Auditing Account Balances: Risk, Sampling, and Procedures

1. 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.

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 5. Select the sample Random or non-random methods, as in sample selection for test of controls. LO6

15. 6. Perform the substantive purpose procedures. Substantive-purpose audit program produces evidence to support or refute management assertions. LO6

16. 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

17. 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

18. 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

19. 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