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 To my wife, Anna, and children, Abigail, Martina and Andrew who, collectively, are an
ongoing source of inspiration, encouragement, and tolerance of my efforts.
—W. Robert Knechel

To my spouse Leslie and my son Alexander who support, encourage, and tolerate my
efforts to be a strong academic and a loving spouse and father.
—Steve Salterio

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 Table of Contents

Chapter 1: Assurance and Auditing

Outline.......................................................................................................................................1
Introduction ............................................................................................................................2
Information, Business, and Global Capital Markets ..................................................2
The Role of Auditing in an International Economic System ..................................4
The Demand for Assurance: Integrity, Trust, and Risk ..............................................7
Incentives ....................................................................................................................8
Ethical principles.......................................................................................................9
The Role of Corporate Governance..................................................................11
The Role of the External Auditor .......................................................................12
Differentiating Assurance, Attestation, Auditing, and Accounting ...................14
The Nature of Assurance and Attestation Engagements .........................17
The Auditing Profession and Regulation ....................................................................18
Entering the Profession: Education, Training, and Certification ............19
Organizational Forms of Public Accounting Firms .....................................19
Regulating the Auditing Profession.................................................................22
Knowledge and Skills Needed by Auditors in the Twenty-First Century.........23
The Plan of this Book..........................................................................................................24
Summary and Conclusion ................................................................................................26
Bibliography of Relevant Literature ..............................................................................27

Chapter 2: Managing Risk: The Role of Auditing

and Assurance
Outline.....................................................................................................................................29
Introduction ..........................................................................................................................30
Risk Management in a Business Enterprise................................................................31
The Nature of Risk ..................................................................................................31
Enterprise Risk Management .............................................................................32
Control Activities for Compliance Risks ..........................................................35
Control Activities over Financial Reporting Risks .......................................35
Implications of Risk Management for Financial Performance ............................38

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Need for External Assurance as a Component of Risk Management ...............40

Role of Rules, Regulation, and Standards on Risk in the Audit ...........................42
Auditing Standards ................................................................................................43
GAAS Audit .........................................................................................................43
Integrated Audit ...............................................................................................46
Ethical Standards ....................................................................................................47
Objectivity and Independence ...................................................................47
Professional Skepticism .................................................................................50
Quality Control Standards ...................................................................................50
Summary and Conclusion ................................................................................................52
Bibliography of Relevant Literature ..............................................................................53

Chapter 3: The Building Blocks of Auditing

Outline.....................................................................................................................................57
Introduction ..........................................................................................................................58
An Overview of the Auditor’s Role ................................................................................59
Management’s Assertions ................................................................................................61
Financial Reporting Assertions ..........................................................................61
Internal Control Assertions .................................................................................64
The Pervasive Concepts of Auditing: Risk, Materiality, and Evidence ..............66
Risk Concepts in Auditing ................................................................................................67
Client Business Risk................................................................................................67
Auditor Engagement Risk....................................................................................68
Audit Risk...................................................................................................................68
Risk of Material Misstatement............................................................................69
Detection Risk ..........................................................................................................70
Materiality ..............................................................................................................................70
Quantitative Materiality .......................................................................................71
Qualitative Materiality ..........................................................................................71
Evidence Collection in Auditing.....................................................................................72
Risk Assessment ......................................................................................................72
Understanding an Organization’s Environment and Risks ......................74
Understanding Risk Management and Internal Control over
Financial Reporting .........................................................................................74
Preliminary Analytical Procedures....................................................................74
Tests of Accounting Information ......................................................................74
Types of Audit Evidence....................................................................................................75
Competence of Audit Evidence .....................................................................................76
The Interrelationship of Risk, Materiality, and Evidence .......................................79
Auditor Responsibilities ....................................................................................................80

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Reasonable Assurance about Errors and Fraudulent

Misstatements ...................................................................................................80
Internal Control over Financial Reporting .....................................................82
Illegal Acts by Clients ............................................................................................82
Assessment of Going Concern...........................................................................83
Summary and Conclusion ................................................................................................85
Bibliography of Relevant Literature ..............................................................................85

Chapter 4: The Audit Process

Outline.....................................................................................................................................89
Introduction ..........................................................................................................................90
Client Acceptance and Retention ..................................................................................90
Factors Affecting Client Acceptability.............................................................91
Communication with the Predecessor Auditor ...........................................95
To Accept or Not? ...................................................................................................95
Engagement Letters ..............................................................................................96
Preliminary Planning ....................................................................................................... 100
Obtain a General Understanding of the Client ......................................... 100
Becoming Familiar with the Organization’s Strategic Plan................... 101
Obtain a High Level Understanding of Information
Processing Systems ...................................................................................... 102
Identify New, and Review Known, Problem Areas that May
Affect Audit Planning .................................................................................. 102
Review Board Minutes................................................................................. 103
Review Preliminary Financial Statements ............................................ 103
Identify Key Accounting Policies ............................................................. 103
Consider Special Circumstances that May Affect Audit
Planning ........................................................................................................... 104
Related Party Transactions......................................................................... 104
Need for Specialists ...................................................................................... 105
Use of Internal Auditors .............................................................................. 106
Discuss and Assess Fraud Risk and the Risk of Material
Misstatement .................................................................................................. 107
An Overview of the Audit Process .............................................................................. 112
Communicating the Results of the Audit ................................................................ 114
GAAS Audit Opinions .........................................................................................114
Integrated Audit Opinions including Effectiveness of
Internal Control over Financial Reporting............................................ 117
Summary and Conclusion ............................................................................................. 119
Bibliography of Relevant Literature ........................................................................... 119

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Chapter 5: Understanding the Client’s Industry

and Business: Strategic Analysis and
Management Controls
Outline.................................................................................................................................. 123
Introduction ....................................................................................................................... 124
Knowledge Acquisition for Risk Assessment.......................................................... 126
Strategic Risk Analysis........................................................................................128
Process Risk Analysis ..........................................................................................128
Residual Risk Analysis ........................................................................................129
Understanding a Client’s Objectives and Strategies to Achieve
Objectives .....................................................................................................................129
Analyze the Organization’s Strategic Plan .................................................. 129
The Impact of Strategic Positioning Decisions ......................................... 130
The Impact of Strategic Risk Assessment on Financial Statements
and the Audit............................................................................................................... 131
Organizational Business Models ................................................................................. 133
Components of an Organizational Business Model................................ 133
An Example of an Organizational Business Model .................................. 135
Risk Assessment: Strategic Risks ................................................................................. 137
Macro-Environmental Forces (PEST Factors) ............................................. 137
Industry Forces (Porter’s Five Forces) ........................................................... 138
Strategic Risk Assessment Implications for the Audit ......................................... 141
Management Controls.................................................................................................... 146
Types of Management Control ....................................................................... 146
Evaluating Management Controls ................................................................ 147
Evidence of Management Controls Mitigating Risk ............................... 148
Limitations of Management Control ............................................................ 150
Linking Strategic Risks to Business Processes ........................................................ 151
Summary and Conclusion ............................................................................................. 152
Bibliography of Relevant Literature ........................................................................... 153

Chapter 6: Understanding the Client’s Industry and

Business: Processes and Process Controls
Outline.................................................................................................................................. 155
Introduction ....................................................................................................................... 156
Internal Operations and Business Processes .......................................................... 157
Primary Processes................................................................................................158
Support Processes ...............................................................................................160
Linking Strategic Risks to Business Processes ........................................................ 162
An Overview of Process Analysis ................................................................................ 166
Process Maps...................................................................................................................... 167

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Process Objectives ..............................................................................................168

Process Activities .................................................................................................169
Information Flows ...............................................................................................171
Accounting Impact of Process Activities..................................................... 172
Risk Assessment: Process Risks .................................................................................... 175
People Risks ...........................................................................................................175
Direct Process Risks............................................................................................. 178
Indirect Process Risks .........................................................................................178
Assessing Process Risks ..................................................................................... 179
Process Control Activities .............................................................................................. 181
Performance Reviews......................................................................................... 183
Physical Controls.................................................................................................. 184
Segregation of Duties ........................................................................................ 184
Information Systems and Processing Controls ...................................................... 185
General Controls ..................................................................................................185
Application Controls .......................................................................................... 186
Process Controls: Human Resource Management .............................................. 189
Control Effectiveness and Residual Risks ................................................................. 190
Summary and Conclusion ............................................................................................. 191
Bibliography of Relevant Literature ........................................................................... 192

Chapter 7: Risk Mitigation and the Audit: Internal

Control over Financial Reporting In A
GAAS Audit
Outline.................................................................................................................................. 195
Introduction ....................................................................................................................... 196
Using Internal Control to Mitigate Risk .................................................................... 197
Management’s Fundamental Responsibility for Internal Control ...... 198
Internal Control Defined ................................................................................... 198
Components of Internal Control .................................................................... 199
Levels of Control Activity ..................................................................................202
Internal Control and Financial Reporting in a GAAS Audit ............................... 203
The Financial Reporting Process ................................................................................. 204
Source Documents and Transactions ........................................................... 205
Journals ...................................................................................................................207
Ledgers....................................................................................................................207
Financial Statements ..........................................................................................208
Impact of Information Technology on Financial Reporting ................. 208
The Role of Internal Control over Financial Reporting ....................................... 210
The Auditor’s Role in Evaluating Internal Control over
Financial Reporting ...................................................................................................211

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Assessing Control Risk ....................................................................................... 216

Control Risk and Tests of Financial Statement Assertions .................... 220
The Auditor’s Control Reporting Responsibilities in a
GAAS Audit ...................................................................................................... 220
An Example of Internal Control Evaluation and Control Risk
Assessment .................................................................................................................. 222
Evaluating Internal Control over Financial Reporting ............................ 223
Assessing Control Risk ....................................................................................... 226
Control Risk Assessments and Planned Audit Procedures ................... 228
Summary and Conclusion ............................................................................................. 229
Appendix A: Information Technology and Internal Controls ........................... 231
Impact of Information Technology ............................................................... 231
Myths Concerning Information Technology and Internal
Control .............................................................................................................. 232
Illustrative Controls in a Computerized Information System .............. 234
Summary ................................................................................................................ 236
Appendix B: Flowcharting Techniques ..................................................................... 236
Overview of Flowcharting ................................................................................236
Key Elements of a Flowchart ........................................................................... 237
Guidelines for Flowchart Preparation .......................................................... 238
Bibliography of Relevant Literature ........................................................................... 239

Chapter 8: Internal Control over Financial

Reporting In an Integrated Audit
Outline.................................................................................................................................. 241
Introduction ....................................................................................................................... 242
Management’s Responsibility for Internal Control .............................................. 243
COSO’s Internal Control Defined.................................................................... 244
Components of Internal Control .................................................................... 245
Control Environment ................................................................................... 246
Risk Assessment............................................................................................. 249
Control Activities ........................................................................................... 252
Information and Communication ........................................................... 254
Monitoring ..................................................................................................... 257
Integrating Internal Controls .................................................................... 258
Applying the COSO Framework ............................................................... 259
Consideration of Internal Control over Financial Reporting in an
Integrated Audit .........................................................................................................261
Classifying Control Deficiencies ..................................................................... 263
Requirement for the Auditor to Plan Internal Control Tests................. 264
The Special Role of Entity Level Controls in an Integrated Audit ....... 265

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Assessment of Control Risk: Implications for Tests of

Financial Statement Assertions................................................................ 266
The Auditor’s Reporting Responsibilities in an Integrated Audit....... 268
Management Remediation of Material Weaknesses and
Auditor Reporting on such Remediation ............................................. 269
Summary and Conclusion ............................................................................................. 270
Bibliography of Relevant Literature ........................................................................... 271

Chapter 9: Inquiry and Analytical Evidence

Including Auditing of Accounting Estimates
Outline.................................................................................................................................. 273
Introduction ....................................................................................................................... 274
A Traditional View of Inquiry Evidence ..................................................................... 276
A Rigorous Approach to Obtaining Inquiry Evidence......................................... 277
Planning Client Inquiries................................................................................... 277
Conducting Client Inquiries.............................................................................280
Introduction to Analysis................................................................................................. 281
Preliminary Analytical Procedures Example .............................................. 283
Techniques for Obtaining Analytical Evidence ......................................... 284
Basic Judgmental Methods.............................................................................. 285
Advanced Judgmental Methods ................................................................... 291
A Rigorous Approach to Obtaining Analytical Evidence ................................... 293
Performing Structured Analysis ..................................................................... 293
Substantive Analytical Procedures................................................................ 296
Potential Pitfalls from Using Analysis as Evidence ............................................... 297
Inquiry and Analysis in Assessing Fraud Risk ......................................................... 299
Inquiry and Analysis for Auditing Accounting Estimates .................................. 301
Summary and Conclusion ............................................................................................. 304
Appendix: Statistical Methods for Obtaining Analytical Evidence ................ 305
Overview of Univariate Regression ............................................................... 305
An Application of Regression Analysis to Auditing................................. 306
Consideration of Key Assumptions ............................................................... 311
Bibliography of Relevant Literature ........................................................................... 312

Chapter 10: Designing Substantive Tests:

Responses to Residual Risks
Outline.................................................................................................................................. 315
Introduction ....................................................................................................................... 316
Assertions, Risks, and Evidence Revisited................................................................ 317
Analyzing Residual Risks Identified from Strategic and
Process Analysis ..........................................................................................................319

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The Audit Risk Model ...................................................................................................... 322

Risk of Material Misstatement......................................................................... 323
Detection Risk .......................................................................................................325
Applying the Audit Risk Model....................................................................... 326
Setting Audit Risk ................................................................................................328
Materiality ........................................................................................................................... 329
Overall Materiality ...............................................................................................329
Performance Materiality ................................................................................... 331
Qualitative Considerations in Setting Materiality .................................... 332
Allocation of Materiality to Accounts ........................................................... 333
Determining the Nature, Extent, and Timing of Substantive
Testing............................................................................................................................334
Appropriateness of Audit Evidence ........................................................................... 335
An Example: Linking Residual Risk Assessments to Tests of
Management Assertions ......................................................................................... 338
Developing the Audit Plan for Tests of Management Assertions ................... 341
Selecting Effective and Efficient Audit Procedures to
Test Assertions ............................................................................................... 342
Segmenting the Audit Plan ............................................................................. 343
The Substantive Audit Program ..................................................................... 346
Special Issues Related to Tests of Accounting
Estimates .......................................................................................................... 350
Summary and Conclusion ............................................................................................. 352
Bibliography of Relevant Literature ........................................................................... 352

Chapter 11: Audit Testing for the Sales and

Customer Service Process
Outline.................................................................................................................................. 355
Introduction ....................................................................................................................... 356
An Overview of Objectives and Activities Related to Sales
and Customer Service ..............................................................................................359
Process Objectives ..............................................................................................359
Process Activities .................................................................................................361
Transactions Arising from Sales and Customer
Service Process............................................................................................... 363
Risk Assessment for Sales and Customer Service ................................................. 366
Analysis of Process Controls ............................................................................ 368
Entity Level Controls over Sales and Customer Service ..................................... 369
Analysis of Internal Control over Financial Reporting......................................... 372
Testing Internal Control over Financial Reporting................................... 375
Control Tests of Sales Transactions................................................................ 376

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Conclusions about Residual Risks from Sales and

Customer Service .......................................................................................... 377
Identifying Significant Residual Risks........................................................... 377
Planning Tests of Management Assertions: Revenue and Accounts
Receivable .................................................................................................................... 378
Substantive Analytical Procedures................................................................ 379
Substantive Tests of Sales Transactions ....................................................... 381
Substantive Tests of the Aged Receivables Trial
Balance.............................................................................................................. 383
Confirmations ....................................................................................................... 383
Cut-Off Tests .......................................................................................................... 387
Tests of Revenue Recognition ......................................................................... 387
Tests of Accounting Estimates: Uncollectible Amounts ........................ 389
Summary and Conclusion ............................................................................................. 390
Appendix A: Planning Tests of Financial Statement Assertions
Related to Cash Balances ........................................................................................ 391
Tests of Cash Receipts ........................................................................................393
Bank Confirmations ............................................................................................ 393
Bank Reconciliations ..........................................................................................393
Proof of Cash .........................................................................................................395
Tests of Interfund Transfers .............................................................................. 397
Conclusion .............................................................................................................398
Appendix B: An Overview of Working Paper Documentation
Techniques ................................................................................................................... 398
The Need for Documentation ......................................................................... 398
Audit Documentation Identification ............................................................ 400
Paperless Audits ................................................................................................... 400
Documentation Referencing ........................................................................... 401
Cross References ..................................................................................................401
Tickmarks................................................................................................................ 402
Conclusion ............................................................................................................. 403
Bibliography of Relevant Literature ........................................................................... 403

Chapter 12: Audit Testing for the Supply Chain and

Production Process
Outline.................................................................................................................................. 407
Introduction ....................................................................................................................... 408
An Overview of Objectives and Activities Related to Supply Chain
and Production Management ...............................................................................411
Process Objectives ..............................................................................................411
Process Activities .................................................................................................413

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Transactions Arising from Supply Chain and

Production Management........................................................................................416
Purchases................................................................................................................418
Disbursements .....................................................................................................419
Production .............................................................................................................419
Risk Assessment for Supply Chain and Production Management ................. 420
Analysis of Process Controls ............................................................................ 423
Entity Level Controls Affecting Supply Chain and Production
Management Process ............................................................................................... 426
Analysis of Internal Control over Financial Reporting......................................... 427
Testing Internal Control over Financial Reporting................................... 430
Conclusions about Residual Risks from Supply Chain and
Production Management ........................................................................... 432
Identifying Significant Residual Risks........................................................... 433
Planning Tests of Management Assertions: Purchases and
Accounts Payable .......................................................................................................434
Substantive Analytical Procedures ............................................................... 434
Tests of Purchase and Disbursement Transactions ................................. 436
Tests of Accounts Payable Trial Balance ...................................................... 438
Tests for Unrecorded Liabilities ...................................................................... 438
Confirmation of Payables ................................................................................. 438
Planning Tests of Management Assertions: Inventory ....................................... 440
Substantive Analytical Procedures ............................................................... 442
Tests of Inventory Purchases, Conversion, and Movement .................. 443
Inspection or Observation of the Inventory Count ................................. 444
Inventory Price Tests and Tests of Estimates: Obsolescence ................ 447
Tests of Inventory Compilation ...................................................................... 448
Cut-Off Tests .......................................................................................................... 448
Summary and Conclusion ............................................................................................. 448
Bibliography of Relevant Literature ........................................................................... 450

Chapter 13: Auditing Resource Management Processes

Outline.................................................................................................................................. 453
Introduction ....................................................................................................................... 454
Part A: Auditing the Property Management Process........................................... 456
Process Map........................................................................................................... 456
Internal Threat Analysis .....................................................................................460
Analysis of Internal Control over Financial Reporting............................ 460
Evaluation of Process Performance Indicators.......................................... 463
Tests of Financial Statement Assertions: Property, Plant,
Equipment, Intangible Assets, and Depreciation ........................................... 463

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Substantive Analytical Procedures................................................................ 465

Tests of Valuation and Allocation Including Tests for
Asset Impairment.......................................................................................... 466
Tests of Transactions...........................................................................................468
Part B: Auditing the Financial Management Process........................................... 469
Process Map........................................................................................................... 469
Internal Threat Analysis .....................................................................................473
Analysis of Internal Control over Financial Reporting............................ 473
Evaluation of Process Performance Indicators.......................................... 476
Tests of Financial Statement Assertions: Investments, Borrowed
Funds, and Equity ......................................................................................................477
Substantive Tests for Investments ................................................................. 477
Substantive Tests for Borrowed Funds ......................................................... 481
Substantive Tests for Equity ............................................................................. 483
Summary and Conclusion ............................................................................................. 485
Appendix: Substantive Tests for Transactions and Accounts in
Human Resource Management ............................................................................486
Human Resource Transactions ....................................................................... 487
Tests of Financial Statement Assertions: Payroll and
Accrued Liabilities......................................................................................... 487
Tests of Transactions...........................................................................................491
Substantive Analytical Procedures................................................................ 493
Cut-Off Tests .......................................................................................................... 493
Confirmation of Obligations............................................................................ 494
Bibliography of Relevant Literature ........................................................................... 495

Chapter 14: Completing the Audit I: Final Evidence

Aggregation and Analysis
Outline.................................................................................................................................. 499
Introduction ....................................................................................................................... 500
An Overview of Final Evidence Aggregation and Finalization of the
Financial Statements ................................................................................................501
Group Audits or Audits of Consolidated Financial Statements
Consolidation Issues........................................................................................... 503
Part of an Audit Performed by a Different Auditor.................................. 504
Final Analytical Review—Business Measurement Analysis .............................. 506
Evaluating Performance: Financial Performance
Measures .......................................................................................................... 507
Evaluating Performance: Nonfinancial Performance
Measures .......................................................................................................... 508
Business Measurement Analysis Based on the
Balanced Scorecard ...................................................................................... 509

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Evaluation of Potential Going Concern Issues ....................................................... 512

Assessing the Risk of Financial Failure ......................................................... 513
Considering Management Responses to Going Concern
Threats .............................................................................................................. 514
Accounting Choices and the Quality of Earnings ................................................. 516
The Impact of Accounting Choices, Policies, and Procedures ............. 518
Seven Ways Accounting Choices Can Lower Earnings Quality ........... 519
Assessing Earnings Quality .............................................................................. 520
Completion Procedures ................................................................................................. 521
Review for Contingent Liabilities ................................................................... 522
Attorney (Legal) Confirmations ...................................................................... 524
Review of Subsequent Events......................................................................... 526
Representation Letters ...................................................................................... 528
Final Evidence in Integrated Audits about Internal Control over
Financial Reporting ................................................................................................... 531
Final Evaluation of Audit Evidence............................................................................. 532
Evaluation of Presentation and Disclosure Assertions........................... 532
Review of Accounting Estimates.................................................................... 533
Review of Audit Documentation and Conclusions ................................ 535
Client Negotiation and Resolution of Misstatements ............................ 535
Final Technical Review ....................................................................................... 538
Summary and Conclusion ............................................................................................. 539
Bibliography of Relevant Literature ........................................................................... 539
On-line Appendix: Comprehensive Approach to Business
Measurement: An Example

Chapter 15: Completing the Audit II: Audit Reporting

Outline.................................................................................................................................. 543
Introduction ....................................................................................................................... 544
Communications of Audit Results to Those Charged with
Governance and Management .............................................................................545
Formal Reporting to the Audit Committee or “Those
Charged With Governance” ....................................................................... 546
Reports on Internal Control Issues Discovered as Part of the
GAAS Audit ...................................................................................................... 550
Reporting Matters to Audit Committees about the
Effectiveness of Internal Control over Financial Reporting
as Part of an Integrated Audit................................................................... 551
Management Letters .......................................................................................... 551
External Communication of Audit Results .............................................................. 552
Components of an Auditor’s Report in a GAAS Audit ............................ 553
Types of Opinions ................................................................................................ 564

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Key Audit Matters ................................................................................................571

Audit Reporting in an Integrated Audit ..................................................... 574
Group Audit Reporting Where There Is a Significant
Component Auditor ..................................................................................... 585
Discovery of a Misstatement in the Financial Statements after the
Auditor’s Report and Financial Statements have been Released ............. 586
Future Changes to the Integrated Audit Report ...................................... 587
Summary and Conclusion ............................................................................................. 587
Bibliography of Relevant Literature ........................................................................... 588
On-line Appendix: Auditor’s Report for GAAS Audits under IAASB
Standards (2007–2016)

Chapter 16: The Ethical Auditor: Factors Affecting

Auditor Decision Making
Outline.................................................................................................................................. 591
Introduction ....................................................................................................................... 592
Auditing as a Profession................................................................................................. 593
Auditing as an Ethical Judgment Process................................................................ 594
Ethics and Judgment .........................................................................................595
Professional Audit Judgment and Ethical Decision
Making .............................................................................................................. 595
Threats to the Quality of Individual Auditor Judgment ..................................... 598
Concerns about Bias in Individual Professional Judgment .................. 599
Concerns about Ethical Reasoning in Individual Professional
Judgment......................................................................................................... 602
Reducing Ethical Dilemmas and Judgment Biases among
Professionals ................................................................................................... 605
Institutional Forces that Reinforce Ethical Auditor Judgment ......................... 606
A Codes of Ethics for Professional Accountants ....................................... 607
Rules Regarding Auditor Independence..................................................... 608
Audit Firm and Audit Partner Rotation ........................................................ 618
Auditing Standards .............................................................................................621
Audit Quality Framework and Indicators .................................................... 622
Audit Firm Quality Control Standards .......................................................... 624
Peer Reviews and Practice Inspections........................................................ 625
Institutional Forces that Punish Lapses in Auditor Judgment ......................... 627
Regulatory Intervention ...................................................................................627
Legal Liability: Overview...................................................................................627
Legal Liability: Common Law .......................................................................... 628
Legal Liability: Statutory Law .......................................................................... 635
Legal Prosecution: Criminal Law .................................................................... 639

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Summary and Conclusion ............................................................................................. 641

Bibliography of Relevant Literature .......................................................................... 642

Chapter 17: Interpreting Sample-Based Audit Evidence

Outline.................................................................................................................................. 645
Introduction ....................................................................................................................... 646
The Role of Sampling in an Audit ............................................................................... 647
Selecting a Sample for Audit Testing ........................................................................ 649
Population of Prenumbered Documents.................................................... 649
A Technique for Refining Sample Selection: Stratified
Sampling .......................................................................................................... 656
Other Types of Populations.............................................................................. 656
Tests of Process Controls and Transactions: Attribute Sampling and
Sample Evaluation ..................................................................................................... 657
Step 1: Identify the Audit Procedure and the Purpose of
the Test .............................................................................................................. 658
Step 2: Define the Population and Sample Unit....................................... 658
Step 3: Define the Deviation Conditions..................................................... 658
Step 4: Specify the Tolerable Deviation Rate (TDR) ................................. 659
Step 5: Specify the Acceptable Risk of Overreliance (ARO)
on Controls ...................................................................................................... 659
Step 6: Estimate the Expected Deviation Rate (EDR) .............................. 660
Step 7: Determine the Sample Size (n) ........................................................ 660
Step 8: Select the Sample .................................................................................661
Step 9: Perform the Audit Procedure and Document
the Results ....................................................................................................... 662
Step 10: Generalize the Sample Results to the Population .................. 663
Step 11: Analyze Individual Deviations ....................................................... 664
Step 12: Conclude Whether the Assertion Tested is
Acceptable....................................................................................................... 665
Tests of Account Balance Details: Dollar Unit Sampling .................................... 666
Step 1: Identify the Audit Procedure and Purpose of the Test ............ 667
Step 2: Define the Population and Sample Unit....................................... 667
Step 3: Define the Error Conditions Applicable to the
Audit Procedure............................................................................................. 668
Step 4: Specify the Tolerable Error Level (TEL) .......................................... 668
Step 5: Specify the Acceptable Risk of Incorrect
Acceptance (ARIA) ........................................................................................ 668
Step 6: Estimate the Expected Error Level (EEL) and the
Expected Tainting Factor (ETF) ................................................................. 668
Step 7: Determine the Sample Size (n) ........................................................ 669
Step 8: Select the Sample .................................................................................670

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Step 9: Perform the Audit Procedure and Document the Results ..... 672
Step 10: Generalize the Sample Results to the Population .................. 672
Step 11: Analyze Individual Errors ................................................................. 673
Step 12: Conclude Whether the Account Balance Tested is
Acceptable....................................................................................................... 674
Judgmental Approaches to Sampling ...................................................................... 675
Common Errors in Sampling ........................................................................................ 677
Summary and Conclusion ............................................................................................. 678
Bibliography of Relevant Literature ........................................................................... 678

Index .................................................................................................................................... 683

KNECHEL (Auditing 4e) 2-col BOOK.indb 23 05/09/2016 09:32

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 Homemade Vaporizer

A simple vaporizer which can be used by designers to project their

colors in a fluid spray, or by housekeepers to disinfect or perfume
their apartments, can be made in the following manner: Two goose
quills are forced through holes in a cork at right angles to each other,
as shown. Place the vertical quill in a bottle containing the fluid to be
sprayed and by blowing through the horizontal quill a very effective
spray will be produced.—Contributed by Hazel Kolar, Maywood, Ill.
¶Old wringer clamps, used for holding the wringer to the tub, are
very handy around a workbench.
 Tooth Powder Used on Tracing Cloth
Tooth powder is an excellent substitute for the powders which are
sold for the purpose of preparing the glossy surface of tracing linen
to receive ink. The gritty element removes the excess gloss which
prevents the ink from taking hold. A second dusting with talcum
powder makes a perfect surface for inking in.
 A Small Gas Furnace

A small gas furnace for melting small quantities of gold, silver, or

other metals, can be easily made as follows: Procure a cylinder of
stovepipe iron of the desired size, say 4¹⁄₂ or 5 in. in diameter, and 6
in. long. Turn in the edge of one end so that it will hold loosely a disk
of iron of the same thickness as the cylinder, to form the bottom.
Punch ¹⁄₈-in. holes, about 1 in. apart, all over the cylinder and the
bottom. This is to allow for the escape of moisture and air. Attach
three legs to the sides with rivets, evenly spaced so as to raise the
bottom 4 in. In the side of the cylinder cut a hole, 1¹⁄₄ in. in diameter,
its center being 1¹⁄₂ in. from the bottom. Select a glass bottle whose
diameter is 1 or 1¹⁄₂ in. less than that of the cylinder.
Make a putty of fire clay, and add about five per cent of plaster of
Paris, and also add about a teaspoonful of vinegar, to prevent a too
rapid setting. Place a mass of the putty in the bottom of the cylinder
and press in the bottle after its surfaces have been well greased.
The bottle should be well centered in the cylinder. Press the bottle
well down, so that its bottom is on a level with the lower edge of the
hole in the side. Fill in the putty to form the sides, tamping it well all
around the bottle, and build it up a little above the metal of the sides,
carefully smoothing off the edge. With the fingers, or a spatula of
some kind, cut out the putty in the hole to form an opening, ³⁄₄ in. in
diameter. Allow the putty to set for more than an hour, and then with
a circular, or twisting, motion remove the bottle. To prevent a vacuum
in the bottom that will prevent removing the bottle easily, puncture
the putty that lies on the disk with a hatpin, to allow the air to pass.
A few places will be found where the putty has not filled in
properly, and these should be patched up while the filling is yet soft.
The clay will probably shrink after standing for a time, and should be
pressed out against the sides while in a plastic state. When dry, the
furnace is ready for use.
In furnaces of this kind the jet of a large gas blowtorch is to be
used. If a standard is rigged up to hold the blowtorch, it will be much
easier for the operator. The jet from the pipe is thrown in the hole at
the side and a crucible is placed in the furnace. It is well to make a
cover similar to the body of the furnace with a hole in the center a
little larger than the hole in the side.
A more efficient furnace can be made with two holes in the side,
opposite each other, for using a double jet from blowtorches.—
Contributed by James H. Beebee, Rochester, N. Y.
 The Magic Clock Hand
The hand, or pointer, is the only working part needed to perform
the trick. A clockface can be drawn on any piece of white paper, and
a pin stuck in its center on which the hand revolves. The hand A is
cut from a piece of sheet brass, and may be in any form or design
desired, but it must balance perfectly on the axle, which passes
through a ¹⁄₄-in. hole in the center, or else the magic part will fail. The
illustration shows a good design with dimensions that will cause it to
balance well; however, this can be adjusted by removing some metal
from the end that is heavier with a file or tinner’s snips, or a bit of
solder may be stuck to the lighter end.
 Design of a Hand That will Balance Well and the Parts for Its Axle

A disk, B, is cut from a piece of sheet brass, 1¹⁄₈ in. in diameter,

twelve ³⁄₃₂-in. holes are drilled at equal distance apart near the edge,
and a ¹⁄₄-in. hole is drilled in its center. This disk is soldered to the
hand where both ¹⁄₄-in. holes will coincide. It is necessary to procure
two washers, C and D, that are embossed, or raised, in the center,
and about 1¹⁄₄ in. in diameter. These can be purchased from a dealer
in curtain rods, the rod parts wanted being the washers used on the
ends. A careful mechanic can raise the center portion of a brass disk
by beating it over a hole with a ball-peen hammer.
One of the washers, C, has a spring, E, soldered at one end, and
the other carries a small projection that will engage the holes in the
disk, B. The projection can be made by driving the metal out with a
center punch, set on the opposite side.
The washer D is provided with a lead weight, F, and a ¹⁄₄-in. stud,
G, is soldered in the center. The stud has a ¹⁄₁₆-in. hole drilled
through its center for the pin axle. The weight is made by filling the
washer with melted lead, which when cold is removed and sawn in
two. One piece is then stuck in the washer with shellac. The stud is
⁷⁄₈ in. long with the upper part, about ¹⁄₄ in. in length, filed, or turned
down, smaller, and threaded. Just below the thread, or on the
shoulder, the body is filed square to fit a square hole filed in the face
washer C carrying the spring. This square hole and stud end are
necessary in order that both washers may turn together.
 A Number is Mentioned and the Performer Gives the
Washers a Twist to Set the Concealed Weight so That the
Hand When Hung on the Dial will be Drawn to Point Out the
Number Selected

The dial can be made of a piece of thick cardboard, or thin wood,

with the numbers from 1 to 12 painted on, like a clockface. A pin, ¹⁄₁₆
in. in diameter, or an ordinary large pin, is run through the center so
that it will project on the face side on which the hand is to revolve.
The washer D with the weight is placed on the rear side of the
hand with the fixed stud run through the hole in the center of the
hand; then the washer C is placed on the square part of the stud,
and the nut J, which should have a round, knurled edge, is turned on
the threads. This will cause the projection on the spring E to engage
one of the small holes on the disk B. In turning the two washers, C
and D, with the thumb and first finger of the right hand, the projection
snapping into the holes of the disk B can be felt. The hand is placed
on the pin of the clockface, and the washers are turned so that the
weight will make it point to 12. Scratch a mark on the hand at H, also
mark a line on the front washer at this point. These lines are
necessary, as they enable the performer to know how many holes to
snap the spring over to have the hand point at any desired number.
By reversing the hand it will point to a different number; for
instance, if set for 8 and put on the pin backward, it will point to 4,
and so on, with other settings. The dial can be held in the hand,
hung on a stand, or fastened to a wall, and can be used to tell the
day of the week, time of day, cards selected, etc. The audience can
call for any number on the clockface, and the setting of the disks is
an easy matter while holding the hand, or pointer, in the hands, so
that it cannot be detected.
 Uses for Steel Wool
The use of steel wool in place of sandpaper when finishing off new
or old work, when preparing it for varnishing or other finishes, will be
found very helpful. It is put up in small packages and can be
obtained in several grades of fineness. It is especially useful when
removing old finishes, in and around moldings, etc., since it
conforms to irregular shapes as sandpaper will not. Put on a pair of
heavy canvas gloves when using steel wool. They will keep the fine
slivers out of the skin. These gloves will also be found useful when
varnishing and painting.
 Turning Long Wood Rods
To turn a long wood rod of small diameter is not an easy job for the
amateur, and a suitable tool for the purpose is seldom found in the
amateur’s outfit. The tool illustrated can be easily made from
materials that are always at hand. A block of hard wood, A, is first
provided, and a hole, B, large enough to admit the square strip from
which the rod is to be turned, is bored in the end, whereupon the
hole C, which has the diameter of the finished rod, is bored through
the block. The hole D is next bored at right angles to the axis of the
hole C, and so placed that its edge just touches the outer edge of the
hole C. This hole is to receive an ordinary gouge, and must be of
such size as to receive the gouge snugly.

A Block of Wood Fashioned to Hold an Ordinary Gouge for Turning Small

Wood Rods

The gouge is ground back far enough on the under side to make
the cutting edge level with its back, and then beveled off on the
inside to a sharp edge. The gouge E is placed in the hole D with the
cutting edge on the center line, as shown, and held in place with a
wood plug, F. A little soap applied to the bore C will prevent binding.
To use the tool, a strip of wood is pointed sufficiently to allow it to
enter the hole C a short distance. The strip may be rotated by
holding it in the chuck of a lathe while the tool is held in the hand,
using the handle of the gouge to prevent its turning with the stick.—
Contributed by J. A. Brearley, Washington, D. C.
Hanging Ladder for a Hatchway
 A handy ladder to swing from a hatchway can be made of a solid
plank, as shown. Cut the plank to the length desired and saw
notches on each side to form steps. With a solid hook to fasten it in a
similar hook in the ceiling, at the edge of the opening, it makes a
novel yet practical ladder.—Contributed by Victor Carpenter, South
Bend, Ind.
 An Oilcan Stopper
An empty cartridge shell makes an excellent stopper for an oilcan
in case the original stopper becomes lost. The cap in the shell is
removed and the hole enlarged with the tang of a file so that a
leather thong can be inserted. A knot is tied in the thong on both
sides of the base, to prevent the thong from slipping either way. The
end of the thong is tied to the bail of the can.
 Enamel for Steel Fishing Rods
Make a thin solution of shellac in alcohol and add a teaspoonful of
Venice turpentine to each half pint, and the same quantity of
lampblack for a black enamel. Scrape the bare spots on the rod and
heat it slightly, to melt the shellac for the first coat. Use a fine brush
and apply two or three coats, which will give a smooth, glossy, and
elastic surface that will not scale or crack.
 Bench Receptacles for Small Articles
When working with small, round articles, such as ball bearings, it
often happens that they roll off the bench and are lost. To remedy
this, I bored several holes, each 2 in. in diameter, in a convenient
place in the workbench top, making them about ³⁄₈ in. deep, for the
different articles. To make the small parts easily accessible the holes
were filled in with thick paste made of plaster of Paris which was
molded into a saucer shape. After the plaster became thoroughly dry
the inner surface was painted over with white enamel. This made
them easily cleaned with a damp cloth. Any article dropped into
these depressions will roll to the center, and as the sides are curved
it can be easily picked up when it is wanted.—Contributed by Frank
L. Matter, Portland, Oregon.
 Ruler with Round and Flat Edges

The Molding Presents a Round Edge for a Pen and a Flat One for a Pencil

Picking up a smooth piece of ordinary wood molding, intending to

use it as a ruler, I found that its shape, A, combined the properties of
the round ruler and flat ruler, as well as assuming the third position
D. A simple reverse changes the edge from a round to a sharp or
flat, accommodating it to a pen or pencil, as shown. Such a piece of
molding can be procured from a local lumber dealer.—Contributed
by James M. Kane, Doylestown, Pa.