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Learning Objectives. LO6 Develop a simple audit program for an account balance, considering the influences of risk and tolerable misstatement. a. Specify objectives and a population of data. b. Determine sample size and select sample units.
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Learning Objectives LO6 Develop a simple audit program for an account balance, considering the influences of risk and tolerable misstatement. a. Specify objectives and a population of data. b. Determine sample size and select sample units. c. Evaluate monetary error evidence from a balance audit sample. LO7 Apply and integrate the chapter topics to analyze a practical auditing situation/case/scenario.
Substantive Procedures for Auditing Account Balances Substantive tests of details auditing is the performance of procedures to obtain direct evidence about the dollar amounts and disclosures in the financial statements. • Substantive procedures include: • analytical procedures, and • test of details of transactions and balances. LO6
Risk Model Expansion Detection risk (DR) is actually a combination of two risks: • Analytical procedures risk (APR) • The probability that analytical procedures will fail to detect material errors. • Risk of incorrect acceptance (RIA) • The probability that tests of details procedures will fail to detect material errors. LO6
Risk Model Expansion Expanded risk model: AR = IR * CR * APR * RIA Only risk of incorrect acceptance can be controlled by the auditor. Solve the risk model for RIA: with AR, IR, and AP held constant RIA varies inversely with CR or control risk. LO6
Sampling Risk In sampling for substantive procedures, the auditor faces two sampling risks. • The risk of incorrect acceptance (beta risk) • Accepting a balance as materially correct when material misstatements have occurred. • The risk of incorrect rejection (alpha risk) • Deciding a balance is materially misstated when it is not. LO6
Sampling Risk Risk of incorrect acceptance is considered the more important of the two. • Incorrect acceptance leads to audit failure. • Incorrect rejection leads to additional audit procedures to determine actual misstatement. • Auditor will determine that the amount is not materially misstated. • Audit effectiveness (the right conclusion) is more important than efficiency (least work). LO6
Sampling Steps for Account Balance Audit • Specify the audit objectives. • Define the population. • Choose an audit sampling method. • Determine the sample size. • Select the sample. • Perform the substantive-purpose procedures. • Evaluate the evidence. LO6
Plan the Procedures The first three steps represent the problem-recognition phase. • The client’s implicit assertions with respect to balances include existence, completeness, valuation, ownership and presentation. • Are the client assertions about the balances accurate? LO6
1. Specify the Audit Objectives Objective is to decide whether the client’s assertions about existence, rights, and valuation are materially accurate. • Hypothesis testing: auditors hypothesize that the book value is materially accurate and test that hypothesis. LO6
2. Define the Population Definition of population must match objectives. • Examine individually significant items. • Individual items that exceed materiality. • Apply stratification to the remaining population. • Subdivide the population by account balance size. LO6
3. Choose an Audit Sampling Method Auditor will decide whether to use statistical or judgmental sampling methods. • For statistical sampling methods, classic variables sampling methods and attribute sampling methods (dollar unit sampling) are available. LO6
Perform the Procedures Steps 4 to 6 represent the evidence-collection phase. • Sample size determination requires consideration of several factors. It is important to get the sample size right, to avoid over-auditing or under-auditing. LO6
4. Determine the Sample Size The sample size is based on the following: • risk of incorrect acceptance (RIA), • risk of incorrect rejection (RIR), • material misstatement amount, • expected dollar misstatement in the population, • variability within the population, and • size of the population. DUS can be used to calculate a sample size. LO6
5. Select the sample Random or non-random methods, as in sample selection for test of controls. LO6
6. Perform the substantive purpose procedures. Substantive-purpose audit program produces evidence to support or refute management assertions. LO6
7. Evaluate the Evidence Evaluate the evidence: • Determine amount of known misstatement. • Total amount of errors actually uncovered by procedures. • Determine the likely misstatement. • Project the misstatement found in the sample to the population. • Average difference method. • Dollar-unit sampling projection method. LO6
7. Evaluate the Evidence Consider sampling risks: • Auditor uses professional judgment and experience to consider these risks. Quantitative evaluation: • Follow up on all differences uncovered to determine any misunderstanding of GAAP, simple mistakes, intentional irregularities, or management override of controls. LO6
7. Evaluate the Evidence Evaluate the misstatement: • Known misstatement and likely misstatement are combined and compared to materiality. • Sample risk gives rise to “possible misstatements.” • Misstatements that remain undetected in units not sampled. • Can be calculated where statistical methods are used. LO6
Timing of Substantive Procedures Account balances can, in part, be audited at an interim date. • Auditor will extend the interim date audit conclusions to balance sheet date. • Audit work is performed at interim dates: • to spread auditor’s workload over the year, and • to allow for timely production of audit report following year end. • Poor controls, or significant business risk may preclude performing procedures at interim. LO6
