CHAPTER ONE

TESTING AND AUDIT

SAMPLING

Compiled by Bereket S. (Asst. Prof)

2 Outline of Chapter

1.1. Audit Sampling Concepts

1.2. Sampling for Tests of Controls

1.3. Sampling for Substantive Tests

3
Types of Audit Tests
Generally, there are two types of audit tests:
1.Tests of controls
 Are procedures directed toward the evaluation of
the effectiveness of the design and implementation
of internal controls.
 Design issue: evaluate whether the control has
been properly designed to prevent or detect
material misstatements
 Implementation issue: evaluate whether the
control is operating effectively at a point in time.
 Cont’d…
4
Audit procedures that can be used for tests of control
include:
 Inquiries of appropriate management, supervisory,
and staff personnel
 Inspection of documents, reports, and electronic
files
 Observation of the application of specific control
 Walk-throughs (trace transactions from its
origination to its inclusion in the financial statements
through inquiry, observation, & inspection.)
 Reperformance of the application of the control by
 Cont’d…
5
2. Substantive tests
 Are procedures that provide direct evidence as to the fairness of management’s
financial statement assertions
 Provide monetary misstatements
 Detect material misstatements (Birr error or fraud) in an account balance, transaction
classes, and disclosure components of the financial statements.
Three categories of substantive tests:
1. Substantive tests of transactions
 Test to detect error or fraud in individual transactions to get evidence on:
 Validity, Completeness, Valuation. Accuracy, Cut-off audit objectives
Example:
 Vouching the debits in accounts receivable to entries in the sales journal and
supporting sales
 invoices (vouching)
 Testing whether the cost of goods included in the vendor’s invoice is properly recorded
 Cont’d…
6
2. Substantive Tests of account balances
 Involve examining support for the ending balance directly
 Concentrate on the details of amounts contained in an account
balance in order to establish whether any material
misstatements are included in the accounts presented in the
financial statements
Example:
a. Test of Accounts Payable balance: The auditor may perform
the following:
 Examine a sample of the individual vendor invoices for validity and valuation
objectives
 Send confirmation to vendors with zero balances in their accounts in order to test the
completeness objective

b. Test of Accounts Receivable Balance: confirming an ending

 Cont’d…
7 3. Analytical Procedures
 Analytical procedures refer to the evaluation of financial
information made by a study of plausible relationships among
both financial and non-financial data
 Knowledge of the client’s business and industry is the
prerequisite for the proper application of analytical procedures
 Analytical procedures may range from the use of simple
comparison to the use of more complex models.
 Examples of simple models include comparison and ratios
Example: comparing the current account receivable balance
with the prior year’s or budgeted balance
 Examples of ratios used in analytical procedures include:
short-term liquidity ratios, Activity ratios, Profitability
ratios , Coverage ratios
 Cont’d…
8
The purposes of analytical procedures are:
 To assist the auditor in planning the nature, timing, and extent of other audit
procedures
 To obtain evidential matter about particular assertions related to account
balances or classes of transactions
 To get overall review of the financial information in the final review stage of
the audit
The major types of analytical procedures include:
1. Comparison of current year financial information with comparable prior
period after consideration of known changes
2. Comparison of current year financial information with budgets, projections,
and forecasts
3. Relationship among elements of financial information within the current
period
4. Comparison of the client’s financial information with industry data
 Selecting Items for Testing to Gather
9 Audit Evidence
 When designing audit procedures, the
auditor should determine appropriate
means of selecting items for testing. The
means available to the auditor are:
1. Selecting all items (100% examination)
2. Selecting specific items
3. Audit sampling ( which sampling techniques
to use)
 Selecting All Items
10
 The auditor may decide that it will be most appropriate
to examine the entire population of items that make up
an account balance or class of transactions (more
common in substantive testing):
 When the population constitutes a small number of
large value items;
 When both inherent and control risks are high;
 Other means do not provide sufficient appropriate
evidence, or;
 When the repetitive nature of a calculation or other
process performed by a computer information system
makes a 100% examination cost effective.
 Selecting Specific Items
11
 The auditor may decide to select specific items from a
population based on such factors as knowledge of the
client’s business, preliminary assessments of inherent
and control risks, and the characteristics of the
population being tested. Specific items selected may
include:
 High value or key items (example, items that are unusual,
suspicious, particularly risk-prone or that have a history of error.)
 All items over a certain amount
 Items to obtain information (example, about the client’s
business, the nature if transactions, accounting, and internal
control systems.)
 Items to test procedures (to determine whether or not a
particular procedure is being performed).
 Audit Sampling
12
Meaning of Audit Sampling
 Sampling refers to the process of selecting a group of
items from a large group of items. The assumption of
sampling is that the sample is the representative of
the population.
 Audit sampling refers to the application of an
audit procedure to less than 100% of the items
within an account balance and class of
transactions for the purpose of evaluating some
characteristic of the balance or class.
 Auditors may encounter two types of risk in evidence
gathering process: Sampling risk and Non
 Cont’d…
13
Sampling risk
 The possibility that the sample drawn is not
representative of the population and, as a result, the
auditor will reach an incorrect conclusion.
 Is a function of sample size; the larger the sample
size, the lower the sampling risk and vice versa.
 It can be quantified by using statistical sampling.
 Key issue: balance sampling risk with the cost of
using large sample.
 Cont’d…
14
Non-sampling risk
 The possibility that the auditor uses inappropriate
audit procedures, fail to detect a misstatement when
applying an audit procedure, or misinterpret an audit
result.
 It can not be quantified using statistical sampling.
 The uncertainty related to such risk can be controlled
by:
 Adequate training
 Proper planning
 Effective supervision
 Class Discussion
15

 Audit sampling is needed for audit test.

However, all audit tests do not involve audit
sampling. Which audit tests do not involve
sampling?
 LIST OF AUDIT PROCEDURES THAT
16
DO NOT INVOLVE SAMPLING
 LIST OF AUDIT PROCEDURES THAT
17
DO NOT INVOLVE SAMPLING
 Type I and Type II Errors

18

In Relation to Tests of controls

1.Type I Error (alpha)
 The risk that the assessed level of control risk based on the
sample is greater than the true operating effectiveness of the
control
 Risk of assessing control risk too high
2. Type II Error (beta)
• The risk that the assessed level of control risk based on the
sample is less than the true operating effectiveness of the
control
• Risk of assessing control risk too low
 Cont’d…
19
In relation to Substantive tests
1. Type I Error (alpha)
• The risk that the sample supports the conclusion that the recorded account
balance is materially misstated when it is not materially misstated
• Risk of incorrect rejection.
• Relates to the efficiency of the audit (more audit work than necessary)
2. Type II Error (beta)
 The risk that the sample supports the conclusion that the recorded account
balance is not materially misstated when it is materially misstated
 Risk of incorrect acceptance
 Relates to the effectiveness of the audit (less audit work than necessary
and may lead to litigation against the auditor)
 Allowance for Sampling Risk (Precision)

20
 Precision measures the closeness between a sample estimate and the
population characteristic being estimated.
 Allowance for sampling risk (AFSR) is the uncertainty that results from
sampling. It is the difference between the expected mean of the population
and the tolerable deviation or misstatement.
 Allowance for sampling risk is the range set by + and - limits from the sample
results within which the true value of the population characteristics being
measured is likely to lie.
Example:
 Suppose an auditor expects that a control would have a 3% deviation (failure)
rate and s/he was willing to tolerate a deviation rate of 5%, the allowance for
sampling risk would be 2% (i.e. 5% - 3% = 2%).
 Assume the auditor tested 50 items and found one deviation, the sample
deviation rate is 2% (i.e. 1/50 = 0.02). If the upper tolerable limit is 3.5%, the
allowance for sampling risk would be 1.5%
 Types of Audit Sampling
21

A) NON-STATISTICAL SAMPLING or JUDGMENT SAMPLING

procedures are designed and executed on the basis of
the auditor’s sound objective and reasoning judgment.
 Subjective influence and probabilities reasoning are
not formally derived from mathematical sampling
proofs and theorems.
 Although sampling risk exists with statistical sampling,
no method for objectively measuring it is available.
However, properly designed non-statistical sampling
methods can provide results as effective as those
obtained from statistical sampling methods.
 Cont’d…
22
Types of Non-Statistical Sampling
1. HAPHAZARD SAMPLING. A haphazard sample consists of
sampling units without any conscious bias that is without any
special reason for including or omitting items from the sample.
 If used, a haphazard sample should not consist of items
selected in a careless manner, and that the sample should be
expected to be a representative of the population.
 Example, a haphazard sample of check vouchers contained in
a file drawer might be selected by pulling vouchers without
regard for the vouchers’ size, shape or location of the drawer.
 Cont’d…
23
2. BLOCK SELECTION. A block sample consists of all items in a
selected time period, numerical sequence, or alphabetical
sequence.
 EXAMPLE, the auditor might examine all cash payment
transactions in the first week of June or the last week of
December.
 Due to the relatively large number of blocks needed to form a
reasonable audit conclusion, block sampling cannot generally
be relied upon to efficiently produce a representative sample
and therefore is not acceptable for statistical or non-statistical
audit sampling.
 Cont’d…
24
3. JUDGMENTAL SAMPLING. The auditor selects large or unusual
items from the population and uses some other judgmental
criterion for selection.
 Obviously, this selection method has a conscious bias and
cannot be considered a representative selection method.
 The fact that judgmental selection is not appropriate for audit
sampling does not mean that the auditor should stop using
judgment in selecting items to be examined. The point is that
the items selected using judgment criteria are not necessarily
representative of the population and conclusions based on
these items should not be extended to the population.
 Cont’d…
25
B) STATISTICAL SAMPLING is a mathematically derived tool
which provides the auditor with an objective basis for expressing
conclusions about population characteristic based upon a
sample of items from the population. It means any approach to
sampling that has the following characteristics:
1. Random selection of a sample.
2. Use of probability theory to evaluate sample results, including
measurement of sampling risk.
 The primary benefit of statistical methods is the
quantification of sampling risk. For example, a 95%
confidence level provides a sampling risk of 5%, which
cannot be quantified in non-statistical sampling methods.
 Requirements of Statement on Audit
26 Standards (SAS) No. 39 regarding Audit
Sampling
A. Planning
The audit sampling application must be well-planned
and give adequate consideration to:
• The relationship of the sample to the objective (s) of
the test
• The maximum deviation rate from a control that
would support the planned level of control risk for
tests of controls
• The amount of monetary misstatement in an account
balance that may exist without causing financial
statements to be misstatement in substantive test.
• The risk of assessing control risk too low or the risk of
incorrect acceptance.
 Cont’d…
27

B. Sample Selection Methods

 The sample should be the representative of the population
 All items must have the opportunity to be selected
 May use either of the sample selection methods:
 Cont’d…
28

C. Performance and Evaluation

Must address four issues:
1)The auditor must consider the effect of not being able to apply
a planned audit procedure to a sampled item
2)The auditor should project the sample results to the
population being tested and compare those results with the
planned amounts
3)The auditor must give appropriate consideration to sampling
risk
4)The auditor must adequately consider qualitative aspects of
misstatements such as:
 The nature and causes of misstatements
 Application of Audit (attribute) Sampling to Tests of Control

29

 Attribute sample is concerned with one-sided test because the

auditor is generally concerned with the maximum deviation rate
in the population.
Step 1: State the objectives of the audit test.
 The objective is to evaluate the operating effectiveness of
internal control
Step 2: Define the control deviation conditions
 A deviation is a departure from adequate performance of the
internal control
 It is necessary to clearly define the situation in which deviation
occurs.
Eg. Let’s say the objective of the test is to check whether purchase
invoice was approved by the finance manager before being
 Cont’d…
30
Step 3: Define the population & sampling units
Population: Population depends on the objective of
the test. If the objective of the test is to check whether
purchase invoice was approved by the finance
manager before being recorded, all purchase orders
received during the period are considered population.
The auditor should ensure that the sample frame is
complete.
Sampling unit: Sampling unit refers to the individual
members of the population. A sampling unit may be a
document, an entry or a line item. In the above
example, the sampling unit is individual purchase
 Cont’d…
31
Step 4: Determine the sample size
Factors to be considered in determining the sample size:
1. Determining the acceptable risk of assessing control risk too low
2. The tolerable deviation rate
the maximum deviation from a prescribed control that the auditor is willing to accept
without altering the planned assessed level of control risk
The suggested tolerable deviation rates for assessed levels of control risk

3. The expected population deviation rate

 Cont’d…
32
Step 5: Select the sample
Once the sample size is determined, the sample will be selected using the appropriate techniques
Step 6: Perform the audit procedures/Test the sample items/
 In conducting the planned audit procedures, the following are not considered deviation
 properly Voided documents
 Unused or inapplicable documents
Step 7: Evaluate the Sample Result
1. Calculate the sample results
• Sample deviation rate
• Computed upper deviation rate
2. Performing Error Analysis
Step 8: Draw final conclusion
 involves comparing the tolerable deviation rate to the computed upper deviation rate
Step 9: Document the sampling Procedures
• All steps performed so far should be documented in the auditor’s working papers
 Application of Audit Sampling to Substantive Tests-Monetary Unit Sampling

33
Step 1: State the objectives of the audit test
 When auditors sample for tests of details of balances, the objective is to determine
whether the account balance being audited is fairly stated.
 Sampling may be used for substantive testing to test the reasonableness of
assertions about a financial statement amount, and to develop an estimate of
some amount.
Step 2: Define Misstatement Conditions
 Misstatement conditions are any conditions that represent a monetary
misstatement in a sample item.
 A misstatement is defined as the difference between monetary amounts in the
client’s records and amounts supported by audit evidence.
Step 3: Define the population and the sampling units
 In testing for the existence objective, the recorded dollar population is the
population.
 For MUS the population is defined as the monetary value of an account balance,
such as accounts receivable, investment securities, or inventory
 Cont’d…
34
Step 4: Determine the sample size
Factors to be considered:
1. Variation within the population
 Population variation and sample size have direct relationship in classical variables sampling.
 As population variation increases, the sample size should increase
 Population variation Can be minimized by stratifying the population
 Population variation does not affect the sample size when monetary unit sampling is used because the
sample selection method considers indirectly.
2. Acceptable risk of incorrect acceptance (type II error)
 There is an inverse relationship between risk of incorrect acceptance and the sample size
 The lower the risk for incorrect acceptance, the larger the sample size must be
3. Tolerable misstatement
 The tolerable misstatement is the amount of the preliminary judgment about materiality that is allocated
to an account
 The tolerable misstatement is the maximum amount by which the account can be misstatement with the
auditor still accepting the account as being fairly presented
 Tolerable misstatement is inversely related to sample size.
 The lower the amount of tolerable misstatement, the larger the sample size must be.
 Cont’d…
35
4. Expected misstatement
 The expected misstatement is the amount of misstatement that the
auditor believes exists in the population.
 The expected misstatement can be developed based on the assessment of
inherent risk, prior year's results, a pilot sample, the results of related
substantive tests, or the results of tests of controls.
 There is a direct relationship between expected misstatement and sample
size.
 The larger the expected misstatement, the larger the sample size must be
5. Population size
 Population size is directly related to sample size
 The larger the population size, the larger the sample size must be.
 Cont’d…
36
 Determination of sample size for Monetary-Unit Sampling:
 Attribute sampling table can be used
 Steps:
1. Determine the risk for incorrect acceptance
2. Convert the tolerable misstatement and the expected misstatement to
percentages of book value
3. Determine sample size using the following formula:
 Cont’d…
37
Example
 Suppose the auditor has established a tolerable misstatement of Br. 250,000 and
an expected misstatement of Br. 50,000 for an account receivable account with a
book value of Br. 5,000,000. The risk of incorrect acceptance is 5% and the
corresponding reliability factor and expansion factor (adjustment of expected
misstatement for the risk of incorrect acceptance) are 3.00 and 1.6 respectively.
Note that the reliability factor and expansion factor are obtained from relevant
tables.
a) Tolerable misstatement rate = 250,000/5,000,000 = 0.05
b) Expected misstatement = 10,000/5,000,000 = 0.01
c) Sample size (n)
 Cont’d…
38
 For Monetary-Unit Sampling, (by applying systematic
sampling method) probability-proportional-to-size method is
used, which gives each birr in the population an equal change
of being selected and divides the population in to equal
groups of birr. Each group of birr represents a sampling
interval, which is obtained by dividing the book value of the
population by the sample size
 Assume a client’s book value of accounts receivable is
Br.5,000,000, and the auditor determined a sample size of 88.
The sampling interval will be Br. 56,818. The auditor randomly
selects a number between o and 56,818 and then select every
56,818th Birr to identify the balance to be included in the
sample.
 Cont’d…
39
Step 6: Perform the audit procedures/Test
Step 7: Evaluate the sample results
Step 8: Draw final conclusions
Step 9: Document the sampling procedures
40
End of chapter one

Thank you