1. 11 - 1 Copyright  2003 Pearson Education Canada Inc. CHAPTER 11 Audit Sampling Concepts

2. 11 - 2 Copyright  2003 Pearson Education Canada Inc. What is a representative sample? A representative sample has the same characteristics as the population from which the sample was taken.

3. 11 - 3 Copyright  2003 Pearson Education Canada Inc. What can make a sample non- representative? Sampling errors occur because of the nature of sampling; the proper sampling method was selected, applied, and interpreted but failed to uncover material misstatements.

4. 11 - 4 Copyright  2003 Pearson Education Canada Inc. What can an auditor do to reduce the risk of sampling errors? increase sample size

5. 11 - 5 Copyright  2003 Pearson Education Canada Inc. What can make a sample non- representative? - sampling errors - nonsampling errors result from auditor failure to recognize errors or excep- tions or from the selection of ineffec- tive or inappropriate procedures oops!

6. 11 - 6 Copyright  2003 Pearson Education Canada Inc. What can an auditor do to reduce the risk of nonsampling errors? increase auditor competence Continuing Professional Education

7. 11 - 7 Copyright  2003 Pearson Education Canada Inc. Audit sampling can be based on: statistics OR judgment

8. 11 - 8 Copyright  2003 Pearson Education Canada Inc. nonstatistical sampling statistical sampling primary advantage: the sampling risk can be quantified primary advantage: employs auditor’s experience and judgment

9. 11 - 9 Copyright  2003 Pearson Education Canada Inc. nonstatistical sampling judgmentally select a representative sample sample selection Nonstatistical sampling employs nonprobabilistic selection - the auditor decides which population items to select.

10. 11 - 10 Copyright  2003 Pearson Education Canada Inc. nonprobabilistic selection methods - judgmental (directed sample) selection auditor selects items based on charac- teristics because random selection does not consider: ~ each type of transaction sample selection nonstatistical sampling judgmentally select a representative sample

11. 11 - 11 Copyright  2003 Pearson Education Canada Inc. nonprobabilistic selection methods - judgmental (directed sample) selection auditor selects items based on charac- teristics because random selection does not consider: ~ each type of transaction ~ each preparer of transactions sample selection nonstatistical sampling judgmentally select a representative sample

12. 11 - 12 Copyright  2003 Pearson Education Canada Inc. nonprobabilistic selection methods - judgmental (directed sample) selection auditor selects items based on charac- teristics because random selection does not consider: ~ each type of transaction ~ each preparer of transactions ~ large dollar balances sample selection nonstatistical sampling judgmentally select a representative sample

13. 11 - 13 Copyright  2003 Pearson Education Canada Inc. sample selection nonprobabilistic selection methods - block sampling - selection of a sequence and examining every item in the sequence Example: examine all cancelled cheques of February Ace Corporation 324 $ pay to the order of date nonstatistical sampling judgmentally select a representative sample CANADIAN BANK

14. 11 - 14 Copyright  2003 Pearson Education Canada Inc. nonprobabilistic selection methods - haphazard selection - auditor selects items without regard to characteristics sample selection Beware of bias! nonstatistical sampling judgmentally select a representative sample

15. 11 - 15 Copyright  2003 Pearson Education Canada Inc. statistical sampling randomly select a representative sample sample selection Statistical sampling employs probabilistic selection - every population item has a known chance of being selected.

16. 11 - 16 Copyright  2003 Pearson Education Canada Inc. statistical sampling randomly select a representative sample sample selection probabilistic selection methods - simple random sample selection used to sample populations that are not segmented for audit purposes See pg 318

17. 11 - 17 Copyright  2003 Pearson Education Canada Inc. statistical sampling randomly select a representative sample sample selection probabilistic selection methods - random number tables Know benefits & drawback Pg 318

18. 11 - 18 Copyright  2003 Pearson Education Canada Inc. statistical sampling randomly select a representative sample sample selection probabilistic selection methods - computer generation of random numbers

19. 11 - 19 Copyright  2003 Pearson Education Canada Inc. statistical sampling randomly select a representative sample sample selection probabilistic selection methods - systematic selection - the auditor cal- culates an interval, starts at random, and selects every nth item. Beware of possible bias with numeric tests, e.g., every 314th cheque is written on a Friday.

20. 11 - 20 Copyright  2003 Pearson Education Canada Inc. Audit sampling is a method used to determine the proportion of population items containing a particular attribute. Audit Sampling

21. 11 - 21 Copyright  2003 Pearson Education Canada Inc. When is audit sampling appropriate? Example: credit authorization of sales SALES INVOICE 38527 Date: Ace Company Customer: 834 Reynolds Rd. Winnipeg, MB R2V 4E3 Sales Representative: Quantity Description Price total invoice amount Terms of sale (including discounts and freight costs): Carrier: Credit authorization: tests of controls

22. 11 - 22 Copyright  2003 Pearson Education Canada Inc. - attribute - acceptable risk of assessing control risk too low (ARACR) - tolerable exception rate (TER) - estimated population exception rate (EPER) - initial sample size - exception - sample exception rate (SER) - computed upper exception rate (CUER) - considering the extent of exceptions, the worst likely population exception rate Audit Sampling Terms

23. 11 - 23 Copyright  2003 Pearson Education Canada Inc. Audit Sampling Sequence 1. State the objectives of the audit test.

24. 11 - 24 Copyright  2003 Pearson Education Canada Inc. 1. State the objectives of the audit test. Example: The auditor wants to deter- mine the acceptability of the notes re- ceivable balance of $600,000. notes receivable $600,000 acceptable? Audit Sampling Sequence

25. 11 - 25 Copyright  2003 Pearson Education Canada Inc. 1. Determine the objectives of the test. 2. Decide if audit sampling applies. Does the auditor plan to reach conclusions based on a sample? Audit Sampling Sequence

26. 11 - 26 Copyright  2003 Pearson Education Canada Inc. 1. Determine the objectives of the test. 2. Decide if audit sampling applies. 3. Define misstatement conditions. Misstatement conditions are any conditions that represent monetary fraud, errors or irregularities in the accounting records. Audit Sampling Sequence

27. 11 - 27 Copyright  2003 Pearson Education Canada Inc. 1. Determine the objectives of the test. 2. Decide if audit sampling applies. 3. Define misstatement conditions. 4. Define the population. notes receivable dollars Audit Sampling Sequence

28. 11 - 28 Copyright  2003 Pearson Education Canada Inc. 1. Determine the objectives of the test. 2. Decide if audit sampling applies. 3. Define misstatement conditions. 4. Define the population. 5. Define the sampling unit. one customer name or loan number Audit Sampling Sequence

29. 11 - 29 Copyright  2003 Pearson Education Canada Inc. 1. Determine the objectives of the test. 2. Decide if audit sampling applies. 3. Define misstatement conditions. 4. Define the population. 5. Define the sampling unit. 6. Specify tolerable misstatement. What amount of monetary fraud, error or irregularity can exist in notes receivable without causing the financial statements to be materially misstated? Audit Sampling Sequence

30. 11 - 30 Copyright  2003 Pearson Education Canada Inc. 6. Specify tolerable misstatement. based on auditor judgment Audit Sampling Sequence What amount of monetary fraud, error or irregularity can exist in notes receivable without causing the financial statements to be materially misstated?

31. 11 - 31 Copyright  2003 Pearson Education Canada Inc. 6. Specify tolerable misstatement. In the notes receivable example, tolerable mis- statement is established at $24,000 for both over- and understatements. Audit Sampling Sequence What amount of monetary fraud, error or irregularity can exist in notes receivable without causing the financial statements to be materially misstated?

32. 11 - 32 Copyright  2003 Pearson Education Canada Inc. 7. Specify acceptable risk of incorrect acceptance. What level of risk is the auditor willing to take of concluding that the account balance is not materi- ally misstated when, in fact, it is materially misstated. Audit Sampling Sequence

33. 11 - 33 Copyright  2003 Pearson Education Canada Inc. 7. Specify acceptable risk of incorrect acceptance. What level of risk is the auditor willing to take of concluding that the account balance is not materi- ally misstated when, in fact, it is materially misstated. also based on auditor judgment Audit Sampling Sequence

34. 11 - 34 Copyright  2003 Pearson Education Canada Inc. 7. Specify acceptable risk of incorrect acceptance. What level of risk is the auditor willing to take of concluding that the account balance is not materi- ally misstated when, in fact, it is materially misstated. In the notes receivable example, ARIA is established at 5%. Audit Sampling Sequence

35. 11 - 35 Copyright  2003 Pearson Education Canada Inc. 8. Estimate misstatements in the population. What is the amount of mis- statement that the auditor expects to find in the population? Audit Sampling Sequence

36. 11 - 36 Copyright  2003 Pearson Education Canada Inc. What is the amount of mis- statement that the auditor expects to find in the population? based on auditor judgment and prior year results 8. Estimate misstatements in the population. Audit Sampling Sequence

37. 11 - 37 Copyright  2003 Pearson Education Canada Inc. What is the amount of mis- statement that the auditor expects to find in the population? In the example, EPER is 1.5%; i.e., the auditor expects that 1.5% of the notes receivable balance is misstated. 8. Estimate misstatements in the population. Audit Sampling Sequence

38. 11 - 38 Copyright  2003 Pearson Education Canada Inc. 9. Determine the initial sample size. For nonstatistical sampling, professional judgment of auditor is used to determine initial sample size. Audit Sampling Sequence

39. 11 - 39 Copyright  2003 Pearson Education Canada Inc. 9. Determine the initial sample size. For statistical sampling of test of controls, population size, TER, ARACR, and EPER are all factors used to determine initial sample size. Audit Sampling Sequence

40. 11 - 40 Copyright  2003 Pearson Education Canada Inc. Audit Sampling Sequence 10. Select the sample. Nonprobabilistic: - Directed sample selection - Block sample selection - Haphazard sample selection

41. 11 - 41 Copyright  2003 Pearson Education Canada Inc. Audit Sampling Sequence 10. Select the sample. Probabilistic: - Simple random sample selection - Systematic sample selection - Probability proportionate-to-size sample selection

42. 11 - 42 Copyright  2003 Pearson Education Canada Inc. 11. Perform the audit procedures. Through confirmation of selected notes receivable balances, $1,380 of misstatements were discovered in a sample of $35,500. Audit Sampling Sequence Canada 48

43. 11 - 43 Copyright  2003 Pearson Education Canada Inc. 12. Generalize from the sample to the population. Audit Sampling Sequence Project the sample misstatement results to the population and consider sampling error and sampling risk: sample misstatement total recorded point estimate total sample pop. value of misstatement x=

44. 11 - 44 Copyright  2003 Pearson Education Canada Inc. 12. Generalize from the sample to the population. Project the sample misstatement results to the population and consider sampling error and sampling risk: In the notes receivable example: Audit Sampling Sequence sample misstatement total recorded point estimate total sample pop. value of misstatement x = $1,380 $35,500 x $600,000 = $23,324 point estimate

45. 11 - 45 Copyright  2003 Pearson Education Canada Inc. 12. Generalize from the sample to the population. Audit Sampling Sequence tolerable misstatement - point estimate = allowance for sampling error $24,000 - $23,324 = $676 The auditor must also judgmentally assess sampling error, considering several factors. The most important of these factors is the difference between the point estimate and tolerable misstatement.

46. 11 - 46 Copyright  2003 Pearson Education Canada Inc. 12. Generalize from the sample to the population. The auditor must also judgmentally assess sampling error, considering several factors. The most important of these factors is the difference between the point estimate and tolerable misstatement. In the notes receivable example: Audit Sampling Sequence tolerable misstatement - point estimate = allowance for sampling error $24,000 - $23,324 = $676

47. 11 - 47 Copyright  2003 Pearson Education Canada Inc. 13. Analyze exceptions or misstatements. evaluate the nature and cause of each misstatement Audit Sampling Sequence

48. 11 - 48 Copyright  2003 Pearson Education Canada Inc. 13. Analyze the exceptions or misstatements. evaluate the nature and cause of each misstatement This evaluation may affect the auditor’s conclu- sions regarding financial statements, client operations, and/or other areas. Audit Sampling Sequence

49. 11 - 49 Copyright  2003 Pearson Education Canada Inc. 14. Determine the acceptability of the population. Decision Rule: Considering sampling error, if the point estimate is less than the tolerable mis- statement, accept the conclusion that the book value is not misstated by a material amount. Audit Sampling Sequence

50. 11 - 50 Copyright  2003 Pearson Education Canada Inc. In the notes receivable example: Decision Rule: Considering sampling error, if the point estimate is less than the tolerable mis- statement, accept the conclusion that the book value is not misstated by a material amount. original point estimate estimate of point estimate incl. of misstatement sampling error sampling error += $23,324 + $1,500 = $24,824 judgmentally determined conclusion?

51. 11 - 51 Copyright  2003 Pearson Education Canada Inc. $24,824>$24,000 tolerable misstatement The notes receivable balance of $600,000 is not acceptable. In the notes receivable example: Decision Rule: Considering sampling error, if the point estimate is less than the tolerable mis- statement, accept the conclusion that the book value is not misstated by a material amount. original point estimate estimate of point estimate incl. of misstatement sampling error sampling error += $23,324 + $1,500 = $24,824 conclusion?

52. 11 - 52 Copyright  2003 Pearson Education Canada Inc. - take no action until tests of other audit areas are completed - perform expanded audit tests in specific areas - increase sample size - request the account balance be adjusted - request the client to correct the population - refuse to give an unqualified opinion What are the auditor’s options? book value is not acceptable

53. 11 - 53 Copyright  2003 Pearson Education Canada Inc. When an internal control is judged unacceptable, what options does the auditor have?

54. 11 - 54 Copyright  2003 Pearson Education Canada Inc. - revise the Tolerable exception rate This may be considered ethically questionable. WHY? When an internal control is judged unacceptable, what options does the auditor have?

55. 11 - 55 Copyright  2003 Pearson Education Canada Inc. - expand the sample size When is this appropriate? When an internal control is judged unacceptable, what options does the auditor have?

56. 11 - 56 Copyright  2003 Pearson Education Canada Inc. This is only appropriate if the auditor believes that the sample was not repre- sentative of the population. When an internal control is judged unacceptable, what options does the auditor have? - expand the sample size

57. 11 - 57 Copyright  2003 Pearson Education Canada Inc. - revise the assessed control risk up- ward, and increase tests of details of balances for related accounts (a/r, sales, bad debt expense, allowance for doubtful accounts) When an internal control is judged unacceptable, what options does the auditor have?

58. 11 - 58 Copyright  2003 Pearson Education Canada Inc. When an internal control is judged unacceptable, the auditor is required to communicate this weakness to management, and may inform the audit committee as well.

59. 11 - 59 Copyright  2003 Pearson Education Canada Inc. Homework 11-23 not required 11-24 not required Do only 11-25