1. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-1 Chapter Eight Audit Sampling: An Overview and Application to Tests of Controls Chapter Eight Audit Sampling: An Overview and Application to Tests of Controls

2. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-2 Introduction Auditing standards recognize and permit both statistical and non-statistical 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 of well-controlled, automated accounting systems. 1 2 Advent of powerful PC audit software to download and examine client data. 2

3. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-3 Introduction Technology will never eliminate the need for auditors to rely on sampling to some degree because: 1.Many control processes require human involvement. 2.Many testing procedures require the auditor to physically examine an asset. 3.In many cases auditors are required to obtain and examine evidence from third parties.

4. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-4 Definitions and Key Concepts On the following screens we will define: 1.Audit Sampling 2.Sampling Risk 3.Confidence Level 4.Tolerable and Expected Error On the following screens we will define: 1.Audit Sampling 2.Sampling Risk 3.Confidence Level 4.Tolerable and Expected Error

5. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-5 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.

6. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-6 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.

7. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-7 Sampling Risk Three Important Factors in Determining Sample Size 1.The desired level of assurance in the results (or confidence level), 2.Acceptable defect rate (or tolerable error), and 3.The historical defect rate (or estimated error). 1.The desired level of assurance in the results (or confidence level), 2.Acceptable defect rate (or tolerable error), and 3.The historical defect rate (or estimated error).

8. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-8 Confidence Level complement Confidence level is the complement of sampling risk. 5 percent 95 percent The auditor may set sampling risk for a particular sampling application at 5 percent, which results in a confidence level of 95 percent.

9. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-9 Tolerable and Expected Error Once 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. Allowance for sampling risk

10. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-10 Audit Evidence – To Sample or Not?

11. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-11 Audit Evidence – To Sample or Not? o 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. o 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. o 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. o 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.

12. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-12 Audit Evidence – To Sample or Not?  Reperformance. 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.  Reperformance. 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.

13. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-13 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.

14. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-14 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.

15. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-15 Types of Audit Sampling Auditing standards recognize and permit both statistical and non-statistical methods of audit sampling. In non-statistical (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 the sample results. The auditor is able to use the most efficient sample size and quantify sampling risk.

16. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-16 Types of Audit Sampling Advantages of statistical sampling 1.Design an efficient sample. 2.Measure the sufficiency of evidence obtained. 3.Quantify sampling risk. Advantages of statistical sampling 1.Design an efficient sample. 2.Measure the sufficiency of evidence obtained. 3.Quantify sampling risk. Disadvantages of statistical sampling 1.Training auditors in proper use. 2.Time to design and conduct sampling application. 3.Lack of consistent application across audit teams. Disadvantages of statistical sampling 1.Training auditors in proper use. 2.Time to design and conduct sampling application. 3.Lack of consistent application across audit teams.

17. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-17 Statistical Sampling Techniques 1.Attribute Sampling. 2.Monetary-Unit Sampling. 3.Classical Variables Sampling.

18. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-18 Attribute Sampling Used 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 cheques have two independent signatures. Yes, I know. We are planning a test of that control using attribute sampling.

19. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-19 Monetary-Unit Sampling Monetary-unit sampling uses attribute sampling theory to estimate the monetary (e.g. in €) 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

20. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-20 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.

21. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-21 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 PerformEvaluateDocument

22. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-22 Planning The objective of attribute sampling when used for tests of controls is to evaluate the operating effectiveness of the internal control.

23. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-23 Planning All or a subset of the items that constitute the class of transactions make up the sampling population.

24. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-24 Planning Each sampling unit makes up one item in the population. The sampling unit should be defined in relation to the control being tested.

25. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-25 Planning A deviation is a departure from adequate performance of the internal control.

26. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-26 Planning The confidence level is the risk that the sample results will support a conclusion that the control is functioning effectively when in fact it is not. Generally, when the auditor has decided to rely on controls, the confidence level is set at 90% or 95%. The means the auditor is will to accept a 10% or 5% risk of accepting the control as effective when it is not.

27. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-27 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.

28. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-28 Planning Suggested Tolerable Deviation Rates for Assessed Levels of Control Risk

29. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-29 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.

30. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-30 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:

31. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-31 Population Size Population size is not an important factor in determining sample size. The population size has little or no effect on the sample size, unless the population is relatively small, say less than 500 items.

32. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-32 Performance Every item in the population has the same probability of being selected as every other sampling unit in the population.

33. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-33 Performance The auditor determines the sampling interval by dividing the population by the sample size. A starting number is selected in the first interval and every n th item is selected.

34. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-34 Performance For example, assume each sales invoice is to have a related shipping document. If the shipping document is present, the control is working properly. If the shipping document is not present a control deviation exist.

35. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-35 Performance Unless the auditor finds something unusual about either of these items, they should be replaced with a new sample item.

36. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-36 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.

37. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-37 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.

38. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-38 Evaluation 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.

39. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-39 Evaluation The auditor compares the tolerable deviation rate to the computed upper deviation rate.

40. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-40 Attribute Sampling Example The auditor has decided to test a control at Calabro Paging 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:

41. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-41 Attribute Sampling Example Part of the table used to determine sample size when the auditor specifies a 95% desired confidence level.

42. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-42 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.

43. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-43 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.

44. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-44 Attribute Sampling Example Part of the table used to determine the computed upper deviation rate at 95% desired confidence level:

45. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-45 Attribute Sampling Example Tolerable Deviation Rate (6%) Computed Upper Deviation Rate (8.2%) < Auditor’s Decision: Does not support reliance on the control. Auditor’s Decision: Does not support reliance on the control.

46. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-46 Non-statistical Sampling for Tests of Control Determining the Sample Size An auditing firm may establish a sampling policy like the one below: Such a policy will promote consistency in sampling applications.

47. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-47 Non-statistical Sampling for Tests of Control Selecting the Sample Items Non-statistical 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.

48. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-48 Non-statistical Sampling for Tests of Control Calculating the Upper Deviation Rate With a non-statistical sample, the auditor can calculate the sample deviation rate, but cannot quantify the computed upper deviation rate and sampling risk associated with the test.

49. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-49 Considering the Effect of Population Size This table assumes a desired confidence of 90%, a tolerable deviation rate of 10%, and an expected population deviation rate of 1%: n = sample size from tables N = number of units in the population finite population correction factor =

50. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 8-50 End of Chapter 8