Audit Sample: Simulating Scientific Approach

The sampling approach in audit is practical embodiment of “reasonable assurance” concept. Steve Collings, the assessor of F8 ACCA paper, has written article, where briefly explained the main principles of sampling in audit context. In this post I would like to discuss some issues regarding sampling phenomena.

A Little Bit of Theory

Based on the distinctive characteristics of statistical sampling (random selection and use of probability theory) following classification of sampling methods can be inferred from the ISA 530:

1.      Statistical sampling:

1.1.   Random sampling;

1.2.   Systematic sampling;

1.3.   Monetary unit sampling.

2.      Non-statistical sampling:

2.1.   Haphazard sampling;

2.2.   Block selection.

Actually, there are two steps in sampling process: determining the number of items you need to select from general population, and, aftermath select those items appropriately to make sample representative. By “representative” I mean that sampled population has to possess all qualities pertained to general population. 

History

Power in his book “Audit Society: Rituals of Verification” provides some insights on the sampling application in early years of audit. Block-tests – the form of proto-sampling – was used in late XIX century to test relevant transactions within particular month. However, the scholar notes that such method “lacked statistically precise notions of representativeness”.

Normal probability distribution 

Power states that American audit was pioneer in application statistically reasoned sampling methods. The process of formalisation and development of statistical methodology in audit began in 1930s-1940s. The drivers of these methods application were pragmatism and economic focus of US firms.

So at the moment we (auditors) have to be grateful to mathematical statistics and more specifically to probability theory. Obviously, now unlike before our pursuit to be more efficient and profitable backed up scientific or semi-scientific methods and strengthened by audit standards and legislation.

Practical Perspectives

However, working in audit firm you do not have to be a mathematician to apply variety of samples. Nowadays in most cases audit firms use sampling software. To be successful in running sample process following items need to be entered into program:

·      Risk level, which is usually significant, moderate or low;

·      Number of items in general population;

·      Total value of general population;

·      Total value and number of key material items, which need to pre-selected for separate testing in addition to test of sampled items.

Risk level is essential for determining right number of items in sample, the mistake could result overaudit or wrong audit opinion.

We should not forget about the judgment in audit profession. Of course, the process of calculation the number of sampled items is rather formalised, but judgment could be used in setting up initial risk per flow of transactions, establishing key material items, utilising selection process (e.g. systematic vs. haphazard). If the judgment is used it would be necessary to document appropriately the reason and factors prompting it. This is especially relevant in cases when the judgmental approach substantially differs from what is reasonably expected in similar circumstances.

Ethical Auditor: Independence vs Rotation

Rotation

My previous post on ethics was rather popular, which gives me reasons to suggest that people are interested in auditors’ behavior and their place in business culture. Last week The Economist published interesting article about independence of auditors. Here are very appealing facts in the article:

    “… 1896 was also the year that Barclays, a British bank, chose an ancestor of PwC as its auditor, a relationship unbroken to this day. Fidelity is the norm in auditing. GE, Procter & Gamble and Dow Chemical have also clocked up centuries with their auditors. The average tenure for an auditor of a British FTSE 100 company is 48 years. Two-thirds of Germany’s DAX 30 have had their auditors for over 20 years.”

There are several opinions presented in article, one of which suggests that to address the issue it necessary to impose audit firm rotation. After reading I decided to discuss independence, because it is quite disputable area.

Current Situation: Partner Rotation

The literature on audit states that there is familiarity threat, which could arise between staff of audit firm and client. The risk is that auditor would lose professional scepticism because of too close relations with client. To address this issue official documents like SOX (in USA) and accounting codes like ACCA Code of Ethics and Conduct set specific requirements on audit partners rotation in case of dealing with listed (or public interest) clients. The requirements are as follows:

1.  Engagement partner should be rotated after 5 years;

2.    Other key audit partners should be rotated after 7 years;

3.    Partner responsible for quality control should be rotated after 7 years

However, current talks about rotation of firm suggest that above measures are not enough to provide independent audit opinion.

Who to Decide

Now we are coming to the point of appointing auditors on top management level. As known auditors, which expected to be appointed have to be approved by shareholders on annual general meetings. If shareholders did it for 100 years as in above case with Barclays then it all right. They bear all risks of such appointment and they should have understood it. 

However, in current stakeholder theory – shareholders are not the only persons who are affected by activity of listed Company. If it is “public interest entity” then the potential effect on other members of public gives right to public to interfere in the process of auditor appointment. I wrote about it in previous post considering proposals of European Commission on extra audit regulations.

The appointment of auditor becomes especially significant in case of financial institutions in our days as panic on market related with bankruptcies might jeopardize whole economy.

More Regulation – Better Results?

The above article gives example of number of studies which founded that rotations do not necessary results increase of audit quality. On the contrary, because of lack of client knowledge the quality might deteriorate. On the other hand, then it would be necessary to establish special rules for information transfer between auditors to provide better client understanding. The third point is that all these regulation might become too huge for auditors and add much more to existing bureaucracy in our profession.

What are your ideas in this issue, please share your thoughts in comments.  

Job Search: PwC Insight Day in Leeds

I continue to narrate about my adventures during my job search. This time I was lucky enough to accomplish 2 objectives: I visited rather interesting Leeds City and got information about PricewaterhouseCoopers (PwC) recruitment process.

As a result of PwC Insight Day I’ve understood that generally htis kind of event are useful in case:

·     you are graduate and want to enter graduate recruitment process;

·  you are experienced professional, but just want to get some insight about local office atmosphere and type of people you are expected to work with.

Generally PwC employees performed rather diligently for their grades. PwC associates (two-three years in audit practice firm) tried their best to give potential employees the idea of what they are doing in different departments of firm and were open to for questions.

What I found interesting is that PwC has established separate department for testing controls – “Risk Assurance”. Usually in audit firms we have separate department specialized in IT controls and applications. Risk assurance people in PwC deal with all kind controls, including manual. The risk assurance associate told me that they might even test manual controls for audit team in usual audit engagements. However, the ultimate goal of setting up this department, as I think, was to have trained employees specialized in compliance engagements, e.g. SOX.

In addition, I liked Leeds! It is a very cute town with nice architecture and great industrial history. Generally, the nice place to live and work.

Accountancy in Literature: Of Human Bondage

Mildred and Philip
in 1934 film version

Following my promise to produce non-specialist text on week-ends, I would like to introduce my finding about perception of accounting profession in the end of XIX century… at least in literature. I have read Of Human Bondage by Somereset Maugham recently. In this novel, young fellow Phillip and his relatives try to find his path in this world and consider accounting profession also. Here are some extracts from great novel:

The family lawyer of Philips’ aunt and uncle “suggested that Philip should become a chartered accountant”. He explained following in his letter to relatives:

  “… the growth of modern businesses and the increase of companies had led to the formation of many firms of accountants to examine the books and put into the financial affairs of their clients an order which old-fashioned methods had lacked. Some years before a Royal Charter had been obtained, and the profession was becoming every year more respectable, lucrative, and important.”

At those times, when the “gentlemen” and “man of profession” were not empty phrases in England, it was really important to find out if this profession fits gentleman. Maugham illustrates this:

  “The Vicar (Philip’s uncle – my note) of Blackstable wrote to ask Mr. Nixon (family lawyer – my note) whether it was a profession suited to a gentleman; and Mr. Nixon replied that, since the Charter, men were going into it who had been to public schools and a university...”

As seen having degrees both from public school and university meant that person is supposed to be a gentleman. Some words about how internship was arranged at those years:

  “The chartered accountants… …happened to have a vacancy for an articled pupil (trainees, interns – my note), and would take Philip for a fee of three hundred pounds. Half of this would be returned during the five years the articles(internship – my note) lasted in the form of salary…

… if Philip disliked the work and after a year wished to leave, Herbert Carter, for that was the accountant’s name, would return half the money paid for the articles.”

Philip performed badly as accounting trainee and Mr. Carter, the head of accounting firm, had to lecture him:

  “Mr. Goodworthy (senior accountant – my note) tells me you’re slack. You won’t do any good as a chartered accountant unless you look alive. It’s a fine profession, and we’re getting a very good class of men in it, but it’s a profession in which you have to... …in which you have to look alive.”

Somerset Maugham

Unfortunately, Philip did not like our remarkable profession, which was getting on its feet at those days. After having quite exciting live experience Philip became a doctor.    

I advise to read this novel by S. Maugham to everybody who loves a good piece of fiction literature. If you have seen mentioning of accountancy in books and any other interesting cultural contexts (movies, pictures, photos etc.) please share information in comments to my blog or feel free to email me.  

Recruitment in Audit: Chatting with KPMG

I have finalised all my study responsibilities to my University and now in the process of job search. Surely, I consider all top audit firms as target employers along with other honourable companies. So, I am going to start new column in my blog about my adventures and tips in finding job in audit/assurance business.

Looking through Big 4 audit firms sites I mentioned that KPMG provides opportunity to ask KPMG recruiters questions through chat facility. Specifically the message on their site stated following:

“If you’d like to ask one of our recruiters a question, you can chat to them online between 12.30pm and 1.30pm, Monday to Friday. Click here to speak to a recruiter.”

 So, guess what I did? I clicked!!! ;) I did it exactly at the time they asked me to do so. However, I was surprised when nobody from recruitment team appeared during mentioned chat session. I was patiently waiting for half an hour and no one from KPMG appeared there. You know, it does not mean anything but leaves a bit of negative impression… if you promise something – then do it please, or remove “chat” opportunity from your glorious site…

Ok, that is all for today… if you have your own stories please leave comment, email me. As always, ready to discuss audit topics.  

Some Colour to Fraud Investigation

Lisa Weaver, the examiner of P7, wrote the article about forensic auditing in Student Accountant in 2008. I can not say it is the most jolly reading in the world, but I still  recommend it to all accountancy students for effective preparation to exam or job interview in forensic department.

In fact the fraud is highly tested area in all accountancy certification exams, in  ACCA (F8, P1,P7) and US CPA. I would like to add some “colour” to the considerations about fraud investigation engagements.

Types of Fraud

Ms Weaver kindly mentioned for us that there are three types of fraud:

·        corruption,

·        asset misappropriation,

·        financial statements fraud.

According to PwC’s report “Global Economic Crime Survey” her statement is very close to reality. I highly recommend to read that report, because it is quite interesting and practical product. PwC gives a table of the most popular economic crimes, which is in line with Weaver’s article:

Lets dive in financial statement fraud.

Financial Statement Fraud

Elliot and Elliot in their book state that inventory valuation gives lots of opportunities for creative accounting. Inferring from Treadway Comission Report they consider that ‘fraud often involved overstatement of revenues and assets with inventory fraud’ featuring understating bad debt allowances, overstating value of inventory. There are several groups of inventory related fraud: year-end manipulations, purchases not recorded (cut-off issues), fictitious transfers of non-existent inventory, carrying obsolete inventory at a cost, reducing cost of goods sold by adjusting journal entries.

Fraud and Bankruptcies

Gaughan, referring to Dun & Bradstreet research, noted than in 2000s number of bankruptcies related with fraud significantly increased. WorldCom, Enron, Adelfia, Refco, Parmalat were ‘brought down by management fraud’. He also mentioned BancruptcyData.com table of the largest bankruptcies. I have found it’s updated version since he has written his book, here it is:

As we already know accounting fraud (so called, ‘Repo 105’) was also involved in Lehman’s case. Though it was not the primary reason for their collapse, but still conceal of fraud contributed to the overall situation. This is how Sikka describes this case in his article:

‘Lehman’s own accounting personnel described Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet as opposed to legitimately meeting balance sheet targets at quarter end”, but the bank received a clean bill of health from auditors Ernst & Young. The insolvency examiner was critical of auditors and protracted litigation will follow.’

By The Way

There is a special certification of specialists in fraud investigations which is carried out by Association of Certified Fraud Examiners. CFEs are the guys, just like us, accountants J However, additionally to common accountancy subjects they study things as criminology and have special training to present evidence in court.

By the way, have you ever been involved in fraud investigations or may be you performed fraud investigation procedures within audit engagements? Please share information. 

References

Elliot, B. and Elliot, J. (2007). Financial Accounting and Reporting. 11^th Edition. Pearson Education Ltd.

BankruptcyData.com (2010). Site Link:

 http://www.bankruptcydata.com/Research/Largest_Overall_All-Time.pdf

Gaughan, P.A. (2007). Mergers, Acquisitions and Corporate Restructurings. Forth Edition. John Wiley and Sons Inc.

PwC. (2009) Global Economic Crime Survey: Economic Crime in a Downturn. November 2009, PwC

Sikka, P. (2011).The EU man cometh. PQ Magazine. No. 1, p. 27.

Weaver, L. (2008). Forensic Auditing. Student Accountant. September 2008, p. 58-60.

Week-end: Audit Commercials

My favourite TV/video commercial in audit area was made by Ernst & Young. Yes, I know it is old :) But I can't give up the idea to display it in my blog.

If you know any other TV ads on YouTube related with audit and as cute as the one above, then please share with me information in comments. Have a nice week-end!