ST.

VINCENT COLLEGE
Business School
• Leganes • Pototan • Ivisan

COO FORM 12

SUBJECT TITLE: AUDITING AND ASSURANCE: SPECIALIZED INDUSTRIES

INSTRUCTOR: MARY JANE A. INTAO, CPA
SUBJECT CODE: AT2

MODULE 1

TOPIC 1: SUBSTANTIVE PROCEDURES

Learning Objectives
At the end of this topic, students will be able to:
1. Explain the different types of substantive procedures.
2. Discuss the auditor’s responsibility when misstatements are identified and when these
misstatements are uncorrected.
3. Understand when external confirmation is used and how they should be controlled.

NOTES:

Substantive procedures

Substantive procedures are used to detect material misstatements at the assertion level. They
are applied when the auditor’s purpose is to see whether the peso amount (or units) of an account
is properly stated.

Substantive procedures for material classes of transactions, account balances and disclosures
are always required to obtain sufficient appropriate audit evidence.

Types of Substantive Procedures:

1. Substantive analytical procedures – consist of the analysis of significant ratios and trends
including the resulting investigation of fluctuations and relationships that are inconsistent with
other relevant information or which deviate from predictable amounts.

2. Test of details – tests used to determine the actual details making up an account balance,
classes of transactions or disclosures.

a. Tests of transactions.

These are tests of the processing of individual transactions by inspection of the documents
and accounting records involved in processing.

b. Tests of balances.

These are tests applied directly to the details of balances in general ledger accounts.

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c. Tests of disclosures.

These are procedures to evaluate whether the overall presentation of the financial
statements, including the related disclosures, is in accordance with the applicable financial
reporting framework.

More type of evidences are obtained by using test of details of balances; however, this is the most
costly. Analytical procedures are the least costly to perform.

Nature, Timing and Extent of Substantive Procedures

Nature of S.P.

The auditor may perform (1) Substantive Anal. Proc. only, (2) Test of Details only, or (3) Both.
The auditor should consider the:
a. Effectiveness and efficiency of procedures and other audit procedures
b. Materiality
c. Accuracy information to be obtained
d. Assessment of inherent and control risks

Timings of S.P.

The auditor may perform the procedure (1) at interim date or (2) at period end

Performing at an interim date increases the risk that the auditor will not detect misstatements that
may exist at period end.

When unexpected misstatements are detected at interim date, the auditor may modify the nature,
timing, and extend of audit procedures.

Extent of S.P.

The extent of substantive procedures will depend on the results of test of controls or risk
assessment procedures.

Commonly used audit procedures:

1. Inspection of records or documents (Existence)

2. Inspection of tangible assets – physical examination of the assets. (Existence)
3. Observation – looking at the process or procedure being performed by others.
4. Inquiry – seeking information of knowledgeable persons, both financial and non-financial,
throughout the entity or outside the entity. It provides information not previously possessed
by the auditor. (Complementary to other procedures)
5. Confirmation – the process of obtaining representation of information or of an existing
condition directly from third party. (Required for accounts receivables) (Existence, and
Rights and Obligations)
6. Recalculation – checking the mathematical accuracy of documents or records.
7. Reperformance – auditor’s independent execution of procedures or controls that were
originally performed as part of the entity’s internal control.

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7. Analytical procedures – consists of evaluation of financial information made by a study

of plausible relationships among both financial and non-financial data.
8. Trace – to follow a transaction through the steps of the system. (Completeness – detects
understatements)
9. Vouch – to prove accuracy of accounting entries by tracing to supporting documents
(Existence/Occurrence – detects overstatements)

External Confirmation

The process of obtaining and evaluating audit evidence through a direct communication from a
third party in response to a request for information about a particular item affecting assertions
made by management in the financial statements.

External confirmation of an account receivable, existence and cut-off assertions;

In the case of goods held on consignment, existence and the rights and obligations assertions.

Types of external confirmation:

1. Positive external confirmation.

Request asks the respondent to reply to the auditor in all cases either by indicating the
respondent's agreement with the given information, or by asking the respondent to fill in
information.

2. Negative external confirmation.

Request asks the respondent to reply only in the event of disagreement with the information
provided in the request. Used when:

• The assessed level of inherent and control risk is low.

• A large number of small balances is involved.
• A substantial number of errors is not expected.
• The auditor has no reason to believe that respondents will disregard these requests.

Auditor’s Responsibility when misstatements are identified

Related Standard: PSA 450, “Evaluation of Misstatements Identified during the Audit”.

1. When misstatements are identified, they must be classified into:

a. Factual Misstatement - Misstatement about which there is no doubt

b. Judgmental Misstatement – differences arising from:

◼ Management judgement concerning accounting estimate that the auditor considers

unreasonable

◼ Management’s selection or application of accounting policies that the auditor

considers inappropriate

c. Projected Misstatement – auditors best estimate of misstatements in the population.

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1. Determine whether the original audit strategy and audit plan need to be revised. (depends on
the materiality of the misstatement).

2. All misstatement accumulated must be communicated to the appropriate level of

management, unless prohibited by law or regulation.

Auditor’s Responsibility when misstatements are uncorrected

Uncorrected misstatements are to be determined whether material or not, individually or in

aggregate.

In making this determination the auditor shall consider:

a. The size and nature of the misstatement

b. The effect of the uncorrected misstatement to prior periods and to the financial statements
as a whole

AUDIT OF SPECIFIC ACCOUNTS (SUBSTANTIVE PROCEDURES)

SUMMARY AUDIT PROCEDURES: CASH, RECEIVABLES, INVENTORY

CASH RECEIVABLES INVENTORY

Presentation and • Review disclosures for • Review disclosures for • View disclosures for
Disclosure compliance with GAAP compliance with GAAP compliance with GAAP

• Inquire about • Inquire about pledging, • Inquire about pledging

compensating balance discounting
requirements and
restrictions
• Review loan agreements • Review purchase
for pledging, factoring commitments

Existence or • Confirmation • Confirmation • Confirmation of consigned

Occurrence inventory and inventory in
warehouse

• Count cash on hand • Inspect notes • Observe inventory count

• Prepare bank transfer • Vouch (examine shipping

schedule documents, invoices, credit
memo

Rights and • Review bank statements • Inquire about factoring of • Inquire about inventory from
Obligations receivables vendors on consignment

Completeness • Review cutoffs (receipts • Review cutoffs (sales, cash • Review cutoffs (sales, sales
and Cutoff and disbursements) receipts, sales returns) returns, purchases, purchase
returns)

• Perform analytical • Perform analytical • Perform test counts and

procedures procedures compare with client’s
counts/summary
• Review bank reconciliation • Inquire about consigned
inventory
• Obtain bank cut-off • Perform analytical
statement to verify procedures
reconciling items on bank
reconciliation

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Valuation, • Foot summary schedules • Foot subsidiary ledger • Foot and extend summary
Allocation and schedules
Accuracy
• Reconcile summary • Reconcile subsidiary • Reconcile summary
schedules ledger to general ledger schedules to general ledger

• Test translation of any • Examine subsequent cash • Test inventory costing

foreign currencies receipts method

• Age receivables to test • Examine inventory quality

adequacy of allowance for (salable)
doubtful accounts
• Test inventory obsolescence

SUMMARY AUDIT PROCEDURES: MARKETABLE SECURITIES, PROPERTY, PLANT AND

EQUIPMENT, PREPAIDS

MARKETABLE SECURITIES PROPERTY, PLANT, PREPAIDS

EQUIPMENT
Presentation and • Review disclosures for • Review disclosures for • Review disclosures for
Disclosure compliance with GAAP compliance with GAAP compliance with GAAP
• Inquire about pledging • Inquire about liens and • Review adequacy of
restrictions insurance coverage
• Review loan agreements • Review loan agreements
for pledging for liens and restrictions
• Review management’s
classification of securities

Existence or • Confirmation of securities • Inspect additions • Confirmation of deposits and

Occurrence held by third parties insurance
• Inspect and count • Vouch additions • Vouch (examine) insurance
policies (miscellaneous
support for deposit)
• Vouch (to available • Review any leases for
documentation) proper accounting
• Perform search for
unrecorded retirements

Rights and • Review minutes for

Obligations approval of additions

Completeness • Review cutoffs (examine • Perform analytical • Review cutoffs

and Cutoff transactions near year-end) procedures
• Perform analytical • Vouch major entries to • Perform analytical procedures
procedures repairs and maintenance
expense
• Reconcile dividends
received to publish records

Valuation, • Foot summary schedules • Foot summary schedules • Foot summary schedules
Allocation and
Accuracy

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• Reconcile summary • Reconcile summary • Reconcile summary
schedules to general ledger schedules to general schedules to general ledger
ledger
• Test amortization of • Recalculate depreciation • Recalculate prepaid portions
premiums and discounts
• Determine the market value
for trading and available-
for-sale securities
• Review audited financial
statements of major
investees

SUMMARY AUDIT PROCEDURES: PAYABLES (CURRENT), LONG-TERM DEBT, OWNERS’

EQUITY

PAYABLES (CURRENT) LONG-TERM DEBT OWNER’S EQUITY

Presentation and • Review disclosures for • Review disclosures for • Review disclosures for
Disclosure compliance with GAAP compliance with GAAP compliance with GAAP
• Review purchase • Inquire about pledging of • Review information on
commitments assets stock options, dividend
restrictions
• Review debt agreements
for pledging and events
causing default

Existence or • Confirmation • Confirmation • Confirmation with registrar

Occurrence and transfer agent (if
applicable)
• Inspect copies of notes and • Inspect copies of notes • Inspect stock certificate
note agreements and note agreements book (when no registrar or
transfer agent)
• Vouch payables (examine • Trace receipt of funds (and • Vouch capital stock entries
purchase order, receiving payment) to bank account
reports, invoices) and cash receipts journal

Rights and • Review minutes for proper • Review minutes for proper
Obligations authorization authorization
• Inquire of legal counsel on
legal issues
• Review Articles of
Incorporation and bylaws
for propriety of equity
securities

Completeness • Review cutoffs (purchases, • Review cutoffs (examine • Perform analytical

and Cutoff purchase returns, transactions near year- procedures
disbursements) end)
• Perform analytical • Perform analytical • Inspect treasury stock
procedures procedures certificates

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• Perform search for • Inquire of management as
unrecorded payables to completeness
(examine unrecorded
invoices, receiving reports,
purchase orders)
• Inquire of management as • Review bank confirmation
to completeness for unrecorded debt

Valuation, • Foot subsidiary ledger • Foot summary schedules • Agree amounts to general
Allocation and ledger
Accuracy
• Reconcile subsidiary ledger • Reconcile summary • Vouch dividend payments
to general ledger schedules to general
ledger
• Recalculate interest • Vouch entries to account • Vouch all entries to
expense (if any) retained earnings
• 13. For payroll, review year- • Recalculate interest • Recalculate treasury stock
end accrual expense and accrued
interest payable
• 14. Recalculate other
accrued liabilities

EXERCISES SUBSTANTIVE PROCEDURES

1. The auditor is not always required to perform

a. Risk assessment procedures. c. Substantive procedures.
b. Test of controls. d. Both a and c

2. Which statement is incorrect regarding Inspection as an audit procedure?

a. Inspection consists of examining records or documents or physical examination of
assets.
b. Inspection of tangible assets may provide reliable audit evidence with respect to their
existence and about the entity’s rights and obligations on the assets.
c. Inspection of individual inventory items ordinarily accompanies the observation of
inventory counting.

3. Which statement is incorrect regarding Inquiry?

a. Responses to inquiries may provide the auditor with information not previously
possessed or with corroborative audit evidence.
b. Responses to inquiries might provide information that differs significantly from other
information that the auditor has obtained.
c. Responses to inquiries may provide a basis for the auditor to modify or perform
additional audit procedures.
d. Inquiry alone is sufficient to test the operating effectiveness of controls.

4. To provide reliable evidence, confirmations must be controlled by

a. The auditor.
b. The client’s internal audit department.
c. Client’s controller.
d. A client employee responsible for accounts receivable.
5. An auditor should test bank transfers for the last part of the audit period and first part of the
subsequent period to detect whether
a. The cash receipts journal was held open for a few days after year-end.
b. The last checks recorded before year-end were actually mailed by year-end.
c. Cash balances were overstated because of kiting.

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d. Any unusual payments to or receipts from related parties occurred.

6. An auditor’s decision either to apply analytical procedure or perform test of details is determined
by
a. Relative effectiveness and efficiency of the tests.
b. Availability of data aggregated at a high level.
c. Auditor’s familiarity with industry trends.
d. Timing of test performed after the balance sheet date.

7. Test of details are performed to

a. Detect material misstatements.
b. Test the effectiveness of the internal control
c. Detect fraud.
d. Obtain understanding of the entity and its environment

8. Auditors will sometimes use substantive analytical procedures over test of details because the
a. Analytical procedures are more reliable.
b. Analytical procedures are more persuasive.
c. Test of details are more expensive.
d. Test of details are more difficult to interpret.

9. In establishing the existence and ownership of a long-term investment in the form of publicly
traded stock, an auditor should inspect the securities or
a. Correspond with the investee company to verify the number of share owned.
b. Inspect the audited financial statements of the investee company.
c. Confirm the number of shares owned that are held by an independent custodian.
d. Determine that the investment is carried at fair value.

10. If the objective of a test of details is to detect overstatements of sales, the auditor
should compare transactions in the
a. Cash receipts journal with the sales journal.
b. Sales journal with the cash receipts journal.
c. Source documents with the accounting records.
d. Accounting records with the source documents

11. Which of the following is a substantive procedure that an auditor most likely would
perform to verify the existence and valuation of recorded accounts payable?
a. Investigating the open purchase order file to ascertain that prenumbered purchase orders
are used and accounted for.
b. Receiving the client’s mail; unopened, for a reasonable period of time after yearend to
search for unrecorded vendor’s invoices.
c. Vouching selected entries in the accounts payable subsidiary ledger to purchase orders
and receiving reports.
d. Confirming accounts payable balances with known suppliers who have zero
b. balances.

12. Which of the following might be detected by an auditor’s review of the client’s sales
cutoff?
a. Excessive goods returned for credit.
b. Unrecorded sales discount.
c. Lapping of year-end accounts receivable.
d. Inflated sales for the year.

--- END OF TOPIC 1 ---

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TOPIC 2: AUDIT SAMPLING

Learning Objectives
At the end of this topic, students will be able to:
1. Explain the use of audit sampling and its limitations
2. Identify the risks associated with the use of sampling in auditing.
3. Enumeration and explain their understanding of different sample selection methods.
4. Differentiate variable sampling plan and attributes sampling plan.
5. Discuss the factors that can affect the sample size.

AUDIT SAMPLING

The auditor may decide to apply audit sampling to an account balance or class of transactions.
Audit sampling (sampling) involves the application of audit procedures to less than 100% of items
within an account balance or class of transactions such that all sampling units have a chance of
selection.

Terms normally associated with sampling:

Population means the entire set of data from which a sample is selected and about
which the auditor wishes to draw conclusions. For example, all of the items
in an account balance or a class of transactions constitute a population. A
population may be divided into strata, or sub- populations, with each
stratum being examined separately. The term population is used to include
the term stratum.

Sampling unit means the individual items constituting a population, for example checks
listed on deposit slips, credit entries on bank statements, sales invoices
or debtors’ balances, or a monetary unit.

Sampling frame means the documentary evidence which physically represents the
sampling units in a given population.

Sample the portion of the population that will be subjected to audit testing. The
selected sample should be representative of the population.

Error For purposes of PSA 530, means either control deviations, when
performing tests of control, or misstatements, when performing
substantive procedures.

Tolerable error means the maximum error in a population that the auditor is willing to
accept.

Stratification is the process of dividing a population into subpopulations, each of which

is a group of sampling units which have similar characteristics (often
monetary value).

Sampling is NOT involved in:

1. 100% examination;
2. Selective testing; and
3. Audit procedures which either
(1) have very limited purposes and provide only a small portion of the evidence
needed to meet an audit objective or
(2) intentionally exclude a portion of the population such as:

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a. Performing a walkthrough test;

b. Testing controls that leave no audit trail (such as observing client

personnel as they perform internal control activities); c) Performing
analytical procedures;

Advantages of sampling over complete (100%) verification

1. Timeliness Sampling requires lesser time; audit would be completed on a more

timely basis.
2. Efficiency Sampling can considerably reduce audit costs.
3. Effectiveness Sampling can provide valid conclusions that the sample reflects the
same characteristics as the population.

Risk Considerations in Obtaining Evidence

Sampling risk and non-sampling risk can affect the components of audit risk.

a. Sampling Risks

Sampling risk arises from the possibility that the auditor’s conclusion, based on a sample
may be different from the conclusion reached if the entire population were subjected to the
same audit procedure.

b. Non Sampling Risks

Nonsampling risk arises from factors that cause the auditor to reach an erroneous
conclusion for any reason not related to the size of the sample, such as:

1. Failure to select appropriate audit procedures

2. Failure to recognize errors in documents examined
3. Misinterpreting the results of audit tests

For both tests of control and substantive tests, sampling risk can be reduced by increasing
sample size, while non-sampling risk can be reduced by proper engagement planning,
supervision, and review.

Types of Sampling Risks

Sampling Risks: Tests of Controls

1. Risk of under-reliance – Sample does not support the auditor’s planned degree of reliance
on the control when true compliance rate supports such reliance. Also known as the risk
of assessing control risk too high - the risk the auditor will conclude that control risk is
higher than it actually is.

2. Risk of over-reliance – Sample supports the auditor’s planned degree of reliance on the
control when true compliance rate does not justify such reliance. Also known as the risk
of assessing control risk too low - the risk the auditor will conclude that control risk is
lower than it actually is.

Sampling Risks: Substantive Testing

1. Risk of incorrect rejection – the risk the auditor will conclude that a material error exists
when in fact it does not.

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2. Risk of incorrect acceptance – the risk the auditor will conclude that a material error
does not exist when in fact it does.

Effect of sampling risk on audit

1. Efficiency – The risk of under-reliance and the risk of incorrect rejection (both referred to
as Alpha Risk) affect audit efficiency as it would usually lead to additional work to establish
that initial conclusions were incorrect.

2. Effectiveness – The risk of over-reliance and the risk of incorrect acceptance (both
referred to as Beta Risk) affect audit effectiveness and is more likely to lead to an
inappropriate audit opinion.

General approaches to audit sampling

a. Statistical sampling – approach to sampling that has the characteristics of:

◼ random selection of a sample; and

◼ use of probability theory to evaluate sample results, including measurement of
sampling risk.

Advantages Disadvantages
Helps auditor: May involve additional costs in
1) Design an efficient sample; 1) Training auditors;
2) Measure the sufficiency of evidential 2) Designing samples;
matter obtained;
3) Objectively evaluate sample results. 3) Selecting items to be tested.

When applying statistical sampling, the sample size can be determined using either
probability theory or professional judgment.

b. Nonstatistical sampling – A sampling approach that does not have characteristics of

statistical sampling.

Reasons for use – Often less costly and time-consuming to apply than statistical
sampling, but can be as effective in achieving audit objectives.

Similarities of Statistical Sampling and Nonstatistical Sampling

Both statistical and nonstatistical sampling

1. Can provide sufficient, competent evidential matter;

2. Involve judgment in planning, executing the sampling plan, and evaluating the
sample results;
3. Require that sample item be selected in such a way that sample can be expected to be
representative of the population.

Choice of approach – The decision whether to use a statistical or non-statistical sampling

approach is a matter for the auditor’s judgment regarding the most efficient manner to obtain
sufficient appropriate audit evidence in the particular circumstances.

Sample size is not a valid criterion to distinguish between statistical and non-statistical
approaches. Sample size is a function of various factors. When circumstances are similar, the
effect on sample size of certain factors will be similar regardless of whether a statistical or non-
statistical approach is chosen.

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Sample Selection Methods

Appropriate for statistical and nonstatistical sampling

(a) Use of a computerized random number generator or random number tables.

(b) Systematic selection, in which the number of sampling units in the population is
divided by the sample size to give a sampling interval, for example 50, and having
determined a starting point within the first 50, each 50th sampling unit thereafter is
selected. Although the starting point may be determined haphazardly, the sample
is more likely to be truly random if it is determined by use of a computerized random
number generator or random number tables. When using systematic selection, the
auditor would need to determine that sampling units within the population are not
structured in such a way that the sampling interval corresponds with a particular
pattern in the population.

Not appropriate for statistical sampling

(c) Haphazard selection, in which the auditor selects the sample without following a
structured technique. Although no structured technique is used, the auditor would
nonetheless avoid any conscious bias or predictability (for example avoiding
difficult to locate items, or always choosing or avoiding the first or last entries on a
page) and thus attempt to ensure that all items in the population have a chance of
selection. Haphazard selection is not appropriate when using statistical sampling.

(d) Block selection involves selecting a block(s) of contiguous items from within the
population. Block selection cannot ordinarily be used in audit sampling because
most populations are structured such that items in a sequence can be expected to
have similar characteristics to each other, but different characteristics from items
elsewhere in the population. Although in some circumstances it may be an
appropriate audit procedure to examine a block of items, it would rarely be an
appropriate sample selection technique when the auditor intends to draw valid
inferences about the entire population based on the sample.

Usage of Sampling (Characteristic of Interest)

The characteristic of interest depends on the type of test that will be performed on the sample
selected.

Test of controls – the characteristic of interest is the deviation or occurrence rate, which
is the number of times a deviation from the prescribed internal control occurs in the
sample.

Substantive testing – the characteristic of interest is the monetary amount of misstatement

in an account balance.

Dual-purpose tests. Those in which a sample is used to test a control and to serve as a
substantive test of a recorded balance or class of transactions. When a dual-purpose test is
used, auditors select the sample size as the higher of that required for the two purposes

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Types of Sampling Plans

a. Attributes sampling – a statistical sampling plan used in test of controls. This is appropriate:

1) When the auditor wishes to estimate the true but unknown population deviation rate;
2) If the expected deviation rate is high based on prior experience.

b. Variables sampling – a sampling plan used in substantive testing to estimate the total peso
amount (or possibly units) of a population or the peso amount of an error in a population.

Attribute Sampling Plan

1. Determine the objective(s) of the tests

2. Define the attribute (characteristic of a control) and deviation (absence of an attribute)
3. conditions
4. Define the population
5. Determine the method of sample selection
6. Determine sample size
7. Perform the sampling plan
8. Evaluate sample results
9. Document the sampling plan, the procedures performed, and the conclusions reached

Factors Influencing Sample Size for Tests of Control

The following are factors that the auditor considers when determining the sample size for a test
of control. These factors need to be considered together.

FACTOR EFFECT ON
SAMPLE SIZE
An increase in the auditor’s intended reliance on accounting and
internal control systems Increase

An increase in the rate of deviation from the prescribed control

procedure that the auditor is willing to accept (Tolerable deviation rate) Decrease

An increase in the rate of deviation from the prescribed control

procedure that the auditor expects to find in the population (Expected
Increase
deviation rate)

An increase in the auditor’s required confidence level (or conversely,

a decrease in the risk that the auditor will conclude that the control risk
is lower than the actual control risk in the population – risk of assessing Increase
control risk too low)

An increase in the number of sampling units in the population

Negligible effect

Other Sampling Techniques for Test of Controls

1. Sequential (Stop-or-Go) Sampling

Audit sampling can be accomplished with either a fixed or sequential sampling plan.

a. Fixed sampling plan – the auditor tests a single plan, such as attribute estimation.
b. Sequential sampling plan – the sampling is performed in several steps. Following each
step, the auditor decides whether to stop testing or to go on to the next step.

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Sequential sampling plan can be used as an alternative to attribute estimation when an
auditor expects zero or very few deviations within an audit population.

2. Discovery Sampling

Discovery sampling plan may be appropriate when:

a. the audit objective is to observe at least one deviation at a specified critical rate;
b. the expected population deviation rate is near zero; and
c. the auditor desires a specified probability of observing at least one deviation of the actual
population rate exceeds the critical rate (this is comparable to the tolerable rate in attribute
estimation and sequential sampling).

Variables Sampling Plan

1) Determine the objective(s) of the tests

2) Define the population
3) Choose an audit sampling approach/technique
4) Determine sample size
5) Determine the method of sample selection
6) Perform the sampling plan
7) Evaluate sample results
8) Document the sampling plan, the procedures performed, and the conclusions reached

Factors Influencing Sample Size for Substantive Procedures

The following are factors that the auditor considers when determining the sample size for a
substantive procedure. These factors need to be considered together.

FACTOR EFFECT ON
SAMPLE SIZE
An increase in the auditor’s assessment of inherent risk Increase
An increase in the auditor’s assessment of control risk (or a decrease
in reliance on internal controls) Increase

An increase in the use of other substantive procedures directed at the

same financial statement assertion Decrease

An increase in the auditor’s required confidence level (or conversely,

a decrease in the risk that the auditor will conclude that a material error
Increase
does not exist, when in fact it does exist – risk of incorrect acceptance)

An increase in the total error that the auditor is willing to accept

(tolerable error) Decrease

An increase in the amount of error the auditor expects to find in the

population (expected error) Increase

Stratification of the population when appropriate

Decrease
The number of sampling units in the population
Negligible Effect

Sampling techniques for Variables Sampling

◼ Probability-proportional-to-size (PPS) sampling

◼ Classical variables sampling

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Probability-proportional-to-size (PPS) sampling

PPS sampling is a sampling technique that uses attribute sampling theory to evaluate the results
when a large number of transactions are captured within a single account. In PPS sampling, the
auditor randomly selects individual pesos from a population and then audits the balances,
transactions, or documents – called logical units – that include the pesos selected. Each peso in
the population has an equal chance of being selected, but the likelihood of selecting any one
logical unit for testing is directly proportional to its size.

Classical variables sampling

Classical variables sampling relies on normal distribution theory to evaluate audit samples. These
may be appropriate when the audit objective is to estimate the true but unknown monetary
balance. The three commonly used classical variables sampling techniques are:

(1) Ratio estimation – uses the ratio of audited amounts to recorded amounts in the sample to
estimate the total peso amount of the population (also called point estimate) and an allowance
for sampling risk. Where: SAV = sample audited value; SBV = sample recorded book value;
PBV = population book value; and EPAV = estimated population audited value, the formula is:

SAV/SBV x PBV = EPAV +(-) sampling risk

The use of ratio estimation is appropriate when the misstatement in an account is directly
proportional to its book value.

(2) Difference estimation – uses the average difference between audited amounts and individual
recorded amounts in the sample to estimate the total audited amount of the population and
an allowance for sampling risk. Where: SAV = sample audited value; SBV = sample
recorded book value; SS = sample size; and P = number of items in population, the formula
is:

(SAV – SBV)/SS x P = Projected error

The use of difference estimation is more appropriate when the misstatement in an

account is not affected by the book value of the item being examined.

(3) Mean-per-unit estimation – projects sample average (mean) to the total population by
multiplying the sample average by the number of items in the population. Using the same
legend above, the formula is:

SAV/SS x P = EPAV +(-) sampling risk

The use of mean-per-unit estimation is appropriate when the individual population items do
not have recorded values.

Before applying ratio or difference estimation, the following three conditions must exist:

1. Each population item must have a recorded value (e.g., perpetual rather than
periodic, inventory)

2. Total population book value must be known (e.g., a recorded general ledger book value)
and must correspond to the sum of all individual population items.

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3. Expected differences between audited and recorded book values must not be too rare.

Comparative advantages and disadvantages of PPS and classical variables sampling

Probability-proportional-to-size (PPS) sampling Classical variables sampling

Advantages Advantages
◼ Automatically results in stratified sample ◼ May result in smaller sample size if there
because items are selected in proportion are many individual differences between
to their peso amounts. recorded and audited amounts in the
◼ Usually results in a smaller sample size population.
than classical variables sampling when ◼ Selection of zero or negative balances
no errors are expected. within a sample does not require special
◼ Can be designed more easily and sample sample design considerations.
selection can begin before the complete ◼ If necessary, it is easier to expand
population is available. samples than PPS.

Disadvantages Disadvantages
◼ Evaluation of the sample will require special ◼ More complex than PPS
sample design considerations if sample
includes understatement errors

◼ Evaluation may overstate the allowance ◼ To determine sample size, the auditor
for sampling risk when errors are found. must have an estimate of the population
standard deviation.
◼ Generally includes an assumption that ◼ Normal distribution theory, the basis
the audited amount of a sampling unit underlying classical variables sampling,
should not be less than zero or greater may not be appropriate when the sample
than the recorded amount. size is not large and there are either very
large items or very large differences
between recorded and audited amounts
in the population

END.

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EXERCISES:

Basic Sampling Concepts/PSA 530 – Audit Sampling and Other Selective Testing Procedures

1. The entire set of data about which the auditor wishes to draw conclusions is called
a. Population. c. Sampling frame.
b. Sample. d. Sampling unit.

2. Which of the following constitutes audit sampling?

a. Selecting and examining specific items to determine whether or not a particular
procedure is being performed.
b. Examining items to obtain information about matters such as the client’s business, the
nature of transactions, accounting and internal control systems.
c. Examining items whose values exceed a certain amount so as to verify a large
proportion of the total amount of an account balance or class of transactions.
d. Applying audit procedures to less than 100% of items within an account balance or
class of transactions such that all sampling units have a chance of selection.

3. The following situations will likely lead the auditor to use 100% testing, except
a. When the population constitutes a small number of large value items.
b. When both inherent and control risks are high and other means do not provide sufficient
appropriate audit evidence
c. When the repetitive nature of a calculation or other process performed by a computer
d. information system makes a 100% examination cost effective. d. When testing controls
that leave audit trail.

5. Which of the following is true about sampling and non-sampling risks?

a. Sampling risk can be reduced by increasing sample size.
b. Sampling risk cannot be eliminated.
c. Non-sampling risk can be eliminated by proper engagement planning, supervision, and
review.
d. Non-sampling risk arises from the possibility that the auditor’s conclusion, based on a
sample may be different from the conclusion reached if the entire population were
subjected to the same audit procedure.

6. Which statement is incorrect about sampling risk?

a. Sampling risk arises from the possibility that the auditor’s conclusion, based on a
sample may be different from the conclusion reached if the entire population were
subjected to the same audit procedure.
b. Risk of assessing control risk too low and risk of incorrect acceptance affects audit
effectiveness as it would usually lead to additional work to establish that initial
conclusions were incorrect.
c. The mathematical complements of sampling risks are termed confidence levels.
d. Risk of assessing control risk too high is the risk that the auditor will conclude, in the
case of a test of control, that control risk is higher than it actually is.

7. When the auditor goes through a population and selects items for the sample without regard to
their size, source, or other distinguishing characteristics, it is called
a. Block selection c. Systematic selection
b. Random selection d. Haphazard selection

8. Which of the following statements is not correct?

a. It is acceptable for auditor to use statistical sampling methods.
b. It is acceptable for auditor to use non-statistical sampling methods.
c. The primary benefit of statistical sampling methods is the quantification of sampling risk.
d. An advantage of using statistical sampling is that the cost/benefit ratio is always
positive.

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ATTRIBUTES SAMPLING

9. Tests of controls provide reasonable assurance that controls are applied as prescribed. A
sampling method that is useful when testing controls is:
a. Nonstatistical sampling c. Discovery sampling
b. Attribute estimation sampling d. Stratified random sampling

10. Statistical sampling may be applied to test controls when a client’s control procedures
a. Depend primarily on segregation of duties.
b. Are carefully reduced to writing and are included in client accounting manuals.
c. Leave an audit trail as evidence of compliance.
d. Enable the detection of fraud.

11. When sampling for attributes, which of the following would decrease sample size?

Risk of assessing Tolerable rate of Expected population

Control risk too low deviation deviation rate
a. Increase Decrease Increase
b. Decrease Increase Decrease
c. Increase Increase Decrease
d. Increase Increase Increase

12. A statistical sampling technique that will minimize sample size whenever a low deviation rate
is expected is
a. Ratio-estimation sampling. c. Stratified mean-per-unit sampling.
b. Difference-estimation sampling. d. Stop-or-go sampling.

13. If the auditor is concerned that a population may contain exceptions, the determination of a
sample size sufficient to include at least one such exception is a characteristic of
a. Discovery sampling c. random sampling
b. Variable sampling d. PPS

14. At times a sample may indicate that the auditor’s assessed level of control risk for a given
control is reasonable when, in fact, the true compliance rate does not justify the assessed level.
This situation illustrates the risk of
a. Assessing control risk too low c. Incorrect precision
b. Assessing control risk too high d. Incorrect rejection

15. The likelihood of assessing control risk too high is the risk that the sample selected to test
controls
a. Does not support the auditor’s planned assessed level of control risk when the true
operating effectiveness of the control justifies such an assessment.
b. Contains misstatements that could be material to the financial statements when aggregated
with misstatements in other account balances or transaction classes.
c. Contains proportionately fewer monetary errors or deviations from prescribed internal
control policies or procedures than exist in the balance or class as a whole.
d. Does not support the tolerable misstatement for some or all of management’s assertions.

VARIABLES SAMPLING

16. In applying variables sampling, an auditor attempts to

a. Estimate a qualitative characteristic of interest.
b. Determine various rates of occurrence for specified attributes.
c. Discover at least one instance of a critical deviation.
d. Predict a monetary population value within a range of precision.

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17. While performing a substantive test of details during an audit, the auditor determined that the
sample results supported the conclusion that the recorded account balance was materially
misstated. It was, in fact, not materially misstated. This situation illustrates the risk of
a. Assessing control risk too low. c. Incorrect rejection.
b. Assessing control risk too high. d. Incorrect acceptance.

18. The risk of incorrect acceptance and the risk of assessing control risk too low relate to the
a. Preliminary estimates of materiality levels c. Efficiency of the audit
b. Allowable risk of tolerable error d. Effectiveness of the audit

19. In statistical sampling methods used in substantive testing, when would an auditor most likely
stratify a population into meaningful groups?
a. If the population has highly variable recorded amounts.
b. If probability proportional to size sampling is used.
c. If the auditor’s estimated tolerable misstatement is extremely small.
d. If the standard deviation of recorded amounts is relatively small.

20. How would increases in tolerable misstatement and assessed level of control risk affect the
sample size in a substantive test of details?

Increase in tolerable Increased in assessed

Misstatement level of control risk
a. Increase sample size Increase sample size
b. Increase sample size Decrease sample size
c. Decrease sample size Increase sample size
d. Decrease sample size Decrease sample size

--- END OF TOPIC 2 ---

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TOPIC 3: COMPLETING THE AUDIT AND POST-AUDIT RESPONSIBILITIES

NOTES:

COMPLETING THE AUDIT

Various issues that the auditor considers in completing audit examination:

1. Related party transactions
2. Subsequent events review
3. Litigations, claims, and assessment
4. Management representation
5. Wrap-up Procedures

RELATED PARTY TRANSACTIONS (PSA 550, “Related Parties)”

◼ Related parties – one party has the ability to control the other party or exercise
significant influence over the other party in making financial and operating decisions.

◼ Related party transactions – involve a transfer of resources or obligations between

parties, regardless of whether a price is charged.

Management’s responsibility. Management is responsible for the identification and disclosure

of related parties and transactions with such parties.

Auditor’s responsibility. The auditor should obtain and review information provided by the
directors and management identifying the names of all known related parties and related party
transactions,

SUBSEQUENT EVENTS REVIEW

Subsequent events – refer to events occurring between period end and the date of the auditor’s
report and facts discovered after the date of the auditor’s report.

Types of subsequent events are:

a. Type 1 Subsequent Events.

Those events that provide evidence of conditions that existed at the date of the financial
statements. These events require adjustment to the financial statements.

1. Collection of receivables or settlement of liabilities in amounts substantially different

from amounts recorded at the balance sheet date.
2. Realization of a loss on the sale of investments, inventories, or properties held for sale
when the subsequent sale merely confirms a previously existing unrecognized loss.
3. Discontinuance, at an estimated loss, of operations of a subsidiary where the
contributing circumstances unfolded over a period of time prior to the balance sheet
date.

b. Type 2 Subsequent Events.

Those events that are indicative of conditions that arose after the date of the financial
statement. These events require disclosure in, but not adjustment to, the financial statements.
Examples include business combinations, issuance of new notes, bonds, or other
indebtedness, changes in capital structure, declaration of unusual cash or stock dividends or
omission of a regular dividend and damage from fire, flood, or other casualty.

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Procedures when Facts are Discovered After the Date of the Auditor’s Report but Before
the Financial Statements are Issued

1. Discuss the matter with management and, where

appropriate, those charged with governance.

2. Determine whether the financial

statements need amendment and, if so,

3. Inquire how management intends to address

the matter in the financial statements.

If amendment is necessary

n Carry out procedures necessary Auditor’s report has NOT been released
to the amendment n Express a qualified or
adverse opinion
n Extend the audit procedures to
the date of the new auditor’s Auditor’s report has been released
n Notify BODs not to issue the
report
FS and the auditor’s report
n Take action to prevent
n Provide a new auditor’s report on
reliance on the auditor’s
the amended financial report
statements

MANAGEMENT DID NOT AGREE TO

MANAGEMENT AGREES TO AMEND AMEND

INQUIRY REGARDING LITIGATION AND CLAIMS

The auditor should carry out procedures in order to become aware of any litigation and claims
involving the entity which may have a material effect on the financial statements. Since
management is the primary source of information about such contingencies, the auditor’s
procedures should include:

1. Making appropriate inquiries of management including obtaining representations.

2. Reviewing board minutes and correspondence with the entity’s lawyers.
3. Examining legal expense accounts.
4. Using any information obtained regarding the entity’s business including
information obtained from discussions with any in-house legal department.

The letter of inquiry should be prepared by management but sent by the auditor and request the
lawyer to communicate directly with the auditor. The letter would ordinarily specify:

1. A list of litigation and claims.

2. Management’s assessment of the outcome of the litigation or claim and its estimate of
the financial implications, including costs involved.
3. A request that the lawyer confirms the reasonableness of management’s assessments
and provides the auditor with further information if the list is considered by the lawyer
to be incomplete or incorrect.

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The auditor considers the status of legal matters up to the date of the audit report. In some
instances, the auditor may need to obtain updated information from lawyers.

If management refuses to give the auditor permission to communicate with the entity’s lawyers,
this would be a scope limitation and should ordinarily lead to a qualified opinion or a disclaimer of
opinion.

If the lawyer fails to respond or responds insufficiently, refuses to respond in an appropriate

manner, and the auditor is unable to obtain sufficient appropriate audit evidence by applying
alternative procedures, the auditor would consider whether there is a scope limitation which may
lead to a qualified opinion or a disclaimer of opinion.

ASSESSMENT OF GOING CONCERN ASSUMPTION

Management should make an explicit assessment of its ability to continue as a going concern
entity. In assessing whether the going concern assumption is appropriate, the management takes
into account all available information for the foreseeable future, which should be at least twelve
months from the balance sheet date.

MANAGEMENT REPRESENTATIONS

A written representation can take the form of either the following:

a. A letter from the auditor outlining the auditor's understanding of management's

representations, duly acknowledged and confirmed by management.
b. Relevant minutes of meetings of the board of directors or similar body or a signed copy
of the financial statements.
c. A representation letter from management (most common practice).

• Confirm representations explicitly or implicitly provided throughout the audit.

• Indicate and document the continuing appropriateness of such representations.
• Reduce the possibility of misunderstanding.

A management representation letter would ordinarily be addressed to the auditor and dated the
same date as the auditor's report, that is, the end of field work. It would ordinarily be signed by
the senior executive officer and the senior financial officer. Management’s refusal to provide
representations that the auditor considers necessary would constitute a scope limitation that
would require an auditor to express a qualified opinion or a disclaimer of opinion.

ANALYTICAL PROCEDURES FOR OVERALL REVIEW

The auditor should apply analytical procedures at the overall review stage of the audit, and it
should be performed at or near the end of the audit when forming an overall conclusion as to
whether the financial statements as a whole are consistent with the auditor’s knowledge of the
business. The conclusions drawn from the results of such procedures are intended to corroborate
conclusions formed during the audit of individual components or elements of the financial
statements and assist in arriving at the overall conclusion as to the reasonableness of the financial
statements.

POST AUDIT RESPONSIBILITIES

Subsequent Discovery of Facts

The auditor has no responsibility to make any inquiry regarding previously issued financial
statements unless he becomes aware of a material fact,

which existed at the date of the auditor’s report; and

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which, if known at that date may have caused the auditor to modify the report.

Subsequent discovery of omitted procedures

Guidelines:
1. Assess the importance of the omitted procedures to the auditor’s ability to
support his opinion.

Results of other audit procedures that were applied may compensate for or make the
omitted procedures less important. Evaluating such results may involve:
a. Reviewing the working papers
b. Discussing the circumstances with the engagement personnel
c. Reevaluating the scope of the audit

2. Undertake to apply the omitted procedures or the corresponding alternative

procedures.

If the auditor determines that the omission of the procedures impairs his current ability to
support his opinion, and the auditor believes that there are persons currently relying, or
likely to rely on the report, the auditor should promptly apply the omitted procedures or the
corresponding alternative procedures.

If, after applying the omitted procedures, the auditor determines that the financial
statements are materially misstated and that the auditor’s report is inappropriate, the
auditor should discuss the matter with the management and takes steps to prevent future
Reliance on the report.

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EXERCISES:

1. The responsibility for the identification and disclosure of related parties and transactions with
such parties rests with the
a. Auditor
b. Entity’s management
c. Financial Reporting Standards Council (FRSC)
d. Securities and Exchange Commission (SEC)

2. Which of the following events most likely indicates the existence of related parties?
a. Making a loan without scheduled terms of payment for repayment of the funds.
b. Discussing merger terms with a company that is a major competitor.
c. Selling real estate at a price that differs significantly from its book value.
d. Borrowing a large sum of money at a variable rate of interest.

3. Which of the following audit procedures is most likely to assist an auditor in identifying related
party transactions?
a. Inspecting communications with law firms for evidence of unreported contingent liabilities.
b. Reviewing accounting records for nonrecurring transactions recognized near the balance
sheet date.
c. Retesting ineffective controls previously reported to the audit committee.
d. Sending second requests for unanswered positive confirmations of accounts receivable.

4. For a reporting entity that has participated in related party transactions that are material,
disclosure in the financial statements should include
a. A reference to deficiencies in the entity’s internal control.
b. A statement to the effect that a transaction was consummated on terms equivalent to those
that prevail in arm’s-length transactions.
c. The nature of the relationship and the terms and manner of settlement.
d. Details of the transactions within major classifications.

5. As used in PSA 560 (Subsequent Events), the term “subsequent events” refers to
I. Events occurring between the date of the financial statements and the date of the
auditor’s report.
II. Facts that become known to the auditor after the date of the auditor’s report.

a. I only
b. II only
c. Both I and II
d. Neither I nor II

6. Which of the following procedures would an auditor most likely perform to obtain evidence
about the occurrence of subsequent events?
a. Inquiring as to whether any unusual adjustments were made after the date of financial
statements.
b. Confirming a sample of material accounts receivable established after the date of financial
statements.
c. Comparing the financial statements being reported on with those of the prior period.
d. Investigating personnel changes in the accounting department occurring after the date of
the financial statements.

7. Which of the following conditions or events most likely would cause an auditor to have
substantial doubt about an entity’s ability to continue as a going concern?
a. Cash flows from operating activities are negative.
b. Stock dividends replace annual cash dividends.
c. Significant related party transactions are pervasive.
d. Research and development projects are postponed.

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8. A purpose of a management representation letter is to reduce

a. The possibility of a misunderstanding concerning management’s responsibility for the
financial statements.
b. The scope of an auditor’s procedures concerning related party transactions and
subsequent events.
c. Audit risk to an aggregate level of misstatement that could be considered material.
d. An auditor’s responsibility to detect material misstatements only to the extent that the letter
is relied on.

9. Analytical procedures used in the overall review stage of the audit generally include
a. Retesting controls that appeared to be ineffective during the assessment of control risk.
b. Considering unusual or unexpected account balances that were not previously identified.
c. Gathering evidence concerning account balances that have not changed from the prior
year.
d. Performing test of transactions to corroborate management’s financial statement
assertions.

10. The primary source of information to be reported about litigations, claims, and assessments
is the
a. Independent auditor
b. Client’s management
c. Court records
d. Client’s lawyer

11. The letter of audit inquiry should be

a. Prepared and sent by the auditor.
b. Prepared by the management and sent by the auditor.
c. Prepared and sent by management.
d. Prepared by the auditor and sent by management.

--- END OF PRELIM MODULE ---

References:

Auditing Theory Volume 2. 2016 Edition. (HARVEY S. CHEN, CPA)

CPA Examination Reviewer: Auditing Theory 2018-2019 Edition. (GERARDO S. ROQUE)

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