Internal Audit, Test Checking and Audit Sampling
1. Internal Audit & Statutory Framework (Section 138)
Internal Audit is an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. It evaluates risk management, internal controls, and governance processes.
Mandatory Applicability under Section 138 of Companies Act 2013:
Internal audit is legally mandatory for:
- Every Listed Company.
- Every Unlisted Public Company meeting any of the following thresholds in the preceding financial year:
- Paid-up share capital of INR 50 Crore or more; or
- Turnover of INR 200 Crore or more; or
- Outstanding loans or borrowings from banks/PFIs exceeding INR 100 Crore; or
- Outstanding deposits of INR 25 Crore or more.
- Every Private Company having:
- Turnover of INR 200 Crore or more; or
- Outstanding loans or borrowings from banks/PFIs exceeding INR 100 Crore.
Who Can Be Appointed? A Chartered Accountant (in practice or employment), a Cost Accountant, or any other qualified professional decided by the Board.
2. Test Checking in Auditing
Test Checking is an auditing technique where the auditor examines a representative percentage of entries within an accounting head rather than verifying 100% of the transactions, inferring the accuracy of the whole population from the sample examined:
Pros and Cons of Test Checking
Advantages of Test Checking
- Significant Time & Cost Savings: Enables the auditor to complete statutory audits for massive enterprises within statutory deadlines.
- Focus on High-Risk Areas: Allows the audit team to concentrate their intellectual effort on critical estimates, valuations, and extraordinary items.
- Statistical Validity: If internal checks are robust, testing a representative sample yields dependable conclusions about the entire ledger.
Disadvantages & Vulnerabilities
- Undetected Fraud: Carefully camouflaged individual frauds or fictitious journal entries may fall into uninspected batches.
- False Sense of Security: Clerks may realize only a fraction of entries are inspected and become negligent.
- Auditor Remains Liable: The auditor cannot escape liability for professional negligence merely by pleading that they performed test checking!
Crucial Precautions to be Observed in Test Checking:
An auditor must not apply test checking blindly. The following safeguards are essential:
- Never Apply to Sensitive Areas: Test checking must never be used for:
- Cash book entries and bank reconciliations (must be tested 100%).
- Extraordinary or non-recurring transactions (asset sales, mergers).
- Year-end closing adjustment entries and provisions.
- First and Last Month Testing: Transactions recorded in the first month and the final month of the financial year should be examined extensively to detect cut-off manipulation.
- Random and Unbiased Selection: Sample entries must be selected across all operational cycles without predictable patterns known to client staff.
- Immediate Expansion upon Finding Error: If test checking reveals even a single significant error or suspicious transaction, the auditor must immediately expand sample size or switch to 100% detailed checking for that ledger.
3. Audit Sampling (Standard on Auditing - SA 530)
Under SA 530 - Audit Sampling, audit sampling is defined as:
“The application of audit procedures to less than 100% of items within a population of audit relevance such that all sampling units have a chance of selection in order to provide the auditor with a reasonable basis on which to draw conclusions about the entire population.”
Comparison of Sampling Risk vs. Non-Sampling Risk
Sampling Risk
The risk that the auditor's conclusion based on a sample may differ from the conclusion reached if the entire population were subjected to the same audit procedure:
- Risk of Incorrect Acceptance: Assessing controls as effective when they are actually defective (affects audit effectiveness; high risk of undetected material error).
- Risk of Incorrect Rejection: Assessing controls as defective when they are actually effective (affects audit efficiency; causes unnecessary additional testing).
Non-Sampling Risk
The risk that the auditor reaches an erroneous conclusion for any reason **unrelated to sample size**:
- Use of inappropriate audit procedures.
- Misinterpreting audit evidence or failing to recognize an error.
- Human fatigue, lack of professional skepticism, or audit assistant inexperience.
4. Statistical vs. Non-Statistical Sampling
Auditors employ two primary sampling methodologies under SA 530:
| Dimension | Statistical Sampling | Non-Statistical (Judgmental) Sampling |
|---|---|---|
| Scientific Basis | Grounded in mathematical probability theory and standard deviation. | Based entirely on the subjective personal judgment, experience, and intuition of the auditor. |
| Measurability of Risk | Sampling risk can be quantified mathematically with precise confidence levels (e.g., 95% confidence). | Sampling risk cannot be measured mathematically. |
| Objectivity | Objective; removes personal bias in sample selection. | Prone to auditor bias or subjective oversight. |
| Defense in Court | Provides defensible mathematical documentation proving due professional care was exercised. | More difficult to defend if critical frauds were missed in unselected transactions. |
5. Primary Sample Selection Methods (SA 530)
Five Recognized Sample Selection Techniques
Method 1
Simple Random Selection:
Every sampling unit has an equal probability of selection using computer-generated random number generators or mathematical random number tables.
Method 2
Systematic Selection:
Selecting items using a constant interval (e.g., every 50th invoice) after a random starting point between 1 and 50.
Method 3
Monetary Unit Sampling (MUS):
A value-weighted selection method where individual currency units within ledger balances are sampling units, giving higher-value items a proportionally greater chance of selection.
Method 4
Haphazard Selection:
The auditor selects sample items without following a structured mathematical technique, while intentionally avoiding conscious bias or predictability.
Method 5
Block Selection:
Selecting a contiguous block of transactions (e.g., all vouchers from May 1 to May 15). Generally discouraged as it rarely yields a representative sample of annual operations.
6. Key Exam Review Questions
- Which companies are legally required to appoint an Internal Auditor under Section 138 of the Companies Act 2013?
- What precautions must an auditor observe when employing test checking? What transactions must never be subjected to test checking?
- Define Audit Sampling according to SA 530. Differentiate between Sampling Risk and Non-Sampling Risk.