Chapter 5

Question 1

What is the difference between nonstatistical and statistical sampling?

Answer 1

Statistical sampling
- Uses laws of probability for selection and evaluation of a sample

• Allows for quantification of audit risk and sufficiency of audit evidence’

Nonstatistical sampling:

• Does not utilize statistical models in calculations
• Audiors use their judgment to determine sample sized to evaluate the selected samples

Question 2

When is professional judgment necessary in theuse of statistical or nonstatistical sampling by an auditor?

Answer 2

The audior must use professional judgment to:

• Define the population and sampling unit
• Select the appropriate sampling method
• Evaluate whether the audit evidence is appropriate
• Evaluate the nature of deviations or errors
• Consider sampling risk
• Evaluate sample results and project to the population

Question 3

Define sampling risk

Answer 3

Sampling risk is the risk that the auditor’s conclusion based on a sample is different from the conclusion that would have been reached if the tests had been applied to all items in the population

Question 4

Define the two aspects of sampling risk tests of controls

Answer 4

Risk of assessing control risk too low:

• Deciding the control is more effective/reliable than it really is: affects audit effectiveness

Risk of asessing control risk too high:

• Deciding the control is less effective/reliable that it really is; affects audit efficieny

Question 5

Identify two aspects of sampling risk that the auditor would be concerned with when performing substantive testing

Answer 5

Risk of incorrect acceptance:

• Deciding from the sample that the balance is correct when it is really materially misstated; affects audit effectiveness

Risk of incorrect rejection:

• Deciding from the sample that the balance is materially misstated when it is really correct; affects audit efficiency

Question 6

What is the relationship between sampling risk and reliability (confidence level)?

Answer 6

Sampling Risk

+

Confidence Level

=

100%

Question 7

What is attribute sampling?

Answer 7

Attribute sampling is a statistical sampling method used to estimate a rate of occurence in a sample. It is used in tests of controls

Question 8

Define tolerable deviation rate (for attribute sampling) and tolerable misstatement (for variables sampling).

Answer 8

Tolerable deviation rate: The maximum rate (%) of deviation from a control procedure that the auditor is willing to accept while still relying on the control

Tolerable misstatement: The largest amount of misstatement the auditor believes can exist in a balance or class of transactions without causing the F/S to be materially misstated.

Question 9

What factors affect sampliing size for an attribute sampling application?

Answer 9

The following factors affect sample size in an attribute sampling application:

• Risk of assesing control risk too low (inverse relationship)
• Tolerable deviation rate (inverse relationship)
• Expected deviation rate (direct relationship)

Question 10

What rates are compared in drawing a conclusion about an attribute sampling application?

Answer 10

The auditor compares the upper deviation rate to the tolerable deviation rate in drawing conclusions about an attribute sampling application. If the upper deviation rate exceeds the auditor’s tolerable deviation rate, the auditor will not rely on the control. (The upper deviation rate is the deviation rate plus an allowance for sampling risk).

Question 11

What factors affect sample size for a variables sampling application?

Answer 11

The following factors affect sample size in a variables sampling application:

• Standard deviation or population variability (direct relationship)
• Tolerable misstatement (inverse relationship)
• Acceptable level of risk (inverse relationship)
• Expected size and frequency of misstatements (direct relationship)
• Assesed level of risk (direct relationship)

Question 12

Describe variables sampling

Answer 12

Variables sampling is a statistical sampling method used to estimate the numerical amount of a population. It may be used to substantiate management’s assertions in the F/S by determining whether amounts are reasonable. Often, this is accomplished by developing independent estimates of F/S amounts. Variable sampling is used primarily in substantive testing.

Question 13

What amounts are compared in drawing a conclusion about a variables sampling application?

Answer 13

The auditor compares the client’s book value to the calculated range in a variables sampling application. If the recorded book value is within the acceptable range, the book value is considered fairly stated. (The calculated range is the point estimate, as determine from the sample, plus/minus an allowance for sampling risk)

Question 14

What is discovery sampling?

Answer 14

Discovery sampling is a type of attribute sampling used when the expected deviation rate is zero or near zero

Question 15

What are the sampling plans commonly used for variables estimation?

Answer 15

• Mean-per-unit estimation: The sample mean is multiplied by the number of items in the population to estimate population value
• Ratio estimation: The ratio between book value and audited value (from a sample) is used to estimate population value
• Difference estimation: The difference between book value and audited value (from a sample) is used to estimate population value

Question 16

Define Probability-Proportional-to-size (PPS) sampling

Answer 16

Probability-Proportional-to-Size (PPS) sampling is a hybrid sampling technique that uses attribute sampling theory to express a conclusion in dollar amounts rather than as a rate of occurence. The sampling unti is defined as an individual dollar in a population, which creates the effect of stratified sampling (the unit’s chance of being selected increases as its amount increases)

Question 17

What are the advantages and disadvantages of using PPS sampling?

Answer 17

Advantages:

• Automatic stratification
• Efficient (smaller sample)

Disadvantages:

• May require special considerations for negative, zero, and understated balances

Question 18

How is the sampling interval determined in a PPS sampling application?

Answer 18

Sampling interval =

Tolerable misstatement
Reliability factor

(The reliability factor comeds from a table and is based on the risk of incorrect acceptance).

Question 19

What are the three primary purposes for obtaining written representations from management?

Answer 19

• To confirm representations explicity or implicity given to the auditor
• To indicate and document the continuing appropriateness of such representations
• To reduce the possibility of misunderstanding concerning matters that are subject of the representations

Question 20

What general types of items are included in a management representation letter, and who would sign it?

Answer 20

A management representation letter generally includes information related to:

• The F/S
• The completeness of information
• Fraud
• Related party transactions
• Recognition, measurement, and disclosure
• Subsequent events
• Issues specific to a particular entity

The management representation letter should be signed by the CEO, CFO, and any other members of management who are responsible for and knowledgeable about the items contained in the letter

Question 21

List the items that an auditor is required to communicate to those charged with governance

Answer 21

The auditor is required to communicate with those charged with governance regarding:

• The auditor’s responsibility under GAAS
• The planned scope and timing of the audit
• Significant audit finds, including:
  
  • Signficiant accounting policies
  • Management’s judgments and accounting estimates
  • The auditor’s judgment about the quality of the entity’s accounting principles
  • Difficulties encountered in performing the audit; disagreements with management.
  • Uncorreced misstatements
  • Management issues discussed prior to retention
  • Audit adjustments
  • Consultation (by managment) with other accountants
  • Other items required by AICPA standards or the Sarbanes-Oxley Act

Note: The communication can be oral or written, but must be documented in the audit documentation (working papers)

Question 22

What are the functions of the audit committee?

Answer 22

The audit committee typically:

1. Selects and appoints the independent auditor and sets the audit fee
2. Reviews the nature and details of the audit engagement
3. Reviews the quality of the auditor’s work
4. Reviews the scope of the audit
5. Determines that any recommendations made by the auditor are given proper attention
6. Maintains lines of communication between the auditor and the BOD
7. Helps solve any disagreements related to the accounting treatment of material items in the F/S
8. Evaluates the internal control of the company with the help of the independent auditor
9. Makes reports to the BOD and the stockholders when necessary
10. Assures that the auditor is independent of the company

Note: The audit committee has additional responsibilities under Sarbanes-Oxley

Question 23

What is a control deficiency?

Answer 23

A control deficiency exists when the design or operation of a control does not allow management or employees, in teh normal course of performing their assigned functions, to prevent or detect/correct misstatements on a timely basis.

Question 24

What is a significant deficiency?

Answer 24

A significant deficiency is a deficiency, or a combination of defiences, in internal control over financial report that is less severe than a material weakness, yet important enought to merit attention by those charged with governance (responsible for oversight of the company’s financial report).

Question 25

What is a material weakness?

Answer 25

A material weakness is a deficiency, or a combination of deficiences, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim F/S will not be prevented or detected/corrected on a timely basis.

Question 26

What is the auditor’s responsibility with respect to control deficiencies identified during an audit of a nonissuer?

Answer 26

• The auditor has a responsibility to evaluate control deficiences identified during the audit to determine whether they represent significant deficiencies or material weaknesses.
• Significant deficiencies and material weaknesses should be communicated in writing to management and those charged with governance within 60 days of the report release date.
• The communication with management and those charged with governance should be restricted use.

Question 27

What is an integrated audit. When is an integrated audit required?

Answer 27

An intergrated audit requires the auditor to audit both the F/S and internal control over financial reporting. The two audits must be performed together, and two opinions (one on the F/S and one on the effectiveness of internal control) will be rendered. An integrated audit is required:

1. For all audits of issuers.
2. When an auditor is engaged to examine the internal control of a nonissuer.

Question 28

Describe the top-down approach used to select controls to test for issuer/nonissuer clients

Answer 28

The top-down approach includes the following chronological levels:

• F/S level - the auditor evaluates overall risk
• Entity level - the auditor identifies and tests controls pertaining to:
• The control environment
• Management override
• Monitoring the results of operations and other controls
• Period-end financial reporting
• Centralized operations
• Accounts, Disclosure, and Assertions level - The auditor evaluates qualitative and quantitative risk factors to identify significant accounts, disclosures, and assertions for which there is a reasonable possibility of material misstatement. Once identified, the controls are tested.

Question 29

What is the accountant’s responsibility with respect to control deficiencies indentified during an engagement to examine the internal control or a nonissuer?

Answer 29

Significant deficiencies and material weaknesses should be communicated in writing to management and those charged with governance by the report release date.

Control deficiencies that are not significant deficiencies or material weaknesses should be communicated in writing to management within 60 days of the report release date.

A material weakness results in an adverse opinion

Question 30

How are control deficiencies, significant deficiencies, and material weaknesses communicated by the auditor to the issuer in an integrated audit?

Answer 30

All internal control deficiencies over financial reporting that were identified during the audit should be communicated to management in writing. The audit committee should be informed when the communication was made.

Any significant deficiencies identified during the audit should be communicated in writing to the audit committee.

Any material weaknesses identified during the audit should be communicated in writing to both management and the audit committee prior to the issuance of the auditor’s report on internal control over financial reporting.

Question 31

How does the extent of testing of internal controls differ between a F/S audit and an examination of internal control for nonissuers?

Answer 31

The extent of testing of internal controls for a F/S audit more limited than in an internal control examination

When rendering an opinion on internal control for an examination of internal controls, the auditor should obtain evidence regarding the effectiveness of selected controls over all relevant assertions. This level of testing is not required for a F/S audit.