CHAPTER 18
AUDIT SAMPLING FOR SUBSTANTIVE TESTS
Questions & Answers
1. When auditing account balances, why is an incorrect acceptance decision
considered more serious than an incorrect rejection decision?
Answer:
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. What are the two methods of projecting the known misstatement to the
population?
Answer:
The two methods of projecting the known misstatement to the population
are the average difference method and the ratio method
3. What kind of evidence evaluation consideration should an auditor give to the
peso amount of population unit that cannot be audited?
Answer:
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. What audit purpose is served by stratifying an account balance population
and by removing some units from the population for 100% Audit attention?
Answer:
18-2 Solutions Manual – Public Accountancy Profession
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).
5. What should be the relationship between tolerable misstatement in the
audit of an account balance and the amount of monetary misstatement
considered material to the overall financial statements?
Answer:
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. What general set of audit objectives can you use as a frame of reference to
be specific about the particular objectives for the audit of an account
balance?
Answer:
The appropriate general set of objectives is the objective(s) of obtaining
vidence 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. What is the influence on peso-value variables sample sizes the risk of
incorrect acceptance, the risk of incorrect rejection, the tolerable
misstatement, the population variability and population size?
Answer:
Influence on sample size:
Sample Size Relationships: Audit of Account Balances
Predetermined
Sample Size Will Be:
High Rate Low Rate Sample
Audit Sampling for Substantive Tests 18-3
Sample Size or Large or Small Size
Influence Amount Amount Relation
1. Risk of Smaller Larger Inverse
incorrect
acceptance
2. Risk of Smaller Larger Inverse
incorrect
rejection
3. Tolerable Smaller Larger Inverse
misstateme
nt
4. Expected Larger Smaller Direct
misstateme
nt
5. Population Larger Smaller Direct
variability
6. Population Larger Smaller Direct
size
8. What are the three basic steps in quantitative evaluation of monetary
amount evidence when auditing an account balance?
Answer:
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.
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. The projected likely misstatement may be calculated, yet further
misstatement might remain undetected in the population. How can
auditors take the further misstatement under consideration when
completing the quantitative evaluation of monetary evidence?
Answer:
Non-statistical measurements 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
18-4 Solutions Manual – Public Accountancy Profession
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.What additional considerations are in order when auditors plan to audit
account balances at an interim date several weeks or months before the
client’s fiscal year-end-date?
Answer:
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.
11.Differentiate between classical variables sampling and probability
proportional to size sampling?
Answer:
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.How does detection risk affect sample size in substantive testing?
Audit Sampling for Substantive Tests 18-5
Answer:
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. Define precision and reliability for variables sampling?
Answer:
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.Under What conditions may PPS sampling be used?
Answer:
PPS sampling is restricted to populations for which the auditor suspects few
errors of overstatement only.
15.Name 3 areas of computer application in sampling. How does the computer
facilitate sampling in each of the areas?
Answer:
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.
Multiple Choice Questions/Answers
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
Book Value 48,000 490,000 – 485,100 = P4,900
3. c. = 0.99 ;
P480
120
d. = P4
1,200 x P4 = P4,800
18-6 Solutions Manual – Public Accountancy Profession
P 17,500
P500,000
7. b = 3.5%
P450,000 x 3.5% = P157,500
Cases
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.
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 of population audited value to book value, and (2) applying the
estimated ratio to the population book value. The computations are as
follows:
Audit Sampling for Substantive Tests 18-7
(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 representative of the population with respect to the ratio of
audited values to book values.
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:
18-8 Solutions Manual – Public Accountancy Profession
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).
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.
5. a. (1)Required sample size is calculated as follows:
Recorded amount of population
x Reliability factor
Tolerable misstatement –
Sample size =
(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.
Audit Sampling for Substantive Tests 18-9
(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
Value d Value Misstatemen g% g Misstatemen
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 =
Reliabilit Projected Incrementa
y Factor Incremen (Incremen Misstatemen l Allowance
t t – 1) t
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
18-10 Solutions Manual – Public Accountancy Profession
(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.
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.
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
Value d Value Misstatemen g% g Misstatemen
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
