AUDIT EVIDENCE AND SAMPLING
1 Audit Evidence and Documentation
2 Audit Sampling
By the end of this session, students should be able to:
Audit evidence and documentation:
• Explain the assertions contained in the financial statements
• Explain the principles and objectives of transaction testing, account balance testing and disclosure testing
• Explain the use of assertions in obtaining audit evidence
• Discuss the sources and relative merits of the different types of evidence
• Discuss the quality of evidence obtained
Audit sampling and other means of testing:
• Define audit sampling and explain the need for sampling
• Identify and discuss the differences between statistical and non-statistical sampling
• Discuss and provide relevant examples of the application of the basic principles of statistical sampling and other selective testing procedures
• Discuss the results of statistical sampling, including consideration of whether additional testing is required
This chapter discusses audit evidence by considering practical issues concerning audit evidence. It also discusses sample selection methods and evaluates sample results.
1 Audit evidence and documentation
1.1 Audit evidence
Audit evidence is all the information used by the auditor in arriving at the conclusion on which the audit opinion is based. Audit evidence is any information that corroborates or refutes an assertion. Audit evidence includes the information contained in the accounting records underlying the financial statements and other information.
Sufficient appropriate audit evidence must be obtained by performing audit procedures to afford a reasonable basis for an opinion regarding the financial statements under audit.
Management assertions embodied in financial statements
Management assertions or financial statement assertions is the set of information that the preparer of financial statements (that is management) is providing to another party.
When directors or management produce financial statements, they assert that the individual items are correctly described and are showing figures which are mathematically correct or fairly stated and above all, the financial statements show a true and fair view.
The following are the financial statements (management) assertions.
• Existence or Occurrence–Assets, liabilities, and owners’ equity accounts reflected in the financial statements exist; the recorded transactions have occurred.
• Completeness–All transactions, assets, liabilities, and elements of owners’ equity that should be presented in the financial statements are included.
• Rights and Obligations–The client has rights to assets and obligations to pay liabilities that are included in the financial statements.
• Valuation or Allocation–Assets, liabilities, owners’ equity, revenues, and expenses are presented at amounts that are determined in accordance with generally accepted accounting principles.
• Presentation and Disclosure–Accounts are described and classified in the financial statements in accordance with generally accepted accounting principles and all material disclosures are provided.
• Accuracy – Amounts and other data relating to recorded transactions have been recorded properly.
• Cutoff – Transactions have been recorded in the proper accounting period.
All these assertions can be alternatively categorized into three broad categories as below.
• Occurrence — the transactions actually took place.
• Completeness — all transactions that should have been recorded have been recorded.
• Accuracy — the transactions were recorded at the appropriate amounts.
• Authorization — all transactions were properly authorized.
• Cutoff — the transactions have been recorded in the correct accounting period.
• Classification — the transactions have been recorded in the proper accounts.
ii Accounts balances
• Existence — assets, liabilities and equity balances exist.
• Rights and Obligations — the entity holds or controls the rights to its assets and owes obligations to its liabilities.
• Completeness — all assets, liabilities and equity balances that should have been recorded have been recorded.
• Valuation and Allocation — assets, liabilities and equity balances are included in the financial statements at appropriate amounts and any resulting valuation or allocation adjustments are appropriately recorded.
iii Presentation and disclosure
• Occurrence — the transactions have occurred.
• Rights and Obligations — the transactions pertained to the entity.
• Completeness — all disclosures that should have been included in the financial statements have been included.
• Classification and Understandability — financial statements are appropriately presented and described, and information in disclosures is clearly expressed.
• Accuracy and Valuation — financial and other information is disclosed fairly and at appropriate amounts.
The auditor’s attitude to each item in the accounts will be to identify the express and implied assertions made by directors or management in including the item in the accounts. The other is that the auditor must evaluate each assertion for relative
importance to assess quality and quantity of evidence required; the auditor will collect the evidence and all information necessary to conduct the audit.
Types of Audit Evidence
The following are the types of audit evidence.
• Physical evidence: This is evidence that can actually be seen by auditors. This involves examination of physical assets, witnessing the internal control and bookkeeping procedures being carried out. This type of evidence is generally effective for supporting the existence assertion.
• Third-party representations: These are testimonies from independent third parties. They include third party representations, debtors’ circularization confirmations, lawyers’ letters and reports of specialists.
• Documentary evidence: These are findings from documentation of items recorded in the accounts; this demonstrates that a transaction occurred. Confirmation that items recorded in the supporting documentation are recorded in the accounting records supports completeness.
There are three basic types of documentary evidence. There are those documents created by outside parties and transmitted directly to auditor like bank statements; those created by outside parties and held by client like share certificates, title deeds, loan certificates, leases, contracts, franchises and invoices; those created and held by client like policy documents, copy invoices and minutes of meetings and electronic documents.
• Re computations: This is the results obtained from checking of arithmetic accuracy of client records. Computations are performed independently by auditor and are used to verify mathematical accuracy of client’s analyses and records.
• Results of data interrelationships: Data interrelationships (i.e., analytical procedures) rely on plausible relationships among financial and non-financial data. These are effective for testing reasonableness of certain account balances and can be used as primary or corroborating evidence, depending on the nature of account.
• Client representations: These are oral and written client representations. Responses to questions and inquiries to clients during an audit constitute audit evidence. Oral representations are generally not sufficient as primary evidence, but may provide corroboration for other evidence. Written representations (representation letter) are required, but should not be used as a substitute for other audit procedures.
• Accounting records: Clients’ accounting records (e.g. ledgers and journals) may provide worthwhile evidence in themselves. This can also include checking the internal control system of the client.
• Results of inspection of assets: Inspection of assets that are recorded in the accounting records confirms existence and also gives evidence about valuation. When an asset is recorded in the accounts, it gives evidence of completeness.
• Reconciliations: Checking the reconciliations of client’s control account can provide evidence of completeness.
• External events: The auditor should use his knowledge of current events in assessing company’s accounts, for example, considering the value of overseas subsidiaries.
1.2 Qualities of audit evidence
Auditors are required to obtain sufficient, appropriate (valid or reliable) audit evidence to be able to draw reasonable conclusions on which to base the audit opinion.
(a) Sufficiency or persuasiveness of audit evidence
Sufficiency of audit evidence is the measure of the quantity of the audit evidence. There are a number of factors affecting auditor’s judgement about what is sufficient audit evidence. The following are the factors.
(iii) The auditor’s knowledge of the business and its industry. If the auditor knows the client and the industry of the client, he/she can collect enough evidence.
(iv) The degree of audit risk. Audit risk is the risk that auditors may give an inappropriate opinion on the financial statements. In order to reduce this risk the auditor should collect a lot of audit evidence. Assessment of audit risk is done by considering nature and materiality of items in the accounts; for example, inventory is material and difficult to measure. Furthermore there is auditor’s experience of the reliability of the management and staff and the records. The financial position of the client and possible management bias can also affect audit risk.
(v) The persuasiveness of the evidence. This refers to the nature of the evidence and whether it will influence the auditor to use it or not.
(vi) The nature of the accounting and internal control system. Weak accounting and internal control system will influence auditors to obtain large amount of evidence.
(b) Appropriateness or reliability or validity of audit evidence
Appropriateness of audit evidence is the measure of the quality and reliability of the evidence. Reliability can be measured based on the following factors, which are also known as the generalizations of audit evidence.
(i) Documentary evidence. This is more reliable than oral evidence.
(ii) Evidence from outside the enterprise is more reliable than that secured from within the enterprise.
(iii) Evidence originated by the auditor is more reliable than the one obtained from others.
(c) Relevance of audit evidence
(d) Usefulness of audit evidence
The evidence collected should support the goals and objectives of the audit exercise.
Basic techniques for collecting audit evidence
Audit technique refers to a method and means adopted by the auditor for collection and evaluation of audit evidence in different situations.
The following are the audit techniques for collecting audit evidence.
Physical examination and count:
• This involves examining assets to determine their existence and valuation like inventory.
• Watching a procedure (e.g. physical inventory counts, distribution of wages, opening of mail)
• Limited to the point in time when the observation takes place
• The person performing the procedure may act differently when being observed Enquiry:
• Seeking information from knowledgeable persons inside or outside the entity,
• Evaluating responses to those enquiries, and corroborating those responses with other audit evidence
• External confirmation, a specific type of enquiry that involves seeking confirmation from a third party (e.g. a bank or trade receivable)
• Checking the mathematical accuracy of documents or records (e.g. adding up the list of year-end trade receivables)
• Independently carrying out procedures or controls, which were originally performed by the client (e.g. reperforming the aging of year-end trade receivables)
• Evaluating and comparing financial and/or non-financial data for plausible relationships and investigating unexpected fluctuations for example, comparing last year’s gross profit percentage to this year’s and ensuring any change is in line with expectations
1.3 Reliance on Others’ Work
Using the Work of an Auditor’s Expert (ISA620)
An expert is a person or firm possessing special skills, knowledge and experience in a particular field other than accountancy and auditing (for example; lawyers, engineers, chemists etc.). Accountant/auditors are highly trained and experienced in their field but may have limited knowledge in other fields. An expert may be engaged by the client to provide specialized advice on certain matters, or may be engaged by the auditor to help obtain certain evidence and assurance on certain matters regarding financial statements.
Experts may be engaged to help in matters such as;
• Valuation of certain types of assets such as land and buildings or plant and machinery.
• Determination of quantities or physical condition of assets such as stocks.
• Determination of amounts using specialized methods and techniques such pensions and actuaries.
• Measurement of work completed and work in progress on contracts.
• Offering professional opinion such as legal opinion etc.
When planning to use the work of an expert the auditor should assess the need, materiality of the matter and the risk associated with the work of an expert. The auditor should also consider the following factors;
• Expert’s professional competence in his field, by assessing professional qualification, experience and resources of the expert.
• Independence of the expert from the client company, by assessing whether he is an employee or not, or related in some way to the company. More independent experts are preferable.
• The expert’s scope and quality of work, which can be carried out by assessing; assumptions and techniques used and data sources, and the results of the expert’s work in light of the auditor’s knowledge of the business of the client and the results obtained by auditor’s other procedures.
Note: Even if an auditor relies on expert’s work, he is still responsible for the overall assessment and conclusion of the audit. The auditor should not make any reference to the work of experts in his overall conclusion. If there were any problems in the work of an expert’s work on which the auditor placed reliance, it is the auditor who will be answerable (refer to detection risk)
1.4 Using the work of Internal Auditors (ISA 610 -Revised)
When planning the audit procedures auditors should consider the presence and activities of internal audit. He should assess their effect, if any, on the external audit work. While the external auditor is still responsible for the overall audit opinion, he may rely on some of the internal audit work to complement his.
An internal audit is an appraisal or monitoring function or activity established within an entity to examine, evaluate and report to management on the adequacy and effectiveness of accounting systems and internal controls. This is a non-statutory yet important function for achieving one of the corporate governance objectives, especially in large companies. It is mostly an established department within an entity, but the service may also be outsourced from external firms.
Scope of Internal Audit in an Entity
The scope of internal audit may vary widely but normally include the following activities;
• Review of accounting systems and internal controls for adequacy and effectiveness.
• Examination of financial and operational information for accuracy and reliability.
• Review of economy, effectiveness and efficiency of business operations.
• Review the entity’s compliance with laws and regulations.
• Carry out special investigations as may be required by management from time to time (i.e., investigations into suspected fraud)
Factors to Consider When Relying on Internal Audit Work
Reliance on some of the internal audit work might reduce the procedures the external auditor would carry out to form conclusions. When planning to rely on internal audit work on certain matters as source of evidence to form these conclusions, the external auditor should assess the need, materiality of the matter and the risk associated with it. This is so because as noted with experts’ work, the external auditor will still be responsible for any work they rely on internal auditors. The following are some of the factors to be considered by the external auditor when placing reliance on internal audit work;
i. Organizational Status
Consider to whom internal auditors report (preferably to the board of directors or audit committee of the board) and whether there exist some restriction to their work. This would enhance or affect their operational independence.
ii. Scope of the Function
Consider the extent and nature of their assignment performed and actions taken by management to assess the internal audit effectiveness in the entity.
iii. Technical Competence
Assess whether internal auditors are properly qualified and experienced through checking their membership of professional bodies such ACCA, the Institute of Internal Auditors (IIA) and other relevant bodies.
iv. Due Professional Care
Assess whether internal audit work is properly carried out such as; planning, supervision, review and documentation and the quality of their internal audit reports
A service organization is an organization, person or firm that provides services to another organization. In modern business environment most organizations outsource some of their non-core services or activities to outside firms such as; security, sanitation, accounting, information technology, legal etc. instead of employing their own staff to do them. This is done through established contracts with the outsourced firms. This can be considered at two levels;
• Where the firm’s services are limited to recording and processing clients transactions to the clients while the client retains authority over them (i.e., accounting services, tax compilation etc.).
• Where firms execute transactions and maintain accountability over them (i.e., most legal services and audit services)
Therefore the auditor should determine the significance of the service organization or firm’s activities to the client and their relevance to the audit, and how he would obtain evidence from them if necessary, especially in the second case above, such as reports and direct confirmations including, with permission from the client, communicating directly with service organizations auditors. Care should however be exercised to avoid noncompliance or contravention of the professional duty of confidentiality. The auditor is again still responsible for his conclusions even where some of the information was obtained from client’s service organizations or their auditors.
Auditors are required to prepare on a timely basis audit documentation that; provides a sufficient and appropriate record of the basis of the audit report, and evidence that the audit was performed in accordance with standards and regulatory requirement (the Companies Act)
Audit documentation is the record of audit procedures performed, relevant audit evidence obtained and conclusions reached. The term ‘working papers’ or ‘work papers’ are also sometimes used.
Documentation should be in form of audit working papers, which are a record of audit procedures performed and relevant audit evidence obtained and conclusions reached. Audit working papers should always be sufficiently complete and detailed to enable the reporting partner with no previous connection with the audit to subsequently ascertain from them what work was performed and to support the conclusions reached.
Importance and purpose of Documentation
(a) It provides evidence of the auditor’s basis for a conclusion about the achievement of the overall objective.
(b) It provides evidence that the audit was planned and performed in accordance with ISAs and other legal and regulatory requirements.
(c) It assists the engagement team to plan and perform the audit.
(d) It assists team members responsible for supervision to direct, supervise and review audit work
(e) It enables the team to be accountable for its work
(f) It allows a record of matters of continuing significance to be retained for future reference.
(g) It enables the conduct of quality control reviews and inspections (both internal and external).
(h) To ensure work delegated by the reporting partner has been properly performed.
The only source is detailed working papers prepared by the audit staff. (i) They encourage the auditor to adopt a methodical approach.
1.5.1 Form and content of working papers
The ISA requires working papers to be sufficiently complete and detailed to provide an overall understanding of the audit. Auditors cannot record everything they consider. Therefore judgement must be used as to the extent of working papers, based on the following general rule:
Good audit documentation is one that “would be necessary to provide an experienced auditor, with no previous connection with the audit, with an understanding of the work performed, the results of audit procedures, audit evidence obtained, significant matters arising during the audit and conclusions reached”.
1.5.2 Factors affecting form and content of audit work papers The form and content of working papers are affected by matters such as:
• The size and complexity of the entity
• The nature of the audit procedures to be performed
• The identified risks of material misstatement
• The significance of the audit evidence obtained
• The nature and extent of exceptions identified
• The need to document a conclusion or the basis for a conclusion not readily determinable from the documentation of the work performed or audit evidence obtained
• The audit methodology and tools used
1.5.3 Examples of working papers
• Information obtained in understanding the entity and its environment, including its internal control, such as the following:
i. Information concerning the legal documents, agreements and minutes
ii. Extracts or copies of important legal documents, agreements and minutes
iii. Information concerning the industry, economic environment and legislative environment within which the entity operates. iv. Extracts from the entity’s internal control manual
• Evidence of the planning process including audit programs and any changes thereto
• Evidence of the auditor’s consideration of the work of internal audit and conclusions reached
• Analyses of transactions and balances
• Analyses of significant ratios and trends
• Identified and assessed risks of material misstatements
• A record of the nature, timing, extent and results of audit procedures
• Evidence that the work performed was supervised and reviewed
• An indication as to who performed the audit procedures and when they were performed
• Details of audit procedures applied regarding components whose financial
statements are audited by another auditor
• Copies of communications with other auditors, experts and other third parties
• Copies of letters or notes concerning audit matters communicated to or discussed with management or those charged with governance, including the terms of the engagement and material weaknesses in internal control
• Letters of representation received from the entity
• Conclusions reached by the auditor concerning significant aspects of the audit, including how exceptions and unusual matters, if any, disclosed by the auditor’s procedures were resolved or treated.
• Copies of the financial statements and auditors’ reports
• Notes of discussions about significant matters with management and others
• In exceptional circumstances, the reasons for departing from a basic principle or essential procedure of an ISA and how the alternative procedure performed achieve the audit objective
The auditor should record the identifying characteristics of specific items or matters being tested. Firms should have standard referencing and filing procedures for working papers, to facilitate their review.
1.5.4 Types of Audit files
For recurring audits, working papers may be split between permanent audit file and current audit file.
Permanent audit file
Permanent audit files (containing information of continuing importance to the audit). These contain:
• Engagement letters
• New client questionnaire
• The memorandum of association
• Articles of association
• Other legal documents such as prospectuses, leases, sales agreement
• Details of the history of the client’s business
• Board minutes of continuing relevance
• Previous years’ signed accounts, analytical review and management letters
• Accounting systems notes, previous years’ control questionnaires
Current audit files
Current audit files contain information of relevance to the current year’s audit. These should be compiled on a timely basis after the completion of the audit and should contain:
• Audit programmes
• Risk assessments
• Sampling plans
• Analytical review
assembled, the auditor should document:
• Who made the changes, and when, and by whom they were reviewed
• The reasons for making changes
• The effect of changes on the auditors’ conclusions
If, in exceptional circumstances, changes are made to an audit file after the audit report has been signed, the auditor should document:
• The circumstances
• The audit procedures performed, evidence obtained, conclusions drawn
• When and by whom changes to audit documents were made and reviewed
Working papers should be headed with the following:
• The name of the client
• The year-end date
• The file reference of the working paper
• The name of the person preparing the working paper
• The date the working paper was prepared
• The subject of the working paper
• The name of the person reviewing the working paper
• The date of the review
Working papers should also show:
• The objective of the work done
• The sources of information
• How any sample was selected and the sample size determined.
• The work done
• A key to any ticks or symbols • Appropriate cross referencing
• The results obtained
• Analysis of errors or other significant observations
• The conclusions drawn
• The key point highlighted including the need for further work.
Working papers should be clearly referenced. The referencing system used should be logical, facilitate review by enabling reviewers to be able to find their way about the audit file easily and help ensure that audit work is completely carried out and no important tasks are missed.
1.6 Review of audit working papers
Audit work performed by each assistant should be reviewed by personnel of appropriate experience to consider whether:
(a) The work has been performed in accordance with the audit plan.
(b) The work performed and the results obtained have been adequately documented.
(c) Any significant matters have been resolved or are reflected in audit conclusions.
(d) The objectives of the audit procedures have been achieved.
(e) The conclusions expressed are consistent with the results of the work performed and support the audit opinion.
When the audit work has been completed and reviewed, the audit engagement partner completes an overall review of the working papers to ensure that he is able to issue his opinion.
Throughout the audit, a system of review of all working papers will be used. In the case of a large audit, the work of assistants will be reviewed by the supervisor(s). When a review takes place, the reviewer will often use a separate working paper to record queries and their answer.
Review of audit work takes a number of different forms:
(i) Hot review (Pre –issuance review). The working papers produced by a member of the audit staff are checked by a more experienced member of the staff prior to the signing of the audit report. Such a review is usually evidenced by the reviewer initialing that particular working paper.
(ii) Cold review (Post-audit review). At the end of the audit, but before the audit report is signed, the manager or partner should review the audit file and the final accounts.
(iii) Audit review department. Some firms use a small group of experienced employees to form a review team or department. This team has the job of reviewing in detail the work performed by an audit group and ensuring that the audit has been conducted in accordance with the firm’s standard procedures.
(iv) Peer review. A system where one firm of auditors reviews the working practices of another firm and reports to the partners of the investigated firm on the ways in which their procedures might be improved.
1.7 Changes to working papers
It is necessary to modify or and add new audit documentation to a file after the audit report has been signed, the auditor should document:
• Who needs the changes, and when, and by whom they were reviewed.
• The reasons for making changes
• The effect of changes on the auditors’ conclusions
If, in exceptional circumstances, changes are made to an audit file after the audit report has been signed, the auditor should document:
• The circumstances
• The audit procedures performed, evidence obtained, conclusions drawn
• With and by whom changes to audit documents were made and reviewed
1.8 Standardised and automated working papers
The use of standardised working papers, for example, checklists and specimen letters, may improve the efficiency of audit work but they can be dangerous because they may lead to auditors mechanically following an approach without using audit judgement.
Automated working paper packages have been developed which can make the documenting of audit work much easier. Such programs aid preparation of working papers, lead schedules, the trial balance and the financial statements themselves. These are automatically cross-referenced, adjusted and balanced by the computer.
1.8.1 Advantages of automated working papers
Use of automated working papers benefits the auditor as follows • The risk of errors is reduced.
• The working papers will be neater and easier to review.
• The time saved will be substantial as adjustments can be made easily to all working papers, including those summarising the key analytical information.
• Standard forms do not have to be carried to audit locations.
• Audit working papers can be transmitted for review via a modem or fax facilities.
1.8.2 Disadvantages of standardised working papers
• It may be inappropriate to follow set procedures for a particular client.
• Adopting a standard approach may stifle initiative and discourage the exercise of professional judgement
• If audit staff adopt a ‘mechanical’ approach to completing the working papers and the audit tests this may lead to a lack of appreciation of test objectives and may lead to staff failing to appreciate the implications of errors and deviations found.
1.9 Safe custody and retention of working papers
Judgement may have to be used in deciding the length of holding working papers, and further consideration should be given to the matter before their destruction. The Malawi Company’s Act recommends seven years as a minimum period.
Working papers are the property of the auditors. They are not a substitute for, nor part of, the entity’s accounting records.
Auditors must follow ethical guidance on the confidentiality of audit working papers. They may, at their discretion, release parts of or whole working papers to the entity, as long as disclosure does not undermine ‘the independence or validity of the audit process. Information should not be made available to third parties without the permission of the entity.
2 Audit Sampling
2.1 Meaning of Audit Sampling
Audit sampling is the testing of less than 100% of the items within a population to obtain and evaluate evidence about some characteristic of that population, in order to form a conclusion concerning the population. The definition of audit sampling specifically states that “all sampling units have a chance of selection”. Thus, 100% examination and selecting specific items are clearly non-sampling procedures.
Objectives of Audit sampling
Auditors should carry out procedures designed to obtain sufficient appropriate audit evidence to determine with reasonable confidence whether the financial statements are free of material misstatements.
The words ‘reasonable’ and ‘material’ show that it is not necessary that auditors should ensure that financial statements are absolutely 100% accurate. Sampling does not provide absolute proof of 100% accuracy but it can provide reasonable assurance that some elements of the financial statements are free from material misstatements.
(i) Population: This is a set of data which may be a set of account balances or transactions.
(ii) Sampling units: These are the individual items making up the population.
(iii) Non-sampling tests: These are audit tests where no sampling is required.
Why a complete check of all balances and transactions may not be required?
The following are the reasons why sampling is justified.
(i) Economic reason: The cost in terms of expensive audit resources would be prohibitive.
(ii) Time reason: The complete check would take so long that accounts would be delayed and be irrelevant for decision making.
(iii) Practical reason: Users of accounts do not expect 100% accuracy of the accounts.
(iv) Psychological reason: A complete check would be boring to the audit staff and render their work ineffective.
(v) Fruitfulness reason: A complete check would not add much to the worth of figures if, as would be normal, few errors were discovered.
Cases where a 100% check is still necessary
(a) Categories which are few in number but of great importance e.g. land and buildings.
(b) Categories with special importance where materiality does not apply, for example, directors’ emoluments and loans.
(c) Unusual, one-off or exceptional items.
(d) Any area where the auditor is put upon enquiry.
(e) High risk areas.
Matters to consider when deciding whether to sample or not
Factors which may be taken into account in considering whether or not to sample include the following.
Material item can affect the truth and fairness of the accounts.
(b) The number of items in the population
If the items are few a hundred percent check is appropriate.
(c) Reliability of other forms of evidence
If other evidence is very strong, then a detailed check of a population may be unnecessary.
(d) Cost and time considerations
If a complete and detailed check may increase audit costs and time then sampling would help.
(e) A combination of evidence seeking methods
If the auditor has at his disposal a number of audit evidence collection methods, then sampling would be justified. To obtain the overall level of assurance required, a costeffective combination of sampling and non-sampling procedures should be determined.
Stages of audit sampling
Audit sampling goes through the following stages.
Stage 1: Planning the sample. When planning the sample the following issues are considered.
• Audit objectives: This looks at the aim of carrying out the test and the contribution it makes to the overall assessment of true and fair view.
• The population: It is important to define the population.
• The sampling unit: Consider the items that make up the population.
• The definition of error in substantive tests: For example, in stock calculations, an error of greater than K1 only may be considered an error for this purpose.
• The definition of deviation in compliance tests: The deviation may be any failure to carry out a control procedure or it may be a partial failure.
• The assurance required: This is a function of the other sources of evidence available.
• The tolerable error: This is the maximum error in the population that auditors are willing to accept and still conclude that audit objectives have been achieved. It is related to and affected by materiality considerations, assessment of control risk, and results of other audit procedures.
The essential procedure is to set a tolerable error rate and then to project the error rate in the population implied by the sampling results and then to compare the two. If the projected error is larger than the tolerable error then further auditing procedure will be necessary in the area.
• Stratification: It may be desirable to stratify the population into sub-populations and sample them separately or in some cases as high value items, do a hundred percent check.
Stage 2: Selection of the items to be tested.
Evaluating the results. This should also be done in stages:
Analyze the errors/deviations detected in relation to the planning
Use the errors/deviations detected to estimate the total error in the population. This is called projection of the errors from the sample to the
Assess the risk of an incorrect solution. This will be related to the amount of projection of error compared with tolerable error and the availability of Definitions of related terms
(a) Stratification: This is the process of dividing a population into sub-populations, each of which is a group of sampling units, which have similar characteristics often monetary value.
(b) Error: This means either control deviations, when performing tests of controls or misstatements when performing tests of details.
(c) Expected error: This is the error that the auditor expects to be present in the population.
(d) Tolerable error: This is the maximum error in the population that the auditor would be willing to accept.
(e) Anomalous error: This is an error that arises from an isolated event that has not recurred other than on specifically identifiable occasions and is not representative of errors in the population.
(f) A confidence level is the degree of assurance that material error does not exist; it is the converse of risk.
(g) Sampling risk is the risk that the sample is not representative of the population from which it is drawn and thus the auditor’s conclusion is different to that which would be reached if the whole population was examined. Sampling risk is frequently expressed as a %. For example, 5% means that there is a 1 in 20 chance of material error going undetected (this is the risk accepted by many audit firms for any specific audit tests). Risk can also be expressed in terms of confidence levels (assurance required) and reliability factors.
This may result in:
• The risk of incorrect rejection (also called Alpha risk) which arises when the sample indicates a higher level of errors than is actually the case. This situation is usually resolved by additional audit work being performed. This risk affects audit efficiency but should not affect the validity of the resulting audit conclusion.
• The risk of incorrect acceptance’ (also called Beta risk) when material error is not detected in a population because the sample failed to select sufficient items containing errors. This risk, which affects audit effectiveness, can be quantified using statistical sampling techniques. Although it is possible that an unqualified auditors’ report could be issued inappropriately, such errors should be detected by other complementary audit procedures (assuming that the sample size is appropriate to the level of detection risk).
(h) Non-sampling risk is the component of detection risk that is not due to examining only a portion of the data. Non-sampling risk is the risk which “arises from
factors that cause the auditor to reach an erroneous conclusion for any reason not related to the size of the sample”. Thus non-sampling risk can also arise, for example, if the auditor fails to recognize an error in an individual item in a sample. The auditor seeks to minimize the risk of erroneous conclusions by proper planning, supervision and review. Examples of sources of non-sampling risk include;
• Failure to investigate significant fluctuations in relationships when placing reliance on analytical procedures
• Placing reliance on management representations as a substitute for other audit evidence that could reasonably be expected to be available
• Selective testing which does not constitute audit sampling (e.g., selection of risk-prone items) is also subject to non-sampling risk.
Factors to consider when selecting a sample
The auditor should select items for the sample with the expectation that all sampling units in the population have equal chance of selection.
An audit sample should be:
• Random: Each items of the population should have an equal chance of being selected.
• Representative: The sample should be representative of the differing items in the whole population i.e. should not be biased.
• Protective of the auditor: More intensive auditing should occur on high value items known to be of high risk.
• Unpredictable: Client should not be able to guess which items will be examined.
2.2 Sampling Techniques
There are two techniques.
(a) Judgemental sampling
Judgemental sampling is the selection of a sample of appropriate size on the basis of the auditor’s judgement of what is desirable. It is also called non-statistical sampling.
Advantages of judgemental sampling
(i) Well understood and refined by experience.
(ii) His judgement and expertise can be brought into play.
(iii) No special knowledge of statistics is required.
(iv) No time is spent on mathematical calculations; all audit time is spent on auditing.
Disadvantages of judgemental sampling
(i) It is unscientific
(ii) It is wasteful because unusually large samples are taken for testing.
(iii) No quantitative results are obtained.
(iv) There may be personal bias in the selection of samples.
(v) There is no real logic in sample selection.
(vi) Vague conclusions are reached on the evidence from samples.
(b) Statistical sampling
Statistical sampling is any approach to sampling that involves random selection of a sample and use of probability theory to evaluate sample results including measurement of sampling risk.
Advantages of statistical sampling
(i) It is scientific
(ii) It is defensible (it can be justified)
(iii) It is efficient because reasonable sample sizes are taken.
(iv) It provides precise mathematical statements about probabilities of being correct.
(v) Uniform standards among different audit firms are achieved.
Disadvantages of statistical sampling
(ii) This requires highly competent audit employees that have knowledge of statistics.
(f) Multi stage sampling
This method is appropriate when data is stored in two or more levels e.g. stock in a retail chain of shops. First of all a sample of shops is randomly selected and then secondly stock items from the chosen shops are randomly selected.
(g) Block sampling
This involves choosing at random one block of items e.g.; all March invoices. This method is however not recommended because it does not have the desired characteristics.
(h) Value weighted selection ( Monetary unit sampling)
This method uses the currency unit rather than the items as the sampling population.
There are several factors which must be considered when deciding upon the sample size.
(a) Population size. The larger the population the larger the sample size.
(b) Level of confidence. Auditors work to levels of confidence which can be expressed e.g. a 95% confidence level means that there are 19 out of 20 that the sample is representative of the population as a whole. The converse view is that there is one chance in twenty that the sample is non-representative of the population as a whole.
(c) Precision. In a given sample size higher confidence can be expressed in a wider precision interval making sample size smaller.
(d) Risk. In high risks areas a large sample will be desirable because high confidence levels narrow precision intervals are required.
(e) Materiality. Materiality should be considered in fixing sample size because first populations that are material to the overall audit opinion must be sampled with smaller precision intervals and higher confidence levels. The second reason is within a population; a materiality factor can be subjectively estimated.
(f) Subjective factors. The auditor expects to gain audit evidence about a population from a sample. However other audit evidence is available in addition to the evidence from the sample.
(g) Expected error or deviation rate. Sample size required is a function of the error rate. If the results indicate that the level of error was higher than expected, a larger sample may have to be taken.
Uses of statistical sampling
Statistical sampling plans can be used in all auditing situations when evidence about a population is obtained by sampling.
Some popular uses are in compliance testing and substantive testing. In compliance testing, for example, the auditor would wish to confirm a particular control with sampling. In substantive testing, a client with very unreliable internal controls the auditor may wish to verify that all dispatches in a year have resulted in invoices in that year; the correspondence between dispatch note and invoice can be sampled.
2.3 Evaluation of Sample Results
When designing tests to be carried out on a particular account balance or class of transaction the auditor should have a pre-define error or misstatements that he wants to discover or confirm their absence, such as overstatements/understatements, miscasting, non disclosures etc. Some might be quantitative while others may be qualitative, but the auditor should consider any possible effects on other parts of the audit or the overall financial statements.
The auditor needs also to consider whether the misstatements seem to be anomalous, or they are likely to be repetitive.
Anomalous errors are errors that arise from isolated events that has not recurred other than on specifically identifiable occasion and is therefore not representative of errors in the population. Extra work has to be carried out to prove that an error is not representative of the errors in the population.
Projection of Errors in the Population
The auditor should project errors results from the sample to those expected or probable errors from the population by extrapolation. For substantive tests the auditor will estimate any further errors that might not have been detected because of the techniques. Before forming conclusions the auditor should consider the effects of the projected errors on other areas and make comparison between the projected population errors to the tolerable errors and materiality rates set earlier. If it exceeds or is close to tolerable errors, then the auditor should reassess the sampling risk. If it is unacceptable they should consider extending audit procedures or performing alternative procedures.
Sampling risk is the possibility that the auditor’s conclusion about the population based on sample results, may be different from the conclusions that could have been reached had the entire population been subjected to the same audit procedures. This may arise from two circumstances:
• Risk of incorrect rejection, that’s although the sample results support the conclusion that an account balance or class of transaction is materially misstated, it is in fact not materially misstated.
• Risk of incorrect acceptance, that’s although sample result support the conclusion that an account balance of class of transaction is not materially misstated, it is in fact materially misstated.
In statistical sampling, the auditor can use widely accepted statistical calculation to infer the possible results that are expected for the population from the sample results such as through use of proportions below:
End of Chapter Questions
The audit guidelines on planning, control and documentation contains the following statement with regard to audit working papers:
‘Audit working papers should always be sufficiently complete and detailed to enable an experienced auditor with no previous connection with the audit to subsequently ascertain from them what work was performed and to support the conclusions reached.’
a) Describe four benefits that the auditor will obtain from working papers. 8 Marks
b) List four types of information that are retained in the audit permanent file and state why they should be available for easy reference. 8 Marks
c) Comment on the problems with using standardized working papers. 4 Marks
Total 20 Marks