Audit Exam 3

What is CH. 8 about?

Can I trust the controls?

Goal = Determine whether a control is operating effectively

What is CH.9 about?

Can I trust the account balance?

Goal = Determine whether an account balance is fairly stated

Why do auditors use sampling?

Auditors cannot efficiently test every transaction.

Sampling allows auditors to:

• Save time

• Save cost

• Obtain sufficient evidence

• Reach conclusions about the entire population

Remember:

Auditors provide reasonable assurance, not absolute assurance

Audit Sampling

Testing less than 100% of a population and using the results to draw conclusions about the entire population

Sampling Risk

The possibility that the sample is not representative of the population

Risk of Incorrect Rejection (Type I Error)

The auditor concludes something is wrong when it is actually okay.

Example:

• Auditor concludes a control is ineffective.

• Control actually works.

Result:

• More audit work than necessary.

• Inefficient audit.

AKA False Alarm

Risk of Incorrect Acceptance (Type II Error)

Auditor concludes everything is okay when it is actually not.

Example:

• Auditor concludes control is effective.

• Control actually fails.

Result:

• Auditor gathers too little evidence.

• Material misstatements may go undetected.

AKA Dangerous Error

Which risk worries auditors more?

Risk of Incorrect Acceptance (Type II).

Why?

Because the auditor may issue an opinion on materially misstated financial statements

What is Confidence Level?

The level of assurance the auditor wants from the sample.

Higher confidence =

• More assurance

• Less sampling risk

• Larger sample size

What is the relationship between confidence level and sample size?

Direct relationship.

Higher confidence → Higher sample size

Lower confidence → Lower sample size

More confidence requires more evidence

Tolerable Deviation Rate

Maximum amount a control can fail and still be considered effective.

Question being answered:

"How much control failure am I willing to accept?"

Expected Population Deviation Rate

The amount of control failure the auditor expects to find before testing begins.

Based on:

• Prior audits

• Risk assessment

• Experience

Tolerable Misstatement

Maximum dollar misstatement the auditor is willing to accept and still consider the account fairly stated.

Question being answered:

"How wrong can this account be before it becomes materially misstated?"

Expected Misstatement

The amount of error the auditor expects exists in the account balance before testing begins.

Based on:

• Prior audits

• Risk assessments

• Pilot samples

• Control testing results

Attribute Sampling

A statistical sampling method used primarily for testing controls.

It estimates:

"What percentage of transactions failed the control?"

Deviation

A failure of a control.

Examples:

• Missing approval signature

• Unauthorized transaction

• Incorrect pricing review

Means the control did not operate as intended.

Sample Deviation Rate

The auditor's best estimate of the population deviation rate.

Represents:

"How often did the control fail in my sample?"

Computed Upper Deviation Rate (CUDR)

Sample Deviation Rate + Allowance for Sampling Risk

"The highest likely deviation rate in the population."

How does the auditor determine whether a control is effective?

Compare:

Computed Upper Deviation Rate (CUDR) to Tolerable Deviation Rate

If: CUDR ≤ TDR = Control is effective.

If: CUDR > TDR = Control is ineffective

Monetary-Unit Sampling (MUS)

A statistical sampling method used to test account balances.

Instead of estimating control failures, it estimates dollar misstatements.

Think:

Attribute Sampling = Control effectiveness

MUS = Account balance fairness

Why do auditors like MUS?

Because:

• Larger dollar balances are more likely to be selected.

• It works well when few misstatements are expected.

• It focuses on overstatement risk.

What accounts are commonly tested with MUS?

Accounts where overstatement is a concern:

• Accounts Receivable

• Loans Receivable

• Investment Securities

• Inventory

Why is MUS naturally biased toward larger balances?

Because every dollar has an equal chance of selection.

A larger account contains more dollars.

More dollars = greater chance of selection

What is the sampling unit in MUS?

An individual dollar.

Every dollar in the population has an equal chance of being selected

Logical Unit

The actual account, invoice, or customer balance containing the selected dollar.

The auditor examines the logical unit, not the individual dollar

Projected Misstatement

The auditor's estimate of the total misstatement in the population based on sample results.

Think:

"Best estimate of likely population error."

Upper Misstatement Limit (UML)

Projected Misstatement + Allowance for Sampling Risk

“Worst-case likely misstatement”

Basic Precision

An allowance for sampling risk even when no errors are found.

Why?

Because the auditor only tested a sample and cannot assume the rest of the population is perfect

How does the auditor conclude whether an account is fairly stated?

Compare:

Upper Misstatement Limit (UML) to Tolerable Misstatement (TM)

If: UML ≤ TM = Account is fairly stated.

If: UML > TM = Account may be materially misstated.

Why does increasing sample size improve audit quality?

Increasing sample size reduces sampling risk and increases confidence that the sample represents the population

Why can't auditors rely solely on audit analytics and technology instead of sampling?

Many audit procedures still require:

• Human judgment

• Physical inspection

• Confirmations

• Observation

• Evaluation of evidence

Technology helps but doesn't eliminate audit sampling

When should auditors test 100% of a population?

When:

• Population contains a few significant items

• Large transactions make up most of the account

• Risk is very high

• Sampling would not provide sufficient evidence

Why is there always an allowance for sampling risk?

Because the auditor never knows for certain whether the sample perfectly represents the population.

Sampling always involves uncertainty

Why is the revenue process so important in auditing?

Revenue affects many major accounts:

• Sales revenue

• Accounts receivable

• Cash

• Allowance for uncollectible accounts

• Bad debt expense

• Sales returns and allowances

Because revenue directly affects profits, management often has incentives to manipulate it. Auditors therefore treat revenue as a high-risk area

Why is revenue recognition considered a significant audit risk?

Auditing standards require auditors to presume there is a risk of material misstatement due to fraud related to revenue recognition.

Managers are often pressured to:

• Meet earnings targets

• Increase stock prices

• Obtain bonuses

• Satisfy lenders

As a result, revenue is one of the most commonly manipulated accounts

What is the core principle of revenue recognition under ASC 606?

Revenue should be recognized when the company transfers promised goods or services to customers in an amount it expects to receive in exchange

Which industries create more revenue-recognition risk?

Industries involving estimates and long-term arrangements:

• Construction

• Defense contracting

• Service contracts

• Installment sales

• Complex software agreements

More judgment = more risk of material misstatement

What fraud schemes are commonly used to overstate revenue?

The textbook and slides highlight:

• Early revenue recognition

• Holding the books open

• Fictitious sales

• Failure to record returns

• Percentage-of-completion fraud

• Related-party transactions

• Overstated receivables

• Liability omission

These are classic exam questions

Channel Stuffing

A company pressures distributors to buy excessive amounts of inventory before period-end to artificially increase current-period sales.

The products are recorded as sales even though demand may not exist.

Red flag: unusually high sales at year-end

Bill-And-Hold Sale

The customer supposedly purchases goods, but the seller keeps possession of them.

Because delivery usually has not occurred, revenue may not be appropriate.

Auditors carefully scrutinize these transactions

Why are related-party sales risky?

Related parties may not negotiate at arm's length.

Transactions can be used to:

• Inflate revenue

• Hide losses

• Shift profits

Auditors give these transactions special attention

What are the major functions in the revenue process?

1. Order entry

2. Credit authorization

3. Shipping

4. Billing

5. Cash receipts

6. Accounts receivable

7. General ledger

Auditors must understand how transactions move through each function

Why is credit authorization important?

It prevents sales to customers who cannot pay.

Without good credit controls:

• Bad debts increase

• A/R may be overstated

• Allowance estimates may be inaccurate

Why is shipping an important control point?

Revenue generally should not be recognized until goods are shipped.

Without shipping evidence:

• Sales may be fictitious

• Revenue may be recognized too early

Shipping documents often provide evidence for occurrence and cutoff

Why is segregation of duties critical in the revenue process?

No one person should be able to:

1. Authorize transactions

2. Handle assets

3. Record transactions

Separating duties reduces opportunities for fraud and concealment

Why should shipping and billing be separated?

If one person controls both:

• Goods could be shipped without recording sales

• Inventory could be stolen

• Unauthorized shipments could occur

Why should cash receipts and accounts receivable functions be separated?

To prevent an employee from:

• Stealing customer payments

• Altering customer accounts

• Hiding theft through write-offs

This is one of the most heavily tested controls in auditing

Lapping

A fraud where an employee steals a customer's payment and covers the theft using payments from other customers.

Example:

• Customer A pays

• Employee steals the cash

• Customer B's payment is applied to Customer A

• Cycle continues

It requires access to both cash receipts and A/R records

What control best prevents lapping?

Segregating:

• Cash receipts

• Accounts receivable

When one person cannot access both, lapping becomes much harder

Why is Occurrence usually the biggest concern for revenue?

Management is more likely to overstate revenue than understate it.

Auditors worry about:

• Fictitious sales

• Premature sales

• Recording revenue before shipment

Occurrence asks:

"Did the sale really happen?"

How do auditors test the Occurrence assertion for sales?

Vouch from:

Sales Journal → Shipping Document → Customer Order

If supporting documents exist, the sale likely occurred

How do auditors test Completeness for sales?

Trace from:

Shipping Documents → Sales Invoice → Sales Journal

This ensures all shipments were recorded as revenue

How do auditors test Cutoff for revenue?

Compare:

• Shipping dates

• Invoice dates

• Journal entry dates
  
  

Goal:

Ensure sales are recorded in the proper accounting period

Why are analytical procedures useful in revenue auditing?

They can identify unusual trends indicating:

• Fictitious sales

• Unrecorded sales

• Bad debt issues

• Pricing changes

• Channel stuffing
  
  

Analytical procedures are often an efficient source of evidence

Why might auditors compare gross profit percentages to prior years?

Unexpected increases or decreases may indicate:

• Revenue misstatements

• Inventory misstatements

• Pricing changes

• Fraudulent reporting
  
  

Gross profit trends are powerful fraud indicators

Why analyze days outstanding in accounts receivable?

It helps determine whether receivables are collectible.

Large increases may indicate:

• Collection problems

• Understated bad debts

• Overstated accounts receivable

Why are A/R confirmations considered strong audit evidence?

Because the information comes directly from an independent third party.

Third-party evidence is generally more reliable than evidence produced internally

Which assertion is primarily tested by A/R confirmations?

The customer confirms that the receivable is real and owed
Primary: Existence

Secondary: Cutoff, completeness, rights & obligations

What is a positive confirmation?

The customer must respond whether they agree or disagree.

Response is always required.

Provides stronger evidence

What is a negative confirmation?

The customer only responds if they disagree.

Nonresponse is assumed to mean agreement.

Provides weaker evidence

When should positive confirmations be used?

When:

• Balances are large

• Risk is high

• Errors are expected

Auditors want direct customer responses

Why are negative confirmations less reliable?

Because nonresponse could mean:

• Customer agrees OR

• Customer ignored the request

The auditor cannot know which is true

What happens when a customer does not respond to a positive confirmation?

Auditors must perform alternative procedures to establish the existence and valuation of the accounts receivable

Nonresponse does not eliminate the need for evidence

What alternative procedures are used when confirmations are not returned?

1. Examine subsequent cash receipts (payments made by the customer after year-end)

2. Inspect shipping documentation (bills of lading / proof of delivery)

3. Examine customer orders

4. Review supporting correspondence

Goal:

Obtain evidence that the receivable exists and is collectible

What is the overall purpose of Chapter 17?

Focuses on what auditors do after completing testing of accounts and controls but before issuing the audit report.

The auditor must determine:

• Is sufficient evidence obtained?

• Are there contingent liabilities?

• Were there subsequent events?

• Can the client continue as a going concern?

• Are disclosures complete?

• Is the audit report appropriate?

Contingent Liability

A potential obligation arising from past events where the final outcome depends on a future event.

Key idea:

Something may happen in the future that creates a loss, but uncertainty still exists at year-end

What are common examples of contingent liabilities?

• Pending lawsuits

• Threatened litigation

• Income tax disputes

• Product warranties

• Regulatory fines

• Guarantees of another party's debt

• Agreements to repurchase receivables

What are the three likelihood categories for contingencies?

Probable

Future event is likely to occur.

Reasonably Possible

More than remote but less than likely.

Remote

Very small chance of occurring.

These categories determine accounting treatment

When is a contingent liability accrued (recorded/change numbers)?

The company records a liability and expense when:

1. Loss is probable

2. Loss can be reasonably estimated

MUST BE BOTH

This affects both the balance sheet and income statement

When is a contingent liability DISCLOSE (write a note) but NOT ACCRUE (change the numbers)

When:

• The loss is reasonably possible, OR

  • "It's a Maybe"

• The amount cannot be reasonably estimated

  • “"It's Likely, but We Have No Idea How Much"

The event is disclosed in the footnotes but not recorded as a liability.

When is neither disclosure nor accrual needed?

When the contingency is remote.

The chance of loss is so small that GAAP generally does not require recognition or disclosure

What procedures do auditors use to identify contingent liabilities?

• Read board minutes

• Review contracts

• Review loan agreements

• Inspect leases

• Review tax returns and IRS reports

• Confirm guarantees with lenders

• Inspect legal correspondence

Why are board meeting minutes important?

Minutes frequently discuss:

• Litigation

• Lawsuits

• Major disputes

• Uncertainties

• Significant transactions

These often reveal contingent liabilities that may not appear elsewhere

What is a letter of audit inquiry?

A letter sent to the company's attorneys to corroborate management's descriptions of litigation, claims, and assessments.

This is the primary source of evidence regarding lawsuits

Why do auditors obtain attorney letters?

To determine

• Existing lawsuits

• Threatened litigation

• Possible claims

• Likelihood of unfavorable outcomes

• Estimated losses

Attorneys provide independent evidence about legal matters

Why is an attorney letter considered strong evidence?

Because it comes from an independent third party who has direct knowledge of the client's legal issues

What is a commitment?

A future obligation arising from a current contract.

Examples:

• Purchase agreements

• Long-term supply contracts

• Fixed-price sales contracts

These are not contingent liabilities because the obligation already exists

Why do auditors review commitments?

Because commitments can create future financial risks and often require financial statement disclosure

What is a subsequent event?

An event occurring:

After the balance sheet date (12/31)

BUT

Before issuance of the financial statements.

Auditors must evaluate whether it affects the financial statements

What are the two categories of subsequent events?

Type I (Recognized)

Condition existed at year-end.

Requires adjustment.

EX: Imagine a customer owed your stand $100 on December 31st, but they were already struggling financially. On January 15th, the customer declares bankruptcy. Because they were already broke before December 31st, you must change your December 31st numbers to record that loss

Type II (Unrecognized)

Condition did not exist at year-end.

Requires disclosure only.
EX: On January 10th, a fire burns down your lemonade stand's storage shed . Your shed was completely fine on December 31st, so you don't change last year's numbers . Instead, you add a note to the report saying: "Note: Our shed burned down on January 10th."

How do you identify a Type I subsequent event?

Ask:

"Did the condition exist on the balance sheet date?"

If yes → Type I.

These events provide additional evidence about an existing condition

Give a Type I Example

Customer bankruptcy shortly after year-end caused by financial problems that already existed before year-end.

The financial statements should be adjusted

How do you identify a Type II subsequent event?

Ask:

"Did the condition arise after year-end?"

If yes → Type II.

Disclosure is normally required, but no adjustment

Give a Type II example

A fire destroys the company's warehouse after year-end.

The condition did not exist on the balance sheet date.

Disclosure required; no adjustment

What procedures help auditors identify subsequent events?

• Read interim financial statements

• Read board minutes

• Examine journals after year-end

• Inquire of management

• Inquire of legal counsel

• Obtain representation letter

What is a management representation letter?

A written document signed by management confirming important representations made during the audit.

Usually signed by:

• CEO

• CFO

Often dated the same date as the auditor's report

Why do auditors obtain a representation letter?

To document that management accepts responsibility for:

• Financial statements

• Internal controls

• Disclosures

• Fraud prevention

• Compliance with laws

What happens if management refuses to provide a representation letter?

This creates a severe scope limitation and normally leads to:

• Disclaimer of opinion, or

• Withdrawal from the engagement

Wh

What does “going concern” mean?

The assumption that the company will remain in business and continue operating in the foreseeable future.

A healthy company is considered a going concern

What is the auditor evaluating in a going concern assessment?

Whether there is substantial doubt that the company can continue operating for one year from the issuance date of the financial statements

“they act like detectives checking if the company is in danger of running out of money and closing down”

What does “substantial doubt” mean?

It is probable the company will be unable to meet its obligations during the next year

What financial indicators may signal going concern problems?

• Recurring losses

• Negative cash flows

• Negative working capital

• Negative net worth

• Current year deficit

• Inability to pay debt

What nonfinancial indicators may signal going concern problems?

• Loan defaults

• Loss of major customers

• Loss of suppliers

• Work stoppages

• Litigation

• Lack of financing

What are the four auditor steps in evaluating going concern?

1) Identify going concern problems

2) Evaluate management's plans

3) Conclude whether substantial doubt remains

4) Evaluate management's disclosures

What are examples of management plans to address going concern issues?

• Sell assets

• Borrow money

• Restructure debt

• Cut expenses

• Raise equity financing

What final procedures must auditors perform before issuing the report?

• Final analytical procedures

• Management representation letter

• Workpaper review

• Evaluate misstatements

• Evaluate disclosures

• Going concern evaluation

• Engagement quality review

Why perform final analytical procedures?

To perform a final "reasonableness" or "smell test" on the financial statements and identify remaining unusual relationships

Why are qualitative materiality factors important?

A small dollar misstatement can still be material if it:

• Changes a loss into profit

• Helps meet earnings targets

• Affects bonuses

• Violates loan covenants

• Involves fraud