undefined | unit 3 auditing techniques

AUDIT1

UNIT III

Auditing Techniques

Q1) What do you mean by test checking? Explain its advantages and disadvantages.

A1) Test checking in Audit means checking a few transactions selected at random from a large number of transactions. It is also known as “Selective Verification” or “Sampling Process“. It is a substitute for detailed checking. It involves only a partial checking. The auditor normally does not check completely all the records made into the books of accounts but, through a process of sampling, selects a few items and if they are found correct, he presumes that the remaining entries would also be correct likewise.

Thus, test checking is based on a simple theme that” if a representative number of transactions, so selected at random by the auditor for test checking, is found to be correct, the remaining ones would also be correct.”

Thus, the whole system of test checking implies selecting and checking only a few selected transactions so as to enable the auditor to form his final judgement as to the whole set of transactions.

ADVANTAGES OF TEST CHECKING

Test checking can give the following advantages:

1. Reduces Volume of Work: The work of an auditor is reduced considerable as he checks only few transactions, extra time available can be utilised for concentrating on areas of considerable importance.

2. Reduces Time and Cost: Test checking is one of the technique which reduces time, cost and energy of both the auditor and the client.

3. Quick Completion of Audit Work: Test check enables the auditor to complete the work quickly as the auditor checks only a few or limited transactions.

4. Effective Means of Checking: Test checking can be effective if the auditor selects the transaction to be checked carefully.

5. Scientific Assessment of Risk: The risk of material misstatement in the financial statement is assessed by the auditor in a scientific manner by drawing samples and studying them in detail.

6. Serves as a Guide: It serves as a guide for the auditor to arrive at conclusion regarding the true and fair view of the state of affairs of business.

Q2) Explain Tolerable Errors and Expected Errors

A2)

TOLERABLE ERROR

Tolerable error is the maximum error in the population that the auditor would be willing to accept and still concludes that the result from the sample has achieved the audit objective. Tolerable error is considered during the planning stage and, for substantive procedures, is related to the auditor’s judgement about materiality. The smaller the tolerable error, the greater the sample size will need to be.

In tests of control, the tolerable error is the maximum rate of deviation from a prescribed control procedure that the auditor would be willing to accept, based on the preliminary assessment of control risk.

In substantive procedures, the tolerable error is the maximum monetary error in an account balance or class of transactions that the auditor would be willing to accept so that when the results of all audit procedures are considered, the auditor is able to conclude, with reasonable assurance, that the financial statements are not materially misstated.

EXPECTED ERROR

If the auditor expects error to be present in the population, a larger sample than when no error is expected ordinarily needs to be examined to conclude that the actual error in the population is not greater than the planned tolerable error. Smaller sample sizes are justified when the population is expected to be error free. In determining the expected error in a population, the auditor would consider such matters as error levels identified in previous audits, changes in the entity’s procedures, and evidence available from other procedures.

Q3) What are the differences between internal control and internal check?

A3)

DIFFERENCE BETWEEN INTERNAL CHECK AND INTERNAL CONTROL

BASIS FOR COMPARISON	INTERNAL CHECK	INTERNAL AUDIT
Meaning	Internal Check is a system, wherein division of work and allocation of responsibilities are organized in such a manner that the work of one employee is spontaneously looked over by another.	Internal Audit is the ongoing critical examination of the financial and operational activities of the concern, by an internal auditor.
Method	Work of one person is automatically checked by another person.	Work performed by the employees is examined by a separate group.
Commencement of Work	Commences from the moment a transaction is entered.	Once the transaction has been recorded in the books.
Involved evaluation of	Accounting and clerical accuracy	Effectiveness of management control
Performed by	Existing staff	A specially dedicated team of auditors
Cost Involvement	Economical	Comparatively Expensive
Thrust of System	Prevention of errors and frauds	Detection of errors and frauds
Tool for	Arrangement of the work	Examination of the work

Q4) Briefly explain the advantages and disadvantages of internal control.

A4) ADVANTAGES OF INTERNAL CONTROL

An audit control system can give the following advantages:

1. Detection of Errors and Frauds: Internal control systems are structured in such a way that work done by one employee in a process is checked by another without knowledge of the former. In such an environment, any fraud committed is brought to light unless there is collusion among fraudsters.

2. Time Saving: Auditor can test check or sample checks the transactions to ensure reliability, and accuracy of entries in the books. Hence, he can complete his audit work and prepare financial statements within the prescribed time.

3. Minimum Scope for Errors and Frauds: Each employee does only a limited work assigned to him, moreover, consciousness of his work being independently checked by another keeps him to be always alert at work. In such a context, chances for commission of error or fraud are lesser.

4. Operational Efficiency:

It facilitates fixation of accountability, error – free work performance, accuracy reliability and authenticity of entries and eradicate inefficiency, fraud, theft, etc. Moreover, this system enables the management to assess the performance of employees. All these collectively contribute to enhance the operational efficiency of organization as a whole.

DISADVANTAGES OF INTERNAL CONTROL

An audit control system can give the following limitations or disadvantages:

1. Organizational Structure: Deficiencies in organizational structure make internal control ineffective.

2. Size of the Organization: Small organizations have very low levels of internal control, which are almost negligible due to more interference by owners and management.

3. Unusual Transactions: The internal control procedures normally fail to keep a check on unusual transactions.

4. Costly: The implementation of internal control procedures and processes involves incurring costs in terms of time, effort and resources.

5. Abuse of Power: Members at the top-level management may override or interfere with control.

6. Collusion of two or more People: It may lead to internal controls being over- ridden.

7. Obsolescence: Control system may become redundant with passage of time if not updated with change in the size and nature of business.

8. Human Error: Internal control fails as there are possibilities of human errors.

9. Frequent follow-up measures: Follow-up procedures need to be frequent to ensure its effectiveness, which is extremely time-consuming.

Q5) Which are the major precautions to be taken before test check?

A5) PRECAUTIONS BEFORE TEST CHECK

While applying test checks the auditor should take the following precautions:

As far as possible sample transactions should be selected from every book.

The selection for transactions should be so distributed that the work of almost all the clerks of the client is checked.

The items should be selected at random.

As fraudulent manipulations are common during the first and last months of the period under audit, the entries made during these periods should be checked thoroughly.

In the selection of entries and accounts for applying test checks, care should be taken to check the different portions of the work at each audit.

Cash book and pass book should be checked thoroughly.

The auditor should select the transactions on his own. He should not consult the staff of the client while selecting the transactions.

If the auditor exercises the above safeguards with care and caution, the results are bound to be encouraging and satisfactory.

Q6) How to evaluate the results of sampling?

A6)

EVALUATION OF SAMPLE RESULTS

Auditing procedures that are appropriate to the particular audit objective should be applied to each sample item. In some circumstances the auditor may not be able to apply the planned audit procedures to selected sample items because, for example, supporting documentation may be missing. The auditor's treatment of unexamined items will depend on their effect on his evaluation of the sample.

If the auditor's evaluation of the sample results would not be altered by considering those unexamined items to be misstated, it is not necessary to examine the items. However, if considering those unexamined items to be misstated would lead to a conclusion that the balance or class contains material misstatement, the auditor should consider alternative procedures that would provide him with sufficient evidence to form a conclusion.

The auditor also should evaluate whether the reasons for his or her inability to examine the items have (a) implications in relation to his or her risk assessments (including the assessment of fraud risk), (b) implications regarding the integrity of management or employees, and (c) possible effects on other aspects of the audit.

The auditor should project the misstatement results of the sample to the items from which the sample was selected. There are several acceptable ways to project misstatements from a sample. If the sample results suggest that the auditor's planning assumptions were incorrect, he should take appropriate action.

The auditor should relate the evaluation of the sample to other relevant audit evidence when forming a conclusion about the related account balance or class of transactions.

Projected misstatement results for all audit sampling applications and all known misstatements from non sampling applications should be considered in the aggregate along with other relevant audit evidence when the auditor evaluates whether the financial statements taken as a whole may be materially misstated.

Q7) Which are the methods to select sample?

A7) METHODS OF SAMPLING

1. Simple random sampling

In a simple random sample, every member of the population has an equal chance of being selected. Your sampling frame should include the whole population.

To conduct this type of sampling, you can use tools like random number generators or other techniques that are based entirely on chance.

2. Systematic sampling

Systematic sampling is similar to simple random sampling, but it is usually slightly easier to conduct. Every member of the population is listed with a number, but instead of randomly generating numbers, individuals are chosen at regular intervals.

3. Stratified sampling

Stratified sampling involves dividing the population into subpopulations that may differ in important ways. It allows you draw more precise conclusions by ensuring that every subgroup is properly represented in the sample.

To use this sampling method, you divide the population into subgroups (called strata) based on the relevant characteristic (e.g. gender, age range, income bracket, job role).

Based on the overall proportions of the population, you calculate how many people should be sampled from each subgroup. Then you use random or systematic sampling to select a sample from each subgroup.

4. Cluster sampling

Cluster sampling also involves dividing the population into subgroups, but each subgroup should have similar characteristics to the whole sample. Instead of sampling individuals from each subgroup, you randomly select entire subgroups.

If it is practically possible, you might include every individual from each sampled cluster. If the clusters themselves are large, you can also sample individuals from within each cluster using one of the techniques above.

This method is good for dealing with large and dispersed populations, but there is more risk of error in the sample, as there could be substantial differences between clusters. It’s difficult to guarantee that the sampled clusters are really representative of the whole population.

Q8) Explain the purpose of sampling.

A8) Auditors usually perform the audit sampling on both the test of control and substantive audit procedures. In the test of controls, auditors use the sampling method to evaluate whether the client’s internal controls work effectively. In substantive audit procedures, they use the sampling method to estimate the amount of misstatement in an account balance.

Also, auditors usually design audit sampling that provides them a reasonable basis to draw conclusions about the population from which the sample is selected. Hence, it saves them a lot of time and effort comparing to auditing the entire population of an account balance.

Moreover, the audit sampling method is usually used when auditors want to make an investigation on a specific matter that comes up when performing the audit work.

In summary, purposes of audit sampling include:

To gather audit evidence to make a conclusion on the client’s controls and account balances

To reduce the work done but still provide a reasonable basis to draw conclusions

To comply with an applicable auditing standard

To be used as a tool to investigate a specific matter that could lead to misstatement which is due to error or fraud.

Q9) What are the factors to be considered for test checking? When it can be used?

A9) FACTORS TO BE CONSIDERED FOR TEST CHECKING

As far as possible sample transactions should be selected from every book.

The selection of transactions should be so distributed that the work of almost all the clerks of the client is checked.

The items should be selected at random.

As fraudulent manipulations are common during the first and last months of the period under audit, the entries made during these periods should be checked thoroughly.

In the selection of entries and accounts for applying test checks, care should be taken to check the different portions of the work at each audit.

Cash book and pass book should be checked thoroughly.

The auditor should select the transactions on his own. He should not consult the staff of the client while selecting the transactions.

If the auditor exercises the above safeguards with care and caution, the results are bound to be encouraging and satisfactory.

APPLICABILITY OF TEST CHECKING

Test checking can be applied in the following situations:

1. When there are large volumes of identical or routine transactions.

2. When transactions are large.

3. When the auditor has to certify the accounts quickly after the close of the accounting period.

4. When the auditor has past experience about the nature of transactions of the clients organisation.

5. When a satisfactory system of internal control and check system exist.

10. Which are the purposes of internal control?

PURPOSE OF INTERNAL CONTROL

To ensure that the business transactions take place as per the general and W accounting period in which they take place. It confirms that the financial statement fulfils the relevant statutory requirements.

To provide security to the company’s assets from unauthorised use. For this purpose, physical security systems are used to provide protection such as security guards, anti-theft devices, surveillance cameras, etc.

To compare the assets in the record with tthat of the existing ones at regular intervals and report to those charged with governance, in case any difference is found.

To evaluate the system of accounting for complete authorisation of the transactions.

To review the working of the organization and the loopholes in the operations and take necessary steps for its correction.

To ensure there is the optimum utilization of the firm’s resources, i.e. men, material, machine and money.

To find out whether the financial statements are in alignment with the accounting concepts and principles.

An ideal internal control system of an organization is one that ensures best possible utilization of the resources, and that too for the intended use and helps to mitigate the risk involved in it concerning the wastage of organization’s funds and other resources.

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