Chapter Eleven - Basic Audit Sampling Concepts References _——————— Auditing Standards and Other Auditing Literature ‘Auditing and Assurance Standards Council (AASC), PSA 375: Understanding the Entity and its Environment and Assessing the Risk of Material Misstatemen AASC, PSA 320; Audit Matorialty AASC, PSA 330: The Auditor's Procedures in Response to Assessed Risks AASC, PSA 500 (Revised): Audit Evidence i iene ‘AASC, PSA 530: Audit Sampling and Other Means of Te: International Auditing and Assurance Standards Board, 2008 JAASB Handbook International Auditing and Assurance Standards Board, 2014 AASB Handbook i Books Cabrera, Elenita B. Principles of Auditing, 2001. Ricchiute, David N, Auditing and Assurance Services 7e, 2003 Santos, Petroniio S, Basic Auditing: Theory and Concepts, 2002 : Taylor, Donald H. and G. William Glezen, Auditing: An Assertians Approach, 7e, 1997 y Whittington, ©: Ray and Kurt Pany, Principles of Auditing 1fe a Websites Activity-Based Risk Evaluation Model (ABREMA) — by the Australian Educational Research Pty Ltd (AER) — Official Website (www.abrema.net/abrema) Discussion Questions 1. Whatis audit sampling? 2. Define the following terms: a. Error in the context of tests of controls b. Error in the context of substantive tests 3. What are the two components of detection risk? Explain each component briefly. 4. Can you eliminate sampling risk? Explain. 5. Describe the relationship between sampling risk and sample size. 6. How is non-sampling risk reduced? 7. In tests of controls, there are two types of sampling risk. For each type, give @ short description and identify whether it affects audit efficiency or audit effectiveness. 8. In substantive tests, there are two types of sampling risk. For each type, give a short description and identify whether it affects audit efficiency or audit effectiveness. 9. Which one is of greater concern to the auditor: risk affecting audit effectiveness ar risk affecting audit efficiency? Explain. 10. What are the risk considerations In obtaining audit evidence? 11. Enumerate the different means of selecting items for testing. - What are the two general approaches to audit sampling? Explain briefly,f. Perform the Sampling plan. g- Evaluate sample results, h. Comply with documentation requirements. 7. Discuss the substantive (on Prejection techniques for sampling in ‘antive tests. The common sampli ~ Projection techniques used for eee ayn tests are: difference estimation and ratio estimated total ne eiee_ estimation is used to measure the is'both airecord palsteriene amount in a population when there sample. Ratio Seer value and an audited value for each item in the that chia ae imation is similar to difference estimation except ctsraneot estimate of the population misstatement is times the t PE Ce ng. the portion of sample amount misstated ee ‘otal recorded population book value. Under mean-per- unit estimation, the auditor is concerned with the audited value rather than the misstatement amount of each item in the sample. 8. Define PPS sampling. In PPS sampling, the auditor randomly selects individual pesos from a population and then audits the balances, transactions, or documents - called logical units - that include the pesos selected. Each peso in the population has an equal chance of being selected, but the likelihood of selecting any ‘one logical unit for testing is directly proportional to its size. 9. Identify other sampling considerations. PSA 530 (Redrafted) includes the following considerations when performing audit sampling: a. Nature and causes of errors b. Projecting errors c. Evaluating sample results Important Terms. and Concepts. 100% Examination Population = ‘Anomaly Attribute Attributes sampling plan Audit risk. ‘Audit sampling Block selection Control risk Detection risk eviation jiference estimation Probability-proportional-to-size (PPS) Projection Random-number sampling Ratio estimation e Risk of assessing control risk too high Risk of assessing control risk too low Risk of incorrect acceptance Risk of incorrect rejection Risk of material misstatement ‘Sampling risk ‘Sampling unit Selecting specific items Sequential sampling Statistical sampling Stratification Systematic sempiing Total error Value-weighted selection ‘Variables sampling plan 427 RAEREDES 2 Sar) FSummary of Learning Objectives 1, Define audit sampling. Audit sampling (sampling) involves the : application of audit procedures to less than 100% of items within a class of transactions or account balance such that all sampling units have a chance of selection. 2. Explain the different risk considerations in obtaining audit . evidence. When testing less than 100% of the items in a population, the audit is subject to sampling risk. Even if the auditor tests 100% of the population, the auditor still has to contend with non-sampling risk. AS a rule, sampling risk is reduced by increasing the sample size, while non-sampling risk is reduced through proper planning and supervision of the audit work. Sampling risk may apply to tests of controls (risk of overreliance and risk of underreliance) and to substantive tests (risk of incorrect rejection and risk of incorrect acceptance). 3. Differentiate statistical from mon-statistical sampling. Statistical sampling involves the use of probability theory allows for the measurement of sampling risk. Non-statistical sampling relies on subjective judgment to determine sample size and evaluate sample results. 4. Discuss sampling approaches ‘and other means of testing. Sampling approaches may be statistical or non-statistical. Other means of testing include 100% examination, selecting specific items, or audit sampling. 5. Illustrate sampling for tests of controls. Sampling for tests of controls Usually involves the use of an attribute sampling plan. Under this plan, the following procedures are performed: a. Determine the objective(s) of the test. b. Define the attribute and deviation conditions. c. . Define the population. d. Choose an audit sampling approach / technique. @. Determine the sample size and sample selection method. f. Perform the sampling plan. g. Evaluate sample results. h. Comply with documentation requirements. 6. Illustrate sampling for substantive tests. Sampling for substantive tests usually involves the use of a variable sampling plan. Under this plan, the following procedures are performed: _ a. Determine the objective(s) of the test. @ and sample selection method.Auditing and Assurance Principles Evaluating the Sample Results Be: aren should evaluate the sample results to determine whether the assessment of the relevant characteristic of the Population is confirmed or needs to be revised’, In the case of tests of controls, an unexpectedly high sample error rate may lead to an increase in the assessed risk of material misstatement, unless further audit evidence substantiating the initial assessment is obtained. In the case of tests of detalls, an unexpectedly high error amaunt in a sample may cause the auditor to believe that a class of transactions or account balance is materially misstated, in the absence of further audit evidence that no material misstatement exists. If the total amount of projected error plus anomalous error is less than but close to that which the auditor deems tolerable, the auditor considers the persuasiveness of the sample results in the light of ather audit procedures, and may consider it appropriate to obtain additional audit evidence, The total of projected error plus anomalous error is the auditor’s best estimate of error in the population. However, sampling "results are affected by sampling risk, Thus when the best estimate of error is close to the tolerable error, the auditor recognizes the risk that a different sample would result in a different best estimate that could exceed the tolerable error. Considering the results of other audit procedures helps the auditor to assess this risk, while the risk is reduced if additional audit evidence is obtained. If the evaluation of sample results indicates that the assessment of ‘the relevant characteristic of the population needs to be revised, the auditor ma |. Request management to investigate identified errors and the potential for further errors, and to make any necessary \djustments; and/or ify the nature, timing and extent of further audit procedures. example, in the case of tests of controls, the auditor might d the sample size, test an alternative control or modify substantive procedures; and/or the effect on the audit report. 425Chapter Eleven ~ Basic Audit Sampling Concepts Difference estimation |. Compute for the average difference between SAV and SBV = Average or mean audited value ~ Average or mean book value = P76 - P80 Answer: Pd overstated 2, Compute for projected misstatement sire Average difference (number 1) x number of items in the population = PA x 4,800 accounts Answer: P19,200 overstated 3. Compute for the EPAV. PBY + projected misstatement 380,000 — P19,200 overstatement Answer: P360,800 Mean-per-unit (MPU) estimation 1. Compute for EPAV . = Average or mean audited value x number of items in the population = P76 x 4,800 accounts Answer: P364,800 Note: Assume that there is an allowance for sampling risk amounting to (40,000, then the EPAV would be in the range of P324,800 and P404,800. Probability-Proportiona ize (PPS) Sampling Sample selection of individual peso amounts in a population by the use of random or systematic sample selection. PPS sampling is a sampling technique that uses attribute a sampling theory to evaluate the results when a large number of transactions are captured within a single account. In PPS sampling, the auditor randomly selects individual pesos from a population and then audits the balances, transactions, ar documents - called logical units - that include the pesos selected. Each peso in the population has an equal chance of being selected, but the likelihood of selecting any one logical unit for testing is directly proportional to its size. PPS sampling is most ppropriate when no errors are expected (although it is also ropriate when one or few errors are expected); and testing for Verstatement (normally for assets and income),Ree Re eee ne €Stimation) the auditor is concerned with the Heer newe rather than the misstatement amount of each item in Rethodiisie ee for the definition of what is being measured, this esate Peuese in exactly the same manner as the difference ~The point estimate of the audited value is the average audited value of items in the sample times the population size. The computed precision interval is computed on the basis of the audited value of the sample items rather than the misstatements. The use of mean-per-unit estimation is appropri is lations do not have recorded values. PPropriate when individual populati Comprehensive example on projection of errors An extemal auditor sent out Positive’ confirmation requests to 2,000 customers. Population size is 4,800 accounts, with a total recorded value of P380,000. Presented below are the summary results of the examination of confirmation replies received from customers Book value of samples selected P159,960 Audited value of samples selected 151,360 Difference P_8,600 Average/mean book value (P159,960 = 2,000) P80 (rounded) Average/mean audited value (P151,360 ~ 2,000) P76 (rounded) Ratio estimation 1. Compute for the ratio of sample audited value to sample book value Sample Audited Value (SAV): ne P151,360 ‘Sample Book Value (SBV) 7 159,960 Answer: 94.62% or 95% (rounded) 2. Compute for the Estimated Audited Value (EAY) or estimated population audited value (EPAV) ratio x Population Book Value (PBY) 9462 x P380,000 Answer: P359,556 3. Compute for the sample misstatement AV - SBY = P151,360 — P159,960 Answer: P8,600 overstated 423Chapter Eleven — Basie Audit Sampling Concepts Projecting Errors Projections for Tests of Controls For tests of controls, no explicit projection of errors is necessary since the sample error rate Is also the projected rate of error for the population as a whole. Projections for Substantive Tests For tests of details, the auditor should project monetary errors found in the sample to the population, and should consider the effect of the projected error on the particular audit objective and on other areas of the audit. The auditor projects the total error for the Population to obtain a broad view of the scale of errors, and to compare this to the tolerable error. For tests of details, tolerable error is the tolerable misstatement, and will be an amount less than or equal to the auditor's materiality used for the Individual class of transactions ‘or account balances being audited. Anomalous Errors When an error has been established as an anomalous error, it may be excluded when projecting sample errors to the population. The effect of any such error, if uncorrected, still needs to be considered in addition to the projection of the non-anomalous errors. Stratification If a class of transactions or account balance has been divided into strata, the error Is projected for each stratum separately. Projected ! errors plus anomalous errors for each stratum are then combined ; when considering the passible effect of errors on the total class of transactions or account balance. Commonly Used Projection Techniques | Commonly used projection techniques are difference estimation, ratio estimation, and mean-per-unit estimation. } Difference estimation is used to measure the estimated total misstatement amount in a population when there is both a recorded value and an audited value for each item in the sample. This method frequently results in smaller sample sizes than any other method, and it is relatively easy to use. The use of difference estimation is appropriate when the misstatement in an account |s not affected by the book value of the item being examined. Ratio estimation is similar to difference estimation except that the point estimate of the population misstatement is determined by e portion of sample amount misstated times the total lation book value. The ratio estimates results in even es than difference estimation if the size of the jopulation is proportionate to the recorded value The use of ratio estimation is appropriate an account Is directly proportional to itsAuditing and Assurance Principles @ The direct effe statements; ang of Wentifled errors on the financial b. The effectiv audi ‘eness of internal control and their effect on the it approach when, fi for example, management override of acortra oe et ea In these c; conttols perfor’ othe auditor determines whether the tests of evidence, wheth Provide an appropriate basis for use as audit 2 er additional tests of controls are necessary, oF Whether the potential risk ‘S Of mi: Jeli Sabeeanen erect Tiss OF misstatement need to be addressed ea peebeing the errors discovered, the auditor may observe that location common feature, for example, type of transaction, lon, product line or period of time. In such circumstances, the auditor may decide to identify all items in the population that possess the common feature, and extend audit procedures in that stratum. In addition, such errors may be intentional, and may indicate the possibility of fraud Sometimes, the auditor may be able to establish that an error arises from an isolated event that has not recurred other than on specifically identifiable occasions and Is therefore not representative of similar errors in the population (an anomalous error). To be considered an anomalous error, the auditor has to have a high degree of certainty that such error is not representative of the population. The auditor obtains this certainty by performing additional audit procedures. The additional audit procedures depend on the’situation, but are adequate to provide the auditor with sufficient appropriate audit evidence that the error does not affect the remaining part of the population. One example is an error caused by a computer breakdown that Is known to have occurred on only one day during the period In that case, the auditor assesses the effect of the breakdown, for example by examining specific transactions processed on that day, and Conciders the effect of the cause of the breakdown.on, audit procedures and conclusions. Another example isvanverror that Is found to be aised by, use of an incorrect formula in calculating all Inventory Wales at one particular branch. To establish that this js an anomalous error, the auditor needs to ensure the correct formula has been used at other branches. 421 ea a omeChapter Eleven - Basic Audit Sampling Concepts 3. The auditor's required confidence level. The greater the degree of confidence that the auditor requires that the results of the sample are in fact indicative of the actual amount of error in the population, the larger the sample size needs to be. 4. The total error the auditor is willing to accept (tolerable error). The lower the total error that the auditor Is willing to | accept, the larger the sample size needs to be, } 5. The amount of error the auditor expects to find in the i population (expected error). The greater the amount of error iW the auditor expects to find in the population, the larger the sample size needs to be in order to make a reasonable estimate of the actual amount of error in the population. Factors relevant to the i auditor’s consideration of the expected error amount include the extent to which item values are determined subjectively, the Tesults of risk assessment procedures, the results of tests of i control, the results of audit procedures applied in prior periods, and the results of other substantive procedures. 6. Stratification. When there is a wide range (variability) in the monetary size of items in the population. It may be useful to group items of similar size into separate sub-populations or strata. This is referred to as stratification. When @ population can be appropriately stratified, the aggregate of the sample sizes from the Strata generally will be less than the sample size that would have been required to attain a given level of sampling risk, had one sample been drawn from the whole population. 7, The number of sampling units in the population. For large populations, the actual size of the population has little, if any, peect on sample size. Thus, for small populations, audit sampling ionten not 25 efficient as alternative means of obtaining sufficient appropriate audit evidence, (However, when using monetaty unit sampling, an increase in the monetary value of the population sampling: Sample size, unless this Is offset by @ proportional increase in materiality.) Nature and Cause of Errors The auditor should consider the sample results, the nature and cause of any errors identified, and their possible effect. on the particular audit objective and on other areas of the audit. Shen performing tests of controls, the auditor Is_ primarily r ‘with obtaining audit evidence that controls operated ely throughout the period of reliance, This Includes obtaining Tuence about how controls were applied at relevant times period under audit, the consistency with which they were nd by whom or by what means they were applied. The jveness of the operation of controls recognizes that qthe way controls are applied by the entity may occur: ich errors are identified, the ‘auditor makes specificAuditing and Assurance Principles Table 11-5 Factors Affecting ‘Sample Size for Substantive Tests Factors Effect i hate : sample size Tease in the auditor's assessment of inherent risk Increase ‘An in : An increase in the auditor's assessment of contol ask @r a jecrease in reliance on internal controls) Tnereate, ‘An increase in the use of other substantive procedures directed at the same financial statement assertion ee ‘An increase in the auditor's required confidence level (or conversely. a decrease in the risk that the auditor will conclude that a material error does not exist, when in fact it | !nsr°a8® does — risk of incorrect acceptance) ‘An increase in the total error that the auditor is willing to accept (tolerable error) Decrease ‘An increase inithe amount of error the auditor expects to find || in the population (expected error) | eee Stratification of the population when appropriate Decrease Negligible Effect ‘The number of sampling units in the population 1, The auditor's assessment of the risk of material misstatement. The higher the auditor's assessment of the risk of material misstatement, the larger the sample size needs to be. The auditors assessment of the risk of material misstatement Is affected by inherent risk and control risk. For example, if the auditor does not perform tests of controls, the auditor's risk assessment cannot be reduced for the effective operation of internal controls with respect to the particular eesertion. Therefore, in order to reduce audit risk to an acceptably iow level, the auditor needs a low detection risk and will rely more tn substantive procedures. The more audit evidence that's creained from tests of details (that Js, (the lower tha detection risk), the larger the sample size will need to be. fer substantive procedures directed at the "4 fe vrepeactin, The more the auditor is relying on other stantive procedures (tests of detalls or substantive analytical a s) to reduce to an acceptable level the detection risk particular class of transactions or account balance, the je the auditor will require from sampling ‘and, mailer the sample size can be. 419Chapter Eleven ~ Basic Audit Sampling Concepts If non-statistical sampling is used, the sample deviation rate shall be compared against the tolerable deviation rate and evaluated as follows: IfSDR=or controls may be effective (CR = Less than High) IfSDR>TDR'> controls are not effective (CR = High) Ih the above example, SDR of 4% is less than the TDR of 6%; hence, the conclusion is that the authorization controls over purchases are effective, If statistical sampling is used, the auditor must first consider the effect of sampling risk, Assume that in the above example, the appropriate allowance for sampling risk is 1%, ‘The sample deviation rate shall first be added to the allowance for sampling risk — (4% + 1%) to compute the upper deviation rate (5%). Then the upper deviation rate shall be compared against the tolerable deviation rate and evaluated as follows IUDR-=or controls may be effeetive (CR = Less than High) IfUDR> TDR > controls are not effective (UDR = High) Inthe above example, the UDR of 5% is less than the TDR of 6%; hence, the conclusion is that the authorization controls over purchases are effective. Variables Sampling The procedures for variables sampling are presented below: Determine the objective(s) of the test. Define “fair presentation” and “material misstatement”. Define the population. Choose an audit sampling approach / technique. Determine the sample size and the sample selection method. Perform the sampling plan. Evaluate sample results. ‘Comply with documentation requirements. oe OC Ue Selmer Sample size for Substantive Tests Table 11-5 presents factors that the auditor considers when fetermining the sample size for sampling in substantive audit cedures. These factors need to be considered together.a Wale 21 ting the nple k of an ditor qual, s of the e is Auditing and Assurance Principles risk assess, eee Procedures undertaken to obtain an intercat ee Control), changes in personnel or in periods and the one fesUlts oF audit procedures applied in prior Geto fates ordinae Of other audit procedures. tigh, expected assessed ish San warrant ttle, if any, “reduction of the aeiimeens of material misstatement, and therefore in such "es tests of controls would ordinarily be omitted. The auditor's re quired confidence level. The greater the degree of confidence that the auditor requires that the results of the sample are in fact indicative of the actual incidence of error in” the population, the larger the sample size needs to be. eee sampling units in the population. For large pea . the actual size of the population has little, if eny, ‘on sample size. For small populations however, audit sampling is often not as efficient as alternative means of obtaining sufficient appropriate audit evidence. Other Sampling Applications for Tests of Controls Sequential sampling is used when the! auditor,expects very few deviations within the population being tested. Underthis method, the auditor has no fixed sample size. After testing a sample, the auditor makes a decision whether to stop testing or to continue with the sampling plan (hence the name stop-or-go sempling) Discovery sampling is most appropriate when no deviations are expected within the population (thus, even a single deviation is 2 ¢ause for concern). This is normally used when the auditor suspects fraud. Discovery sampling involves the determination of 2 sample size which is sufficient to discover at least one deviation to confirm whetner fraud has. occurred. Basic example on evaluation of samples while performing tests of controls ‘An external auditor is testing the authorization controls over purchases. Accordingly, the auditor decided to sample purchase invoices and trace them to the related approved purchase orders. Suppose that the auditor decided that based on an understanding of the client's internal control and the auditor's judgment, the auditor expects that there are three purchases with improper authorization (deviations) for every 100 purchase transactions (i... expected population deviation rate is 3%): : & belicves that he can tolerate up to six deviations for every 100 purchase transactions (i-¢., tolerable deviation rate 1s 6%); control risk at a LESS THAN HIGH because \ditor assesses ‘Accordingly, the auditor & (3%) is less than the tolerable deviation the expected population deviation rate lected 100 samples and noted four deviations in the sample 417 CPE REN AS 4 UMEChapter Eleven = Basic Audit Sampling Concepts Sample Size for Tests of Controls Table 11-4 enumerates the following factors that affect the sample size for tests of controls. The following are factors that the auditor considers when determining the sample size for a test of control. These factors need to be considered together. Table 11-4 Factors Affecting Sample Size for Tests of Controls Fi Effect on actors sample size An increase in the auditor's intended reliance on accounting lncreare and internal control systems. An increase in the rate of deviation from the prescribed control procedure that the auditor is willing to accept Decrease (Tolerable deviation rate} An increase in the rate of deviation from the prescribed control procedure that the auditor expects to find in the Increase population (Expected deviation rate) ‘An increase in the auditor's required confidence level (or conversely, a decrease in the risk that the auditor will conclude that the control risk is lower than the actual control risk in the population —risk of assessing control risk too low) An increase in the number of sampling units in the | Negligible ulation. Effect Increase 1, The extent to which the risk of material misstatement is reduced by the operating effectiveness of controls. The more assurance the auditor intends to obtain from the operating effectiveness of controls, the lower the auditor's assessment of the risk of material misstatement will be, and the larger the sample size will need to be. When the auditor’s assessment of the risk of material misstatement at the assertion level includes an expectation of the operating effectiveness of controls, the auditor is required to perform tests of controls. Other things being equal, the more the auditor relies on the operating effectiveness of controls in the risk assessment, the greater is the extent of the auditor's tests of controls (and therefore, the sample size is increased). 2, The rate of deviation from the prescribed control activity the auditor is willing to accept (tolerable error). The lower the rate of deviation that the auditor is willing to accept, the larger the sample size needs to be. 3. The rate of deviation from the prescribed control activity the auditor expects to find in the population (expected error). The higher the rate of deviation that the auditor expects, the larger the sample size needs to be so as to be in a position to make a reasonable estimate of the actual rate of deviation. Factors relevant to the auditor's consideration of the expected error rate include the auditor's understanding of the business (in particular,Auditing and Assurance Principles characteristic that i c \dicates a high testing the valua igher risk of error, for example, when Bpaoe tion of accounts receivable, balances may be stratified The resul eS ranin aa St seule Procedures applied to a sample of items within PERS LO CFS cern ee ee make up that Pact conconeide: conclusion on the entire population, the auditor will eae, r the risk of material misstatement in relation to other strata make up the entire population. eres 20% of the items in a population may make up 90% of the oie balance, The auditor may decide to examine a sample of these items, The auditor evaluates the results of this sample i ae ieaches 4 conclusion on the 90% of value separately from the ie aining 10% (on which a further sample or other means of gathering audit evidence will be used, or which may be considered immaterial). file, He (7) Value-Weighted Selection ae It will often be efficient in performing tests of details, particularly ae when testing for overstatements, to identify the sampling unit as the we individual monetary units (for example, pesos) that make up 2 class of ca transactions or account balance, Having selected specific monetary me Units from within the population, for example, the accounts receivable care balance, the auditor then examines the particular items, for examp ', jadividual balances, that contain these monetary units. This approach to-defining the sampling unit ensures that audit effort is directed to the larger value items because they have @ greater chance of selection, eran result in smaller sample sizes, This approach is ordinarily used uracy insconjunction with the systematic method of sample selection and is nation most efficient when selecting items using CAATS. dures. audit audit Attributes Sampling The procedures for attributes sampling are presented below: Determine the objective(s) of the test. Define the attribute (characteristic of a control) and deviation: (absence of an attribute) conditions. PS, 3. Define the population. 4, Choose an audit sampling approach / technique. 5. Determine the sample size and the sample selection method. 6. Perform the sampling plan 7. Evaluate sample results: 8. Comply with documentation requirements. 415 a ope eaaenea 2B ESE OEChapter Eleven Basic Audit Sampling Concepts Table 11-3 Characteristics of Interest Characteristic Description of Interest The numberof times a Deviation or | deviation from the prescribed Testsofcontrols | seourrence rate | intemal control occurs in the sample. The monetary amount of Substantive tests Misstatements | misstatement in an account balance. invoices, suppliers’ statements, unmatched receiving reports or other populations that provide audit evidence of understatement of accounts payable. If the auditor intends to select payment vouchers from a file, conclusions cannot be drawn about all vouchers for the period unless the auditor is satisfied that all vouchers have in fact been filed (i.e., complete), Similarly, if the auditor intends to use the sample to draw conclusions about whether a control activity operated effectively during the financial reporting period, the population needs to include all relevant items from throughout the entire period. A different approach may be to stratify the population and use sampling only to draw conclusions about the control activity during, say, the first 10 months of a year, and to use alternative audit procedures or a separate sample regarding the remaining two months. Internally Generated Information The auditor is required to obtain audit evidence about the accuracy and completeness of information produced by the entity's information system when that information is used in performing audit procedures. When performing audit sampling, the auditor performs audit Procedures to ensure that the information upon which the audit sampling is performed is sufficiently complete and accurate. G7) Stratification Audit efficiency may be improved if the auditor stratifies a population by dividing it into discrete sub-populations which have an identifying characteristic. The objective of stratification is to reduce the variability of items within each stratum and therefore allow sample size to be reduced without a proportional increase in sampling risk. Sub-populations need to be carefully defined such that any sampling unit can only belong to one stratum When performing tests of details, a class of transaction or account balance or is often stratified by monetary value. This allows greater audit effort to be directed to the larger value items which may contain U greatest potential monetary error in terms of overstatement. rly; a population may be stratified according toa particularsly, Auditing and Assurance Principles sample syste : Syeterotc yactamined by dividing population size bY ion Is us : INO point is select eful for non-statistical sampling, statistical sampling, ed at random, it can be useful for Block selection (cluster Sampling)® This method months peas rivals eee to March. Block sampling often results in Eeslgnealwentey Sampling risk. Although a block sample could be Runbecstor ean blocks to minimize sampling risk, testing large not Use block mee i ee to be Inefficient. Thus, an auditor should unless he or she pling for either Statistical OF non-statistical sampling, Fisk, exercises considerable care in contralling sampling Haphazard sampling Haphazard sampling consists of sampling units selected without Special reasons, but also without conscious bias. for example, a haphazard sample could consist of 90 items selected simply by pulling invoices from a file of cabinet drawer. Like block sampling, haphazerd sampling may fail to select samples that are wholly representative of the population tested. Although it may be useful for non-statistical sampling, haphazard sampling is not appropriate for statistical sampling. Audit Sampling Considerations Characteristics of Interest When designing an audit sample, the auditor should consider the objectives of the audit procedure and the attributes of the population from which the sample will be drawn, The characteristic of interest depends on the type of test that will be performed on the sample selected. Appropriateness and Completeness of the Population It is important for the auditor to ensure that the population is appropriate to the objective of the audit procedure, and complete. ‘Appropriateness involves the consideration of the direction of testing. For example, if the auditor's objective is to test for overstatement of accounts payable, the population could be defined as the accounts payable listing. On the other hand, when testing for understatement of accounts payable, the population is not the accounts payable listing but rather subsequent disbursements, unpaid desirable sample selection method. 413Chapter Eleven — Basic Audit Sampling Concepts Statistical or non-statistical? The choice between a statistical and a non-statistical sampling plan is based primarily on the auditor’s assessment of the relative'costs and benefits. For example, an auditor might use non-statistical sampling if the cost of selecting a statistical random sample was deemed too high, However, an auditor might consider the cost justifiable if the related controls were critical, and a measure of sampling risk was therefore 1 deemed essential. Note that the choice between a statistical and non-statistical sampling plan is made independent of the selection of audit procedures, Audit sampling, whether statistical or non-statlstical, is merely a means for accomplishing audit procedures. Sample Selection Method The objective of audit sampling Is to draw conclusions about one ‘or more population characteristics without testing the entire population. Even with the most carefully designed sampling plan, there jis still a degree of uncertainty about whether sample results are representative of the population, A sample can be evaluated in terms ‘of probability only if the sample is randomly selected and thus free from sampling bias. If each item in a population is not given an equal chance of selection, the sample would be biased toward the population items with the greater chance of selectian. Some common methods of sample selection are presented below®: NN eee Random-Number Sampling This method utilizes “random-nUmber tables or computer- generated random numbers to select sampling units from a population. Random-number tables contain columns and rows of randomly generated digits. An auditor begins at any digit in the table - a fandom start - and proceeds along a column or row or diagonally, selecting digits corresponding to identification numbers on the sampling units (e.g., invoice numbers or check numbers). If the sampling units do not have identifying numbers, the audit assigns numbers to each population item. To minimize potential bias in starting-point selection, an auditor could periodically proceed to anew starting point while selecting the sample. Random-number sampling is appropriate both for statistical and non-statistical sampling plans. Systematic-sampling This involves selecting every n'” item from a population of Sequentially ordered items. Systematic sampling eliminates the need to establish correspondence between population items and random digits, and therefore is useful when population items lack identification bers. The number of sequential items to skip when selecting a es to PSA 530.Auditing and Assurance Principles Nal se General Approaches to Audit Samplin a led _ Statistical Sampling led Statistical rain deere plans apply the laws of(probabilitp'to aid an aildencelonte 1g an efficient sample, in measuring the sufficiency of ple ra a ined, and in evaluating the sample results. It is a Not eterre 2 iGerived tool that provides the auditor with an objective tis Becca a pressing conclusions about a population characteristic low rates PON a sample of items from the population. Table 11-2 shows to 1¢ advantages and disadvantages of statistical sampling: tor, ‘ud Table 11-2 and Advantages and Disadvantages of Statistical Sampling Advantages of Statistical Sampling 1 Itaids an auditor in determining the sample size required to meet given isk objectives Usk 2. It provides more objective audit evidence. ug 3. Itallows an auditor to measure precision, reliability, and sampling error. ae Disadvantages of Statistical Sampling. ie 1. There is a danger of accepting statistical evidence at face value, without ie sufficient skepticism, re 2, The cost of statistical sampling could exceed the benefits. ‘soy 3. Statistical sampling may be less appropriate in some cases than non- statistical sampling or other audit procedures for gathering evidence. Non-Statistical Sampling Non-statistical samplings plans rely exclusively on Gubjective) judgment to determine sample size and evaluate sample results. It is ‘an (a@umitor-derived tool] for examining a sample of items from a population: The auditor uses judgment in deciding which items should be included in the sample. It is not appropriate to use judgment in selecting items for a sample and then use statistical sampling techniques to express a conclusion about the population. Judgment sampling is preferable to statistical sampling when the auditor desires, to perform some operation on the sample items only (for example, find and correct errors). ‘A properly, designed non-statistical sampling application can provide results as effective as those from a properly designed Statistical sampling application. There is, however, one critical difference between a statistical and a non-statistical sampling applicati statistical sampling allows an auditor to measure sampling risk. Statistical sampling plans measure the risk that a sample is not representative of a population; It provides a mathematical measurement of the degree of uncertainty; non- mpling plans do not. 41]Chapter Eleven - Basic Audit Sampling Concepts ther evidence or performs additional Je, an auditor would ordinarily revise of Goods Sold is misstated if a inventory price testing revealed when the auditor considers ot audit procedures. For exampl an initial conclusion that Cost 1 physical inventory observation and i that Inventory was not misstated, and other procedures revealed ‘that Accounts Receivable and Sales were not misstated. 2. Risk of incorrect acceptance, in contrast, is the risk that a sample Supports the conclusion that a recorded account balance is not materially misstated when, unknown to the auditor, the account is materially misstated. Like the risk of assessing control risk too low in attribute sampling, the risk of incorrect acceptance relates to audit. effectiveness and is particularly. critical to’ an auditor, because incorrectly accepting 4 misstated account balance could result in financial statements that are materially misstated and therefore misleading. Non-Sampling Risk Non-sampling risk includes all aspects of audit risk not due to sampling. It includes the possibility of selecting audit procedures that are not appropriate to achieve the specific objective. For example, non-sampling risk could result from human errors, such as failing to detect errors contained within sample items or overlooking or misinterpreting errors that are detected. Several factors can serve to reduce non-sampling risk, including proper planning and supervision and encouraging effective firm-wide quality control. Risk Considerations in Obtaining Audit Evidence Sampling risk and non-sampling risk can affect the components of. the risk of material misstatement. For example, when performing tests of controls, the auditor may find no errors in a sample and conclude that controls are operating effectively, when the rate of error in the population Is, in fact, unacceptably high (sampling risk). Or there may be errors in the sample which the auditor fails to recognize (non- sampling risk). With respect to substantive procedures, the auditor may use a variety of methods to reduce detection risk to an acceptable level. Depending on their nature, these methods will be subject to ‘sampling and/or non-sampling risks. For example, the auditor may ‘choose an inappropriate substantive analytical procedure (non- mpling risk) or may find only minor misstatements in a test of is when, in fact, the population misstatement is greater than the ble amount (sampling risk). For” both tests of controls and of details, sampling risk can be reduced by increasing While non-sampling risk can be reduced by proper jing supervision and review,Auditing and Assurance Principles deviati Calera rat (iss 5 percent) than the auditor was willing Scola ie Percent), Unknown to the auditor, he or she would eo ly be assessing control risk too high because the tuc ulation deviation rate (i.c., 2 i y Rey eee (ic., 2 percent) is less than the tolerable oven Gan be concluded that assessing. control risk too nigh results 9 (doing more substantive tests than necessary). Assessing control risk ta i i poseseina contol 0 high affects the efficiency (time, effort, end Assessing control risk too high results in inefficiency: when an auditor concludes that a control is ineffective and therefore that control risk is high, he ordinarily sets a lower acceptable detection risk and expands the scope of substantive tests to compensate for the perceived control deficiency. If the expanded scope of substantive tests is unjustified, the audit will be less efficient since more substantive tests will be performed than necessary. Example — Risk of Assessing Control Risk Too Low "i If, based on an unrepresentative sample, an auditor estimated a 5 percent rate of deviation but was willing to tolerate 7 percent, and the true, but unknown, population rate was really 8 percent. In this example, the auditor would conclude that the control is effective; therefore, he or she would assess a lower level of control risk in ‘s determining the nature, timing, and extend to of substantive tests, because the sample indicated fewer deviations (i.e., 5 percent) than the auditor was willing to tolerate (7 percent). However, unknown ler to the auditor, he would actually be assessing control risk too low rts since the true population rate (j.¢., 8 percent) exceeds the tolerable he rate (7 percent). He It can be concluded that assessing control risk too low results in under-auditing (doing less substantive tests than necessary). e). Assessing control risk too low affects the effectiveness of the audit risk (j.e., errors in the financial statements may remain undetected) rue because the scope of substantive tests will be restricted under the erroneous assumption that the control is effective and control risk in low, Thus, the substantive tests may be ineffective in detecting material misstatements. Sampling Risk in Substantive Tests Two aspects of sampling risk are critical in substantive tests: 1. Risk of incorrect rejection is the risk that a sample supports the conclusion that 2 recorded account balance is materially misstated when, unknown to the ‘auditor, the account is not materially misstated. Like the risk of assessing control risk too high in attribute sampling, the risk of incorrect rejection relates to the ficiency of an audit, because an initially erroneous conclusion ‘an account balance Is misstated would ordinarily be revised aChapter Eleven = Basic Audit Sampling Concepts The risk that material errors may occur and remain undetected Ig Influenced by two categories of uncertainties: 1. Sampling risk - uncertainties related to sampling. Sampling risk arises from the possibility that the auditor's conclusion, based on sample may be different from the conclusion reached i the entire Population were subjected to the same audit procedure’, Sampling risk results from the fact that a particular audit sample may not be representative of the population tested, That is, the sample may contain disproportionately more or fewer control deviations or monetary differences than exist In the class ‘of transactions or account balance as a whole, suggesting that the Auditor's conclusions may be different if the entire population were tested. Since sampling risk can be reduced simply by increasing sample size, sampling risk varies Inversely with sample size: the greater the sample size, the smaller the sampling risk, This Felationship is quite logical, because if sample size were increaseg to Include all the items in a population, there would be no sampling and therefore no sampling risk. 2. Non-sampling risk ~ uncertainties arising from factors unrelated to sampling. Non-sampling risk includes all aspects of audit risk not due to sampling. Sampling Risk in Tests of Controls Two aspects of sampling risk are critical in test of controls: 1. Risk of assessing control risk too high (or the risk of under reliance), This is. the risk that a sample deviation rate supports assessing control risk at the maximum when, unknown to the auditor, the true deviation rate in the population supports assessing control risk below the maximum. 2. Risk of assessing contro! risktoo\low (or the risk of over reliance). This Is the risk that a sample does support assessing control risk below the maximum when, unknown to the auditor, the true deviation rate in the population supports assessing control risk at the maximum. See examples of both types of sampling risks below: Example — Risk of Assessing Control Risk Too High If, based on an unrepresentative sample, an auditor estimated a 5 Percent rate of deviation but was willing to tolerate only 3 percent, and the true, but unknown, population rate of deviation was really 2 percent. In this example, the auditor would probably conclude that the control is not effective; therefore, he would assess a higher level of control risk in determining the nature, ‘timing, and extent of substantive tesls, because the sample indicated a higher be climinated by testing 100% of the populationGate ene ene et ee 2. The risk that an m nefetiditr ice aterial errors that occur will not be detected by ection risk). Risk of Material Misstatement The risk of materi ullcwe: €rial misstatement can be illustratively shown aS Exhibit 11-1 Risk of Material Misstatement Risk of material misstatement 3 Inherent risk represents the susceptibility of an account balance to errors that, when combined with errors in other accounts, could be material and that are not monitored by related control procedures. For example, inherent risk is higher for liquid assets, such as cash, than for non-liquid assets, such as property, plant, and equipment. Because neither control risk nor inherent risk is directly controllable by an auditor, the risk that material errors will occur - the first component of audit risk - is not directly controllable by the auditor, Control risk represents the likelihood that errors could occur, and could be material when combined with errors in other accounts, but will not be prevented or detected by the entity's internal control structure. For example, control risk would be increased if an entity did not maintain effective physical controls over blank checks. Detection Risk Detection risk is the likelihood that errors could occur and could be material when combined’ with errors in other accounts, but will not be detected by the auditor's procedures. The risk that material errors will hot be detected is directly controllable by the auditor through substantive tests of details and other substantive audit procedures. Detection risk may be further subdivided into: sampling risk and non- sampling risk, Detection risk and its sub-components can be illustratively shown as follows: Exhibit 11-2 Detection RiskChapter Eleven — Basie Audit Sampling Concepts led into strata, or sub- populations, wig, separately. The term population is ys, dit sampling can be Classifieg in A population may be divid' each stratum being examined to include the term stratum. AU relation to audit procedures. Risk Assessment Procedures assessment procedures to obtain a, The auditor performs risk vironment, including its interaj tanding of the entity and its en ee sirordneny risk assessment procedures do not involve the use of audit sampling, However, the auditor often plans end performs tect i understanding of the desi f controls concurrently with obtaining an igh of controls and determining whether they have been implemented, Tests of Control Tests of controls are pt Hass an expectation of F ee the auditer's understanding of internal control, the auditor "identifies the characteristics or attributes that indicate performance of a control, as well as possible deviation conditions which indicate departures from adequate performance. The presence or absence of tributes can then be tested by the auditor. Au sampling for tests controls is generally appropriate when application of the contro! wes audit evidence of performance (for example, initials of the dit manager on a sales invoice indicating ‘credit “approval, or idence of authorization of data input to a microcomputer based data cessing system: erformed when the auditor's risk assessment perating effectiveness of controls, ibstantive Procedures Substantive procedures are concerned with amounts and are of Ewo types: tests of details of classes of transactions, account balances, and disclosures and substantive analytical procedures. The purpose of bstantive procedures is to obtain audit evidence to detect material Misstatements at the assertion level. In the context of substantive ocedures, audit sampling and other means of selecting items for sting, relate only to tests of details. When performing tests of d ls, audit sampling and other means of selecting items for testing Jathering audit evidence may be used to verify one or more Ss about a financial statement amount (for example, the of accounts receivable), or to make an independent estimate nount (for example, the value of obsolete inventories). Audit Sampling and Audit Risk he likelihood that an auditor may unknowingly feil to lion On materially misstated financial statements: lon of two components: will occur in the process by which developed (risk of _ materiAuditing and Assurance Principles to obtain sufficient a of the population wh Audit Sampling PPropriate audit e eh trate Ault evidence regarding the remainder F is material. Audit sampling i than 100% oe involves the application of aud that Phat an atoms within a ciass of eeaaG. provide the eae units have a chance of : tor with a reasonable basis on which to draw conclusions about th i le enti either a statistical or a Meter cae eee OD procedures to less or account balance election in order to The following terms are used in this chapter: 1. ‘Error — m leans elther control deviations, when performing tests of © controls, i OF misstatements, when performing tests of details. D Bs Reman difference between what was expected, based eee jocumentation of controls, and what actually . Deviations are stated in terms of percentages. b. laneeatoasi = difference between the amount computed 7 @ auditor and the amount actually recorded or reflected in the accounting records. Misstatements are presented in terms of monetary amount. Total error - the rate of deviation or total misstatement. Expected error—The error that the auditor expects to be present in the population. 4. Anomaly - an error that arises from an isolated event that has not recurred other than on specifically identifiable occasions and Is therefore not representative of errors in the population 5, Population—The entire set of data from which a sample is selected and about which the auditor wishes to draw conclusions. A population may be divided into strata, or sub-populations, with: eech stratum being examined separately. The term population is used to include the term stratum. 6. Sampling-unit - the individual items constituting 2 population, for example checks listed on deposit slips, credit entries, 6m bank EE ace sents,ileales) nvoloes wor, debtors’ sbalenices er (Al wvoueia'¥. Audit Samplin. ‘on the premise that a sample can be tive of an audit population to warrant valid and ut testing the entire population, An audit fall the items within a class of transactions, socessed for a specified period, or all the ‘an account balances, such as accounts based 405 geezVtapler Lreven = Daste Audit Sampling Concepts Selecting all items (100% examination) The auditor may decide that it will be most appropriate to ‘€xamine the entire population of items that make up a class of transactions 9, account balance (or a stratum within that population). 1999, examination is unlikely in the case of tests of controls; however, it js more common for tests of details. For example, 100% examination may be appropriate when the population constitutes a small number of large value items, when there Is a significant risk and other means do not provide sufficient appropriate audit evidence, or when the repetitive nature of a calculation or other process performeg automatically by an information system makes a 100% examination Cost effective, for example, through the use of computer-assisted audit techniques (CAATs). Selecting Specific Items The auditor may decide to select specific items from a population based on such factors as the auditor's understanding of the entity, the assessed risk of material misstatement, and the characteristics of the Population being tested. The judgmental selection of specific items is subject to non-sampling risk. Specific items selected may include those mentioned in Table 11-12 Table 11-1 Selecting Specific Items Description The auditor may decide to select specific items within a population because they are of high value, or exhibit some other characteristic, for example items that are suspicious, unusual, particularly risk-prone or that have a history of error. The auditor may decide to examine itéms whose All items over a values exceed a certain amount so as to verify a large certain amount proportion of the total amount of class of transactions or account balance The auditor may examine items to obtain information about matters such as the nature of the entity, the nature of transactions, and internal control. The auditor may use judgment to sclect and examine Specific items to determine whether or not a particular control activity ii High value or key items Ttems to obtain information ms to test control tivities ile selective examination of specific items from a class of jons or account balance will often be an efficient means of audit evidence, it does not constitute audit sampling. The audit procedures applied to items selected in this way cannot id to the entire population. The auditor considers the needCHAPTER ELEVEN BASIC AUDIT SAMPLING CONCEPTS Learning Objectives After studying this cha pter, you st 3 TONE TROE ETE eaten y ould be able to: » Ex i , ; eee a different risk considerations in obtaining audit evidence aoe Ntiate statistical from non-statistical sampling. oes sampling approaches and other means of testing. . justrate sampling for tests of controls. . . Iilustrate Sampling for substantive tests. = Discuss the common projection techniques for sampling in substantive tests. + Identify other sampling considerations. pees ene PSA 500 (Redrafted), Audit Evidence states that: When designing tests af controls and tests of details, the auditor shall-determine means: of selecting items for testing that are effective in meeting the purpose of the audit procedure’. ‘Actually, the means of selecting items for testing which are available to the auditor are: 1, Selecting all items (100% examination) 2. Selecting specific items 3. Audit sampling. The decision as circumstances, and t above means may be approprial the decision as to which mean, OT Ree an te basis Ord and audlt efficiency, the auditor needs to be Bene’ cat methods used are effective in providing sufficient Baie faaudl feuitiencesstd.-meet the objectives ef she audit procedure. to which approach to use will depend on the he application of any one ar combination of the te in particular circumstances. While or combination of means, to use is terial misstatement related to the 403