Auditing Principles and Practices II - Exhaustive Study Guide

  • Chapter 1: Audit Sampling

  • Audit sampling refers to the process of using auditing procedures to test less than 100 %100\,\% of various items in a company’s account balance such that each unit may have an equal opportunity of being selected.

  • Definition: The process of selecting a subset of a population of items for the purpose of making inferences to the whole population.

  • Rationale: Sampling procedures are used because it is not practical to examine every single item in a population.

  • Application: Used to conduct tests of controls and substantive tests.

  • Benefits:

    • Helps auditors complete work within a given period.

    • Detects errors and material misstatements.

  • Representative Sample: A sample in which the characteristics of audit interest are approximately the same as those of the population. Auditors never know for certain if a sample is representative unless they subsequently audit the entire population.

Types of Sampling Errors and Risks

  • Nonsampling Risk: The risk that audit tests do not uncover existing exceptions in the sample.

    • Causes:

    1. Auditor’s failure to recognize exceptions due to exhaustion, boredom, or lack of understanding.

    2. Inappropriate or ineffective audit procedures.

  • Sampling Risk: The risk that an auditor reaches an incorrect conclusion because the sample is not representative of the population. This is an inherent part of testing less than the entire population.

    • Control Methods:

    • Adjusting the sample size.

    • Using an appropriate method of selecting sample items.

Audit Sample Selection Approaches and Methods

  • Selection Approaches:

    • All Item Selection: Examining the entire population.

    • Specific Selection: Selecting items based on specific criteria (e.g., high value or high risk).

    • Audit Sampling: Selecting a representative portion.

  • Statistical vs. Non-statistical Sampling:

    • Statistical Sampling: Uses mathematical rules to quantify (measure) sampling risk in planning and evaluation (e.g., 95 %95\,\% confidence level provides a 5 %5\,\% sampling risk).

    • Advantages: Very accurate, economical, reliable, high suitability for surveys, efficient for large universes.

    • Disadvantages: Inadequacy of samples, potential for bias, difficulty in getting representative samples, requires trained manpower.

    • Non-statistical Sampling: Auditor does not quantify sampling risk; items are selected based on auditor belief of what provides the most useful information. Conclusions are reached on a judgmental basis.

Sample Selection Methods

  • Probabilistic Sample Selection: Each item has a known probability of inclusion (associated with statistical sampling).

    1. Simple Random Sample: All items have an equal chance via random number tables or computer generation.

    2. Systematic Sample: The auditor calculates a sampling interval by dividing the population size by the sample size. The first item is chosen at random.

    3. Probability Proportionate to Size (PPS): Probability of selecting an item is proportional to its recorded amount. Evaluated using monetary unit sampling (MUS), emphasizing large dollar items.

    4. Stratified Sample: Population is divided into sub-populations by size; larger samples are taken from the larger sub-populations.

  • Non-probabilistic Sample Selection: Auditor uses professional judgment.

    1. Directed Sample Selection: Based on judgmental criteria like items most likely to contain misstatements, specific characteristics, or large dollar coverage.

    2. Block Sample Selection: Selecting a block of contiguous items (e.g., all sales transactions for the third week of March). Rarely used because inferences are limited to the block examined. To minimize risk, many blocks should be selected.

    3. Haphazard Sample Selection: Selection without regard to size, source, or characteristics. No structured technique used. Not appropriate for statistical sampling.

Audit Sampling for Exception Rates

  • Exception Rate (Occurrence Rate): The ratio of items containing a specific attribute to the total number of items (e.g., invoices not verified 2 %2\,\% of the time).

  • Types of Exceptions:

    1. Deviations from client’s established controls.

    2. Monetary misstatements in transaction data.

    3. Monetary misstatements in account balance details (requires dollar estimate).

  • Formula: Population Exception Rate=Sample Exception Rate+Sampling Error\text{Population Exception Rate} = \text{Sample Exception Rate} + \text{Sampling Error}

  • Example: A 3 %3\,\% sample exception rate and sampling error of 1 %1\,\% with a sampling risk of 10 %10\,\% means the population exception rate is between 2 %2\,\% and 4 %4\,\% at a 10 %10\,\% risk of being wrong (90 %90\,\% confidence).

Audit Sampling for Tests of Controls

  • Tests of controls determine if internal systems comply with policies, laws, and regulations. They detect control failure rates rather than direct monetary errors.

  • Sampling Risks in Tests of Controls:

    • Risk of Assessing Control Risk Too High: Possibility that sample results cause an assessment of control risk higher than warranted.

    • Risk of Assessing Control Risk Too Low: Possibility that results cause an assessment of control risk lower than warranted. This is more dangerous as it inappropriately reduces substantive testing.

  • Guidelines for ARACR (Acceptable Risk of Assessing Control Risk too low) and TER (Tolerable Exception Rate):

    • Lowest Assessed Control Risk: ARACR is Low; TER is 4 %4\,\%.

    • Moderate Assessed Control Risk: ARACR is Medium; TER is 5 %5\,\%.

    • Higher Assessed Control Risk: ARACR is High; TER is 6 %6\,\%.

    • 100% Assessed Control Risk: ARACR is Not Applicable.

14 Steps to Apply Audit Sampling

  • Phase 1: Plan the Sample

    1. State the objectives of the audit test (e.g., test operating effectiveness of controls).

    2. Decide whether audit sampling applies (not applicable to analytical procedures or some observations).

    3. Define attributes and exception conditions (e.g., attribute: "Credit is approved"; exception: "Lack of initials").

    4. Define the population (the entire set of data to generalize about).

    5. Define the sampling unit (the physical unit corresponding to random numbers, e.g., a sales invoice).

    6. Specify the Tolerable Exception Rate (TER): The maximum rate the auditor permits while still concluding the control is effective. Affected by materiality.

    7. Specify ARACR: The risk the auditor is willing to take of accepting a control as effective when the true rate is higher than TER.

    8. Estimate the Population Exception Rate (EPER): What the auditor expects to find before testing.

    9. Determine the initial sample size (influenced by TER, ARACR, and EPER).

  • Phase 2: Select the Sample and Perform the Tests

    1. Select the sample using probabilistic or non-probabilistic methods.

    2. Perform audit procedures: Examine items and record exceptions.

  • Phase 3: Evaluate the Results

    1. Generalize from sample to population: Calculate Sample Exception Rate (SER) as Number of ExceptionsSample Size\frac{\text{Number of Exceptions}}{\text{Sample Size}}. For non-statistical methods, subtract SER from TER to find the calculated sampling error.

    2. Analyze exceptions: Determine causes like carelessness, misunderstood instructions, or intentional failure.

    3. Decide the acceptability of the population: If TER - SER is too small, follow courses of action like revising TER, expanding sample size, or revising assessed control risk.

Sensitivity of Sample Size to Factors

  • Tests of Controls (Table 1-3):

    • Increase ARACR: Decrease Sample Size.

    • Increase TER: Decrease Sample Size.

    • Increase EPER: Increase Sample Size.

    • Increase Population Size: Increase (Minor effect).

  • Substantive Procedures (Table 1-4):

    • Increase Risk of Incorrect Rejection: Decrease Sample Size.

    • Increase Risk of Incorrect Acceptance: Decrease Sample Size.

    • Increase Tolerable Misstatement: Decrease Sample Size.

    • Increase Standard Deviation: Increase Sample Size.

    • Increase Expected Misstatement: Increase Sample Size.

Audit Sampling for Substantive Tests

  • Conducted to provide evidence on completeness, accuracy, and validity of financial statements.

  • Sampling Risks:

    • Risk of Incorrect Rejection (Alpha Risk): Concluding a balance is materially misstated when it is not.

    • Risk of Incorrect Acceptance (Beta Risk): Concluding a balance is not materially misstated when it is.

  • Attributes Sampling: Estimates the rate of occurrence (used for tests of controls).

  • Variables Sampling: Provides an estimate of a numerical quantity (dollar balance). Common plans include Mean-Per-Unit (MPU), Ratio Estimation, and Difference Estimation.

Mean-Per-Unit (MPU) Illustration

  • Case Data:

    • Population Size (NN) = 100,000100,000 accounts.

    • Book Value = $6,250,000\$6,250,000.

    • Tolerable Misstatement (TMTM) = $364,000\$364,000.

    • Estimated Standard Deviation (σ\sigma) = $15\$15.

    • Incorrect Acceptance Risk (5 %5\,\%) Coefficient (ZaZ_a) = 1.641.64.

    • Incorrect Rejection Risk (4.6 %4.6\,\%) Coefficient (ZrZ_r) = 2.002.00.

  • Step A: Determine Sample Size

    • Planned Allowance for Sampling Risk (ASR):     \text{Planned ASR} = \frac{\text{Tolerable Misstatement}}{1 + \begin{pmatrix} \frac{\text{Incorrect Acceptance Coefficient}}{\text{Incorrect Rejection Coefficient}} \end{pmatrix}} = \frac{\364,000}{1 + \begin{pmatrix} \frac{1.64}{2.00} \end{pmatrix}} = \200,000200,000

    • Sample Size (nn):     n=(Population Size×Incorrect Rejection Coefficient×Est. Std. Dev.Planned ASR)2=(100,000×2.00×$15$200,000)2=225 Accountsn = \begin{pmatrix} \frac{\text{Population Size} \times \text{Incorrect Rejection Coefficient} \times \text{Est. Std. Dev.}}{\text{Planned ASR}} \end{pmatrix}^2 = \begin{pmatrix} \frac{100,000 \times 2.00 \times \$15}{\$200,000} \end{pmatrix}^2 = 225\,\text{Accounts}

  • Step B: Compute Acceptance Interval

    • Additional Data: Sample SD = $16\$16; Estimate of total audited value = $6,100,000\$6,100,000.

    • Adjusted ASR:     Adjusted ASR=TM−(Pop. Size×Inc. Accept. Coef.×Sample SDSample Size)\text{Adjusted ASR} = \text{TM} - \begin{pmatrix} \frac{\text{Pop. Size} \times \text{Inc. Accept. Coef.} \times \text{Sample SD}}{\sqrt{\text{Sample Size}}} \end{pmatrix}     \text{Adjusted ASR} = \364,000 - \begin{pmatrix} \frac{100,000 \times 1.64 \times \16}{\sqrt{225}} \end{pmatrix} = \$364,000 - \$174,933 = \$189,067

    • Acceptance Interval: \6,100,000 \pm \189,067189,067 which is [\5,910,933 \text{ to } \6,289,067]6,289,067].

    • Conclusion: The book value of $6,250,000\$6,250,000 falls within the interval, so the account is accepted.

Chapter 2: Audit of Cash and Marketable Securities

  • Nature of Cash: Cash is the most liquid asset, standard medium of exchange, and susceptible to theft. It is the only account included in every cycle.

  • Audit Objectives:

    1. Consider internal control.

    2. Substantive test of existence (existence).

    3. Establish completeness.

    4. Determine ownership (rights).

    5. Establish clerical accuracy of schedules.

    6. Determine proper presentation and disclosure (including restricted funds like compensating balances).

Types of Cash Accounts

  • General Cash Account: Checking accounts; focal point for most cash receipts and disbursements.

  • Imprest Payroll Accounts: Separate account used to improve control over payroll. A check from the general account is deposited into it.

  • Imprest Petty Cash: Preset amount held for incidental expenses/convenience. Replenished as necessary to maintain a fixed balance.

  • Branch Bank Account: Separate balances at different locations to build local relations and permit centralized/decentralized operations.

Principles of Internal Control for Cash

  • Principle 1: Establishment of Responsibility: Assigning tasks to specific individuals; includes authorization and approval.

  • Principle 2: Segregation of Duties: Work of one employee should evaluate another. Separation of related activities (e.g., ordering, receiving, paying) and separation of recordkeeping from physical custody.

  • Principle 3: Documentation Procedures: Use of pre-numbered documents and prompt forwarding to accounting.

  • Principle 4: Physical, Mechanical, and Electronic Controls: Safes, vaults, time clocks, television monitors, and computer passkeys.

  • Principle 5: Independent Internal Verification: Periodic or surprise reviews by independent personnel; discrepancies reported to management.

  • Principle 6: Other Controls: Bonding employees, mandatory vacations, and rotating duties.

Cash Fraud and Defalcation Techniques

  • Skimming: Withholding cash receipts at the point of sale before recording them.

  • Lapping: Postponing entries for cash collections from one customer and applying later collections from another customer to cover the shortage. Prevented by segregation of duties and compulsory vacations.

  • Kiting: Transferring money from one bank to another and recording the deposit in the second bank before the end of the period, while recording the withdrawal in the first bank after the end of the period. Takes advantage of "float."

    • Example (Theft Cover): Mr. Atalay borrows $1,000 Birr\$1,000\,\text{Birr}. He records a deposit to cover the bank reconciliation at year-end but no corresponding disbursement in the other account.

    • Example (Management Fraud): W/ro Akeza draws $300,000 Birr\$300,000\,\text{Birr} from one bank to deposit in another at year-end to overstate the current ratio for a loan application.

  • Window-Dressing: Keeping the cash book open beyond the closing date to include subsequent receipts to improve sales/cash position.

Audit Program for Cash

  • Tests of Controls:

    • Obtain internal control questionnaires.

    • Re-perform reconciliations.

    • Compare cash receipt listings to journals and deposit slips.

    • Compare disbursements to purchase orders and invoices.

  • Substantive Procedures:

    • Standard Confirmation: Send letters to all financial institutions to corroborate the existence of balances.

    • Bank Reconciliation: Review client-prepared reconciliations or prepare them. Verify deposits in transit and outstanding checks.

    • Cut-off Bank Statement: Obtain a partial-period statement (7-10 days after year-end) directly from the bank to verify the accuracy of reconciling items.

    • Cash Count: Physically count cash on hand (petty cash, receipts) in the presence of the custodian.

    • Inter-bank Transfer Schedule: Audit dates of recording for entries in both receiving and disbursing banks to detect kiting.

Audit of Marketable Securities

  • Definition: Short-term, highly liquid investments (e.g., commercial paper, certificates of deposit) convertible to cash within one year. Listed at current market value.

  • Portfolios:

    • Held-to-maturity (debt securities).

    • Trading (bought and held for sale in the near term).

    • Available-for-sale.

  • Internal Controls: Formal security policies, board approval for activities, segregation of authorization/custody/recording, registration in company name, and periodic physical inspection.

  • Substantive Procedures:

    • Footing the schedule of marketable securities.

    • Verifying costs/sales prices via broker’s advices.

    • Recalculating gains and losses.

    • Physical examination or confirmation of securities held by brokers.

    • Verifying market values using market sources.

    • Inquiry into holding periods and restrictions.