- 25 Marks
AA – L2 – Q43 – Audit Sampling
Question
You are planning the audit of the revenue system and year-end trade receivables of Porter Manufacturing.
The company has revenue of approximately $15 million and all of its sales are made on credit. The year-end value of trade receivables is approximately $3 million, and there are about 1,000 customers on the sales ledger.
You have been asked by the partner in charge of the audit to consider whether it would be appropriate to use statistical or judgmental sampling in your audit work.
Required:
(a) Describe and illustrate, by the use of suitable examples, the way in which statistics and judgement can be used in audit sampling, in relation to:
(i) the audit of the revenue system
(ii) writing directly to trade receivables, asking them to confirm the balance owed
(iii) the verification of year-end trade receivables
(b) Based on your answer to (a), above, discuss the advantages and disadvantages of the use of statistical or judgmental sampling.
(c) Explain why the audit of accounting estimates is a difficult area for the auditor.
(d) List the audit evidence you would seek in respect of a provision for damages in respect of an action brought by a customer for breach of contract.
Answer
(ai) When carrying out the audit of the revenue system the auditor is aiming to assure himself that the transactions within the system are being accurately and completely processed, and also that the system will act as a good basis for the preparation of the financial statements.
There are areas of the revenue system when the throughput of transactions is great, e.g.
- the opening of new customer accounts
- the dispatch of goods
- the raising and processing of sales invoices
- the processing of remittances
- the maintenance of day books and ledgers, including additions, postings and analysis.
For areas such as these within the revenue system, statistical techniques can be used to select items for testing.
The use of statistical techniques, based on the mathematical theories of probability, will provide the auditor with the assurance that the total population has the same characteristics as the sample selected for testing.
The number of items to be tested will depend on the level of assurance required by the auditor and also the error rate which he is prepared to accept.
To determine which particular transactions are included within the sample, the auditor may use any one of a number of selection techniques including interval sampling, random sampling (using random number tables), cluster sampling or block sampling.
There will also be areas within the sales system where the volume of transactions is not great, such as: - month-end reconciliations
- month-end, or period-end, postings to the nominal ledger
- the write-off of bad debts.
In these circumstances the use of statistical techniques will not be appropriate because valid conclusions cannot be drawn when population sizes are small.
In such cases, judgemental sampling would be more appropriate. However, the auditor should carefully consider which and how many items should be tested. For example, if the auditor is aware that the sales ledger manager/controller was on holiday in the month of August, he may decide that testing transactions in that month should be considered.
(aii) Before deciding on whether to use statistics or judgement for the selection of receivables in a circularisation, the auditor must establish the purpose of the circularisation.
If the circularisation is part of the auditor’s systems work, to establish the system is working as prescribed, he should use statistical techniques.
The auditor must first establish the level of assurance he requires, certain he wants to be that the results of the sample are truly representative of the population. Then, based on an acceptable error rate (“tolerable error”), the auditor calculates the sample size.
Valid statistical techniques include interval sampling, random sampling, or stratified sampling (e.g., selecting receivables based on balance size). For example, the auditor might select every 10th receivable or use random number tables to pick 100 accounts from the 1,000 customers.
If the circularisation is for year-end verification to confirm the existence or accuracy of balances, judgemental sampling may be more appropriate. The auditor might select:
- High-value receivables (e.g., balances over $50,000).
- Overdue accounts (e.g., receivables over 90 days).
- Accounts with disputes or irregular payment histories.
For example, if the auditor knows a major customer had delivery issues in the last quarter, they might include that customer’s balance in the sample to confirm accuracy.
(aiii) For year-end verification of trade receivables, the auditor’s goal is to confirm the existence, accuracy, and valuation of the balances. Both statistical and judgemental sampling can be used, depending on the audit objective.
Statistical sampling is suitable when the auditor needs to draw conclusions about the entire receivables population. For example, the auditor might use stratified sampling to select receivables by value range (e.g., 10% of balances over $50,000, 5% of balances between $10,000-$50,000). Random sampling could also be used to select 100 accounts from the 1,000 customers to test for existence and accuracy. The sample size would be based on the desired confidence level (e.g., 95%) and tolerable error rate.
Judgemental sampling is often more appropriate for year-end verification because management’s estimates (e.g., allowance for doubtful debts) involve judgement. The auditor might select:
- Receivables with high balances to ensure material amounts are accurate.
- Accounts with overdue payments to assess recoverability.
- Customers with known disputes or irregular transactions.
For example, if a major customer’s balance is 20% of total receivables, the auditor would likely include it in the sample to verify existence and valuation. Similarly, if the auditor knows a customer entered bankruptcy, that account would be selected to evaluate the allowance for doubtful debts.
(b) Judgement is an easier method to understand and calculate, whereas the use of statistics requires a certain amount of skilled and specialist knowledge.
The use of statistics requires more time in selecting items and performing calculations.
Statistics require certain decisions, such as confidence levels and anticipated error rates, which diminish the value of the mathematical calculations to follow.
Statistics can only be effectively used when population sizes are large, and so become ineffective when these sizes are small.
Statistics do not take account of prior years’ experience, which forms a valuable source of knowledge to the auditor.
The use of statistics or judgement in relation to the audit of the sales system and year-end trade receivables will depend on the circumstances of each assignment.
However, as a rule of thumb, when carrying out a systems audit the auditor will want to ensure that the system as a whole is working in theory and practice as prescribed. The use of judgement may direct the auditor to areas that ‘do not look right’, which may be inappropriate, because the auditor primarily wants to draw conclusions about the population as a whole, not to problem areas that will compromise his overall view.
For year-end verification work, judgement may be more appropriate because the preparers of financial statements will invariably use a degree of judgement themselves. However, because statistics are based oni mathematical formulae, the auditor will probably have a better defence in a court of law than if his conclusions are all based on judgement.
(c) Accounting estimates are just that – estimates. They are not capable of precise measurement and management will have used their judgement in arriving at those estimates. The auditor must therefore use his judgement in assessing whether those estimates are reasonable.
Because most of such estimates are made by management, independent audit evidence may be limited. Much of the evidence in respect of the estimates will depend on the reliability of management themselves.
Because of the subjectivity attached to estimates they are a means by which the financial statements could be manipulated. This is therefore a high risk area of the audit.
(d) Examine contract with the customer to establish the nature of the contract.
Review correspondence with the customer and legal advisors to assess the likely outcome.
Review events after the date of the financial statements to establish if the claim was subsequently agreed or settled.
Consider the possibility of other, similar breaches for which a provision is necessary.
Obtain written representations from management that all contingencies have been disclosed.
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