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ADIAC-00048; No of Pages 9
Advances in Accounting, incorporating Advances in International Accounting xxx (2009) xxx–xxx

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Advances in Accounting, incorporating Advances in

International Accounting
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1 Monetary unit sampling: Improving estimation of the total audit error

2 Huong N. Higgins a,⁎, Balgobin Nandram b,1
a
3 Worcester Polytechnic Institute, Department of Management, 100 Institute Road, Worcester, MA 01609, United States
b
4 Worcester Polytechnic Institute, Department of Mathematical Sciences, 100 Institute Road, Worcester, MA 01609, United States

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5

a r t i c l e i n f o a b s t r a c t
76
Q1 8 Available online xxxx In the practice of auditing, for cost concerns, auditors verify only a sample of accounts to estimate the error of 13

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910
11 the total population of accounts. The most common statistical method to select an audit sample is by 14
monetary unit sampling (MUS). However, common MUS estimation practice does not explicitly recognize the 12
15
multiple distributions within the population of account errors. This often leads to excessive conservatism in 16
auditors' judgment of population error. In this paper, we review the common MUS estimation practice, and 17
introduce our own method which uses the Zero-Inflation Poisson (ZIP) distribution to consider zero versus 18
non-zero errors explicitly. We argue that our method is better suited to handle the real populations of 19

25
24
accounting data. DP
account errors, and show that our ZIP upper bound is both reliable and efficient for MUS estimation of

© 2009 Elsevier Ltd. All rights reserved.

20
21
22
23
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26 1. Introduction assumption, combined with MUS sampling bias towards selecting 49
larger accounts, often leads to very large estimations of total error in 50
27 In auditing a company's accounts receivable, the goal of auditors is the population and overly conservative auditors' decisions. 51
28 to verify if the values of the accounts reported by the company are not We acknowledge that the major risk of accounts receivable in 52
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29 materially misstated. To determine the total error in the amount financial reporting is overstatement, so generally auditors should 53
30 reported by the company, auditors must audit all accounts in the prefer methods that result in larger error estimations. However, we 54
31 population of accounts. However, it is costly and it takes much time to argue that estimations in practice are too conservative, and excessive 55
32 audit all accounts. In practice, auditors audit only a sample to estimate conservatism has its own practical problems. For example, discussions 56
33 the total error in the population of accounts. with auditors in three large accounting firms reveal that clients rarely 57
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34 A common statistical sampling method is monetary unit sampling approve large adjustments for error estimations (Elder & Allen, 1998). 58
35 (MUS), where each monetary unit (e.g., dollar) is equally likely to be This, along with the cost of statistical expertise, may cause auditors 59
36 included in the sample. In this method, an account with a book value not to project sample errors to the population at all. Indeed, surveys of 60
37 of $10,000 is ten times as likely to be sampled as an account with a auditors reveal that they often fail to project errors to populations, 61
38 book value of $1000. notwithstanding audit standards and professional guidelines (Burg- 62
This paper addresses the estimation process for MUS sampling. stahler & Jiambalvo, 1986; Akresh & Tatum, 1988; Hitzig, 1995; Elder &
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39 63
40 Common MUS estimation has a shortcoming because it does not Allen, 1998). Overall, excessive conservatism in the estimation method 64
41 explicitly recognize that a total population of account errors typically may lead to projection problems, which impairs the auditor's overall 65
42 consists of distinct distributions, namely one large mass with zero decision process. 66
43 error, a second distribution of small errors, and a third distribution of We introduce our own approach which is better suited to handle 67
44 100% errors. These distribution characteristics of accounting error the real distributions of account errors. We use a regression with 68
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45 populations have been discussed in prior research (e.g. Kaplan, 1973; selection probability as a covariate to address MUS sampling bias. Our 69
46 Neter & Loebbecke, 1975; Chan, 1988). Due to this shortcoming, in technical innovation lies in the development of the Zero-Inflation 70
47 practice sample accounts are incorrectly assumed to have similar Poisson (ZIP) model, using the Poisson distribution to treat errors as 71
48 tainting (ratio of Error-Per-Dollar) to non-sample accounts. This rare count data, and increasing the probabilities of zero errors to 72
inflate the weights of these observations. By handling accounts with 73
zero versus non-zero errors explicitly, our technique does not rely on 74
the assumption of similar tainting in the population. We provide 75
⁎ Corresponding author. Tel.: +1 508 831 5626; fax: +1 508 831 5720. mathematical expressions and, upon request, will furnish the software 76
E-mail addresses: hhiggins@wpi.edu (H.N. Higgins), balnan@wpi.edu (B. Nandram). codes for our ZIP estimation and confidence intervals. Through 77
1
Tel.: +1 508 831 5539; fax: +1 508 831 5824. simulations, we show that our ZIP bound is reliable and efficient for 78

0882-6110/$ – see front matter © 2009 Elsevier Ltd. All rights reserved.
doi:10.1016/j.adiac.2009.06.001

Please cite this article as: Higgins, H. N., & Nandram, B., Monetary unit sampling: Improving estimation of the total audit error, Advances in
Accounting, incorporating Advances in International Accounting (2009), doi:10.1016/j.adiac.2009.06.001
 ARTICLE IN PRESS
2 H.N. Higgins, B. Nandram / Advances in Accounting, incorporating Advances in International Accounting xxx (2009) xxx–xxx

79 MUS estimation of accounting data. Overall, our paper serves bound is also simple to compute and the required statistical tables are 143
80 professionals and academicians by pointing out an improvement readily available. 144
81 potential for MUS estimation.
82 The remainder of the paper is as follows. Section 2 reviews the 3. Data and common estimation 145
83 monetary unit sampling method in the accounting literature and
84 practice of auditing. Section 3 describes our data and demonstrates a 3.1. Data 146
85 common method in current practice to estimate the total error in a
86 population of accounts from which a dollar unit sampling is taken. To illustrate the common estimation method, we use data of a 147
87 Section 4 introduces our Zero-Inflated Poisson (ZIP) estimation company used by Lohr (1999) in her demonstration of MUS. The 148
88 method. Section 5 reports simulations to validate our ZIP upper company has a population of N = 87 accounts receivable, with a total 149
89 bound. Section 6 concludes the paper with a brief summary. book balance of $612,824. We know the book values b1, b2, …, bN for 150
each account in the population. Let B denote the total book value of all 151
90 2. Monetary unit sampling accounts receivable in the population, 152

91 In performing substantive tests of accounts, an auditor often takes B = b1 + b2 + … + bN = 612; 824: ð1Þ
92 a sample to estimate the true total balance of all accounts. Ultimately, 153
154
the auditor's goal is to estimate the total amount of error, which is the If each account in the population were audited, we would obtain 155

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93
94 difference between the true total balance of all accounts and the the set of audit values a1, a2, …, aN. Let A denote the unknown total 156
95 reported balance amount. The standards for audit sampling are set by audit value in our data, 157
96 the Audit Standards Board's Statement on Auditing Standards (SAS)
A = a1 + a2 + … + aN : ð2Þ
97 No 39, (AICPA, 1981) amended by SAS No. 111 (AICPA, 2006).
158
159
Both statistical and non-statistical sampling methods are allowed

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98
We define the error on any account i (i = 1, 2, …, N) by di = bi − ai, 160
99 for substantive tests in auditing (AICPA, 1981, 2008). Both are used by
di ≥ 0. After performing audit on a sample size n, which we suppose is 161
100 a wide-range of public accounting firms (Nelson, 1995) and govern-
predetermined, we observe a1, a2, …, a n (see Kaplan, 1975; 162
101 ment agencies (Annulli, Mulrow & Anziano, 2000). Some surveys
Menzefricke, 1984 for discussions of issues in determining the sample 163
102 show that non-statistical sampling is used more than half the time
size). We wish to fit an + 1, …, aN to predict the total error from all 164
103 (Annulli et al., 2000; Hall, Hunton & Pierce, 2000, 2002). Of course,
104
105
106
107
non-statistical sampling procedures do not afford the full control
provided by statistical theory, and so raise questions concerning
auditors' evaluation of sample results (Messier, Kachelmeier & Jensen,
2001).
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accounts.
Let D denote the total error in the population of all accounts
receivable,

D = d1 + d2 + … + dN : ð3Þ
165
166
167

108 Among statistical sampling techniques, monetary unit sampling 168

169
109 (MUS) is the most commonly used for substantive tests (Tsui, The total error D is also the difference between the total book value 170
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110 Matsumura & Tsui, 1985; Smieliauskas, 1986b; Grimlund & Felix, and the total audit value, 171
111 1987; Hansen, 1993; Annulli et al., 2000; AICPA, 2008). The
112 authoritative guide for the auditing profession, the AICPA's Audit D = B−A: ð4Þ
113 Guide — Audit Sampling (AICPA, 2008), has detailed MUS instructions. 172
173
114 MUS is a statistical sampling method where the probability of an Our ultimate goal is to predict total error D. Because D is unknown, 174
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115 item's selection for the sample is proportional to its recorded amount it is standard practice to estimate its mean and upper bound. 175
116 (probability proportional to size). MUS can be thought of as employ- The book values, audit values, selection probabilities and errors of 176
117 ing the ultimate in stratification by book amount. No further all accounts are tabulated in Table 1. Selection probability is the 177
118 stratification by book amount is possible with dollar units because probability of an account being selected from all the 87 accounts, equal 178
119 all sampling units are of exactly the same size in terms of book value. to the book value of an account divided by the total book balance 179
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120 Consequently, MUS incorporates efficiency advantages similar to $612,824 (e.g. for account 3, the selection probability = 6842/612,824 = 180
121 those of stratification by book value without requiring stratification. 0.011164706). Panel A describes the audit sample, and Panel B the non- 181
122 Despite its widespread use, the relative performance of MUS sample. 182
123 compared to traditional normal distribution variables is often not The audit values and errors of accounts in the audit sample are 183
124 clear (Smieliauskas, 1986b). Prior research has developed a number of known, but these values are unknown for accounts in the non-sample. 184
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125 methods for evaluating MUS samples (Tsui et al., 1985; Smieliauskas, In this company, only a small proportion of audited accounts (4 of 20, 185
126 1986b; Grimlund & Felix, 1987). Evaluating criteria include sample or 80%) are subject to error. 186
127 size (Kaplan, 1975), sampling risks (Smieliauskas, 1986b), sample size
128 implications of controlling for the same level of sampling risks 3.2. Common estimation 187
129 (Smieliauskas, 1986b), and bounds (Tsui et al., 1985; Dworin &
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130 Grimlund, 1986). SAS No. 39 on audit sampling (AICPA, 1981) promulgates that 188
131 Obtaining reliable bounds on the total error in the population is auditors should estimate the total error in the population by 189
132 desirable for making decisions at different confidence levels and projecting sample errors to the population. A common estimation 190
133 probabilistic statements. There are many methods to compute bounds method of the mean population error D is based on tainting, which 191
134 for MUS sampling (Felix, Leslie & Neter, 1981; Swinamer, Lesperance & equals the average error amount per dollar in the audited accounts. 192
135 Will, 2004). The Stringer bound, introduced by Stringer (1963), is used Taintings are multiplied by the total dollars in the sampling intervals, 193
136 extensively by auditors (Bickel, 1992; AICPA, 2008). A feature of thee or average tainting is multiplied by the total dollars in the population, 194
137 Stringer bound which is particularly attractive to auditors is that it to yield an estimate of the total error dollars in the population. This 195
138 provides a non-zero upper bound even when no errors are observed in method is prescribed by the AICPA Audit Guide — Audit Sampling 196
139 the sample. Simulations show that the Stringer bound reliably exceeds (AICPA, 2008). Besides the AICPA guide, many professional publica- 197
Q2 140 the true audit error (Swinamer et al., 2000). This reliability is tions also prescribe this MUS evaluation method (Gafford & 198
141 favorable to auditors who are concerned with strictly overstatements Carmichael, 1984; Guy & Carmichael, 1986; Schwartz, 1997; Yancey, 199
142 (or strictly understatements) in financial statements. The Stringer 2002). 200

Please cite this article as: Higgins, H. N., & Nandram, B., Monetary unit sampling: Improving estimation of the total audit error, Advances in
Accounting, incorporating Advances in International Accounting (2009), doi:10.1016/j.adiac.2009.06.001
 ARTICLE IN PRESS
H.N. Higgins, B. Nandram / Advances in Accounting, incorporating Advances in International Accounting xxx (2009) xxx–xxx 3

t1:1 Table 1
Description of data.
t1:2
t1:3 Panel A: sample
t1:4 Account number Book value (b) Audit value (a) Selection probability (πi) Error (d = b − a)
t1:5 3 6842 6842 0.011164706 0
t1:6 9 16,350 16,350 0.026679765 0
t1:7 13 3935 3935 0.006421093 0
t1:8 24 7090 7050 0.01156939 40
t1:9 29 5533 5533 0.009028693 0
t1:10 34 2163 2163 0.003529562 0
t1:11 36 2399 2149 0.003914664 250
t1:12 43 8941 8941 0.014589833 0
t1:13 44 3716 3716 0.006063731 0
t1:14 45 8663 8663 0.014136196 0
t1:15 46 69,540 69,000 0.113474668 540
t1:16 49 6881 6881 0.011228346 0
t1:17 55 70,100 70,100 0.11438847 0
t1:18 56 6467 6467 0.010552785 0
t1:19 61 21,000 21,000 0.034267587 0

OF
t1:20 70 3847 3847 0.006277496 0
t1:21 74 2422 2422 0.003952195 0
t1:22 75 2291 2191 0.003738431 100
t1:23 79 4667 4667 0.007615563 0
t1:24 81 31,257 31,257 0.051004856 0
t1:25 Total error in the sample 940

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t1:26
t1:27 Panel B: non-sample
t1:28 Account Book Audit Selection Error Account Book Audit Selection Error
number value (b) value (a) probability (πi) (d = b − a) number value (b) value (a) probability (πi) (d = b − a)
t1:29 1 2459 . 0.004013 . 42 9074 . 0.014807 .
t1:30 2 2343 . 0.003823 . 47 8746 . 0.014272 .
t1:31
t1:32
t1:33
t1:34
t1:35
t1:36
4
5
6
7
8
10
4179
750
2708
3073
4742
5424
.
.
.
.
.
.
0.006819
0.001224
0.004419
0.005014
0.007738
0.008851
.
.
.
.
.
.
DP 48
50
51
52
53
54
7141
2278
3916
2192
5999
5856
.
.
.
.
.
.
0.011653
0.003717
0.00639
0.003577
0.009789
0.009556
.
.
.
.
.
.
t1:37 11 9539 . 0.015566 . 57 7642 . 0.01247 .
t1:38 12 3108 . 0.005072 . 58 8846 . 0.014435 .
TE
t1:39 14 900 . 0.001469 . 59 2486 . 0.004057 .
t1:40 15 7835 . 0.012785 . 60 2074 . 0.003384 .
t1:41 16 1091 . 0.00178 . 62 3081 . 0.005028 .
t1:42 17 2798 . 0.004566 . 63 7123 . 0.011623 .
t1:43 18 5432 . 0.008864 . 64 5496 . 0.008968 .
EC

t1:44 19 2325 . 0.003794 . 65 7461 . 0.012175 .

t1:45 20 1298 . 0.002118 . 66 6333 . 0.010334 .
t1:46 21 5594 . 0.009128 . 67 13,597 . 0.022187 .
t1:47 22 2351 . 0.003836 . 68 1317 . 0.002149 .
t1:48 23 7304 . 0.011919 . 69 5437 . 0.008872 .
t1:49 25 4711 . 0.007687 . 71 4030 . 0.006576 .
RR

t1:50 26 4031 . 0.006578 . 72 2620 . 0.004275 .

t1:51 27 1907 . 0.003112 . 73 2416 . 0.003942 .
t1:52 28 3341 . 0.005452 . 76 5882 . 0.009598 .
t1:53 30 8251 . 0.013464 . 77 6596 . 0.010763 .
t1:54 31 4389 . 0.007162 . 78 2626 . 0.004285 .
t1:55 32 5697 . 0.009296 . 80 7571 . 0.012354 .
t1:56 33 7554 . 0.012327 . 82 1331 . 0.002172 .
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t1:57 35 8413 . 0.013728 . 83 5924 . 0.009667 .

t1:58 37 4261 . 0.006953 . 84 4356 . 0.007108 .
t1:59 38 7862 . 0.012829 . 85 6618 . 0.010799 .
t1:60 39 3153 . 0.005145 . 86 5658 . 0.009233 .
t1:61 40 4690 . 0.007653 . 87 6943 . 0.01133 .
t1:62 41 6541 . 0.010674 .
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Book value is the amount reported by the audited company. Audit value is the value audited and verified by the auditors. Selection probability is the probability of which an account is
selected from all the accounts in the population, equal to the book value of an account divided by the total book balance $612,824 (e.g. for account 3, the selection
probability = 6842 / 612824 = 0.011164706). Error is the difference between book value and audit value. Panel A shows the accounts selected by the auditors to be audited (sample),
t1:63 and Panel B the remainder of the population of accounts (non-sample). Accounts in the non-sample do not have audit value.

201 Table 2 illustrates this estimation process. Error-Per-Dollar (taint- sample is the sum of all Errors-Per-Dollar divided by 20, the number of 208
202 ing) indicates the difference per dollar for each account, equal to the accounts in the sample, or 0.008063. Thus the total error for the 209
203 difference in book and audit values divided by the corresponding book population D is estimated as 0.008063 ⁎ 612,824 = $4941. 210
204 value. Account 24, for example, has a book value of $7090 and an error Often, audit units greater than the sampling interval are excluded 211
205 of $40. The error is prorated to every dollar in the book value, leading from the population before sampling (AICPA, 2008). These units are 212
206 to an error (tainting) percentage of $40/$7090 = 0.005642 for each of examined separately, and their projected misstatements equal their 213
207 the 7090 dollars. The average error for the individual dollars in the full misstatements, not an extension of tainting. For example, the 214

Please cite this article as: Higgins, H. N., & Nandram, B., Monetary unit sampling: Improving estimation of the total audit error, Advances in
Accounting, incorporating Advances in International Accounting (2009), doi:10.1016/j.adiac.2009.06.001
 ARTICLE IN PRESS
4 H.N. Higgins, B. Nandram / Advances in Accounting, incorporating Advances in International Accounting xxx (2009) xxx–xxx

t2:1 Table 2
Common error estimation for dollar unit sampling.
t2:2
t2:3 Account Book value Audit value Selection Error Error-Per-Dollar Projected mistatement
number (b) (a) probability (πi) (d = b − a) (tainting) (taintinga sampling interval)
t2:4 3 6842 6842 0.011164706 0 0
t2:5 9 16,350 16,350 0.026679765 0 0
t2:6 13 3935 3935 0.006421093 0 0
t2:7 24 7090 7050 0.01156939 40 0.005642 172.87
t2:8 29 5533 5533 0.009028693 0 0
t2:9 34 2163 2163 0.003529562 0 0
t2:10 36 2399 2149 0.003914664 250 0.10421 3193.12
t2:11 43 8941 8941 0.014589833 0 0
t2:12 44 3716 3716 0.006063731 0 0
t2:13 45 8663 8663 0.014136196 0 0
t2:14 46 69,540b 69,000 0.113474668 540b 0.007765 237.94b
t2:15 49 6881 6881 0.011228346 0 0
t2:16 55 70,100 70,100 0.11438847 0 0
t2:17 56 6467 6467 0.010552785 0 0
t2:18 61 21,000 21,000 0.034267587 0 0

OF
t2:19 70 3847 3847 0.006277496 0 0
t2:20 74 2422 2422 0.003952195 0 0
t2:21 75 2291 2191 0.003738431 100 0.043649 1337.46
t2:22 79 4667 4667 0.007615563 0 0
t2:23 81 31,257 31,257 0.051004856 0 0
t2:24 Total error in the sample 940

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t2:25 Average Error-Per-Dollar 0.008063a
t2:26 Total projected error in the population 4941

Book value is the amount reported by the audited company. Audit value is the value audited and verified by the auditors. Selection probability is the probability of which an account is
selected from all the accounts in the population, equal to the book value of an account divided by the total book balance. Error is the difference between book value and audit value.
Error-Per-Dollar is the ratio between error and book value. The sampling interval is $612,824/20 = $30,641.20.
t2:27 Total error D for the population is estimated as Average Error-Per-Dollar ⁎ total book value, or 0.008063 ⁎ 612,824 = $4941.
t2:29
t2:28
t2:30

215
a

b
DP
The Average Error-Per-Dollar is the sum of all error-per-dollars divided by the number of accounts in the sample (20).
This audit unit is greater than the sampling interval and may be considered separately from the sample evaluation.

projection from account 46 would be its full misstatement of $540 We argue that the approach described above is too conservative. 245
216 instead of $237.94. In this case, the total projected error in the Compared to other bounds, for example the Multinomial-Dirichlet 246
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217 population would be $5243 instead of $4941. bound computed at $11,125 for the same sample, the Stringer bound is 247
218 A common method to estimate the upper bound of D is the too large. References for Multinomial bounds can be found in 248
219 Stringer bound. Let Ti be the tainting of the i-th selected item, Ti ≡ di/ Swinamer et al. (2004) and Neter, Leitch and Fienberg (1978). As 249
220 bi. If M ≡ number of non-zero Ti let 0 b zM ≤ … ≤ z1 be the ordered non Stringer (1963) stresses, if the population is free of errors it gives the 250
221 zero Ti. Let p(j; 1 − α) be the 1 − α exact upper confidence bound for p same answer (overestimate), no matter what sample is drawn from 251
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222 when X has a binomial (n, p) distribution and X = j. Thus p(j; 1 − α) is the population. In fact, simulation studies (Reneau, 1978; Leitch, Neter, 252
223 the unique solution of Plante & Sinha, 1982) find that the Stringer bound is always too 253

 conservative. The trade-off for high reliability is loss of efficiency: the 254
n
n k n−k Stringer bound is always much larger than the population total error 255
∑ p ð1−pÞ = 1−α; ð5Þ
k=j + 1 k (Bickel, 1992; Swinamer et al., 2004). It is probable that many auditors 256
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do not project sample results to populations to avoid unrealistic 257

225
224 if j b n and p(n; 1 − α) = 1. conservatism and client resistance. However, failing to project leads to 258
226 The Stringer bound for the mean of tainting μ is judgment error regarding the financial statements overall. 259
We seek to introduce an alternative method that is reliable but 260
M
μ ST ≡ pð0; 1−αÞ + ∑ ½pðj; 1−αÞ−pðj−1; 1−αފzj : ð6Þ more efficient, to help auditors make realistic projection and 261
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j=1 probabilistic statements about the population error. 262

228
227
229 The upper bound of the total error in the population is μ–ST ⁎ B. 4. Zero-Inflated Poisson regression 263
230 There is a similar bound for the case in which X has a Poisson (n ⁎ p)
231 distribution. To improve on the common estimation method described in 264
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232 The AICPA (2008) publishes tables as aids in calculating the Section 3, our aim is to estimate total error D and its 95% upper 265
233 Stringer upper bound (see Table C.3. “Monetary Unit Sampling — confidence bound. In the first step, we develop the Poisson regression 266
234 Confidence Factors for Sample Evaluation” in Appendix C of the Audit to view each dollar in an account either as error or not (as count data). 267
235 Guide). Our computation of the Stringer 95% upper bound based on In the second step, we further develop the Poisson regression to count 268
236 the binomial distribution for calculating p(n;1 − α) is $129,380. A data with a large number of zero values to suit populations of account 269
237 replication of the Stringer computation using the Poisson instead of errors. 270
238 binomial distribution for p(n;1 − α) yields a similar value, $133,518.
239 The above results, which are based on the common estimation 4.1. Ordinary Poisson regression 271
240 approach, can be summarized as follows. The sample contains known
241 errors of $940. The total error projected in the population is $4941. The We use the generalized regression model to allow for count data so 272
242 Stringer 95% upper confidence bound of total error in the population is that we can capture the distribution of our data more accurately (see 273
243 $133,518. Thus, there is a 5% risk that the recorded amount of $612,824 Nandram, Sedransk & Pickle, 2000 for a detailed discussion of the 274
244 is overstated by more than $133,518. generalized regression model and specifically the Poisson regression). 275

Please cite this article as: Higgins, H. N., & Nandram, B., Monetary unit sampling: Improving estimation of the total audit error, Advances in
Accounting, incorporating Advances in International Accounting (2009), doi:10.1016/j.adiac.2009.06.001
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N
ðhÞ
276 We use random coefficients, instead of fixed coefficients as in a Let EðhÞ = ∑ di be the h-th copy of the 10,000 copies obtained 326
i=1
277 standard linear regression, to treat each account as having its own set from Appendix A, and M = 10,000, h = 1,2, …, M. An estimate of the 327
278 of regression coefficients. By allowing random coefficients, we can overstatement error is 328
279 model the data more flexibly and therefore can achieve more accuracy.
280 This is an important feature of our method to incorporate random
M
281 effects. Using random coefficients also allows us to build confidence ðhÞ
∑E =M = E ð13Þ
282 intervals and upper confidence bounds. We approximate the h=1
283 distribution of the random coefficients by using a standard mode–
284 Hessian normal approximation (Gelman, Carlin, Stern & Rubin, 2004),
285 which allows us to draw samples of the regression coefficients. This and the standard error is 329
330
286 permits us to make copies of the total errors, thus we get the
287 distribution of the total error. In a sample of 10,000 we obtain the sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
M P 2
ðhÞ
288 250th and 9750th values to form the lower and upper ends of the 95% S= ∑ ðE − E Þ = ðM−1Þ: ð14Þ
289 confidence interval. i=1

290 To consider each dollar in an account is either in error or not, our

331
332
291 model is,
To obtain a 95% confidence interval for the total overstatement 333

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error, we order the E(h) from smallest to largest and pick the 250th and 334
di jλi ind
e Poissonðλi bi Þ 9750th value from the lower and upper end of the confidence interval. 335
ð7Þ
The 95% upper confidence bound is the 9500th value. 336
ln λi = ðβ0 + r0i Þ + ðβ1 + r1i Þπi
4.2. Zero-Inflation Poisson regression 337

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292
293 where i = 1,2, …, N, r0i and r1i are random perturbations and are
294 independent and identically distributed with mean 0 and finite We now develop the Poisson regression model to count data with 338
295 variances, and λi is the error rate for a dollar, or equivalently, the many zero values. This is our major innovation to address MUS 339
296 probability that a dollar is in error. Now we have two sets of random estimation errors. We assume that with probability θ the only 340
297 coefficients β0 + r0i and β1 + r1i. possible observation is 0 (i.e. pure zero), and with probability1 − θ, a 341
298 Note that the model with r0i = r1i = 0, i = 1,2, …, N, is Poisson (λ) random variable is observed. In other words, we treat

di jλi ind
e Poissonðλi bi Þ

ln λi = β0 + β1 πi :
ð8Þ
DP errors as nearly impossible, but allow errors to occur according to a
Poisson (λ) distribution. This treatment is termed Zero-Inflation
Poisson (ZIP). For a pioneering description of ZIP regression, see
Lambert (1992). Both the probability θ of the perfect zero error state
342
343
344
345
346
300
299 and the mean number of errors λ in the imperfect state may depend 347
301 This is another important feature of our method because on covariates. Pertinent covariates, such as trade relationships, credit 348
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302 observations are treated according to their selection probabilities π, terms, product prices, etc… can lead to improved precision in 349
303 and so sample and non-sample observations are not assumed to be statistical inference. For a discussion of how to introduce covariates, 350
304 the same. see Nandram et al. (2000), for example. Sometimes θ and λ are 351
305 The first model is centered on the second model. Centering is unrelated; other times θ is a simple function of λ. In either case, ZIP 352
EC

306 achieved by taking r0i = r1i = 0, so that regression models are easy to fit, and the maximum likelihood 353
estimates are approximately normal in large samples of at least 25 354
di jλi ind
β0 + β1 πi (Lambert, 1992). 355
e Poissonðbi e Þ: ð9Þ
As in the ordinary Poisson model in Section 4.1, our model is 356
307
308 Eq. (7). To increase the probabilities of zero errors, we use the 357
309 Centering allows us to use this simpler model to study the original,
RR

following distribution for di, 358

310 more complex model. Because the dis are independent, the log-
311 likelihood function is
β 0 + β 1 πi
pðdi = 0Þ = θ + ð1−θÞe−bi e
n n n
β0 + β1 πi
f ðβ0 ; β1 Þ = β0 ∑di + β1 ∑ πi di − ∑ bi e : ð10Þ
i=1 i=1 i=1 ð15Þ
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313
312 β0 + β1 πi di −bi eβ0 + β 1 πi
ðbi e Þ e
314 We use maximum likelihood estimate in the centered model to pðdi ≠0Þ = ð1−θÞ
di !
315 obtain MLEs. Preliminary estimations are possible at this step,
316 however they do not benefit from the zero inflation process, so they
where di = 1,2,3, …. 359
360
317 are less adjusted for populations with a large number of zero errors.
The random effect corresponding to θ is θ + r21.We do not treat the
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361
318 We show in Appendix A how to obtain 10,000 copies of the
dis equally. Because most of the errors in the sample are zero, different 362
319 overstatement error. We use two estimators: the predicted estimator
treatments of zero-valued dis and non-zero dis are desired to give 363
320 and the projected estimator.
more appropriate weights to the zero values. 364
321 The two estimators are defined as:
We center the ZIP model by taking r0i = r1i = r2i = 0, i = 1, 2, …, N, 365

n N
similar to Eqs. (8) and (9). 366
Predicted: ∑ di + ∑ d˜i ð11Þ Since the dis are independent, we consider their joint probability 367
i=1 i=n + 1 density function: 368
323
322
N
( )
Projected: ∑d˜i ð12Þ n β
−b e 0
+ β1 πi o ðbi e
β0 + β1 πi
β0 + β1 πi di −bie
Þ e
i=1 Lðθ; β0 ; β1 Þ = ∏ θ + ð1−θÞe i ∏ ð1−θÞ :
di = 0 dt N 0 di !

325
324 where dĩ is the predicted value of di. ð16Þ 369
370

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371 Thus the log-likelihood function is Simulation 1 consists of three steps. First, we fill in the missing 411
audit value for the 87 − 20 = 67 accounts in our data set. We use the 412
n bivariate Parzen–Rosenblut kernel density estimator, an independent
−bieβ0 + β1 πi 413
Δðθ; β0 ; β1 Þ = ∑ ln½θ + ð1−θÞe Š + ðN−nÞ lnð1−θÞ ð17Þ
π=1 non-parametric model (Silverman et al., 1986) to fill in the audit 414 Q3
M M values. To model errors, we formulate the missing audit values in the 415
β0 + β1 πi
+ ∑ di ðβ0 + β1 πi Þ− ∑ bie : range 0.90 book value b audit value b book value. We create the 416
l=π + 1 l=π + 1
scenario where 80% of the book values and the audit values are in 417
372
373
perfect agreement. This population is kept fixed throughout. Because 418
374 We use the Expectation Maximization (EM) algorithm to max- we generate all the necessary audit values, we have the entire 419
375 imize the function over θ and ß (see Appendix B). population and the true total population error. 420
376 The values we obtain from the above procedures are: Second, we draw 1000 PPS samples (probabilities of selection are 421
proportional to the book values) without replacement of size 20 from 422
θ̃ = 0:80 β̃0 = −3:25 β̃1 = −14:36: the single populations we construct in the first step. Third, we fit the 423
378
377 ZIP regression model in exactly the same manner we discussed in 424
379 Our estimations are based on two estimators, the predicted Section 3 for the observed data. We compute 90% confidence interval 425
380 estimator and the projected estimator as defined in Eqs. (11) and for each fixed population, whose upper end provides a 95% upper 426
(12). We estimate the mean, standard error, confidence interval, and confidence bound. For comparison, we compute the same for the

OF
381 427
382 upper bound using in a manner as described in Eqs. (13) and (14). We Stringer bound and the Multinomial-Dirichlet bound. The results are 428
383 show in Appendix B how to obtain 10,000 copies of the overstatement shown in Table 3. 429
384 error. Table 3, Columns 2–6 show the reliability results, specifically the 430
385 The predicted estimator has a mean of $3272, a standard error of frequency in which the bounds exceed the true population error. In 431
$1037, a 95% confidence interval of [$1487; $5336], and a 95% upper Simulation 1, the ZIP bound exceeds the true population error 89.5% of

RO
386 432
387 confidence bound of $4848. The projected estimator has a mean of the times, whereas it is supposed to exceed 95% of the times. In 433
388 $3435, a standard error of $1463, a 95% confidence interval of [$931; contrast, the Stringer bound exceeds the true error 100% of the times, 434
389 $6107], and a 95% upper confidence bound of $5444. while this frequency is 96% for the Multinomial-Dirichlet bound. 435
390 As per design, we argue our ZIP method has advantage because it These results demonstrate ZIP's lower reliability than the theoretical 436
391 addresses the selection bias in MUS towards selecting larger accounts, level and the extra conservatism of the Stringer bound. 437
392
393
394
395
it handles populations with a large number of zero values, and it
handles zero versus non-zero values explicitly separately. As a result of
this design, ZIP should be better suited than common estimation
practice for accounting populations.
DP To report on the efficiency, Columns 5 and 6 show the frequency in
which the ZIP bound is larger (more inefficient) than the Stringer
bound and the Multinomial-Dirichlet bound. In Simulation 1, these
frequency numbers are very close to zero (0.7% and 9.6%, respec-
438
439
440
441
tively), indicating the ZIP bound is almost always smaller, or more 442
396 5. Simulations efficient. To further shed light on the size of the other bounds relative 443
TE
to the ZIP bound, Columns 7 and 8 show the ratio of the differential 444
397 We perform three simulations to assess the reliability and size over the ZIP bound. On average, this ratio is about 13 times for the 445
398 efficiency of our ZIP upper bound, using the following definitions by Stringer bound, and 25.8% for the Multinomial-Dirichlet bound. These 446
399 Swinamer et al. (2004): a 95% upper confidence bound is reliable if, results demonstrate the far greater efficiency of the ZIP bound 447
400 when used repeatedly, the bound exceeds the true error 95% of the compared to the other two. 448
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401 time. Efficiency measures the size of the bound: the smaller the bound Simulation 2 is similar to the first, except that the audit values are 449
402 is, the more efficient it is said to be. We compare the reliability and generated by the ZIP model. The generated data have similar 450
403 efficiency of our ZIP method with the Stringer bound, because this characteristics to accounting data in the sense that they come from a 451
404 bound is used the most extensively by accounting auditors as distribution that presumes a very large number of zero errors. From 452
405 discussed in previous sections. We also compare our ZIP method Column 2, the ZIP bound is reliable as its 95% upper bound exceeds the 453
RR

406 with the Multinomial-Dirichlet bound, because this bound demon- true error value 96.8% of the times. From Columns 5 and 6, the frequency 454
407 strates the best reliability for a variety of populations (Tsui et al., in which the ZIP bound is larger than the other two bounds is very small 455
408 1985). More MUS bounds exist but they have relatively more (0.8% and 3%, respectively), denoting ZIP's greater efficiency. 456
409 reliability problems and they all have pros and cons (Grimlund & Simulation 3 is similar to the first two, except that the audit values 457
410 Felix, 1987; Swinamer et al., 2004). are generated to have error distributions identical to Population 4 in 458
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t3:1 Table 3
Simulation results.
t3:2
t3:3 Reliability Efficiency
t3:4 1 2 3 4 5 6 7 8
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t3:5 ZNT SNT MNT ZNS ZNM (S − Z) / Z (M − Z) / Z

t3:6 Simulation 1
t3:7 Data from Parzen–Rosenblut model 0.895 1.000 0.960 0.007 0.096 12.989 0.258
t3:8 Simulation 2
t3:9 Data from ZIP model 0.968 1.000 1.000 0.008 0.030 0.342 0.188
t3:10 Simulation 3
t3:11 Data from Neter Loebbecke population 4 0.984 1.000 1.000 0.009 0.044 0.343 0.182
t3:12 |{z} |{z} |{z}
t3:13 Proportion of 1000 simulations Average over 1000 simulations

Z: ZIP bound, S: Stringer bound, M: Multinomial-Dirichlet bound, T: True value.

t3:14 The rows show the results from three separate simulations. Columns 2–6 show the frequency in which one bound is larger than the true value or another bound. Columns 7 and 8
t3:15 show the relative size of the other bounds compared to the ZIP bound.

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459 Neter and Loebbecke (1975). This population consists of 4033 An estimate of the covariance matrix of β0̂ and β1̂ is the negative 514
460 accounts receivables of a large manufacturer. Neter and Loebbecke inverse Hessian matrix. The Hessian matrix is 515
461 (1975) have made major contributions in analyzing the error
0 n n 1
462 characteristics of accounting populations, and their populations are β + β1 πi β0 + β1 πi
463 often used to represent accounting populations (Chan, 1988; B i∑ bi e 0 ∑ bi πi e C
B =1 i=1 C
464 Smieliauskas, 1986a; Frost & Tamura, 1982). From Column 2, the ZIP B n C
@ β + β1 πi
n
2 β0 + β1 πi
A
465 bound is reliable as its 95% upper bound exceeds the true error value ∑ bi πi e 0 ∑ bi πi e
i=1 i=1
466 98.4% of the times. From Columns 5 and 6, the frequency in which the
467 ZIP bound is larger than the other two bounds is very small (0.9% and
whose elements are all positive values. And the negative inverse 516
517
468 4.4%, respectively), denoting ZIP's greater efficiency. Columns 7–8
Hessian matrix is 518
469 show the magnitude of the Stringer bound is about 34% larger and the
470 Multinomial-Dirichlet bound about 18% larger than the ZIP bound,

−1 a1 c
471 also denoting ZIP's greater efficiency. H =
c a2
472 Summing the simulation studies, results based on a general
473 population without distinct distributions reveal our ZIP method to
where 519
520
474 be very efficient, although with slightly lower reliability than the
475 theoretical level. However, based on populations similar to or taken

OF
n
2 β0 + β1 πi
476 from accounting error populations, the ZIP bound is reliable and more ∑ bi πi e
i=1
477 efficient than the Stringer and Multinomial-Dirichlet bounds. The ZIP a1 = n n n
β0 + β1 πi 2 β0 + β1 πi β0 + β1 πi 2
478 overall performance seems very good, in light of Swinamer et al. ∑ bi e ∑ bi πi e −ð ∑ bi πi e Þ
479 (2004), who use extensive simulations on both real and simulated i=1 i=1 i=1

480 data to compare 14 bounds, and find no single method to be superior 521
522

RO
n
481 in terms of both reliability and efficiency. Given the trade-off between ∑ bi πi e
β0 + β1 πi

482 reliability and efficiency in the state-of-the-art, our ZIP method is very c= i=1
n n n
483 promising as an MUS estimation technique. ð ∑ bi πi e
β0 + β1 πi 2
Þ − ∑ bi e
β0 + β1 πi
∑ bi πi e
2 β0 + β1 πi

i=1 i=1 i=1

484 6. Conclusion 523
524

485
486
487
We propose a method that improves upon the common MUS
estimation approach. MUS estimation as commonly practiced by
accounting auditors does not explicitly recognize that a total
DP a2 = n
∑ bi e
i=1
β0 + β1 πi
n
∑ bi πi e
i=1
i=1
n
∑ bi e
β0 + β1 πi

2 β0 + β1 πi
n
−ð ∑ bi πi e
i=1
β0 + β1 πi 2
Þ
:

488 population of account errors typically consists of multiple distinct

525
526
489 distributions. As a result, this common approach often leads to very
First, we take 527
TE
490 large error estimations and very conservative auditor's decisions on
491 the fairness of client financial statement. For conservatism auditors
 !

should want large estimations of errors and upper bounds, however β0 + r0i ind β̃0 a1 c
e Normalf β̃ ; g
492
β1 + r0i c a2
493 estimations under common practice are too conservative, and 1

494 excessive conservatism has its own problems. Our method, based on
EC

495 Zero-Inflation Poisson distribution, addresses the above shortcoming. where a1, a2, and c are the elements in the previous matrix H− 1. This 528
529
496 We discuss our method and show that for data similar to accounting is a standard approximation and is typically used in generalized 530
497 populations, our bound is reliable and more efficient than common regression model. 531
498 MUS practice, so we would recommend our bound to accounting Next, we show how to construct the confidence interval. 532
499 auditors. For other populations, our method may be slightly less We can see that ln λi = (β0 + r0i) + (β1 + r1i) πi also follows the 533
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500 reliable than theoretically desired, and future research should seek to normal distribution and we can obtain its mean and variance easily, 534
501 improve the method for these populations.
2
ln λi iid
e Normalðβ̃0 + πi β̃1 ; 1 = a1 + πi = a2 + 2πi = cÞ:
Q4 502 7. Uncited reference
535
536
As we discussed earlier, we know that di follows the Poisson 537
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503 Silverman, 1986 β0 + β1 πi

distribution di j λi ind
e Poissonðbi e Þ. This is equivalent to di jλi ind
e 538
lnλi
Poissonðe bi Þ. 539
504 Acknowledgement
We can then draw Z1, Z2, …, ZN, N independent standard normal 540
random variables, and compute 541
505 The authors acknowledge the helpful comments from two
anonymous reviewers and the Journal's associate editor. Any errors qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
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506
507 are the authors' responsibility. lnðλi Þ = ðβ̃0 + πi β̃1 Þ + Zi 1 = a1 + π2i = a2 + 2πi = c

508 Appendix A where i = 1, 2, …, N. 542

543
Thus, we can now draw di as a Poisson random variable with 544
509 For the centered model, the log-likelihood function is parameter λ̃i, i = 1, 2, …, N. So these random draws of λ̃1, λ̃2, …, λ̃N are 545
given by 546
n n n
β0 + β1 πi qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
f ðβ0 ; β1 Þ = β0 ∑ di + β1 ∑ πi di − ∑ bi e :
i=1 i=1 i=1 λ̃i = expfðβ̃0 + πi β̃1 Þ + Zi 1 = a1 + π2i = a2 + 2πi = cg

510
511
512 We use a two-dimensional Newton's method to maximize it over where i = 1, 2, …, N. We repeat this process 10,000 times and obtain 547
548
N
513 β0 and β1. Details are omitted. 10,000 values of the overstatement error ∑ di. 549
i=1

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550 Appendix B After we get all the E{Zi|θ,β0,β1} for the sample using Eq. (B.2), we 588
can optimize h(β0, β1, Zi) and calculate a new θ following Eq. (B.1). 589
551 A Zero-Inflated Poisson (ZIP) regression model Then we can start our second iteration. The MLE of β0, β1 and the new 590
θ obtained will be used to calculate new Zis. After that, we optimize 591
552 Now the joint probability density function becomes h(β0, β1, Zi) and calculate a new θ again. These values will be used 592
in the third iteration. We repeat this process until θ, β0, β1 all converge. 593
( β0 + β1 πi )
n β + β1 πi o ðb eβ0 + β1 πi di −bi e
Þ e Letting H be the Hessian matrix, too cumbersome to present, we take 594
−b e 0
Lðθ; β0 ; β1 Þ = ∏ θ + ð1−θÞe i ∏ ð1−θÞ i
D D
di !
0 1 80 1 9
– θ + r2i >
< β̃0 >
=
ind
554
553 where D is the set of accounts with where di = 0; D is the set of @ β0 + r0i A e Normal B C
@ β̃1 A; −H
−1
:
555 accounts with where di ≠ 0. >
: >
;
β1 + r1i θ̃
556 To apply the Expectation Maximization (EM) algorithm, we
557 introduce a new variable Zi, which is defined as 595
596
We draw a random sample of (β0 +r0i, β1 +r1i, θ+r2i) from the 597
Zi = 1; if di is pure zero; normal density i=1,2,⋯, N. Then we construct λi as λi =eβ0 + r01 + (β1 +r1i)πi 598
Zi = 0; else and we have Zi ~Bernoulli (θ+r2i). Now, if Zi =1, di =0; if Zi =0, we draw 599
N n N

OF
559
558 Thus, we have di from Poisson(biλi). Then we calculate ∑ di and ∑ di + ∑ di to 600
i=1 i=1 i=n + 1
obtain D for the predicted or the projected estimator. We repeat this 601
pðdi = 0j Zi = 1Þ = 1
process 10,000 times and obtain 10,000 values of the overstatement error 602
561
560 N
pðdi ≠0 j Zi = 1Þ = 0: ∑di . 603

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i=1
563
562
564 We can obtain the Hessian matrix of θ ̂, β̂0,1 to maximize the
565 likelihood function; it is more convenient to use the EM algorithm. By References 604
566 EM algorithm, optimizing the joint probability density function above Akresh, A. D., & Tatum, K. W. (1988). Audit sampling — Dealing with the problems. The 605
567 is equivalent to optimizing the following quantity: saga of SAS No. 39 and how firms are handling its requirements. Journal of 606
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569
568
gðθ; Z Þhðβ0 ; β1 ; Z Þ

where
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609
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612
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∑ Zi n−∑ Zi Sampling. New York: AICPA. 614
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˜
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570 Bickel, P. J. (1992). Inference and auditing: The Stringer bound. International Statistical 617
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572 and the MLE of β0 and β1 can be obtained by Newton's method in empirical tests of a decomposition approach. Journal of Accounting, Auditing & 622
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576 into two parts, the first two factors and the last two factors. We Elder, R. J., & Allen, R. D. (1998). An empirical investigation of the auditor's decision to 626
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RR

578 and solve for θ. Thus we have ˜

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∑ Zi n−∑ Zi Frost, P., & Tamura, H. (1982). Jacknifed ratio estimation in statistical auditing. Journal of 631
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CO

˜ D D Gelman, A., Carlin, J. B., Stern, H. S., & Rubin, D. B. (2004). Bayesian data analysis, 2nd 635
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∂ D D methods of evaluating dollar-unit samples. Accounting Review, 62(3), 455−480.
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∂θ ˜ θ 1−θ Guy, D. M., & Carmichael, D. R. (1986). Audit sampling: An introduction to statistical 639
sampling in auditing, 2nd edition, New York: John Wiley & Sons Inc. 640
580
579 Therefore, Hall, T. W., Hunton, J. E., & Pierce, B. J. (2000). The use of and selection biases associated with 641
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642
! Hall, T. W., Hunton, J. E., & Pierce, B. J. (2002). Sampling practices of auditors in public 643
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D θ
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646
Hitzig, N. (1995). Audit sampling: A survey of current practice. CPA Journal, 65(7), 54−58. 647
Kaplan, R. S. (1973). Statistical sampling in auditing with auxiliary information 648
582
581 And the conditional expectation of Zi, estimators. Journal of Accounting Research, 11(2), 238−258. 649
Kaplan, R. S. (1975). Sample size computations for dollar-unit sampling. Journal of 650
θ Accounting Research, 13(3), 126−133. 651
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584
583 Leitch, R. A., Neter, J., Plante, R., & Sinha, P. (1982). Modified multinomial bounds for 654
585 First iteration, we use θ = 0.5 as a random starting value. For β0, β1, larger number of errors in audits. Accounting Review, 57(2), 384−400. 655
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587 values, i.e., β̃0 = −5.71, β1̃ = − 0.22. unit sampling. Journal of Accounting Research, 22(2), 570−587. 658

Please cite this article as: Higgins, H. N., & Nandram, B., Monetary unit sampling: Improving estimation of the total audit error, Advances in
Accounting, incorporating Advances in International Accounting (2009), doi:10.1016/j.adiac.2009.06.001
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Please cite this article as: Higgins, H. N., & Nandram, B., Monetary unit sampling: Improving estimation of the total audit error, Advances in
Accounting, incorporating Advances in International Accounting (2009), doi:10.1016/j.adiac.2009.06.001