Audit Sampling: An Overview and Application to Tests of Controls
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1 Audit Sampling: An Overview and Application to Tests of Controls Chapter 8Audit Sampling: An Overview and Application to Tests of ControlsMcGraw-Hill/Irwin2008 The McGraw-Hill Companies, All Rights Reserved
2 SamplingPrimary purpose is to draw inferences about the whole population based on the results of testing of a subset of the population
3 Development of well-controlled, automated accounting systems. IntroductionAuditing 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:1Development of well-controlled, automated accounting systems.2Advent of powerful PC audit software to download and examine client data
4 IntroductionHowever, 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.
5 Definitions and Key Concepts On the following screens we will define:Sampling RiskConfidence LevelTolerable and Expected ErrorAudit Sampling
6 LO# 1Audit SamplingAudit 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.
7 Sampling RiskRisk that the results of the sample are not representative of the populationReduce this by taking larger sample
8 LO# 2Sampling RiskSampling 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.
9 Non sampling Risk Sampling the wrong populations Misinterpreting the audit results
10 Three Important Factors in Determining Sample Size Sampling RiskLO# 2Three Important Factors in Determining Sample SizeThe desired level of assurance in the results (or confidence level),Acceptable defect rate (or tolerable error), andThe historical defect rate (or estimated error).
11 Confidence level is the complement of sampling risk. LO# 2Confidence LevelConfidence level is the complement of sampling risk.The auditor may set sampling risk for a particular sampling application at percent, which results in a confidence level of 95 percent.
12 Confidence LevelThe larger the sample, the higher the confidence level and the lower the sampling risk.
13 Tolerable and Expected Error LO# 2Tolerable and Expected ErrorOnce the desired confidence level is established, the sample size is determine largely by how much the tolerable error exceeds expected error.Precision, at the planning stage of audit sampling, is the difference between the expected and tolerable deviation rates.Auditing Standardsrefer to Precisionas the “Allowance for sampling risk”
14 Tolerable ErrorThe smaller the difference between tolerable error and expected error, the more precise the measurements and the larger the sample size.
15 Audit Evidence – To Sample or Not? LO# 3Audit Evidence – To Sample or Not?
16 Audit Evidence – To Sample or Not? LO# 3Audit 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.
17 Audit Evidence – To Sample or Not? LO# 3Audit 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.
18 Testing All Items with a Particular Characteristic LO# 3Testing All Items with a Particular CharacteristicWhen 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.
19 Testing Only One or a Few Items LO# 3Testing Only One or a Few ItemsHighly 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.
20 Types of Audit Sampling LO# 4Types of Audit SamplingAuditing 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.
21 Types of Audit Sampling LO# 4Advantages of statistical samplingDesign an efficient sample.Measure the sufficiency of evidence obtained.Quantify sampling risk.Disadvantages of statistical samplingTraining auditors in proper use.Time to design and conduct sampling application.Lack of consistent application across audit teams.
22 Non statistical sampling Professional judgmentFirm guidanceKnowledge about the underlying statistical theories.
24 LO# 4Attribute SamplingUsed to estimate the proportion of a population that possess a specified characteristic. 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.
25 Monetary-Unit Sampling LO# 4Monetary-Unit SamplingMonetary-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.
26 Classical Variables Sampling LO# 4Classical Variables SamplingAuditors 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.
27 Attribute Sampling Applied to Tests of Controls LO#5, 6, & 7Attribute Sampling Applied to Tests of ControlsIn 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.PlanPerformEvaluateDocument
28 LO#5, 6, & 7PlanningThe objective of attribute sampling when used for tests of controls is to evaluate the operating effectiveness of the internal control.
29 LO#5, 6, & 7PlanningAll or a subset of the items that constitute the class of transactions make up the sampling population.
30 LO#5, 6, & 7PlanningEach sampling unit makes up one item in the population. The sampling unit should be defined in relation to the specific control being tested.
31 LO#5, 6, & 7PlanningA deviation is a departure from adequate performance of the internal control.
32 LO#5, 6, & 7PlanningThe 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.
33 LO#5, 6, & 7PlanningThe 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.
34 LO#5, 6, & 7PlanningSuggested Tolerable Deviation Rates for Assessed Levels of Control Risk
35 LO#5, 6, & 7PlanningThe 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.
36 PlanningLO#5, 6, & 7Assume a desired confidence level of 95%, and a large population, the effect of the expected population deviation rate on sample size is shown below:
37 Population Size: Attributes Sampling LO#5, 6, & 7Population Size: Attributes SamplingPopulation 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.
38 LO#5, 6, & 7PerformanceEvery item in the population has the same probability of being selected as every other sampling unit in the population.
39 LO#5, 6, & 7PerformanceThe 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.
40 LO#5, 6, & 7PerformanceFor 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.
41 LO#5, 6, & 7PerformanceUnless the auditor finds something unusual about either of these items, they should be replaced with a new sample item.
42 LO#5, 6, & 7PerformanceIf 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.
43 LO#5, 6, & 7PerformanceIf 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.
44 LO#5, 6, & 7EvaluationAfter 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.
45 Computed Upper Deviation Rate True deviation rate unknownSum of sample deviation rate plus an appropriate allowance for sampling risk
46 LO#5, 6, & 7EvaluationThe auditor compares the tolerable deviation rate to the computed upper deviation rate.
47 Attribute Sampling Example LO#5, 6, & 7Attribute Sampling ExampleThe 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:
48 Attribute Sampling Example LO#5, 6, & 7Attribute Sampling ExamplePart of the table used to determine sample size when the auditor specifies a 95% desired confidence level.
49 Attribute Sampling Example LO#5, 6, & 7Attribute Sampling ExampleThere 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.
50 Attribute Sampling Example LO#5, 6, & 7Attribute Sampling ExampleThe auditor examines each selected contract for credit approval and determines the following:Let’s see how we get the computed upper deviation rate.
51 Attribute Sampling Example LO#5, 6, & 7Attribute Sampling ExamplePart of the table used to determine the computed upper deviation rate at 95% desired confidence level:
52 Attribute Sampling Example LO#5, 6, & 7Attribute Sampling ExampleTolerable Deviation Rate (6%)Computed Upper Deviation Rate (8.2%)<Auditor’s Decision:Does not support reliance on the control.
53 Nonstatistical Sampling for Tests of Control LO# 8Nonstatistical Sampling for Tests of ControlDetermining the Sample SizeAn auditing firm may establish a nonstat sampling policy like the one below:Such a policy will promote consistency in sampling applications.
54 Nonstatistical Sampling for Tests of Control LO# 8Nonstatistical Sampling for Tests of ControlSelecting the Sample ItemsNonstatistical sampling allows the use of random or systematic selection, but also permits the use of other methods such as haphazard sampling.When haphazard sample selection is used, sampling units are selected without any bias, that is to say, without a special reason for including or omitting the item in the sample.
55 Nonstatistical Sampling for Tests of Control LO# 8Nonstatistical Sampling for Tests of ControlCalculating the Upper Deviation RateWith a nonstatistical sample, the auditor can calculate the sample deviation rate, but cannot formally quantify the computed upper deviation rate and sampling risk associated with the test.
56 Considering the Effect of Population Size LO# 8Considering the Effect of Population SizeThis table assumes a desired confidence of 90%, a tolerable deviation rate of 10%, and an expected population deviation rate of 1%:Finite population correction factor=√1 – (n/N)n = sample size from tables N = number of units in the population