Australia and New Zealand

Sampling Experiment

Sampling Experiment – Same Birthday?

Various means of gathering audit evidence  100% examination: this is not a sampling method  Selecting specific items: e.g. high value or high risk — this is not a sampling method. Items selected will not necessarily be representative of the population  Audit sampling

ASA 530: Sampling  ASAs do not prescribe any particular way of determining the sample size or selecting the sample  AARF Audit Guide No 1 (available at Institute library) outlines methods for determining the sample size Sampling

Stratification >Stratification: occurs when the auditor divides the population into a series of sub-populations, each of which has an identifying characteristic, such as dollar value. >Can assist with audit efficiency as it allows the auditor to reduce the sample size by reducing variability, without increasing the sampling risk. >Can direct auditor’s attention to areas of audit interest, especially risky or material items.

Definition and features  Audit sampling: the application of an audit procedure to less than 100% of the items within a population to obtain audit evidence about particular characteristics of the population (ASA 530.06  Audit sampling is important because it provides information on:  How many items to examine  Which items to select  How sample results are evaluated and extrapolated to the population in order to tell us something about the population (e.g. level of misstatement)

ASA 530: Sampling  Key issue is to select a sample that is representative of the population Remember:  % coverage is no guarantee of a representative sample  The number of items in the population has little effect on the sample size, unless the population is small Definition and features

Sampling risk defined  Sampling risk: the probability that the auditor has reached an incorrect conclusion because audit sampling was used rather than 100% examination (i.e. correctly chosen sample was not representative of the population).

Non-sampling risk defined  Non-sampling risk: arises from factors, other than sample size, that cause an auditor to reach an incorrect conclusion, such as the possiblility that:  The auditor will fail to recognise misstatements included in examined items  The auditor will therefore apply a procedure that is not effective in achieving a specific objective.

Characteristic of interest  When sampling, the auditor identifies a particular characteristic of the population to focus upon.  For tests of control, the characteristic of interest is the rate of deviation from an internal control policy or procedure.  For substantive tests, the characteristic of interest is monetary misstatement in the balance.

Statistical sampling defined  Statistical sampling: any approach to sampling that has the following characteristics:  Random sample selection  Use of probability theory to evaluate sample results, including measurement of sampling risk.  Major advantage of statistical sampling over non-statistical sampling methods is defensibility, thorough quantification of sampling risk.  Refer ASA 530.13

Non-statistical sampling  Non-statistical sampling: sampling approaches that do not have all the characteristics of statistical sampling.  Major advantage of non-statistical sampling is greater application of audit experience.  The basic principles and essential procedures identified in ASA 530 apply equally to both statistical and non- statistical sampling.

Plan the sample 1.State the objectives of the audit test 2.Decide whether audit sampling applies 3.Define attributes and deviation conditions 4.Define the population 5.Define the sampling unit 6.Specify the tolerable deviation/misstatement rate 7.Specify allowable risk of overreliance/incorrect acceptance 8.Estimate population deviation/misstatement in the population 9.Determine initial sample size

Select the sample and perform the audit procedures 10. Select the sample 11. Perform the audit procedure

Evaluate the results 12. Generalise from the sample to the population 13. Analyse the exceptions 14. Decide the acceptability of the population

Planning and designing the sample  Auditor must consider:  Objectives of the audit test (usually related to an audit assertion of interest)  Population from which to sample  Possible use of stratification  Definition of the sampling unit.

Planning and designing sample for tests of controls  Auditor should consider:  Audit objectives (assertions of audit interest)  Tolerable error — maximum error rate that would still support control risk assessment  Allowable risk of over-reliance — allowable risk of assessing control risk too low  Expected error — amount of error the auditor expects to find in the population

Defining the audit objective and population  Once the audit objective is specified, such as reliance on controls or misstatement of account balance, the auditor must consider what conditions would constitute an error.  The auditor must ensure that the population from which the sample is to be selected is complete and appropriate to the audit objective.

Defining the sampling unit  Sampling unit is commonly the:  Transactions or balances making up the account balance; or  Individual dollars that make up an account balance or class of transactions, commonly referred to as Probability Proportionate to Size Sampling (PPS) or Dollar Unit Sampling (DUS).

Determining sample size  Sample size is affected by the degree of sampling risk the auditor is willing to accept.  Auditor's major consideration in determining sample size is whether, given expected results from examining sample, sampling risk will be reduced to an acceptably low level.

Sampling for tests of controls, attribute sampling  Audit sampling is useful for tests of controls, especially involving inspection of source documentation for specific attributes such as evidence of authorisation (attribute sampling).  Involves examination of documents for particular attributes related to controls (e.g. authorisation).  Results of attribute sampling can be used to support or refute an initial assessment of control risk.

Factors that influence sample size for tests of controls

Judgemental considering statistical sample sizes Terminology  Risk of overreliance  Tolerable (error) rate  Expected population deviation rate Determining the sample size – test of controls

Sample size estimation for attribute sampling

Reliability factors for assessing required confidence level

Example using Table 2  5% risk of overreliance.  No errors are expected (= 0 deviation rate)  10% tolerable error rate. = Sample size of 29 items Determining the sample size – test of controls

Sample size estimation for attribute samples (alternative method)  An alternative method is to determine sample size by reference to:  Appendix, Table 3, for where allowable risk of over-reliance (ARO) is 10% (90% confidence). This ARO is common in practice.  Appendix, Table 2, for where allowable risk of over-reliance is 5% (95% confidence).

Sampling for substantive tests  The following matters should be considered:  Relationship of sample to relevant audit objective (assertion of audit interest)  Preliminary judgments about materiality levels  Auditor's allowable risk of incorrect acceptance  Characteristics of the population  Use of other substantive procedures directed at same financial report assertion.

Factors that influence sample size for substantive testing

Judgemental considering statistical sample sizes Terminology  Risk of incorrect acceptance  Tolerable error as a % of population  Expected error as a % of tolerable error Determining the sample size – substantive tests

Example using Table 1  Acceptable risk of incorrect acceptance is low.  Few errors are expected.  Tolerable error = 10% of population. = sample size of 23-30 items Determining the sample size – substantive tests

Discussion problem # 4

Judgemental using approximation of a statistical technique Terminology  Audit assurance (substantial, moderate, little)  Expected error (little/no, or some)  Individually significant items  Tolerable error Determining the sample size – substantive tests

Example:  Recorded amount is $500,000.  No individually significant amounts.  Tolerable error = $50,000.  High degree of assurance required.  Few errors expected. Determining the sample size – substantive tests

Formula: = Population recorded amount/tolerable error x assurance (reliability) factor = sample size. = 500,000/50,000 x 3.0 = 30 items Determining the sample size – substantive tests

Selecting the sample  To draw conclusions about population or strata, the sample needs to be typical of characteristics of population or strata.  Sample needs to be selected without bias so that all sampling units in the population or strata have a chance of selection.  Common sampling techniques are:  Random selection — random number generation  Systematic selection  Haphazard selection — select without conscious bias

Steps in systematic selection For example, suppose the sample size is 20 and the number of items in the population is 10,000:  Step 1:Calculate the sample interval:  Step 2:Give every item in population chance of selection by choosing a random number (random start) within range of 1 and sampling interval (in this example, 500), e.g. 217.  Step 3:Continue to add sampling interval to random start, and identify items to be sampled, e.g. item nos. 217, 717, 1217... 9217, 9717.

Performing the audit procedures  To ensure conclusions arising from tests on audit samples are appropriate, auditor must perform testing on each item selected.  If selected item is not appropriate for application of testing procedure, a replacement item can be selected.  If auditor is unable to perform test on a selected item (e.g. loss of documentation), it is considered to be an error.

Tests of control  Determine whether exceptions are errors  Determine the no. of errors/error rate  Compare to tolerable error Analyse the exceptions

Evaluation of attribute sample results  Approach in practice is to use sample deviation rate (SDR) as best estimate of population deviation rate.  For example, auditor selects 25 items, finds one error => SDR rate is 4%.  Auditor compares with tolerable deviation rate (TDR). If SDR <= TDR, sample results support auditor’s planned reliance on IC.  If SDR > TDR, sample results do not support auditor’s planned reliance on IC, auditor will revisit audit plan and reduce reliance on IC and increase substantive testing.

Substantive tests  Determine any differences  Calculate projected error compare to tolerable error Analyse the misstatements

Evaluating sample results  To evaluate sample results, auditor determines the level of error found in sample and directly projects this error to relevant population. For example: sample 20%, find misstatement of $10,000. Therefore projected error = $50,000 ($10,000/20%).  Projected error is then compared with tolerable error for the audit procedure to determine if characteristic of interest can be accepted or rejected.  Auditor should consider both the nature and cause of any errors identified.

Financial report overall  Summary of audit differences (mandatory requirement). Decide the acceptability

Dollar-unit sampling  Sample unit is individual dollar units, not physical units (transactions or balances). A population with $1,000,000 that contains 1,000 physical units or accounts is viewed as a population with 1,000,000 sample units.  Individual dollar selected is attached to that physical unit or account in which it is contained, which will then be tested.

Advantages of dollar-unit sampling (DUS)  Directs auditor’s attention to material items. For example, under traditional sampling, debtor A (owing $10,000) and debtor B (owing $1,000) have equal chance of selection. Under DUS, debtor A is ten times more likely to be selected and tested.  Directs auditor’s attention towards overstatement errors.  However, a disadvantage is that it directs auditor’s attention away from understatement errors.

Illustration of DUS with systematic selection

Determination of sample size for substantive tests For convenience, this is usually presented as: E.g. account balance $1,000,000. Tolerable error $50,000. Expected error is zero and risk of incorrect acceptance is 5%  Reliability factor = 3

Illustration of DUS with systematic selection

Evaluation of sample results for substantive testing

Take Away  Mandatory requirement to consider  Defensible  Focus on key areas  Reduction in audit work? = < $$$  Questions??

charteredaccountants.com.au/training Fundamentals of Auditing in 2007 ICAA Audit Training Series 2008 ASA 500 – Audit Evidence charteredaccountants.com.au

Objective of an Audit  Enable the auditor to express an opinion as to whether the financial report is prepared, in all material respects, in accordance with an applicable financial reporting framework.  The only reason auditors accumulate evidence is to enable them to reach conclusions about whether the financial report is fairly stated in all material respects and to issue an appropriate audit report.

Audit evidence

ASA 500 deals with 4 key issues: 1. Concept of audit evidence 2. Sufficient appropriate audit evidence 3. The use of assertions in obtaining evidence 4. Audit procedures for obtaining audit evidence Audit Evidence

1.Concept of audit evidence  Obtain sufficient appropriate audit evidence to draw reasonable conclusions on which to base the audit opinion. Audit Evidence

Sufficient appropriate audit evidence  Sufficiency: quantity of audit evidence necessary to provide the auditor with a reasonable basis for an opinion on the financial report  Appropriateness: quality of audit evidence  Two dimensions:  Relevance — evidence relates to the financial report assertion of interest  Reliability — influenced by the source and nature of the evidence.

Reliability of audit evidence  Evidence from sources outside an entity is more reliable than evidence obtained solely from within the entity.  Evidence generated internally is more reliable when the internal control structures are effective.  Evidence obtained directly by the auditor is more reliable than evidence obtained from the client.  Evidence in the form of documents or written representations is more reliable than oral representations.  Evidence provided by original documents is more reliable than evidence provided by photocopies or facsimiles.

2.Sufficient, appropriate audit evidence  When you use information produced by the entity, obtain evidence about the accuracy and completeness of the information. Audit Evidence

3.The use of assertions  Use assertions for classes of transactions, account balances and disclosures in sufficient detail to form a basis for the assessment of risks of material misstatement and the design and performance of further audit procedures.  See pg 6 for the new audit assertions. Audit Evidence

Financial report assertions and audit objectives  Directors and managers make assertions (embodied in the financial report) when they present a financial report.  Auditors use these assertions to assess risks by considering different types of potential misstatements that may occur and designing audit procedures in response to risks.  There are three categories of assertions:  Classes of transactions and events  Account balances  Presentation and disclosure.

Financial report assertions and audit objectives Assertions about classes of transactions and events for the period under audit:  Occurrence — transactions and events that have been recorded have occurred and pertain to the entity.  Completeness — all transactions and events that should have been recorded have been recorded.  Accuracy — amounts and other data relating to recorded transactions and events have been recorded appropriately.  Cutoff — transactions and events have been recorded in the correct accounting period.  Classification — transactions and events have been recorded in the proper accounts.

Financial report assertions and audit objectives Assertions about account balances at the period end:  Existence — assets, liabilities and equity interests exist.  Rights and obligations — the entity holds or controls the rights to assets, and liabilities are the obligation of the entity.  Completeness — all assets, liabilities and equity interests that should have been recorded have been recorded.  Valuation and allocation — assets, liability and equity interests are included in the financial report at appropriate amounts and any resulting valuation adjustments are appropriately recorded.

Financial report assertions and audit objectives Assertions about presentation and disclosure:  Occurrence and rights and obligations — disclosed events, transactions and other matters have occurred and pertain to the entity.  Completeness — all disclosures that should have been included in the financial report have been included.  Classification and understandability — financial information is appropriately presented and described, and disclosures are clearly expressed.  Accuracy and valuation — financial and other information is disclosed fairly and at appropriate amounts.

Assertions and objectives for the account balance of inventory of a manufacturing company Financial report assertion Illustrative audit objectives Existence  Inventories included in the balance sheet physically exist.  Inventories represent items held for sale in normal course of business. Completeness  Inventory quantities as per the accounting records include all products, materials and supplies owned by the company that are on hand.  Inventory quantities include all products, materials and supplies owned by the company that are in transit or stored at outside locations. Rights & Obligations  The company has legal title or similar rights or ownership to the inventories.  Inventories exclude items billed to customers or owned by others. Valuation & Allocation  Inventories are properly stated at cost (except when the net realisable value is lower).  Slow-moving, excess, defective and obsolete items included in inventories are properly identified and value.

Audit Evidence 3.The use of assertions  The key issue when using a combined approach is: how do you link your tests of controls to substantive tests in order to reduce the extent of the latter?

3.The use of assertions Tests of controls can be linked to substantive tests using audit assertions:  Accuracy and cut-off links to valuation and allocation.  Occurrence links to existence and rights and obligations.  Completeness links to completeness. Audit Evidence

3.The use of assertions Example:  If sales are accurate and cut-off is appropriate, we have evidence that debtors are properly valued and allocated.  If sales occurred, we have evidence that debtors exist. Audit Evidence

3.The use of assertions Example:  If purchases are complete, we have evidence creditors are complete.  If purchases are accurate and cut- off is appropriate, we have evidence that creditors are properly valued and allocated. Audit Evidence

4.Audit procedures  No mandatory requirements  Standard discusses different types of procedures, eg inspection of documents, recalculation of amounts, CAATs etc Audit Evidence

Common audit procedures  Inspection  Observation  Inquiry  Confirmation  Recalculation  Reperformance  Analytical procedures

The audit trail  Transactions are traced from initial entry in the system to intermediate records, where the transactions become components of subtotals, and ultimately to disposition in the final records, where subtotals are summarised for presentation in the financial report.  Direction of the tracing can be modified: an auditor can trace from point of initiation of transaction to final recording (assertion of completeness), or trace from final record back to point of initiation (assertion of existence or occurrence).

Selecting audit procedures  The selection of audit procedures is influenced by the following factors:  Auditor’s assessment of business risk and inherent risk  Nature of the internal control structure and assessment of control risk  Materiality of particular component of financial report  Experience gained from previous audits  Results of other audit procedures  Source and reliability of information available.

Relationship between financial report assertions, objectives and procedures for inventory purposes

ICAA Audit Training Series 2008 ASA 230 – Audit Documentation charteredaccountants.com.au

Audit documentation Provide:  Sufficient and appropriate record of the basis for auditor’s report  Evidence that audit performed in accordance with auditing standards and applicable legal and regulatory requirements  12 mandatory steps

Form, content and extent Enable an experienced auditor, having no previous connection with the audit to understand:  Nature, timing, and extent of audit procedures performed Record identifying characteristics of specific items or matters being tested  Results of audit procedures and audit evidence obtained  Significant (contentious) matters arising and conclusions reached thereon Document discussions Address contradictions and inconsistency Not necessary to document every matter Oral explanations not adequate support for work performed

Inability to comply with mandatory requirement Rare and exceptional circumstances, factors outside auditor’s control prevent the auditor from complying with essential procedure Need to document:  Circumstances surrounding inability to comply  Reasons for the inability to comply  Justification of how alternative audit procedures achieve objectives of the mandatory requirement

Identification of preparer and review Need to record:  Who preformed audit work and date completed  Who reviewed audit work, date and extent of review Does not imply every working paper is evidenced of review

Assembly of final audit file  Assemble final audit file on a timely basis after the date of the auditor’s report (60 days)  Not delete or discard audit information before end of retention period (7 years)  Necessary to modify audit documentation? When and by whom modifications made (reviewed?) Reasons for modification Effect on auditor’s conclusion

Working papers  These are the specific means used to record audit evidence.  Working papers aid in: Planning and performing the audit Supervising and reviewing the audit work Gathering evidence and providing essential support for the auditor’s opinion.  Two main divisions: 1.Permanent file — store of documents relevant to this audit and future years (e.g. copies of company constitution, continuing contracts) 2.Current working paper file — documentary record of evidence gathered and conclusions reached on this audit.

Current working paper file Includes: 1.Overall audit plan 2.Review of accounting system and related internal controls 3.Audit program, listing the audit procedures undertaken 4.Details of audit testing undertaken 5.Working trial balance — schedule of general ledger accounts 6.Trial balance working paper schedules, including external documents 7.Draft of financial report and audit report.

Confidentiality, safe custody, integrity, accessibility and retrievability Adopt appropriate procedures to maintain confidentiality, safe custody, integrity, accessibility and retrievability of the audit documentation Back up copies??

Legal aspects of working papers  ASA 230 outlines the requirements that working papers be properly prepared and maintained.  Courts have determined that working papers are the property of the auditor.  Auditor should not permit access to audit files by client’s staff, who may then become familiar with audit procedures and could facilitate fraud.  Working papers must be kept for 7 years.

Discussion Problem #1

ICAA Audit Training Series 2008 AGS 1038 – Access to Audit Working Papers charteredaccountants.com.au

Access to audit working papers  AGS 1038 provides guidance on voluntary access to audit documentation  Regulatory access based on relevant legislation

General considerations to requests for access  Confidentiality requirements, except: Legal obligation – refer below Peer review – quality assurance program  Form of release, indemnity, or waiver External auditor Internal auditor Third parties  How grant access Auditor to control access to workpapers  Legal considerations Legal professional privilege

Discussion Problem #2

Module 4 – Topics Covered  ASA 530 - Sampling and Other Means of Testing  ASA 500 – Audit Evidence  ASA 230 – Audit Documentation  AGS 1038 – Access Audit Work Papers Thanks

Charteredaccountants.com.au/training Fundamentals of Auditing in 2007 ICAA Audit Training Series 2008 Module 4 – ASA 530 Sampling ASA 500 Audit Documentation.

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Charteredaccountants.com.au/training Fundamentals of Auditing in 2007 ICAA Audit Training Series 2008 Module 4 – ASA 530 Sampling ASA 500 Audit Documentation.

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