Chapter 8 Audit Sampling: An Overview and Application to Tests of Controls 2008 The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin
Sampling Primary purpose is to draw inferences about the whole population based on the results of testing of a subset of the population
Introduction Auditing standards recognize and permit both statistical and nonstatistical methods of audit sampling. Two technological advances have reduced the number of times auditors need to apply sampling techniques to gather audit evidence: 1 Development ofwell-controlled,automated accounting systems. 2 Advent of powerfulPC audit software todownload andexamine clientdata
Introduction However, technology will never eliminate the need for auditors to rely on sampling to some degree because: • Many control processes require human involvement. • Many testing procedures require the auditor to physically examine an asset. • In many cases auditors are required to obtain and examine evidence from third parties.
Definitions and Key Concepts • On the following screens we will define: • Sampling Risk • Confidence Level • Tolerable and Expected Error • Audit Sampling
LO# 1 Audit Sampling Audit sampling is the application of an audit procedure to less than 100 percent of the items within an account balance or class of transactions for the purpose of evaluating some characteristic of the balance or class.
Sampling Risk • Risk that the results of the sample are not representative of the population • Reduce this by taking larger sample
LO# 2 Sampling Risk Sampling risk is the element of uncertainty that enters into the auditor’s conclusions anytime sampling is used. There are two types of sampling risk. Risk of incorrect rejection (Type I) – in a test of internal controls, it is the risk that the sample supports a conclusion that the control is not operating effectively when, in fact, it is operating effectively. Risk of incorrect acceptance (Type II) – in a test of internal controls, it is the risk that the sample supports a conclusion that the control is operating effectively when, in fact, it is not operating effectively.
Non sampling Risk • Sampling the wrong populations • Misinterpreting the audit results
LO# 2 Sampling Risk Three Important Factors in Determining Sample Size • The desired level of assurance in the results (or confidence level), • Acceptable defect rate (or tolerable error), and • The historical defect rate (or estimated error).
LO# 2 Confidence Level Confidence level is the complementof sampling risk. The auditor may set sampling risk for a particular sampling application at 5 percent, which results in a confidence level of 95 percent.
Confidence Level The larger the sample, the higher the confidence level and the lower the sampling risk.
LO# 2 Tolerable and Expected Error Once the desired confidence level is established, the sample size is determine largely by how much the tolerable error exceedsexpected error. Precision, at the planning stage of audit sampling, is the difference between the expected and tolerable deviation rates. Auditing Standards refer to Precision as the “Allowance forsampling risk”
Tolerable Error The smaller the difference between tolerable error and expected error, the more precise the measurements and the larger the sample size.
LO# 3 Audit Evidence – To Sample or Not?
LO# 3 Audit Evidence – To Sample or Not? • Inspection of tangible assets. Auditors typically attend the client’s year-end inventory count. When there are a large number of items in inventory, the auditor will select a sample to physically inspect and count. • Inspection of records or documents. Certain controls may require the matching of documents. The procedure may take place many times a day. The auditor may gather evidence on the effectiveness of the control by testing a sample of the document packages.
LO# 3 Audit Evidence – To Sample or Not? • Reperformance.To comply with rule 404 of the Sarbanes-Oxley Act, publicly traded clients must document and test controls over important assertions for significant accounts. The auditor may reperform a sample of the tests performed by the client. • Confirmation.Rather than confirm all customer account receivable balances, the auditor may select a sample of customers.
LO# 3 Testing All Items with a Particular Characteristic When an account or class of transactions is made up of a few large items, the auditor may examine all the items in the account or class of transaction. When a small number of large transactions make up a relatively large percent of an account or class of transactions, auditors will typically test all the transactions greater than a particular dollar amount.
LO# 3 Testing Only One or a Few Items Highly automated information systems process transactions consistently unless the system or programs are changed. The auditor may test the general controls over the system and any program changes, but test only a few transactions processed by the IT system.
LO# 4 Types of Audit Sampling Auditing standards recognize and permit both statistical and nonstatistical methods of audit sampling. In nonstatistical (or judgmental) sampling, the auditor does not use statistical techniques to determine sample size, select the sample items, or measure sampling risk. Statistical sampling uses the laws of probability to compute sample size and evaluate results. The auditor is able to use the most efficient sample size and quantify sampling risk.
Disadvantages of statistical sampling • Training auditors in proper use. • Time to design and conduct sampling application. • Lack of consistent application across audit teams. LO# 4 Types of Audit Sampling • Advantages of statistical sampling • Design an efficient sample. • Measure the sufficiency of evidence obtained. • Quantify sampling risk.
Non statistical sampling • Professional judgment • Firm guidance • Knowledge about the underlying statistical theories.
LO# 4 Statistical Sampling Techniques • Attribute Sampling. • Monetary-Unit Sampling. • Classical Variables Sampling.
LO# 4 Attribute Sampling Used to estimate the proportion of a population that possess a specifiedcharacteristic. The most common use of attribute sampling is for tests of controls. Our client’s controls require that all checks have two independent signatures. Yes, I know. We are planning a test of that control using attribute sampling.
LO# 4 Monetary-Unit Sampling Monetary-unit sampling uses attribute sampling theory to estimate the dollar amount of misstatement for a class of transactions or an account balance. This technique is used extensively because it has a number of advantages over classical variables sampling.
LO# 4 Classical Variables Sampling Auditors sometimes use variables sampling to estimate the dollar value of a class of transactions or account balance. It is more frequently used to determine whether an account is materially misstated.
Perform Evaluate Document LO# 5, 6, & 7 Attribute Sampling Applied to Tests of Controls In conducting a statistical sample for a test of controls auditing standards require the auditor to properly plan, perform, and evaluate the sampling application and to adequately document each phase of the sampling application. Plan
The objective of attribute sampling when used for tests of controls is to evaluate the operating effectiveness of the internal control. LO# 5, 6, & 7 Planning
All or a subset of the items that constitute the class of transactions make up the sampling population. LO# 5, 6, & 7 Planning
LO# 5, 6, & 7 Planning Each sampling unit makes up one item in the population. The sampling unit should be defined in relation to the specific control being tested.
LO# 5, 6, & 7 Planning A deviation is a departure from adequate performance of the internal control.
The confidence level is the desired level of assurance that the sample results will support a conclusion that the control is functioning effectively. Generally, when the auditor has decided to rely on controls, the confidence level is set at 90% or 95%. The means the auditor is willing to accept a 10% or 5% risk of accepting the control as effective when it is not. LO# 5, 6, & 7 Planning
The tolerable deviation rate is the maximum deviation rate from a prescribed control that the auditor is willing to accept and still consider the control effective. LO# 5, 6, & 7 Planning
LO# 5, 6, & 7 Planning Suggested Tolerable Deviation Rates for Assessed Levels of Control Risk
LO# 5, 6, & 7 Planning The expected population deviation rate is the rate the auditor expects to exist in the population. The larger the expected population deviation rate, the larger the sample size must be, all else equal.
LO# 5, 6, & 7 Planning Assume a desired confidence level of 95%, and a large population, the effect of the expected population deviation rate on sample size is shown below:
LO# 5, 6, & 7 Population Size: Attributes Sampling Population size is not an important factor in determining sample size for attributes sampling. The population size has little or no effect on the sample size, unless the population is relatively small, say less than 500 items.
Every item in the population has the same probability of being selected as every other sampling unit in the population. LO# 5, 6, & 7 Performance
The auditor determines the sampling interval by dividing the population by the sample size. A starting number is randomly selected in the first interval and every nth item is selected thereafter. LO# 5, 6, & 7 Performance
For example, assume a sales invoice should not be prepared unless there is a related shipping document. If the shipping document is present, there is evidence the control is working properly. If the shipping document is not present a control deviation exist. LO# 5, 6, & 7 Performance
Unless the auditor finds something unusual about either of these items, they should be replaced with a new sample item. LO# 5, 6, & 7 Performance
If the auditor is unable to examine a document or to use an alternative procedure to test the control, the sample item is a deviation for purposes of evaluating the sample results. LO# 5, 6, & 7 Performance
If a large number of deviations are detected early in the tests of controls, the auditor should consider stopping the test, as soon as it is clear that the results of the test will not support the planned assessed level of control risk. LO# 5, 6, & 7 Performance
After completing the audit procedures, the auditor summarizes the deviations for each control tested and evaluates the results. For example, if the auditor discovered two deviations in a sample of 50, the deviation rate in the sample would be 4% (2 ÷ 50).The upper deviation rate is the sum of the sample deviation rate and an appropriate allowance for sampling risk. LO# 5, 6, & 7 Evaluation
Computed Upper Deviation Rate • True deviation rate unknown • Sum of sample deviation rate plus an appropriate allowance for sampling risk
The auditor compares the tolerable deviation rate to the computed upper deviation rate. LO# 5, 6, & 7 Evaluation
LO# 5, 6, & 7 Attribute Sampling Example The auditor has decided to test a control at Calabro Wireless Services. The test is to determine the sales and service contracts are properly authorized for credit approval. A deviation in this test is defined as the failure of the credit department personnel to follow proper credit approval procedures for new and existing customers. Here is information relating to the test:
LO# 5, 6, & 7 Attribute Sampling Example Part of the table used to determine sample size when the auditor specifies a 95% desired confidence level.
LO# 5, 6, & 7 Attribute Sampling Example There are 125,000 audit items in the population numbered from 1 to 125,000. The auditor generates these random numbers using Excel. Each number represents a contract that was to be reviewed for credit approval.
LO# 5, 6, & 7 Attribute Sampling Example The auditor examines each selected contract for credit approval and determines the following: Let’s see how we get the computed upper deviation rate.