1. Electronic Presentations in Microsoft ® PowerPoint ® Prepared by Brad MacDonald SIAST © 2003 McGraw-Hill Ryerson Limited

2. Copyright © 2003 McGraw-Hill Ryerson Limited Chapte r 7 2 Audit sampling

3. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 3 Learning objective 1 Define and explain the terms unique to audit sampling, including the fundamental technical differences between statistical sampling and non-statistical sampling.

4. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 4 Define Audit Sampling Audit sampling is –the application of an audit procedure to less than 100 percent of the items within an account balance population or class of transactions for the purpose of evaluating some characteristic of the balance or class.

5. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 5 Define Terms Audit procedure: –The general audit techniques such as computation, observation, confirmation, enquiry, inspection, and analysis. Account balance: –A control account made up of many constituent items.

6. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 6 Define Terms Class of transactions: –A group of transactions having common characteristics such as cash receipts. Population: –The set of all elements that constitute an account balance or class of transactions. Population unit: –Each of the elements in a population.

7. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 7 Define Terms Sampling unit: –A population unit that is selected in the audit sample. –It may be a customer’s account, an inventory item, a debt issue, a cash receipt, or a cancelled check. Sample: –A set of sampling units.

8. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 8 Sampling and the Extent of Auditing Nature: –The general technique to be used. (computation, observation, confirmation…) Extent: –The amount of work done when the procedures are performed. –Sampling is concerned primarily with extent. Timing: –The point in the audit at which the procedures are to be performed.

9. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 9 Purposes for Audit Sampling Sampling can be used for both tests of controls and balance-audit programs. –For test of controls, sampling is used to determine compliance with control objectives. Samples are drawn from a class of transactions. –For the balance-audit program, sampling is used to evaluate management assertions. Samples are drawn from account balance populations.

10. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 10 Learning Objective 2 Identify audit work considered to be audit sampling and distinguish it from work not considered to be audit sampling.

11. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 11 Inclusions and Exclusions Sampling uses less than the entire population to reach a conclusion about the entire population. –Work is not considered audit sampling when the entire population is audited or where the purpose is general familiarization

12. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 12 Why Auditors Sample Auditors utilize audit sampling when the nature and materiality of the balance or class does not demand a 100% audit, a decision must be made about the balance or class, and the time and cost to audit 100% of the population would be too great.

13. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 13 Statistical Sampling Auditors define statistical sampling as audit sampling that uses the laws of probability for selecting and evaluating a sample for the purpose of reaching a conclusion about the population. –A statistical sample is selected at random. –Statistical calculations are used to measure and express the results.

14. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 14 Statistical Sampling Random sample: –Each population item has an equal likelihood of being selected in the sample. –A random sample is required for statistical sampling. Statistical methods can be used to generate the preliminary estimate of sample size. –A calculation of sample size is not required for a method to be considered statistical sampling.

15. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 15 Non-Statistical (Judgemental) Sampling Non-statistical sampling is audit sampling in which auditors do not utilize statistical calculations to express the results. –The sample selection technique could be random or not. –Consideration of sampling risk in these circumstances means “giving sampling risk some thoughtful attention,” without direct knowledge or measurement of its magnitude.

16. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 16 Sampling and Non-Sampling Risk 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. –Controlled by auditing sufficiently large samples. Non-sampling risk: –All risk other than sampling risk. –Controlled by policies and procedures.

17. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 17 Non-Sampling and Sampling Risk An incorrect assessment by the auditor can occur because he/she –made an improper assessment of inherent and/or control risk, or failed to apply audit procedures carefully (non-sampling risk), or –made error projections, based on the sample results, that led to the wrong conclusion about the population (sampling risk).

18. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 18 Learning Objective 3 Develop a simple audit program for a test of controls audit of a client’s internal control procedures.

19. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 19 Assessing Control Risk Sampling for test of controls is a structured, formal approach in seven steps: 1.Specify the audit objectives. 2.Define deviation conditions. 3.Define the population. 4.Determine the sample size. 5.Select the sample. 6.Perform the test of controls procedures. 7.Evaluate the evidence.

20. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 20 Learning Objective 3A Specify objectives, deviation conditions, populations, and sampling units.

21. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 21 Plan the Procedures Problem recognition phase –The client’s implicit assertions with respect to control is that controls work, and people comply with control procedures. –Are the client assertions about control accurate? 1. Specify the audit objectives. –Identify key controls – those that are central to the assertions being tested.

22. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 22 Plan the Procedures 2. Define the deviation conditions. –Deviation is a departure from the internal control procedure. Also called error, occurrence, or exception. –Define them prior to testing so that the auditors doing the test will know one when they see it. Auditors looks for presence of absence of a control condition. Called attribute testing.

23. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 23 Plan the Procedures 3. Define the population. –The set of all elements in the balance sheet account or in the class of transactions. –Conclusions can only be drawn for the population from which the selection is pulled. Important for validity / completeness –Timing of tests and the ability to obtain a reliable representation of the population are factors to consider in determining the population.

24. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 24 Learning Objective 3B Determine sample size and select sampling units.

25. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 25 4. Determine sample size. Evidence collection phase Factors to influence sample size: –Sampling risk - inverse to sample size –Tolerable deviation rate - directly related to materiality - inversely related to sample size –Expected population deviation rate(EPDR) Sample size varies directly with EPDR. –Population size - slight direct relationship with sample size

26. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 26 5. Select the Sample. Audit sample must be selected from the population for which a conclusion will apply. Sample should be representative of the population. –The sample should mirror the characteristics of the population.

27. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 27 Representative Samples Auditors try to attain representative samples by selecting random samples. –Each unit in the population has an equal chance of selection. –Samples can be selected by: unrestricted random selection, or using a random number generator systematic random selection

28. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 28 Other Sampling Methods For non-statistical methods, other methods of sample selection may be used. –Randomness and representativeness cannot be evaluated in non-statistical samples. –Methods include: haphazard selection block sampling

29. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 29 6. Perform the Procedures. The auditor can now perform the test of control procedures. –More than one test will often be performed on a sample. –Testing will produce evidence as to the effectiveness of the client’s internal controls.

30. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 30 Learning Objective 3C Evaluate evidence from a test of controls audit.

31. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 31 7. Evaluate the evidence. Auditors face two risks in evaluating the evidence. The risk of assessing control risk too low. –Concluding that a control works better than it actually does. This leads to failure to do sufficient balance-audit procedures. It also threatens the effectiveness of the audit.

32. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 32 7. Evaluate the Evidence. Risk of assessing control risk too high: –Concluding that a control does not work well enough to be relied on when it actually does. This triggers unnecessary extension of balance audit procedures. And, it threatens the efficiency of the audit. Audit effectiveness is more important than audit efficiency. –Therefore, auditors reduce risk of assessing control risk too low.

33. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 33Evaluation For non-statistical samples: –Calculate the sample deviation rate (SDR). Determine the rate of errors in the sample. Consider that the actual error rate for the population may differ due to sample risk. –Compare the SDR to the tolerable deviation rate (TDR). TDR – controls are not expected to be perfect; some level of deviations can be tolerated.

34. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 34Evaluation For judgemental sample, an auditor will compare the SDR to the TDR and make a judgement as to the level of sampling risk. –Evaluation depends on auditor’s experience and expertise, but not on statistical methods.

35. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 35Evaluation For statistical sample evaluation, the auditor will assign a level to the risk of evaluating control risk too high. –Using this risk and data from the sample, the auditor can calculate an upper error limit (UEL). –The UEL is compared to the TDR in order to reach a conclusion.

36. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 36 Performing Error Analysis Follow up on all deviations uncovered in testing. –Determine whether errors are pervasive, deliberate, misunderstandings, or related to financial statement balances. Draw final conclusions. –If control risk appears high, auditor must decide whether to do additional substantive procedures, or extend control procedures in the hopes of determining actual risk is lower.

37. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 37 Timing of Test of Controls Audit Procedures Tests of controls can be performed at the interim date. –The auditor must decide what do do about the period after the interim date to the year- end date. The auditor can continue test of controls for the period between interim and statement dates. Testing of controls can be stopped because sufficient evidence is obtained to support a decision.

38. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 38 Learning Objective 4 Develop a simple audit program for an account balance audit considering the influence of risk of material misstatement.

39. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 39 Risk Model Expansion Detection risk (DR) is actually a combination of two risks: –Analytical procedures risk (APR) The probability that analytical procedures will fail to detect material errors. –Risk of incorrect acceptance (RIA) The probability that tests of details procedures will fail to detect material errors.

40. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 40 Risk model expansion Expanded risk model: AR = IR * CR * APR * RIA –Only risk of incorrect acceptance can be controlled by the auditor. Solve the risk model for RIA: –with AR, IR, and AP held constant RIA varies inversely with CR or control risk. RIA = AR IR x CR x APR

41. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 41 Sampling Risk In sampling for substantive procedures, the auditor faces two sampling risks. –the risk of incorrect acceptance Accepting a balance as materially correct when material misstatements have occurred. –the risk of incorrect rejection Deciding a balance is materially misstated when it is not.

42. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 42 Sampling Risk Risk of incorrect acceptance is considered the more important of the two. –Incorrect acceptance leads to audit failure. Concerns audit effectiveness. –Incorrect rejection leads to additional audit procedures to determine actual misstatement. Auditor will determine that the amount is not materially misstated. Concerns audit efficiency. –Effectiveness is more important than efficiency.

43. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 43 Sampling Steps for Account Balance Audit 1.Specify the audit objectives. 2.Define the population. 3.Choose an audit sampling method. 4.Determine the sample size. 5.Select the sample. 6.Perform the substantive-purpose procedures. 7.Evaluate the evidence.

44. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 44 Learning Objective 4A Specify the audit objectives.

45. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 45 Plan the Procedures 1. Specify the audit objectives. –Objective is to decide whether the client’s assertions about existence, rights, and valuation are materially accurate. –Hypothesis testing: auditors hypothesize that the book value is materially accurate, and test that hypothesis.

46. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 46 Plan the Procedures 2. Define the population. –Definition of population must match objectives. –Examine individually significant items. Individual items that exceed materiality –Apply stratification to the remaining population. Subdivide the population by account balance size.

47. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 47 Plan the Procedures 3. Choose an audit sampling method. –Auditor will decide whether to use statistical or judgemental sampling methods. –For statistical sampling methods, classic variables sampling methods and attribute sampling methods (dollar unit sampling) are available.

48. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 48 Learning Objective 4B Determine sample size and select sampling units.

49. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 49 Evidence Collection Phase 4. Determine the sample size. –The sample size is based on the following: risk of incorrect acceptance (RIA) risk of incorrect rejection (RIR) material misstatement amount expected dollar misstatement in the population variability within the population size of the population

50. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 50 Evidence Collection Phase 5. Select the sample. –Random or non-random methods, as in sample selection for test of controls 6. Perform the substantive purpose procedures. –Substantive-purpose audit program produces evidence to support or refute management assertions.

51. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 51 Learning Objective 4C Evaluate monetary error evidence from a balance audit sample.

52. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 52 Evaluate the Evidence 7. Evaluate the evidence. –Determine amount of known misstatement. Total amount of errors actually uncovered by procedures –Determine the likely misstatement. Project the misstatement found in the sample to the population. Average difference method Dollar-unit sampling projection method

53. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 53 Evaluate the evidence Consider sampling risks –Auditor uses professional judgement and experience to consider these risk. Quantitative evaluation: –Follow upon on all differences uncovered to determine any misunderstanding of GAAP, simple mistakes, intentional irregularities, or management override of controls.

54. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 54 Evaluate the evidence Evaluate the misstatement –Known misstatement and likely misstatement are combined and compared to materiality –Sample risk gives rise to “possible misstatements.” Misstatements that remain undetected in units not sampled. Can be calculated where statistical methods are used.

55. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 55 Learning Objective 5 Illustrate some basic audit sampling calculations.

56. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 56 Sample Size Planning n=R/P –n is sample size. –R is confidence level per “R value table.” Based on confidence level and acceptable number of errors. Confidence level is the complement to acceptable risk of incorrect rejection. –P is tolerable misstatement expressed as a proportion.

57. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 57 Sample Evaluation P=R/n –P is the achieved upper error limit for the sample. –R is confidence level per R value table. –n is the sample size.

58. Copyright © 2003 McGraw-Hill Ryerson Limited Chapter 7 58 Timing of Substantive Procedures Account balances can, in part, be audited at an interim date. –Auditor will extend the interim date audit conclusions to balance sheet date. –Audit work is performed at interim dates: to spread auditor’s workload over the year to allow for timely production of audit report following year end –Poor controls, or significant business risk may preclude performing procedures at interim.