AUDITING

BAC2664 (New), BAC2287(Old)

Topic 6, Lecture 7
(1) Materiality, (2) Audit Risk, (3)
Audit Sampling, (4) Audit Evidence
and Procedures

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 (1) Materiality - What is materiality?
ISA 320 (AI 320), Audit Materiality, paragraph 3,
defines materiality as:
“Information is material if its omission or
misstatement could influence the economic
decisions of users taken on the basis of the
financial statements. Materiality depends on the
size of the item or error judged in the particular
circumstances of its omission or misstatement.
Thus, materiality provides a threshold or cut-off
point rather than being a primary qualitative
characteristic which information must have if it is
to be useful.”
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 Significance of Materiality

• Materiality is the criteria used by both

accountants and auditors in distinguishing
between ‘important’ and ‘unimportant’
matters, relating to financial statements.

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 Why auditor is concerned with
materiality?
• because he would like to determine whether the financial
statements prepared by the client’s management, are
not affected by material misstatements which may affect
his opinion on financial statements.
• Furthermore, the concept of materiality is used by the
auditor for the following reasons:
(1) as guide to plan an audit, and in designing the
nature, timing and extent of audit procedures,
(2) as a guide to valuate audit results (sufficiency of audit
evidence),
(3) to express an opinion that the financial statements
give a true and fair view.

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 Factors that can cause Material
Misstatements
• ISA 240, Fraud and Error, discusses the
auditors’ responsibility for the detection of
material misstatements resulting from fraud or
error when carrying out an audit of financial
statements.
• AI 240, paragraph 3, defines and provides
instances of fraud:
“intentional misrepresentations of financial
information by one or more individuals among
management, employees, or third parties. Fraud
may involve:
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 Factors that can cause Material
Misstatements continued

(a) manipulation, falsification, alteration of records

or documents;
(b) Misappropriation of assets;
(c) Suppression, omission of the effects of
transactions from records or documents;
(d) Recording of transactions without substance;
(e) Misapplication of accounting policies.”

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 Factors that can cause Material
Misstatements continued

• AI 240, paragraph 4, defines and provides

instances of error:
“unintentional mistakes in financial information,
such as:
(c) Mathematical or clerical mistakes in the
underlying records and accounting data;
(d) Oversight or misinterpretation of facts;
(e) Misapplication of accounting policies.”

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 Types of Materiality

(1) Quantitative – Monetary Value (RM)

(2) Qualitative (a) Ninth Schedule of Companies
Act 1965 (failure in compliance)
(b) Accounting Standards (failure in
compliance)

Assessment of what is material is a matter of the auditor’s

professional judgement, determined at the planning
stage. However, it is normal if the judgement changes
during the fieldwork.

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 Factors that affect auditor’s judgement

(1) Size of misstatement in term of monetary value

(quantitative)
(2) Cumulative effect of the misstatement
(quantitative)
(3) Nature of misstatement (qualitative)
(4) Users of financial statements (qualitative)

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Size of Misstatement in term of Monetary
Value
• Measured as a percentage (one that the auditor
is comfortable with in order to obtain the degree
of reasonable assurance)
(Guideline: Rule of thumb – 5%)
– turnover, net profit before tax

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 Cumulative effect of Misstatement

• Example:
the misstatement of printing and
stationery, travelling and accommodation,
repair and maintenance, are immaterial
individually, but may be material enough
to effect the net profit if they are grouped
together.

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 Nature of Misstatement

Examples of the qualitative aspect of materiality, are:

(2) Misappropriation of fund RM50 by the cashier
- material, because it reflect a breach of trust by the
cashier.
(2) Directors remuneration RM2,000 per year for each
director
- material, because the amount was fixed at the annual
general meeting.
(3) Loss reported as profit
- may seem immaterial, but, if it mislead the company’s
results, the misstatements are deemed material.

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Users of financial statements
• An auditor shall ensure that the notes to
the accounts contain informative
disclosures that contribute to the users
understanding about the company’s
position and performance.
• Inadequate or improper description of an
accounting policy, could be material if it is
likely that the user of financial statements
would be misled by the description.

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Why concept of Materiality So Important?

• Cost Effective - (100% audit too costly)

• Time - (100% audit requires longer time,
deadline of CA 1965 to be met, tabling of Fin
Stats at AGM)
• Manpower - (100% audit requires audit staff to
be permanently stationed at client’s premises)
• Pragmatic – (in real life there is no 100%
accuracy)
• Psychological – (100% will not motivate audit
staff to work efficiently and effectively)
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 (2) Audit Risk
ISA 200 (AI 200), Objectives and General Principles
Governing Audit of Financial Statements, paragraph 9,
states:
“there are inherent limitations in an audit that affect the
auditor’s ability to detect material misstatements.
These limitations result from factors such as:
(c) The use of testing;
(d) The inherent limitations of any accounting and internal
control system;
(e) The fact that most audit evidence is persuasive rather
than conclusive.”
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 Nature of Audit Test

The cost of testing 100% of a population is high

and may not justify the benefit derived.
Therefore, tests of controls and substantive
tests are performed on material items selected
through sampling techniques.

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 Inherent Limitations of Client’s Internal
Control System
Duty of the company’s management is to design
an internal control system.
However, errors will still occur and go undetected
because of:
(3) Negligence
(4) Inefficiency
(5) Compliance on controls has deteriorated
(6) Communication breakdown.

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 Inherent Limitations of an Audit

Auditors accumulate and rely on evidence that are

persuasive rather than conclusive because:
(2) The transactions, i.e., the data that
substantiate the financial information are
historical in nature, and
(3) The time and manpower constraint.

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 What is Audit Risk?

ISA 400 (AI 400), Risk Assessment and Internal

Control, paragraph 3, defines audit risk as:
“…the risk that an auditor gives an inappropriate
audit opinion when the financial statements are
materially misstated.”

(note: assessment of risk is based on auditor’s

knowledge of clients business, management
integrity and nature of transactions).

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What are the components of Audit Risk?

AI 400, paragraph 3:
(b) Inherent risk – the risk that material misstatements will
occur (high if management lacks integrity, low if
management’s integrity is good)
(c) Control risk – the risk that the client’s system of
internal control will not prevent or correct such
misstatements (high if internal control system is not
effective, and vice versa)
(d) Detection risk – the risk that any remaining material
misstatements will not be detected by the auditor (high
if auditor does not exercise his work with due care).

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Examples of Accounts easily influenced
by Errors
• Depreciation Account:
Complex calculations are more likely to be
misstated than simple calculations.
• Stocks:
Technological developments might make a
particular product obsolete, thereby causing
inventory to be easily overstated
• Debtors Account:
Ageing report does not determine the adequacy
of doubtful debts
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 Detection Risks arises due to…..

(1) An auditor does not examine all transactions of an

account balance or class of transactions.
(2) An auditor might select an inappropriate auditing
procedure and as a result fail to support management
assertions.
(3) An auditor might misapply an appropriate procedure
which may result in failure to support management
assertions.
(4) An auditor might misinterpret the audit results.
(5) An auditor might fail to follow-up on matter which are
put on enquiry, and, therefore, the opinion are formed
without having the full knowledge of the situation.

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 How to assess Audit Risk?

….assessment of IR, CR, DR, represent a matter

of professional judgement….

Inherent Risk:
(4) Knowledge of clients business
(5) Integrity of management
(6) Client motivation to make misstatement
(7) Client knowledge of accounting standards

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 How to assess Audit Risk continued

Control Risk:
(2) Segregation of duties
(3) Inherent limitations of internal control

Detection Risk:
(6) Nature – What audit procedure to use?
(7) Extent – How many samples to select?
(8) Timing – When to start substantive test? Should the
test be done at the balance sheet date or performed
near the balance sheet date?

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 How to minimise Audit Risk?

(1) Plan and delegate the audit with due care.

(2) Audit evidence are properly documented.
(3) The audit staff are competent and perform audit with
due care.
(4) Sample selected should represent the population.
(5) Probe all problems to the end.
(6) Use audit manual.
(7) Avoid misunderstanding with client.
(8) Communication channel among audit staff must be
good in order to solve, on timely basis, any problem
faced during the audit.
(9) The audit fees should be based on auditor’s
knowledge of the client’s business.
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 (3) Audit Sampling

ISA 500 (AI 500) – Audit evidence, paragraph 8

On audit sampling:
“ in forming the audit opinion, the auditor does not
ordinarily examine all of the information available
because conclusions can be reached about an
account balance, class of transactions or control by
way of using judgemental or statistical sampling
procedures.”

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 ISA 530 – Audit Sampling, paragraph 3

Audit sampling:
“…. The application of audit procedures to less than
100% of the items within an account balance or class
of transactions to enable the auditor to obtain and
evaluate audit evidence about some characteristic of
the items selected in order to form or assist in
forming a conclusion concerning the population.”

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 Audit evidence choices that do and do
not involve sampling
• Inspection of tangible assets – inventory
• Inspection of records or documents
• Re-computation
• Confirmation
• Testing all items with a particular characteristics

Note: table 8-1, page 275

Relationship between evidence types and audit
sampling

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 Types of Audit Sampling

Two types:
2 Statistical sampling, and
3 Non-statistical sampling.

Statistical sampling:
Is a way for auditors to make inferences and obtain reasonable
assurance about the class of transactions and account
balances through mathematical calculation. The primary
benefit of statistical methods is the quantification of
sampling risks, and confidence level.

Types of statistical sampling techniques:

Attribute sampling, monetary-unit sampling, classical variables
sampling (page 276)

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 Designing the sample

• Step 1 – determine the test objectives (p 277)

• Step 2 –define the population characteristics (p 278)
• Step 3 – determine the sample size (p 279)
• Step 4 – sample selection (p 282)
• Step 5 – perform the audit procedures (p 282)
• Step 6 – calculate the sample deviation and
computed upper deviation rates (p 284)
• Step 7 – draw final conclusions (p 284)

• Example of an attribute-sample plan (p 285 – 294)

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 Types of Audit Sampling

Non-statistical sampling:
Auditors select sample according to experience and
therefore they are able to quantify sampling risk.
Auditors need to decide how to develop sample
plans and the inferences to be drawn from the
results.

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 Selection of the sample

• Select a representative sample from a population, in

which the characteristics of the sample are the same
as the population

• Population may consist, for example, all entries in an

account, a collection of debtors account balances, or
a collection of sales invoices.

• Auditors must exercise due care in designing and

selecting a sample, and evaluating the results to
make sure that the sample is representative of the
population.

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 Selection of the sample

• Uncertainties arise that have a direct impact on detection risk

are termed:
1 non-sampling risk, and
2 sampling risk.

• Non - sampling risk arise because, for example, most audit

evidence is persuasive rather than conclusive, the auditor
might use inappropriate procedures or might misinterpret
evidence and thus fail to recognise an error.
• The auditor attempts to reduce non-sampling risk to a
negligible degree by appropriate planning, direction,
supervision and review.

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 Selection of the sample

AI 530, paragraph 11, provides instances of sampling

risk:
“ sampling risk arises from the possibility that the
auditor’s conclusion, based on a sample, may be
different from the conclusion that would be reached
if the entire population were subjected to the same
audit procedure.”

Sampling risk is an inherent part of sampling that

results from testing less than the entire population.
Even with zero sampling error, there is always a
possibility that a sample is not representative.

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 Selection of the sample

AI 530, paragraph 19, identifies the most common

methods of selection used by auditors:
1 random selection,
2 systematic selection, and
3 haphazard selection.

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 Random selection

• Random selection ensures that all items in the

population or within each stratum have a known
chance of selection.
• This requires the use of random number tables.
• A random number table is a listing of independent
random digits conveniently arranged in tabular form
to facilitate the selection of sample that may have a
similar number to the random table number.

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 Systematic selection

• Systematic selection involves selecting items using

a constant interval between selections, with the first
interval having a random start.
• The interval might be based on a certain number of
items (e.g., every 20th voucher number) or on
monetary totals (e.g., every RM1,000 in the
cumulative value of the population)

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 Haphazard selection
• Haphazard selection may be an alternative to random selection
provided that the auditor attempts to draw a representative sample
from the entire population with no intention to either include or
exclude specific units.
• When the auditor uses this method, he should guard against making a
selection that is biased, for example, towards items which are easily
located, as they may not be representative.
• In addition, to improve the likelihood of a haphazard selection being
representative for tests of transactions, the auditor should keep the
following in mind:
1 in selecting items for examination, each major type of transaction in
the cycle should be included.
2 when different client’s personnel are responsible for processing
transactions during the accounting period, some transactions
prepared by each person should be tested.
3 when the auditor is testing for errors in amounts, population items
with large balances should be tested more heavily than those with
small balances.

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 Monetary-unit sampling

• Advantages – (p309)
• Disadvantages – (p310)
• Step 1 – determine the test objectives (p310)
• Step 2 – define the population characteristics (p 311)
• Step3 – determine the sample size (p312)
• Step 4 – select sample items (p314)
• Step 5 – perform the audit procedures (316)
• Step 6 – calculate the projected misstatement and the upper
limit on misstatement
• Step 7 – draw final conclusions (p319)

• Example: p316

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 Distinction between statistical and non-
statistical sampling
• Need to have knowledge on
statistical formula.
• Objective results, since the
sample are mathematically
proven to represent the
population.
• Different auditor, with the
same approach will give the
same answer.
• Defensible in the court of
law.
• Can delegate the
responsibility to select audit
sample to lower rank audit
staff. (efficient method)
• Based on experience and
common sense.
• Subjective results, since the
sample may not represent
the population.
• Different auditor will
definitely have different
approaches, and as a result
will give different answer.
• Not defensible in the court
of law.
• Need senior audit staff to
devise the sample size and
selecting sample. (not an
efficient method)
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 Advantages of statistical sampling

1 Provides the auditor with the degree of assurance by

mathematically calculating the precision level and reliability
(i.e., confidence level).
2 Allow the auditor to plan the audit approach in a systematic
and scientific manner.
3 Enables the auditor to interpret the sampling results
objectively on the basis of values for precision and
reliability.
4 Let the auditor to rely on a smaller sample than would be the
case for non statistical sampling.
5 Permit a more intensive examination of sample items since
with smaller sample sizes the auditor is able to thoroughly
scrutinise each item that is drawn.

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Conditions when statistical sampling can
be used
1 The client’s accounting and internal control system
are reliable and effective.
2 The population is large.
3 All items in the population are homogeneous (e.g.,
salaries and wages are not homogeneous since
wages are computed daily or piece rate and
salaries are paid monthly).
4 All items in the population are identifiable and
accessible. Each document must have a serial
number for easy identification and kept on files to
enable access at any convenient time.

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 Circumstances that require 100% audit

1 There are very few items that make up the

accounts.
2 Items of special importance.
3 Extraordinary item or one-off item.
4 Account balances with potential risk.
5 Auditor is put on enquiry.

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 (4) Audit Evidence
ISA 120 (AI 120), Framework of International Standards on
Auditing, paragraph 12, emhasises audit evidence”
‘in forming the audit opinion, the auditor obtains sufficient
appropriate audit evidence to be able to draw
conclusions on which to base that opinion.”

The client should not hinder the auditors in getting

evidence. S174(4) CA 1965, states:
“an auditor of a company has a right of access at all
reasonable times to the accounting and other records
(including registers) of the company, and is entitled to
require from any officer of the company…..such
information and explanations as he desires for the
purpose of audit.”
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 Process of Evidence
The gathering of audit evidence begins from documents,
records, and registers.
Documents – accounting documents, and corroborating
documents
Records – journals and subsidiary ledgers, general ledger
Registers – fixed assets register, payroll register, statutory
register, which support the general ledger account
balances

Audit evidence is obtained by carrying out procedures as

laid down in the audit programs, both from the test of
controls and substantive procedures.
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 Characteristics of Audit Evidence
Audit evidence – information used by auditors to determine
the validity of management assertions, in order to form
an opinion
Sufficient – measure of the quantity of audit evidence
Appropriate – measure of the quality of audit evidence and
its relevance to a particular assertion and its reliability

Validity, relevance, reliability of the historical data and

information, must be persuasive rather than conclusive,
as the information depends on the client’s staff.
The four determinants of the persuasiveness of audit
evidence are as follows: (1) relevance, (2) reliability, (3)
sufficiency, (4) timeliness.

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 Relevance, Reliability, Sufficiency,
Timeliness
Relevance – evidence support the audit objectives or management’s
assertion being tested

Reliability depends on:

(d) Degree of objectivity
(e) Qualifications of information provider
(f) Independence of information provider
(g) Effectiveness of clients internal controls
(h) Auditor’s direct knowledge
(i) Documented evidence
(j) Sufficiency
(k) Quantity
(l) Quality

Timeliness – when evidence is accumulated and the period it covers.

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 Techniques of Obtaining Audit
Evidence
Approach: Techniques:
1 inspection 1 physical examination
2 observation 2 documentation
3 inquiry 3 observation
4 computation 4 representation from
client’s personnel
5 representation from third
party
6 arithmetical accuracy
7 analytical procedures

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 References
1 Lecture notes
2 Tutorial questions
3 Past examination questions
4 ACCA articles
5 Text:
- Chapter 3 (Risk Assessment and Materiality),
- Chapter 4 (Audit Evidence and Audit Procedures),
- Chapter 5 (Planning and Audit Documentation)
- Chapter 8 & 9 (Audit Sampling)

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