Chapter 4 Audit Evidence and Sampling

Chapter 4 Audit Evidence and Sampling

1.Objectives

1.1Explain the nature of audit evidence.

1.2Describe the four audit evidence decisions that the auditor must make to prepare an audit programme.

1.3Determine the factors affecting the persuasiveness of audit evidence.

1.4Describe the methods for obtaining audit evidence.

1.5Explain the concept of representative sampling.

1.6Distinguish between statistical and non-statistical sampling.

1.7Select representative samples.

Sufficiency

Appropriateness

Quality

Methods

Accumulating

Evidence

Audit

Evidence

Statistical

Non-Statistical

Approaches

Procedures

Audit

sampling

Audit

Evidence

and

Sampling

2.Audit Evidence ()

2.1

Definition

Audit evidence is the information obtained by the auditors in arriving at the conclusions on which the audit opinion is based. ()

2.2Audit evidence comprises source documents, accounting records and corroborating () information from both internal and external sources. Audit evidence is accumulated from an appropriate mix of tests of control and substantive tests.

2.3Every auditor has to determine the appropriate type and amount of audit evidence to accumulate to be satisfied that the clients financial statements are fairly presented. This judgement is important because cost of examining and evaluating all available evidence is too high. The auditors decisions on evidence accumulation involve the following aspects.

(a)Audit procedure

In deciding which audit procedures are to be used, it is common to put them down in sufficiently specific terms to be used as instructions during the audit.

(b)Sample size

Once the audit procedure is selected, it is possible to vary the sample size from one to all the items in the population being tested. The sample size for any given procedure is likely to vary from different audit assignments.

(c)Items to be selected

After the sample size has been determined for an audit procedure, it is still necessary to decide which items in the population are to be tested.

(d)Timing

An audit of financial statements usually covers a period such as a year, and an audit is usually not completed until several weeks or months after the end of the period. The timing of audit procedures can therefore vary from early in the accounting period to long after it has ended.

3.Quality of Audit Evidence

(A)Characteristics of quality audit evidence

3.1HKSA 500 states that the auditor should obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base the audit opinion.

3.2

Definition

Sufficiency () and appropriateness () are interrelated and apply to both tests of controls and substantive procedures.

(a)Sufficiency is the measure of the quantity of audit evidence. ()

(b)Appropriateness is the measure of the quality or reliability of the audit evidence. ()

3.3The auditors judgement as to what is sufficient appropriate audit evidence is influenced by a number of factors.

(a)Experience from previous audit including knowledge of business;

(b)The degree of audit risk which results from the assessment of inherent risk and control risk;

(c)The persuasiveness () of the evidence which depends on the source and reliability of the available information;

(d)Materiality of the item involved; and

(e)Results of audit procedures.

3.4Reliability of evidence

QUALITY OF EVIDENCE

External

Audit evidence from external sources is more reliable than that obtained from the entitys records.

Auditor

Evidence obtained directly by auditors is more reliable than that obtained by or from the entity.

Entity

Evidence obtained from the entitys records is more reliable when accounting and internal control system operates effectively.

Written

Evidence in the form of documents or written representation are more reliable than oral representations.

Originals

Original documents are more realistic than photocopies, or facsimiles.

3.5

Test your understanding 1

Audit evidence is obtained from an appropriate mix of control tests and substantive procedures. Sufficiency and appropriateness are interrelated and apply to audit evidence obtained from both control tests and from substantive procedures.

Required:

(a)Briefly describe sufficiency and appropriateness in the context of audit evidence.(2 marks)

(b)Will a large sample of low quality evidence be persuasive to an auditor? Give an example to illustrate your answer.(2 marks)

(c)Discuss the general consideration of reliability of audit evidence.

(5 marks)

(HKIAAT Paper 8 Auditing December 2000)

3.6

Test your understanding 2

Describe the reliability of a number of items of audit evidence relating to non-current assets. These items are:

(a)an invoice from a supplier of an item of plant to the client.

(b)a calculation of the depreciation for the year prepared by the auditor.

(c)a verbal statement from the managing director of the client that the market value of the companys factory premises amounts to $20 million.

(B)Factors affecting the persuasiveness of audit evidence

3.7The factors are as follows:

(a)Competence of evidence

Competence or reliability of evidence refers to the degree to which evidence can be considered believable.

(b)Relevance to the audit objective

Audit evidence must be relevant to the audit objective that the auditor is testing before it can be reliable. Relevance should be considered in terms of specific audit objectives.

(c)Timeliness

For example, evidence obtained from physical inventory count is usually more reliable for balance sheet value when it is obtained as close to the balance sheet date as possible.

(d)Sufficiency of evidence it is measured primarily by:

(i)adequate sample size

(ii)appropriate sampling method samples containing large value items, high likelihood of misstatements, and representative to the population are usually considered to be sufficient.

4.Accumulating Audit Evidence

(A)Use of assertions () in obtaining audit evidence

4.1HKSA 500 Audit Evidence states that the auditor should use assertions in sufficient detail to form a basis for the assessment of risks of material misstatement and the design and performance of further audit procedures.

4.2Financial statement assertions contained:

Assertions

Descriptions

Existence

An asset or liability exists at a given date.

Rights and obligation

An asset or liability pertains () to the entity at a given date.

Occurrence

A transaction or event took place which pertains the entity during the relevant period.

Completeness

There are no unrecorded assets, liabilities, transactions or events, or undisclosed items.

Valuation

An asset or liability is recorded at an appropriate carrying value.

Presentation and disclosure

An item is disclosed, classified and described in accordance with the applicable reporting framework.

(B)Method of accumulating audit evidence

4.3HKSA 500 states that the methods of collecting audit evidence include the followings:

Inspection of assets

Inspection of assets that are recorded in the accounting records confirms existence, give evidence of valuation, but does not confirm rights and obligations.

Confirmation that assets seen are recorded in accounting periods gives evidence of completeness.

Inspection of documentation

Confirmation to documentation of items recorded in accounting records confirms that an asset exists or a transaction occurred. Confirmation that items recorded in supporting documentation are recorded in accounting records tests completeness.

Inspection also provides evidence of valuation/ measurement, rights and obligations and the nature of items (presentation and disclosure). It can also be used to compare documents and confirm authorization.

Documentary Evidence

Tracing () establishing the completeness of transaction processing by following a transaction of forward through the accounting records. For example, comparing information on selected receiving reports to the purchases journals.

Vouching () establishing the existence or occurrence of recorded transactions by following a transaction back to supporting documents from a subsequent processing step (also referred to as tracing back). For example, comparing recorded purchase transactions in the purchases journal to supporting evidence such as invoices, paid cheques, and receiving reports.

Observation

Involves watching a procedure being performed (for example, attendance of stocktake by auditors).

Enquiries

Seeking information from client staff or external sources.

Confirmation

Seeking confirmation from another source of details in clients accounting records, for example, confirmation from bank of bank balances.

Computations

Checking arithmetic of clients records, for example, adding up ledger account.

Analytical procedures

()

Compare the clients gross profit margin with that of the industry average and investigate any significant differences between them.

5.Audit Sampling

5.1

Definition

Audit sampling is the subject of HKSA 530. When designing audit procedures, the auditor should determine appropriate means for selecting items for testing so as to gather audit evidence to meet the objectives of audit tests.

5.2This HKSA is based on the premise () that auditors do not normally examine all the information available to them; it would be impractical to do so and using audit sampling will produce valid conclusions.

5.3The auditor may select certain items from a population because of specific characteristics they possess. The results of items selected in this way cannot be projected onto the whole population but may be used in conjunction with other audit evidence concerning the rest of the population.

(a)High value or key items. The auditor may select high value items or items that are suspicious, unusual or prone () to error.

(b)All items over a certain amount. Selecting items this way may mean a large proportion of the population can be verified by testing a few items.

(c)Items to obtain information about the clients business, the nature of transactions, or the clients accounting or control systems.

(d)Items to test procedures, to see whether particular procedures are being performed.

(A)Considerations of audit sampling

5.4The steps of audit sampling involve the following:

(a)Design the sample:

Auditor should consider the specific audit objectives, the nature of the population from which samples are selected and the sample size when designing an audit sample.

(b)Selection of sample:

Auditor should select sample items that are the representative of the population in respect of characteristics being tested.

For example, the auditor selects specific monetary units from within the accounts receivable balances, the audit effort is directed to the larger value items because they have a greater chance of selection and can reduce the sample size.

Ideally, the auditor should select items for the sample that all sampling units in the population have a chance of being selected.

(c)Evaluation of sample results:

After the appropriate audit procedures have been applied on the samples, the auditor should analyse the errors in the sample and draw conclusions for the population as a whole.

(B)Approaches of audit sampling

5.5Two types of audit sampling:

(a)Statistical sampling uses the laws of probability to select and evaluate the results of an audit sample, therefore, the sampling risk is quantified for drawing the conclusion about the population.

(b)Non-statistical sampling (judgement sampling) the auditor considers sampling risk without using law of probability to measure it.

5.6Statistical sampling techniques are broadly categorized into:

(a)Attribute sampling ()

(i)usually applied in test of controls;

(ii)an attribute is a characteristic that each member of the population either has or does not have (or correct, not correct).

(iii)it can only show the deviations from some benchmark but cannot give the monetary effect of such deviation.

(iv)For example, no initial on the issue of credit notes to customers.

(b)Variable sampling ()

(i)commonly used in substantive procedures;

(ii)a variable is a characteristics that each member of the population has a varying amount or quantity, for example, the amounts owed by debtors.

(c)Monetary unit sampling ()

(i)the sampling unit is the individual monetary value (e.g. one dollar).

(ii)it measures whether or not an individual monetary value is in error and by how much.

(iii)the maximum amount of monetary overstatement or understatement error in the population will be expressed.

(iv)it is used as an alternative to variables sampling methods for performing substantive tests.

(C)Selecting the representative samples

(a)What is a representative sample?

5.7The characteristics of a representative sample are that the audit interest of the sample is approximately the same as that of the population.

(b)Causes of selecting non-representative samples

5.8

Definition

Sampling risks It is an inherent part of sampling that results from testing less than the entire population. Sampling risk arises from the possibility that the auditors conclusion, based on a sample, may be different from that generated from the entire population. ()

5.9The way to control the sampling risk may include:

(a)increasing the sample size will reduce sampling risk.

(b)using an appropriate sampling method will reasonably assure representativeness.

5.10There are sampling risks when an auditor carries out both tests of control and substantive procedures:

(a)Tests of control

(i)risk of under reliance () this is the risk that the assessed level of control risk based on the sample is greater than the actual compliance rate of the control.

(ii)risks of over reliance () this is the risk that the assessed level of control risk based on the sample is less than the actual compliance rate of the control.

(b)Substantive procedures

(i)risk of incorrect rejection () this is the risk that the sample supports the conclusion that the recorded transaction or account balance is materially misstated when, in fact, it is not materially misstated.

(ii)risk of incorrect acceptance () this is the risk that the sample supports the conclusion that the recorded transaction or account balance is not materially misstated when, in fact, it is materially misstated.

5.11

Definition

Non-sampling risk It is the risk of erroneous conclusions being drawn from audit procedures due to any reason other than those which give rise to sampling risk.

5.12Examples of non-sampling risk include:

(a)the use of inappropriate audit procedures,

(b)misinterpretation of audit evidence, and

(c)failure to recognize a misstatement or deviation.

(c)Sample size determination

5.13Examples of some factors affecting sample size:

Examples of factors influencing sample size for tests of control

Conditions leading to

Factors

Smaller sample size

Larger sample size

Reliance on accounting and control systems and hence assessment of control risk

Higher preliminary assessment of control risk

Lower preliminary assessment of control risk

Tolerable error

()

Higher acceptable rate of deviation

Lower acceptable rate of deviation

Expected error

Lower expected rate of deviation in population

Higher expected rate of deviation in population

Required confidence level

Smaller degree of confidence

Greater degree of confidence

Number of items in population

Virtually no effect on sample size unless population is small

Examples of factors influencing sample size for substantive procedures

Conditions leading to

Factors

Smaller sample size

Larger sample size

Assessment of inherent risk

Lower inherent risk

Higher inherent risk

Assessment of control risk

Lower control risk

Higher control risk

Change in detection risk because of other substantive tests related to the same financial statement assertions

Greater use of other substantive tests

Reduced use of other substantive tests

Tolerable error

Large measure of tolerable error

Smaller measure of tolerable error

Expected error

Smaller errors or lower frequency

Larger errors or higher frequency

Number of items in population

Virtually no effect on sample size unless population is small

Required confidence level/acceptable level of detection risk

Smaller degree of confidence (higher acceptance level of detection risk)

Higher degree of confidence (lower acceptance level of detection risk)

Stratification

Stratification of the population, if appropriate

No stratification of the population

5.14The sample size can be calculated as:

Sample size

=

Reliability factor

Precision

Where the reliability factor, taken from tables based on the Poisson sampling distribution is associated with the level of assurance the auditors want or need to obtain from the test. Such a table is given below and it shows the relationship between risk levels, and the reliability factor.

Confidence level

Risk level

Reliability factor (R Factor)

No errors expected

One error expected

99%

1%

4.6

6.61

95%

5%

3.0

4.75

90%

10%

2.3

3.89

85%

15%

1.9

3.38

80%

20%

1.6

3.00

70%

30%

1.2

2.44

5.15Example

Calculate the sample sizes which should be used in tests of control in the following circumstances.

(a)No errors anticipated in the sample, accept 5% risk that four or more items in 100 are incorrect in the population.

(b)One error anticipated in the sample, accept 1% risk that three or more items in 100 are incorrect in the population.

Answer

(a)Sample size = 3.0 / 0.05 = 60 items

(b)Sample size = 6.61 / 0.04 = 165 items

5.16

Test your understanding 3

An international accounting firm has acquired a local accounting firm. The partners of the local accounting firm are reluctant to adopt the international accounting firms sampling technique because they do not feel confident of the results derived from the sampling method used.

The international accounting firm adopts statistical sampling on a number of audit procedures. According to explanations from the international accounting firm, statistical sampling is a method of drawing inferences () about a large volume of data by examination of a sample. It can be used for either attributes or variables.

The international accounting firms provides the following data to demonstrate the efficiency of its sampling technique:

Required:

(a)Identify whether each of the following audit procedures should adopt sampling and, if it should, state whether attribute or variable sampling would typically be used. Organise your answer as follows:

Audit procedures

Involves Sampling?

(Yes or No)

Attribute/Variable

/Not applicable

(i)Interviewing client employees

(ii)Scrutinizing accounting records for usual items

(iii)Test of controls over inventory pricing

(iv)Tests of the amounts of transactions that are not supported by proper approval

(v)Obtaining written representations from management

(vi)Tests of recorded payroll expense

(vii)Observing cash- handling procedures

(viii)Inspecting land and building

(ix)Tests of controls over discounts rates allowed to individual customers

(x)Tests of control over matching suppliers invoices with goods receiving note and shipping documents

(10 marks)

(b)Based on the given set of data, discuss the relationship between extent of testing and degree of assurance.(3 marks)

(c)Explain why audit risk cannot be eliminated even if the total population is audited.(2 marks)

(d)Define the following risks:

(i)inherent risk;

(ii)control risk;

(iii)detection risk;

(iv)sampling risk.(4 marks)

(Total 20 marks)

(Adapted HKIAAT Paper 8 Auditing June 2000)

(d)Sample selection methods

5.17Selection methods for statistical sampling:

(a)Random sample selection ()

ensures that all items in the population have an equal chance of selection, e.g. by use of random number tables (()) or computerized generator ().

(b)Systematic sample selection ()

involves selecting items using a constant interval (e.g. every nth item) between selections, the first interval having a random start.

For example, if a population to be sampled is 600 items and the sample size is 50, the sampling interval will be 12 (= 600/50). One of the first 12 items will be selected as the starting point and thereafter every twelfth item will be selected. In determining the starting point each of the first 12 items (in this example) should have a chance of being selected. The starting point may be selected haphazardly or randomly.

Systematic selection is particularly useful when sampling from non-monetary populations, for example dispatch notes.

(c)Stratified sample selection ()

The population is divided into different strata, each of which has similar characteristic, then sampling techniques such as the random selection method can be applied in each stratum.

Example:

Stratum

Composition of stratum

No. of accounts (method of selection used)

1

Accounts of $10,000 or over

All accounts

2

Accounts of $5,000 to $9,999.99

50 accounts (random number)

3

Accounts of less than $5,000

30 accounts (random number)

5.18Selection methods for non-statistical sampling:

(a)Directed sample selection ()

the selection of each item based on some judgemental criteria by the auditor. The criteria used may include:

(i)items most likely to contain misstatements;

(ii)items containing selected population characteristics;

(iii)large dollar coverage.

(b)Block (or sequence) sample selection ()

is the selection of several items in sequence. Once the first item in the block is selected, the remainder of the block is chosen automatically. For example an auditor may use a sample of 50 consecutive cheques to check whether cheques are signed by authorized signatories rather than picking 50 single cheques throughout the year.

Sequence sampling may however produce samples that are not representative of the population as a whole, particularly if errors only occurred during a certain part of the period, and hence the errors found cannot be projected onto the rest of the population.

Nevertheless, block sampling can result in significant cost savings in audit time, and there are some occasions where practical considerations may require the use of block sampling, for example when visiting a branch.

(c)Haphazard sample selection ()

may be an alternative to random selection provided auditors are satisfied that the sample is representative of the entire population. It is the selection of samples without following a structured techniques regard to their size, source, or other distinguishing characteristics.

(e)Audit sampling procedures

5.19The application of sampling techniques in substantive procedures, illustrated below, involves the following steps:

(a)designing the sample;

(b)selecting a sample;

(c)performing the audit procedures;

(d)evaluating results of the tests; and

(e)summarizing the results.

Sampling

Example of substantive procedures

a. Design the sample

(i)Audit objectives:

Sending debtors confirmations to ensure the existence of debtors and the accuracy of their ledger balances.

(ii)Population and sampling units:

Population total debtors value of $5,525,000, excluding credit balances.

Variability $130 to $182,000

Sub-population five accounts over $65,000, totaling $660,000, were considered to be individually material, leaving a population of 1,195 accounts with a value of $4,865,000 to be sampled.

Sampling unit 1,200 account balances.

(iii)Determining the sample size:

(1)Tolerable error

Amount $170,000

Internal control moderate reliable

Substantive test analytical review and cut-off test provide conclusion of moderate assurance.

(2)Assurance required

Conclude that the required assurance is moderate.

(3)Expected error few or none.

(4)Calculating the sample size

Sample size = Population value/tolerable error x reliability factor

= $4,865,000 / $170,000 x 2.5 = 72

b. Selection of a sample

The sample was selected by using the systematic sampling method from a debtors list that had been tested to and from the debtors ledger and had been agreed in total to the balance on the control account in the general ledger.

c. Performance of the audit procedures

Replies were received from the 5 large customers and from 67 of those sampled. The accounts of the five customers failing to reply were verified by alternative tests on the subsequent settlement from the customers and it is concluded that the balances of these debtors were correctly stated.

d. Evaluation of results of the tests

(i)Analysis of errors:

The reported errors are summarized in the following table.

Population

Sample

Recorded amount

Recorded amount

Audited amount

Misstatement

$

$

$

$

660,000

660,000

659,000

1,000

4,865,000

234,000

230,100

3,900

5,525,000

894,000

889,100

4,900

(ii)Projected error:

The projected error is calculated by using the ratio method:

$3,900/$234,000 x $4,865,000 = $81,083

The client corrected the 3,900 errors found in the sample but disputed the $1,000 error on the large amount resulting in a net projected population error of:

$81,083 $3,900 + $1,000 = $78,183

d. Summarise the results

As the projected population error is significantly lower than the tolerable error, we can conclude that the recorded debtors are in existence and the balances are no materially misstated.

5.20

Test your understanding 4

Grand Ltd and Petit Ltd are garments manufacturing companies, both of them are the audit clients of King & Kong. Both audit teams have identified overstatements in debtor balances from the testing results.

Grand Ltd

Petit Ltd

Tolerable misstatement for debtors

$40,000

$40,000

Expected misstatement

$16,000

$16,000

Book value of total debtors

$1,600,000

$1,600,000

Book values of samples

$896,000

$258,000

Audit value of samples

$890,000

$252,000

Required:

Calculate the projected misstatements for Grand Ltd and Petit Ltd respectively. Based on the projected misstatements, draw conclusions on the debtor balances of Grand Ltd and Petit Ltd.(5 marks)

(Adapted HKIAAT Paper 8 Auditing December 2004 B6(e))

N4-15

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