Workflow: Classical audit sampling

Koen Derks

last modified: 27-10-2021

Scenario

This vignette aims to show how the jfa package facilitates auditors in the standard audit sampling workflow (hereafter “audit workflow”). In this example of the audit workflow, we will consider the case of BuildIt. BuildIt is a fictional construction company in the United States that is being audited by Laura, an external auditor for a fictional audit firm. At the end of the year, BuildIt has provided a summary of its financial situation in the financial statements. Laura’s job as an auditor is to formulate an opinion about the fairness and correctness of BuildIt’s financial statements.

Therefore, Laura needs to obtain sufficient and appropriate evidence for the claim that the misstatement in the financial statements is lower than a certain amount: the materiality. If the financial statements contain errors that are considered material, this means that the errors in the financial statements are large enough that they might influence the decision of someone relying on these financial statements. For Laura, the materiality is set at 5% of the total value of the financial statements.

Since BuildIt is a small company, there is only a single population upon which the financial statements are based. Therefore, laura can use the materiality for the overall financial statements as the performance materiality for the single population. Specifically, BuildIt’s population consists of 3500 items. However, before assessing the details in the population, Laura has performed a test of BuildIt internal control systems and found that they were quite reliable.

In order to formulate an opinion about the misstatement in the population, Laura separates her audit workflow into four stages. First, she will plan the size of the subset she needs to inspect from the financial statements to make a well-substantiated inference about them as a whole. Second, she will select the required subset from the financial statements. Third, she will inspect the selected subset and determines the audit (true) value of the items. Fourth, she will use the information from her inspected subset to make an inference about the misstatement in the population (e.g., in this case also the financial statements as a whole). To start her workflow, Laura first loads BuildIt’s financial statements in R.

library(jfa)
data("BuildIt")

Setting up the audit

Laura wants to make a statement that, with 95% confidence, the misstatement in the financial statements is lower than the performance materiality of 5%. Based on last year’s audit at BuildIt, where the upper bound of the misstatement turned out to be 2.5%, she wants to tolerate at most 2.5% errors in the intended sample. Laura can therefore re-formulate her statistical statement as that she wants to conclude that, when 2.5% errors are found in her sample, she can conclude with 95% confidence, that the misstatement in the population is lower than the materiality of 5%. Below, Laura defines the materiality, confidence level, and expected errors.

# Specify the confidence, materiality, and expected errors.
confidence  <- 0.95   # 95%
materiality <- 0.05   # 5%
expected    <- 0.025  # 2.5%

Many audits are performed according to the audit risk model (ARM), which determines that the uncertainty about Laura’s statement as a whole (1 - her confidence) is a factor of three terms: the inherent risk, the control risk, and the detection risk. Inherent risk is the risk posed by an error in BuildIt’s financial statement that could be material, before consideration of any related control systems (e.g., computer systems). Control risk is the risk that a material misstatement is not prevented or detected by BuildIt’s internal control systems. Detection risk is the risk that Laura will fail to find material misstatements that exist in an BuildIt’s financial statements. The ARM is practically useful because for a given level of audit risk, the tolerable detection risk bears an inverse relation to the other two risks. The ARM is useful for Laura because it enables her to incorporate prior knowledge on BuildIt’s organization to increase the required risk that she will fail to find material misstatements. According to the ARM, the audit risk will then be retained.

\[ \text{Audit risk} = \text{Inherent risk} \,\times\, \text{Control risk} \,\times\, \text{Detection risk}\]

Usually the auditor judges inherent risk and control risk on a three-point scale consisting of low, medium, and high. Different audit firms handle different standard percentages for these categories. Laura’s firm defines the probabilities of low, medium, and high respectively as 50%, 60%, and 100%. Because Laura performed testing of BuildIt’s computer systems, she assesses the control risk as medium (60%).

# Specify the inherent risk (ir) and control risk (cr).
ir <- 1     # 100%
cr <- 0.6   # 60%

Stage 1: Planning an audit sample

Laura can choose to either perform a frequentist analysis, where she uses the increased detection risk as her level of uncertainty, or perform a Bayesian analysis, where she captures the information in the control risk in a prior distribution. For this example, we will show how Laura performs a frequentist analysis. In a frequentist audit, Laura immediately uses the adjusted confidence to calculate the sample size using the planning() function.

# Adjust the required confidence for a frequentist analysis.
c.adj <- 1 - ((1 - confidence) / (ir * cr))
# Step 1: Calculate the required sample size.
stage1 <- planning(materiality = materiality, expected = expected, conf.level = c.adj)

Laura can then inspect the result from her planning procedure by using the summary() function. Her result tells her that, given her prior distribution she needs to audit a sample of 178 items so that, when at most 4.45 errors are found, she can conclude with 91.66% confidence that the maximum error in BuildIt’s financial statements is lower the materiality of 5%.

summary(stage1)
## 
##  Classical Audit Sample Planning Summary
## 
## Options:
##   Confidence level:              0.91667 
##   Materiality:                   0.05 
##   Hypotheses:                    H0: T >= 0.05 vs. H1: T < 0.05 
##   Expected:                      0.025 
##   Likelihood:                    poisson 
## 
## Results:
##   Minimum sample size:           178 
##   Tolerable errors:              4.45 
##   Expected most likely error:    0.025 
##   Expected upper bound:          0.049986 
##   Expected precision:            0.024986 
##   Expected p-value:              < 2.22e-16

Stage 2: Selecting a sample

Laura is now ready to select the required 178 items from the financial statements. She can choose to do this according to one of two statistical methods. In record sampling (units = "items"), inclusion probabilities are assigned on the item level, treating items with a high value and a low value the same, an items of $5,000 is equally likely to be selected as a item of $1,000. In monetary unit sampling (units = "values"), inclusion probabilities are assigned on the level of individual monetary units (e.g., a dollar). When a dollar is selected to be in the sample, the item that includes that dollar is selected. This favors higher items, as an items of $5,000 is five times more likely to be selected than a item of $1,000.

Laura chooses to use monetary unit sampling, as she wants to include more high-valued items. The selection() function allows her to sample from the financial statements. She uses the stage1 object as an input for the selection() function.

# Step 2: Draw a sample from the financial statements.
stage2 <- selection(data = BuildIt, size = stage1, units = "values", values = "bookValue", method = 'interval')

Laura can inspect the outcomes of her sampling procedure by using the summary() function.

summary(stage2)
## 
##  Audit Sample Selection Summary
## 
## Options:
##   Requested sample size:         178 
##   Sampling units:                monetary units 
##   Method:                        fixed interval sampling 
##   Starting point:                1 
## 
## Data:
##   Population size:               3500 
##   Population value:              1403221 
##   Selection interval:            7883.3 
## 
## Results:
##   Selected sampling units:       178 
##   Proportion of value:           0.0001269 
##   Selected items:                178 
##   Proportion of size:            0.050857

Stage 3: Executing the audit

The selected sample can be isolated by indexing the sample object from the sampling result. Now Laura can execute her audit by annotating the sample with their audit value (for exampling by writing the sample to a .csv file using write.csv(). She can then load her annotated sample back into R for further evaluation.

# Step 3: Isolate the sample for execution of the audit.
sample <- stage2$sample

# To write the sample to a .csv file:
# write.csv(x = sample, file = "auditSample.csv", row.names = FALSE)

# To load annotated sample back into R:
# sample <- read.csv(file = "auditSample.csv")

For this example, the audit values of the sample are already included in the auditValue column of the data set .

Stage 4: Evaluating the sample

Using her annotated sample, Laura can perform her inference with the evaluation() function.

# Step 4: Evaluate the sample
stage4 <- evaluation(materiality = materiality, conf.level = c.adj, data = sample, 
                     values = 'bookValue', values.audit = 'auditValue')

Laura can inspect the outcomes of her inference by using the summary() function. Her resulting 91.66% upper bound is 1.396%, which is lower than the materiality of 5%. The output tells Laura the correct conclusion immediately.

summary(stage4)
## 
##  Classical Audit Sample Evaluation Summary
## 
## Options:
##   Confidence level:               0.91667 
##   Materiality:                    0.05 
##   Materiality:                    0.05 
##   Hypotheses:                     H0: T >= 0.05 vs. H1: T < 0.05 
##   Method:                         poisson 
## 
## Data:
##   Sample size:                    178 
##   Number of errors:               0 
##   Sum of taints:                  0 
## 
## Results:
##   Most likely error:              0 
##   91.66667 percent confidence interval: [0, 0.01396] 
##   Precision:                      0.01396 
##   p-value:                        0.00013639

Conclusion

Since the 91.66% upper confidence bound on the misstatement in population is lower than the performance materiality Laura has obtained sufficient evidence to conclude that there is less than 5% risk that the population contains material misstatement.