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Audit Sampling

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Title: Audit Sampling


1
Chapter 9
  • Audit Sampling Part a

2
Overview
  • Audit sampling is defined as applying audit
    procedures to less than 100 percent of a
    population in order to estimate some
    characteristic about that population
  • Typically, auditors sample to determine whether
  • A control procedure is operating effectively
    (test of controls)
  • An account balance is presented fairly
    (substantive test)
  • Fraud exists

3
Overview (continued)
  • In some cases, sampling may not be the best
    approach
  • Some audit procedures do not provide sufficient
    evidence when applied on a sample basis
  • Example auditors read minutes of all BOD
    meetings to identify related party transactions
  • Reading the minutes of a sample of BOD meetings
    would not be sufficient
  • Audit procedures that provide high quality
    evidence at low cost may be applied more
    extensively simply because its cheaper to test
    all items rather than sampling
  • Example auditors typically confirm all bank
    account balances
  • Account balances that are immaterial (or where
    the potential misstatement is immaterial) may not
    be worth sampling
  • Such accounts may be audited more efficiently
    with analytics

4
Overview (continued)
  • From the results of sampling, the auditor makes
    an inference about the underlying population
  • For this inference to be valid, the sampling
    units tested must be representative of the
    underlying population
  • The auditor needs to make four important
    decisions to ensure the sample is representative
    and to control against making an incorrect
    inference
  • Which population should be tested and for what
    characteristics? (population)
  • How many (Sample size)?
  • Which items should be included in the sample?
    (selection)
  • What inferences can be made from the sample?
    (evaluation)

5
Non-sampling and sampling risk
  • When auditors draw an erroneous inference from
    sampling, the cause is either non-sampling or
    sampling risk
  • Non-sampling Risk
  • Occurs when auditor does not appropriately carry
    out audit procedures or misinterprets results
  • Results from human error
  • Cannot be quantified
  • CPA firms try to minimize through quality control
    practices
  • Sampling Risk
  • Occurs when sample is not representative of the
    underlying population
  • Can be controlled through sample size - as sample
    size increases, sampling risk decreases
  • If the sample is 100 of the population, sampling
    risk is zero however, this is often not
    practical

6
Sampling Risks Related to Tests of Controls
  • If the sample is not representative of the
    population, the auditor may draw an incorrect
    conclusion about the effectiveness of a control
  • Auditor assesses control risk too high
  • Sample indicates control is worse than it really
    is
  • As a result, the auditor does not rely on the
    control and does more substantive testing than
    necessary
  • Assessing control risk too high does not directly
    affect audit quality, but does lead to audit
    inefficiencies

7
Sampling Risks Related to Tests of Controls
  • Auditor assesses control risk too low (worst
    type)
  • Sample indicates control is better than it really
    is
  • As a result, the auditor relies on an ineffective
    control (without realizing it's unreliable) and
    substantive testing is not rigorous as it should
    be
  • This increases the risk that material
    misstatements are not found and an incorrect
    audit opinion issued

8
Sampling Risks Related to Substantive Testing
  • If the sample is not representative of the
    population, the auditor may draw an incorrect
    conclusion about whether an account balance is
    presented fairly
  • Incorrect acceptance (worst type)
  • Sample indicates account balance is not
    materially misstated when it is
  • Auditor may issue unqualified opinion on
    materially misstated statements
  • Because of the potential costs associated with
    incorrect acceptance, auditors control for this
    risk

9
Sampling Risks Related to Substantive Testing
(Continued)
  • Incorrect rejection
  • Sample indicates account balance is materially
    misstated when it isn't
  • There are things that reduce this risk
  • Before telling client to adjust its books,
    auditor usually performs additional tests
  • If client believes account balance is correct,
    client will ask auditor to perform more tests
  • These increase probability that incorrect
    rejection will be discovered
  • Incorrect rejection affects the efficiency of the
    audit, but does not affect the fairness of the
    audited financial statements

10
Selecting a Sampling Approach
  • Auditors use both statistical and non-statistical
    sampling techniques
  • Non-statistical sampling
  • Auditor judgment used to determine sample size,
    sample selection, and evaluate sample results
  • Does not provide objective way to control and
    measure sampling risk
  • Because its subjective, results are less
    defendable in legal proceedings
  • May take less time to perform
  • Frequently used in audits of small clients

11
Selecting a Sampling Approach (Continued)
  • Statistical sampling
  • Allows auditor to statistically design an
    efficient sample, measure sufficiency of
    evidence, and evaluate sample results
  • Provides quantified measures of control procedure
    failure rates, amount of error in account
    balances, and sampling risk
  • Requires precise definitions of acceptable risk
    and sample objectives
  • Requires knowledge of statistical sampling
    methods
  • Efficient method for testing large populations

12
Testing Controls and Compliance
  • If an auditor believes a control is effective and
    plans to rely on that control, s/he must test the
    control to see if it is operating effectively
  • Attribute estimation sampling and discovery
    sampling are the statistical methods frequently
    used to test controls
  • In this context, an attribute is the
    characteristic that indicates the control is
    working effectively
  • Example the organization requires all sales on
    account be approved by the credit manager
  • Approval is evidenced by the manager's initials
    on the sales invoice
  • The manager's initials are the attribute
  • The auditor would examine sales invoices and look
    for the initials

13
Attribute Estimation Sampling
  • The appropriate sample size depends on a number
    of factors including
  • Statistical Risk (Risk of assessing control risk
    too low)
  • Risk of concluding controls are effective when,
    in fact, they are not
  • Means auditor relies on an ineffective control
    without realizing it
  • The lower the risk, the larger the sample size

14
Attribute Estimation Sampling (continued)
  • Tolerable failure rate
  • Failure rate at which auditor will determine the
    control is not operating effectively
  • Based on the importance of the control
  • If a control is crucial, the tolerable failure
    rate is set at low level
  • The lower the tolerable failure rate, the larger
    the sample size
  • Expected failure rate
  • Based on auditor's experience with the client
  • The higher the expected failure rate, the larger
    the sample size

15
Attribute estimation sampling as an audit
objective?
  • The steps to implement an attribute estimation
    sampling plan are
  • Identify the attribute to be tested and define
    conditions of failure
  • Define the population to be tested including the
    period covered by the test, sampling unit, and
    ensuring population is complete
  • Determine appropriate sample size
  • Determine effective and efficient method of
    selecting the sample
  • Select and audit sample items
  • Evaluate sample results and reach conclusion on
    audit objectives
  • Document all phases of the sampling plan

16
Attribute Estimation Sampling - Sample Size
  • The appropriate sample size depends on a number
    of factors including statistical risk, and the
    tolerable and expected failure rates
  • Other issues
  • Multiple Attributes
  • Auditors frequently test several attributes using
    the same set of source documents
  • While the sampling risk should be the same, the
    tolerable and expected failure rates may differ
    between controls
  • The result is a different sample size for each
    control
  • There are several approaches to select items for
    the sample
  • Small Populations (Appendix)
  • - If the sample is a large portion of the
    population, auditor may be able to reduce the
    sample size
  • - Use a finite adjustment factor

17
Attribute Estimation Sampling - Sample Selection
  • Once the appropriate sample size has been
    determined, the auditor must decide how to select
    sample
  • Random-based methods eliminate the possibility of
    unintentional bias in the selection process and
    help ensure the sample is representative
  • - Random number - efficient selection method if
    there is an easy way to relate random numbers to
    the population
  • Examples sales invoice number, purchase order
    number
  • Computer programs typically used to generate
    random numbers

18
Attribute Estimation Sampling - Sample Selection
(continued)
  • Systematic selection - selects every nth item in
    the population from a randomly selected starting
    point
  • Sampling interval (n) is determined by dividing
    population size by desired sample size
  • To use this method, auditor must be sure there is
    not a systematic pattern of failures in the
    population

19
Attribute Estimation Sampling - Sample Selection
(continued)
  • Haphazard selection (non-statistical method)
  • Arbitrary selection
  • Not random based
  • Judgmental sampling (non-statistical method)
  • Auditor may use judgment to select sample
  • Not random based

20
Attribute Estimation Sampling - Evaluate Sample
Results (1)
  • The auditor projects the results of sampling to
    the population before drawing a conclusion
  • If the sample failure rate is no greater than the
    expected failure rate, the auditor can conclude
    the control is as effective as expected

21
Attribute Estimation Sampling - Evaluate Sample
Results (2)
  • If the sample failure rate exceeds the expected
    failure rate, the auditor must determine whether
    the projected maximum failure rate is likely to
    exceed the tolerable failure rate
  • To do this, the auditor must determine the upper
    limit of the potential failure rate in the
    population
  • The upper limit is based on the sample failure
    rate and sample size and is adjusted upward for
    sampling error

22
Attribute Estimation Sampling - Evaluate Sample
Results (continued)
  • If the upper limit exceeds the tolerable failure
    rate, the internal control process has
    deficiencies
  • The auditor should either
  • Test a compensating control (if available)
  • Increase the rigor of the subsequent substantive
    testing
  • The auditor should also evaluate
  • The nature of the control procedure failures
    (pattern of error)
  • The effect of such failures on potential
    financial statement misstatement

23
Attribute Estimation Sampling - Evaluate Sample
Results (Continued)
  • When control failures are found, they should be
    analyzed qualitatively as well as quantitatively
  • Auditor should try to determine whether the
    failures
  • Were intentional or unintentional
  • Were random or systematic
  • Had a direct dollar effect

24
Searching for Fraud
  • Discovery sampling may be used to help identify
    potential fraud
  • Tolerable rate is set very low and expected rate
    is set at zero percent
  • Results in large sample size
  • At any point, if evidence of just one potential
    fraud is found, the auditor stops sampling and
    starting investigating to determine if fraud
    actually occurred
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