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CHAPTER 19

AUDIT SAMPLING FOR SUBSTANTIVE TESTS

I. Review Questions

1. An incorrect acceptance decision directly impairs the effectiveness of an audit.


Auditors wrap up the work and the material misstatement appears in the
financial statements.

An incorrect rejection decision impairs the efficiency of an audit. Further


investigation of the cause and amount of misstatement provides a chance to
reverse the initial decision error.

2. The two methods of projecting the known misstatement to the population are the
average difference method and the ratio method. Refer to Chapter 19 for
formula expressions of each.

3. The important thing is to audit all the sample units. You cannot simply discard
one that is hard to audit in favor of adding to the sample a customer whose
balance is easy to audit. This action might bias the sample. If considering the
entire balance to be misstated will not alter your evaluation conclusion, then you
do not need to work on it any more. Your evaluation conclusion might be to
accept the book value, as long as the account counted in error is not big enough
to change the conclusion. Your evaluation conclusion might already be to reject
the book value, and considering another account to be misstated just reinforces
the decision.

If considering the entire balance to be misstated would change an acceptance


evaluation to a rejection evaluation, you need to do something about it. Since
the example seems to describe a dead end, you may need to select more
accounts (expand the sample) and perform the procedures on them (excluding
confirmation) and reevaluate the results.

4. Two main reasons for stratifying a population when sampling for variables
(peso) measurement:
a. Some units may be individually significant (e.g., large) and taking sampling
risk with respect to them is not a good idea.
b. Auditors may want to achieve audit coverage of a large proportion of pesos
in the balance by choosing the largest units (a protective sampling
objective, which is closely related to avoiding sampling risk).
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5. The tolerable misstatement (judged for the audit of a particular account balance)
must be less than the monetary misstatement considered material to the overall
financial statements. Also, the aggregation of multiple tolerable misstatement
amounts for several different balances under audit must be equal to or less than
the amount of monetary misstatement considered material to the overall
statements.

6. The appropriate general set of objectives is the objective(s) of obtaining


evidence about each of the client’s assertions in the financial balance. In
general, the assertions are about:
Existence (and cutoff)
Occurrence (and cutoff)
Completeness (and cutoff)
Rights and obligations (ownership, owership)
Valuation
Measurement
Presentation and disclosure

7. Influence on sample size:

Sample Size Relationships: Audit of Account Balances

Predetermined Sample Size Will Be:


High Rate or Low Rate or Sample Size
Sample Size Influence Large Amount Small Amount Relation
1. Risk of incorrect Smaller Larger Inverse
acceptance
2. Risk of incorrect Smaller Larger Inverse
rejection
3. Tolerable Smaller Larger Inverse
misstatement
4. Expected Larger Smaller Direct
misstatement
5. Population Larger Smaller Direct
variability
6. Population size Larger Smaller Direct

8. The three basic steps in quantitative evaluation are these:


1. Figure the total amount of actual misstatement found in the sample. This
amount is called the known misstatement.
2. Project the known misstatement to the population. The projected amount is
called the likely misstatement.
Audit Sampling for Substantive Tests 19-3
3. Compare the likely misstatement (also called the projected misstatement) to
the tolerable misstatement for the account, and consider the
a. Risk of incorrect acceptance that likely misstatement could be less than
tolerable misstatement even though the actual misstatement in the
population is greater, or the
b. Risk of incorrect acceptance that likely misstatement could be greater
than tolerable misstatement even though the actual misstatement in the
population is smaller.

9. Nonstatistical measurements described in Chapter 19 (page 718) leave only one


avenue for “accounting for further misstatement”: Apply experience and
professional judgment to decide if further misstatement could be large enough to
prevent an acceptance decision. If the projected likely misstatement is a great
deal less than the amount considered material, an auditor could judge that
further misstatement, if known, would not affect acceptance. If projected likely
misstatement is close to the amount considered material, maybe acceptance is
not warranted.

10. Account balances also can be audited, at least in part, at an interim date. When
account balance audit work is done before the company’s year-end date, auditors
must extend the interim-date audit conclusion to the balance-sheet date. The
process of extending the audit conclusion amounts to nothing more (and nothing
less) than performing substantive-purpose audit procedures on the transactions
in the remaining period and on the year-end balance to produce sufficient
competent evidence for a decision about the year-end balance.

Additional considerations include:


a. If the company’s internal control over transactions that produce the balance
under audit are not particularly strong, you should time the substantive
detail work at year-end instead of at interim.
b. If control risk is high, then the substantive work on the remaining period
will need to be extensive.
c. If rapidly changing business conditions might predispose managers to
misstate the accounts (try to slip one by the auditors), the work should be
timed at year-end. In most cases, careful scanning of transactions and
analytical review comparisons should be performed on transactions that
occur after the interim date.

As an example, accounts receivable confirmation can be done at an interim date.


Subsequently, efforts must be made to ascertain whether controls continue to be
strong. You must scan the transactions of the remaining period, audit any new
large balances, and update work on collectibility, especially with analysis of
cash received after the year-end.
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11. Classical variables sampling estimates the value of a population by calculating
the mean and standard deviation of a sample and imputing the results to the
population. Probability proportional to size sampling uses the results of
sampling to calculate an estimated upper error limit and compares this with a
preset tolerable error limit. Although used for substantive testing purposes, PPS
sampling is actually a variation for attribute sampling.

12. Detection (or beta) risk affects sample size inversely for substantive testing
purposes. That is, the higher the acceptable detection risk, the smaller the
sample size; and the lower the acceptable detection risk, the larger the sample
size.

13. Precision is the range + – within which the true answer most likely falls. It is
set by the auditor as a function of materiality and those levels of beta and alpha
risk deemed acceptable. Reliability is the likelihood that the sample range
contains the true value. Also referred to as the confidence level, reliability is set
by the auditor on the basis of overall audit risk.

14. PPS sampling is restricted to populations for which the auditor suspects a few
errors of overstatement only.

15. Several statistical software packages are available to facilitate audit sampling
applications. In addition to calculating sample size and evaluating sample
results, these packages can also assist in the following sampling areas:
a. Stratify populations for sampling purposes;
b. Generate random numbers to facilitate sample selection;
c. Draw the sample, given computerized data bases.

II. Multiple Choice Questions

1. b 5. c 9. d 13. a 17. d
2. a 6. b 10. a 14. a 18. b
3. c&d 7. b 11. a 15. c 19. c
4. b 8. d 12. c 16. d 20. d

Supporting Computations:
Audited Value 47,520 490,000 x 0.99 = 485,100
3. c. Book Value 48,000 = 0.99 ; 490,000 – 485,100 = P4,900

P480
d. 120 = P4

1,200 x P4 = P4,800
P 17,500
P500,000
Audit Sampling for Substantive Tests 19-5
7. = 3.5%

P450,000 x 3.5% = P157,500


III. Comprehensive Cases

Case 1. a. Alpha risk is the risk of rejecting a population that is essentially correct.
Beta risk is the risk of accepting a population that is materially incorrect.
Alpha risk affects audit efficiency because overauditing results from
incorrectly rejecting a population. Beta risk impacts audit effectiveness
because underauditng results from incorrectly accepting a population.
Collectively, alpha and beta risk comprise sampling risk, defined as the
probability that the auditor will draw erroneous conclusions about a
population.

b. Attention to, and quantification of, alpha and beta risk assist the auditor in
applying an audit risk approach to substantive testing. During the audit
planning stage, the auditor identifies areas of high audit risk and sets
detection (beta) risk low for these areas. The result is that more substantive
testing is devoted to the high risk areas relative to the lower risk areas. This
approach enhances both audit efficiency and audit effectiveness.

c. Because it is closely related to the basis for the auditor’s opinion, alpha risk
is usually set equal to overall audit risk. Beta risk is set on the basis of the
auditor’s evaluation of inherent risk and control risk. The greater these risk
factors, as determined by the auditor during the audit planning stages, the
lower the beta risk set by the auditor. The lower the acceptable beta risk,
the larger the sample sizes for substantive testing purposes. Alpha and beta
risk, therefore, provide the necessary link between audit risk analysis and
substantive audit testing.

Case 2. a. (1) Mean-per-unit estimates the total value of a population by (1)


using the sample mean as an estimate of the true population mean, and
(2) extending this estimated population mean by the number of items in
the population. The computations are as follows:

(1) Estimated population mean =

P582,000 / 200 lots = P2,910 per lot

(2) Estimated total value =

P2,910 per lot x 2,000 lots = P5,820,000

(2) Ratio estimation estimates total population value by (1) using the ratio
of the sample audited values to book values as an estimate of the ratio
19-6 Solutions Manual - Principles of Auditing and Other Assurance Services
of population audited value to book value, and (2) applying the
estimated ratio to the population book value. The computations are as
follows:
(1) Estimated ratio of audited to book value =

P582,000 / P600,000 = 97%

(2) Estimated total value =

97% x P5,900,000 = P5,723,000

(3) Difference estimation estimates total population values by (1) using the
average difference between the audited and book values of sample
items as an estimate of the average difference for all population items,
(2) extending the estimated average difference by the number of items
in the population, and (3) using the resulting estimate of the total
difference between audited and book value to compute the estimated
total value. The computations are as follows:

(1) Estimated average difference in audit and book values:

(P582,000 - P600,000) / 200 lots = - P90 per lot

(2) Estimated total difference =

- P90 per lot x 2,000 lots = - P180,000

(3) Estimated total value =

P5,900,000 - P180,000 = P5,720,000

b. The sample contains an element of sampling error with respect to the


average peso value of production lots. The mean book value of the
population is P2,950 (P5,900,000 / 2,000 lots), while the mean book value
in the sample is P3,000 (P600,000 / 200 lots). Mean-per-unit estimation
uses the mean value of the sample as the basis for estimating total value.
Thus, if the sample contains a disproportionate number of higher (or lower)
priced items, this sampling error will affect the estimate of the total
population value.

The estimate of total value developed in ratio estimation is based upon the
ratio of audited values to book values, rather than upon mean peso value. If
this ratio has no tendency to vary with the peso value of the lot, the estimate
of total value is not affected by the mean value of items in the sample.
However, sampling error may still be present if the sample lots are not
Audit Sampling for Substantive Tests 19-7
representative of the population with respect to the ratio of audited values
to book values.

Case 3. The auditors would project the misstatement found in the sample to the
population using either the ratio or difference approach. The ratio approach
would result in a projected misstatement of P65,500. This may be computed by
first calculating the ratio of the audited to book value as 1.0131 [P23,100 /
P22,800 (since there is a net understatement of P300, the audited value is
P23,100)] and estimating the audited value of the population as:

1.0131 x P5,000,000 = P5,065,500 (rounded)

The projected misstatement is thus P65,500 under the ratio method.

The difference approach results in an average difference of P1.50 (P300 net


difference divided by 200 items). Multiplying by the 100,000 invoices indicates
a projected misstatement of P62,400 (P1.50 x 41,600).

Case 4. The audit risk (ultimate risk) of material misstatement in the financial
statements (AR) is the product of:
(1) Inherent risk (IR), the risk of material misstatement in an assertion,
assuming there were no related internal controls.
(2) Control risks (CR), the risk of material misstatement occurring in an
assertion, and not being prevented or detected on a timely basis by the
internal control structure.
(3) Detection risk (DR), the risk that the auditors’ procedures will lead them to
conclude an assertion is not materially misstated, when in fact such
misstatement does exist.

In equation form, this relationship is expressed as follows:

AR = IR x CR x DR

This equation may be restated to solve for the allowable detection risk as
follows:

DR = AR / (CR x IR)

Using the risk levels set forth in the problem, the allowable risk of reliance upon
substantive tests is computed as illustrated below:

DR = .02 / (.2 x .5) = .20

Thus the risk of incorrect acceptance should be limited to 20 percent if the


auditors are to achieve their objective of holding audit risk to 2 percent.
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Case 5. a. (1) Required sample size is calculated as follows:

Recorded amount of population


x Reliability factor
Sample size = Tolerable misstatement –
(Expected misstatement x Expansion factor)

P500,000 x 3
Sample size = P25,000 – (P2,000 x 1.6) = 69

Note: The reliability factor is from the zero misstatements row of the PPS sampling
table given in the case.

(2) The sampling interval is calculated simply by dividing the book value
of receivables by the sample size, as follows:

Sampling interval = Recorded receivables / Sample size


= P500,000 / 69 = P7,246

b. The results may be evaluated as follows:

(1) Projected misstatement =

Book Audite Taintin Samplin Projected


Valu d Misstatemen g% g Misstatemen
e Value t Interval t
P 50 P 47 P 3 6% P7,246 P 435
800 760 40 5% 7,246 362
8,500 8,100 400 NA NA 400
P1,197

(2) Basic precision = Reliability factor x Sampling interval

= 3.0 x P7,246 = P21,738

(3) Incremental allowance =

Reliability Projected Incremental


Factor Incremen (Increment – 1) Misstatement Allowance
Audit Sampling for Substantive Tests 19-9
3.00
4.75 1.75 .75 P435 P326
6.30 1.55 .55 362 199
P525

(4) Upper limit on misstatement = P1,197 + P21,738 + P525

= P23,460

NOTES:
Projected misstatement
(a) Tainting percentages are calculated as the difference between book
and audited value divided by book value (e.g., (P50 – P47) / P50 =
6%).
(b) No tainting percentage is calculated for items in excess of the
sample interval and the actual misstatement is extended to
projected misstatement (as for the third error).

Basic precision is always the reliability factor for zero misstatements


multiplied times the sampling interval.

Incremental allowance
(a) Reliability factors are read from the PPS sampling table given in
the case, starting at zero misstatements.
(b) “Increment – 1” is the difference in the two adjacent reliability
factors minus 1 (e.g., 4.75 – 3.00 – 1.00 = .75).
(c) Misstatements in excess of the sampling interval are not
considered in the incremental allowance. This is because the
nature of the process requires that all items in excess of the
sampling interval be included in the sample – therefore no
allowance for items not in the sample is necessary.

c. The results obtained in part b would indicate that the auditors may accept
the population as not containing a tolerable misstatement at the 5 percent
level of risk of incorrect acceptance. The auditors would also consider the
results obtained in conjunction with other audit tests.

Case 6. a. The advantages of probability-proportional-to-size (PPS) sampling


over classical variables sampling are as follows:
• PPS sampling is generally easier to use than classical variables
sampling.
• The size of a PPS sample is not based on the estimated variation of
audited amounts.
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• PPS sampling automatically results in a stratified sample.
• Individually significant items are automatically identified.
• If no misstatements are expected, PPS sampling will usually result
in a smaller sample size than classical variables sampling.
• A PPS sample can be easily designed and sample selection can
begin before the complete population is available.

b. Sampling interval = Recorded receivables / Sample size

= P300,000 / 60 = P5,000

c. Projected misstatement =

Book Audite Taintin Samplin Projected


Valu d Misstatemen g% g Misstatemen
e Value t Interval t
P 400 P 320 P 80 20% P1,000 P 200
500 0 500 100% 1,000 1,000
3,000 2,500 NA NA NA 500
P1,700

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