CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
internal controls and the ability to choose a specific method, a list of the most reliable to
the least reliable evidence-gathering techniques are in general:
■ recalculation,
■ inspection,
■ reperformance,
■ observation,
■ confirmation,
■ analytical procedures,
■ inquiry.
The most expensive evidence gathering techniques are confirmation and inspection.
Confirmation is costly because of the time and outlay required in preparation, mailing,
receipt, and follow-up. Inspection procedures that require the presence of both the client
and auditors, such as an inventory count, are very expensive. Confirmation of documents
is moderately expensive if clients are organized and have documents easily available.
The three least expensive evidence-gathering procedures are observation, analytical
procedures, and inquiries. Observation is normally done concurrently with other audit
procedures.
The evidence-gathering procedures in order of cost from most costly to least costly are
in general:
■ confirmation (most costly),
■ inspection,
■ recalculation,
■ reperformance,
■ observation,
■ analytical procedures,
■ inquiry (least costly).
10.7 Summary
Auditing is a systematic process of objectively obtaining and evaluating evidence regarding
assertions about economic actions and events. The auditor should obtain sufficient appro-
priate audit evidence to be able to draw reasonable conclusions on which to base the audit
opinion. Evidence is anything that can make a person believe that a fact, proposition, or
assertion is true or false. Audit evidence is different from the legal evidence required by
forensic accounting. In a civil lawsuit, evidence must be strong enough to incline a person
to believe one side or the other. In a criminal case; evidence must establish proof of a crime
beyond a reasonable doubt. Audit evidence provides only reasonable assurance.
The systematic process of gathering evidence starts with evaluating the client and
culminates in the use of substantive procedures. Substantive procedures are tests per-
formed to obtain audit evidence to detect material misstatements in the financial state-
ments, and are of two types: tests of details of transactions and balances, and analytical
procedures. This chapter provides guidance on the basis of evidence (standards of proof
and documentation and financial statement assertions), what constitutes sufficient
380
SUMMARY
appropriate audit evidence (the quantity and quality of audit evidence) and the
substantive audit procedures that auditors use for obtaining that audit evidence.
Evidence in the legal environment may be classified according to its proof results
(direct or circumstantial) or according to its source (documentary, real, or testimonial).
The results of the evidence may either directly or circumstantially support a standard of
proof. Documentary evidence is gathered from written, printed, or electronic sources.
Documentary evidence consists of computer files and records, e-mail, accounting
records, paper (invoices, writings, pictures), documents (contracts, deed, reports), com-
mercial records (e.g. from banks, brokerage, retailers, credit card) and government
records (licenses, real estate, legal).
Management implicitly makes assertions that can be grouped into three substantive
testing areas: classes of transactions and events, account balances at the period end, and
disclosures. The standard assertions are completeness, occurrence, accuracy, rights and
obligations, valuation, and existence. Other assertions are: cutoff, classification, under-
standability, presentation and disclosure, and measurement. The auditor assesses risks of
potential misstatements based on these assertions and designs audit procedures to
discover sufficient appropriate evidence.
The auditor should conclude whether sufficient appropriate audit evidence has been
obtained to reduce to an acceptably low level the risk of material misstatement in the
financial statements. Sufficiency is the measure of the quantity (amount) of audit
evidence. Appropriateness is the measure of the quality of audit evidence; that is, its
relevance and its reliability in providing support for, or detecting misstatements in, the
classes of transactions, account balances, and disclosures and related assertions.
Reliability is the quality of information when it is free from material error and bias and
can be depended upon by users to represent faithfully that which it either purports to
represent or could reasonably be expected to represent. Relevance of evidence is the
appropriateness (pertinence) of the evidence to the audit objective being tested.
Substantive procedures are tests performed to obtain audit evidence to detect material
misstatements in the financial statements. The nature of the test is of two types: tests of details
of transactions and balances, and analytical procedures. Tests of transactions are audit pro-
cedures related to examining the processing of particular classes of transactions through the
accounting system and are usually performed for accounts such as property and equipment,
long-term debt and equity accounts. Tests of balances are audit tests that substantiate the
ending balance of a general ledger account or line item in a financial statement.
Substantive procedures may be described by their nature, timing, and extent. The
nature of substantive procedures includes tests of details (of transactions and of balances)
and substantive analytical procedures. Tests of balances are substantive tests that provide
either reasonable assurance of the validity of a general ledger balance or identify a mis-
statement in the account. There are several considerations in determining the timing of
substantive procedures. When substantive procedures are performed at an interim date,
the auditor should perform further substantive procedures or substantive procedures to
cover the remaining period. In planning tests of details of transactions or balances, the
extent of testing is ordinarily thought of in terms of the sample size, which is affected by
the risk of material misstatement.
An auditor obtains audit evidence by one or more of the following evidence gathering
techniques: inquiry, observation, inspection (of tangible assets, records or documents),
reperformance, recalculation, confirmation, and analytical procedures. Inquiry consists
381
CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
of seeking information from knowledgeable persons inside or outside the entity.
Observation consists of looking at a process or procedure being performed by others.
Inspection consists of examining records, documents or tangible assets. Reperformance is
the auditor’s independent execution of procedures or controls that were originally
performed as part of the entity’s internal control. Recalculation consists of checking the
arithmetical accuracy of source documents and accounting records or of performing
independent calculations. Confirmation consists of the response to an inquiry to
corroborate information contained in the accounting records. There are two forms of
confirmations: positive and negative.
Three substantive tests usually performed are observation of inventory, confirmation
of accounts receivable, and search for unrecorded liabilities. When inventory is material
to the financial statements, the auditor should obtain sufficient appropriate audit
evidence regarding its existence and condition by attendance at physical inventory
counting. Confirmation of accounts receivable provides evidence of the existence of
revenue and current assets. The search for unrecorded liabilities provides evidence as
to completeness and some evidence as to valuation and may be part of the closing
procedures or in concert with the confirmation of accounts payable.
10.8 Answers to Certification Exam Questions
10.1 (C) The requirement is to state the objective of tests of details of classes of transactions.
Choice (C) is the one because substantive procedures are performed in order to detect material
misstatements at the assertion level, and include tests of details of classes of transactions,
account balances, and disclosures and substantive analytical procedures (ISA 330, para. 48).
Choice (A) is incorrect because there is no compliance with IFRS for transactions. IFRS has to do
with accounting methods and disclosure. Choices (B) and (D) are incorrect. Attaining assurance
about the reliability of the information system relevant to financial reporting and valuation of
operating effectiveness of management controls involve assessing control risk, which is an
objective of tests of controls, not substantive tests.
10.2 (A) The question asks what financial statement assertion pertains to the procedure of making
inquiries about slow-moving or obsolete inventory. Answer (A) is the choice because an audit objec-
tive for inventory valuation is to determine that slow-moving, excess, defective and obsolete items
included in inventory are properly identified. These determinations show if inventory is included in the
financial statements at appropriate amounts and any resulting valuation adjustments are appropri-
ately recorded. Answer (B) is not correct. Assertions about rights and obligations deal with whether the
entity holds or controls the rights to assets like inventory and whether liabilities are the obligations of
the entity. Choice (C) is wrong. Assertions about existence deal with whether assets, liabilities, and
equity interests exist Answer (D) is incorrect. Assertions about completeness deal with whether all
assets, liabilities, and equity interests that should have been recorded have been recorded.
10.3 (A) The question is concerned with what assertion fits the audit procedure of recomputing
amortization for intangible assets. Choice (A) is right because the assertion about valuation is that
amortization is included in the financial statements at appropriate amounts and any resulting
valuation adjustments to intangible assets are appropriately recorded. Recalculation of the
amortization and review of the amortization period would test the valuation assertion. Choice (B)
is incorrect. Assertions about existence deal with whether assets, liabilities, and equity interests
exist, which is not directly related to amortization. Choice (C) does not hold true. An assertion
about cutoff is concerned with whether transactions and events have been recorded in the
382
ANSWERS TO CERTIFICATION EXAM QUESTIONS
correct accounting period. Choice (D) is incorrect. Assertions about classification show whether
transactions and events have been recorded in the proper accounts.
10.4 (C) The requirement is to determine what assertion fits the procedure of cutoff tests of direct
purchases at year-end. Answer (C) is right because the auditor uses cutoff test to determine that
inventory quantities include all products, materials, and supplies owned by the company. This
provides assurance about the completeness assertion. Answer (A) is off the mark because
assertions about valuation show whether assets, liabilities, and equity interests are included in the
financial statements at appropriate amounts and any resulting valuation adjustments are appro-
priately recorded. Cutoff tests do not provide evidence related to the valuation assertion for
purchases. Answer (B) is incorrect. Assertions about occurrence deal with whether transactions
and events that have been recorded have occurred and pertain to the entity. Answer (D) is not an
option because an assertion about classification and understandability holds that financial
information is appropriately presented and described, and disclosures are clearly expressed.
10.5 (B) The requirement is to find analysis of which account would yield the most predictable
evidence. Answer (B) is the best choice because interest expense should be predicted from
knowing the interest rate and amount of debt or reading loan contracts. Answer (A) is not good
because credit (which may allow prediction of accounts receivable) and cash sales are rarely
reported separately. Furthermore, a company may have collection experience that varies from
period to period. Similarly, an accounts payable balance (answer (C)) may vary across periods and
depends on ability to pay, discounts offered, and other circumstances that may vary. Travel and
entertainment expenses are related to budget, distribution network, product growth and manage-
ment discretion, which will tend to make the expense unpredictable.
10.6 (D) The requirement is to determine what substantive procedure, along with analytical
review, would be used to test payroll balances considering that control risk is low. Choice (D) is
correct because if the control risk is assessed as low, less substantive testing is necessary. If
control risk is low, substantive testing would normally be limited to analytical procedures and
recalculating year-end accruals. Choice (A) is a no-go because observing distribution of paychecks
is typically performed only when control risk is assessed as high. Choice (B) is not correct.
Although footing and crossfooting the payroll register is an important substantive test, it is of
limited effectiveness. Even if control risk is assessed as low, more effective substantive procedures
should be performed. Choice (C) misses the mark because inspection of payroll tax returns would
be performed only when control risk is assessed as high.
10.7 (A) One must determine what strategy would improve the response rate in a confirmation of
accounts receivable. Answer (A) is the best answer in light of the fact that many accounting
systems facilitate the confirmation of single transactions rather than entire balances. In such
cases, inclusion of statements of account showing details of the balances being confirmed makes
it easier for the customers, and are likely to improve the overall response rate. Answer (B) is
incorrect because selecting only accounts for confirmation that have large balances would not
necessarily improve the response rate. Answer (C) is a no-go because requesting electronic
responses would not necessarily improve the response rate and some clients may not be able to
do that. Answer (D) is incorrect. Why should the customer respond sooner when the consequence
of not responding (receiving a second request) is no big deal?
10.9 Notes
1 IFAC, 2004, Handbook of International Auditing, Assurance, and Ethics Pronouncements, Inter-
national Standard on Auditing 500 (ISA 500), “Audit Evidence,” para. 2, International Federation of
Accountants, New York.
383
CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
2 IFAC, 2004, Handbook of International Auditing, Assurance, and Ethics Pronouncements, Inter-
national Standard on Auditing 500R (ISA 500), “Audit Evidence,” International Federation of
Accountants, New York, February.
3 Adapted and reprinted with permission from AICPA. Copyright © 2000 & 1985 by American
Institute of Certified Public Accountants.
4 A US court decision (US v Sunderland).
5 Adapted and reprinted with permission from AICPA. Copyright © 2000 & 1985 by American
Institute of Certified Public Accountants.
6 IFAC, 2004, Handbook of International Auditing, Assurance, and Ethics Pronouncements, Inter-
national Standard on Auditing 330 (ISA 330), “The Auditor’s Procedures In Response to Assessed
Risks,” para. 70, International Federation of Accountants, New York.
7 IFAC, 2004, Handbook of International Auditing, Assurance, and Ethics Pronouncements, Inter-
national Standard on Auditing 500A (ISA 500), “Audit Evidence,” Para. 7.
8 See note 5. Para. 71.
9 Adapted and reprinted with permission from AICPA. Copyright © 2000 & 1985 by American
Institute of Certified Public Accountants.
10 See note 5. Para. 49.
11 See note 5. Para. 56.
12 Audit sampling (sampling) involves the application of audit procedures to less than 100 percent of
items within an account balance or class of transactions such that all sampling units have a chance
of selection. This will enable the auditor 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 from which the sample is drawn. Audit sampling can use either a statistical or a non-
statistical approach.
13 Computer-assisted audit techniques – applications of auditing procedures using the computer as an
audit tool are known as computer assisted audit techniques (CAATs).
14 Arens, A.A. and Loebbecke, J.K., 2000, Auditing: An Integrated Approach, Prentice Hall, New Jersey,
p. 122.
15 IFAC, 2003, Handbook of International Auditing, Assurance, and Ethics Pronouncements, Inter-
national Standard on Auditing (ISA) 501, “Audit Evidence – Additional Considerations for Specific
Items”, para. 5, International Federation of Accountants, New York.
16 Consignment is a specialized way of marketing certain types of goods. The consignor delivers goods
to the consignee who acts as the consignor’s agent in selling the merchandise to a third party. The
consignee accepts the goods without any liability except to reasonably protect them from damage.
The consignee receives a commission when the merchandise is sold. Goods on consignment are
included in the consignor’s inventory and excluded from the consignee’s inventory since the
consignor has legal title.
17 Adapted and reprinted with permission from AICPA. Copyright © 2000 & 1985 by American
Institute of Certified Public Accountants.
18 IFAC, 2003, Handbook of International Auditing, Assurance, and Ethics Pronouncements, Inter-
national Standard on Auditing (ISA) 505, “External Confirmations,” paras. 20–24, International
Federation of Accountants, New York.
19 Ibid. Para. 23.
20 Ibid. Para. 31.
21 Ibid. Para. 25.
22 Limitation on scope – a limitation on the scope of the auditor’s work may sometimes be imposed by
the entity (e.g. when the terms of the engagement specify that the auditor will not carry out an audit
procedure that the auditor believes is necessary). A scope limitation may be imposed by circum-
stances (e.g. when the timing of the auditor’s appointment is such that the auditor is unable to
observe the counting of physical inventories). It may also arise when, in the opinion of the auditor,
the entity’s accounting records are inadequate or when the auditor is unable to carry out an audit
procedure believed desirable.
384
QUESTIONS, EXERCISES AND CASES
10.10 Questions, Exercises and Cases
QUESTIONS
10.2 Introduction
10.1 What are substantive procedures? Describe the different types of substantive procedures.
10.3 The Basis of Evidence
10.2 Define the three major sources of documentary evidence. List them in the order of their
10.3 reliability.
List the major financial statement assertions. Define the assertions about account
balances at the period end.
10.4 Sufficient Appropriate Audit Evidence
10.4 Why does an auditor prefer persuasive evidence as opposed to conclusive evidence?
10.5 Differentiate between the most reliable evidence and the least reliable evidence.
10.5 Substantive Audit Procedures
10.6 Discuss what is meant by direction of testing.
10.7 What is the difference between test of transactions and test of balances?
10.6 Audit Procedures for Obtaining Audit Evidence
10.8 Why should an auditor corroborate evidence for inquiry? Name a famous court case and
discuss.
10.9 What alternative procedures can an auditor do when he is unable to attend a physical
inventory?
10.10 What are four key characteristics of confirmation?
10.11 If a confirmation is not returned to the auditor what alternative procedures can he
perform?
10.12 List the six evidence gathering techniques in order of reliability. List the six evidence
gathering techniques in order of cost from highest to lowest.
PROBLEMS AND EXERCISES
10.3 The Basis of Evidence
10.13 Management Assertions and Audit Objectives. The following are management assertions
(1 through 9). and audit objectives applied to the audit of accounts payable ((a) through
(h)).
Management Assertion
1 Existence
2 Rights and obligations
3 Occurrence
4 Completeness
5 Valuation
6 Accuracy
7 Cutoff
8 Understandability
9 Classification
385
CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
Specific Audit Objective
(a) Existing accounts payable are included in the accounts payable balance on the
balance sheet date.
(b) Accounts payable are properly classified.
(c) Acquisition transactions in the acquisition and payment cycle are recorded in the
proper period.
(d) Accounts payable representing the accounts payable balance on the balance sheet
date agree with related subsidiary ledger amounts, and the total is correctly added
and agrees with the general ledger.
(e) Accounts in the acquisition and payment cycle are properly disclosed according to
IASs.
(f) Accounts payable representing the accounts payable balance on the balance sheet
date are valued at the correct amount.
(g) Accounts payable exist.
(h) Any allowances for accounts payable discounts is taken.
Required:
A. Explain the differences between management assertions, general audit objectives,
and specific audit objectives, and their relationships to each other.
B. For each specific audit objective, identify the appropriate management assertion.
10.4 Sufficient Appropriate Audit Evidence
10.14 Sufficient Appropriate Audit Evidence. The auditor finds it necessary to rely on audit
evidence that is persuasive rather than conclusive and will often seek audit evidence
from different sources or of a different nature to support the same assertion. The
reliability of audit evidence is not only important in determining sufficiency (quantity) of
the information, but also the appropriateness (quality) of the information. Reliability of
audit evidence is influenced by its source and its nature.
Required:
A. Define these terms: reliability of evidence, persuasiveness of evidence, and relevance
of evidence.
B. Arrange the following people as sources of information from most reliable to least
reliable and explain your reasoning:
1 new company employee,
2 company employee with five years’ experience,
3 company lawyer,
4 internal auditor,
5 external auditor,
6 auditor’s lawyer,
7 banker,
8 top management,
9 board of directors,
10 company supplier,
11 company customer.
10.15 Reliability and Cost of Evidence Gathering Techniques. The financial statements of
Utgard Company of Drammen, Norway, a new client, indicate that large amounts of
notes payable to banks were paid off during the period under audit. The auditor,
Kristinge Korsvold, Statautoriseret Revisor, also notices that one customer’s account is
much larger than the rest, and therefore decides to examine the evidence supporting
this account.
386
QUESTIONS, EXERCISES AND CASES
Required:
Evaluate the reliability of each of the following types of evidence supporting these trans-
actions for:
Notes Payable:
A. Debit entries in the Notes Payable account.
B. Entries in the check register.
C. Paid checks.
D. Notes payable bearing bank perforation stamp PAID and the date of payment.
E. Statement by client’s treasurer that notes had been paid at maturity.
F. Letter received by auditors directly from bank stating that no indebtedness on part of
client existed as of the balance sheet date.
Customer Account:
G. Computer printout from accounts receivable subsidiary ledger.
H. Copies of sales invoices in amount of the receivable.
I. Purchase order received from customer.
J. Shipping document describing the articles sold.
K. Letter received by client from customer acknowledging the correctness of the
receivable in the amount shown on client’s accounting records.
L. Letter received by auditors directly from customer acknowledging the correctness of
the amount shown as receivable on client’s accounting records.
10.5 Substantive Audit Procedures
10.16 Substantive Tests – Analytical Procedures, Balances and Transactions. Substantive
tests include (1) tests of the details of transactions, (2) tests of the details of balances,
and (3) analytical procedures. Listed below are several specific audit procedures.
Identify the type of substantive test – 1, 2, or 3.
A. Compare recorded travel expense with the budget.
B. Vouch entries in the check register to paid checks.
C. Recompute accrued interest payable.
D. Calculate inventory turnover ratios by product and compare with prior periods.
E. Reconcile the year-end bank account.
F. Discuss uncollectible accounts with the credit manager.
G. Count office supplies on hand at year-end.
H. Vouch entries in the sales journal to sales invoices.
I. Comparison of recorded amount of major disbursements with appropriate invoices
J. Comparison of recorded amount of major disbursements with budgeted amounts
K. Comparison of returned confirmation forms with individual accounts
[Adapted from Carmichael et al., 1996, Auditing Concepts and Methods, McGraw Hill,
New York.]
10.17 Tests of Balances. Your client is the Nicholas van Myra Central, a shopping center with
30 store tenants. All leases with the store tenants provide for a fixed rent plus a
percentage of sales, net of sales taxes, in excess of a fixed dollar amount computed on an
annual basis. Each lease also provides that the landlord may engage a Registeraccountant
or Accountant-Administratieconsulent to audit all records of the tenant for assurance that
sales are being properly reported to the landlord.
You have been requested by your client to audit the records of the JaiLai Chinese Ind.
Restaurant to determine that the sales, totaling i725,000 for the year ended December
31, 20X4, have been properly reported to the landlord. The restaurant and the shopping
center entered into a five-year lease on January 1, 20X4. The JaiLai offers only table
387
CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
service. No liquor is served. During meal times there are four or five waitresses in
attendance, who prepare handwritten prenumbered restaurant checks for the customers.
Payment is made at a cash register, staffed by the proprietor, as the customer leaves. All
sales are for cash.
The proprietor also is the bookkeeper. Complete files are kept of restaurant checks and
cash register tapes. A daily sales book and general ledger are also maintained.
Required:
List the auditing procedures that you would employ to test the annual sales of the JaiLai
Chinese Ind. Restaurant. (Disregard vending machine sales and counter sales of chewing
gum and candy, and concentrate on the overall checks that would be appropriate.)
10.6 Audit Procedures for Obtaining Audit Evidence
10.18 Evidence Gathering Techniques. An auditor obtains audit evidence by one or more of the
following evidence gathering techniques: inquiry, observation, inspection, reperformance,
recalculation, confirmation, and analytical procedures.
Required:
For each of the evidence gathering technique give an example of a substantive test
procedure.
10.19 Inquiry, Analytical Procedures, and Observation. In the examination of financial
statements, auditors must judge the validity of the audit evidence they obtain. For the
following questions, assume that the auditors have considered internal control and found
it satisfactory.
Required:
A. In the course of examination, the auditors ask many questions of client officers and
employees.
1 Describe the factors that the auditors should consider in evaluating oral evidence
provided by client officers and employees.
2 Discuss the validity and limitations of oral evidence.
B. Analytical procedures include the computation of various balance sheet and operating
ratios for comparison to prior years and industry averages. Discuss the validity and
limitations of ratio analysis as evidential matter.
C. In connection with an examination of the financial statements of a manufacturing
company, the auditors are observing the physical inventory of finished goods, which
consists of expensive, highly complex electronic equipment. Discuss the validity and
limitations of the audit evidence provided by this procedure.
10.20 Inspection. Discuss what you would accept as satisfactory documentary evidence in
support of entries in the following?
A. Sales journal.
B. Sales returns register.
C. Voucher or invoice register.
D. Payroll register.
E. Check register.
10.21 Accounts Receivable Confirmations – Positive and Negative. In work on accounts
receivable, use of confirmations is of great importance.
388
QUESTIONS, EXERCISES AND CASES
Required:
A. What is an audit confirmation?
B. What characteristics should an audit confirmation possess if an auditor is to consider
it as sufficient appropriate audit evidence?
C. Distinguish between a positive and a negative accounts receivable confirmation.
D. In confirming a client’s accounts receivable, what characteristics should be present in
the accounts if the auditor is to use negative confirmations?
10.22 Attendance at Physical Inventory Counting. A processor of frozen foods carries an
inventory of finished products consisting of 50 different types of items valued at
approximately $2,000,000. About $750,000 of this value represents stock produced by
the company and billed to customers prior to the audit date. This stock is being held for
the customers at a monthly rental charge until they request shipment and is not
separate from the company’s inventory.
The company maintains separate perpetual ledgers at the plant office for both stock
owned and stock being held for customers. The cost department also maintains a
perpetual record of stock owned. The above perpetual records reflect quantities only.
The company does not take a complete physical inventory at any time during the year,
since the temperature in the cold storage facilities is too low to allow one to spend more
than 15 minutes inside at a time. It is not considered practical to move items outside or
to defreeze the cold storage facilities for the purpose of taking a physical inventory.
Because of these circumstances, it is impractical to test count quantities to the extent
of completely counting specific items. The company considers as its inventory valuation
at year-end the aggregate of the quantities reflected by the perpetual record of stock
owned, maintained at the plant office, priced at the lower of cost or market.
Required:
A. What are the two principal problems facing the auditor in the audit of the inventory?
Discuss briefly.
B. Outline the audit steps that you would take to enable you to render an unqualified
opinion with respect to the inventory. (You may omit consideration of tests of unit
prices and clerical accuracy.)
CASES
10.23 Audit Objectives and Financial Statement Accounts. Look at the financial statements
of a major public company. Pick three accounts and discuss the financial statement
assertions that might be associated with those accounts. For example, the financial
statement assertions might be associated with “Accrued Product Liability” are valuation,
existence, completeness, and presentation and disclosure. Valuation relates to product
liability because a judgment (estimate) must be made regarding the expected cost of
defective products.
10.24 Substantive Tests: Balances and Transactions. As part of systematic process of
gathering and evaluating evidence regarding assertions about economic actions and
events, tests of balances and tests of transactions are essential in obtaining audit evidence
to detect material misstatements in the financial statements. In the following case,
assume that you are an auditor. Before you conduct the actual tests you are expected to
understand the concepts and procedures of tests of balances and transactions.
389
CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
Required:
A. There are two types of substantive procedures. Identify each.
B. Describe the difference between tests of balances and tests of transactions. Give an
example for each test and illustrate them.
C. For tests of balances, what are the major account balances in the balance sheet need
to be examined. Why are these tests important?
D. For tests of transactions, what are the major accounts that an auditor need to verify
transaction amounts and trace transactions to accounts in the financial statements.
Why are these tests important?
E. How do inherent properties of double-entry accounting systems relate to the tests of
balances? Give examples of double-entries that show the simultaneous affect of one
transaction has on another.
F. For certain account balances such as assets, auditors prefer to test asset accounts
for overstatement. Explain why. Are there any similar preferences for understatement
for other accounts? If any, explain why.
G. As an auditor, you are aware of the control risks when design tests of transactions.
Explain how these risks might effect the way you design and carry out the procedures.
[Written by Maria Wise, Claudia De Santiago, Perla Barajas, and Cam Long]
10.25 Tests of Balances. Swartz Platten, BV, sells chemicals in large, costly returnable
containers. Its procedures in accounting for the containers are as follows:
1 When containers are purchased, their cost is charged to “Inventory-containers on hand.”
2 Containers are billed to customers at cost; full credit is allowed for all containers
returned in usable condition. The containers remain the property of Swartz Platten.,
at all times.
3 The cost of containers billed to customers is debited to “Accounts receivable-
containers” and credited to “Liability for containers billed.” At the same time, the cost
of the containers billed is transferred to “Inventory-containers out” from “Inventory-
containers on hand.” Subsidiary ledgers are maintained for “Accounts receivable-
containers” and “Inventory-containers out.”
4 When containers are returned in usable condition, the entries in 3 are reversed.
5 A physical inventory of containers on hand is taken at the fiscal year-end.
6 As a partial control over containers in the hands of customers, sales representatives
are asked to estimate periodically the number of containers held by each customer.
These estimates are checked for reasonableness against the amount shown for the
customer in the “Inventory-containers out” subsidiary ledger.
7 Physical shortages, unusable returned containers, and other inventory adjustments are
charged or credited to “Containers expense-net.” The corresponding adjustments to
“Liability for containers billed” are also charged or credited to “Containers expense-net.”
8 Containers kept by customers for more than one year are deemed unusable Roger
van Deelgaard had been the auditor of Swartz Platten. for many years. He issued an
unqualified opinion on the financial statements for the previous fiscal year. Two months
before the current year-end, Swartz Platten’s accountant requested that van Deelgaard
investigate a strange situation which had developed: the balance in the “Liability for
containers billed” had been steadily increasing, to the point where it exceeded the
combined balances in “Inventory-containers out” and “Inventory-containers on hand.”
Required:
A. What might have caused the situation described by the company’s accountant?
B. List the procedures van Deelgaard should employ to determine the nature and extent
of the misstatement.
[CICA adapted]
390
Appendix to Chapter 10
Audit Sampling and Other Selective Testing
Procedures
Lucas A. Hoogduin
10.A.1 Preface
This appendix gives practical guidance on ISA Standard 530, Audit Sampling and Other
Testing Procedures. Although most of the standard is devoted to audit sampling, it also covers
detail testing procedures on items that were not selected randomly, or on all items in a
population.
The Standard’s official text is given in boxes, like this.
Wherever we deemed it appropriate, we have added comments and practical hints. Some of
the paragraphs speak for themselves, and we did not feel compelled to make any comment at
all.
The reader does not need a lot of statistical background to follow the discussions, but some
mathematical skill is helpful. We have not tried to give the full mathematical derivation of
formulae and results, as we believe there are some good textbooks on this matter available (for
example, Statistiek voor accountancy by Paul Touw and Lucas Hoogduin, Academic Service,
Schoonhoven, 2002, ISBN 90 395 1743 6, which is currently being translated into English).
For almost a decade, detail testing has not been very popular among auditors. However, book-
keeping scandals around the turn of the century (see the Concept and a Company cases
throughout this book) have changed the environment considerably. Auditors feel more secure
if they can base their audit opinion more on the results of detail testing, and audit clients
appreciate it more if the audits are not carried out with interviews only. With the pendulum
swinging back to detail testing, ISA 530 will become more popular in the near future.
Lucas Hoogduin is Director of KPMG’s Business Advisory Services at their world headquarters. He has had
many years of statistical audit experience, authoring several books on statistics. He brings long experience and
statistically correct thinking to the IFAC standard on statistical sampling.
391
CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
The Standard is organized in different sections that will be described below:
Section Paragraphs
Introduction 1–2
Definitions 3–12
Audit Evidence 13–17
Risk Considerations in Obtaining Evidence 18–20
Procedures for Obtaining Evidence
Selecting Items for Testing to Gather Audit Evidence 21
Statistical versus Non-Statistical Sampling Approaches 22–27
Design of the Sample 28–30
Sample Size 31–39
Selecting the Sample 40–41
Performing the Audit Procedure 42–43
Nature and Cause of Errors 44–46
Projecting Errors 47–50
Evaluating the Sample Results 51–53
54–56
10.A.2 Introduction
1. The purpose of this Standard is to establish standards and provide guidance on the use
of audit sampling procedures and other means of selecting items for testing to gather
audit evidence.
2. 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.
We will deal with appropriate means for selecting items for testing. But when does this need
to be done? “When designing audit procedures” is a half-hearted answer. For what parts of a
set of financial statements does the auditor design audit procedures?
10.A.3 Definitions
The Standards start off with a series of definitions. We will provide some background infor-
mation on the various terms, and cross-reference them to the paragraphs where they play a
most prominent role.
3. “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. This will enable the auditor 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 from which the sample
is drawn. Audit sampling can use either a statistical or a non-statistical approach.
392
DEFINITIONS
In the statistical realm, a random sample is defined as a sample taken in such a way that all
combinations of sampling units have the same chance of selection. The difference between
these two definitions may seem academic. On closer examination, however, it will follow that
a selection procedure commonly used by auditors, systematic selection also known as fixed
interval selection, is considered to be audit sampling under the ISA definition, whereas for real
statisticians it is not a random sample. Another difference is that the ISA standard mentions
just a chance of selection, whereas statisticians would like to see that the combinations of
sampling units have the same chance of selection.1
The second sentence of this paragraph explains why it is important that all sampling units
have a chance of selection: the objective is to form a conclusion about the population from
which the sample is drawn. Statistical sampling employs the knowledge about all possible
samples that could be drawn from the population, to ensure that the sample result, such as an
interval estimate, is correct in at least, say, 95 percent of the cases.
(See also our comments on paragraph 10, where statistical sampling is discussed.)
4. For purposes of this Standard, “error” means either control deviations, when performing
tests of control, or misstatements, when performing substantive procedures. Similarly,
total error is used to mean either the rate of deviation or total misstatement.
A misstatement is the difference of the book value, the recorded value in the client’s accounts,
and the audit value, the value that the auditor believes it to be. Control deviations imply weak-
nesses in design or operation of internal controls. Errors may be adjustable or non-adjustable.
If an error is adjustable, the auditor may post an adjustment based on the errors found, or in
some cases even on the extrapolation of these errors as an estimate of the total error in the
population. In some cases, errors are not adjustable, for example, the lack of internal control
on the delivery of goods at a warehouse.
5. “Anomalous error” means an error that arises from an isolated event that has not recurred
other than on specifically identifiable occasions and is therefore not representative of
errors in the population.
This is a concept that has to be applied carefully. A wrongful interpretation or application
could easily lead to errors not being detected. We will get back to this in the discussion of
paragraph 50 later.
6. “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. A population may be
divided into strata, or sub-populations, with each stratum being examined separately.
The term population is used to include the term stratum.
See also paragraph 35 and our comments thereon. There the Standard also gives examples
of populations that can be investigated to give audit evidence on a certain balance, where the
population is not that balance.
393
CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
7. “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. There are two types of sampling risk:
a. the risk the auditor will conclude, in the case of a 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. This type of risk affects audit effectiveness and is
more likely to lead to an inappropriate audit opinion; and
b. the risk the auditor will conclude, in the case of 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. This type of risk affects audit efficiency as it would
usually lead to additional work to establish that initial conclusions were incorrect.
The mathematical complements of these risks are termed confidence levels.
The terminology in this paragraph is a little careless. In statistics, we use two different
methods, estimation and hypothesis testing. To add to the linguistic confusion, we can test a
hypothesis with an interval estimate.
In classical hypothesis testing, there are two risks defined. If we conclude that control risk is
lower than it actually is, or if we conclude that a material error does not exist when in fact it
does, we commit a Type I error. The risk of committing this type of error is usually called
alpha-risk, but unfortunately in most auditing literature it is referred to as beta-risk. The
converse, the type of risk in the b-part of the paragraph, is called a Type II error. This error is
related to the decision to reject a population that in fact does not contain a material error.
Statisticians typically call the risk of committing this type of risk beta-risk, whereas auditors
would call it alpha-risk.
The mathematical complement of the Type I error can be called a confidence level, because
in most cases we use an interval estimate to test the hypothesis. The mathematical com-
plement of the Type II error is called the power of the test. It is a measure of how effective the
test employed is in discriminating between populations that contain material errors and
populations that contain non-material errors.
Let us illustrate these concepts with a simple example. We have two populations, A and B,
which contain 100 items. Population A contains 10 errors (10 percent of 100) and 90
non-errors, and population B contains 3 errors (3 percent of 100) and 97 non-errors. The
“tolerable” error, which is subjectively determined by the auditor (see paragraph 12) for
this test is 10 errors (10 percent). Since population A has an unacceptable 10 percent errors,
population A should be rejected, whereas population B (with a more tolerable 3 percent
errors) should be approved.
The auditor now will define a decision rule, and calculate a sample size that coincides with
it. Without boring the reader with the calculations now, we state that the auditor chooses a
sample size of 25. We will lift this veil in our discussion on paragraph 40. The auditor approves
the population if no errors are found, and rejects the population if the sample reveals one or
more errors.
We now compare the possible sampling outcomes (finding no errors or finding errors) for
the two populations. The probability of finding no errors in a sample of 25 from population A
is 4.8 percent.2 That is how the auditor got the sample size of 25. He allows a risk of approxi-
mately 5 percent (closest equivalent is 4.8 percent) that a sample from a population will reveal
no errors. If, unknown to the auditor, the population is an incorrect one, the auditor will
394
DEFINITIONS
Certification Exam Question Appendix 10.1
Which of the following best illustrates the concept of sampling risk?
(A) A randomly chosen sample may not be representative of the population as a whole
on the characteristic of interest.
(B) An auditor may select audit procedures that are not appropriate to achieve the
specific objective.
(C) An auditor may fail to recognize errors in the documents examined for the chosen
sample.
(D) The documents related to the chosen sample may not be available for inspection.
approve this population, and commit a Type I error. In terms of an interval estimate, we could
say that the auditor is 95.2 percent confident that the true number of errors in population A
is somewhere between 0 and 10. We see therefore that the confidence level of 95.2 percent
(100 percent less 4.8 percent probability of errors) is the mathematical complement of the risk
related to the Type I error.
The probability of finding no errors in a sample of 25 from population B is 41.8 percent.3
This may be shatteringly low, if you understand the consequences. It means that there is a
probability of less than 50 percent that the auditor will draw the correct conclusion if the
population contains a 3 percent error rate. The probability of 41.8 percent is the power of
the test. It tells us something about how good this test is in making a distinction between
populations that contain a 10 percent error rate and populations that contain a 3 percent error
rate. The mathematical complement of the power of the test is the chance of Type II error.
This error is related to the decision to reject a population that in fact does not contain a
material error.
If the auditor believes that a power of 41.8 percent is too low, he may change his decision
rule. He could, for instance approve populations if the sample reveals only 0 or 1 error, and
reject them otherwise. This will be at the expense of a larger sample size: a sample size of 39
will do the trick.4
8. “Non-sampling risk” arises from factors that cause the auditor to reach an erroneous
conclusion for any reason not related to the size of the sample. For example, most
audit evidence is persuasive rather than conclusive, the auditor might use inappropriate
procedures, or the auditor might misinterpret evidence and fail to recognize an error.
Non-sampling risk is discussed in paragraph 20.
9. “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’ (customer’s) balances, or a monetary unit.
Two different purposes are intertwined in this definition of the sampling unit. The statistical
purpose of the sampling unit is to identify individual units that could be subject to investi-
gation. The total set of sampling units is called a population. If we take a random sample, all
possible combinations of sampling units have the same probability of selection. For monetary
unit sampling, the sampling unit is the monetary unit. For variables estimation techniques, the
sampling unit is the physical unit, for example an invoice or an inventory location.
395
CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
The auditor’s purpose of the sampling unit is to determine at what level of detail he wants to
perform his audit procedures. It is often advised that the lower the detail, the more effective
the audit procedure will be. Take for instance the test on existence of accounts receivable. The
auditor will send out confirmation requests to gather audit evidence, but he will have to
choose between the customer’s (debtor’s) balance, the outstanding invoice or even a line item
on that invoice as the sampling unit.
If the auditor takes the line item as the sampling unit, the effort to obtain audit evidence is
minimum: the customer (debtor) only has to confirm what he owes with regard to this line
item, and if the customer fails to reply the auditor only has to perform alternative procedures
to obtain the necessary audit evidence.5
10. “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.
Here we should also comment on two other terms that often crop up in discussions on the use
of sampling. The first one is representativeness, and the other is homogeneity. We draw a
random sample in the hope that it is representative. This means that the sample reflects the
attributes of the population on which we wish to form a conclusion. For instance, if 5 percent
of the population items were in error, then a sample of 60 items would hopefully reveal three
errors. Only if this sample result is obtained (and the probability of this result is only
23 percent6) can the sample be considered to be representative.
Now, based on only three errors from a 60 population with 23 percent probability, we are
faced with two problems: what should we do with the 77 percent of results that are not repre-
sentative, and how can we ever find out if the sample was representative? The first problem is
easily solved. After finding three errors in a sample of 60, no rational being will claim that the
population contains exactly 5 percent errors. With possible sample results of zero, one, two,
etc. to 60 errors, this would infer that the population contains 0 percent, 123 percent,
331 percent, etc. or 100 percent errors. The consequence is that it is implied that any value
between the respective point estimates cannot exist. This is, of course, not true.
A statistician is more careful in drawing conclusions about the population error rate.
For instance, with three errors found in a sample of 60, he will not claim that the population
error rate is exactly 5 percent, but state that he is, say, 95 percent confident that the popula-
tion error rate is between 1.37 percent and 12.42 percent.7 He can claim his confidence of
95 percent, because he knows that the procedure he uses for calculating the bounds of the
interval estimate will yield a correct statement with at least the stated confidence.
The problem of representativeness cannot be solved. We could only know whether a sample
is representative or not if we were to know the characteristics of the population. But that is
exactly the reason for sampling: to find out about these characteristics. Still, even though this
problem cannot be solved, it is important to realize the notion of representativeness. First, by
random sampling we know that there is only a limited probability of non-representative
samples that lead to an invalid conclusion. Secondly, careful scrutiny of the sample findings
396
AUDIT EVIDENCE
may inspire the auditor to investigate the problem at hand further, knowing that even random
samples may lead to wrong conclusions.
Finally a word on homogeneity. If we sample from a population that contains two equal
subpopulations A and B, and subpopulation A has no errors, whereas subpopulation B has a
10 percent error rate, then it is often felt that this will cause problems because the population
is not homogeneous. This is only partly true. The problem only lies in the fact that there is
extra information about the distribution of the error. If we do not take this extra information
into account when planning the sample, then the sample results will be the same as if we
would take a sample of 60 from the entire population. Taking the extra information into
account will lead us to sample more items from part B and less items from part A. In fact, the
best allocation would be to sample all 60 items from part B, but that is not quite fair because
it assumes that we know that part A is flawless.
If the auditor fears that the population under review is heterogeneous, he may choose to stratify
the population. As we will see later when we discuss stratification, there should be a significant
difference in error rates between the subpopulations to make stratification worthwhile.
11. “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).
Stratification is further discussed in paragraphs 36 to 38. Stratification by monetary value is
only useful for variables estimation techniques, which will be shown to be much more
ineffective than monetary unit sampling. Stratification for monetary unit sampling hardly
occurs in practice, as it is only effective if the auditor can discern sub-populations that have
significantly different error rates.
12. “Tolerable error” means the maximum error in a population that the auditor is willing to
accept.
The concept of tolerable error is mainly devised as a means to establish the minimum work to
be performed on a certain balance or class of transactions. It is derived from materiality. It is
sad that the profession has embraced the adjective “tolerable.” If you look at it from a clean
perspective, for instance in terms of hypothesis testing, the error the auditor is testing for may
not be as tolerable as it seems. In fact, the auditor tries his utmost to detect the error if it exists
and is covered by professional standards if he is unlucky not to detect it. We would therefore
prefer the term “important” error instead of “tolerable.”
10.A.4 Audit Evidence
Most of the guidance in this section is self-explanatory. We will only provide an important
comment on paragraph 17.
13. In accordance with Standard 500 “Audit Evidence”, audit evidence is obtained from an
appropriate mix of tests of control and substantive procedures. The type of test to be
performed is important to an understanding of the application of audit procedures in
gathering audit evidence.
397
CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
■ Tests of Control
14. In accordance with Standard 400 “Risk Assessments and Internal Control” tests of control
are performed if the auditor plans to assess control risk less than high for a particular
assertion.
15. Based on the auditor’s understanding of the accounting and internal control systems, the
auditor identifies the characteristics or attributes that indicate performance of a control,
as well as possible deviation conditions which indicate departures from adequate
performance. The presence or absence of attributes can then be tested by the auditor.
16. 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 Procedures
17. Substantive procedures are concerned with amounts and are of two types: analytical
procedures and tests of details of transactions and balances. The purpose of
substantive procedures is to obtain audit evidence to detect material misstatements in
the financial statements. 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).
Highlight the second sentence in this paragraph: the auditor uses substantive procedures
to detect material misstatements. In the auditor toolbox there is a very ingenious statistical
method to assist him. But do not be fooled by the last sentence: it is not the auditor’s primary
duty to make precise estimates. The amount of work necessary to achieve this is much more
than what is typically needed for the detection of material errors. It is the client’s responsibility
to make precise estimates, and the auditor’s responsibility to assess the method employed or
to test the estimate.
If the auditor finds evidence that the assertion under review may be materially misstated, he
should think twice before he starts collecting sufficient data material for a precise estimate.
Paragraph 34 leaves the door open to this endeavor. If everything else fails, and the client is
willing to pay for it, the auditor may test a large proportion or even all items in the population
to find and adjust the errors.
■ Risk Considerations in Obtaining Evidence
This section deals with the risk of an incorrect conclusion. It does not provide strict rules as to
what the maximum allowable risk should be.
398
AUDIT EVIDENCE
18. In obtaining evidence, the auditor should use professional judgment to assess
audit risk and design audit procedures to ensure this risk is reduced to an
acceptably low level. (Bold type in the IFAC standards means that it is required).
19. Audit risk is the risk that the auditor gives an inappropriate audit opinion when the
financial statements are materially misstated. Audit risk consists of inherent risk – the
susceptibility of an account balance to material misstatement, assuming there are no
related internal controls; control risk – the risk that a material misstatement will not be
prevented or detected and corrected on a timely basis by the accounting and internal
control systems; and, detection risk – the risk that the material misstatements will not
be detected by the auditor’s substantive procedures. These three components of audit
risk are considered during the planning process in the design of audit procedures in
order to reduce audit risk to an acceptably low level.
Before we dig in to the mathematical calculation of sample sizes, first a word on the level of
sampling risk that the auditor is willing to accept. As explained in this paragraph, the accept-
able level of detection risk is determined by the assessments of inherent and control risk (see
Chapter 8). Since detection risk covers all substantive procedures, the acceptable level of
sampling risk is dependent on the amount of audit evidence obtained from substantive
procedures as well as the assessments of inherent and control risk.
There is no clear-cut formula that determines an exact level of acceptable sampling risk
based on the risk assessments. It is generally accepted that audit evidence obtained from other
procedures will increase the acceptable level of sampling risk, but the extent to which this
minimum level can be increased is mainly a matter of professional judgment.
20. Sampling risk and non-sampling risk can affect the components of audit risk. For
example, 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 that the auditor
fails to recognize (non-sampling risk). With respect to substantive procedures, the
auditor may use a variety of methods to reduce detection risk to an acceptable level.
Depending on their nature, these methods will be subject to sampling and or non-
sampling risks. 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). For both tests of control and substantive tests, sampling risk can be
reduced by increasing sample size, while non-sampling risk can be reduced by proper
engagement planning, supervision, and review.
■ Procedures for Obtaining Evidence
21. Procedures for obtaining audit evidence include inspection, observation, inquiry and
confirmation, computation and analytical procedures. The choice of appropriate
procedures is a matter of professional judgment in the circumstances. Application of
these procedures will often involve the selection of items for testing from a population.
399
CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
Analytical procedures feel a bit out of place here, as a whole ISA Standard (520) is devoted
to them. What is meant here are analytical procedures that can be applied on a detail level.
(See Chapter 9 on analytical procedures.)
10.A.5 Selecting Items for Testing to Gather Audit Evidence
22. When designing audit procedures, the auditor should determine appropriate
means of selecting items for testing. The means available to the auditor are:
a. Selecting all items (100% examination);
b. Selecting specific items; and
c. Audit sampling.
Selecting all items will be further discussed in paragraph 24. Selecting specific items is
explained in paragraphs 25 and 26. A round-up comment on audit sampling is given in
paragraph 27, but it is the main subject of the remaining paragraphs of this Standard after a
discourse on non-statistical sampling in paragraphs 28 to 30.
23. The decision as to which approach to use will depend on the circumstances, and the
application of any one or combination of the above means may be appropriate in
particular circumstances. While the decision as to which means, or combination of
means, to use is made on the basis of audit risk and audit efficiency, the auditor needs
to be satisfied that methods used are effective in providing sufficient appropriate audit
evidence to meet the objectives of the test.
■ Selecting all items
24. The auditor may decide that it will be most appropriate to examine the entire population
of items that make up an account balance or class of transactions (or a stratum within
that population). 100% examination is unlikely in the case of tests of control; however,
it is more common for substantive procedures. For example, 100% examination may be
appropriate when the population constitutes a small number of large value items, when
both inherent and control risks are high and other means do not provide sufficient
appropriate audit evidence, or when the repetitive nature of a calculation or other
process performed by a computer information system makes a 100% examination cost
effective.
■ Selecting Specific Items
25. The auditor may decide to select specific items from a population based on such
factors as knowledge of the client’s business, preliminary assessments of inherent and
control risks, and the characteristics of the population being tested. The judgmental
selection of specific items is subject to non-sampling risk.
400
STATISTICAL VERSUS NON-STATISTICAL SAMPLING APPROACHES
Specific items selected may include:
■ High value or key items. The auditor may decide to select specific items within a
population because they are of high value, or exhibit some other characteristic, for
example items that are suspicious, unusual, particularly risk-prone or that have a
history of error.
■ All items over a certain amount. The auditor may decide to examine items whose
values exceed a certain amount so as to verify a large proportion of the total amount
of an account balance or class of transactions.
■ Items to obtain information. The auditor may examine items to obtain information
about matters such as the client’s business, the nature of transactions, accounting
and internal control systems.
■ Items to test procedures. The auditor may use judgment to select and examine
specific items to determine whether or not a particular procedure is being performed.
As we focus on sampling issues in this appendix the judgmental selection is not discussed
further.
26. While selective examination of specific items from an account balance or class of
transactions will often be an efficient means of gathering audit evidence, it does not
constitute audit sampling. The results of procedures applied to items selected in this
way cannot be projected to the entire population. The auditor considers the need to
obtain appropriate evidence regarding the remainder of the population when that
remainder is material.
■ Audit Sampling
27. The auditor may decide to apply audit sampling to an account balance or class of
transactions. Audit sampling can be applied using either non-statistical or statistical
sampling methods. Audit sampling is discussed in detail in paragraphs 31 through 56.
Although the bulk of this Standard is devoted to audit sampling, the reader should not forget
that any type of evidence gathering on the detail level is the objective of this Standard.
10.A.6 Statistical versus Non-Statistical Sampling Approaches
28. The decision whether to use a statistical or non-statistical sampling approach is a
matter for the auditor’s judgment regarding the most efficient manner to obtain
sufficient appropriate audit evidence in the particular circumstances. For example, in
the case of tests of control the auditor’s analysis of the nature and cause of errors will
often be more important than the statistical analysis of the mere presence or absence
(that is, the count) of errors. In such a situation, non-statistical sampling may be most
appropriate.
401
CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
This paragraph gives one good example of when non-statistical sampling is to be preferred
above statistical sampling. A second example lies in populations that are not available in
machine-readable format.
29. When applying statistical sampling, the sample size can be determined using either
probability theory or professional judgment. Moreover, sample size is not a valid criterion
to distinguish between statistical and non-statistical approaches. Sample size is a
function of factors such as those identified in Appendices 1 and 2. When circumstances
are similar, the effect on sample size of factors such as those identified in Appendices 1
and 2 will be similar regardless of whether a statistical or non-statistical approach is
chosen.
This is in line with the main differences between statistical and non-statistical sampling. Not a
word on sample sizes. We believe, however, that for a non-statistical sample to be as effective
as a statistical sample, the sample size needs to be nearly doubled.
30. Often, while the approach adopted does not meet the definition of statistical sampling,
elements of a statistical approach are used, for example the use of random selection
using computer generated random numbers. However, only when the approach
adopted has the characteristics of statistical sampling are statistical measurements of
sampling risk valid.
The example says that random numbers are used to select the sample items. A sad example.
Why on earth would an auditor use a randomly generated sample, which is the most cumber-
some part of statistical sampling, and then leave out the evaluation of the results using prob-
ability theory. How would that look in court, when the statistical evaluation would yield a
different conclusion from the non-statistical conclusion the auditor has formed?8
Certification Exam Question Appendix 10.2
An advantage of using statistical over non-statistical sampling methods in tests of
controls is that the statistical methods:
(A) Can more easily convert the sample into a dual-purpose test useful for substantive
testing.
(B) Eliminate the need to use judgment in determining appropriate sample sizes.
(C) Afford greater assurance than a non-statistical sample of equal size.
(D) Provide an objective basis for quantitatively evaluating sample risk.
10.A.7 Design of the Sample
Sample design is very important. Sample design must consider the objectives to test, the defi-
nition of the population, the sampling method and sample size. Most of these choices cannot
be reversed after the audit evidence has been obtained. We will explain these concepts with the
aid of a simple example: an inventory count (stock-take).
402
DESIGN OF THE SAMPLE
■ Inventory Count Example
Assume that you are the auditor of a large company that operates a central warehouse
supplying more than 100 shops in a certain region. Even though internal controls are con-
sidered to be good, it appears that at the end of every year all small deviations have added up
to a material error.
31. When designing an audit sample, the auditor should consider the objectives of
the test and the attributes of the population from which the sample will be drawn.
The objective of the inventory count is to assess completeness, existence and accuracy of
inventories. The attributes that you will test is the total inventory value in a given inventory
location.
32. The auditor first considers the specific objectives to be achieved and the combination
of audit procedures which is likely to best achieve those objectives. Consideration of
the nature of the audit evidence sought and possible error conditions or other
characteristics relating to that audit evidence will assist the auditor in defining what
constitutes an error and what population to use for sampling.
Given the fact that you expect an overall error that is material, you cannot place any reliance
on internal control, and inherent risk is set as high. You will use statistical sampling to esti-
mate the total value of inventories within precision bounds that are less than tolerable error.
You are aware that selected items may be in error because inventory items are stored at a dif-
ferent location than actually recorded. Because you are concerned that total inventory may be
understated, you use the collection of all inventory locations as the population, and define the
inventory location as the sampling unit.
33. The auditor considers what conditions constitute an error by reference to the objectives
of the test. A clear understanding of what constitutes an error is important to ensure
that all, and only, those conditions that are relevant to the test objectives are included in
the projection of errors. For example, in a substantive procedure relating to the existence
of accounts receivable, such as confirmation, payments made by the customer before
the confirmation date but received shortly after that date by the client are not
considered an error. Also, a misposting between customer accounts does not affect the
total accounts receivable balance. Therefore, it is not appropriate to consider this an
error in evaluating the sample results of this particular procedure, even though it may
have an important effect on other areas of the audit, such as the assessment of the
likelihood of fraud or the adequacy of the allowance for doubtful accounts.
We already mentioned that inventory could be stored in a different location than recorded.
This could lead to errors when you select a location that is physically empty, for which the
related inventory item is stored elsewhere in the warehouse. Conversely, you could select a
location that is empty, and find misplaced goods there. Errors like these should level out in
total, but as part of a sample they could lead to large extrapolated differences.
To avoid this problem, you may print out a listing of all empty locations, and check that
they, indeed, are empty. If locations are found empty that are not on the list, these are
reported. Likewise, if a location that is supposed to be empty actually holds any goods, the
number of items and article number are written down. With this extremely useful routine a
first stratification is made. All inventory locations that contain misplaced items, plus all empty
403
CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
locations are segregated and all of them are audited. The population subject to sampling now
comprises of all inventory location in which some (positive) value is accounted.
Likewise, you could select all locations that hold negative values. In practice, negative values
cannot exist, and the locations holding them are very likely in error.
34. When performing tests of control, the auditor generally makes a preliminary assess-
ment of the rate of error the auditor expects to find in the population to be tested and
the level of control risk. This assessment is based on the auditor’s prior knowledge or
the examination of a small number of items from the population. Similarly, for
substantive tests, the auditor generally makes a preliminary assessment of the amount
of error in the population. These preliminary assessments are useful for designing an
audit sample and in determining sample size. For example, if the expected rate of error
is unacceptably high, tests of control will normally not be performed. However, when
performing substantive procedures, if the expected amount of error is high, 100%
examination or the use of a large sample size may be appropriate.
For the population under review, you expect a large error. Still, this does not mean that we
have to perform a 100 percent examination. The sample size is determined under the
following observations:
■ The expected error will be comparable to the error found in previous inventory counts.
■ The maximum allowable sampling risk will be 5 percent.
■ Tolerable error for inventories is known.
■ You will stratify the population by book value per inventory location.
■ The population size is large. After the preliminary stratification you have approximately
20,000 locations left that contain some positive value.
Certification Exam Question Appendix 10.3
Which of the following sample planning factors would influence the sample size for a
substantive test of details for a specific account?
Expected amount of Measure of tolerable
misstatements misstatement
(A) No No
(B) Yes Yes
(C) No Yes
(D) Yes No
Population
35. It is important for the auditor to ensure that the population is:
a. Appropriate to the objective of the sampling procedure, which will include consideration
of the direction of testing. For example, if the auditor’s objective is to test for over-
statement of accounts payable, the population could be defined as the accounts
payable listing. On the other hand, when testing for understatement of accounts pay-
able, the population is not the accounts payable listing but rather subsequent disburse-
ments, unpaid invoices, suppliers’ statements, unmatched receiving reports or other
populations that provide audit evidence of understatement of accounts payable; and
404
DESIGN OF THE SAMPLE
b. Complete. For example, if the auditor intends to select payment vouchers from a file,
conclusions cannot be drawn about all vouchers for the period unless the auditor is
satisfied that all vouchers have in fact been filed. Similarly, if the auditor intends to
use the sample to draw conclusions about the operation of an accounting and
internal control system during the financial reporting period, the population needs to
include all relevant items from throughout the entire period. A different approach
may be to stratify the population and use sampling only to draw conclusions about
the control during, say, the first 10 months of a year, and to use alternative
procedures or a separate sample regarding the remaining two months.
In the example of the inventory count (stock-take), taking the listing of all stock would be
appropriate for the test. However, the listing may not be complete. An alternative would be to
use the inventory locations as the sampling unit. This could satisfy both the appropriateness
and completeness conditions, unless the company stores part of its stock outside known
locations.
Stratification
36. Audit efficiency may be improved if the auditor stratifies a population by dividing it
into discrete sub-populations which have an identifying characteristic. The objective of
stratification is to reduce the variability of items within each stratum and therefore allow
sample size to be reduced without a proportional increase in sampling risk. Sub-
populations need to be carefully defined such that any sampling unit can only belong to
one stratum.
The most important feature mentioned in this paragraph is the variability of items. For the
purpose of estimation or hypothesis testing, we can distinguish between two causes of vari-
ability, error rate and error value. In monetary unit sampling, the auditor only has to worry
about the error rate as a source of sampling variability. This is because the sampling unit in the
statistical definition is the monetary unit, and all monetary units are equal in size. There
simply does not exist any variability in terms of error value.
37. When performing substantive procedures, an account balance or class of transactions
is often stratified by monetary value. This allows greater audit effort to be directed to
the larger value items which may contain the greatest potential monetary error in terms
of overstatement. Similarly, a population may be stratified according to a particular
characteristic that indicates a higher risk of error, for example, when testing the
valuation of accounts receivable, balances may be stratified by age.
Let us get one thing straight. If the auditor is primarily concerned with overstatement, and he
desires to direct his effort to the larger value items which may contain the greatest potential
monetary error in terms of overstatement, the solution is not stratification but monetary unit
sampling. True, a stratified variables estimation sample will yield more precise results than an
unstratified sample of the same size, but both will be outperformed by a monetary unit sample
of the same size.
405
CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
38. The results of procedures applied to a sample of items within a stratum can only be
projected to the items that make up that stratum. To draw a conclusion on the entire
population, the auditor will need to consider risk and materiality in relation to whatever
other strata make up the entire population. For example, 20% of the items in a
population may make up 90% of the value of an account balance. The auditor may
decide to examine a sample of these items. The auditor evaluates the results of this
sample and reaches a conclusion on the 90% of value separately from the remaining
10% (on which a further sample or other means of gathering evidence will be used, or
which may be considered immaterial).
Stratification in this paragraph is somewhat different from that in the previous paragraph.
In this paragraph, guidance is given to situations where the auditor focuses his audit effort to
the few largest items that make up most of the population. The auditor audits a sample of
these and has to decide whether he has gathered sufficient audit evidence for the population as
a whole. It goes without saying that this approach is non-statistical. A monetary unit sample
would have selected a larger number of high-value items and a smaller number of low-value
items, and the results could then be evaluated to form an opinion on the population as a
whole.
Projection of results of a stratified sample will be further discussed in paragraph 52.
Value weighted selection
39. It will often be efficient in substantive testing, particularly when testing for over-
statements, to identify the sampling unit as the individual monetary units (e.g. dollars)
that make up an account balance or class of transactions. Having selected specific
monetary units from within the population, for example, the accounts receivable
balance, the auditor then examines the particular items, for example, individual
balances, that contain those monetary units. This approach to defining the sampling
unit ensures that audit effort is directed to the larger value items because they have a
greater chance of selection, and can result in smaller sample sizes. This approach is
ordinarily used in conjunction with the systematic method of sample selection
(described in Appendix 3) and is most efficient when selecting from a computerized
database.
Monetary unit sampling is the most efficient and effective sampling technique in the
auditor’s toolbox. It is particularly useful when testing for overstatements, and it is advisable
to use it in cases where the population is available in machine-readable format.
The remark about the advantages of selecting larger value items is strange. Statistically
speaking, we do not select larger or smaller items. We select individual monetary units, and
the auditor only needs to know to which physical unit they belong to be able to pull the
evidence material to ascertain whether the monetary unit is correct or incorrect. The efficiency
and effectiveness of monetary unit sampling is not affected by the error distribution: it does
not matter whether a few large items collectively contain a material error or that a large
number of small errors in lower-value items constitute a material error. Monetary unit
sampling only “looks at” individual monetary units, that may or may not be in error.
We will continue the discussion on how to select items in the discussion on paragraph 43.
406
DESIGN OF THE SAMPLE
■ Sample Size
40. In determining the sample size, the auditor should consider whether sampling
risk is reduced to an acceptably low level. 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.
As discussed in paragraph 19, the sampling risk that the auditor is willing to accept is
dependent on his assessments of inherent and control risk, and the amount of audit evidence
obtained from substantive analysis and other substantive procedures other than sampling
relating to the same audit objective.
Having said that, we can now concentrate on the mathematical side of the story. Let us first
turn to the example mentioned in paragraph 7, where the auditor calculated a sample of 25.
We will now explain where this number comes from and what factors influence sample sizes
in general.
The decision rule is: approve the population if no errors are found and reject it if an error
is found. There is a population of 100 items, of which ten were in error. The auditor has
decided that he wants to run a risk of no more than 5 percent that he will not find any errors
in his sample.
The auditor increases the sample size until the cumulative product is less than 5 percent.
By calculating the hypergeometric distribution (using, for example, Microsoft Excel’s
HYPGEOMDIST function), the auditor can verify that the probability of finding 24 correct
items out of a population of 100 that contains ten errors is approximately 5.5 percent, and for
25 items it is 4.8 percent. The conclusion is that a sample of 25 is sufficiently large.
Let us now have a look at the factors that affect the sample size. First, clearly, the acceptable
sampling risk is a determining factor. If the sampling risk were 10 percent instead of 5 percent,
the sample size would be only 20, and if sampling risk were 1 percent the sample size has to be
at least 36. The lower the acceptable sampling detection risk, the higher the sample size.
Certification Exam Question Appendix 10.4
The tolerable error for a test of a control is generally:
(A) Lower than the expected rate of errors in the related accounting records.
(B) Higher than the expected rate of errors in the related accounting records.
(C) Identical to the expected rate of errors in related accounting records.
(D) Unrelated to the expected rate of errors in the related accounting records.
Secondly, the “tolerable error” is a strong influence. In the example above, tolerable error is
supposed to be ten items out of 100. If the auditor wants to cover for not finding any errors
from a population of 100 that contains five errors, then he should look harder for them. At
5 percent sampling risk, he should audit at least 45 items to be confident enough to find at
least one error, or, in other words, if the sample of 45 does not reveal any errors, he will be
(95 percent) confident that the population does not contain more than five errors.
Alternatively, if the tolerable error is 20 items, then a sample size of 13 is sufficient. The lower
the tolerable error, the higher the sample size.
407
Sample sizeCHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
Does the population size play a role in this? (See Illustration 10.A.1.) The question has two
sides to it, depending whether the tolerable error is a constant, or is expressed as a percentage
of the population. The first side is easily solved: if the tolerable error is a constant, then
increasing the population will decrease the tolerable error. If the population size would be 200
and the tolerable error would remain at ten, then the sample size would be 51. This result also
answers the second side of the question: a 5 percent error in a population of 200 calls for a
sample of 51, whereas a sample of 45 was sufficient for a 5 percent error in a population of 100.
The effect of the population size will wear off dramatically, though.
ILLUSTRATION 10.A.1
Minimum sample size to detect 5 percent error 9
70
60
50
40
30
20
10
0
20 100 180 260 340 420 500 580 660 740 820 900 980 1060 1140 1220 1300
Population size
As a rule of thumb, we usually apply the hypergeometric distribution if the sample size is
less than one-tenth of the population size, and use the binomial distribution in all other cases.
If the population size for instance were 600, we would calculate the sample size at 59, which
would be less than one-tenth of the population size. It would then not be necessary calculate
the sample size with the hypergeometric distribution. If we did, the result would be 56.
As a conclusion, we may say that the population size does have an effect on the sample size,
but that effect is dependent on whether the tolerable error is expressed as a percentage of the
population or not, and the effect diminishes if the population becomes larger than 10 times
the sample size as calculated using the binomial distribution.
Finally, the decision rule plays an important part. In the example that we introduced in
the discussion on paragraph 7, we saw that if we wanted to reduce the risk of inadvertently
rejecting a population that contains a not-so-material error, we could do this by changing the
decision rule. More precisely, we increased the critical region, rejecting a population if the
sample revealed two or more errors, and accepting a population if no more than one error was
found. The minimum sample size would have to be increased from 25 to 39.
408
DESIGN OF THE SAMPLE
Illustration 10.A.2 shows what inputs are needed in the software package IDEA to calculate
the required sample size:
ILLUSTRATION 10.A.2
IDEA Audit Software Screen to Determine Sample Size9
Illustration 10.A.2 shows that for a desired confidence of 90 percent, a population size of
$118,498,593, a tolerable error of $10,000,000, and an expected error of $0, the sample size
would be 27. IDEA uses fixed interval section for the selection process and therefore calculates
the sampling interval at $118,498,593 divided by 27. It also shows that the total tainting of the
sampled item has to be 0 for the population to be approved. (See also the various evaluation
screens in our discussion on paragraph 54.)
41. The sample size can be determined by the application of a statistically-based formula or
through the exercise of professional judgement objectively applied to the circumstances.
Appendices 1 and 2 [of the Standard] indicate the influences that various factors
typically have on the determination of sample size, and hence the level of sampling risk.
409
CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
In the discussion to the previous paragraph, we have seen that the factors that determine the
minimum sample size are:
■ sampling risk,
■ tolerable error,
■ population size (Appendix 2 to the Standard calls the effect negligible),
■ decision rule (referred to as the amount of error the auditor expects to find in the
population.
The only other effect on the sample size is stratification, but as we have pointed out in our
discussion on paragraph 36, stratification is only useful for variables estimation techniques:
that is, all substantive sampling procedures other than monetary unit sampling.
The determination of the minimum sample size then boils down to the effects of sampling
risk and tolerable error, if we can neglect the effect of population size and assume we only
approve the population if no errors were found. The sample size required is found by dividing
the logarithm of the sampling risk by the logarithm of (1 0 p), where p is the tolerable error
expressed as a percentage of the total book value of the population.
Professional judgment objectively applied to the circumstances may produce a sample size
that is different from the sample size obtained statistically. If the non-statistical sample size is
lower, the auditor should have sound reasons to approve a population if errors were found
in the sample. Moreover, even if he does not find any errors, he should document what
supporting audit evidence allows him to use a lower non-statistical sample size.
■ Selecting the Sample
42. 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. Because the purpose of sampling is to
draw conclusions about the entire population, the auditor endeavors to select a
representative sample by choosing sample items which have characteristics typical of
the population, and the sample needs to be selected so that bias is avoided.
See our discussion on the definition of audit sampling in paragraph 3 and of statistical
sampling in paragraph 10.
43. The principal methods of selecting samples are the use of random number tables or
computer programs, systematic selection and haphazard selection. Each of these
methods is discussed in Appendix 3 [of the Standard].
There are various ways to select individual monetary units. One method is systematic
sampling, which is supported by generalized audit software such as IDEA or ACL. It is also
referred to as fixed interval selection. The advantages of systematic sampling are that all items
larger than the sampling interval have a 100 percent selection probability, and that it is avail-
able in the software packages mentioned. There are two disadvantages:
1 Strictly speaking systematic sampling does not agree with our definition of random sampling.
410
DESIGN OF THE SAMPLE
2 The method performs poorly if the error pattern in the population coincides with the
sampling pattern.
It is very easy to obtain a monetary unit sample from a population that is available in a
spreadsheet, such as Microsoft Excel. The auditor should perform the following steps to
achieve this:
1. Calculate the sample size, and decide what the sampling interval would be if systematic
sampling were deployed.
2. Select all items in the population that are larger than the sampling interval.
3. Recalculate the sample size based on the smaller population with the large items left out.
4. Calculate into a new cell the book value of the item divided by a random number
(uniformly distributed between 0 and 1). The Excel formula #RAND() produces such
random numbers.
5. Sort the file in descending order on the result from step 4. Select the desired number of
items from the top.
■ Performing the Audit Procedure
44. The auditor should perform audit procedures appropriate to the particular test
objective on each item selected.
45. If a selected item is not appropriate for the application of the procedure, the procedure
is ordinarily performed on a replacement item. For example, a voided check may be
selected when testing for evidence of payment authorization. If the auditor is satisfied
that the check had been properly voided such that it does not constitute an error, an
appropriately chosen replacement is examined.
This is sound practice, because it actually means that the population was ill-defined, and
the population that was sampled from actually contains items not of interest to the auditor.
46. Sometimes however, the auditor is unable to apply the planned audit procedures to a
selected item because, for instance, documentation relating to that item has been lost.
If suitable alternative procedures cannot be performed on that item, the auditor
ordinarily considers that item to be in error. An example of a suitable alternative
procedure might be the examination of subsequent receipts when no reply has been
received in response to a positive confirmation request.
It may sound very strict to consider items on which no suitable substantive procedures can
be performed as errors, but in doing so the auditor gains an idea on the worst-case situation.
In practice, it may be advised to run two separate evaluations, one with the uncertain items
evaluated as errors, and one with the uncertain items not evaluated as errors. The two evalua-
tions then provide a bandwidth that more precisely describes the population.
■ Nature and Cause of Errors
This is a very important section from an auditing point of view. When following the guidance
provided in these paragraphs, the auditor extends the knowledge about the errors from the
411
CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
simple occurrence to the cause, thus broadening his judgment necessary to arrive at the
correct conclusion. A mere mathematical treatment of audit evidence is not sufficient.
47. 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.
48. When conducting tests of control, the auditor is primarily concerned with the design
and operation of the controls themselves and the assessment of control risk. However,
when errors are identified, the auditor also needs to consider matters such as:
a. the direct effect of identified errors on the financial statements; and
b. the effectiveness of the accounting and internal control systems and their effect on
the audit approach when, for example, the errors result from management override
of an internal control.
49. In analyzing the errors discovered, the auditor may observe that many have a common
feature, for example, type of transaction, location, product line or period of time. In
such circumstances, the auditor may decide to identify all items in the population that
possess the common feature, and extend audit procedures in that stratum. In addition,
such errors may be intentional, and may indicate the possibility of fraud.
Stratification may be done ex-post, that is, after the initial or pilot sample has revealed that
errors may be concentrated in one or more sub-populations. Just stratifying the population is
not sufficient. That is why this paragraph suggests that audit procedures be extended in the
high-error strata. Only then will the overall estimate be more precise and will the auditor
benefit from stratification.
50. Sometimes, the auditor may be able to establish that an error arises from an isolated
event that has not recurred other than on specifically identifiable occasions and is
therefore not representative of similar errors in the population (an anomalous error). To
be considered an anomalous error, the auditor has to have a high degree of certainty
that such error is not representative of the population. The auditor obtains this certainty
by performing additional work. The additional work depends on the situation, but is
adequate to provide the auditor with sufficient appropriate evidence that the error does
not affect the remaining part of the population. One example is an error caused by a
computer breakdown that is known to have occurred on only one day during the period.
In that case, the auditor assesses the effect of the breakdown, for example by
examining specific transactions processed on that day, and considers the effect of the
cause of the breakdown on audit procedures and conclusions. Another example is an
error that is found to be caused by use of an incorrect formula in calculating all
inventory values at one particular branch. To establish that this is an anomalous error,
the auditor needs to ensure the correct formula has been used at other branches.
As already mentioned, when the “anomalous error” was first introduced in the Definitions
section, the concept was dangerous. This paragraph provides guidance on what to do when
the auditor believes the errors found are of an anomalous nature. In any case, just labeling
412
DESIGN OF THE SAMPLE
errors as anomalous should be avoided, and not taken into further consideration for the
assessment of a material error in the population.
■ Projecting Errors
51. 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 on the particular test objective and on other areas of the audit. 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. For substantive procedures, tolerable error is
the tolerable misstatement, and will be an amount less than or equal to the auditor’s
preliminary estimate of materiality used for the individual account balances being
audited.
This might be insufficient guidance and could lead to potential misappropriation of audit
sampling. What does the auditor’s decision process look like? How do errors need to be pro-
jected and what exactly is compared to the tolerable error? We can best explain what is needed
when monetary unit sampling is used. After that, we can discuss how the same would apply for
variables estimates, and finally for non-statistical samples.
In monetary unit sampling, for every single sampled item an audit value is established,
and compared to the book value. Then a “tainting” (the difference between book and audit
value) is calculated as a percentage of the book value. So if the book value equals the audit value,
the tainting is zero, and if the audit value is zero (the item is entirely wrong) the tainting is
100 percent.
The results of the sample are then fed into a computer program, which calculates a point
estimate of the error in the population, and a one-sided interval estimate of this error. The
point estimate is the most likely estimate, and the upper limit of the interval estimate is the
worst-case estimate. The auditor bases his decision on the position of both statistics relative to
the tolerable error.
If the upper limit of the interval estimate is lower than the tolerable error, the auditor can
conclude that the population does not contain a material error. If the upper limit of the
interval estimate is higher than the tolerable error, and the point estimate is also higher, then
the auditor has gathered convincing evidence that the population may contain a material
error.
In all other cases, the risk of a material error is too large for the auditor to live with, but the
evidence does not guarantee an error of this size. The auditor has to find out what is wrong,
usually by investigating more items from the same population.
So far so good for monetary unit sampling. Let us now see what the differences are for
variables estimates,10 that is, all other forms of statistical sampling that are not value-weighted.
In variables estimation, the auditor obtains a point estimate on the error in the population,
as well as a one-sided interval estimate. However, the calculations underlying these statistics
assume that the data used are normally distributed, and in most cases they are not. The effect
of this is that the upper limit on the interval estimate is treacherously underestimated. As a
result, the upper limit will much more often be less than a tolerable error, which will make the
auditor believe that he can approve the population.
Non-statistical sampling can only be evaluated as a variables estimation technique, and has
haphazard selection as an additional disadvantage. This implies that the same decision rules
413
CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
apply as for variables estimation, including the warning that upper limits tend to be
dangerously understated.
52. [When an error has been established as an anomalous error, it may be excluded when
projecting sample errors to the population. The effect of any such error, if uncorrected,
still needs to be considered in addition to the projection of the non-anomalous errors.]
If an account balance or class of transactions has been divided into strata, the error is
projected for each stratum separately. Projected errors plus anomalous errors for each
stratum are then combined when considering the possible effect of errors on the total
account balance or class of transactions.
Let us have a look at an example. The population consists of 11,449 items with a total book
value of $522,800. The population is split into two sub-populations, one containing 2,613
items with a higher than average value, the other containing the remaining 8,836 items with a
value less than $46.
We sampled 171 items from the top stratum and 86 from the bottom stratum. The total
error (book value minus audit value) in the top stratum sample was $429.24, that in the
bottom stratum sample $33.13. Illustration 10.A.3 demonstrates the error projection using
the ratio estimation method (Panel A) and difference method of projection (Panel B).
ILLUSTRATION 10.A.3
Error Projection
Panel A Ratio Estimation Method
Stratum Error found Book value Error ratio Total book Projected
(A) of sampled (C) # (A) (B) value in error
items (B)
2.0076% stratum (D) (C) " (D)
Lower 33.13 1,650.20
1.7692% 159,222.33 3,196.60
Upper 429.24 24,261.28
Total 363,577.67 6,432.56
522,800.00 9,629.16
Panel B Difference Method
Stratum Error found Sample size Average Total number Projected
Lower (A) (B) error of items in error
Upper stratum (D)
Total (C) # (A) (B) (C) " (D)
33.13 86 0.38523 8,836 3,403.91
429.24 171 2.51018 2,613 6,559.09
11,449 9,963.00
This example shows, as the Standard describes, that findings from a stratum should only be
extrapolated over that stratum. Only then will the auditor benefit from the effort he has been
through to stratify the population.
414
DESIGN OF THE SAMPLE
It may strike the reader as odd that the extrapolation methods generate two different
estimates. Well, if they would generate the same result, there would not be a good reason for
the existence of multiple methods. So two questions arise:
1 Is there a general condition under which they generate the same estimate?
2 Can we give any advice on when to use which method?
The answer to the first question is that the two estimators give the same result if the average
book value in the sample equals the average book value in the population. The answer to the
second question is determined by which statistics can be more easily obtained – the total book
value per stratum or the number of items per stratum.
53. For tests of control, no explicit projection of errors is necessary since the sample error
rate is also the projected rate of error for the population as a whole.
This is beside the point. The sample error rate is also the projected rate of error for the
population as a whole for substantive tests.
Sometimes, tests of controls are set up in the form of a so-called sequential sampling
procedure. In its practical form, the auditor samples 30 items. If no errors are revealed, the
auditor places full reliance on controls. For every error found, an additional ten items are
audited. The procedure should be stopped after having audited 60 items. If the total number
of errors is more than six, then no reliance can be placed on controls. If the total number of
errors is between three and six, the auditor assigns moderate reliance.
■ Evaluating the Sample Results
54. 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 the case of a test of controls, an unexpectedly
high sample error rate may lead to an increase in the assessed level of control risk,
unless further evidence substantiating the initial assessment is obtained. In the case of
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, in the absence of further evidence that no material misstatement exists.
An example of the evaluation using IDEA is given in Illustration 10.A.4.
55. If the total amount of projected error [plus anomalous error] is less than but close to
that which the auditor deems tolerable, the auditor considers the persuasiveness of the
sample results in the light of other audit procedures, and may consider it appropriate to
obtain additional audit evidence. The total of projected error plus anomalous error is
the auditor’s best estimate of error in the population. However, sampling results are
affected by sampling risk. Thus when the best estimate of error is close to the tolerable
error, the auditor recognizes the risk that a different sample would result in a different
best estimate that could exceed the tolerable error. Considering the results of other
audit procedures helps the auditor to assess this risk, while the risk is reduced if
additional audit evidence is obtained.
415
CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
ILLUSTRATION 10.A.4
IDEA Evaluation of Sample Results11
The guidance provided in this paragraph is mainly geared toward non-statistical sampling. As
we have mentioned earlier in the discussion on paragraph 51, the evaluation of statistical
samples uses the position of the upper limit of the interval estimate relative to tolerable error
as the primary point of focus. As long as it is less than tolerable error, the auditor can approve
the population. If it is larger, then the position of the point estimate will give a clue as to
whether it is worthwhile continuing sampling items to gather evidence.
In non-statistical sampling we cannot obtain an upper limit of the interval estimate. That is
why we have to choose a subjective boundary on the point estimate to decide whether the
population can be approved or not. If the boundary is chosen too low, we would be better
protected against inadvertently approving populations that contain material errors, but at the
same time we would more often reject populations that have a smaller than material error.
Conversely, if we take the boundary too high, then the probability of inadvertently approving
populations that contain material errors further increases.
A minimal sample size is not sufficient to approve a population if the extrapolated error is
less than one-third of tolerable error. The sample size must be nearly doubled to guard the
auditor against the risk of inadvertently approving the population. As the sample size
increases, the probability of inadvertent approval decreases. This is an indication that at
higher sample sizes, say more than two times the minimum size necessary for a monetary unit
sample, the decision point for non-statistical samples could be increased also.
416
ANSWERS TO CERTIFICATION EXAM QUESTIONS
56. If the evaluation of sample results indicates that the preliminary assessment of the
relevant characteristic of the population needs to be revised, the auditor may:
a. request management to investigate identified errors and the potential for further
errors, and to make any necessary adjustments; and or
b. modify planned audit procedures. For example, in the case of a test of control, the
auditor might extend the sample size, test an alternative control or modify related
substantive procedures; and or
c. consider the effect on the audit report.
This paragraph deals with the question: What do you have to do if you found (too many)
errors? The first suggestion is to have the client sort out his problems and clean up the mess
before you can sign off.
The second solution is to do the cleaning yourself. It means more audit work and probably
an adjustment of the population under review on the basis of your sample findings. The
adjustment can be made for the errors found or for the extrapolated error.
If both these solutions are not feasible, the ISA suggests that you do not issue an unqualified
opinion. This requires some courage, because it jeopardizes the relationship with the client.
10.A.8 Answers to Certification Exam Questions
10A.1 (A) We are to find the answer that represents the concept of sampling risk. 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.
Choices (B), (C), and (D) are all incorrect because they relate to errors which could occur even if
100 percent of the population were examined, in other words, non-sampling risk.
10A.2 (D) One must identify an advantage of statistical sampling over non-statistical sampling.
Answer (D) is correct because statistical sampling means any approach to sampling that has the
following characteristics: random selection of a sample; and use of probability theory to evaluate
sample results, including measurement of sampling risk. These are objective characteristics and
they are evaluated using a quantative method – statistical analysis. Choice (A) is incorrect because
dual-purpose tests, which both test a control and serve as substantive test, can use either a sta-
tistical or a non-statistical sample. Choice (B) is not correct because both statistical and non-sta-
tistical sampling require the use of judgment. Choice (C) is wrong because assurance may be
provided by either statistical or non-statistical sampling.
10A.3 (B) Does either the expected amount of misstatement or the measure of tolerable mis-
statement influence sample size for a substantive test of details? Check (B) as right because both
the expected amount of misstatement and the tolerable misstatement affect sample size.
Increases in the expected amount of misstatements increase sample size, while increases in the
tolerable misstatement decrease sample size. Choices (A), (C) and (D) are incorrect because both
expected amount of misstatements and measure of tolerable misstatement increase, not one or
the other.
10A.4 (B) What is the relationship between the tolerable error and the expected rate of errors for
a test of a control? Tolerable error means the maximum error in a population that the auditor is
willing to accept. Choice (A) is bogus because if the tolerable error rate is less than the expected
417
CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
rate, the auditor would not plan to rely on internal control and would therefore omit tests of
controls. Choice (C) is a loser because testing of controls is inappropriate if the expected rate of
errors equals the tolerable error rate (mathematically, in this case, the sample size would equal
the population size). Choice (D) is off the mark because to perform tests of controls one must
assume that the tolerable rate of deviations is more than the expected error rate.
10.A.9 Notes
1 The slightly careless wording used in the ISA standard avoids discussions on monetary unit
sampling, where the sampling unit statistically is the monetary unit, but physically is the item that
contains the monetary unit that is selected. As a result, in monetary unit sampling the monetary
units have the same selection probability, but the physical units have selection probabilities that are
proportional to their size.
2 Calculated with the hypergeometric distribution. In Excel: #HYPGEOMDIST(0; 25; 10; 100).
3 Again, the hypergeometric distribution is employed. In Excel: #HYPGEOMDIST(0, 25, 3,100).
4 With a sample size of 39, the probability of finding 0 or 1 errors from a population of 100 that
contains ten errors is 4.4 percent. The Excel equivalent is #HYPGEOMDIST(0, 39, 10,100) !
HYPGEOMDIST(1, 39, 10, 100). The power of the test has now increased to 66.4 percent #
HYPGEOMDIST(0, 39, 3,100) ! HYPGEOMDIST(1, 39, 3, 100).
5 But there is a little catch to that. It occurs when monetary unit sampling is deployed, where negative
(credit) items do not have a chance of selection and the sample size is directly proportional to the
total balance of positive (debit) items. A balance that has a lot of unmatched credit items at a lower
level may inflate when the sampling unit is chosen at that lower level. Moreover, the auditor then
also has to devise an audit procedure on the completeness of credit items. If the sampling unit is
chosen at the balance level, this will automatically provide information on the completeness of credit
items.
6 Calculated with the binomial distribution, in Excel #BINOMDIST(3, 60, 0.05, 0).
7 Calculated with the exact upper and lower bounds for the binomial distributions.
8 Comment: More often we encounter situations, where the sample was drawn haphazardly and the
sample results are evaluated as if they were produced by a statistical sample.
9 IDEA® is a registered trademark of CaseWare International Inc.
10 Sorry about the complexity. The notion is important though. This is the first time where it is claimed
that variables estimation is a dangerous technique. Software like IDEA support it and suggest that it
works better than MUS if the expected error is larger than 50 percent of tolerable error. This is not
true. We have recently found proof that a value-weighted selection is the best possible approach,
especially in cases where only overstatements are expected, but also in many other cases. Moreover,
most auditors are not aware that the confidence intervals for variables estimation are under-
estimated. This means that they are led to believe that they have gained enough confidence whereas
the true confidence is much lower.
11 IDEA® is a registered trademark of CaseWare International Inc.
418
QUESTIONS, EXERCISES AND CASES
10.A.10 Questions, Exercises and Cases
QUESTIONS
10A.1 Name the factors that an auditor typically takes into consideration when determining
10A.2 the necessary sample size.
10A.3 What is the difference between the significance level of a test and the power of a test?
10A.4 Is Type II error also part of the audit risk?
When projecting errors for a non-statistical sampling method, the auditor can choose
10A.5 between extrapolating over the number of items in the population and extrapolating
10A.6 over the book value in the population. Typically, these methods will generate different
results. Under which circumstances will the results be the same?
10A.7 Why is it difficult to determine the sample size for the estimate of the population error
10A.8 with a given confidence and pre-determined precision.
10A.9 To determine the completeness of accounts payable at year-end, the auditor decides
to define the sampling population as the payments after year-end. Why does this test
have limited value?
What are the requirements for a representative sampling technique to qualify as a
“statistical” sample?
Appendices 1 and 2 to ISA 530 list a number of factors that influence sample size. Are
these factors only relevant for statistical samples?
Some people claim that an audit risk of 5 percent implies that 5 percent of financial
statements with unqualified opinions contain material errors. What is your view on this?
EXERCISES
10A.10 Sampling for attributes is often used to allow an auditor to reach a conclusion
concerning a rate of occurrence in a population. A common use in auditing is to test
the rate of deviation from a prescribed internal control procedure to determine whether
the planned assessed level of control risk is appropriate.
Required:
A. When an auditor samples for attributes, identify the factors that should influence the
auditor’s judgment concerning the determination of:
1 acceptable level of risk of assessing control risk too low,
2 tolerable deviation rate, and
3 expected population deviation rate.
B. State the effect on sample size of an increase in each of the following factors,
assuming all other factors are held constant:
1 acceptable level of risk of assessing control risk too low,
2 tolerable deviation rate, and
3 expected population deviation rate.
C. Evaluate the sample results of a test for attributes if authorizations are found to be
missing on seven check requests out of a sample of 100 tested. The population con-
sists of 2,500 check requests, the tolerable deviation rate is 8 percent, and the
acceptable level of risk of assessing control risk too low is considered to be low.
D. How may the use of statistical sampling assist the auditor in evaluating the sample
results described in C above?
[Adapted and reprinted with permission from AICPA. Copyright © 2000 & 1985 by
American Institute of Certified Public Accountants.]
419
CHAPTER 10 SUBSTANTIVE TESTING AND EVIDENCE
10A.11 Rong & Wright, CA, of Hong Kong has decided to rely on an audit client’s affecting
receivables. Rong & Wright plans to use sampling to obtain substantive evidence
concerning the reasonableness of the client’s accounts receivable balances. Rong &
Wright has identified the first few steps in an outline of the sampling plan as follows.
1 Determine the audit objectives of the test.
2 Define the population.
3 Define the sampling unit.
4 Consider the completeness of the population.
5 Identify individually significant items.
Required:
Identify the remaining steps which Rong & Wright should include in the outline of the
sampling plan.
[Adapted and reprinted with permission from AICPA. Copyright © 2000 & 1985 by
American Institute of Certified Public Accountants.]
420
Chapter 11
COMPLETING THE AUDIT
11.1 Learning Objectives
After studying this chapter, you should be able to:
1 Reiterate the procedures for the audit completion stage.
2 State the elements of a system of quality control of an audit firm.
3 Give the implications of the Sarbanes-Oxley Act for quality control and audit
review.
4 Understand why letters from client legal counsel are necessary and what
they contain.
5 Obtain evidence that management acknowledges its responsibility for the
fair representation of the financial statements in a management
representation letter.
6 Conduct a review for contingent liabilities and commitments.
7 Explain what a related party transaction is and the procedures required to
determine the completeness of information provided by management.
8 Conduct a review after the balance sheet date for subsequent events and
understand what events cause financial statement adjustments.
9 Know the auditor’s responsibilities when facts are discovered after the
issuance of the audit report.
10 Explain the procedures involved in the review of financial statements
including disclosures and other information presented with the audited
financial statements.
11 Design and perform the wrap-up procedures.
12 Determine procedures to evaluate going concern issues.
13 Discuss the design and use of matters for the attention of partners.
CHAPTER 11 COMPLETING THE AUDIT
ILLUSTRATION 11.1
Audit Process Model – Phase Flow Diagram
Phase I Procedures:
Client Acceptance (1) Evaluate the client's background andd reasons
Objective: Determine both acceptance
of a client and acceptance by a client. for the audit.
Decide on acquiring a new client or (2) Determine whether the auditor is able to meet
continuation of relationship with an
existing one and the type and amount the ethical requirements regarding the client.
of staff required. (3) Determine need for other professionals.
(4) Communicate with predecesser auditor.
(5) Prepare client proposal.
(6) Select staff to perform the audit.
(7) Obtain an engagement letter.
Phase II Procedures:
Planning the Audit (1) Obtain industry, company, legal, related party
Objective: Determine the amount and
type of evidence and review required to and financial background information.
give the auditor assurance that there is (2) Perform procedures to obtain an understanding
no material missatement of the
financial statements. of internal control.
(3) Assess the risks of material misstatements of
the financial statements.
(4) Determine materiality.
(5) Prepare the planning memorandum and audit
program (audit plan), which contains the
auditor’s response to the identified risk.
Phase III Procedures:
Testing and Evidence (1) Tests of controls.
Objective: Test for evidence (2) Substantive tests of transactions.
supporting internal controls and the (3) Analytical procedures.
fairness of the financial statements. (4) Tests of details of balances.
(5) Search for unrecorded liabilities.
Phase IV Procedures:
Evaluation and Reporting (1) Evaluate governance evidence.
Objective: Complete the audit (2) Perform procedures to identify subsequent
procedures and issue an opinion.
events.
(3) Review financial statement and other report
material.
(4) Perform wrap–up procedures.
(5) Prepare Matters for Attention of Partners.
(6) Report to the board of directors.
(7) Prepare Audit report.
422
INTRODUCTION
11.2 Introduction
The audit is not over until the audit report is signed. And even then it may not be over if
facts are discovered after the balance sheet date and before the next report. After the field-
work is almost complete, a series of procedures are generally carried out to “complete the
audit.” The intent of these procedures is to review the audit work, get certain assurances
from the client, uncover any potential problems, check compliance with regulations, and
check the consistency of the material that is to be presented to the users of financial
statements.
In this text so far we have followed the standard audit process model (Illustration 11.1)
through its phases – for client acceptance (Phase I), planning (Phase II), and elements of
testing and evidence (Phase III). In this chapter, we will discuss the last phase, Phase IV,
evaluation and reporting.
The procedures for completing this audit phase are: evaluate governance evidence; do
procedures to identify subsequent events; review financial statements and other report
material; do wrap-up procedures, prepare Matters for Attention of Partners; report to the
board of directors and prepare audit report (which will be discussed in Chapter 12 Audit
Reports and Communication). These procedures and the objective of the evaluation and
reporting phase are shown in Illustration 11.2.
ILLUSTRATION 11.2
Audit Process Model – Phase IV Evaluation and Reporting
Objective: Complete the audit procedures and issue an opinion.
Procedures
1 Evaluate governance evidence.
2 Perform procedures to identify subsequent events.
3 Review financial statements and other report material.
4 Perform wrap-up procedures.
5 Prepare Matters for Attention of Partners.
6 Report to the board of directors.
7 Prepare Audit report.
The initial audit procedure in the closing cycle is usually to evaluate governance evidence,
the evidence pertaining to the company and management. This means obtaining a legal
letter and a management representations letter. Next in the governance evaluation is to
look at contingent liabilities and related parties.
Discovery of subsequent facts and events may be essential to a correct opinion. The
auditor must consider events up to the date of the auditor’s report and between the
balance sheet date and the issuance of the statements. Discovery of facts after the financial
statements’ issuance are not generally as crucial.
Of course, the auditors must review financial statements and financial statement
disclosures, but they must also review other information contained in the annual report.
423
CHAPTER 11 COMPLETING THE AUDIT
Other information that needs looking into is the board of directors’ report, corporate
governance disclosures (where applicable) and all other information in the annual report
to shareholders.
The last work of the closing cycle is wrap-up procedures, matters for supervisors,
report to the audit committee, and the audit report itself. Wrap-up procedures include:
■ analytical procedures,
■ review working papers,
■ evaluation of going concern,
■ client approval of adjusting entries.
Reporting and evaluation of matters for supervisory attention includes reports to
managers and partners.
Prior to the final audit report the auditors will usually discuss their findings with the
audit committee especially irregularities, illegal acts and reportable conditions. The final
step in the closing cycle is the audit report, discussed in Chapter 12 Audit Reports and
Communication.
Certification Exam Question 11.1
International Standards on Quality Control (ISQC) apply to:
(A) Auditing services only.
(B) Auditing and management advisory services.
(C) Auditing and tax services.
(D) Auditing and accounting and review services.
11.3 Quality Control
According to International Standard on Quality Control 1 (ISQC 1),1 the audit firm
should establish a system of quality control designed to provide it with reasonable
assurance that the firm and its personnel comply with professional standards and regu-
latory and legal requirements, and that reports issued by the firm or engagement partners
are appropriate in the circumstances.
■ Elements of a System of Quality Control
The elements of quality control policies adopted by an audit firm normally incorporate
policies related to general firm activities and personnel. General firm activities for which
quality control policies and procedures are required include leadership responsibilities
for quality within the firm, acceptance and retention of clients, engagement performance,
and monitoring. Quality controls applied to human resources include ethical require-
ments. The quality control policies and procedures should be documented and
communicated to the firm’s personnel.
424
QUALITY CONTROL
■ Quality Control Leadership
The firm should establish policies and procedures designed to promote an internal
culture based on the recognition that quality is essential in performing engagements.
Such policies and procedures should require the firm’s chief executive officer (or equiva-
lent) or, if appropriate, the firm’s managing board of partners (or equivalent), to assume
ultimate responsibility for the firm’s system of quality control. That person should have
sufficient and appropriate experience and ability to assume the responsibility.
■ Ethical and Independence Requirements
The firm should establish policies and procedures designed to provide it with reasonable
assurance that the firm and its personnel comply with relevant ethical requirements and
maintain independence where required by the IFAC Code and national ethical require-
ments. The firm should establish policies to insure that it is notified of breaches of
independence requirements, and to enable it to take appropriate actions to resolve such
situations. At least annually, the firm should obtain written confirmation of compliance
with its policies and procedures on independence from all applicable firm personnel.
The audit firm should establish policies and procedures:2
■ setting out criteria for determining the need for safeguards to reduce the familiarity
threat to an acceptable level when using the same senior personnel on an assurance
engagement over a long period of time;
■ for all audits of financial statements of listed entities, requiring the rotation of the
engagement partner after a specified period in compliance with the IFAC Code and
national ethical requirements that are more restrictive.
■ Acceptance and Continuance of Client Relationships and Specific
Engagements
The firm should establish policies and procedures for the acceptance and continuance of
client relationships and specific engagements, designed to provide it with reasonable
assurance that it:
■ has considered the integrity of the client and does not have information that would
lead it to conclude that the client lacks integrity;
■ is competent to perform the engagement and has the capabilities, time and resources to
do so;
■ can comply with ethical requirements.
When deciding to continue an existing engagement or accept a new engagement with an
existing client, and where difficult issues have been identified, the firm should document
how the issues were resolved. Where the firm obtains information that would have caused
it to decline an engagement if that information had been available earlier, the firm should
consider the professional and legal responsibilities that apply to the circumstances and
the possibility of withdrawing from the engagement or from both the engagement and the
client relationship.
An evaluation of prospective clients and a review, on an ongoing basis, of existing
clients should be conducted. The continued adequacy and operational effectiveness of
425
CHAPTER 11 COMPLETING THE AUDIT
quality control policies and procedures require monitoring. The firm’s general quality
control policies and procedures should of course be communicated to its personnel.
■ Engagement Quality Control Review
The audit firm should establish policies and procedures for an engagement quality
control review that provides an objective evaluation of the significant judgments made by
the engagement team.3 Firms should require an engagement quality control review for all
audits of financial statements of listed entities. They should set policies for assurance
and related services engagements, and all other audits and reviews of historical financial
information.
The work performed by each person in the audit team may be reviewed by personnel of
at least equal competence to consider whether:
■ The work has been performed in accordance with the audit program.
■ The work performed and the results obtained have been adequately documented.
■ All significant audit matters have been resolved or are reflected in audit conclusions.
■ The objectives of the audit procedures have been achieved.
■ The conclusions expressed are consistent with the results of the work performed and
support the audit opinion.
■ Monitoring
The firm should establish policies and procedures to see that quality control systems are
relevant, adequate, operating effectively, and complied with in practice. Such policies and
procedures should include ongoing evaluation and a periodic inspection of a selection of
completed engagements.
At least annually, the firm should communicate the results of the monitoring of its
quality control system to engagement partners and other appropriate individuals within
the firm. Such communication should include the following:4
■ a description of the monitoring procedures performed;
■ the conclusions drawn from the monitoring procedures;
■ where relevant, a description of systemic, repetitive or other significant deficiencies
and of the actions taken to resolve or amend those deficiencies.
Supervisory personnel should:
1 Monitor the progress of the audit to consider whether:
a assistants have the necessary skills and competence to carry out their assigned tasks;
b assistants understand the audit directions;
c the work is being carried out in accordance with the overall audit plan and the audit
program.
2 Become informed of and address significant accounting and auditing questions raised
during the audit, by assessing their significance and modifying the overall audit plan
and the audit program as appropriate.
3 Resolve any differences of professional judgment between personnel and consider the
level of consultation that is appropriate.
426
QUALITY CONTROL
■ Human Resources
The firm should establish policies and procedures to insure that it has sufficient personnel
with the capabilities, competence, and ethical commitment to perform its engagements in
line with professional standards and regulatory and legal requirements. The firm should
assign responsibility for each engagement to an engagement partner with the appropriate
capabilities, competence, authority, and time to perform the role. The firm should also
assign appropriate staff with the necessary capabilities.
Presently two IAASB standards apply to audit quality: International Standards on
Quality Control (ISQC) and ISA 220,5 “Quality Control For Audit Work.” IAASB issues
International Standards on Quality Control (ISQCs) as the standards to be applied for all
services falling under the Standards of the IAASB (i.e. ISAs, International Standards on
Assurance Engagements (ISAEs), and International Standards on Related Services
(ISRSs)). 6
Certification Exam Question 11.2
One of a certified audit firm’s basic objectives is to provide professional services that
conform to professional standards. Reasonable assurance of achieving this basic
objective is provided through:
(A) A system of quality control.
(B) A system of peer review.
(C) Continuing professional education.
(D) Compliance with International Financial Reporting Standards.
ISA 220 establishes standards and provides guidance on specific quality control proce-
dures only for audit engagements. ISA 220 includes specific requirements for an engage-
ment quality control reviewer to perform an objective evaluation of compliance with
applicable professional standards. The responsibilities of the engagement partner under
ISA 220 are shown in Illustration 11.3.
■ The Sarbanes-Oxley Act Quality Control and Audit Review
The Sarbanes-Oxley Act (SOX) addresses overall review procedures required of the
auditor such as quality control, second partner review, and partner rotation. It also dis-
cusses the client’s audit committee responsibilities and inspection by the Public Company
Accounting Oversight Board (PCAOB).7
SOX applies not only to US audit firms, but also to audit firms throughout the world.8
Any foreign public accounting firm that prepares or furnishes an audit report on a
company publicly traded in the US is subject to SOX, in the same manner and to the same
extent as a public accounting firm that is organized and operates under the laws of the
USA or any state. The PCAOB may determine that a foreign public accounting firm, even
though it does not issue audit reports, plays such a substantial role in the preparation and
furnishing of such reports that it should be treated as a public accounting firm subject to
SOX. 9
427
CHAPTER 11 COMPLETING THE AUDIT
ILLUSTRATION 11.3
Responsibilities of the Engagement Partner
Direct Audit engagement
Ensure Legal and regulatory standards
Review Working papers for audit evidence
Facilitate Consultation on contentious matters
Ensure Quality control review process
Communicate Formal complaints regarding application of professional standards
Quality Control Policies
The Sarbanes-Oxley Act10 (SOX) requires that every registered public accounting firm
auditing publicly traded companies include in their quality control policies standards
relating to:
■ monitoring of professional ethics and independence from issuers on behalf of which
the firm issues audit reports;
■ consultation within such firm on accounting and auditing questions;
■ supervision of audit work;
■ hiring, professional development, and advancement of personnel;
■ the acceptance and continuation of audit engagements;
■ internal inspection;
■ such other requirements as the Public Company Accounting Oversight Board (PCAOB)
may prescribe.
PCAOB Inspections
In order to insure quality control, the PCAOB conducts a continuing program11 of
inspections12 to assess the degree of compliance of the audit firm’s performance of audits
and issuance of audit reports with the rules of the PCAOB and professional standards.
The PCAOB evaluates the sufficiency of the quality control system of the firm, and the
manner of the documentation and communication of that system by the firm; and
performs such testing as appropriate of the audit, supervisory, and quality control
procedures of the firm.
428
QUALITY CONTROL
The PCAOB is required to inspect a registered public accounting firm under SOX,
section 104. The PCAOB will inspect and review selected audit and review engagements of
the firm (which may include audit engagements that are the subject of ongoing litigation
or other controversy between the firm and one or more third parties). A written report of
the findings of the PCAOB is transmitted to the appropriate regulatory authorities. The
report is made available in appropriate detail to the public, (except that the quality control
portions of the report may not be made public under certain considerations).13
Certification Exam Question 11.3
The Sarbanes-Oxley Act requires that every registered public accounting firm auditing
publicly traded companies include in their quality control policies standards relating to
all of the following except:
(A) Consultation within such firm on accounting and auditing questions.
(B) Hiring, professional development, and advancement of personnel.
(C) Internal control policies.
(D) Internal inspection.
Ex-Employee Conflicts of Interest
In determining the acceptance and continuation of audit engagements the audit firm
must consider ex-employee conflicts of interest and audit partner rotation. An account-
ing firm cannot perform any audit service for a firm if a chief executive officer, controller,
chief financial officer, chief accounting officer, or equivalent position, was employed by
that accounting firm and participated in any capacity in the audit of that issuer during the
one-year period preceding the date of the initiation of the audit.14 The audit partner must
be rotated away from that client every five years.
Partnership Review and Rotation
Audits should be reviewed by partners in the accounting firm not connected with the
audit and should rotate their audit partners every five years. Under SOX, section 103,
auditors should provide a concurring or second partner review by a qualified person
associated with the public accounting firm, other than the person in charge of the audit,
or by an independent reviewer. SOX, section 303 makes it unlawful for a registered public
accounting firm to provide audit services to an issuer if the lead audit partner having
primary responsibility for the audit, or the audit partner responsible for reviewing the
audit, has performed audit services for that issuer in each of the five previous fiscal years
of that issuer. Section 103 also states the quality control standards that were discussed in
11.3 Quality Control, above.
Audit Committee Review of Auditors
Under SOX, section 301,15 public company audit committees are directly responsible for
the appointment, compensation, and oversight of the work of any registered public
accounting firm employed by their company (including resolution of disagreements
between management and the auditor regarding financial reporting). Each such registered
public accounting firm reports directly to the audit committee. Auditors may also have to
discuss accounting complaints with the audit committee. Each audit committee must have
429
The words you are searching are inside this book. To get more targeted content, please make full-text search by clicking here.
Principles of Auditing - An Introduction to International Standards
Discover the best professional documents and content resources in AnyFlip Document Base.
Search
Principles of Auditing - An Introduction to International Standards
- 1 - 50
- 51 - 100
- 101 - 150
- 151 - 200
- 201 - 250
- 251 - 300
- 301 - 350
- 351 - 400
- 401 - 450
- 451 - 500
- 501 - 550
- 551 - 600
- 601 - 650
- 651 - 700
- 701 - 713
Pages: