Special Audit Techniques

CA Final Paper 3: Advanced Auditing & Professional Ethics Chapter 5

CA Arijit Chakraborty

Agenda for discussion - Special Audit Techniques

Audit evidence -Confirmation, inquiry, observation, Analytical review

Statistical Sampling- concept, types, technique, sampling risk , audit planning

Risk Based audit

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Special Audit Techniques

Inquiry

Observation

Confirmation

Analytical review

Statistical sampling , risk, error

Risk based audit

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Learning Objectives

1. Understand the concept and purpose of special audit techniques (SAT)

2. Learn the linkage of SAT with Audit Standards

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to determine correspondence between

auditor evidence

management assertions

established criteria

accumulates and evaluates

Auditor workflow-1

then communicates results to

established criteria

auditor

management assertions

Users

evidence

accumulates and evaluates

to determine correspondence between

Auditor workflow- 2

Sufficient Appropriate Audit Evidence ( SAAE)

• “Audit Evidence” SA 500 (Revised)

• , “Audit Evidence—Specific Considerations for Selected Items”

SA 501 (Revised)

• “External Confirmations” SA 505 (Revised),

• “Initial Audit Engagements – Opening Balances”

SA 510 (Revised)

• “Analytical Procedures” SA 520 (Revised)

Sufficient Appropriate Audit Evidence ( SAAE)

• “Audit Sampling” SA 530 (Revised)

• “Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures” SA 540 (Revised)

• “Related Parties” SA 550

• “Subsequent Events” SA 560 (Revised)

• “Going Concern” SA 570 (Revised)

• ”Written Representations” SA 580 (Revised)

Inspection

Observation

Confirmation

Re-calculation

Re-performance

Analytical Procedures

Inquiry

Inquiry alone, ordinarily, does not provide SAAE

Obtaining Audit Evidence - I

SA 500 : Audit Evidence

Evidential matter: • Any information that corroborates or refutes an

assertion

Audit Evidence

Some Relevant Terms used in SA 500:

Accounting Records

Appropriateness(of audit evidence)

Audit Evidence

Management’s Expert

Sufficiency(of audit evidence)

Types of Evidence

Physical evidence

Third-party representations

Documentary evidence

Computations

Data Interrelationships

Client representations

Accounting records

Types of Evidence Physical Evidence

Evidence that can actually be seen by auditors.

• This type of evidence is generally effective for supporting the existence assertion.

Types of Evidence Third Party Representations

Confirmations

Lawyers’ Letters

Reports of Specialists

Types of Evidence Documentary Evidence

Created by outside parties and transmitted directly to auditor

Created by outside parties and held by client

Created and held by client

Electronic documents

Types of Evidence Computations Computations are: performed independently by auditor

Types of Evidence Data Interrelationships

Data interrelationships (i.e., analytical procedures) rely on relationships among financial and non-financial data.

Effective for testing “reasonableness” of certain account balances

Types of Evidence Oral and Written Client Representations

Responses to questions and inquiries toclients during an audit constitute auditevidence.

Types of Evidence Accounting Records

Clients’ accounting records (e.g. ledgers and journals) may provide worthwhile evidence in themselves.

• Depends on the effectiveness of internal controls

Audit Procedures

• Physical examination • Observation • Confirmation • Tracing • Vouching • Inspection • Reconciliation • Re-performance • Analytical procedures • Inquiry • Comparison

Physical Evidence

Third-Party Representations

Documentary Evidence

Computations

Data Interrelationships

Client Representations

Accounting Records

Reliability of Certain Types of Audit Evidence

RELIABILITY TYPE EXAMPLE

High Physical Inventory Observation Documentary External Cutoff Bank Statement External/Internal Purchase Invoice Internal Sales Invoice

Low Client Representations Management representation Letter

Statistical Sampling

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Special audit techniques

Statistical Sampling

Provide guidance regarding the design and selection of an audit sample

Guide on the use of audit sampling in the audit engagement

Guidance on use of sample in risk assessment procedures and tests of controls performed by auditor

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Scope • Applies when auditor decides to use audit sampling in

performing audit procedures • Deals with auditor’s use of statistical and non-statistical

sampling when-

• Complements SA 500

Designing and selecting

audit sample

Performing tests of controls

and tests of details Evaluating results

from sample

Objective

Objective of Auditor when using Audit Sampling are – • √ To provide a reasonable basis • √ To draw conclusions • √ About population from which

sample is selected

Sampling – design & selection Design of Sample

The auditor should consider:

Specific audit objectives Population Sample size

Selection of Sample Commonly used methods:

Random selection and Use of CAATs Systematic selection Haphazard selection

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Sample Design, Size and Selection of Item (A) Sample Design • Purpose of audit procedure

• Characteristics of population • To design audit sample & determine sample size

• Tests of controls – Assessment of expected rate of deviation

• Tests of details – Assessment of expected misstatement

• Decision to use statistical or non-statistical is a matter for auditor’s judgment – sample size is not a valid criterion

(B) Sample Size

Auditor to determine sample size sufficient to reduce sampling risk to an acceptably low level • Lower the risk auditor willing to accept, greater the

sample size

Sample size determined by application of –

• Statistically based formula, or • Exercise of professional judgment

(C) Selection of Items for Testing Auditor to select representative sample – Each sampling unit in the population has a chance of selection

Statistical Sampling –

each unit has known probability

of being selected

Non-statistical Sampling –

judgment is used to select items

Methods of selecting sample

Random selection

Applied through random generators, e.g., random number tables

Systematic selection

Number of sampling units/ sample size = sampling interval

Monetary unit sampling

Type of value w eighted selection – sample size, evaluation results in monetary amounts

Haphazard selection

Selection w ithout follow ing structured technique

Block selection

Selection of blocks of contiguous items from w ithin the population

Nature & Cause of Deviations and Misstatements

Investigate nature & cause

of any deviations/ misstatements

Evaluate their possible effect on

-Purpose of audit procedure

-Other areas of audit

If common feature then identify all such items in a population

& extend audit procedures

to those items

Projecting Misstatements

Tests of details – project misstatements to population • Gives broad view of scale of misstatement but

insufficient to determine amount to be recorded • Consider effect of uncorrected misstatement

Tests of controls - no explicit projection necessary • Sample deviation rate is also projected deviation

rate

Evaluating Results of Audit Sampling

Tests of controls – unexpectedly high sample deviation

Tests of details – unexpectedly

high sample misstatement

May lead to an increase in assessed risk of material

misstatement

Unless further evidence substantiating initial

assessment Is obtained

May cause to believe that class of transactions/ account

balance is misstated

Unless there is absence of further evidence that there is no misstatement

Evaluation of Sample Results

Analyse the nature and cause of any errors detected in the sample;

Project the errors found in the sample to the population;

Reassess the sampling risk; and

Consider their possible effect on the particular audit objective and on other areas of the audit engagement.

Risk may be reduced if additional audit evidence is obtained

Analytical Review Procedures

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Special audit techniques

Analytical Procedures, SA 520

Applied

• At planning stage – to understand business and identify potential risks • Near end of audit – to conclude whether FSs correspond to knowledge

of business

When analytical procedures identify significant variances or inconsistent relationships – further investigation / explanations / corroborative evidence needed

Analytical Procedures: Overview Provide guidance regarding the application of analytical procedures during audit

Deals with the aspects such as:

• the nature and purpose of analytical procedures, • analytical procedures as risk assessment procedures and

planning the audit • Analytical procedures as substantive procedures • Analytical procedures in the overall review at the end of

audit • Extent of reliance on analytical procedures

Extent of Usage of the Analytical Procedures The significance of the area being examined.

The adequacy of the system of internal control.

The availability and reliability of financial information.

The precision with which the results of analytical procedures can be predicted.

The availability and comparability of information regarding the industry in which the organization operates.

The extent to which other auditing procedures provide support for audit results.

Analytical Review - stages

Analytical Procedures in the Overall Review at the End of the Audit

forming an overall conclusion as to whether the systems, processes and controls as a whole are robust, operating effectively and are

consistent with the auditor's knowledge of the business.

Analytical Procedures as Substantive Procedures procedures to reduce detection risk relating to specific financial

statement assertions

Analytical Procedures as Risk Assessment Procedures and in Planning the Audit

to obtain an understanding of the business, the entity and its environment and in identifying areas of potential risk.

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Risk Based Audit

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Special audit techniques

Risk Based Audit – Learning objective

Applying risk based framework to audit, understanding audit risk

Prioritizing high risk areas in the audit plan

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Audit Risk

Audit accepts the risk that the audit conclusion may be wrong and that Audit may have allowed material error to remain undetected in the account.

Only a very small degree of audit risk would be acceptable as otherwise the audit process may lose its purpose.

A very high level of assurance (or confidence) is required when expressing the audit opinion.

Relationship between materiality and audit risk

To calculate the level of assurance (or confidence) required from substantive audit tests, risk model is employed.

Risk Model

Analytical tool for planning and execution.

Detects high-risk areas for concentrated audit efforts.

Audit can thus focus on areas which are likely to generate better assurance instead of sampling and testing of larger but low risk areas.

Structures the audit procedures and reorganizes the audit work in terms of risk perception

Audit Risk

Risk of Material Risk that the Auditors Audit Risk = Misstatement * Fail to Detect the Misstatement = Inherent Control Detection Risk * Risk * Risk

Inherent Risk

The risk of a material misstatement occurring in an assertion assuming no related internal controls.

Control Risk

Risk that a material misstatement in an assertion will not be prevented or detected on a timely basis by the company’s internal control.

Detection Risk

Risk that the auditors’ procedures will lead them to conclude that a material misstatement does not exist in an assertion when in fact such misstatement does exist.

Detection risk restricted by performing substantive tests

Audit Risk Formula

AR = IR x CR x DR

AR = Audit risk

IR = Inherent risk

CR = Control risk

DR = Detection risk

Illustration of Audit Risk

Audit Risk Formula Solving for Detection Risk

Implications • Assuming constant, sufficiently low AR,

detection risk is inversely related to IR and CR • ↑ combined IR and CR ↓ allowed DR ↑

substantive evidence

CRIRARDR×

=

Risk exposure

Risk exposure (likelihood of occurrence) to be assessed on a scale of 1-10 (10 being most likely).

Risk based Audit

Understand client’s business , operations, industry, legal regulations

Document possible risks which can impact account balance, class of transaction and Financial Statements

Prioritize risk exposure – High, Medium, Low

Conduct audit as per risk priority

Risk exposure is product of probability of occurrence and financial impact

RISK STATEMENTS – Risk prioritization examples

S. No

Risk statement

Risk Risk

exposure

Heat zone

Severity

Detectab

Ility

Impact

1

Invoice may be raised without effecting physical delivery of the goods from depot/ plant

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8

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5

R1

2 Sales order may not be executed in time and in full

4

6

24

4

Y2

3 Debit / credit notes sent to customers may not contain adequate details

2

4

8

3

G2

RISK STATEMENTS –Examples

S. No

Risk statement

Risk

Risk Risk exposure

Heat zone

Severity

DetectabIlity

Impact

1

Depreciation rates may have been incorrectly set up

5

6

30

5

R3

2 Vendors account may not have been reconciled/ confirmed as per laid down frequency

5

5

25

4

Y2

3

Line items (individual entries) clearing may not have been carried out in vendor accounts

3

6

18

3

G2

Lesson Summary

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3. We had discussed the concept and usage of Risk based audit

2. We had also seen the classification of special audit techniques and discussed the techniques

1. We have learnt the meaning and purpose of special audit techniques

Testing time

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Special audit techniques- Multiple Choice Questions

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Multiple Choice Questions

Question 1

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Which of the following analytical procedures is most applicable to inventory?

a. Comparison of sales of current and prior years. b. Comparison of gross profit ratios of current and

prior years. c. Comparison of marketing expense with budget. d. Comparison of ratios of sales to accounts

receivable of current and prior years. Solution b Reason Because the amount shown for inventory affects

cost of sale and the gross profit ratio, fluctuations in this ratio are investigated in connection with the audit inventory.

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The inventory observation provides least

evidence of a. Presentation c. Valuation b. Existence d. Rights Solution A Reason Observation of inventory on hand provides little

evidence about the classification of inventory.

Question 2

Question 3

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The observation of inventories is a(n) a. Generally accepted auditing standard. b. Generally accepted auditing procedure c. Alternative auditing procedure. d. Optional auditing procedure. Solution b Reason Observation of inventories is a procedure, i.e.,

an act to be performed.

Question.4

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During an inventory observation auditors normally record certainty of their test counts to

a. Be used in compiling the client’s inventory. b. Check the accuracy of the client’s account. c. Compare with the final inventory listing. d. Test the client’s counting procedure.

Solution c Reason Recorded test counts are compared with the client’s

final inventory listing to provide assurance that the client’s counts were not changed between the time they were made and the time the final inventory listing was prepared.

Question.5 During an inventory observation an auditor

may detect obsolete items by all of following except

a. Observing unusual amounts of rust or dust. b. Observing items with prior year inventory tags. c. Computing gross profit ratios. d. Inquiry of plants personnel. Solution C Reason The gross profit ratio will not detect obsolete goods

in inventory although other ratios such as inventory turnover will.

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Question.6

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To test the receiving cut off auditors record the last several numbers of documents used prior to the taking of the inventory. These documents are

a. Vendor invoices. b. Purchase orders. c. Receiving reports. d. Purchase requisition Solution c Reason Receiving reports are used to test the receiving cut off.

Question.8

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In which of the following types of inventories would an auditor be least likely to need the assistance of a specialist to determine existence?

a. Baked goods b. Coal Pile c. Precious gems d. Art work Solution a Reason The auditor could evaluate baked goods, but would

need a surveyor for the coal pile and appraisers for the gems and art work.

Question.9

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The most important objective in the audit of current liabilities is

a. Existence b. Completeness c. Valuation d. Presentation and disclosure. Solution c Reason Unrecorded items constitute the auditor’s main risk when

auditing current liabilities.

Question.10 In determining which accounts payable to select for

confirmation, an auditor is most likely to pick a. Accounts with the largest balances to obtain dollar coverage. b. Major vendors and suppliers regardless of the amount of the

balances. c. Accounts with debit balances. d. Any account with zero balance. Solution b Reason Because the auditor is primarily concerned with the

completeness assertion, he or she sends confirmations to vendors that should have large balances (the major vendors).

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True and False

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• The taking of an accurate physical inventory is a generally accepted auditing procedure.

F The observation of the

physical inventory is a generally accepted auditing procedure.

True and False.1

True and False.2

• Before the start of the inventory, the auditor should review the client’s inventory instructions.

T

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True and False.3

• The test of inventory pricing in a job-order cost system usually involves a review of the flow and accumulation of costs by cost centre for the major products.

F

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True and False.4

• The objective of a receiving cut off test is to determine whether items that are received near the end of the year and included in inventory also are recorded as purchases and accounts payable.

T

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True and False.5

• The auditor tests a client’s inventory cut off to determine that physical items and their related costs are treated in a consistent manner.

T

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CA Final question ( May 2009) • What are the considerations to be kept in mind while

performing analytical procedures on date prepared by the client ?

• Solution outline • Refer SA 520 – Analytical Procedures • Factors • 1. accuracy with which expected results of

substantive analytical procedures can be predicted. • 2. degree to which information can be segregated • 3. availability of financial and non-financial

information

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Thank You

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