CPA REVIEW SCHOOL OF THE PHILIPPINES AT-8708 Manila AUDITING THEORY CPA Review AUDIT SAMPLING 1. “Audit Sampling” involves the application of audit procedures to less than 100% of items within an account balance or class of transactions. 2. Sampling may be statistical or nonstatistical. I. STATISTICAL SAMPLING means any approach to sampling that has the following characteristics: a) Random selection of a sample; and b) Use of probability theory to evaluate sample results. II. NONSTATISTICAL SAMPLING — A sampling approach that does not have characteristics (a) and (b). AUDIT SAMPLING PLAN refers to the procedures an auditor applies to accomplish a sampling application. It aids an auditor in forming conclusions about one or more characteristics of either a particular class of transactions or a particular account balance. 1. ATTRIBUTE SAMPLING * Applicable to tests of control. * Used to test an entity’s rate of deviation (also called rate of occurrence) from a prescribed control procedure. 2. VARIABLES SAMPLING * Applicable to substantive tests. * Most commonly used to test whether recorded account balances are fairly stated. ‘SAMPLING RISK 1, “Sampling risk” arises from the possibility that the auditor’s condusion, based on a sample may be different from the conclusion reached if the entire population were subjected to the ‘same audit procedures. 2. The confidence level (also called reliability level) is the mathematical complement of the applicable sampling risk factor. 3. Sampling risk is to be measured and controlled. The auditor controls sampling risk by specifying the acceptable level when developing the sampling plan. 4. For tests of control, sampling risk has the following aspects: a. Risk of assessing control risk too low (Risk of overreliance/Beta risk/Type II risk) * The risk that the auditor will conclude that control risk is lower than it actually is. * It affects audit effectiveness and 's more likely to lead to an inappropriate audit opinion. b._ Risk of assessing control risk too high (Risk of Underreliance/Alpha risk/Type I risk) + The risk that the auditor will conclude that control risk is higher than it actually is. + It affects audit efficiency as it would usually lead to additional work to establish that initial conclusions were incorrect. 5. For substantive tests, sampling risk has the following aspects: @. Risk of incorrect acceptance (Beta risk/Type II risk) Page 1 of 10 PagesCPAR = MANILA, AT-8708 * The risk that the auditor will conclude that a material error does not exist when in fact It does. + It affects audit effectiveness and Is more likely to lead to an inappropriate audit opinion. b. Risk of incorrect rejection (Alpha risk/Type I risk) ‘The risk that the auditor will conclude that a material error exists when in fact It does not. «It affects audit efficiency as it would usually lead to additional work to establish that initial conclusions were incorrect. NONSAMPLING RISK ‘Nonsampling risk arises from factors that cause the auditor to reach an erroneous conclusion for any reason not related to the size of the sample. For example, most audit evidence is persuasive rather than conclusive, the auditor might use inappropriate procedures, or the auditor might misinterpret evidence and fail to recognize an error. STEPS IN AN ATTRIBUTE SAMPLING PLAN 1. Define the objectives of the plan. ‘The auditor should clearly state what Is to be accomplished. 2. Define the population. For example, if an auditor's objective is to test controls designed to assure that all shipped goods are invoiced, the population would be defined as all shipping documents issued during the period, not all sales invoices. 3. Define the attribute and deviation conditions. An attributeis a characteristic of a control. For example, the supervisor's signature of approval on a document. A deviations the absence of an attribute. 4. Determine the sample size. ‘The sample size is determined by considering the following factors: a. Risk of assessing control risk too low b. Tolerable deviation rate ¢. Expected population deviation rate Risk of assessing control risk too low © There is an inverse relationship between this risk and the sample size. The higher the acceptable risk, the smaller the sample size. Because the risk of assessing control risk too low relates to the effectiveness of the audit, it is kept at a relatively low level by the auditor. Tolerable deviation rate (tolerable error) © This is the maximum deviation rate that the auditor is willing to accept. + The lower the rate of deviation that the auditor Is willing to accent, the larger the sample size needs to be. Expected population deviation rate (expected error) «The rate of deviation from the prescribed control procedure the auditor expects to find in the population. «The higher the rate of deviation that the auditor expects, the larger the sample size needs to be 50 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, procedures undertaken to obtain an understanding of the accounting and internal control systems); + Changes in personnel or in the accounting and internal control systems; + The results of audit procedures applied in prior periods; and + The results of other audit procedures. Page 2 of 10 PagesCPAR MANILA ar-s708 5. Determine the method of sample selection. ‘Some commonly used methods are: 2. Random number sampling Each item in the population has an equal chance and nonzero probability of selection. «It is usually accomplished by generating random numbers from a random number table or computer program and tracing them to associated documents or items in the population. «Its appropriate for both statistical and nonstatistical sampling. b. Systematic selection © The number of sampling units in the population is divided by the sample size to give a sampling interval, for example 50, and having determined the starting point within the first 50, each 50 sampling unit is thereafter selected. * Although the starting point may be determined haphazardly, the sample is more likely to be truly random if it is determined by use of a computerized random number generator or random number tables. + When using systematic selection, the auditor would need to determine that sampling units within the population are not structured in such a way that the sampling interval corresponds with a particular pattern in the population. ¢. Block selection (or cluster sampling) It involves selecting a block(s) of contiguous items from within the population. * It cannot ordinarily be used in audit sampling because most populations are structured such that items in sequence can be expected to have similar characteristics to each other, but different characteristics from items elsewhere in the population. «Although in some circumstances it may be an appropriate audit procedure to examine a block of items, it would rarely be an appropriate sample selection technique when the auditor intends to draw valid inferences about the entire population based on the sample. d. Haphazard selection © The auditor selects the sample without following a structured technique. * It is not appropriate when using statistical sampling. e. Stratification © This involves subdividing a population into subpopulations or strata, i.e., a group of ‘sampling units which have similar characteristics (often monetary value). «The strata must be explicitly defined so that each sampling unit can belong to only one stratum. © This method enables the auditor to direct his efforts towards the items he considers would potentially contain the greater monetary error. ._ Perform the sampling plan. ‘The sampling units selected should be examined for the attributes of interest and deviations should be documented in the working papers. . Evaluate and document results. These include: a. Determining the sample deviation rate. Sample Deviation Rate = Number of deviations observed Saniple size b. Determining the maximum population deviation rate (achleved upper deviation limit) and the allowance for sampling risk (achieved precision). ‘+ The maximum deviation rate Is based on the sample size and the number of deviations discovered. There are standard tables that yield maximum population deviation rates at specified risks of assessing control risk too low. Page 3 of 10 Pagesane, (CPAR - MANILA ara708 * Allowance for sampling risk = Maximum Deviation Rate ~ Sample Deviation Rate Considering qualitative information. ‘The auditor considers each of the deviation’s nature, importance, and probable cause. Reaching an overall conclusion. In assessing control risk, the auditor considers all available quantitative and qualitative information. COMMONLY USED ATTRIBUTES SAMPLING TECHNIQUES 1. Attribute estimation sampling A statistical sampling plan for tests of controls. Appropriate when an auditor wishes to estimate a true but unknown population deviation rate. Uses a fixed sampling plan, i.e., the auditor tests a single sample. 2. Sequential sampling (also called stop-or-go sampling) ‘The sampling plan is performed in several steps. Following each step, the auditor decides whether to stop or to go on to the next step. Appropriate when the auditor expects zero or very few deviations. 3. Discovery sampling Appropriate when the expected deviation rate Is near zero and when the auditor's objective is to find at least one deviation in a sample if the actual population deviation Fate exceeds or equals a predetermined critical rate (tolerable deviation rate). ‘STEPS IN A VARIABLES SAMPLING PLAN 1 Determine the objectives of the test. The auditor's objective is to test the reasonableness of a recorded account balance, called hypothesis testing. Define the population and sampling unit. For example, the population might consist of 1,000 accounts receivable with a reported book value of 1,500,000. Choose an audit sampling technique. a b. Statistical vs Nonstatistical : Classical Variables Sampling vs Probability-Proportional-To-Size Sampling Determine the sample size. The auditor considers the following: a Variation within the population = Sample size varies in the same direction as the variation in population amounts. AS population variation increases, so does the sample size. «An estimate of population variation Is made by determining a population standard deviation. Acceptable risk of incorrect rejection Acceptable risk of incorrect acceptance d. Tolerable error - the maximum monetary error that may exist In an account balance without causing the financial statements to be materially misstated. Determine the method of sample selection. Perform the sampling plan. Evaluate the sample results. Page 4 of 10 PagesAT-8708 a. Projecting the sample error to the population b. Considering sampling risk . Considering qualitative information dd. Reaching an overall conclusion CLASSICAL VARIABLES SAMPLING TECHNIQUES i jects the a. MEAN-PER-UNIT ESTIMATION — A classical variables sampling technique that proj sample average to the total population by multiplying the sample average by the number of items in the population. b. DIFFERENCE ESTIMATION - A classical variables sampling technique that uses the average difference between audited amounts and individual recorded amounts to estimate the total audited amount of a population and an allowance for sampling risk. ¢. RATIO ESTIMATION — A classical variables sampling technique that uses the ratio of audited ‘amounts to recorded amounts in the sample to estimate the total amount of the population and an allowance for sampling risk. Conditions for using difference and ratio estimation 1. Each population item must have a recorded book value. 2. Total population book value must be known. 3. Expected differences between audited and recorded book values must not be too rare. Choosing between difference and ratio estimation Ratio estimationis more appropriate when the differences are nearly proportional to book values. Difference estimation is more appropriate when there is little or no relationship between the absolute amounts of the differences and the book values. PROBABILITY-PROPORTIONAL-TO-SIZE SAMPLING (PPS) ‘* PPS uses a peso as the sampling unit. ‘+ PPS sampling gives each individual peso in the population an equal chance of selection. ‘* PPS is only useful for TESTS OF OVERSTATEMENTS (e.g., assets) since the sample selection method dictates that the larger the transaction or amount, the more likely that it will be selected. * PPS is inappropriate for testing liabilities because understatement is the primary audit consideration. Examples of Factors Influencing Sample Size for Tests of Control Effect on Factor ‘Sample Size ‘An increase in the auditor's intended reliance on accounting and internal control systems. Increase ‘An increase in the rate of deviation from the prescribed control procedure that the auditor is willing to accept (tolerable errav) Decrease An increase in the rate of deviation from the prescribed control procedure that the auditor expects to find in the populatich (expected error) Increase ‘An increase in the auditor's required confidence level (or conversely, a Gecrease in the risk that the auditor will conclude that the control risk 's lower than the actual control risk in the population) Increase ‘An increase in the number of sampling units in the population Negligible effect Page 5 of 10 PagesCPAR MANILA aces Examples of Factors Influencing Sample Size for Substantive Procedures Effect on Factor Sample Size ‘An increase in the auditor’s assessment of inherent risk. Increase ‘An increase in the auditor’s assessment of control risk. Increase ‘An increase in the use of other substantive procedures directed at the ‘same financial statement assertion Decrease ‘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 does exist) Increase An increase in the total error that the auditor is willing to accept (tolerable error) Decrease ‘An increase in the amount of error the auditor expects to find in the population (expected error) Increase Stratification of the population when appropriate Decrease ‘The number of sampling units in the population Negligible effect MULTIPLE CHOICE QUESTIONS 1. Audit sampling involves the ‘A. Selection of all items over a certain amount. B. Application of audit procedures to less than 100% of items within a class of transactions ‘or an account balance such that all items have a chance of selection. Application of audit procedures to all items that comprise a class of transactions or an c account balance. D. Application of audit procedures to all items over a certain amount and those that are unusual or have a history of error. 2. Population, as defined in PSA 530, means the entire set of data from which a sample is selected and about which the auditor wishes to draw conclusions. It is important for the auditor to ensure that the population is I. Appropriate to the objective of the audit procedure. Il, Complete. A. Lonly C. Both I and It B. Ilonly D. Neither I nor It 3. An advantage of statistical over nonstatistical sampling methods in tests of controls is that the statistical methods A. Afford greater assurance than a nonstatistical sample of equal size. B. Provide an objective basis for quantitatively evaluating sampling risks. C. Can more easily convert the sample into a dual-purpose test useful for substantive testing. D. Eliminate the need to use judgment in determining appropriate sample sizes. ‘The risk of incorrect acceptance and the likelihood of assessing control risk too low relate to the A. Effectiveness of the audit. B. Efficiency of the audit. C. Preliminary estimates of materiality levels. D. Tolerable misstatement. ‘The likelihood of assessing control risk too high Is the risk that the sample selected to test ‘A. Does not support the auditor's planned assessed level of control risk when the true operating effectiveness of intemal control justifies such an assessment. Page 6 of 10 Pages(CPAR = MANILA At-8708 B. Contains misstatements that could be material to the financial statements when aggregated with misstatements in other account balances of transactions classes. C. Contains proportionately fewer deviations from prescribed internal controls than exist in the balance or class as a whole. D. Does not support the tolerable misstatement for some or all of management's assertions. 6. While performing a test of detalls during an audit, the auditor determined that the sample results supported the conclusion that the recorded account balance was materially misstated. It was, in fact, not materially misstated. This situation illustrates the risk of A. Incorrect rejection C. Assessing control risk too low B. Incorrect acceptance D. Assessing control risk too high 7. Which of the following sample planning factors would influence the sample size for 2 substantive test of details for a specific account? Expected Error Tolerable Error A No No B. Yes Yes G No Yes D. Yes No ‘An underlying feature of random-based selection of items is that each A. Stratum of the accounting population be given equal representation in the sample. 8. Item in the accounting population be randomly ordered. . Item in the accounting population should have an opportunity to be selected. D. Item must be systematically selected using replacement. 9. Which of the following best illustrates the concept of sampling risk? A randomly chosen sample may not be representative of the population as @ whole on the characteristic of interest. B, An auditor may select audit procedures that are not appropriate to achieve the specific objective. C. An auditor may fail to recognize errors in the documents examined for the chosen sample. D. The documents related to the chosen sample may not be available for inspection. * 10. Which of the following statistical selection techniques is least desirable for use by an auditor? A. Systematic selection C. Block selection B. Stratified selection D. Sequential selection 11. The expected population deviation rate of client billing errors is 3%. The auditor has established a tolerable rate of 5%. In the review of client invoices the auditor should use A. Stratified sampling C. Discovery sampling B. Variable sampling D. Attribute sampling 12. Which of the following sampling methods would be used to estimate a numerical measurement of a population, such as a peso value? A. Attributes sampling CC. Variables sampling B, Stop-or-go sampling ©. Random-number sampling 13. Which of the following statements is correct concerning statistical sampling in tests of controls? A. Deviations from control procedures at a given rate usually result in misstatements at a higher rate. B. As the population size doubles, the sample size should also double. C. The qualitative aspects of deviations are not considered by the auditor. D. There is an inverse relationship between the sample size and the tolerable rate. Page 7 of 10 Pages