Week 6 - Lecture 6 - Audit Sampling - Audit Testing - Sales and Collection Cycle PDF

AUDIT PRACTICE AND PROCEDURES II Audit Sampling, Audit Testing, Sales and Collection Cycle Week Six Recap of Last Class  Audit Sampling The clarified audit standards define audit sampling as: The selection and evaluation of less than...

AUDIT PRACTICE AND PROCEDURES II Audit Sampling, Audit Testing, Sales and Collection Cycle Week Six Recap of Last Class  Audit Sampling The clarified audit standards define audit sampling as: The selection and evaluation of less than 100 percent of the population of audit relevance such that the auditor expects the items selected to be representative of the population and, thus, likely to provide a reasonable basis for conclusions about the population.  REPRESENTATIVE SAMPLES When selecting a sample from a population, the auditor strives to obtain a representative sample. A representative sample is one in which the characteristics in the sample are approximately the same as those of the population. This means that the sampled items are similar to the items not sampled. In practice, auditors never know whether a sample is representative, even after all testing is complete. (The only way to know if a sample is representative is to subsequently audit the entire population.) However, auditors can increase the likelihood of a sample being representative by using care in designing the sampling process, sample selection, and evaluation of sample results. A sample result can lead to an incorrect conclusion due to sampling error or nonsampling error. The risk of these two types of errors occurring is called sampling risk and nonsampling risk.  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. Auditors have two ways to control sampling risk: 1. Adjust sample size 2. Use an appropriate method of selecting sample items from the population  Nonsampling risk Nonsampling risk is the risk that the auditor reaches an incorrect conclusion for any reason not related to sampling risk. The two causes of nonsampling risk are the auditor’s failure to recognize exceptions and inappropriate or ineffective audit procedures.  Statistical Versus Nonstatistical Sampling Audit sampling methods can be divided into two broad categories: statistical sampling and nonstatistical 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 performed in a manner that provides the desired sampling risk and minimizes the likelihood of nonsampling 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 tests Assume that an auditor selects a sample of 100 duplicate sales invoices from a population, tests each to determine whether a shipping document is attached, and determines that there are three exceptions. Let’s look at those actions step-by-step:  Statistical sampling Statistical sampling differs from nonstatistical sampling in that, by applying mathematical rules, auditors can quantify (measure) sampling risk in planning the sample (step 1) and in evaluating the results (step 3). (You may remember calculating a statistical result at a 95 percent confidence level in a statistics course. A 95 percent confidence level provides a 5 percent sampling risk.)  Nonstatistical sampling In nonstatistical sampling, auditors do not quantify sampling risk. However, a properly designed nonstatistical sample that considers the same factors as a properly designed statistical sample can provide results that are as effective as a properly designed statistical sample.  Probabilistic Versus Nonprobabilistic Sample Selection Both probabilistic and nonprobabilistic sample selection fall under step 2. When using probabilistic sample selection, the auditor randomly selects items such that each population item has a known probability of being included in the sample. This process requires great care and uses one of several methods discussed shortly. In nonprobabilistic sample selection, the auditor selects sample items using nonprobabilistic methods that approximate a random sampling approach. Auditors can use one of several nonprobabilistic sample selection methods.  Applying Statistical and Nonstatistical Sampling in Practice and Sample Selection Methods Auditing standards permit auditors to use either statistical or nonstatistical sampling methods. However, it is essential that either method be applied with due care. All steps of the process must be followed carefully. When statistical sampling is used, the sample must be a probabilistic one and appropriate statistical evaluation methods must be used with the sample results to make the sampling risk computations. Auditors may make nonstatistical evaluations when using probabilistic selection, but it is never acceptable to evaluate a nonprobabilistic sample using statistical methods. Probabilistic sample selection methods include the following: 1. Simple random sample selection 2. Systematic sample selection 3. Probability proportional to size sample selection Nonprobabilistic sample selection methods include: 1. Haphazard sample selection 2. Block sample selection  PROBABILISTIC SAMPLE SELECTION METHODS Statistical sampling requires a probabilistic sample to measure sampling risk. For probabilistic samples, the auditor uses no judgment about which sample items are selected, except in choosing which of the four selection methods to use.  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 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  Systematic Sample Selection In systematic sample selection (also called systematic sampling), 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. In a population of sales invoices ranging from 652 to 3,151, with a desired sample size of 125, the interval is 20 [(3,151 – 651)/125]. The auditor first selects a random number between 0 and 19 (the interval size) to determine the starting point for the sample. If the randomly selected number is 9, the first item in the sample will be invoice number 661 (652 + 9). The remaining 124 items will be 681 (661 + 20), 701 (681 + 20), and so on through item 3,141.  NONPROBABILISTIC SAMPLE SELECTION METHODS Nonprobabilistic sample selection methods are those that do not meet the technical requirements for probabilistic sample selection. Because these methods are not based on mathematical probabilities, the representativeness of the sample may be difficult to determine.  Haphazard Sample Selection 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.  Block Sample Selection 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.  SAMPLING FOR EXCEPTION RATES Auditors use sampling for tests of controls and substantive tests of transactions to determine whether controls are operating effectively and whether the rate of monetary errors is below tolerable limits. To do this, auditors 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. 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 the client’s established controls 2. Monetary misstatements in populations of transaction data 3. Monetary misstatements in populations of account balance details 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.  APPLICATION OF NONSTATISTICAL AUDIT SAMPLING The auditor first determines whether to apply nonstatistical sampling to those attributes where sampling applies. As previously discussed, there are three phases when sampling for tests of controls and substantive tests of transactions. The auditor must (1) plan the sample; (2) select the sample and perform the audit procedures; and (3) evaluate the results to conclude on the acceptability of the population. These three phases involve 14 well-defined steps. Auditors should follow these steps carefully to ensure proper application of both the auditing and sampling requirements.  Plan the Sample State the Objectives of the Audit Test The objectives of the test must be stated in terms of the transaction cycle being tested. Typically, auditors define the objectives of tests of controls and substantive tests of transactions: Test the operating effectiveness of controls Determine whether the transactions contain monetary misstatements. The objectives of these tests in the sales and collection cycle are usually to test the effectiveness of internal controls over sales and cash receipts and to determine whether sales and cash receipts transactions contain monetary misstatements. Auditors normally define these objectives as a part of designing the audit program. Decide Whether Audit Sampling Applies Audit sampling applies whenever the auditor plans to reach conclusions about a population based on a sample. The auditor should examine the audit program and select those audit procedures where audit sampling applies. To illustrate, assume the following partial audit program: 1. Review sales transactions for large and unusual amounts (analytical procedure). 2. Observe whether the duties of the accounts receivable clerk are separate from handling cash (test of control). 3. Examine a sample of duplicate sales invoices for a. credit approval by the credit manager (test of control). b. existence of an attached shipping document (test of control). c. inclusion of a chart of accounts number (test of control). 4. Select a sample of shipping documents and trace each to related duplicate sales invoices (test of control). 5. Compare the quantity on each duplicate sales invoice with the quantity on related shipping documents (substantive test of transactions).  Select the Sample and Perform the Audit Procedure Select the Sample - After auditors determine the initial sample size for the audit sampling application, they must choose the items in the population to include in the sample. Auditors can choose the sample using any of the probabilistic or nonprobabilistic methods we discussed earlier in this chapter. To minimize the possibility of the client altering the sample items, the auditor should not inform the client too far in advance of the sample items selected. The auditor should also control the sample after the client provides the documents. Several additional sample items may be selected as extras to replace any voided items in the original sample. Perform the Audit Procedure - The auditor performs the audit procedures by examining each item in the sample to determine whether it is consistent with the definition of the attribute and by maintaining a record of all the exceptions found. When audit procedures have been completed for a sampling application, the auditor will have a sample size and number of exceptions for each attribute. To document the tests and provide information for review, auditors commonly include a schedule of the results. Some auditors prefer to include a schedule listing all items in the sample; others prefer to limit the documentation to identifying the exceptions.  Evaluate the Results Generalize from the Sample to the Population - The sample exception rate (SER) can be easily calculated from the actual sample results. SER equals the actual number of exceptions divided by the actual sample size. Figure 15-3 summarizes the exceptions found for tests of attributes 1 through 9. In this example, the auditor found zero exceptions for attribute 1 and two exceptions for attribute 2, making the SER 0 percent (0 ÷ 75) for attribute 1, and 2 percent for attribute 2 (2 ÷100). When evaluating a sample for tests of controls and substantive tests of transactions, the auditor should evaluate sampling risk. When nonstatistical sampling is used, sampling risk cannot be directly measured. One way to evaluate sampling risk is to subtract the sample exception rate from the tolerable exception rate to find the calculated sampling error (TER – SER), and evaluate whether it is sufficiently large to conclude that the true population exception rate is acceptable. For example, if an auditor takes a sample of 100 items for an attribute and finds no exceptions (SER = 0) and TER is 5 percent, calculated sampling error is 5 percent (TER of 5 percent – SER of 0 = 5 percent). If the auditors had found four exceptions, calculated sampling error would have been 1 percent (TER of 5 percent – SER of 4 percent). It is much more likely that the true population exception rate is less than or equal to the tolerable exception rate in the first case than in the second one. Therefore, most auditors would probably find the population acceptable based on the first sample result and not acceptable based on the second.  STATISTICAL AUDIT SAMPLING The statistical sampling method most commonly used for tests of controls and substantive tests of transactions is attributes sampling. (When the term attributes sampling is used in this text, it refers to attributes statistical sampling. Nonstatistical sampling also has attributes, which are the characteristics being tested for in the population, but attributes sampling is a statistical method.) The application of attributes sampling for tests of controls and substantive tests of transactions has far more similarities to nonstatistical sampling than differences. The same 14 steps are used for both approaches, and the terminology is essentially the same. The main differences are the calculation of initial sample sizes using tables developed from statistical probability distributions and the calculation of estimated upper exception rates using tables similar to those for calculating sample sizes  SAMPLING DISTRIBUTION Auditors base their statistical inferences on sampling distributions. A sampling distribution is a frequency distribution of the results of all possible samples of a specified size that could be obtained from a population containing some specific characteristics. Sampling distributions allow the auditor to make probability statements about the likely representativeness of any sample that is in the distribution. Attributes sampling is based on the binomial distribution, in which each possible sample in the population has one of two possible values, such as yes/no, black/white, or control deviation/no control deviation. APPLICATION OF ATTRIBUTES SAMPLING Select the Sample and Perform the Audit Procedures 10. Select the sample. The only difference in sample selection for statistical and nonstatistical sampling is the requirement that probabilistic methods must be used for statistical sampling. Either simple random or systematic sampling is used for attributes sampling. 11. Perform the audit procedures. Same for attributes and nonstatistical sampling. Evaluate the Results 12. Generalize from the sample to the population. For attributes sampling, the auditor calculates an upper precision limit (CUER) at a specified ARO, again using special computer programs or tables developed from statistical formulas.  METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES In designing tests of details of balances for accounts receivable, auditors must satisfy each of the eight balance-related audit objectives. These eight general objectives are the same for all accounts. Specifically applied to accounts receivable, they are called accounts receivable balance-related audit objectives and are as follows:1 1. Accounts receivable in the aged trial balance agree with related master file amounts, and the total is correctly added and agrees with the general ledger. (Detail tie-in) 2. Recorded accounts receivable exist. (Existence) 3. Existing accounts receivable are included. (Completeness) 4. Accounts receivable are accurate. (Accuracy) 5. Accounts receivable are correctly classified. (Classification) 6. Cutoff for accounts receivable is correct. (Cutoff) 7. Accounts receivable is stated at realizable value. (Realizable value) 8. The client has rights to accounts receivable. (Rights)  DESIGNING TESTS OF DETAILS OF BALANCES Accounts Receivable Are Correctly Added and Agree with the Master File and the General Ledger - Ordinarily, auditors test the information on the aged trial balance for detail tie-in before any other tests to verify that the population being tested agrees with the general ledger and accounts receivable master file. Recorded Accounts Receivable Exist - Confirmation of customers’ balances is the most important test of details of balances for determining the existence of recorded accounts receivable. When customers do not respond to confirmations, auditors also examine supporting documents to verify the shipment of goods and evidence of subsequent cash receipts to determine whether the accounts were collected. Existing Accounts Receivable Are Included - It is difficult for auditors to test for account balances omitted from the aged trial balance except by relying on the self-balancing nature of the accounts receivable master file. For example, if the client accidentally excluded an account receivable from the trial balance, the only likely way it will be discovered is for the auditor to foot the accounts receivable trial balance and reconcile the balance with the control account in the general ledger Accounts Receivable Are Accurate - Confirmation of accounts selected from the trial balance is the most common test of details of balances for the accuracy of accounts receivable. When customers do not respond to confirmation requests, auditors examine supporting documents in the same way as described for the existence objective. Auditors perform tests of the debits and credits to individual customers’ balances by examining supporting documentation for shipments and cash receipts. Accounts Receivable Are Properly Classified - Normally, auditors can evaluate the classification of accounts receivable relatively easily, by reviewing the aged trial balance for material receivables from affiliates, officers, directors, or other related parties. Auditors should verify that notes receivable or accounts that should be classified as noncurrent assets are separated from regular accounts, and significant credit balances in accounts receivable are reclassified as accounts payable. Cutoff for Accounts Receivable Is Correct - Cutoff misstatements exist when current period transactions are recorded in the subsequent period or vice versa. The objective of cutoff tests, regardless of the type of transaction, is to verify whether transactions near the end of the accounting period are recorded in the proper period. The cutoff objective is one of the most important in the cycle because misstatements in cutoff can significantly affect current period income. For example, the intentional or unintentional inclusion of several large, subsequent period sales in the current period—or the exclusion of several current period sales returns and allowances—can materially overstate net earnings. Cutoff misstatements can occur for sales, sales returns and allowances, and cash receipts. For each one, auditors require a threefold approach to determine the reasonableness of cutoff: 1. Decide on the appropriate criteria for cutoff. 2. Evaluate whether the client has established adequate procedures to ensure a reasonable cutoff. 3. Test whether the cutoff was correct. Accounts Receivable Is Stated at Realizable Value - Accounting standards require that companies state accounts receivable at the amount that will ultimately be collected. The realizable value of accounts receivable equals gross accounts receivable less the allowance for uncollectible accounts. To calculate the allowance, the client estimates the total amount of accounts receivable that it expects to be uncollectible. Obviously, clients cannot predict the future precisely, but it is necessary for the auditor to evaluate whether the client’s allowance is reasonable, considering all available facts. The Client Has Rights to Accounts Receivable - The client’s rights to accounts receivable ordinarily cause no audit problems because the receivables usually belong to the client. In some cases, however, a portion of the receivables may have been pledged as collateral, assigned to someone else, factored, or sold at discount. Normally, the client’s customers are not aware of the existence of such matters, so the confirmation of receivables will not bring them to light. To uncover instances in which the client has limited rights to receivables, the auditor may review the minutes, discuss with the client, confirm with banks, examine debt contracts for evidence of accounts receivable pledged as collateral, and examine correspondence files.  CONFIRMATION OF ACCOUNTS RECEIVABLE The primary purpose of accounts receivable confirmation is to satisfy the existence, accuracy, and cutoff objectives.. A confirmation is a direct written response from a third party in paper or electronic form, and they are considered to be highly reliable evidence because they are received directly from third parties. Although an oral response provides audit evidence, it is not considered a confirmation..  Types of Confirmation Positive Confirmation - A positive confirmation is a communication addressed to the debtor requesting the recipient to confirm directly whether the balance as stated on the confirmation request is correct or incorrect. A blank confirmation form is a type of positive confirmation that does not state the amount on the confirmation but requests the recipient to fill in the balance or furnish other information. Because blank forms require the recipient to determine the information requested, they are considered more reliable than confirmations that include balance information. Blank forms are rarely used in practice because they often result in lower response rates. An invoice confirmation is another type of positive confirmation in which an individual invoice is confirmed, rather than the customer’s entire accounts receivable balance. Many customers use voucher systems that allow them to confirm individual invoices but not balance information. As a result, the use of invoice confirmations may improve confirmation response rates..  Types of Confirmation Negative Confirmation A negative confirmation is also addressed to the debtor but requests a response only when the debtor disagrees with the stated amount.  Sampling Decisions Sample Size - The major factors affecting sample size for confirming accounts receivable fall into several categories and include the following: Performance materiality Inherent risk (relative size of total accounts receivable, number of accounts, prior-year results, and expected misstatements) Control risk Achieved detection risk from other substantive tests (extent and results of substantive tests of transactions, analytical procedures, and other tests of details) Type of confirmation (negatives normally require a larger sample size) Timing - The most reliable evidence from confirmations is obtained when they are sent as close to the balance sheet date as possible. This permits the auditor to directly test the accounts receivable balance on the financial statements without making any inferences about the transactions taking place between the confirmation date and the balance sheet date. However, as a means of completing the audit on a timely basis, it is often necessary to confirm the accounts at an interim date. Verification of Addresses and Maintaining Control - The auditor should perform procedures to verify the addresses or email addresses used for confirmation. For example, auditors should consider performing additional procedures when the address is a post office box or when an email address is inconsistent with the customer’s Web site address. For confirmations sent by mail, the auditor must maintain control of the confirmations until they are returned from the customer. The client may assist with preparing the confirmations, but the auditor must be responsible for mailing the confirmation outside the client’s office. Follow-Up on Nonresponses - It is inappropriate to regard confirmations mailed but not returned by customers as significant audit evidence. For example, nonresponses to positive confirmations do not provide audit evidence. Similarly, for negative confirmations, the auditor should not conclude that the recipient received the confirmation request and verified the information requested. Negative confirmations do, however, provide some evidence of the existence assertion. When positive confirmations are used, auditing standards require follow- up procedures for confirmations not returned by the customer. It is common to send second and sometimes even third requests for confirmations.