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Audit Process: Sample Selection Background:

Audit is a Science of examining the records and forming an opinion. A Statutory Auditor would be required to form an opinion on the Financial Statements, whereas Internal Auditors are required to report on efficiency and efficacy of the Internal Control System. However, for any type of attest functions, an Auditor is required to look into the records under a microscope. Considering the size of the Operations of the Client and the complexity of business involved, is an auditor expected to verify 100% of the records? No, not required. An Auditor is not expected to verify 100% of the records, a portion of the records are expected to be verified and the results are extrapolated to the population. The procedure to obtain or to decide on the less than 100% of the Population is called as Sample Selection.

Taste the Population!


In simple words, the Sample should be a representative of the Population. To a large extent the Qualities of Sample should reflect that of the Total Population. Therefore, it is imperative to understand what is the Population we are auditing. For Example: Say, You are verifying Sales. The Sales Population has to contain all the Types of Customers, Whether it is Domestic or Export, Sales to Related or Unrelated Party, Discounts given or not, etc., The Sample should be selected from each of the types of category. This is discussed in greater details elsewhere in this document.

Select the right thing:


When are we so choosy about what we wear and what laptop we use, we need to be choosier, about the numbers we select to verify. There is no Science or Art behind our choice of Clothes or Laptops, we listen to our heart, and if time is paucity we listen to the Sales Guy! One cant afford this in an Audit. We need to listen to the Art of picking up Sample. Sample Selection is a Science; since the Auditor has to ensure that the sample selected covers every segment of the Population and as mentioned earlier should reflect the Population. When it comes to choice between Samples, well its an Art. An Art perfected only by experience during professional engagements.

Whats the Secret Formula to Choose the Right Sample?


Well, lets wind up from the World of Auditing for a while, and move to the World of Statistics. Thats where the sample selection techniques are discussed. Both SA 550 and Researchers M. Hanson and P. Hauser, in their Article Principles of Sample Design, describe the pre-requisites of Population which impact Sample Selection, as follows: 1. 2. 3. Quality of Resource, Limitations of the Resource or the Availability of Information, Availability of Statistical Data.

Assess the Population


Lets be clear. The first step in Auditing is to assess the Situation. Remember SA 315, it is important to understand the Clients Business, Industry and Economy, Applicability of Laws, Management Structure and How Committed they are. Based on these parameters, a fair estimate of the Quality of the Book Keeping is made. Is the Management aggressive in choosing Accounting Policies? Are there are special or industry specific laws that govern the business of the Client? To what extent the economic condition and industrial relationships influence the decision making purpose? An experience auditor will be able to make a mental picture of the State of the Affairs. Once, we have a fair idea of the Quality of the Book Keeping, the next step is break up the entire population into segments. Population should be segregated based on the nature of Product or Service rendered. The preliminary analysis is essential to understand the trend of the Activity. 1

Segregation of Data
The Population should be first analyzed based on their contents. For Example: In case of Sales, the segregation could be done as given in Table 1. After the Preliminary analysis like rendered above, the segregation of the data should be further analyzed based on: 1. 2. 3. 4. 5. Percentage of the sub-component to the Total Segment Number of times a variable has repeated Above or Below the Average Having Unusual Trends Seasonal or Cyclical Changes.

The Analysis may be done, as given in Table 1:


Pre-dominant Feature Customer Centric Segregation Criteria Customer wise Contribution to Revenue Based on Monetary Value Based on Type of Product or Service Export Sales and Domestic Sales Based on the Period Based on Products Sales to Related Parties and to Non-Related Parties Secondary Analysis % Of Contribution by Customers Highest, Lowest, Above and Below Average from Mean Analysis on Season or Period Based on a Customer or Value Based on Period or Season Period wise Analysis. A Combination of any of the above methods.

Retail Sales Product Dominated Geographically Diversified Supply to a Single customer Variety of Products Pre-dominantly Related Parties and also Non-Related Parties

The segregation of the segments will help in getting a macro level view of the spread of the Population. Students of Statistics know the above process as Stratification.

Golden Rule
Any Audit Procedure can be classified into 2 components: a. b. Testing the Control Testing the Details

Of all the Statistical and Mathematical Models one may use, at the end of the day it is the Auditors professional judgment on the quality of accounts and initial due-diligence will influence the extent of verification that is planned. Lets take some examples and discuss how the sample selection is influenced, in other words, these are the incidents where Sample Size would Increase. It is better not to decrease the sample size; since the variety of population should not be disturbed.

Auditors Assessment on Controls

Client Specific: Operational Controls is Weak and higher level of verification is required Ex: Internal Controls as per Internal Audit Report or Discussion with Client indicates weak, Weak Delegation of Authority, Frequent changes in Policy without adequate explanation. Lower Rate of Tolerable Error - Ex: Multiple Regulations and Complexity of Accounts where errors may cost the Companys business and Audit Risk is high, especially in case of Listed Companies and PSU. Previous Audit Experience with Client and in Industry where Sample results has proved to be contrary to the Result of the Population. During the course of Audit; there are indications of higher rate of Errors in Accounting; then Sample size should be revised at higher end. Auditor Specific: Auditor based on his experience and professional judgment is skeptical about the Accounting practice.

Cherry Picking
Now that we know how the layout or view of the Population is, its time to pick the cherries, which would undergo the magnifying lens. Yes, the samples are now selected. Within each sub-segment, there are lots of data lying to be chosen. How do we choose the right ones? Is choosing the right one an Art or Science? Should we throw dice and chose the number? Here is where the Science of Statistics applies. Lets see what Statistics have to say as to how to select a sample: Random Number: This technique uses Random Number Table to choose among the uniform data, having homogenous characteristics. Systematic Selection: In this technique, sample size is arrived at first determining the Quantity of Sample Size. Say there are 1000 Invoices. Sample Size th th required is 100. Therefore, every 10 Invoice may be selected after 100 Invoice. Monetary Unit Selection a. Samples of all amounts below or above a particular amount may be chosen. For Example: All invoices worth Rs.10,000/- or more is chosen. Use of Pareto Analysis: ABC Analysis of the Data is done, and the segment, which yields the majority percentage, will be selected as sample. Sample which are higher or below the Average Amount.

b.

c.

Haphazard Selection Samples are selected using blindfold theory i.e., how would chose something if you were blindfolded. It is purely based on guess and is not scientific in nature. Block Selection 3

Selecting a group of data say, if there are 1000 invoices, one choses Invoice No. 500 to Invoice No. 600. Drawback in this method is the spread is narrowed and the best of samples may not be available and they necessary are not representative of sample, Multi-Stage Sample Involves sampling at various levels. In the first levels Sample Data are short-listed and then from the short list the final sample is selected.

Practical Application
Method Random Number Systematic Selection Monetary Unit Selection Haphazard Selection Block Selection Multi-Stage When to use? Characteristics of the variables are homogenous. When there is no major difference in the spread of the Population. When Opinion is sought on the Quality of the ledger Account. Non-significant items, but still need to be verified. If there are indications of errors in a particular area or cluster. Where Sample is required from a combination of variables.

After Selecting Sample


Normal Audit Procedures like Vouching, Physical Verification, and Analytical Procedures are to be carried out with the samples. In case of Statutory Audits, it plays a pivotal role in forming an opinion on the quality of the ledger accounts or the facts that are being reported. Therefore, it is very important that the audit procedures are to be performed on the Samples with great care. In case of Internal Audits, where normally, auditor use Womb to Tomb approach, i.e., where the verification is done from the Point of Origination to the Point of Culmination, the samples will reflect the prevailing system in an organization and also reflect the operational gaps.

Results of Verification
Lets remember, the outcome of the verification i.e., we could conclude that there is delay in accounting or accounting is incomplete or documentation is inadequate, etc., is only for the sample tested. However, since the sample reflects the population, one needs to extrapolate the results at the Population level. In simple words, we conclude that the Population has passed or failed the test of verification based on the samples we select. Hence, the selection of right sample is very important.

Noticing Red Flags


As mentioned earlier, an opinion is formed based on the sample selected. As an Auditor, we at times, have to question our own judgment. What if the Sample itself was wrong? What if the abnormal results were one off the case and there is no indication or the results are not corroborated with other tests? Yes, there is always a possibility that sample can go wrong. There is always a possibility that the results may portray a picture better or worse than the entire population that is the Risk that an auditor has to take with the process. This risk is called Sample Risk.

Can Auditor go wrong?


An Auditor would either conclude that the Controls are working effectively and in fact they may not be working effectively. This could lead to inappropriate audit opinion.

Or, the Auditor may conclude that the Controls are not working properly, on the other extreme. This could lead to Auditor performing additional functions, which may not be required at all. Either the Auditor Overestimates or Underestimates the effectiveness of the Controls. This could happen after the Sample Selection. To a step back; what if the method of Sampling was right and Audit Procedures were inappropriate? Example: Relying more on Internal Evidence than the External Evidence. Not enquiring into long outstanding dues represented in the Reconciliation Statements. It is called as Non-Sampling Risk. This could lead to incorrect audit conclusions of the Sample and which is extrapolated to the Population.

How much can go wrong?


There will be a degree of mis-match with the Population. The degree of mis-match is identified through the Probability Theory. This could be used if the Sample Selection was based on some statistical data. What ever may be the theory of probability, an auditor should always approach the work with professional skepticism. Things can go wrong, but one has to ensure it does not go wrong beyond expectations. How much margin of error can the auditor tolerate or are acceptable to him? This margin of error is called Tolerable Mis-Statement (in case of Monetary Values) Tolerable Rate of Deviation (while evaluating internal control procedures). In simple words, Errors / Total Sample gives a % of mis-statements. Translate this into Population i.e., Population x % of Errors (x Probability) will give how wrong is the Population. This has to be compared with the Materiality levels set up the Auditor. If it crosses the levels, the Red Flag has to be raised.

Concluding the Verification


If the results extrapolated to the Population and the Auditor concludes that the deviations are more than the tolerable range (i.e., Materiality), the sample size may have to be revised to obtain greater amount of comfort on the accounting; beside doing other audit procedures to corroborate the audit evidence already obtained. Bibliography: 1. 2. 3. 4. SA 530 (Revised) : Audit Sampling Tumbling Dice and Birthdays Understanding the Central Limit Theorem Michelle Paret (Product Marketing Manager) and Eston Martz (Senior Creative Services Specialist), Minitab Inc., Audit Sampling Requires Auditor Judgment The Agency Examiner December 1994 How to Use Statistical Sample by Jim Kaplan AuditNet 2003 (The AuditNet Monograph Series