Lesson 3 – Major Phases of an Audit - Part II

Audit of Business Transaction Cycles and Audit Sampling

Overview:

Auditors generally divide an entity’s information system into business processes or

transaction cycles. Using this approach, the auditor is able to gather evidence by examining the
processing of related transactions from their origin to their ultimate disposition in accounting
journals and ledgers. The five basic processes are (1) the revenue process, (2) the purchasing
process, (3) the human resource management process, (4) the inventory management process,
and (5) the financing process. Auditors divide the financial statement components into business
processes or cycles in order to manage the audit better.

In the early days of auditing, it was not unusual for the independent auditor to examine
all of the records of the company being audited. However, as companies grew in size and
complexity, it became uneconomical to examine all the accounting records and supporting
documents. Auditors found it necessary to draw conclusions about the fairness of a company’s
financial statements based on an examination of a subset of the records and transactions. As a
result, the auditor provides reasonable, not absolute, assurance that the financial statements
are fairly presented. The justification for accepting some uncertainty is the trade-off between the
cost of examining all the data and the cost of making an incorrect decision based on a sample
of the data.

Learning Objectives:

After studying this lesson, the student should:

 Identify the fundamental tasks performed in the transaction cycles.

 Describe the functional departments involved in transaction cycles activities and
trace the flow of these transactions through the organization.
 Understand the documents, journals, and accounts that provide audit trails,
promote the maintenance of historical records, support internal decision making,
and sustain financial reporting.
 Identify the risks associated with various transaction cycles and recognize the
controls that reduce those risks.
 Identify the nature and purposes of audit sampling.
 Describe differences between statistical and non-statistical sampling; attribute
and variable sampling, including the risks associated.

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  Identify the nature of various sample selection methods under attribute and
variable sampling
 Understand the steps in performing audit sampling and how to document the
samples selection

Course Materials:

A. Revenue Cycle

The revenue cycle is a recurring set of business activities and related information
processing operations associated with providing goods and services to customers and collecting
cash in payment for those sales. The basic activities in the revenue cycle are: order entry -
soliciting and processing customer activities- filling customer orders and shipping merchandise-
invoicing customers and maintaining customer accounts collections - the cashier handles
remittances and deposits them in the bank; accounts receivable personnel credits customer
accounts for the payments received.

The sales department receives the order information from the customer, either by mail,
phone, or in person. Information is captured on a sales order form which includes customer
name, account number, name, number and description of items ordered, quantities and unit
prices plus taxes, shipping info, discounts, freight terms. This form is usually prepared in
multiple copies that are used for credit approval, packing, stock release, shipping, and billing.
The credit department provides transaction authorization by approving the customer for a credit
sale and returns and allowances. The shipping department receives information from the sales
department in the form of packing slip and shipping notice. When the goods arrive from the
warehouse, the documents are reconciled with the stock release papers. The goods are packed
and labeled. The packing slip is included. The shipping notice is sent to billing. A bill of lading is
prepared to accompany the shipment.

The common documents in revenue cycle are as follows:

 Sales invoice notifies customer of amount to be paid.
 Monthly statement summarizes all transactions that occurred during month.
 Credit memo authorizes the billing department to credit the customer's account,
should be issued by credit manager.

The following are the threats and related controls for Revenue Cycle:

Threat 1: Sales to customers with poor credit.

Controls: Having an independent credit approval function and maintaining good
customer accounting can help to prevent problems.

Threat 2: Shipping errors

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Controls: Reconciling shipping notices with picking tickets; bar-code scanners; and data
entry application controls will help to catch these errors.

Threat 3: Theft of inventory

Controls: Secure the location of inventory and document transfers; release only with
valid shipping orders; have good accountability for picking and shipping; and finally,
periodically reconcile records with a physical count.

Threat 4: Failure to bill customers

Controls: Separating shipping and billing and pre-numbering of shipping documents
helps along with reconciliation of all sales documents.

Threat 5: Billing errors

Controls: Reconciliation of picking tickets and bills of lading with sales orders; data entry
edit controls; and price lists may prevent billing errors.

Threat 6: Theft of cash

Controls: Segregation of duties is essential to prevent this serious problem (the following
duties should be separate: handling cash and posting to customer accounts; handling
cash and authorizing credit memos and adjustments; issuing credit memos and
maintaining customer accounts); use of lockboxes for receipts and electronic fund
transfer (EFT) for disbursements; mailing customer statements monthly; use cash
registers in retail operations where cash payments are received; deposit cash daily in
the bank; and have the bank reconciliation function performed by independent third
parties.

Threat 7: Posting errors in updating accounts receivable.

Controls: Use of editing and batch totals is essential here.

Threat 8: Loss of data.

Controls: Regular backups are essential with one copy stored off-site; and logical and
physical access controls to prevent leakage to competitors and irregularities.

Threat 9: Poor performance

Controls: Use sales and profitability analyses; accounts receivable aging; and cash
budgets to track operations.

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*Each of these substantive tests of transactions could be conducted as a test of controls or a dual-
purpose test. Of these six assertions, the cutoff assertion is the one that is most often conducted as a
substantive procedure.

B. Expenditure Cycle

The expenditure cycle is a recurring set of business activities and related data
processing operations associated with the purchase of and payment for goods and services.
The basic activities in the expenditure cycle are: Requesting the purchase of needed goods.
Ordering goods to be purchased. Receiving ordered goods. Approving vendor invoices for
payment. Paying for goods purchased.

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 Inventory control monitors inventory and authorizes restocking with a purchase
requisition. A copy is retained and one is sent to accounts payable. Purchasing acts on the
purchase requisition and prepares a purchase order. The original is sent to a vendor. Copies go
to inventory control and accounts payable. A blind copy is sent to receiving and another is filed
in purchasing.

When the goods are received, the receiving staff count and inspect the goods. The blind
PO tells what goods were ordered. The count is a significant control check. Receiving prepares
a receiving report. One copy accompanies the goods to the storeroom. Other copies go to
purchasing, inventory control, and accounts payable.

Accounts payable reconciles the purchase requisition, purchase order and receiving
report. When the vendor invoice arrives, it is examined thoroughly and reconciled and if all
documents agree, the transaction is recorded in the purchases journal and the accounts
payable subsidiary ledger. The information is filed until the time arises to make payment. The
general ledger department receives a journal voucher from AP and a summary from inventory
control. The inventory and accounts payable control accounts are updated.

For the disbursements, accounts payable reviews the documents related to a liability:
purchase requisition, purchase order, receiving report, and vendor invoice. If proper, cash
disbursements department is authorized to make payment.

Cash disbursements prepares the check, a separate person signs it, sends it to the
vendor, and notifies accounts payable. At the end of the period, cash disbursements and
accounts payable send summary information to general ledger.

The following are the threats and related controls for Expenditure Cycle:

Threat 1: Stock-outs
Controls: Inventory control system; accurate perpetual inventory; and vendor
performance analysis is needed to prevent this problem.

Threat 2: Requesting goods not needed.

Controls: Review and approval by supervisors; use of pre-numbered requisition forms;
and restricted access to blank purchase orders.

Threat 3: Purchasing goods at inflated prices.

Controls: Competitive bidding and proper supervision; approved purchase orders; and
price list consultations are needed to prevent this problem.

Threat 4: Purchasing goods of inferior quality.

Controls: Use experienced buyers who know good vendors; review purchase orders; and
incorporate approved vendor list into formal procedures.

Threat 5: Purchasing from unauthorized vendors.

Control: Pre-numbered purchase orders should be approved; restrict access to approved
vendor list and have procedures in place for any change to the list.

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 Threat 6: Kickbacks paid to buyers to influence their decisions.
Controls: Clear conflict of interest policy prohibiting the acceptance of any gift from
vendors; disclosure of financial interest policy for purchasing agents; and vendor audits.

Threat 7: Receiving unordered goods.

Controls: Receiving department must reject any goods for which there is no approved
purchase order.

Threat 8: Errors in counting goods received.

Controls: Use "blind" P.O. copies to force receiving personnel to actually count goods;
provide incentives for counting goods.

Threat 9: Theft of inventory.

Controls: Secure inventory storage locations; make transfers of inventory with proper
approval and documentation; do periodic physical count and reconciliation with recorded
amounts.

Threat 10: Errors in vendor invoices.

Controls: Invoice accuracy should be verified and compared to P.O.s and receiving
report data.

Threat 11: Paying for goods not received.

Controls: Voucher package and original invoice should be necessary for payments.

Threat 12: Failure to take available purchase discounts.

Controls: File approved invoices by due date; track invoices by due date; use a cash
budget to plan for cash needs.

Threat 13: Paying same invoice twice.

Controls: Invoices should be approved only with a full voucher package and paid ones
should be canceled so they cannot be used again; do not pay invoices marked
"Duplicate" or "Copy".

Threat 14: Recording and posting errors for purchases and payments.
Controls: Data entry controls, and periodic reconciliation of subsidiary ledger with
general ledger control account.

Threat 15: Misappropriation of cash by paying fictitious vendors and alteration of checks.
Controls: Restrict access to cash, blank checks, and check signing machine; use check
protection, pre-numbered checks, and imprinted amounts on checks to cut down on
forgery and fraud; use petty cash fund for small expenditures only; have proper
segregation of duties and independent bank reconciliation function.

Threat 16: Theft associated with Electronic Fund Transfer (EFT) use.
Controls: Access controls to the system; encryption of transmissions; timestamp and
number transmissions; control group should monitor all EFT activity.

Threat 17: Loss of data.

Controls: Use file labels, back up of all data files regularly; and, use access controls.

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 The Fixed Asset System processes nonroutine transactions which are recorded as capital
assets. The receiving department delivers fixed assets to the user/manager. The fixed asset
department performs the record keeping function. Asset acquisition handles the steps leading to
the acquisition of new fixed assets: recognition of need, authorization and approval, possible
capital investment analysis, and selection of supplier. Because of the value of fixed assets,
special approvals are needed.

INDEPENDENT VERIFICATION CONTROLS.

1. Periodically, the internal auditor should review the asset acquisition and approval
procedures to determine the reasonableness of key factors including: the useful life of the asset,
the original financial cost, proposed cost savings as a result of acquiring the asset, the discount
rate used, and the capital budgeting method used in justifying decisions to buy or dispose of
assets.
2. The internal auditor should verify the location, condition, and fair value of the
organization’s fixed assets against the fixed asset records in the subsidiary ledger.
3. The automatic depreciation charges calculated by the fixed asset system should be
reviewed and verified for accuracy and completeness. System errors that miscalculate
depreciation can result in the material misstatement of operating expenses, reported earnings,
and asset values.

AUTHORIZATION CONTROLS. Because fixed assets are requested and employed by end-
users asset acquisitions should be formal and explicitly authorized. Each material transaction
should be initiated by a written request from the user or department. In the case of high-value
items, there should be an independent approval process that evaluates the merits of the request
on a cost-benefit basis.

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 *These tests of details of transactions are commonly conducted as a dual-purpose test (i.e., in
conjunction with tests of controls).
†These tests can be conducted manually or using CAATs.

C. Payroll Cycle

Payroll lends itself to batch computerization because it is processed at fixed time

intervals which permits some time lag. Processing the payroll file usually involves most
employees each time it is processed, which is an efficient use of computer resources and can
be accomplished with a single pass through the file.

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 Three types of controls can be used to circumvent payroll errors in a Human Resource
Management (HRM)/payroll system. Batch totals are used to verify totals entered into the
system both at the time of data entry and at each stage in the processing. Hash totals are
particularly useful in this regard, since hash totals calculated at the time of original data entry
and again at each stage in the process can be compared. When the comparisons match
throughout the process, three conclusions can be made:

1) all payroll records have been processed;

2) the data input was accurate; and
3) no bogus timecards were entered at any point after initial input.

Upon completion of a payroll, the payroll register should be cross-footed to verify that the
totals of the net pay column and other deduction columns equal the total of the gross pay
column. A third control is the use of a payroll clearing account. This is a general ledger account
that can be used as part of a two-step accuracy and completeness process. First, the payroll
control account will be debited for the amount of the gross pay for the pay period; cash and
other various withholding liability accounts are credited. Second, the cost accounting process
distributes labor costs to various expense categories and credits the payroll control account for
the total amount of the debits made to the other accounts. The result is that the payroll control
account will have a zero balance. This becomes an internal check known as a zero-balance
check, indicating that the proper postings have been made to all of the accounts associated with
payroll for a given pay period.

Many problems may result when there are unauthorized changes to the payroll master
file. Unauthorized changes may be made to employee pay rates, resulting in the company
paying too much in wages. "Ghost" or "phantom" employees may be added to the payroll
master to divert funds to dishonest employees through the issuance of paychecks to such
"employees." Likewise, terminated employees may still be paid, resulting in the fraudulent
diversion of payroll funds. Two controls that should be implemented and maintained to provide
overall control of the payroll master file: proper segregation of duties and controlling access to
the file. Good internal control dictates that only authorized HRM personnel be allowed to update
the payroll master file for any hiring, termination, pay raise, and promotion. HRM personnel,
who have such access to the payroll master file, should never be allowed to directly participate
in actual payroll processing or paycheck distribution. This way an adequate control is created to
match actual paychecks (or earnings statements when direct deposit is in place) with
employees when a manager, supervisor, or other third-party hand out the checks (or earnings
statements). Also, a different individual should approve all changes to the payroll master file in
writing other than the individual who recommends or initiates the changes. User IDs and
passwords should always be used to control access to the payroll master file, and an access
control matrix should be established to define what actions each authorized employee is
allowed to make and confirms the files the employee may access.

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* These tests of details of transactions are commonly conducted as dual-purpose tests (i.e., in
conjunction with tests of controls).

D. Inventory Management Process

The production cycle is a recurring set of business activities and related data processing
operations associated with the manufacture of products. There are four basic activities in the
production cycle: product design, planning and scheduling, production operations, and cost
accounting.

The threats to the production cycle and the applicable control procedures used to
mitigate each threat are as follows:

Threat 1: Unauthorized transactions

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 Controls: Accurate sales forecasts, maintaining accurate inventory records; authorizing
production; restricting access to the production planning program; and review and
approval of capital expenditures

Threat 2: Theft or destruction of inventories and fixed assets

Controls: Restrict physical access to inventories; document internal physical flow of
assets; proper segregation of duties; periodic physical count and reconciliation of
inventory; document and authorize materials requests and disposal of fixed assets; and
have adequate insurance

Threat 3: Recording and posting errors

Controls: Automate data collection procedures; online data entry edit controls; and
conduct periodic physical inventory and fixed asset counts

Threat 4: Loss of data

Controls: Regularly back up files; keep additional master files; use internal and
external file labels; restrict access; and keep logs of all activities

Threat 5: Inefficiencies and quality control problems

Controls: Prepare regular performance reports; highlight exception reports and
variances; compare actual performance to budgeted performance; measure throughput; and
measure the cost of quality control.

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*Many of these tests of details of transactions are commonly conducted as dual-purpose tests (i.e., in
conjunction with tests of controls).

E. Financing Process

For many entities, accounts receivable and inventory represent the major current assets
included in the financial statements. Also included in most financial statements are accounts
that are referred to as other assets. A common type of other asset is a prepaid expense.
Examples of prepaid expenses include
• Prepaid insurance.
• Prepaid rent.
• Prepaid interest.

One major difference between asset accounts such as accounts receivable or inventory
and prepaid expenses is the materiality of the account balances. On many engagements,
prepaid expenses, deferred charges, and intangible assets are not highly material. As a result,
substantive analytical procedures may be used extensively to verify these account balances.

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 The auditor’s approach to the audit of investments varies depending on the size of the
investment and the amount of investment activity. For an entity that has a large investment
portfolio, the auditor is likely to follow a reliance strategy in which internal control is formally
evaluated and tests of controls are performed in order to set control risk below the maximum.
However, for the vast majority of entities that do not require an audit of internal controls over
financial reporting, it is more efficient for the auditor to follow a substantive strategy and perform
a detailed audit of the investment securities at year-end.

*These tests of details of transactions are commonly conducted as dual-purpose tests (i.e., in conjunction
with tests of controls).

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 Audit Sampling

Audit sampling is the process of selecting and evaluating a sample of items from a
population of audit relevance such that the auditors expect the sample to be representative of
some characteristic of the population. With this definition, representative means that the sample
will result in conclusions that are similar to those that would be drawn if the same procedures
were applied to the entire population.

Statistical sampling applies the laws of probability to selecting sample items for
examination and evaluating sample results. Specifically, statistical sampling methods enable the
audit team to make quantitative statements about the results and to measure the sufficiency of
evidence gathered (i.e., determine a sufficient sample size) and evaluate the results in such a
way to control sampling risk. Nonstatistical sampling plans do not meet either of these
criteria. Thus, these two types of plans differ in terms of how sample size is determined and how
the results are evaluated.

Sampling risk is the risk that the auditors’ conclusion based on a sample might be
different from the conclusion they would reach if they examined every item in the entire
population. Sampling risk is reduced by increasing the size of the sample. At the extreme, when
an entire population is examined there is no sampling risk. But auditing large samples or the
entire population is costly. Auditors may also draw erroneous conclusions because of
nonsampling errors, these are due to factors not directly caused by sampling. For example, the
auditors may fail to apply appropriate audit procedures, or they may fail to recognize errors in
the documents or transactions that are examined. The risk pertaining to nonsampling errors is
referred to as nonsampling risk.

Due to sampling risk, the auditor faces the chance that sampling may lead to one of two
possible types of decision errors: (1) deciding that the population tested is not acceptable when
in reality it is and (2) deciding that the population tested is acceptable when in reality it is not. In
statistical terms, these errors are known as Type I and Type II errors, respectively. More
formally, Type I and Type II errors are defined as follows:

• Risk of incorrect rejection (Type I). In testing an internal control, this is the risk that
the sample supports a conclusion that the control is not operating effectively when, in
truth, it is operating effectively. When an auditor is evaluating the level of reliance
that can be placed on a control in the context of a financial statement audit, this risk
is also commonly referred to as the risk of underreliance or the risk of assessing
control risk too high. In substantive testing, this is the risk that the sample supports
the conclusion that the recorded account balance is materially misstated when it is
actually not materially misstated.

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 • Risk of incorrect acceptance (Type II). In testing a control, this is the risk that the
sample supports a conclusion that the control is operating effectively when, in truth, it
is not operating effectively. When an auditor is evaluating the level of reliance that
can be placed on a control in the context of a financial statement audit, this risk is
also commonly referred to as the risk of overreliance or the risk of assessing
control risk too low. In substantive testing, this is the risk that the sample supports
the conclusion that the recorded account balance is not materially misstated when it
is actually materially misstated.

In general, sampling can be viewed as including the following major steps:

The major types of statistical sampling plans used for audit sampling include the following:

1. Attributes sampling. This sampling plan enables the auditors to estimate the rate of
occurrence of certain characteristics in the population (e.g., deviations from performance
of a prescribed control). Attributes sampling frequently is used in performing tests of
controls.

2. Discovery sampling. This form of attributes sampling is designed to locate at least one
deviation (exception) in the population. Discovery sampling often is used in situations in
which the auditors expect a very low rate of occurrence of some critical deviation. As an
example, the auditors might use discovery sampling to attempt to locate a fraudulent
cash disbursement.

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 3. Classical variables sampling. These sampling applications provide the auditors with
an estimate of a numerical quantity, such as the dollar balance of an account. As would
be expected, this technique is primarily used by auditors to perform substantive
procedures. For example, variables sampling might be used to plan, perform, and
evaluate a sample of accounts receivable selected for confirmation. Frequently used
variables sampling plans include mean-per-unit estimation, ratio estimation, and
difference estimation.

4. Probability-proportional-to-size (PPS) sampling. This technique applies attributes

sampling theory to develop an estimate of the total dollar amount of misstatement in a
population. Probability-proportional-to-size sampling is used as an alternative to classical
variables sampling methods for performing substantive tests of transactions or balances.
Unlike classical variables sampling techniques that define the sampling unit as each
transaction or account balance in the population, PPS sampling defines the sampling
unit as each individual peso making up the book value of the population.

Sample selection methods are the following:

1. Unrestricted Random Selection (Random Selection). When using unrestricted

random selection (random selection), the audit team identifies a series of random
numbers from either a random number of table or computer program and selects the
numbered item in the corresponding population.
2. Systematic Random Selection (Systematic Selection). When using systematic
random selection (systematic selection), the audit team randomly selects a starting point
from within the population and includes every nth item thereafter, where n is determined
based on the number of items in the population and the necessary sample size.
3. Haphazard Selection. When using haphazard selection, items are selected in an
unstructured manner but without any intentional bias. One significant limitation of
haphazard selection is that, unlike either random selection or systematic selection, the
sampling method cannot be described in sufficient detail to permit another individual to
replicate it.
4. Block Selection. The use of block selection involves selecting a series of contiguous (or
adjacent) items from the population. Block selection is less desirable because it is
difficult to efficiently obtain a representative sample; ordinarily, a relatively large number
of blocks need to be selected to be representative.

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 Proper documentation for audit samples could be a focal point of supervisory or quality
reviews. Some important information that may be documented are as follows:
• The objective of the sampling application, characteristic of interest, and definition of
the population
• The factors affecting sample size (along with the method or rationale for the selected
level of those factors) and determination of sample size.
• The method of selecting the sample and description of items selected for
examination.
• The method of measuring sample items and summary of measurements
• The evaluation of sample results and overall conclusion with respect to the sample.

Some important concepts to sampling are as follows:

 Allowance for sampling risk (ASR). Also referred to as precision, an interval around
the sample results in which the true population characteristic is expected to lie.
 Confidence level. In attributes sampling, the complement of the risk of assessing
control risk too low. In variables sampling, the complement of the risk of incorrect
acceptance. Thus, if the risk of assessing control risk too low (or of incorrect
acceptance) is .05, the confidence level is .95.
 Deviation rate. A defined rate of departure from prescribed controls. Also referred to as
occurrence rate or exception rate.
 Difference estimation. A sampling plan that uses the difference between the audited
(correct) values and book values of items in a sample to calculate the estimated total
audited value of the population.
 Expected population deviation rate. An advance estimate of a deviation rate. This
estimate is necessary for determining the required sample size in an attributes sampling
plan.
 Mean. The average item value, computed by dividing total value by the number of items
composing total value.
 Mean-per-unit estimation. A classical variables sampling plan enabling the auditors to
estimate the average dollar value (or other variable) of items in a population by
determining the average value of items in a sample.
 Projected misstatement. An estimate of the most likely amount of monetary
misstatement in a population.

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  Ratio estimation. A sampling plan that uses the ratio of audited (correct) values to book
values of items in the sample to calculate the estimated total audited value of the
population.
 Reliability. The complement of the risk of incorrect acceptance.
 Representative sample. A sample possessing essentially the same characteristics as
the population from which it was drawn.
 Sequential (stop-or-go) sampling. A sampling plan in which the sample is selected in
stages, with the need for each subsequent stage being conditional on the results of the
previous stage.
 Standard deviation. A measure of the variability or dispersion of item values within a
population; in a normal distribution, 68.3 percent of all item values fall within ±1 standard
deviation of the mean, 95.4 percent fall within ±2 standard deviations, and 99.7 percent
fall within ±3 standard deviations.
 Stratification. Dividing a population into two or more relatively homogeneous subgroups
(strata). Stratification increases the efficiency of most sampling plans by reducing the
variability of items in each stratum.
 Tolerable deviation rate. The maximum population rate of deviations from a prescribed
control that the auditor will tolerate without modifying the planned assessment of control
risk.

Multiple Choice Questions

1. An entity's financial statements were misstated over a period of years due to large amounts
of revenue being recorded in journal entries that involved debits and credits to an illogical
combination of accounts. The auditor could most likely have been alerted to this fraud by
a. Scanning the general journal for unusual entries.
b. Performing a revenue cut-off test at year-end.
c. Tracing a sample of journal entries to the general ledger.
d. Examining documentary evidence of sales returns and allowances recorded after
year-end.

2. An auditor reconciles the total of the accounts receivable subsidiary ledger to the general
ledger control account, as of August 31, 2019. By this procedure, the auditor would be most
likely to learn of which of the following?
a. An August invoice was improperly computed.
b. An August check from a customer was posted in error to the account of another
customer with a similar name.
c. An opening balance in a subsidiary ledger account was improperly carried forward
from the previous accounting period.
d. An account balance is past due and should be written off.

3. On receiving the bank cutoff statement, the auditor should trace

a. Deposits in transit on the year-end bank reconciliation to deposits in the cash receipts
journal.
b. Checks dated prior to year-end to the outstanding checks listed on the year-end bank
reconciliation.
c. Deposits listed on the cutoff statement to deposits in the cash receipts journal.
d. Checks dated subsequent to year-end to the outstanding checks listed on the year-
end bank reconciliation.

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4. In conducting a search for unrecorded liabilities, the auditor should do all EXCEPT:
a. Examine paid invoices for a short period following the balance sheet date and trace to
client's year-end adjustment for unrecorded liabilities.
b. Examine unpaid invoices for a short period following the balance sheet date and trace
to client's year-end adjustment for unrecorded liabilities.
c. Examine prior year's audit workpapers to ascertain that adjustments for unrecorded
liabilities have not been overlooked.
d. Examine invoices paid a few days prior to the balance sheet date.

5. In performing an audit on the existence of inventory contained in a warehouse, an auditor is

primarily concerned with
a. Observing and testing the number of units on hand.
b. Determining if the value of the inventory is reasonable.
c. Identifying the ownership of the inventory.
d. Locating slow moving items contained in inventory.

6. Which of the following accounts would contain the best data for an auditor performing an
analytical review to evaluate the reasonableness of the annual payroll?
a. Payroll taxes expense. c. Payroll taxes withheld.
b. Sales and cost of goods sold. d. Credit union payable.

7. The most significant audit step in substantiating additions to the office equipment account
balance is
a. Examination of vendors' invoices and receiving reports for current year's acquisitions.
b. Review of transactions near the balance sheet date for proper period cutoff.
c. Calculation of ratio of depreciation expense to gross office equipment cost.
d. Comparison to prior year's acquisitions.

8. In testing the reasonableness of interest income, an auditor could most effectively use
analytical tests involving
a. The beginning balance in the investments account for fixed income securities.
b. The average monthly balance in the investments account for fixed income securities.
c. The ending balance in the investment accounts for fixed income securities.
d. Documentary support of specific entries in the account.

9. All corporate capital stock transactions should ultimately be traced to the _____________.
a. Minutes of the Board of Directors. c. Cash receipts journal.
b. Cash disbursements journal. d. Numbered stock certificates.

10. Confirmation is most likely to be a relevant form of evidence with regard to assertions about
accounts receivable when the auditor has concerns about the receivables' ______________.
a. Valuation c. Classification
b. Existence d. Completeness

11. If all other factors in a sampling plan are held constant, changing the measure of tolerable
error to a smaller value would cause the sample size to be:
a. Smaller c. Larger
b. Unchanged d. Indeterminate

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12. In order to quantify the risk that sample evidence leads to erroneous conclusions about the
sampled population:
a.Each item in the sampled population must have an equal chance of being selected.
b.Each item in the sampled population must have a chance of being selected
proportional to its book value.
c. Each item in the sampled population must have an equal or known probability of being
selected.
d.The precise number of items in the population must be known.

13. The tolerable occurrence rate for a control test is generally, what?
a. Lower than the expected occurrence rate in the related accounting records.
b. Higher than the expected occurrence rate in the related accounting records.
c. Identical to the expected occurrence rate in the related accounting records.
d. Unrelated to the expected occurrence rate in the related accounting records.

14. In examining cash disbursements, an auditor plans to choose a sample using systematic
selection with a random start. The primary advantage of such a systematic selection is that
population items
a. Which include errors will not be overlooked when the auditor exercises compatible
reciprocal options.
b. May occur in a systematic pattern, thus making the sample more representative.
c. May occur more than once in a sample.
d. Do not have to be prenumbered in order for the auditor to use the technique.

15. Attribute sampling, as applied to control testing, can assist the auditor in several ways.
Which of the following tasks is not enhanced by sampling?
a. Determining the number of documents to examine in testing for a specific attribute.
b. Selecting the documents to be tested.
c. Examining the documents.
d. Evaluating the sample results.

16. Several risks are inherent in the evaluation of audit evidence which has been obtained
through the use of statistical sampling. Which of the following risks is an example of the risk
of underassessment of control risk?
a. Failure to properly define the population to be sampled.
b. Failure to draw a random sample from the population.
c. Failure to accept the statistical hypothesis that internal control is unreliable when, in
fact, it is.
d. Failure to accept the statistical hypothesis that a book value is not materially misstated
when the true book value is not materially misstated.

17. A bank auditor is interested in estimating the average account balance of its depositors
based on a sample. This substantive test is an example of
a. Attribute sampling. c. Discovery sampling.
b. Acceptance sampling. d. Variables sampling.

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18. In conducting a substantive test of an account balance, an auditor hypothesizes that no
material error exists. The risk that sample results will support the hypothesis when a
material error actually does exist is the risk of
a. Incorrect rejection. c. Alpha error.
b. Incorrect acceptance. d. Type I error.

19. What effect does an increase in the standard deviation have on the required sample size of
mean-per-unit estimation and probability proportional to size sampling? Assume no change
in any of the other characteristics of the population and no change in desired precision and
confidence.
Mean-per-unit Estimation PPS
a. Decrease in sample size No change in sample size
b. No change in sample size Decrease in sample size
c. Increase in sample size No change in sample size
d. No change in sample size Increase in sample size

20. An advantage of statistical over non-statistical sampling is that statistical sampling:

a. Enables auditors to objectively measure the reliability of their sample results.
b. Permits use of a smaller sample size than would be necessary with non-statistical
sampling.
c. Is compatible with a wider variety of sample selection methods than is non-statistical
sampling.
d. Allows auditors to inject their subjective judgment in determining sample size and
selection process in order to audit items of greatest value and highest risk.

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