AUDIT SAMPLING (iSA 530) Notes
QUESTION ONE
- What is audit sampling
- Distinguish between audit risk and sampling risk
- What conditions are necessary to carry out sampling?
- What are management representations and when does the auditor seek such representations?
- What should the auditor consider before relying on the work of an expert?
QUESTION TWO
in the context of iSa 530 (audit Sampling and other means of Testing), explain and provide examples of the terms ‘sampling risk’ and ‘non-sampling’ risk.
Briefly explain how sampling and non-sampling risk can be controlled by the audit firm.
QUESTION THREE
Tam Co is owned and managed by two brothers with equal shareholdings. The company specialises in the sale of expensive motor vehicles. Annual revenue is in the region of USD 7,000,000 and the company requires an audit under local legislation. About 500 cars are sold each year, with an average value of USD 14,000, although the range of values is from USD 130,000 to USD 16,000. Invoices are completed manually with one director signing all invoices to confirm the sales value is correct. All accounting and financial statement preparation is carried out by the directors. A recent expansion of the company’s showroom was financed by a bank loan, repayable over the next five years.
The audit manager is starting to plan the audit of Tam Co. The audit senior and audit junior assigned to the audit are helping the manager as a training exercise.
Comments are being made about how to select a sample of sales invoices for testing. audit procedures are needed to ensure that the managing director has signed them and then to trace details into the sales day book and sales ledger. ‘We should check all invoices’ suggests the audit manager ‘how about selecting a sample using statistical sampling techniques’ adds the audit senior. ‘Why waste time obtaining a sample?’ asks the audit junior. he adds ‘taking a random sample of invoices by reviewing the invoice file and manually choosing a few important invoices will be much quicker.’
Required:
- Briefly explain each of the sample selection methods suggested by the audit manager, audit senior and audit junior, and discuss whether or not they are appropriate for obtaining a representative sample of sales invoices.
- Define ‘materiality’ and explain why the auditors of Tam Co must form an opinion on whether the financial statements are free from material misstatement
QUESTION FOUR
Audit sampling is a technique for drawing conclusions about the characteristics of a population by testing a sample drawn therefrom. Internal and external auditors use it for both tests of controls, and substantive testing.
Required:
Describe the following:
i. Judgment sampling and statistical sampling; ii. A representative sample; iii. Tolerable error; iv. Two different methods of selecting a representative sample; v. The extrapolation of errors.
QUESTION ONE
- Audit sampling involves the application of substantive or compliance procedures to less than 100% of items within an account balance or class of transactions to be enable the auditor obtain and evaluate some characteristics of the balance and form a conclusion concerning that characteristic.
- Audit risk means the risk that the auditor gives an inappropriate audit opinion when the financial statements are materially misstated. Audit risk has three components: inherent risk, control risk and detection risk.
Inherent risk is the susceptibility of an account balance or class of transactions to misstatements that could be material assuming that there were no related internal controls
Control risk is the risk that a material misstatement that occurs in an account balance or class of transactions and that could be material will not be prevented or detected and corrected on timely basis by the accounting and internal control system.
Detection risk is the risk that auditor’s substantive tests will not detect a misstatement that exists in an account balance that could be material.
On the other hand, sampling risk arises from the possibility that the auditor’s conclusion based on the tests performed on the selected sample may be different from the conclusion that could be reached if the entire population was subjected to the same procedure.
- Conditions necessary to carry out sampling.
- The population must consist of items of the same nature and subject to the same level of risk i.e. it must be homogeneous.
- The population should cover the whole of the period under review and not just a few months.
- The population must be large enough to allow statistical methods to be used to select and evaluate a sample.
- The estimated rate of error must be low. if many errors are expected, compliance testing should be abandoned and the auditor should extent the level of substantive testing.
- management representations representations by management are a source of audit evidence normally sought from the directors at the concluding stages of an audit to confirm various matters stated in the accounts particularly those which concern questions of facts or judgment which difficult for the auditor to prove objectively. There is no need to obtain a letter of representation on bank balance as this can be approved objectively but there is need to obtain representations that all contingent liabilities have been properly stated as this is difficult to prove.
management makes various oral representations throughout the audit process in response to specific enquiries. The auditor should not rely on unsupported oral representations of management as being sufficient and reliable evidence when they relate to matters material to the financial statements. The auditor should obtain written representations from management on mattes material to the financial information when other sufficient appropriate audit evidence cannot reasonably be expected to exist.
- Factor to consider before relying on work of an expert
- The skills and competence of the expert. This is done by considering the expert’s professional qualifications, membership to appropriate professional bodies, experience and reputation in the field the auditor is seeking evidence.
- objectivity and independence of the expert. The risk of impairment increases when the expert is employed by the client or where he is related financially with the client.
- The sources of data used by the expert in arriving at his opinion. if the sources can be regarded as reliable, the auditor can reasonably use the work of the expert as audit evidence.
- The assumptions and methods used by the expert. These should be reasonable and appropriate to the circumstances.
QUESTION TWO
- Sampling risk is the possibility that the auditor’s conclusion, based on a sample, may be different from the conclusion reached if the entire population were subjected to the audit procedure.
The auditor may conclude from the results of testing that either material misstatements exist, when they do not, or that material misstatements do not exist when in fact they do.
Sampling risk is controlled by the audit firm ensuring that it is using a valid method of selecting items from a population and/or increasing the sample size.
non-sampling risk arises from any factor that causes an auditor to reach an incorrect conclusion that is not related to the size of the sample.
Examples of non-sampling risk include the use of inappropriate procedures, misinterpretation of evidence or the auditor simply ‘missing’ an error.
non-sampling risk is controlled by providing appropriate training for staff so they know which audit techniques to use and will recognize an error when one occurs.
- The audit manager suggests checking all invoices, effectively ignoring any statistical sampling; in other words this is not statistical sampling. Audit tests will be applied to all of the sales invoices. This approach may be appropriate for the audit of Tam because:
- The population is relatively small and it is likely to be quicker to test all the items than spend time constructing a sample.
- all the transactions are not large but could be considered material in their own right, e.g. compared to project. as all the transactions are material, then they all need to be tested.
The audit senior suggests using statistical sampling. This will mean selecting a limited number of sales invoices from the population using probability theory ensuring a random selection of the sample and then applying audit tests to those invoices only. This approach may be appropriate because:
- The population consists of similar items (i.e. it is homogeneous) and there are no indications of the control system failing or changing during the year. There is the query about how long it will take to determine and produce a sample, which may make statistical sampling inappropriate in this situation.
The audit junior suggests using ‘random’ sampling, which the junior auditor appears to understand as manually choosing which invoices to look at. The approach therefore involves an element of bias and is not statistical or true ‘random’ sampling. While this approach appears to save time, it is not appropriate because:
- The sample selected will not be chosen ‘randomly’ but on the whim of the auditor. Human nature will tend to avoid difficult items for testing.
- also, as invoices will not have been chosen using statistical sampling, no valid conclusion can be drawn from the results of the test. If an error is found it will be difficult extrapolating that error on to the population.
QUESTION THREE
Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements.
Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement.
It is important that the auditors of Tam ensure that the financial statements are free from material error for the following reasons:
- There is a legal requirement to audit financial statements and present an opinion on those financial statements. If the auditors do not detect a material error then their opinion on the financial statements could be incorrect
- There are only two owner/directors who will be the initial users of the financial statements. While the owners/directors maintain the accounting records, the directors will want to know if there are material errors resulting from any mistakes they may have made; the auditor has a responsibility to the members to ensure that the financial statements are materially correct.
- There are also other users of the financial statements who will include the taxation authorities and the bank who have made a loan to the company. They will want to see ‘true and fair’ accounts. The auditors must therefore ensure that the financial statements are free from material misstatement to avoid any legal liability to third parties if they audit the financial statements negligently.
QUESTION FOUR
Description
a. Judgment and statistical sampling
Judgment sampling uses the auditor’s judgment to select the number of items to be tested, which items to be tested, and to interpret the results. Statistical sampling uses probability theory to do the same. Some judgment is always used in statistical sampling in the assessment of materiality and in the determination of what constitutes tolerable error, for example. b. representative sample a representative sample is one whose characteristics are the same as, or similar to, the characteristics of the population as a whole. all sample selection methods attempt to select samples that are representative.
For example, a sample of invoices that have not been properly authorized in 5% of cases will be representative of all invoices if the population as a whole also has around 5% of invoices not authorized.
- Tolerable error
Tolerable error is the maximum error that the auditor is prepared to accept and still conclude that the audit objective has been achieved.
For example, in relation to receivables, the auditor may be prepared to form the conclusion that receivables are not materially misstated if sampling shows that the receivables population has a value that is within plus or minus, say, 5% of the figure in the financial statements.
- Different methods of sample selection
- Random selection requires the use of random number tables in order to select a representative sample.
- Haphazard selection may be deemed to approximate to random selection provided that no bias is displayed.
- Interval (or systematic) selection involves taking every nth item, starting at random. Monetary unit sampling is also a form of systematic selection.
- Block selection methods (taking one full part of the population) will probably not result in a representative selection.
- Block selection might involve obtaining confirmation of receivables from one region of the country only, for example.
- Extrapolation of errors
Errors found in a sample are extrapolated across the population as a whole, in order to enable the auditor to form a conclusion on whether the population is materially misstated. it is important to remember that there is not necessarily a direct, linear relationship between errors in samples and errors in the populations from which they are drawn.
