LECTURE 7.

AUDIT TESTS AND AUDIT SAMPLING

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 Objectives
After studying this chapter, you should be able to:
1. Understand the nature of Test of controls.
2. Understand the general nature of analytical
procedures.
3. Describe four general analytical procedures.
4. Understand the nature of Test of details
5. Understand the key concepts related to Audit
sampling
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 Contents
 7.1. Overview of audit tests
 7.2. Test of controls
 7.3. Substantive procedures
 7.3.1. Analytical Procedures
 7.3.2. Test of details
 7.4. Audit sampling
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 7.2. Test of controls

TESTS OF CONTROLS are audit

procedures to test the effectiveness
of control policies and procedures
in support of a reduced control
risk.

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Tests of controls are necessary in two
circumstances.
1. When the auditor’s risk assessment includes
an expectation of the operating effectiveness
of controls, the auditor is required to test
those controls to support the risk assessment.
2. When substantive procedures alone do not
provide sufficient appropriate audit evidence,
the auditor is required to perform tests of
controls to obtain audit evidence about their
operating effectiveness.
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 Timing of Tests of Controls
The timeliness of evidential matter is about when the
evidence was obtained and the portion of the audit
period to which it may be applied.
 some tests of controls, such as observation of
inventory, pertain only to the point in time at which
the auditing procedure was applied
 the auditor performs other tests that are capable of
providing audit evidence that the control operated
effectively at relevant times during the audit period.

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 7.3.1. Analytical Procedures
Analytical procedures consist of
the analysis of significant ratios
and trends including the
resulting investigation of
fluctuations and relationships
that are inconsistent with other
relevant information or deviate
from predicted amounts. 7
Analytical Procedures
A basic premise of using
analytical procedures is that
there exist plausible
relationships among data
and these relationships can
reasonably be expected to
continue.
 trend analysis,
ratio analysis,
General Analytical
reasonableness tests
Procedures statistical analysis
data mining analysis

Trend analysis is the analysis of

changes in an account balance
over time.
Ratio analysis is the comparison of
relationships between financial
statement accounts, the
comparison of an account with
non-financial data, or the
comparison of relationships
between firms in an industry.
 trend analysis,
ratio analysis,
General Analytical
reasonableness tests
Procedures statistical analysis
data mining analysis

Reasonableness testing is the

analysis of account balances or
changes in account balances
within an accounting period in
terms of their “reasonableness”
in light of expected relationships
between accounts.
Statistical analysis is the analysis of
data using statistical methods
 trend analysis,
ratio analysis,
General Analytical
reasonableness tests
Procedures statistical analysis
data mining analysis
Data mining is a set of computer-
assisted techniques that use
sophisticated statistical analysis,
including artificial intelligence
techniques, to examine large
volumes of data with the objective
of indicating hidden or unexpected
information or patterns. For these
tests auditors generally use
computer aided audit software
(CAATs).
Required Analytical
Procedures
Analytical procedures are
performed at least twice in
an audit - in planning and
in completion procedures.

planning completion
 Trend
Analysis
 It works best when the account or relationship is
fairly predictable
 The number of years used in the trend analysis is a
function of the stability of operations.
 The most precise trend analysis would be on
disaggregated data (for example, by segment,
product, or location, and monthly or quarterly
rather than on an annual basis).
 At an aggregate level it is relatively imprecise
because a material misstatement is often small
relative to the aggregate account balance.
 Ratio
Analysis
% It’s most appropriate when the
relationship between accounts is fairly
predictable and stable
% It’s more effective than trend analysis because
comparisons between the balance sheet and
income statement can often reveal unusual
fluctuations that an analysis of the individual
accounts would not.
% Like trend analysis, ratio analysis at an
aggregate level is relatively imprecise.
 Ratios

 Liquidity: Current Ratio

Quick Ratio

 Solvency: Debt to Equity

Times Interest Earned
Debt to Service Coverage
 Profitability: Net profit margin
Gross Margin
Return on investment
 Activity: Receivable Turnover
Inventory Turnover
Asset Turnover
 7.4. Audit sampling
“Audit sampling” (sampling) involves the
application of audit procedures to less than
100% of items within an account balance or
class of transactions such that all sampling
units have a chance of selection.
From the sample the auditor forms a
conclusion about the population from which
the sample is drawn.
Audit sampling can use either a statistical or a
non-statistical approach.
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 Sampling Terms
 “Population” means the entire set of data from
which a sample is selected and about which the
auditor wishes to draw conclusions.
 For example, all of the items in an account balance
or a class of transactions constitute a population.
 “Error” means either control deviations, when
performing tests of control, or misstatements, when
performing substantive procedures.
 “Sampling risk” arises from the possibility that
the auditor’s conclusion, based on a sample may be
different from the conclusion reached if the entire
population were subjected to the same audit
procedure.
 Types of Sampling Risk
There are two types of sampling risk:
 The risk the auditor will conclude, in the test of
control, that control risk is lower than it actually is,
or in the case of a substantive test, that a material
error does not exist when in fact it does.
 The risk the auditor will conclude, in a test of
control, that control risk is higher than it actually is,
or in the case of a substantive test, that a material
error exists when in fact it does not.
 Terms: Statistical Sampling
% “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, including measurement of sampling risk.
% A sampling approach that does not have
characteristics (a) and (b) is considered non-
statistical sampling.
 More Sampling Terms

 “Sampling unit” means the individual items

constituting a population, for example checks listed
on deposit slips, credit entries on bank statements,
sales invoices or debtors’ balances, or a monetary
unit.
 “Stratification” is the process of dividing a
population into subpopulations, each of which is a
group of sampling units which have similar
characteristics (often monetary value).
 “Tolerable error” means the maximum error in a
population that the auditor is willing to accept.
 Audit Testing
 Audit sampling is used for both tests of controls (attributes
sampling) and for substantive procedures (usually, variables
sampling)
 For control sampling the auditor identifies
the characteristics or attributes that indicate
performance of a control
possible deviations which indicate in-adequate
performance.
presence or absence of attributes by testing
 Substantive procedures audit sampling is used to verify
assertions about a financial statement amount (for example, the
existence of accounts receivable), or to make an independent
estimate of some amount (for example, the value of obsolete
inventories).
 Non-sampling risk
Includes all aspects of audit risk that are
not due to sampling
Examples are:
The failure to select appropriate audit
procedures
The failure to recognize misstatements in
documents examined
Misinterpreting the results of audit tests.
 Sampling Risk
It is the risk that the auditor’s conclusion,
based on a sample, might be different
from the conclusion that would be
reached if the test were applied in the
same way to the entire population
Tests of controls risks include the risk of
assessing control risk too high or too low
Substantive test risks include incorrect
rejection and incorrect acceptance
 Sampling risk and non-sampling risk

When performing tests of control, the auditor may find

no errors in a sample and conclude that control risk is
low, 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).

 For example, the auditor may choose an inappropriate

analytical procedure (non-sampling risk) or may find
only minor misstatements in a test of details when, in
fact, the population misstatement is greater than the
tolerable amount (sampling risk).
Sampling risk can be reduced by increasing sample size,
while non-sampling risk can be reduced by proper
engagement planning, supervision, and review.
Appropriate Tests of Control
Audit sampling for tests of control is
generally appropriate when application
of the control leaves evidence of
performance (for example, initials of the
credit manager on a sales invoice
indicating credit approval, or evidence of
authorization of data input to a
microcomputer based data processing
system).
Substantive Tests of Details
When performing substantive tests of details, audit
sampling and other means of selecting items for
testing and gathering audit evidence may be used
to:
 verify one or more assertions about a financial
statement amount (for example, the existence of
accounts receivable), or
 to make an independent estimate of some amount
(for example, the value of obsolete inventories).
 Sample Size
 Sample size is affected by the level of sampling risk
that the auditor is willing to accept. The lower the
risk the auditor is willing to accept, the greater the
sample size will need to be.
 The tolerable rate is the maximum rate of
deviation from policy that an auditor will accept
without modifying the planned assessed level of
control risk.
 When the planned assessed level of control risk is
low, and the degree of assurance desired from the
sample is high, the tolerable rate should be low.
(Especially when other tests of controls are not
done)
 Selecting the Sample
 The auditor should select items for the sample with
the expectation that all sampling units in the
population have a chance of selection.
 Statistical sampling requires that sample items are
selected at random so that each sampling unit has
a known chance of being selected. The sampling
units might be physical items (such as invoices) or
monetary units. With non-statistical sampling, an
auditor uses professional judgment to select the
items for a sample.
 Sample Selection Methods
 Use of a computerized random number generator
or random number tables.
 Systematic selection, in which the number of
sampling units in the population is divided by the
sample size to give a sampling interval.
 Haphazard selection, in which the auditor selects
the sample without following a structured
technique. Haphazard selection is not appropriate
when using statistical sampling.
 Block selection involves selecting a block(s) of
contiguous items from within the population. Block
selection cannot ordinarily be used in audit
sampling.
 Evaluation of Sample Results
 The auditor should consider the sample
results, the nature and cause of any errors
identified, and their possible effect on the
particular test objective and on other areas
of the audit.
 For substantive procedures, the auditor
should project monetary errors found in the
sample to the population, and should
consider the effect of the projected error.
 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.
 Tolerable error is will be an amount less
than or equal to the auditor’s
preliminary estimate of materiality.
 Evaluating the
Sample Results
The auditor should evaluate the sample results to
determine whether the preliminary assessment of
the relevant characteristic of the population is
confirmed or needs to be revised.
 In test of controls, an unexpectedly high sample
error rate may lead to an increase in the assessed
level of control risk.
 In a substantive procedure, an unexpectedly high
error amount in a sample may cause the auditor to
believe that an account balance or class of
transactions is materially misstated.
 Nonstatistical Sampling (1 of 4)
 The 14 audit sampling steps for tests of details of balances
(1 of 4):
 (1) State the objectives of the audit test
 (2) Decide whether audit sampling applies
 (3) Define a misstatement/Define attributes and
exception conditions—for tests of controls (TOC) and
substantive tests of transactions (TOT)
 Nonstatistical Sampling (2 of 4)
 The 14 audit sampling steps for tests of details of balances
(2 of 4):
 (4) Define the population
 (5) Define the sampling unit
 (6) Specify tolerable misstatement/Specify the tolerable
exception rate—for TOC and TOT
 (7) Specify acceptable risk of incorrect
acceptance/Specify acceptable risk of overreliance—for
TOC and TOT
 Nonstatistical Sampling (3 of 4)
 The 14 audit sampling steps for tests of details of balances
(3 of 4):
 (8) Estimate misstatements in the population/Estimate
the population exception rate—for TOC and TOT
 (9) Determine the initial sample size
 (10) Select the sample
 (11) Perform the audit procedures
 Nonstatistical Sampling (4 of 4)
 The 14 audit sampling steps for tests of details of balances
(4 of 4):
 (12) Generalize from the sample to the population
 (13) Analyze the misstatements/Analyze the exceptions
for TOC and TOT
 (14) Decide the acceptability of the population
 Thank You for Your Attention
Any Questions?