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RISK ANALYSIS
AND
STATISTICAL SAMPLING IN AUDIT
The Risk Model
Theory and Assumptions
Control Risk (CR)
Risk that the internal control systems in an organization
will not be able to detect an error or material misstatement
Inherent Risk (IR)
Susceptibility of a class of transactions to material
misstatement or errors
Risk of Occurrence of Error
Detection Risk (DR)
Risk that auditor’s substantive tests will not be able to
detect a material misstatement in the audited transactions
Overall Audit Risk (OAR)
Assurance required from audit procedures
the maximum risk the auditor is willing to accept
OAR = CR x IR x DR
OAR defined by the audit institution
• A constant pre-determined quantity
Objective of the auditor
assess inherent and control risks in the entity
design and perform compliance and substantive tests
to provide sufficient assurance that the product of the risks
identified ≤ overall audit risk
solve the equation for DR assessing IR and CR
Detection Risk (DR)
DR is actually a combination of:
Analytical procedures risk (AP): Risk that analytical
procedures will fail to detect material errors
Tests of detail risk (TD): Risk that detailed test
procedures will fail to detect the material errors
DR = AP X TD
OAR = IR X CR X AP X TD
Auditor exercises professional judgment in
assessing IR, CR and AP and solves the
equation for TD
Confidence Level
Detection Risk is closely related to the
confidence that the auditor wishes to obtain from
his substantive tests.
Increased confidence => Low DR => more
transactions and balances need to be tested
substantively
Confidence Level = 100%-Detection Risk
Detection Risk
Only risk that the auditor has under his control
Must be kept low
Materiality and Audit Risk-I
Independent of OAR
Related to VALUE, NATURE and CONTEXT of
Error
Materiality relates to the maximum possible
misstatements/ error
Risk -- concerned with the likelihood of error
Materiality – concerned with extent to which
we can tolerate error
Materiality and Audit Risk -II
Auditor to ensure:
Maximum possible error at the desired
assurance level < Materiality
IR + CR => Expected error rate in the
population
Materiality => Tolerable error rate in
the population
Assessment of Risks-I
Variables sampling
estimates a quantity
e.g. amount of sundry debtors shown in the
balance sheet
the underassessment in a tax circle.
Monetary Unit Sampling
provides quantitative results and is suited to
most audit situations
More accurate in low level error situations with a
relatively small population, where there are no
negative or zero balances.
‘PPS’ or ‘Probability Proportional to Size’
the probability of selection becomes proportional to the
size of a/c
high value items tend to get more weight and
therefore more probability of getting picked up in
any random selection, since
Sampling Methods
Is it necessary to estimate?
Assumption of homogeneity-how true?
Sampling distribution of mean
normal for large sample
What about smaller samples?
For small samples- what distribution (t?).
Testing for a single attribute (say classification
mistake)
- Binomial/ Poisson distribution?
To evolve a framework for application -
I
To integrate the risk model of audit with sampling
theory
To identify the population distribution and the
corresponding sampling frame for auditing
To suggest an appropriate sampling method for
selection of sample elements identification of areas
for application of attribute/ variable/ monetary unit
sampling;
To suggest an appropriate formula for
determination of sample size
To evolve a framework for application -
II
To evolve an theoretical framework and
practical method for projecting sample
results into population and for estimating
the population value
To suggest ways to minimize audit risk,
especially risks of over reliance and
incorrect acceptance;
To suggest a practical way to apply the
theoretical frame in a simple manner
OUR CONCERNS
OBJECTIVITY
RATIONALITY
SIMPLICITY
USER FRIENDLINESS
PRACTICABILITY
ADAPTABILITY
LEGALITY
ASSURANCE