Chapter 09 International

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Chapter Nine
Audit Sampling: An Application to Substantive Tests of Account Balances
McGraw-Hill/Irwin
Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
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Substantive Tests of Details of Account Balances

The statistical concepts we discussed in the last chapter apply to this chapter as well. Three important determinants of sample size are 1. Desired confidence level.
2. Tolerable misstatement (error).

3. Estimated misstatement (error). Misstatements discovered in the audit sample must be projected to the population, and there must be an allowance for sampling risk.
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Substantive Tests of Details of Account Balances

Consider the following information about the inventory account balance of an audit client:
Book value of inventory account balance Book value of items sampled Audited value of items sampled Total amount of overstatement observed in audit sample 3,000,000 100,000 98,000 2,000
The ratio of misstatement in the sample is 2% (2,000 100,000)

Applying the ratio to the entire population produces a best estimate of misstatement of inventory of 60,000. (3,000,000 2%)
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Substantive Tests of Details of Account Balances The results of our audit test depend upon the tolerable error associated with the inventory account. If the tolerable error is 50,000, we cannot conclude that the account is fairly stated because our best estimate of the projected error is greater than the tolerable error.
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Monetary-Unit Sampling (MUS)

MUS uses attribute-sampling theory to express a conclusion in monetary amounts (e.g. in euros or other currency) rather than as a rate of occurrence. It is commonly used by auditors to test accounts such as accounts receivable, loans receivable, investment securities and inventory.
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MUS uses attribute-sampling theory to estimate the percentage of monetary units in a population that might be misstated and then multiplies this percentage by an estimate of how much the euros are misstated.
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Advantages of MUS
1. When the auditor expects no misstatement, MUS usually results in a smaller sample size than classical variables sampling. 2. The calculation of the sample size and evaluation of the sample results are not based on the variation between items in the population. 3. When applied using the probability-proportional-to-size procedure, MUS automatically results in a stratified sample.
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Disadvantages of MUS
1. The selection of zero or negative balances generally requires special design consideration. 2. The general approach to MUS assumes that the audited amount of the sample item is not in error by more than 100%. 3. When more than one or two misstatements are detected, the sample results calculations may overstate the allowance for sampling risk.
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Steps in MUS Sampling Application

Planning 1. Determine the test objectives. 2. Define the population characteristics. Define the population. Define the sample unit. Define a misstatement. 3. Determine the sample size, using the following inputs: The desired confidence level or risk of incorrect acceptance. The tolerable misstatement. The expected population misstatement. Population size. Performance 4. Select sample items. 5. Perform the auditing procedures. Evaluation 6. Calculate the projected misstatement and the upper limit on misstatement. 7. draw final conclusions.
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Planning 1. Determine the test objectives. 2. Define the population characteristics. Define the population. Define the sample unit. Define a misstatement.
Sampling may be used for substantive testing to: 1. Test the reasonableness of assertions about a financial statement amount. 2. Develop an estimate of some amount.
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For MUS the population is defined as the monetary value of an account balance, such as accounts receivable, investment securities or inventory.
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An individual euro represents the sampling unit.
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A misstatement is defined as the difference between monetary amounts in the clients records and amounts supported by audit evidence.
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3. Determine the sample size, using the following inputs: The desired confidence level or risk of incorrect acceptance. The tolerable misstatement. The expected population misstatement. Population size.
Factor Desired confidence level Tolerable mistatement Expected mistatement Population size
McGraw-Hill/Irwin
Relationship to Sample Size Direct Inverse Direct Direct
Change in Factor Lower Higher Lower Higher Lower Higher Lower Higher
Effect on Sample Decrease Increase Increase Decrease Decrease Increase Decrease Increase
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Performance 4. Select sample items. 5. Perform the auditing procedures. Evaluation 6. Calculate the projected misstatement and the upper limit on misstatement 7. Draw final conclusions.
The auditor selects a sample for MUS by using a systematic selection approach called probabilityproportionate-to-size selection. The sampling interval can be determined by dividing the book value of the population by the sample size. Each individual euro in the population has an equal chance of being selected.
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Assume a clients book value of accounts receivable is 2,500,000, and the auditor determined a sample size of 93. The sampling interval will be 26,882 (2,500,000 93). The random number selected is 3,977 the auditor would select the following items for testing:
Account 1001 Ace Emergency Center 1002 Admington Hospital 1003 Jess Base 1004 Good Hospital Corp. 1005 Jen Mara Corp. 1006 Axa Corp. 1007 Green River Mfg. 1008 Bead Hospital Centers 1213 Andrew Call Medical 1214 Lilly Health 1215 Janyne Ann Corp. Total Accounts Receivable
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Balance 2,350 15,495 945 21,893 3,968 32,549 2,246 11,860 26,945 1,023 2,500,000
Cumulative Euros 2,350 17,845 18,780 40,673 44,641 77,190 79,436 91,306 2,472,032 2,498,977 2,500,000
Sample Item 3,977 30,859 57,741 84,623 2,477,121 (1) (2) (3) (4)
3,977 26,882 30,859
(93)
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Performance 4. Select sample items. 5. Perform the auditing procedures. Evaluation 6. Calculate the projected misstatement and the upper limit on misstatement 7. Draw final conclusions.
After the sample items have been selected, the auditor conducts the planned audit procedures on the logical units containing the selected euro sampling units.
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Evaluation 6. Calculate the projected misstatement and the upper limit on misstatement 7. Draw final conclusions.
The misstatements detected in the sample must be projected to the population.

Example Information
Book value Tolerable misstatement Sample size Desired confidence level Expected amount of misstatement Sampling interval 2,500,000 125,000 93 5% 25,000 26,882
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Basic Precision
If no misstatements are found in the sample, the best estimate of the population misstatement would be zero euros.
Sample Size 65 70 85 80 90 100 125 Actual Number of Deviations Found 0 1 2 3 4.6 7.1 9.4 11.5 4.2 6.6 8.8 10.8 4.0 6.2 8.2 10.1 3.7 5.8 7.7 9.5 3.3 5.2 6.9 8.4 3.0 4.7 6.2 7.6 2.4 3.8 5.0 6.1
26,882 3.0 = 80,646 upper misstatement limit

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Misstatements Detected
In the sample of 93 items the following misstatements were found:
Customer Good Hospital Marva Medical Supply Axa Corp. Learn Heart Centers Book Value 21,893 6,705 32,549 15,000 Audit Value 18,609 4,023 30,049 Difference 3,284 2,682 2,500 15,000 Tainting Factory 15% 40% NA 100%
Because the Axa balance of 32,549 is greater than the 3,284 21,893 =Since 15% all interval of 26,882, no sampling risk is added. the euros in the large accounts are audited, there is no sampling risk associated with large accounts.
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Compute the Upper Misstatement Limit
We compute the upper misstatement limit by calculating basic precision and ranking the detected misstatements based on the size of the tainting factor from the largest to the smallest.
Tainting Customer Factor Basic Precision 1.00 Learn Heart Centers 1.00 Marva Medical 0.40 Good Hospital 0.15 Add misstatments greater that the sampling interval: Axa Corp. NA Sample Interval 26,882 26,882 26,882 26,882 Projected Misstatement NA (26,882) (10,753) (4,032) 95% Upper Limit 3.0 1.7 (4.7 - 3.0) 1.5 (6.2 - 4.7) 1.4 (7.6 - 6.2) Upper Misstatement 80,646 45,700 16,130 5,645
26,882 NA Upper Misstatement Limit
2,500 150,621
(0.15 26,882 1.4 = 5,645)

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Evaluation 6. Calculate the projected misstatement and the upper limit on misstatement 7. Draw final conclusions.
In our example, the final decision is whether the accounts receivable balance is materially misstated or not. We compare the tolerable misstatement to the upper misstatement limit. If the upper misstatement limit is less than or equal to the tolerable misstatement, we conclude that the balance is not materially misstated.
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In our example the upper misstatement limit of 150,621 is greater than the tolerable misstatement of 125,000, so the auditor concludes that the accounts receivable balance is materially misstated. When faced with this situation, the auditor may:
1. Increase the sample size.

2. Perform other substantive procedures. 3. Request the client adjust the accounts receivable balance. 4. If the client refuses to adjust the account balance, the auditor would consider issuing a qualified or adverse opinion.
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Risk When Evaluating Account Balances
True State of Financial Statement Account Auditor's Decision Based on Sample Evidence Supports the fairness of the account balance Does not support the fairness of the account balance Not Materially Misstated Correct decision Risk of incorrect rejection (Type I) Materially Misstated Risk of incorrect acceptance (Type II) Correct Decision
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Why is Sample Size Not Used in Evaluating MUS Results?

Most MUS evaluation approaches use the misstatement factors and increments associated with a sample size of 100, regardless of the actual sample size used by the auditor.
Number of Errors 0 1 2 3 4 95% Confidence Level Misstatement Incremental Factor Increase 3.0 4.7 1.7 6.2 1.5 7.6 1.4 9.0 1.4 90% Confidence Level Misstatement Incremental Factor Increase 2.3 3.9 1.6 5.3 1.4 6.6 1.3 7.9 1.3
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Effect of Understatement Misstatements

MUS is not particularly effective at detecting understatements. An understated account is less likely to be selected than an overstated account.
Customer Wayne County Medical Book Value 2,000 Audit Value 2,200 Difference (200) Tainting Factor -10%
The most likely error will be reduced by 2,688 ( 0.10 26,882)
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Non-statistical Sampling for Tests of Account Balances

The sampling unit for non-statistical sampling is normally a customer account, an individual transaction, or a line item on a transactions. When using non-statistical sampling, the following items must be considered:
o Identifying individually significant items.

o Determining the sample size. o Selecting sample items.
o Calculating the sample results.
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Identifying Individually Significant Items

The items to be tested individually are items that may contain potential misstatements that individually exceed the tolerable misstatement. These items are tested 100% because the auditor is not willing to accept any sampling risk.
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Determining the Sample Size

Sample = Size
Population book value Tolerable misstatement
Assurance factor
Combined Assessment of Inherent and Control Risk Maximum Slightly below maximum Moderate Low
Risk That Other Substantive Procedures Will Fail to Detect Material Misstatements Slightly Below Maximum Maximum Moderate Low 3.0 2.7 2.3 2.0 2.7 2.4 2.0 1.6 2.3 2.1 1.6 1.2 2.0 1.6 1.2 1.0
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Selecting Sample Items

Auditing standards require that the sample items be selected in such a way that the sample can be expected to represent the population.
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Calculating the Sample Results

One way of projecting the sampling results to the population is to apply the misstatement ratio in the sample to the population. Assume the auditor finds 1,500 in misstatements in a sample of 15,000. The misstatement ratio is 10%. If the population total is 200,000, the projected misstatement would be 20,000 (200,000 10%)
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A second method is the difference estimation. This method projects the average misstatement of each item in the sample to all items in the population. Assume misstatements in a sample of 100 items total 300, and the population contains 10,000 items.
The projected misstatement would be 30,000, (300 100 = 3 10,000).
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Non-statistical Sampling Example

The auditors of Calabro Paging Service have decided to use non-statistical sampling to examine the accounts receivable balance. Calabro has 11,800 accounts with a balance of 3,717,900. The auditors stratify the accounts as follows:
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The auditors decide . . .
o There is a low assessment for inherent and control risk.
o The tolerable misstatement is 40,000, and the expected misstatement is 15,000. o There is a moderate risk that other auditing procedures will fail to detect material misstatements. o All customer account balances greater than 25,000 are to be audited.
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Sample = Size
Population book value Tolerable misstatement
Assurance factor
3,717,900 550,000
Sample = Size
3,167,900 40,000
1.2 = 95 rounded
Combined Assessment of Inherent and Control Risk Maximum Slightly below maximum Moderate Low
McGraw-Hill/Irwin
Risk That Other Substantive Procedures Fail to Detect Material Misstatement Slightly Below Maximum Maximum Moderate Low 3.0 2.7 2.3 2.0 2.7 2.4 2.0 1.6 2.3 2.1 1.6 1.2 2.0 1.6 1.2 1.0
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The auditor sent positive confirmations to each of the 110 (95 + 15) accounts selected. Either the confirmations were returned or alternative procedures were successfully used. Four customers indicated that their accounts were overstated and the auditors determined that the misstatements were the result of unintentional error by client personnel. Here are the results of the audit testing:
Stratum >25,000 >3,000 <3,000 Book Value 550,000 850,500 2,317,400 Book Value of Sample 550,000 425,000 92,000 Audit Value of Sample 549,500 423,000 91,750 Amount of OverStatement 500 2,000 250
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As a result of the audit procedures, the following projected misstatement was prepared:
Amount of Stratum Misstatement >25,000 500 >3,000 2,000 <3,000 250 Total projected misstatement Ratio of Misstatement in Stratum Tested 100% 2,000 425,000 850,500 250 92,000 2,317,400 Projected Misstatement 500 4,002 6,298 10,800
The total projected misstatement of 10,800 is less than the expected misstatement of 15,000, so the auditors may conclude that there is a low risk that the true misstatement exceeds the tolerable misstatement.
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Why Did Statistical Sampling Fall Out Of Favor?

1.Firms found that some auditors were over relying on statistical sampling techniques to the exclusion of good judgment. 2.There appears to be poor linkage between the applied audit setting and traditional statistical sampling applications.
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Classical Variable Sampling

Classical variables sampling uses normal distribution theory to evaluate the characteristics of a population based on sample data. Auditors most commonly use classical variables sampling to estimate the size of misstatement. Sampling distributions are formed by plotting the projected misstatements yielded by an infinite number of audit samples of the same size taken from the same underlying population.
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Classical Variables Sampling
A sampling distribution is useful because it allows us to estimate the probability of observing any single sample result.
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In classical variables sampling, the sample mean is the best estimate of the population mean.
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Advantages
1. When the auditor expects a large number of differences between book and audited values, this method will result in smaller sample size than MUS. 2. The techniques are effective for both overstatements and understatements. 3. The selection of zero balances generally does not require special sample design considerations.
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Disadvantages
1. To determine sample size, the auditor must estimate the standard deviation of the audited value or differences.
2. If few misstatements are detected in the sample data, the true variance tends to be underestimated, and the resulting projection of the misstatements to the population is likely not to be reliable.
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Applying Classical Variables Sampling

Defining the Sampling Unit
The sampling unit can be a customer account, an individual transaction, or a line item. In auditing accounts receivable, the auditor can define the sampling unit to be a customers account balance or an individual sales invoice included in the account balance.
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Determining the Sample Size
Population size ZIA SD Sample = Tolerable misstatement Estimated misstatement Size
where ZIA = One-tailed Z value for the specified level of the risk of incorrect acceptance. SD = Estimated standard deviation. 2
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The risk of incorrect acceptance is the risk that the auditor will mistakenly accept a population as fairly stated when the true population misstatement is greater than tolerable misstatement.
Risk of Incorrect Acceptance 2.5% 5.0% 10.0% 15.0% 20.0% Z Value 1.96 1.65 1.28 1.04 0.84
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The year-end balance for accounts receivable contains 5,500 accounts with a book value of 5,500,000. The tolerable misstatement for accounts receivable is set at 50,000. The expected misstatement has been judged to be 20,000. The risk of incorrect acceptance is 2.5%. Based on work completed last year, the auditor estimates the standard deviation at 31. Lets calculate sample size.
Sample = Size
5,500 1.96 31 50,000 20,000
= 125
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The sample selection usually relies on randomselection techniques. Upon completion, 30 of the customer accounts selected contained misstatements that totaled 330.20. Our first calculation is the mean misstatement in an individual account which is calculated as follows: Mean Total audit difference misstatement = Sample size per sampling item = 330.20 = 2.65 125
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The mean misstatement must be projected to the population. Projected population = Population size Mean misstatement (in sampling units) per sampling item misstatement = 5,500 2.65 = 14,575
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Point estimate of accounts receivable balance . . .
Accounts receivable Book Projected population = point estimate value misstatement
= 5,500,000 14,575 = 5,485,425
The sum of the audited differences squared is equal to 36,018.32. We will use this value to calculate the standard deviation.
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The formula for the standard deviation is . . .
Total audit differences squared Sample Mean difference Size per sampling item2
SD =
Sample size 1
36,018.32 (125 2.652) 124
= 16.83
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Confidence Population = ZIA bound size SD Sample size
16.83 = 5,500 1.96 125

Population Confidence = point estimate interval
= 16,228
Confidence bound
= 5,485,425 16,228
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Book value
5,500,000
Lower bound
5,469,197
Point estimate
5,485,425
Upper bound
5,501,652
Confidence interval
If the precision interval includes the book value, the evidence supports the conclusion that the account is not materially misstated.
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Book value
5,508,000
Lower bound
5,469,197
Point estimate
5,485,425
Upper bound
5,501,652
Confidence interval
When the evidence indicates that the account may be materially misstated the auditor might consider (1) increasing sample size, (2) performing additional substantive procedures, (3) adjusting the account, or (4) issue a qualified or adverse opinion.
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End of Chapter 9
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9-1

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Substantive Tests of Details of Account Balances

2. Tolerable misstatement (error).

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Substantive Tests of Details of Account Balances

The ratio of misstatement in the sample is 2% (2,000 100,000)

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Monetary-Unit Sampling (MUS)

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Monetary-Unit Sampling (MUS)

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Monetary-Unit Sampling (MUS)

Monetary-Unit Sampling (MUS)

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Steps in MUS Sampling Application

Steps in MUS Sampling Application

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Steps in MUS Sampling Application

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Steps in MUS Sampling Application

An individual euro represents the sampling unit.

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Steps in MUS Sampling Application

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Steps in MUS Sampling Application

Relationship to Sample Size Direct Inverse Direct Direct

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Steps in MUS Sampling Application

Steps in MUS Sampling Application

3,977 26,882 30,859

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Steps in MUS Sampling Application

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Steps in MUS Sampling Application

The misstatements detected in the sample must be projected to the population.

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Steps in MUS Sampling Application

26,882 3.0 = 80,646 upper misstatement limit

Steps in MUS Sampling Application

Steps in MUS Sampling Application

26,882 NA Upper Misstatement Limit

(0.15 26,882 1.4 = 5,645)

Steps in MUS Sampling Application

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Steps in MUS Sampling Application

1. Increase the sample size.

Risk When Evaluating Account Balances

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Why is Sample Size Not Used in Evaluating MUS Results?

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Effect of Understatement Misstatements

The most likely error will be reduced by 2,688 ( 0.10 26,882)

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Non-statistical Sampling for Tests of Account Balances

o Identifying individually significant items.

o Calculating the sample results.

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Identifying Individually Significant Items

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Determining the Sample Size

Population book value Tolerable misstatement

Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

Selecting Sample Items