Auditing A Risk Based Approach To Conducting A Quality Audit Johnstone 10th Edition Solutions Manual

Auditing A Risk Based-Approach to Conducting a
Quality Audit Johnstone 10th Edition Solutions

Manual
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Auditing A Risk Based-Approach to Conducting a Quality Audit Johnstone 10th Edition Solution
Solutions for Chapter 8

True-False Questions
8-1 T
8-2 F
8-3 T
8-4 F
8-5 F
8-6 F
8-7 T
8-8 F
8-9 F
8-10 T
8-11 T
8-12 F
8-13 T
8-14 T
Multiple-Choice Questions
8-15 A
8-16 C
8-17 E
8-18 A
8-19 E
8-20 C
8-21 D
8-22 A
8-23 E
8-24 C
8-25 B
8-26 D
8-27 E
8-28 A
Review and Short Case Questions
8-29
Sampling is used in testing both controls and account balances and assertions and involves
looking at less than 100% of the transactions that occurred during the period under audit.
Sampling techniques would be appropriate when an auditor wants to perform procedures such as
examining documents, reperforming calculations, or sending confirmations.
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
8-1
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GAS) are software programs designed specifically for auditors. GAS can be used to facilitate and
automate the testing of 100% of a population when appropriate and to help focus the auditor’s
attention on specific risk areas or transactions. GAS is software designed to read, process, and
write data. Auditors can use GAS to import a client’s computerized data; then the software can
be applied to the data in a variety of ways.
8-30
Exhibit 8.1
Approaches to Gathering Audit Evidence about Assertions
Financial Using Sampling to Gather Evidence Using GAS to Gather Evidence
Statement
Assertion
Existence or Take a sample of recorded transactions Sort the file to identify the largest
occurrence and for selected items examine items, the smallest items, the last
underlying evidence or send out transactions during the year (for testing
confirmations. cutoff), or the most frequent items
within the file; also useful in scanning
for unusual transactions.
Completeness Take a sample of subsequent cash Sort the file by vendor to identify the
disbursements to search for under- most commonly used vendors, or the
recorded liabilities. least commonly used vendors; or
comparing the list of vendors from the
prior year to the current year.
Rights or Often done in conjunction with Sort a file to scan for unusual
obligations existence testing, including examining transactions.
source documents.
8-2
Valuation or Select items and trace back to source Foot the file and test computations.
Allocation documents, such as purchase
agreements or invoices.
Presentation Verify estimates or other items for
and Disclosure proper disclosure.
8-31
Sampling units refer to the individual items to be tested. The sampling units make up the
population. The population is a group of transactions or the items that make up an account
balance for which the auditor wants to estimate some characteristic, such as the effectiveness of a
control procedure or estimate the extent of misstatement in an account.
8-32
The auditor needs to answer four critical questions when sampling:
1. Which population and sampling unit should be tested and what characteristics should be
examined (population)?
2. How many items should be selected for audit testing (sample size)?
3. Which items should be included in the sample (selection)?
4. What inferences can be made about the overall population from the sample (evaluation)?
8-33
Sampling risk is the risk that the auditor’s conclusion based on a sample might be different from
the conclusion he or she would reach if the test were applied in the same way to the entire
population. Nonsampling risk is the risk that the auditor reaches an erroneous conclusion for any
reason not related to sampling risk.
8-34
a.
Risk of incorrect acceptance of internal control reliability The risk that the auditor will
conclude that the state of internal controls is effective when internal controls are actually not
effective (also referred to as the risk of assessing control risk too low).
8-3
Risk of incorrect rejection of internal control reliability The risk that the auditor will
conclude that the state of internal controls is not effective when internal controls are actually
effective (also referred to as the risk of assessing control risk too high).
Risk of incorrect acceptance of book value The risk that the auditor will conclude that the
account balance does not contain a material misstatement when the account balance actually
does contain a material misstatement.
Risk of incorrect rejection of book value The risk that the auditor will conclude that the
account balance contains a material misstatement when the account balance actually does not
contain a material misstatement.
b.
The auditor should be most concerned about the risk of incorrect acceptance of either internal
control reliability or of book value because these lead to audit ineffectiveness. While the auditor
will certainly not want to be inefficient, ineffectiveness is a greater risk.
8-35
Exhibit 8.4
Comparison of Nonstatistical and Statistical Sampling
Nonstatistical Sampling Statistical Sampling
Sample size Sample size is determined by auditor Auditor judgment is quantified and
judgment. sample size is determined by
probability theory.
Sample selection Selection involves any method that the The sample must be randomly
auditor believes is representative of selected to give each unit in the
the population. population an equal chance to be
included in the sample.
Judgment sampling can also be The population of interest can also
directed at a portion of the population, be directed, for example the
for example all transactions during the transactions during the last 10 days
8-4
last 5 days of the year. of the year can be statistically
selected.
Evaluation Evaluation is based on auditor Evaluation is based on statistical
judgment and projections based on inference that is used to assist
sample results. auditor judgment.
Costs • Lower selection cost because only • Requires knowledge of
requires audit judgment to statistical sampling methods
determine an appropriate sample and/or special computer
size and evaluate the results sampling software is required
• Does not provide an objective way and often involves training
to control and measure sampling costs
risk • Requires auditor to define
acceptable risk in advance.
Benefits • Can be based on auditor’s prior Helps the auditor:
expectations about errors in the • Design an efficient sample
account • Measure the sufficiency of
• May take less time to plan, select, the evidence
and evaluate the sample • Evaluate the results by
providing an objective
measure of sampling risk
• Gain efficiencies through
computerized selection and
8-5
statistical evaluation
• Defend sample inferences
because they are based on
statistical theory
Helps the auditor evaluate the
sample by providing a
quantitative measure of:
• The most likely and
maximum failure rate of a control
procedure that is being evaluated
for effectiveness
• The most likely and
maximum amount of
misstatement in the recorded
account balance or class of
transactions
• The risk that the auditor
may make an incorrect
judgment about the state of
controls or correctness of
account balances
8-6
8-36
Attributes sampling is a statistical sampling method used to estimate the rate of control
procedure failures based on selecting one sample and performing the appropriate audit
procedure. An attribute is a characteristic of the population of interest to the auditor.
An example of an attribute of interest to an auditor would be evidence that the client has matched
vendor invoice details with the purchase order and receiving report before payment approval, and
noting that they match before authorizing a payment for the goods received.
An example of a control failure would be if the appropriate client employee failed to seek credit
approval for a new account, even though doing so is required by company policy.
8-37
In defining the population, the following factors need to be addressed:
• The period to be covered by the test; for example, the year when evaluating controls
• The sampling unit; for example, an item that would indicate the operation of a control
• The completeness of the population
8-38
The AICPA’s 2012 Audit Sampling guide formally defines the tolerable rate of deviation as a
rate of deviation set by the auditor in respect of which the auditor seeks to obtain an appropriate
level of assurance that the rate of deviation set by the auditor is not exceeded by the actual rate of
deviation in the population. This term is sometimes referred to as the tolerable failure rate. In
more practical terms, the auditor’s tolerate rate of deviation is the level at which the control’s
failure to operate would cause the auditor to conclude that the control is not effective and would
likely change the auditor’s planned assessment of control risk in performing tests of account
balances.
8-39
Sampling risk Tolerable rate of Expected Sample Size

deviation population (expected errors)
deviation rate
a. 5% 2% 1% 590 (6)
b. 5% 6% 5% 1,580 (79)
c. 5% 10% 8% 649 (52)
d. 10% 2% 1% 398 (4)
e. 10% 6% 5% 1,019 (51)
f. 10% 10% 8% 424 (34)
8-7
8-40
Sampling risk Tolerable rate of Expected Sample Size

deviation population
deviation rate
a. 10% 20% 0% 11
b. 5% 20% 0% 14
c. 5% 20% 0.25% 22
d. 5% 10% 0% 29
e. 10% 10% 0.25% 38
f. 10% 15% 7% 52
g. These assumptions imply that in order to justify these relatively small sample sizes, the auditor
will have to accept a relatively high tolerable rate of deviation, while expecting a relatively low
expected population deviation rate; these assumptions may be unrealistic thus calling into
question very low sample sizes.
8-41
a. An increase in sampling risk results in a smaller sample because the auditor is willing to
accept more risk of the audit conclusion being in error. As a general sampling rule, the more risk
the auditor is willing to take of being wrong, the smaller will be the sample size.
b. An increase in the tolerable rate of deviation results in a smaller sample because the sample
does not have to be as precise - there is a bigger range between the tolerable failure rate and
expected failure rate. Additionally, this increase likely means the auditor has concluded the
control is less important - also resulting in a smaller sample size.
c. An increase in the expected population deviation rate results in a larger sample results because
the sample has to be more precise - there is a smaller range between the tolerable failure rate and
expected failure rate.
d. Increase in population size normally does not affect the sample size unless the population size
is relatively small; then a larger sample would be required, but not in proportion to the increase
in population size.
8-42
a. Simple random sampling. Selecting a random sample by matching random numbers generated
by a computer or selected from a random-number table with, for example, document numbers
such as an invoice or a purchase order.
b. Systematic sampling. Selecting a random sample by matching random numbers generated by a

computer or selected from a random-number table with, for example, document numbers such as
an invoice or a purchase order.
8-8
c. Systematic random sampling. This sampling technique involves systematic sampling in which
the first item is selected randomly from the interval.
d. Haphazard sampling. A nonstatistical sample selection method that attempts to approximate a

random selection by selecting sampling units without any conscious bias, or special reason for
including or omitting certain items from the sample.
e. Block sampling. A sampling technique that involves selecting a sample that consists of
contiguous population items, such as selecting transactions by day or week.
8-43
Sampling risk Sample Size Number of Upper Limit of
Deviations Deviations
a. 5% 20 0 14.0%
The upper limit is

greater than 0, even
though there were
no deviations,
because the sample
size is very low; so
there is a strong
possibility that even
though the auditor
detected no
deviations in the
sample of 20 items,
there exist
deviations that the
auditor failed to
detect.
b. 5% 75 5 13.6%
c. 5% 150 10 11.1%
d. 10% 20 0 10.9%
The upper limit is

greater than 0, even
though there were
8-9
no deviations in the
sample, because the
sample size is very
low; so there is a
strong possibility
that even though
the auditor detected
no deviations in the
sample of 20 items,
there exist
deviations that the
auditor failed to
detect.
e. 10% 75 5 12.1%
f. 10% 150 10 10.1%
Interpretations:
a. The auditor is 95% confident that that the upper limit of the real deviation rate in the
population does not exceed 14.0%. Stated another way, it means that there is a 5% chance that
the real deviation rate exceeds 14.0%. Because the tolerable deviation rate is 12%, the auditor
concludes that the control is not operating effectively.
b. The auditor is 95% confident that that the upper limit of the real deviation rate in the
concludes that the control is not operating effectively.
c. The auditor is 95% confident that that the upper limit of the real deviation rate in the
concludes that the control is operating effectively.
d. The auditor is 90% confident that that the upper limit of the real deviation rate in the
e. The auditor is 90% confident that that the upper limit of the real deviation rate in the
concludes that the control is not operating effectively. However, given how close the upper limit
8-10
is to the tolerable rate, the auditor might consider increasing the sample size a bit to be more
certain about this conclusion.
f. The auditor is 90% confident that that the upper limit of the real deviation rate in the
8-44
In any sampling application there exists sampling risk. The upper limit takes sampling risk into
account and is the best indicator of the maximum deviation rate in the population and should be
compared to the tolerable failure rate.
The alternative courses of action are:
• A compensating control procedure could be identified and tested. The decision to test the
compensating control procedure will depend on the perceived effectiveness of the control and
the additional cost to test the control procedure.
• A larger sample could be taken, but this is not likely to be cost-beneficial unless the
auditor has reason to believe the original sample was not representative.
• The assessment of control risk can be set higher than originally planned and the
nature, timing, and/or the extent of the related substantive tests can be modified. If the upper
limit does not exceed the tolerable failure rate by very much, this modification could be very
slight. For example, if the upper limit was 5.4% and the tolerable rate was 5%, very little
modification is needed.
• The auditor will analyze the nature of the control deviations and determine the
implications on the type of misstatements, or causes of misstatements, that might occur in the
financial statements and adjust the nature, timing, and/or extent of the planned substantive
testing.
8-45
a.
Control Upper Limit of Control Failures
1 The upper limit is 3%.
2 Since the control calls for credit approval to be noted on the customer
orders, there are five deviations (the auditor must conclude there was no
credit approval for the two sales for which no customer order could be
found). The upper limit is 10.3%.
3 The upper limit is 7.6%.
6 The upper limit is 6.2%.
8-11
7 There are 6 deviations. The upper limit is 11.5%.
b. The upper limit of deviation for all controls tested except 1 (sales manager approval
of sales over $10,000) and 5 (proper pricing) exceeded the tolerable deviation rate.
Thus, there are problems with proper credit approval, lack of supporting shipping
documents and customer orders, premature recording of sales, and billing for larger
quantities that customers ordered. These deficiencies in internal controls would
probably result in an adverse opinion on internal controls because they are likely to
cause the auditor to conclude that there is a reasonable possibility that a material
misstatement could exist. Certainly, the pattern of errors suggests pervasive internal
control problems related to revenue and accounts receivable.
Control c. Potential Misstatements d. Effect on rest of audit

2&6 The allowance for doubtful accounts • Carefully review the aging of the
may be understated because of the lack year-end receivables.
of proper credit approval. • Increase coverage of confirmations
and subsequent collections.
The lack of customer orders for two • Increase the extent of cutoff testing
recorded sales could mean that the sales particularly for sales recorded just
were not ordered by customers resulting prior to year-end.
in artificially inflated sales. • Review the extent of subsequent
sales returns to determine if they are
3 The lack of shipping documents could more than normal. This may require
indicate misplaced documents or that estimating sales returns and
the sales did not take place. The auditor allowances as of year-end to match
should be professionally skeptical and with the sales.
assume the worst – the sales did not take • Heightened alertness to other
place. approaches management may use to
manage its earnings, particularly in
4 Sales being recorded prior to shipment the area of accounts based on
could be an honest mistake due to the estimates
temporary employee. However, this
may result in sales recorded in the
current year that should be recorded
next year.
7 Billing for more quantities than

customers ordered results in inflated
sales and receivables.
8-46
a. Misstatement. An error, either intentional or unintentional, that exists in a transaction or

financial statement account balance. For substantive sampling purposes, a misstatement
involves differences between recorded values and audited values.
8-12
b. Factual misstatement. A misstatement that has been specifically identified and about which
there is no doubt. Also referred to as a known misstatement.
c. Projected misstatement. The best estimate of the actual amount of dollar misstatements in the
population based on projecting the sample results to the population. The projected
misstatement is calculated as the sampling interval multiplied by the tainting percentage.
Also see likely misstatement or most likely misstatement.
d. Tolerable misstatement. A rate of deviation set by the auditor in respect of which the auditor
seeks to obtain an appropriate level of assurance that the rate of deviation set by the auditor is
not exceeded by the actual rate of deviation in the population. Also referred to as the
tolerable failure rate.
e. Expected misstatement. The level of misstatement that the auditor expects to detect, and it is
based on projected misstatements in prior-year audits, results of other substantive tests, audit
judgment, and knowledge of changes in personnel and the accounting system.
8-47
The sampling unit when gathering evidence about misstatements in account balances and
associated assertions is the individual auditable elements that make up individual account
balances. Examples in the context of accounts receivables include the customer’s balance,
individual unpaid invoices, or a combination of these two.
8-48
Stratification involves the division of a population into two or more sub-groups. Top-stratum
items are those that are large-value items that exceed the sampling interval. All items in the top-
stratum are audited. In contrast, lower-stratum items are lower-value items that are less than the
sampling interval. These items are sampled.
8-49
When using nonstatistical sampling, the auditor must use judgment in determining the sample
size, selecting the sample, and evaluating the sample results:
a. In determining the sample size, all significant items should be tested. The auditor should
select all items over a specific dollar amount, and then, depending on audit objectives, select
items with other characteristics, such as items billed in the last week or billed to specific
parties.
b. The sample should be selected to increase the likelihood that the sample is representative of
the population. The auditor may obtain a representative sample using a random-based
method or haphazard sampling.
c. As is true for statistical sampling, the sample results should be projected to the population
and compared with the tolerable misstatement. The auditor should also consider whether
there is an adequate allowance for sampling risk, the difference between the projected
misstatement and tolerable misstatement.
8-13
8-50
a. Lower stratum projected misstatement: ($600/$185,000) * $1,500,000 = $4,864.86

Plus top-stratum misstatement 1,000.00
Total projected misstatement $5,864.86
b. Tolerable misstatement has been set at $25,000 so the projected misstatement is significantly
less than tolerable misstatement. No further work needs to be performed.
c. When the total estimated misstatement exceeds the tolerable misstatement, the auditor has
available several possible courses of action. The auditor can:
Ask the client to correct the factual misstatements. If this is done, the total estimated
misstatement can be adjusted for those corrections but not for the projection of
misstatements associated with those items. In some cases, simply correcting the factual
misstatement can bring the total estimated misstatement below the auditor’s tolerable
misstatement level.
Analyze the detected misstatements for common problem(s). When misstatements are
discovered, the auditor should look beyond the quantitative aspects of the misstatements
to understand the nature and cause of the misstatements—especially to determine if there
is a systematic pattern to the misstatements. If a systematic pattern is found, the client can
be asked to investigate and make an estimate of the correction needed. The auditor can
review and test this estimate. Further, the auditor can recommend improvements to
prevent such errors in the future. For example, assume several confirmation replies
indicate that merchandise was returned prior to year end but credit was not recorded until
the subsequent year. A careful review of receiving reports related to merchandise returned
prior to year end and of credits recorded in the subsequent year will provide evidence
regarding the extent of the needed correction. The auditor should also consider the
relationship of the misstatements to other phases of the audit—problems in recording
receivables may also reveal problems in the accuracy of recorded sales.
Design an alternative audit strategy. Discovering more misstatements than expected in

the planning stage of the audit suggests that the planning assumptions may have been in
error and internal controls were not as effective as originally assessed. In such cases, the
auditor should plan the rest of the audit accordingly. For public companies, significant
problems with internal control will cause the auditor to consider whether it is necessary to
express an adverse opinion on the effectiveness of the client’s internal controls over
financial reporting.
Expand the sample. The auditor can increase the sample size. Although, this approach
may not be very useful if the first sample is representative of the population.
Change the audit objective to estimating the correct value. In cases where material
misstatements are likely, it may be necessary to change from an objective of testing
details to an objective of estimating the correct population value. A lower detection risk
and a smaller tolerable misstatement should be used because the auditor is no longer
8-14
testing the balance but estimating the correct population value from the sample. The
auditor will expect the client to adjust the book value to the estimated value. A larger
sample size will normally be required. Because of the frequency of misstatements
underlying the misstated balance, the auditor should use one of the classical statistical
sampling methods to evaluate the results.
8-51
Strengths of MUS include:
• MUS is generally easier to apply than other statistical sampling approaches.

• MUS automatically selects a sample in proportion to an item’s dollar amount, thus
providing automatic stratification of the sample.
• If the auditor expects (and finds) no misstatements, MUS usually results in a highly
efficient sample size.
Examples of the circumstances in which MUS might be used include:
• Accounts receivable confirmations (when credit balances are not significant).

• Loans receivable confirmations (e.g., real estate mortgage loans, commercial loans, and
installment loans).
• Inventory price tests in which the auditor anticipates relatively few misstatements and the
population is not expected to contain a significant number of large understatements.
• Fixed-asset additions tests where existence is the relevant assertion.
8-52
The auditor should also be aware of difficulties in using MUS:
• MUS is not designed to test for the understatement of a population.

• If an auditor identifies understatements in a MUS sample, evaluation of the sample
requires special considerations.
• Selection of zero or negative balances requires special design considerations.
8-53
The sample size of a MUS sample is a function of the following factors: (1) the risk of incorrect
acceptance, (2) the ratio of expected misstatement to tolerable misstatement, and (3) the ratio of
tolerable misstatement to the population.
8-15
8-54
Risk of Incorrect Ratio of Expected Ratio of Tolerable Sample Size
Acceptance to Tolerable Misstatement to
Misstatement Population
a. 5% 0.20 50% 10
b. 10% 0.20 30% 12
c. 15% 0.30 8% 43
d. 20% 0.30 5% 56
e. 25% 0.40 4% 73
f. 30% 0.40 3% 80
g. 35% 0.60 2% 169
h. 50% 0.60 1% 170
8-55
a. $8,500,000 ÷ 10 = $850,000; no need to round down

b. $8,500,000 ÷ 12 = 708,333 rounded down to 700,000
c. $8,500,000 ÷ 43 = $197,674 rounded down to $195,000
d. $8,500,000 ÷ 56 = $151,786 rounded down to $150,000
e. $8,500,000 ÷ 73 = $116,438 rounded down to $115,000
f. $8,500,000 ÷ 80 = $106,250 rounded down to $105,000
g. $8,500,000 ÷ 169 = $50,296 rounded down to $50,000
h. $8,500,000 ÷ 170 = $50,000; no need to round down
8-56
a. From Exhibit 8.7, the sample size is 54.

b. The sampling interval = $5,643,200 ÷ 54 = 104,689
c. $104,689 unless you round the interval down to the next $1,000 or $10,000. If you rounded
down to $100,000, then the largest number for a random start would be $100,000.
d. Using a sampling interval of $100,000, items 4, 6, 10, and 14 would be included in the
sample:
8-16
Sample Item
- Selection
Cumulative Amount
Item Book Value Amount
Random Start 25,000

1 3,900 28,900
2 26,000 54,900
3 5,000 59,900
4 130,000 189,900 100,000
5 2,000 191,900
6 260,000 451,900 200,300, &
400,000
7 100 452,000
8 25,000 477,000
9 19,000 496,000
10 10,000 506,000 500,000
11 9,000 515,000
12 2,500 517,500
13 65,000 582,500
14 110,000 692,500 600,000
15 6,992 699,492
e. The probability of selecting each item is as follows:
Book
Item Value Probability of Selection
1 3,900 3.9% = 3,900 / 100,000

2 26,000 26.0% = 26,000 / 100,000
4 130,000 100.0% = 130,000 / 100,000
6 260,000 100.0%
8-17
f. Because logical units with recorded amounts greater than the sampling interval
might be selected more than once, the actual number of logical units selected for
the sample might be less than the computed sample size.
8-57
a. The audit conclusion if no misstatements are found in the sample is that the
auditor is 70 percent confident that accounts receivable are not overstated by more
than $121,000 (the basic precision = 1.21 x $100,000). Because this is less than
the tolerable misstatement of $200,000, you can conclude that the account balance
is not materially overstated.
b. The audit evaluation of the sample results is as follows:
Confidence Tainting Sampling Conclusion
Factor* Percent Interval
Factual misstatement in 2,000
top-stratum
Basic precision 1.21  100,000 = 121,000
Projected misstatement:
First largest tainting % 750/15,000 = 5%
Second largest tainting % 90/9000 = 1%
6%  100,000 = 6,000
Incremental allowance for sampling risk 1,330**
Total Estimated Misstatement: 130,330
*Confidence factors come from the 30% column in Exhibit 8.9.
** See below for the calculation of this value.
8-18
Projected Misstatement Incremental Changes in Projected Misstatement X
Confidence Factor Factor (Step 3)
(Step 2)
5,000 + 2.44 – 1.21 = 1.23 6,150 +
1,000 3.62 – 2.44 = 1.18 1,180
6,000 (Step 1) 7,330 (Step 4)
Incremental allowance for sampling risk: 7,330 – 6,000 = 1,330 (Step 5)
c. These results are acceptable because the total estimated misstatement ($130,330) is
less than tolerable misstatement ($175,000).
d. When the total estimated misstatement exceeds the tolerable misstatement, the
auditor has available several possible courses of action. The auditor can:
Ask the client to correct the factual misstatements. If this is done, the total estimated
misstatement can be adjusted for those corrections but not for the projection of
misstatements associated with those items. In some cases, simply correcting the
factual misstatement can bring the total estimated misstatement below the auditor’s
tolerable misstatement level.
Analyze the detected misstatements for common problem(s). When misstatements are
discovered, the auditor should look beyond the quantitative aspects of the
misstatements to understand the nature and cause of the misstatements—especially to
determine if there is a systematic pattern to the misstatements. If a systematic pattern
is found, the client can be asked to investigate and make an estimate of the correction
needed. The auditor can review and test this estimate. Further, the auditor can
recommend improvements to prevent such errors in the future. For example, assume
several confirmation replies indicate that merchandise was returned prior to year end
but credit was not recorded until the subsequent year. A careful review of receiving
reports related to merchandise returned prior to year end and of credits recorded in the
subsequent year will provide evidence regarding the extent of the needed correction.
The auditor should also consider the relationship of the misstatements to other phases
of the audit—problems in recording receivables may also reveal problems in the
accuracy of recorded sales.
Design an alternative audit strategy. Discovering more misstatements than expected

in the planning stage of the audit suggests that the planning assumptions may have
been in error and internal controls were not as effective as originally assessed. In such
cases, the auditor should plan the rest of the audit accordingly. For public companies,
8-19
significant problems with internal control will cause the auditor to consider whether it
is necessary to express an adverse opinion on the effectiveness of the client’s internal
controls over financial reporting.
Expand the sample. The auditor can increase the sample size. Although, this approach
may not be very useful if the first sample is representative of the population.
Change the audit objective to estimating the correct value. In cases where material
misstatements are likely, it may be necessary to change from an objective of testing
details to an objective of estimating the correct population value. A lower detection
risk and a smaller tolerable misstatement should be used because the auditor is no
longer testing the balance but estimating the correct population value from the
sample. The auditor will expect the client to adjust the book value to the estimated
value. A larger sample size will normally be required. Because of the frequency of
misstatements underlying the misstated balance, the auditor should use one of the
classical statistical sampling methods to evaluate the results.
8-58
a. Round the ratio of expected to tolerable misstatement up to 30%, and round the ratio of the
tolerable misstatement to the population book value down to 4%. From Exhibit 8.7, the
sample size is 109. This is found by looking in the 10% row, the 0.30 row, and the 4%
column.
Sampling interval = population size / sample size, so:
Sampling interval = $8,124,999 / 109 = $74,541, which would likely be rounded down to
$70,000.
8-20
b. The total estimated misstatement is calculated as follows:
Factual misstatement in 2,000
top-stratum
Basic precision 2.31  70,000 = 161,700
Projected misstatement in
lower stratum:
First largest tainting % 11.93%
11.93%  70,000 = 8,352
Incremental allowance for sampling risk 4,844**
in lower stratum
Total Estimated Misstatement: 176,896
** See below and Exhibit 8.12 for the calculation of this value.
First largest tainting % = $41,906.45 - $36,906.45 = $5,000 / $41,906.45 = 0.119313
Projected Misstatement Incremental Changes in Projected Misstatement X
Confidence Factor Factor (Step 3)
(Step 2)
8,352 (Step 1) 3.89 – 2.31 = 1.58 13,196 (Step 4)
The statistical conclusion is that the auditor is 90% confident that this population is not
overstated by more than $176,896. Because the total estimated misstatement is less than the
8-21
tolerable misstatement ($275,000), the auditor can conclude that, at the desired level of risk of
incorrect acceptance, the population does not contain a material amount of overstatement.
8-59
a. Round the ratio of the tolerable misstatement to the population book value down to 2%. From
Exhibit 8.7, the sample size is 171. This is found by looking in the 10% row, the 0.20 row, and
the 2% column.
Sampling interval = population size / sample size, so:
Sampling interval = $8,425,000 / 171 = $49,269, which would likely be rounded down to
$45,000.
b.
Item Dollar/Percent Misstatement Problem

1. $0 / 0% Account balance is correct, just
posted to wrong customer.
2. $20,000; 50%; Lower-stratum Credit memo problem.
3. $75,000; Top-stratum Cost overrun.
4. $ 5,000; Top-stratum Cost overrun
5. $ 122; 100 percent; Lower- Credit memo problem.
stratum
8-22
c. The total estimated misstatement is calculated as follows:
Factual misstatement in
top-stratum ($75K + $5K) $80,000
= 2.31  45,000 = 103,950
Basic precision
Projected misstatement in
the lower stratum:
First largest tainting % 100%
Second largest tainting % 50%
150%  45,000 = 67,500
Incremental allowance for sampling risk in lower
stratum 36,000**
Total Estimated Misstatement: $287,450
** See below and Exhibit 8.12 for the calculation of this value.
8-23
First largest tainting % = $122 – 0 = 122 / $122 = 100%
Second largest tainting % = $40,000 - $20,000 = $20,000 / $40,000 = 50%
Projected Misstatement Incremental Changes in Projected Misstatement X Factor (Step
Confidence Factor 3)
(Step 2)
45,000 + 3.89 – 2.31 = 1.58 71,100 +
22,500 5.33 – 3.89 = 1.44 32,400
67,500 (Step 1) 103,500 (Step 4)
The statistical conclusion is that the auditor is 90% confident that this population is not
overstated by more than $287,450. Because the total estimated misstatement is more than the
tolerable misstatement ($200,000), the auditor can conclude that, at the desired level of risk of
incorrect acceptance, the population does contain a material amount of overstatement.
d. The auditor would expand audit tests on the account balance. There are two types of
misstatement patterns that should concern the auditor. First, there appears to be a problem with
timely issuance of credit memos. The auditor should find out more about the causes of the credit
memo problems and examine the process of issuing credit memos further. Second, there is a
pattern of cost overruns on large projects. The auditor would want to expand audit work to
examine a number of other large contracts to determine whether cost overruns were applicable to
other contracts, including those that had been closed during the period (sales may be overstated
even if there is a zero accounts receivable balance).
8-60
When the total estimated misstatement exceeds the tolerable misstatement, the auditor has
available several possible courses of action. The auditor can:
• Ask the client to correct the factual misstatements. If this is done, the total estimated
misstatement can be adjusted for those corrections but not for the projection of misstatements
associated with those items. In some cases, simply correcting the factual misstatement can
bring the total estimated misstatement below the auditor’s tolerable misstatement level.
• Analyze the detected misstatements for common problem(s). When misstatements are
discovered, the auditor should look beyond the quantitative aspects of the misstatements to
understand the nature and cause of the misstatements—especially to determine if there is a
systematic pattern to the misstatements. If a systematic pattern is found, the client can be
asked to investigate and make an estimate of the correction needed. The auditor can review
8-24
and test this estimate. Further, the auditor can recommend improvements to prevent such
errors in the future. For example, assume several confirmation replies indicate that
merchandise was returned prior to year end but credit was not recorded until the subsequent
year. A careful review of receiving reports related to merchandise returned prior to year end
and of credits recorded in the subsequent year will provide evidence regarding the extent of
the needed correction. The auditor should also consider the relationship of the misstatements
to other phases of the audit—problems in recording receivables may also reveal problems in
the accuracy of recorded sales.
• Design an alternative audit strategy. Discovering more misstatements than expected in the
planning stage of the audit suggests that the planning assumptions may have been in error
and internal controls were not as effective as originally assessed. In such cases, the auditor
should plan the rest of the audit accordingly. For public companies, significant problems with
internal control will cause the auditor to consider whether it is necessary to express an
adverse opinion on the effectiveness of the client’s internal controls over financial reporting.
• Expand the sample. The auditor can calculate the additional sample size needed by
substituting the most likely misstatement from the sample evaluation for the original
expected misstatement in the sample interval formula and determine a new interval and total
sample size based on the new expectations. The number of additional sample items can then
be determined by subtracting the original sample size from the new sample size. The new
sampling interval can be used for selection of items not already included in the sample.
• Change the audit objective to estimating the correct value. In cases where material
misstatements are likely, it may be necessary to change from an objective of testing details to
an objective of estimating the correct population value. A lower detection risk and a smaller
tolerable misstatement should be used because the auditor is no longer testing the balance but
estimating the correct population value from the sample. The auditor will expect the client to
adjust the book value to the estimated value. A larger sample size will normally be required.
Because of the frequency of misstatements underlying the misstated balance, the auditor
should use one of the classical statistical sampling methods to evaluate the results.
8-61
Scenario 1 (a). The implication of the closeness of this amount to the tolerable misstatement is
that the auditor should exercise considerable professional skepticism in concluding that the
account balance is correct in all material respects.
Appropriate Course of Action Considering Option (a). Utilitarian Theory and Rights Theory
imply that the auditor should do what is in the interests of shareholders and debt holders in this
setting, since these stakeholders have a vested financial interest in the accuracy of the financial
information. These individuals have a right to receive financial information that is correct in all
material respects. Turning to the ethical decision making framework, the auditor should consider
the following steps:
1. Identify the ethical issue. By doing no more audit work, the auditor is in danger of
concluding that the account balance is materially correct when, in fact, it may not be. The
auditor should analyze the causes of the misstatements. If they appear to be errors rather
than fraud, no further action might be needed. However, if the misstatements may be the
8-25
result of fraud, further action is required. Further, the auditor might want to reconsider
the initial professional judgments made when developing the sampling plan and assess
whether these judgments are reasonable (e.g., should tolerable deviation rate be lower,
should risk of incorrect acceptance be lower).
2. Determine the affected parties. As noted above, the shareholders and debt-holders are the
most significant affected parties.
3. Develop alternative courses of action. One course of action is to do nothing, i.e., maintain
the status quo and do no more sampling. Another course of action is to do more sampling
and/or to reconsider the initial judgments referred to in 1 above.
4. Determine likely consequences. If the auditor does nothing, the account balance may be
correct, and in that case there is no harm done. If the account balance is materially
overstated, the stock may be over-priced, or debt-holders may be providing funds at
inappropriate interest rates. If the auditor collects a larger sample, it may be that the
account balance is correct, and in that case there is no harm done (except that audit effort
is increased, and this has an associated cost). If the auditor collects a larger sample and
finds that the account balance is decidedly overstated, then the auditor could insist that
the client write the account down to a more reasonable level, and stakeholder rights will
be protected.
5. The Rights Framework would likely eliminate the do nothing course of action because of
the associated downside risk, which applies to many stakeholders. The cost of collecting
additional audit evidence is likely very small in relation to the potential benefits achieved
from calculating an accurate accounts receivable balance.
6. The appropriate course of action is to collect additional audit evidence.
Scenario 1 (b). Utilitarian Theory and Rights Theory imply that the auditor should do what is in
the interests of shareholders and debt-holders in this setting, since these stakeholders have a
vested financial interest in the accuracy of the financial information. These individuals have a
right to receive financial information that is correct in all material respects. Turning to the ethical
decision making framework, the auditor should consider the following steps:
1. Identify the ethical issue. By disregarding the detected overstatements, the upper
misstatement limit calculation is incorrect. The statistical conclusion will be invalid, i.e.,
the account balance is clearly materially misstated if the auditor goes along with what the
senior proposes.
2. Determine the affected parties. As noted above, the shareholders and debt-holders are the
most significant affected parties.
3. Develop alternative courses of action. One course of action is to do nothing, i.e., maintain
the status quo and do as the senior proposes. Another course of action is to make the
correct calculations and try to convince the senior that the associated result is appropriate.
A third course of action is to bring the matter to the attention of the manager or partner
immediately and involve them in the decision making process. Also, the audit firm
should have a whistleblower hotline to which this could be reported.
4. Determine likely consequences. If the auditor does nothing, the account balance will
clearly be misstated, and stakeholders will be materially misinformed. If the auditor
convinces the senior to revise the calculation, the account balance can be properly
adjusted (assuming that the client agrees). If the senior is not convinced, the auditor faces
the difficult choice of ignoring the issue or notifying his/her superiors, which will likely
8-26
alienate the senior. But if the manager and partner agree with the staff auditor, then the
account balance can be properly adjusted. If the staff auditor immediately informs the
manager and partner, the same (hopefully good) outcome can occur, but the senior will
very likely be alienated from the staff auditor.
5. The Rights Framework would clearly eliminate the do nothing course of action because
of the associated downside risk, which applies to many stakeholders. The option of
immediately informing superiors without first allowing the senior to change his mind will
lead to inevitable alienation in the audit team. The option of trying to convince the senior
may yield a positive outcome, and it allows the senior to “save face” and change his mind
before the staff auditor goes to his/her superiors.
6. The option of trying to convince the senior (and hoping for a good outcome) seems like
the best option.
Scenario 2. The information in the problem implies that there is a 10% chance that the actual
amount of the overstatement is no greater than $230,000. While this amount is greater than the
original tolerable misstatement amount of $215,000, it is less than the new amount of $250,000.
The implication of the change in the tolerable misstatement amount with regards to whether the
accounts receivable amount requires downward adjustment is that the new amount suggests that
the misstatement is not material, so no adjustment would be required. What is very important is
whether the staff auditor believes the senior’s rationale for the change (i.e., that the client is in
good financial health and has relatively strong internal controls). If that is truly the case, then
there is no ethical dilemma. But the staff auditor would likely question why this change, and in
this direction, is being made now—did the senior obtain new information that made the original
judgments inappropriate?
If that is not the case, then the auditor should follow the ethical decision making framework
outlined in Chapter 4. That decision making might proceed as follows:
1. Identify the ethical issue. By altering the tolerable amount simply so that the
misstatement will not be material, the senior allows a materially misstated amount to
be reported. The additional ethical issue is that of the senior’s deceptive and
calculating behavior, which harms the character of the engagement team and the audit
firm.
2. Determine the affected parties. As noted above, the shareholders and debt holders are
the most significant affected parties. In addition, other individuals at the audit firm
are harmed because if this behavior is allowed to occur unchecked, then their right to
working at an ethical and professionally-bound workplace is violated.
3. Develop alternative courses of action. One course of action is to do nothing, i.e.,
maintain the status quo and do as the senior proposes. Another course of action is to
convince the senior that his proposal is inappropriate. A third course of action is to
bring the matter to the attention of the manager or partner immediately and involve
them in the decision making process.
4. Determine likely consequences. If the auditor does nothing, the account balance will
clearly be misstated, and stakeholders will be materially misinformed. If the auditor
convinces the senior not to falsely recalculate materiality, the account balance can be
properly adjusted (assuming that the client agrees). If the senior is not convinced, the
8-27
auditor faces the difficult choice of ignoring the issue or notifying his/her superiors,
which will likely alienate the senior. But if the manager and partner agree with the
staff auditor, then the account balance can be properly adjusted. If the staff auditor
immediately informs the manager and partner, the same (hopefully good) outcome
can occur, but the senior will very likely be alienated from the staff auditor.
5. The Rights Framework would clearly eliminate the do nothing course of action
because of the associated downside risk, which applies to many stakeholders. The
option of immediately informing superiors without first allowing the senior to change
his mind will lead to inevitable alienation in the audit team. The option of trying to
convince the senior may yield a positive outcome, and it allows the senior to save
face and change his mind before the staff auditor goes to his/her superiors.
6. The option of trying to convince the senior (and hoping for a good outcome) seems
like the best option.
Scenario 3. Management’s incentive is generally to overstate assets, including accounts

receivable. This trend of overstatements reveals either that management is intentionally
overstating the accounts, or they have not invested in adequate internal controls or accounting
staff to assure the accurate recording of accounts receivable. Therefore, the audit firm should
consider this issue in its client continuance decision, increasing the assessed risk profile of
management, and making sure to employ an appropriate level of professional skepticism during
the conduct of the audit. The ethical implication of this issue is that management may not be as
trustworthy as previously thought. A lack of trust has a pervasive effect on the audit because it
calls into question management’s possible motivations to misstate other accounts, or to provide
inaccurate descriptions of facts. Auditors in this situation will carefully consider whether they
want to retain this client in the future. If the audit firm does retain the client, the auditor should
increase their professional skepticism, heighten inherent risk assessments, and conduct a more
substantive audit as a result.
8-62
a. Analyze a file. Use GAS to create a graphical analysis of items making up a population, for
example graphing the dollar value of account balances to see how many are above a certain
amount.
b. Select transactions based on logical identifiers. Use GAS to select transactions that are
greater than a certain dollar amount, or that occur during a certain period in time, such as the
last week of the year and the first week of the next year.
c. Select samples. Use GAS to select a sample using a program such as ACL.
d. Evaluate samples. Use GAS to evaluate a sample using a program such as ACL.
e. Print confirmations. Use GAS to select account balances for confirmation, and print
confirmations for mailing.
f. Analyze overall file validity. Use GAS to read a computer file and compare individual items
with control parameters to determine whether edit controls were overridden.
g. General control totals. Use GAS to count the number of transactions contained in a file and
compare that total to the number of individual records.
h. Perform numerical analyses. Use GAS to study patterns of data, for example according to
Benford’s Law.
8-28
8-63
Advantages of using GAS as part of the audit include:
• The software is independent of the system being audited and simply needs a read-only
copy of the file to avoid any corruption of an organization’s data.
• The software includes many audit-specific routines, such as sampling.
• The software can provide documentation of each test performed in the software that can
be used as documentation in the auditor’s work papers.
• GAS can help auditors be more efficient in completing their audit responsibilities related
to gathering and evaluating audit evidence.
Academic Research Case
a. The paper provides data on the sampling practices of auditors in industry, government
and public accounting. Auditors were surveyed to determine if they used statistical or
nonstatistical sampling techniques to determine sample size, to select sample items, and to
evaluate sample outcomes. The following issues were also addressed:
• training and education received by auditors concerning sampling methods and debiasing
techniques,
• sources auditors relied on for guidance on sampling procedures, and
• whether debiasing techniques were used when employing nonstatistical methods to determine
samples for audit testing.
b. The results of the surveys indicated that 85% of the respondents rely on nonstatistical
methods to plan sample sizes within all three areas of audit practice being surveyed. Haphazard
sampling was the most commonly used method to select samples (74% of respondents).
Respondents also indicated that 15% of their samples were selected using statistical methods.
However, 36% of the samples were evaluated using statistical methods. This indicates that 21%
of auditors’ nonstatistical samples were being improperly evaluated with statistical methods. The
use of improper statistical evaluation methods to evaluate samples obtained using nonstatistical
methods is more predominant in industry audits.
All respondents indicated reliance on employer guidance when seeking guidance on sampling
methods and most reported reliance on AICPA literature. However, 100 % of those surveyed in
the industry field indicated reliance on IIA standards. However, none of the other audit fields
surveyed indicated any reliance on the IIA standards.
Eighty-seven percent of the respondents indicated minor coverage of statistical sampling

methods as part of their college courses, while 91% indicated minor coverage of nonstatistical
sampling methods in college courses.
Regarding biases related to nonstatistical sample selections most respondents reported any such
issues to be minor during sampling selection. None of the respondents used any procedures to
8-29
Auditing A Risk Based-Approach to Conducting a Quality Audit Johnstone 10th Edition Solution
mitigate the possibilities of any biases affecting sampling selection; nor did they report any
meaningful instruction on the use of mitigating procedures.
c. Sampling methods used during sample selection can have a major impact on the outcome
of the audit opinion. The method used to select samples of evidence for auditing can affect the
number and type of items selected for review. The method used to evaluate the sample outcome
can also affect the outcome of the audit. Several well designed studies have documented biases
in nonstatistical sample selections. The auditor needs to be aware that nonstatistical sample
methods can lead to biased selections, unless debiasing techniques are used. The absence of
meaningful debiasing procedures for nonstatistical sample selections and evaluations may create
a legal exposure for the auditor.
The findings allow practicing auditors to benchmark their current sampling processes against the
current norms. Auditors (who rely mostly on nonstatistical methods for sampling selections)
should consider the need for debiasing techniques and restrict the use of statistical evaluations to
applications that rely on statistical selection methods to avoid samples being improperly
evaluated.
University educators should consider devoting additional class time to nonstatistical sampling
methods including the weaknesses of these methods and how to work with them. Standard-
setting bodies should consider developing detailed sampling standards specifically tailored for
auditors in industry and government as the current standards are mostly related to public
accounting.
d. Surveys were mailed to 600 randomly selected offices of auditors working in public
accounting, industry, federal and state government. The surveys requested these offices to have
auditors who had performed sampling techniques within the last 6 months to complete and return
the questionnaires. 223 usable surveys were returned. The selected surveys included auditors
with an average experience of 2.6 years and half held entry level staff positions.
e. The student (and practice) should be aware that the research for this paper was done in
mid-1997. The research on the use of alternative statistical selection methods was limited to
evaluation methods that distinguished between statistical and non-statistical evaluation of
sampling.
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Approaches to Gathering Audit Evidence about Assertions

Financial Using Sampling to Gather Evidence Using GAS to Gather Evidence

confirmations. cutoff), or the most frequent items

within the file; also useful in scanning

for unusual transactions.

disbursements to search for under- most commonly used vendors, or the

recorded liabilities. least commonly used vendors; or

comparing the list of vendors from the

prior year to the current year.

obligations existence testing, including examining transactions.

Allocation documents, such as purchase

Presentation Verify estimates or other items for

and Disclosure proper disclosure.

The auditor needs to answer four critical questions when sampling:

3. Which items should be included in the sample (selection)?

Comparison of Nonstatistical and Statistical Sampling

Nonstatistical Sampling Statistical Sampling

judgment. sample size is determined by

auditor believes is representative of selected to give each unit in the

the population. population an equal chance to be

included in the sample.

Judgment sampling can also be The population of interest can also

directed at a portion of the population, be directed, for example the

Evaluation Evaluation is based on auditor Evaluation is based on statistical

judgment and projections based on inference that is used to assist

sample results. auditor judgment.

Costs • Lower selection cost because only • Requires knowledge of

requires audit judgment to statistical sampling methods

determine an appropriate sample and/or special computer

size and evaluate the results sampling software is required

• Does not provide an objective way and often involves training

to control and measure sampling costs

risk • Requires auditor to define

acceptable risk in advance.

Benefits • Can be based on auditor’s prior Helps the auditor:

expectations about errors in the • Design an efficient sample

account • Measure the sufficiency of

• May take less time to plan, select, the evidence

and evaluate the sample • Evaluate the results by

measure of sampling risk

• Gain efficiencies through

computerized selection and

• Defend sample inferences

because they are based on

Helps the auditor evaluate the

quantitative measure of:

• The most likely and

maximum failure rate of a control

procedure that is being evaluated

• The most likely and

misstatement in the recorded

account balance or class of

• The risk that the auditor

may make an incorrect

judgment about the state of

In defining the population, the following factors need to be addressed:

• The completeness of the population