- Tests of details of balances are substantive procedures where auditors test individual items that make up account balances to determine if the balances are materially misstated.
- The key aspects of tests of details of balances include defining the population, sampling unit, and tolerable misstatement, specifying the acceptable risk of incorrect acceptance, and estimating potential misstatements in the population. These aspects help determine an appropriate sample size for testing.
- A lower acceptable risk of incorrect acceptance or a higher estimated potential for misstatements in the population will result in a larger required sample size. Effective internal controls or analytical procedures that indicate balances are likely fairly stated allow auditors to relax criteria and potentially reduce sample sizes.
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Original Title
Ch1 part 2 Audit Sampling for tests of details of balance.pptx
- Tests of details of balances are substantive procedures where auditors test individual items that make up account balances to determine if the balances are materially misstated.
- The key aspects of tests of details of balances include defining the population, sampling unit, and tolerable misstatement, specifying the acceptable risk of incorrect acceptance, and estimating potential misstatements in the population. These aspects help determine an appropriate sample size for testing.
- A lower acceptable risk of incorrect acceptance or a higher estimated potential for misstatements in the population will result in a larger required sample size. Effective internal controls or analytical procedures that indicate balances are likely fairly stated allow auditors to relax criteria and potentially reduce sample sizes.
- Tests of details of balances are substantive procedures where auditors test individual items that make up account balances to determine if the balances are materially misstated.
- The key aspects of tests of details of balances include defining the population, sampling unit, and tolerable misstatement, specifying the acceptable risk of incorrect acceptance, and estimating potential misstatements in the population. These aspects help determine an appropriate sample size for testing.
- A lower acceptable risk of incorrect acceptance or a higher estimated potential for misstatements in the population will result in a larger required sample size. Effective internal controls or analytical procedures that indicate balances are likely fairly stated allow auditors to relax criteria and potentially reduce sample sizes.
Tests of details of balance are part of substantive
procedure. Substantive procedures include the
following: Substantive tests of transactions Substantive tests of balances Analytical procedures In substantive tests of transactions, the auditor is concerned about both the effectiveness of internal controls and the monetary correctness of transactions in the accounting system. In tests of details of balances, the concern is determining whether the dollar amount of an account balance is materially misstated Auditing part II for class of 2018 1 Analytical procedures include comparisons of reported amounts with, comparable periods, financial relationships, nonfinancial information, budgets and expected outcomes calculated by auditor. When control risk is lower, auditor can rely more on analytical procedures and less on detailed Substantive tests of transactions and balances. Links for Ch 1 part 2\Examples of substantive tests of balance.doc Auditing part II for class of 2018 2 Though substantive procedures include both analysis and tests of details of balances, analysis is not subject to sampling because analytical procedures are applied to overall balances and financial relationships (to 100% of the items on financial statement).
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Tests of Details of Balance Details of an account balance are the items and transactions that make up the account balance. For example, three customers, Mr. A, Ms. B, and Mrs. C owe the company $50,000, $80,000, and $150,000 respectively, and make up the total accounts receivable balance of $280,000. A test of details for accounts receivable could consist of verifying (testing) the individual customer balances (details making up the total balance). (Note, however, that testing 100% of the accounts does not constitute audit sampling.) Auditing part II for class of 2018 4 Why audit sampling for tests of details of balance? Purpose of audit sampling for tests of details of balance This test is designed to Measure whether dollar amounts of account balances are materially misstated or not. OR Detect material misstatement in an account balance. The test provides results in dollar terms
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Sampling risks related to tests of details of balance 1. Risk of Inappropriate Acceptance (RIA), which results in ineffective audit, which is the most concerned about 2. Risk of Incorrect Rejection (RIR), is risk that leads to too much audit work being done or inefficient audit.
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Links for Ch 1 part 2\illustration of 14 steps.doc 1. State the Objectives of the Audit Test The objective of sampling for tests of details of balances is to determine whether the account balance being audited is fairly stated. 2. Decide Whether Audit Sampling Applies Sampling may not apply in testing some account, (when small balance accounts are ignored, when 100% of large balance accounts are audited-sampling is not applied) For the population in Table 17-1, the auditor may decide to audit only items over $5,000 and ignore all others because the total of the smaller items is immaterial. The auditor may also decide to audit all items above the tolerable amount of say $15,000
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3. Define a Misstatement Because audit sampling for tests of details of balances measures monetary misstatements, a misstatement exists whenever a sample item is misstated. In auditing AR, any client misstatement in a customer balance included in the auditor’s sample is a misstatement.
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4. Define the Population In tests of details of balances, the population is defined as the items making up the recorded dollar population. The recorded population of accounts receivable in Table 17-1 consists of 40 accounts totaling $207,295. The auditor will evaluate whether the recorded population is overstated or understated. Auditing part II for class of 2018 9 …1. Steps in Non-statistical sampling ..4. Define the Population Auditors stratify the population to emphasize certain population items and deemphasize others. Usually, they define each stratum on the basis of the size of recorded dollar values. Such stratum help auditors to emphasize the larger recorded dollar values, eg In most audit sampling situations, including confirming accounts receivable, emphasis is given for larger recorded dollar values Auditing part II for class of 2018 10 Stratum Stratum Number In Dollars in Criteria population Population 1 > $15,000 3 $88,955 2 $5000 - $15,000 10 71,235 3 < $5,000 27 47,105 40 $207,295 There are many alternative ways to stratify this population. One example is to have four strata (make stratum 3 items between $2,000 and $5,000, and add a fourth stratum for items less than $2,000).
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The need to use the right population for each assertion Eg. In testing for existence objective, the recorded dollar population (account balances) constitute the population.
In testing for completeness objective, the
sample should be selected from a different source (eg customers with zero balance) Auditing part II for class of 2018 12 5. Define the Sampling Unit Since for non-statistical audit sampling in tests of details of balances, the sampling unit is almost always the items making up the account balance, the sampling unit will be the customer number. 6. Specify Tolerable Misstatement Why it is needed? Auditors use tolerable misstatement, for determining sample size and evaluating results in non-statistical sampling. Auditing part II for class of 2018 13 How auditors determine the tolerable amount? The auditor starts with a preliminary judgment about materiality and uses that total in deciding tolerable misstatement for each account. For example: -Overall materiality estimated based on estimated after-tax income: $177,000 -Accounts receivable, to be tested, amount to $235,000. Total assets are $3,550,000, Tolerable misstatement for accounts receivable: 235,000/3,550,000 x 177,000=11,717 However, in many cases, such a systematic approach will not be appropriate, and the auditor will have to rely more on qualitative factors to arrive at tolerable misstatement for each balance. The primary basis for materiality decisions is always the auditor’s judgment. Auditing part II for class of 2018 14 7. Specify Acceptable Risk of Incorrect Acceptance (ARIA) ARIA is sampling risk (risk of making incorrect acceptance or risk of making incorrect rejection of an account balance) But auditors focus on risk of incorrect acceptance (Note that ARIA is the equivalent term to ARACR (acceptable risk of assessing control risk too low) for tests of controls and substantive tests of trans actions.) Auditing part II for class of 2018 15 ARIA measures the auditor’s desired assurance for an account balance. For greater assurance in auditing a balance, auditors will set ARIA lower. Like for ARACR, ARIA can be set quantitatively (such as 5% or 10%), or qualitatively (such as low, medium or high).
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How ARIA relates to sample size? There is an inverse relationship between ARIA and required sample size. If, for example, an auditor decides to reduce ARIA from 10% to 5%, the required sample size will increase. Stated differently, if the auditor is less willing to take risk, a larger sample size is needed.
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How ARIA relates to assessed control risk? Assessed control risk in the audit risk model is the major factor that affects auditor's decision regarding the level of ARIA When internal controls are effective, control risk can be reduced, permitting the auditor to increase (relax) ARIA. This, in turn, reduces the sample size required for the test of details of the related account balance.
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Tests of details of balances for monetary misstatements can be reduced if auditors find internal controls effective after assessing control risk and performing tests of controls. If analytical procedures (substantive tests ) indicate that the account balance is likely to be fairly stated, ARIA can be increased/relaxed (sample size can be reduced) .
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8. Estimate Misstatements in the Population The auditor makes this estimate based on the following: Prior experience with the client and by assessing inherent risk, By considering the results of tests of controls, substantive tests of transactions, and analytical procedures already performed. How estimated Misstatements in the Population affects sample size? As the amount of misstatements expected in the population approaches tolerable misstatement, the planned sample size increases. Auditing part II for class of 2018 20 9. Determine the Initial Sample Size When using non-statistical sampling, auditors determine the initial sample size by considering the factors discussed so far. ..\Links\Links for sdb\Factors considered in determining sample size.docLinks for sdb\Factors considered in determining sample size.doc Considering all of these factors requires considerable judgment. Auditors usually make the sample size decision by following guidelines provided by their firm or some other source. Figure 17-2 presents a grid for combining these factors and a formula for computing sample size based on the AICPA Audit Sampling Auditing Guide.Links for sdb\Figure 17-2 Formula for computing sample size in tests of details of balance non statistical method.doc ..\Links\Links for sdb\Figure 17-2 Formula for computing sample size in tests of details of balance non statistical method.doc
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9. Determine the Initial Sample Size When using non-statistical sampling, auditors determine the initial sample size by considering the following factors:Links for Ch 1 part 2\Factors considered in determining sample size.doc Auditing part II for class of 2018 22 Illustration on how to determine sample size Links for Ch 1 part 2\Figure 17-2 Formula for computing sample size in tests of details of balance non statistical method.doc Phase 2: Select the Sample and Perform the Audit Procedures 10. Select the Sample For non-statistical sampling, auditing standards permit the auditor to use any of the selection methods discussed earlier. In selecting the method, consideration should be given for the advantages and disadvantages including the cost
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When stratified sampling method is used, the auditor selects samples independently from each stratum. In our example from Table 17-1, the auditor will select seven sample items from the 10 population items in stratum 2 and six of the 27 items in stratum 3.
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11. Perform the Audit Procedures The auditor applies the appropriate audit procedures (eg. Confirmation ) to each item in the sample to determine whether it contains a misstatement. It is assumed that auditors send the sample of positive confirmations and determine the amount of misstatement in each account confirmed; for non-responses, they use alternative procedures to determine the misstatements. The assumption is that the auditor sends first and second requests for confirmations and performs alternative procedures. Auditing part II for class of 2018 25 Also assume the auditor reaches the following conclusions about the sample after reconciling all timing differences: Dollars Audited Stratum Sample Recorded Audited Client Size Value Value Misstatement 1 3 $88,955 $91,695 $(2,740) 2 7 43,995 43,024 971 3 6 13,105 10,947 2,158 16 $146,055 $145,666 $389
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Phase 3: Evaluating the result 12 & 14. Generalize from the Sample to the Population and Decide the Acceptability of the Population The auditor must generalize from the sample to the population by : 1. Projecting misstatements from the sample results to the population and 2. Considering sampling error and sampling risk (ARIA).
In this example, will the auditor conclude that accounts
receivable is overstated by $389? No.
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Decide the Acceptability of the Population This process involves the computation of a point estimate
Calculating a point estimate.
The point estimate can be calculated in different ways, but a common approach is to assume that misstatements in the unaudited population are proportional to the misstatements in the sample. Calculation must be done for each stratum and then totaled, rather than combining the total misstatements in the sample. In our example, the point estimate of the misstatement is calculated by using a weighted-average method, as shown below:
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Client Misstatement / Recorded Recorded x Value for the = Point estimate of Value of the stratum Misstatement Stratum Sample 1 $ (2,740 )/$88,955 x $ 88,955 = $ (2,740) 2 $ 971 /$43,995 x 71,235 = 1,572 3 $ 2,158 /$13,105 x 47,105 = 7,757 $ 6,589
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What does this point estimate of $6,589 indicate, overstatement/understatement? • The point estimate of the misstatement in the population, $6,589, indicates existence of an overstatement. Can this figure represent overstatement in the population? No The point estimate of $6,589 is based on sample Due to sampling error, the point estimate, by itself, may not be an adequate measure of the population misstatement (it may not exactly measure the misstatement in the population; it may be closer to the misstatement in the population)
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Accept/not accept decision: Population is not accepted when: the auditor concludes that the misstatement in a population exceed the tolerable misstatement (after considering sampling error) Population is accepted when: the auditor concludes that the misstatement in a population may not exceed tolerable misstatement (after considering sampling error) But what factors should auditors consider in determining sampling error (possibility that the misstatement in a population may exceed tolerable misstatement ) in non statistical method? Auditing part II for class of 2018 31 An auditor using non-statistical sampling cannot formally measure sampling error and therefore must subjectively consider the possibility that the true population misstatement exceeds a tolerable amount. Auditors do this by considering: 1. The difference between the point estimate and tolerable misstatement (this is called calculated sampling error) 2. The extent to which items in the population have been audited 100 % 3. Whether misstatements tend to be offsetting or in only one direction 4. The amounts of individual misstatements 5. The sample size
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Consideration of the difference between the point estimate and tolerable misstatement (calculated sampling error) In our example, suppose that tolerable misstatement is $40,000. Calculated sampling error: 40,000- 6589= 33,411, this much greater than the point estimate (larger gap) In that case, the auditor may conclude it is unlikely, that the true population misstatement exceeds the tolerable amount Suppose that tolerable misstatement is $15,000 as before, Calculated sampling error: 15,000- 6589= 8,411 (only $8,411 greater than the point estimate, ( narrow gap) In that case, the auditor will consider other factors since the gap is narrower, there could be a possibility that misstatement in the population could exceed the tolerable misstatement Auditing part II for class of 2018 33 Consideration of the extent to which items in the population have been audited 100 % If the larger items in the population were audited 100% (if 100% of the accounts with larger balances are audited) any unidentified misstatements will be restricted to smaller items.
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Consideration of whether misstatements tend to be offsetting or in only one direction If the misstatements tend to be offsetting and are relatively small in size, the auditor may conclude that the true population misstatement is likely to be less than the tolerable amount.
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Consideration of sample size and individual misstatement amount When sample size is considered large, auditors will be more confident and willing to accept that the true population misstatement is less than tolerable misstatement. If one or more of these other conditions differs, auditors may judge the chance of a misstatement in excess of the tolerable amount to be high and the recorded population unacceptable.
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13. Analyze the Misstatements Auditors should evaluate the nature and cause of each misstatement found in tests of details of balances. Assume when the auditor confirmed accounts receivable, all misstatements are resulted from the client’s failure to record returned goods. The auditor will determine: Why that type of misstatement occurred so often? The implications of the misstatements on other audit areas, The potential impact on the financial statements, and its effect on company operations. The same approach is followed for all misstatements.
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Why auditors analyze the cause of misstatement? Analysis help auditros to decide whether any modification of the audit risk model is needed. In the previous example, if the auditor concluded that the failure to record the returns resulted from a breakdown of internal controls, it might be necessary to reassess control risk. That in turn will probably cause the auditor to reduce ARIA, which will increase planned sample size.
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Action When a Population is Rejected When the auditor concludes that the misstatement in a population may exceed tolerable misstatement after considering sampling error, the population is not considered acceptable. At that point, an auditor has several possible courses of action. 1. Take No Action Until Tests of Other Audit Areas are Completed Ultimately, the auditor must evaluate whether the financial statements taken as a whole are materially misstated. If offsetting misstatements are found in other parts of the audit, such as in inventory, the auditor may conclude that the estimated misstatements in AR are acceptable. - Auditing part II for class of 2018 39 However, before the audit is finalized, the auditor must evaluate whether a misstatement in one account may make the financial statements misleading even if there are offsetting misstatements. 2. Perform Expanded Audit Tests in Specific Areas If an analysis of the misstatements indicates that most of the misstatements are of a specific type, it may be desirable to restrict the additional audit effort to the problem area. For example, if an analysis of the misstatements in confirmations indicates that most of the misstatements result from failure to record sales returns, the auditor can make an extended search of returned goods to make sure that they have been recorded.
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3. Increase the Sample Size When the auditor increases the sample size, sampling error is reduced However, for tests such as AR confirmation and inventory observation, it is often difficult to increase the sample size because of the practical problem of “reopening” those procedures once the initial work is done. By the time the auditor discovers that the sample was not large enough, several weeks have usually passed.
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It is much more common to increase sample size in audit areas other than confirmations and inventory observation, but it is occasionally necessary to do so even for these two areas. When stratified sampling is used, increased samples usually focus on the strata containing larger amounts, unless misstatements appear to be concentrated in some other strata. Auditing part II for class of 2018 42 4. Adjust the Account Balance When the auditor concludes that an account balance is materially misstated, the client may be willing to adjust the book value based on the sample results. In the preceding example, assume the client is willing to reduce book value by the amount of the point estimate ($6,589) to adjust for the estimate of the misstatement. The auditor’s estimate of the misstatement is now zero, but it is still necessary to consider sampling error. Auditing part II for class of 2018 43 4. Adjust the Account Balance Again, assuming a tolerable misstatement of $15,000, the auditor must now assess whether sampling error exceeds $15,000, not the $15,000-$6,589= $8,411 originally considered. If the auditor believes sampling error is $15,000 or less, AR is acceptable after the adjustment. If the auditor believes it is more than $15,000, adjusting the account balance is not a practical option. Auditing part II for class of 2018 44 5. Request the Client to Correct the Population In some cases, the client’s records are so inadequate that a correction of the entire population is required before the audit can be completed. For example, in AR, the client may be asked to correct the AR records and prepare the AR listing again if the auditor concludes that it has significant misstatements. When the client changes the valuation of some items in the population, the results must be audited again.
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6. Refuse to Give an Unqualified Opinion If the auditor believes that there is a reasonable chance that the financial statements are materially misstated, it would be a serious breach of auditing standards to issue an unqualified opinion. For purposes of reporting on internal control, the material misstatement should be considered a potential indicator of a material weakness in internal control over financial reporting.