Auditing principles and practice -II 2008

Unit One
SAMPLING IN AUDIT

1.1 Rationale for and the methods of Audit sampling

Sampling is application of audit procedures to less than 100 % of the items within an account
balance or class of transactions to obtain and evaluate audit evidence about some characteristic
of the items selected in order to form or assist in forming a conclusion concerning the
population.

Sampling is performed because it is more efficient than testing 100% of a population. In tax audits, if the
taxpayer and the Department can agree on a representative sample, it can save both parties time and
money. By definition, any procedure that does not examine 100% of the items in question is a sampling
procedure.

Auditors usually do not test 100% of transactions or items in account balances because the cost
of doing so would be prohibitive. Also, auditors seek only reasonable assurance. Audit sampling
occurs whenever an auditor draws a conclusion about an entire class of transactions or account
balance based on the results of a (representative) sample from the class or the balance. Audit
sampling addresses the sufficiency aspect of evidence as required under GAAS, insofar as it
relates to the extent of audit procedures used. Why do auditors use sampling?

Auditors use sampling

 to test controls (compliance tests) for assessing control risk, and

 to test balances (substantive tests) for determining whether balances are materially
misstated.

Sampling risk

Sampling risk is the risk that an auditor reaches an incorrect conclusion because the sample is not
representative of the population. Sampling risk is an inherent part of sampling that results from
testing less than the entire population..

The following are the basic factors affecting sample size:

Population size,standard deviation,materiality and Reliability.

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Methods of Sampling

Audit sampling methods can be divided into two broad categories: statistical sampling and non-
statistical sampling. These categories are similar in that they both involve three phases:
1. Plan the sample
2. Select the sample and perform the tests
3. Evaluate the results

The purpose of planning the sample is to make sure that the audit tests are per -formed in a
manner that provides the desired sampling risk and minimizes the likelihood of non-sampling
error. Selecting the sample involves deciding how a sample is selected from the population. The
auditor can perform the audit tests only after the sample items are selected. Evaluating the results
is the drawing of conclusions based on the audit test.
Statistical and non-statistical sampling

1. Statistical sampling

Statistical sampling involves the use of mathematical procedures auditors can quantify (measure)
sampling risk in planning the sample (step 1) and in evaluating the results (step 3).

2. Non-statistical sampling,

Auditors do not quantify sampling risk. Instead, auditors select sample items they believe will
provide the most useful information, given the circumstances, and reach conclusions about
populations on a judgmental basis. For that reason, the use of non-statistical sampling is often
termed judgmental sampling.

A. Types of Statistical sampling

Four types of sample selection methods are commonly associated with statistical audit sampling.
All four methods are probabilistic.
1. Simple random sample selection
2. Systematic sample selection
3. Probability proportional to size sample selection
4. Stratified sample selection

1. Simple random sample selection

In a simple random sample, every possible combination of population items has an equal
chance of being included in the sample. Auditors use simple random sampling to sample
populations when there is no need to emphasize one or more types of population items. Say,
for example, auditors want to sample a client’s cash disbursements for the year. They might
select a simple random sample of 60 items from the cash disbursements journal, apply

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appropriate auditing procedures to the 60 items selected, and draw conclusions about all
recorded cash disbursement transactions.When auditors obtain a simple random sample, they
must use a method that ensures all items in the population have an equal chance of selection.
Suppose an auditor decides to select a sample from a total of 12,000 cash disbursement
transactions for the year. A simple random sample of one transaction will be such that each
of the 12,000 transactions has an equal chance of being selected. The auditor will select one
random number between 1 and 12,000. Assume that number is 3,895. The auditor will select
and test only the 3,895th cash disbursement transaction. For a random sample of 100, each
population item also has an equal chance of being selected. Random numbers are a series of
digits that have equal probabilities of occurring over long runs and which have no
identifiable pattern. Auditors most often generate random numbers by using one of three
computer sample selection techniques: electronic spreadsheets, random number generators,
and generalized audit software. Computer programs offer several advantages: time savings,
reduced likelihood of auditor error in selecting the numbers, and automatic documentation.
Because most auditors have access to a computer and to electronic spreadsheets or random
number generator programs, they usually prefer to use computer generation of random
numbers over other probabilistic selection methods.
2. Systematic sample selection

In systematic sample selection - the auditor calculates an interval and then selects the items for
the sample based on the size of the interval. The interval is determined by dividing the
population size by the desired sample size.
The advantage of systematic selection is its ease of use. In most populations, a systematic sample
can be drawn quickly and the approach automatically puts the numbers in sequence, making it
easy to develop the appropriate documentation.
A concern with systematic selection is the possibility of bias. Because of the way systematic
selection is done, once the first item in the sample is selected, all other items are chosen
automatically.
3. Probability proportional to size sample selection
A sample is taken where the probability of selecting any individual population item is
proportional to its recorded amount (PPS).

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4. Stratified sample selection
The population is divided into sub populations by size and larger samples are taken of the
larger subpopulations.
B. Non statistical sampling
Three types of sample selection methods are commonly associated with non-statistical audit
sampling. All three methods are non- probabilistic.
 Directed sample selection
 Block sample
 Haphazard sample selection
1. Directed sample selection
In directed sample selection auditors deliberately select each item in the sample based on their
own judgmental criteria instead of using random selection. Commonly used approaches include:
 Items Most Likely to Contain Misstatements
Auditors are often able to identify which population items are most likely to be misstated.
Examples are accounts receivable outstanding for a long time, purchases from and sales to
officers and affiliated companies,and unusually large or complex transactions. The auditor can
efficiently investigate these types of items and the results can be applied to the population
judgmentally. In evaluating such samples, auditors typically reason that if none of the items
selected are misstated, it is unlikely that the population is materially misstated.
 Items Containing Selected Population Characteristics
By selecting one or more items with different population characteristics, the auditor may be able
to design the sample to be representative. For example, the auditor might select a sample of cash
disbursements that includes some from each month, each bank account or location, and each
major type of acquisition.
 Large Dollar Coverage
Auditors can sometimes select a sample that includes a large portion of total population dollars
and thereby reduce the risk of drawing an improper conclusion by not examining small items.
This is a practical approach on many audits, especially smaller ones, where a few population
items make up a large portion of the total population value. Some statistical sampling methods
are also designed to accomplish the same effect.

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2. Blocked sample
In block sample selection auditors select the first item in a block, and the remainder of the block
is chosen in sequence. For example, assume the block sample will be a sequence of 100 sales
transactions from the sales journal for the third week of March. Auditors can select the total
sample of 100 by taking 5 blocks of 20 items, 10 blocks of 10, 50 blocks of 2 or one block of
100.
It is ordinarily acceptable to use block samples only if a reasonable number of blocks is used. If
few blocks are used, the probability of obtaining a non-representative sample is too great,
considering the possibility of employee turnover, changes in the accounting system, and the
seasonal nature of many businesses. For example, in the previous example, sampling 10 blocks
of 10 from the third week of March is far less appropriate than selecting 10 blocks of 10 from 10
different months.
Block sampling can also be used to supplement other samples when there is a high likelihood of
misstatement for a known period. For example, the auditor might select all 100 cash receipts
from the third week of March if that is when the accounting clerk was on vacation and an
inexperienced temporary employee processed the cash receipt transactions.
3. Haphazard sample selection
Is the selection of items without any conscious bias by the auditor. In such cases, the auditor
selects population items without regard to their size, source, or other distinguishing
characteristics.
The most serious shortcoming of haphazard sample selection is the difficulty of remaining
completely unbiased in the selection. Because of the auditor’s training and unintentional bias,
certain population items are more likely than others to be included in the sample.
Although haphazard and block sample selection appear to be less logical than directed sample
selection.

1.2 Audit sampling for tests of controls and Substantive test of transaction
Auditors use sampling for tests of controls and substantive tests of transactions to estimate the
percent of items in a population containing a characteristic or attribute of interest. This percent
is called the occurrence rate or exception rate.

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For example, if an auditor determines that the exception rate for the internal verification of sales
invoices is approximately 3 percent, then on average 3 of every 100 invoices are not properly
verified.
Auditors are interested in the following types of exceptions in populations of accounting data:
1. Deviations from client’s established controls
2. Monetary misstatements in populations of transaction data
3. Monetary misstatements in populations of account balance details

Knowing the exception rate is particularly helpful for the first two types of exceptions, which
involve transactions. Therefore, auditors make extensive use of audit sampling that measures the
exception rate in doing tests of controls and substantive tests of transactions. With the third type
of exception, auditors usually need to estimate the total dollar amount of the exceptions because
they must decide whether the misstatements are material. When auditors want to know the total
amount of a misstatement, they use methods that measure dollars, not the exception rate.
 The exception rate in a sample is used to estimate the exception rate in the entire
population, meaning it is the auditor’s “best estimate” of the population exception
rate.
The term exception should be understood to refer to both deviations from the client’s control
procedures and amounts that are not monetarily correct, whether because of an unintentional
accounting error or any other cause. The term deviation refers specifically to a departure from
prescribed controls.

Assume, for example, that the auditor wants to determine the percentage of duplicate sales
invoices that do not have shipping documents attached. Because the auditor cannot check every
invoice, the actual percentage of missing shipping documents remains unknown. The auditor
obtains a sample of duplicate sales invoices and determines the percentage of the invoices that do
not have shipping documents attached. The auditor then concludes that the sample exception rate
is the best estimate of the population exception rate.Because the exception rate is based on a
sample, there is a significant likelihood that the sample exception rate differs from the actual
population exception rate. This difference is called the sampling error.

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The auditor is concerned with both the estimate of the sampling error and the reliability of that
estimate, called sampling risk. Assume the auditor determines a 3 percent sample exception rate,
and a sampling error of 1 percent, with a sampling risk of 10 percent. The auditor can state that
the interval estimate of the population exception rate is between 2 percent and 4 percent (3
percent
Auditors use 14 well defined steps to apply audit sampling to test of control and substantive test of
transaction.
Plan the Sample
1. State the objectives of the audit test.
2. Decide whether audit sampling applies.
3. Define attributes and exception conditions.
4. Define the population.
5. Define the sampling unit.
6. Specify the tolerable exception rate.
7. Specify acceptable risk of assessing control risk too low.
8. Estimate the population exception rate.
9. Determine the initial sample size.
Select the Sample and Perform the Audit Procedures
10. Select the sample.
11. Perform the audit procedures.
Evaluate the Results
12. Generalize from the sample to the population.
13. Analyze exceptions.
14. Decide the acceptability of the population

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UNIT TWO
AUDIT OF CASH AND MARKETABLE SECURITIES
2.1 Internal control over cash transactions

2.1.1 Internal control over cash receipts

Cash is any medium of exchange that a bank will accept at face value. It includes coins, bank
deposit, currency, checks, bank drafts and money orders.

Cash receipts resulted from a variety of activities. For example, cash is received from revenue
transactions, short and long term borrowings, the issuance of stock, the sale of marketable securities, long
term investments and other assets. The scope of this section is limited to cash receipts from cash sale and
collection from customers on credit sales. The basic internal controls over cash receipts include the
following:

 Authority to collect cash should be clearly defined.

 Collections should be recorded when received.
 Receipts should be banked immediately.
 Each day’s receipts should be recorded promptly in the cashbook.
 Do not permit any one employee to handle a transaction from beginning to end.
 Separate cash handling from recordkeeping.
 Centralize receiving of cash to the extent practical.
 Record cash receipts on a timely basis.
 Encourage customers to obtain receipts and observe cash register totals.
 Make all disbursements by check or electronic funds transfer, with the exception of small
expenditures from petty cash.
 Have monthly bank reconciliations prepared by employees not responsible for the issuance of
checks or custody of cash. The completed reconciliation should be reviewed promptly by an
appropriate official.
 Monitor cash receipts and disbursements by comparing recorded amounts to forecasted
amounts

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2.1.2 Internal Control Over Cash Disbursements

There are two cash disbursements functions as follows:

1. Paying the liability

2. Recording the cash disbursements

These functions should not be performed by the same department or individual. The basic internal
controls over cash disbursements include.

 Unused checks should be held in a secure place

 The person who prepares checks should have no responsibility over purchase ledger or sales
ledger.
 Checks should be signed only when evidence of a properly approved transaction is available.
 These checks should be evidenced by signing the supporting documents.
 Check signatories should be restricted to the minimum practical number.
 Two signatories at least should be required except perhaps for checks of small amounts.
 Checks should be crossed before being signed.
 Supporting documents should be cancelled as paid to prevent their use to support further check
payments.
 Checks should preferably dispatch immediately.
 Segregation of duties
 Payment by check or electronic funds transfer
 Pre-numbered check
 Match of purchase order and receiving documents with vendor’s invoice
 Monthly bank reconciliation

Control over Petty Cash

 The level and location of cash floats should be laid down formally
 Cash should securely hold (safe box).
 There should be restricted access to the floats.
 All expenditure should require a voucher system signed by a responsible official, not the petty
cashier.
 Vouchers should be produced before the check is signed for reimbursement.
 A maximum amount should be placed on a petty cash payment to discourage normal purchase
procedures being by passed.
 Periodically the petty cash should be reconciled by an independent person.

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2.2 Audit program for cash

The following audit program indicates the general pattern of work performed by the auditors in the
verification of cash.

 Consider internal control for cash.

 Obtain an understanding of internal control for cash.
 Assess control risk and design additional tests of controls for cash.
 Perform additional tests of control for those controls, which the auditors plan to consider in
their assessment of control risk.

(a) Test the accounting records and reconciliation by re-performance

 Compare the detail of a sample of recorded disbursements in cash payments journal to accounts
payable postings, purchase orders, receiving reports, invoices, and paid checks.
 Compare the detail of a sample of recorded cash receipts listings to the cash receipts, journal,
accounts receivable postings, and authenticated deposit slips.
 Reassess control risk and design substantive tests for cash.

B. Perform substantive tests of cash transaction and balances

 Obtain analysis of cash balances and reconcile to the general ledger.

 Send standard confirmation forms to banks to verify amounts on deposit.
 Obtain or prepare reconciliation of bank accounts as of the balance sheet date and consider the
need to reconcile bank activity for additional months.
 Obtain a cutoff bank statement containing transactions of at least seven business days subsequent
to balance sheet date.
 Verify the client’s cutoff of cash receipts and disbursements.
 Trace all bank transfers for last week of audit year and first week of following year.
 Evaluate proper financial statement presentation and disclosure of cash.
 Reassess control risk and design substantive tests.

2.3 Internal control over Marketable Security

Marketable Security- Marketable securities are very liquid securities that can be converted into
cash quickly at a reasonable price. Are securities or debts that are to be sold or redeemed within
a year. These are financial instruments that can be easily converted to cash such as government
bonds, Treasury bill, common stock or certificates of deposit.

Internal control over Marketable Security

 Establishment of formal investment policies
 Review and approval of investment activities by the investment committee of the
board of directors
 Separation of duties among employees

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1. Authorizing purchases and sales
2. Having custody of the securities
3. Maintaining records
 Detailed records of all securities owned and the related revenue from interest and
dividends
 Registration in the name of the company
 Periodic physical inspection of securities
 Determination of accounting for complex instruments by competent personnel

2.4 Audit program for marketable security

The following audit program indicates the general pattern of work performed by the auditors in the
verification of marketable security.

 Use the understanding of the client and its environment to consider inherent risks,
including fraud risks related to financial investments.
 Obtain an understanding of internal control over financial investments
 Assess the risks of material misstatement and design further audit procedures

 Perform further audit procedures—tests of controls.

1. Examples of tests of controls:

a. Trace several transactions for purchases and sales of investments through the
accounting system.

b. Review and test reports of investment activity prepared for the investment committee.

c. Inspect reports by internal auditors regarding their periodic inspection and review of
securities and derivative instruments.

d . Inspect monthly reports on securities owned, purchased, and sold and amounts of
revenue earned and budgeted.

2. Perform further audit procedures—substantive procedures for investment

transactions and year-end balances.
 Obtain or prepare analyses of the investment accounts and related revenue, gain, and
loss accounts and reconcile them to the general ledger.
 Inspect securities on hand and review agreements underlying derivatives.
 Confirm securities and derivative instruments with holders and counterparties.
 Vouch selected purchases and sales of financial investments during the year and
verify the client’s cutoff of investment transactions.

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 Review investment committee minutes and reports.
 Perform analytical procedures.
 Make independent computations of revenue from securities.
 Inspect documentation of management’s intent to classify derivative transactions as
hedging activities.
 Evaluate the method of accounting for investments.
 Test the valuation of financial investments.
 Evaluate financial statement presentation and disclosure of financial investments.

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