COLLEGE OF SCIENCE AND TECHNOLOGY

Cagamutan Norte, Leganes, Iloilo - 5003

Tel. # (033) 396-2291 ; Fax : (033) 5248081
Email Address : svcst_leganes@yahoo.com

COO – FORM 12

SUBJECT TITLE: AUDITING AND ASSURANCE: SPECIALIZED INDUSTRIES

INSTRUCTOR: HARVEY S. CHEN, CPA, MBA
SUBJECT CODE: AT2

PRELIM MODULE

Topic 1: AUDIT OF SPECIFIC ACCOUNTS

LEARNING OBJECTIVES:

At the end of this topic, the students are expected to

1. Understand and explain the substantive procedures to audit assets;

2. Understand and explain the substantive procedures to audit liabilities;
3. Understand and explain the substantive procedures to audit shareholders’
equity;
4. Understand and explain the substantive procedures to audit revenue; and
5. Understand and explain the substantive procedures to audit expenses

NOTES:

1.1 Substantive Procedures to Audit Asset Accounts

Substantive Procedures to Audit Cash

a. Prepare a bank transfer schedule for the last week of the audit year and the first
week of the following year to disclose misstatements of cash balances resulting
from kiting.

A bank transfer schedule shows the dates of all transfers of cash among the
client’s various bank accounts. Its primary purpose is to help auditors to detect
kiting. The schedule is prepared by using bank statements for the periods before
and after year-end and by using the firm’s cash receipts and disbursements
journals

Kiting is a form of fraud that overstates cash by causing it to be simultaneously

included in two or more bank accounts. Kiting is possible because a check takes
several days to clear the bank on which it is drawn (the “float period”).

Following is an example of how kiting can be used to conceal a prior embezzlement

in a company that has two bank accounts (one in ABC Bank and one in XYZ Bank).

Date Situation
12/15 Bookkeeper writes himself a P50,000 check on the ABC account, and
cashes it — no journal entry is made.

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 12/16 Bookkeeper loses the money gambling in the casino.
12/31 Bookkeeper, fearing the auditors will detect the fraud, conceals the
shortage by
 Writing a P50,000 unrecorded check on XYZ account and depositing
it in the ABC account. This will cover up the shortage because Valley
will credit the account for the P50,000, and the check will not clear
the XYZ account until January — no journal entry is made until after
year-end.
 When the XYZ bank reconciliation is prepared at 12/31, the check is
not listed as outstanding.

The following is an example of a bank transfer schedule that will help an auditor to
detect the kiting described above:

Date Date
Amount Bank drawn Books Bank Bank deposited Books Bank
on in
P50,000 XYZ 1/2 1/2 ABC 1/3 12/31

An analysis of the schedule reveals that at December 31, the cash is double
counted: it is included in both the ABC account (the bank gave credit for the deposit
on 12/31) and in the XYZ account.

b. Send confirmation letters to financial institutions to verify existence of the amounts

on deposit.

Auditors use a standard confirmation form to obtain information from financial

institutions. The form requests information on two types of balances — deposits
and loans. The form requests financial institutions to indicate any exceptions to
the information noted, and to confirm any additional account or loan balance
information that comes to their attention while completing the form. The form is
designed to substantiate evidence primarily on the existence assertion, and not
to discover or provide assurance about accounts not listed on the form (evidence
on the completeness assertion is not elicited).

c. Review year-end bank reconciliations to verify that cash has been properly stated
as of year-end.

Auditors generally prepare either a two- or a four-column bank reconciliation for

the difference between the cash per bank and per books. The four-column
approach (also called a proof of cash) will allow the auditor to reconcile

 All cash receipts and disbursements recorded on the books to those on the
bank statement.
 All deposits and disbursements recorded on the bank statement to the
books.

A four-column reconciliation will not allow the auditor to verify whether

 Checks written have been for the wrong amounts and so recorded on both
the books and the bank statement.
 Unrecorded checks or deposits exist that have not cleared the bank.

In the earlier kiting example, note that the ABC four-column reconciliation will
detect the kiting because the 12/15 credit for the check used in the embezzlement
will have been included in the ABC bank statement disbursements, but not on the
books as of 12/31. This is because the embezzlement will result in a P50,000
unreconciled difference between the book and bank totals in the disbursements
column of the reconciliation. The XYZ reconciliation, by itself, will not assist in
detection of the kiting because both book and bank entries occur after year-end.

d. Obtain a bank cutoff statement to verify whether the reconciling items on the year-
end bank reconciliation have been properly reflected.

A bank cutoff statement is a bank statement for the first 8-10 business days
after year-end. Its primary purpose is to help auditors to verify reconciling
items on the year-end bank reconciliation. Tests performed using a cutoff

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 statement include verifying that outstanding checks have been completely and
accurately recorded as of year-end, and that deposits in transit have cleared within
a reasonable period. The statement is sent directly by the bank to the auditor. In
the aforementioned kiting example, the cutoff statement for the XYZ account will
allow the auditor to detect the fraud since it will include the December 31
unrecorded check.

e. Other typical substantive audit procedures for cash

Review disclosures for compliance with applicable financial reporting

framework.
Inquire of management concerning compensating balance requirements and
restrictions on cash. Such restrictions on cash, when material, should be
disclosed in the financial statements.
Count cash on hand at year-end to verify its existence.
Review the cutoff of cash receipts and cash disbursements around year-end to
verify that transactions affecting cash are recorded accurately and in the proper
period.
Review bank statements to verify that book balances represent amounts to
which the client has rights.
Perform analytical procedures to test the reasonableness of cash balances.
Tests here may include comparisons to prior year cash balances and these
procedures help verify the existence and completeness as well as the accuracy
of cash transactions.
Foot summary schedules of cash and agree their total to the amount which will
appear on the financial statements.
Reconcile summary schedules of cash to the general ledger.
Test translation of any foreign currencies.

Substantive Procedures to Audit Receivables

a. Confirm accounts and notes receivable by direct communication with debtors to

verify the existence and gross valuation of the accounts.

Confirmation of accounts receivable is a generally accepted auditing procedure.

Auditors are required to confirm receivables, unless (1) accounts receivable are
immaterial, (2) confirmations would be ineffective as an audit procedure, or (3)
the combined assessment of inherent and control risk is low, and that assessment,
with other substantive evidence, is sufficient to reduce audit risk to an acceptably
low level.

Receivable confirmations primarily test the existence assertion, and only to a

limited extent the completeness and valuation assertions. Know the difference
between the positive and negative forms of confirmation request.

 The positive form requests a reply from debtors.

Some positive forms request the recipient to indicate either agreement or

disagreement with the information stated on the request.

Other positive forms, “blank forms,” do not state the amount (or other
information), but request the respondent to fill in the balance or furnish
other information, and when used, often result in lower response rates.

When no reply is received to a positive confirmation, a second request is

normally mailed to the debtor; if no reply to the second request is received,
the auditor normally performs alternative procedures (e.g., examination of
shipping documents, subsequent cash receipts, sales agreements).
However, the auditor may consider not performing alternative procedures
when (1) no unusual qualitative factors or systematic characteristics related
to responses have been identified, and (2) the nonresponses in total, when
projected as 100% misstatements to the population, are immaterial.

 The negative form requests the recipient to respond only if he or she

disagrees with the information stated on the request. Negative confirmation
requests may be used when:

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  The combined assessed level of inherent risk and control risk is low
 A large number of small balances is involved
 The auditor has no reason to believe that recipients are unlikely to give
them adequate consideration.

When no reply is received to the negative form, the assumption is made

that the debtor agrees with the amount and that evidence as to the
existence assertion has been collected.

Confirmations of accounts receivable can detect lapping. Lapping is an

embezzlement scheme in which cash collections from customers are stolen and the
shortage is concealed by delaying the recording of subsequent cash receipts. A
simplified lapping scheme is shown below.

Date Situation Bookkeeping entry

1/7 A pays P500 on account. No entry, bookkeeper cashes check and keeps
proceeds
1/8 B pays P200 on account. Cash 500
C pays P300 on account. Accounts Receivable – A 500
1/9 D pays P500 on account. Cash 500
Accounts Receivable – B 200
Accounts Receivable – C 300
1/10 Bookkeeper determines Allowance for Doubtful Accounts 500
D is unlikely to purchase Accounts Receivable – D 500
from company in the
future

Lapping most frequently occurs when one individual has responsibility for both
recordkeeping and custody of cash. Although the best way to control lapping is to
segregate duties and thereby make its occurrence difficult, it may be detected by
using by confirming receivables through investigating all exceptions noted, and
emphasize accounts that have been written off and old accounts.

For all accounts, watch for postings of cash receipts which have taken an unusually
long time. For example, when a reply to a confirmation suggests that the account
was paid on December 29, investigate when the posting occurred.

b. Review the cutoff of sales and cash receipts around year-end to verify that
transactions affecting accounts receivable are recorded in the proper period.

A sale is properly recorded when title passes on the items being sold. Title passes
for items sold FOB shipping point when the item is shipped from inventory; title
passes for items sold FOB destination when the item is received by the purchaser.

A proper credit sales cutoff generally affects at least four components of the
financial statements: accounts receivable, sales, cost of goods sold, and inventory.
Cash receipts should be recorded when the check (or cash) is received from a
customer.

c. Prepare an aging accounts receivable schedule.

The auditor should age accounts receivable to test the adequacy of the allowance
for doubtful accounts. An aging schedule is used to address the receivable
valuation assertion. Such a schedule summarizes receivables by their age (e.g.,
0–30 days since sale, 31–60 days since sale...). Estimates of the likely amount of
bad debts in each age group are then made (typically based on historical
experience) to estimate whether the amount in the allowance for doubtful accounts
is adequate at year-end.

d. Perform analytical procedures for accounts receivable, sales, notes receivable,

and interest revenue.

Typical ratios include: (a) the gross profit rate, (b) accounts receivable turnover,
(c) the ratio of accounts receivable to credit sales, (d) the ratio of accounts written
off to the ending accounts receivable, and (e) the ratio of interest revenue to notes

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 receivable. These procedures typically provide evidence to support the existence,
completeness, accuracy, and valuation assertions.

e. Other typical substantive audit procedures for receivables

Review disclosures for compliance with applicable financial reporting

framework.
Inquire of management about pledging, or discounting of receivables to verify
that appropriate disclosure is provided.
Review loan agreements for pledging and factoring of receivables to verify that
appropriate disclosure is provided.
Inspect notes on hand and confirm those not on hand by direct communication
with holders. For notes receivable, the auditor will generally be able to inspect
the actual note. This procedure is particularly important in situations in which
the note is negotiable (i.e., salable) to third parties.
Vouch receivables to supporting customer orders, sales orders, invoices,
shipping documents, and credit memos to verify the existence of accounts, and
occurrence and accuracy of sales transactions.
Inquire about factoring of receivables to verify that the client maintains rights
to the accounts.
Foot the accounts and notes receivable subsidiary ledgers to verify clerical
accuracy.
Reconcile subsidiary ledgers to the general ledger control accounts to verify
clerical accuracy.
Examine cash receipts subsequent to year-end to test the adequacy of the
allowance for doubtful accounts to determine appropriate valuation.
Discuss the adequacy of the allowance for doubtful accounts with management
and the credit department and compare it to historical experience to verify
valuation.
Consider changes in the economy or the company’s customers that might affect
the valuation of accounts receivable.

Substantive Procedures to Audit Inventories

a. Observe the taking of the physical inventory and make test counts to verify the
existence (and to a limited extent the ownership and valuation) of inventory.

Observation by the auditor of the client’s counting of inventory is a generally

accepted auditing procedure and departure from it should be justified. During the
inventory observation the auditor seeks to determine that recorded inventory items
do not exist (addressing the existence assertion), that all items are recorded
(completeness), and that the client has properly considered the condition of the
items (valuation).

The auditor should be familiar with various situations that may affect the auditor’s
observation:

 When a client uses statistical methods in determining inventory quantities,

the auditor should be satisfied that the sampling plan has statistical validity.
 The existence of good internal control, including an accurate perpetual
inventory system, may allow an effective count to be made prior to year-
end. In such circumstances, the auditor will rely upon internal control and
tests of updating of inventory through year-end to determine that year-end
inventory exists and is properly valued. The auditor may verify the accuracy
of the perpetual inventory records by examining receiving reports and
vendor invoices.
 For a first-year client the auditor will probably not have been present for
the count of the beginning inventory, a necessary input to determining cost
of goods sold. If adequate evidence is available (e.g., acceptable
predecessor auditor working papers), no report modification may be
necessary. When adequate evidence is not available, the auditor may be
required to qualify his/her audit report due to the scope limitation. Any
resulting misstatement affects both current and prior year income and is
therefore likely to result in qualification of the opinion on the income

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 statement. The statement of financial position at year-end will be
unaffected due to the self-correcting nature of such an error.
 A first-year client may have engaged the auditor subsequent to year-end
and the auditor may also have missed the year-end inventory count. In
addition, other events may make it impossible for the auditor to be present
for the client’s count of inventory. In such circumstances, alternate
procedures may sometimes be used to establish the accuracy of the count
(e.g., good internal control); however, these alternate procedures should
include some physical counts of inventory items and should include
appropriate tests of intervening transactions.

b. Perform test counts during the observation of the taking of the inventory and
compare them to the client’s counts and subsequently to the accumulated
inventory to verify the accuracy of the count and its accumulation.

c. Confirm consigned inventory and inventory in warehouses.

Some companies store inventory items in public warehouses. In such a situation,

the auditor should confirm in writing with the custodian that the goods are being
held. Additionally, if such holdings are significant, the auditor should apply one or
more of the following procedures:

 Review the client’s control procedures relating to the warehouseman.

 Obtain a CPA’s report on the warehouseman’s internal control.
 Observe physical counts of the goods.
 If warehouse receipts have been pledged as collateral, confirm with lenders
details of the pledged receipts.

d. Review cutoffs of sales, sales returns, purchases, and purchase returns around
year-end to verify that transactions affecting inventory are recorded in the proper
period.

Know here that the objective is to include in inventory those items for which the
client has legal title.

e. Test the pricing of inventory to verify that it is valued at NRV and that inventory
and cost of goods sold transactions are accurately recorded.

The accuracy of pricing is determined by reference to vendor invoices (for

wholesalers and retailers) and to vendor invoices, requisitions, and labor reports
(for manufacturers). In certain circumstances a specialist may be needed to assist
in valuation of inventory.

f. Perform analytical procedures to test the reasonableness of inventory.

Analytical procedures include calculation of gross profit margins by product, and

inventory turnover rates. Analytical procedures are particularly effective at
identifying obsolete inventory and, therefore, are useful in determining its proper
valuation.

g. Other typical substantive audit procedures for inventory

Review disclosures for compliance with applicable financial reporting

framework.
Inquire of management about pledging of inventory and verify the adequacy
of disclosure.
Review purchase and sales commitments to verify whether there may be a
need to either accrue a loss and/or provide disclosure. Generally,
commitments are not disclosed in the financial statements unless uneconomic
commitments result in a need to accrue significant losses (due to current price
changes).
Inquire of management as to the existence of consigned inventory to verify
the adequacy of its disclosure. Know that inventory consigned out remains
the property of the client until it is sold. Inventory consigned to the client
should not be included in the physical count since it belongs to the consignor.
Foot and extend summary inventory schedules to verify clerical accuracy.

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 Account for all inventory tags and count sheets to verify that inventory has
been completely recorded.
Reconcile inventory summary schedules to the general ledger to verify clerical
accuracy.
Test the inventory cost method to verify that it is in conformity with applicable
financial reporting framework. The auditor should determine the method of
pricing used and whether it is acceptable and consistent with the prior years
(e.g., FIFO, weighted average).
Examine inventory quality and condition to assess whether there may be
evidence suggesting that it is in unsatisfactory condition.
Perform any necessary additional tests of inventory obsolescence to verify the
valuation of inventory.

Substantive Procedures to Audit Investment Securities

a. Inspect and count securities on hand (often in a bank safe deposit box).

This procedure addresses the existence of the securities and provides evidence
that no fraud involving “substitution” (e.g., unauthorized sale and subsequent
repurchase) of securities has occurred during the year. A client employee should
be present during the inspection to avoid confusion over any missing securities. In
examining the security certificates, the auditor determines whether securities held
are identical to the recorded securities (certificate numbers, number of shares, face
value, etc.).

When an auditor is unable to inspect and count securities held in a safe-deposit

box at a bank until after the balance sheet date, a bank representative should be
asked to confirm that there has been no access between the balance sheet date
and the security count date.

b. Obtain confirmation of securities in the custody of others.

If client securities are held by independent custodians (e.g., a bank or trust

company), evidence related to the existence assertion is obtained by confirming
securities with such independent custodians.

c. Simultaneous verification

Because of the liquid nature of some securities (e.g., financial asset at FVPL), the
auditor’s inspection is generally performed at year-end simultaneously with the
audit of cash, bank loans (e.g., a revolving credit agreement), and other related
items.

d. Other typical substantive audit procedures for investment securities

Review disclosures for compliance with applicable financial reporting

framework.
Inquire of management about pledging of investment securities and verify that
appropriate disclosure is provided.
Review loan agreements for pledging of investment securities and verify that
appropriate disclosure is provided.
Review management’s classification of securities held for investment (e.g.,
financial asset at FVPL, FVOCI or amortized cost).
Vouch purchases and sales of securities during the year. This audit procedure
will provide evidence relating to all financial statement assertions. Included
here will be recomputation of gains and losses on security sales.
Review the cutoff of cash receipts and disbursements around year-end to
verify that transactions affecting investment securities transactions are
recorded accurately and in the proper period.
Perform analytical procedures to test the reasonableness of investment
securities. A typical analytical procedure is to verify the relationship between
interest and dividend income to the related securities. The auditor will also be
able to recompute the interest and dividend income if so desired.
Reconcile amounts of dividends received to published dividend records
generally available from databases maintained on the Internet to verify the
completeness and accuracy of dividend revenue.

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 Foot and extend summary investment security schedules to verify clerical
accuracy.
Reconcile summary inventory schedules to the general ledger to verify clerical
accuracy.
Test amortization of premiums and discounts to verify that investments are
properly valued.
Determine the market value of securities classified as financial assets at FVPL
or FVOCI at the date of the balance sheet.
Review audited financial statements of major investments to test whether they
are properly valued at year-end.

Substantive Procedures to Audit Property, Plant, and Equipment (PP&E)

a. Obtain or prepare an analysis of repairs and maintenance expense and vouch

transactions to discover items that should have been capitalized.

A PP&E acquisition may improperly be recorded in the repair and maintenance

expense account. Therefore, an analysis of repairs and maintenance may detect
understatements of PP&E. Alternatively, an analysis of PP&E may disclose
repairs and maintenance that have improperly been capitalized, thereby resulting
in overstatements of PP&E.

Expenditures that make the asset more productive or extend its useful life should
be capitalized in the asset account (betterment) or as a debit to accumulated
depreciation (life extension).

b. Vouch additions and retirements to PP&E to verify their existence, accuracy, and
the client’s rights to them.

Typically, large PP&E transactions support will include original documents such as
contracts, deeds, construction work orders, invoices, and authorization by the
directors. This procedure will also help to identify transactions that should be
expensed rather than capitalized.

c. Perform search for unrecorded retirements and for obsolete equipment.

Disposals may occur due to retirements or thefts of PP&E items. Simple

retirements of equipment are often difficult to detect since no journal entry may
have been recorded to reflect the event. Unrecorded or improperly recorded
retirements (and thefts) may be discovered through examination of changes in
insurance policies, consideration of the purpose of recorded acquisition,
examination of property tax files, discussions, observation, or through an
examination of debits to accumulated depreciation and of credits to miscellaneous
revenue accounts.

Inquiry of the plant manager may disclose unrecorded retirements and/or obsolete
equipment.

d. Other Typical substantive audit procedures for PP&E

Review disclosures for compliance with applicable financial reporting

framework.
Inquire of management concerning any liens and restrictions on PP&E. PP&E
may be pledged as security on a loan agreement and such restrictions are
disclosed in the notes to the financial statements.
Review loan agreements for liens and restrictions on PP&E and verify that
appropriate disclosure is provided.
Inspect major acquisitions of PP&E to verify their existence.
Review any leases for proper accounting to determine whether the related
PP&E assets should be capitalized.
Review minutes of the board of directors (and shareholders) to verify that
additions have been properly approved.
Foot PP&E summary schedules to verify clerical accuracy.
Recalculate depreciation to establish proper valuation of PP&E. In addition, the
existence of recurring losses on retired assets may indicate that depreciation
charges are generally insufficient.

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 Reconcile summary PP&E schedules to the general ledger to verify clerical
accuracy.
Perform analytical procedures to test the reasonableness (existence,
completeness, and valuation) of PP&E. Typical analytical procedures involve a
(a) comparison of total cost of PP&E divided by cost of goods sold, (b)
comparison of repairs and maintenance on a monthly and annual basis, and
(c) comparison of acquisitions and retirements for the current year with prior
years.
Consider any conditions that indicate that assets may be impaired to
determine that the assets are properly valued. Indications of possible
impairment include discontinuance of a business segment or type of product,
excessive capacity, loss of major customers, etc.

e. Intangible assets are audited similar to PP&E. They are generally valued at cost
and amortized over their useful lives. However, goodwill is not amortized; instead
it is tested for impairment at least annually. Research and development
expenditures are not capitalized. They are expensed as incurred.

Substantive Procedures to Prepaid Expenses

a. Vouch additions to accounts (examine insurance policies and miscellaneous other

support for deposit) to verify existence and accuracy.

b. Confirm deposits and insurance with third party to verify their existence and
valuation.

Insurance policies may be confirmed with the company’s insurance agent and/or
payments may be vouched.

c. Review disclosures for compliance with applicable financial reporting framework.

The lack of insurance (or self-insurance) on an asset (or inadequate insurance) will
not typically result in report modification, although this may be disclosed in the
notes to the financial statements.

d. Other typical substantive audit procedures for prepaid expenses

Review the adequacy of insurance coverage.

Perform analytical procedures to test the reasonableness of prepaid assets. A
primary procedure here is comparison with prior year balances and obtaining
explanations for any significant changes.
Foot prepaid summary schedules to verify accuracy.
Reconcile summary schedules to the general ledger to verify proper accuracy
and valuation.
Recalculate prepaid portions of prepaid assets to verify proper valuation.

1.2 Substantive Procedures to Audit Liability Accounts

Substantive Procedures to Audit Payables (Current)

a. Perform search for unrecorded payables to determine whether liabilities have been
completely recorded.

The search for unrecorded liabilities is an effort to discover any liabilities that
may have been omitted from recorded year-end payables (completeness). Typical
procedures include the following:

 Examination of vendors’ invoices and statements both immediately prior

to and following year-end
 Examination, after year-end, of the following to test whether proper cutoffs
have occurred:
 Cash disbursements
 Purchases
 Unrecorded vouchers (receiving reports, vendors’ invoices, purchase
orders)

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  Analytical procedures
 Internal control is analyzed to evaluate its likely effectiveness in preventing
and detecting the occurrence of such misstatements.

b. Confirm accounts payable by direct correspondence with vendors.

Confirmations may be sent to vendors. However, such confirmation procedures

are sometimes omitted due to the availability of externally generated evidence
(e.g., both purchase agreements and vendors’ invoices) and due to the inability of
confirmations to adequately address the completeness assertion. (Auditors are
primarily concerned about the possibility of understated payables; a major payable
will not in general be confirmed if the client completely omits it from the trial
balance of payables.)

Accounts payable confirmations are usually used in circumstances involving (1)

bad internal control, (2) bad financial position, and (3) situations when vendors do
not send month-end statements.

However, when an auditor has chosen to confirm payables despite the existence of
vendor statements, the confirmation will generally request the vendor to send the
month-end statement to the auditor. For this reason, the balance per the client’s
books is not included on such a confirmation.

Confirmations are sent to (1) major suppliers, (2) disputed accounts, and (3) a
sample of other suppliers. Major suppliers are selected because they represent a
possible source of large understatement: the client will normally have established
large credit lines. The size of the recorded payable at year-end is of less
importance than for receivables. While as a practical matter large year-end
recorded balances will normally be confirmed, the emphasis on detecting
understated payables may lead the auditor to also confirm accounts with relatively
low recorded year-end balances. Also, if the payables to be confirmed are selected
from a list of vendors instead of from the recorded year-end payables, the
completeness assertion as well as the existence assertion may be addressed.

c. Recalculate other accrued liabilities.

The approach for accruals is largely one of (1) testing computations made by the
client in setting up the accrual, and (2) determining that the accruals have been
treated consistently with the past.

Examples of accounts requiring accrual include property taxes, pension plans,

vacation pay, service guarantees, commissions, and income taxes payable.

d. Other typical substantive audit procedures for payables

Review disclosures for compliance with applicable financial reporting

framework.
Review purchase commitments to determine whether there may be a need to
either accrue a loss and/or provide disclosure.
Inspect copies of notes and note agreements.
Vouch balances payable to selected creditors by inspecting purchase orders,
receiving reports, and invoices to verify existence, accuracy, valuation, and to
a lesser extent, completeness.
Review the cutoff of purchases, purchase returns, and disbursements around
year-end to verify that transactions are recorded in the proper period.
Perform analytical procedures to test the reasonableness of payables.
Examples here are ratios such as accounts payable divided by purchases, and
accounts payable divided by total current liabilities.
Inquire of management as to the completeness of payables.
Foot the subsidiary accounts payable ledger to test clerical accuracy.
Reconcile the subsidiary ledger to the general ledger control account to verify
clerical accuracy.
Recalculate interest expense on interest-bearing debt.
Recalculate year-end accrual for payroll. A typical procedure here is to allocate
the total days in the payroll subsequent to year-end between the old and new
years and to determine whether the accrual is reasonable.

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 Substantive Procedures to Audit Long-Term Debt

a. Confirm long-term debt with payees or appropriate third parties (including any
applicable sinking fund transactions).

Confirmations are frequently used; recall that when the debt is owed to banks,
confirmation is obtained with the standard bank confirmation. Moreover, if a debt
trustee is used, it will be possible to obtain information through use of a
confirmation whether the repayments have been made.

b. Review minutes of board of directors’ and/or shareholders’ meetings

This procedure is performed in order to verify that transactions have been properly
authorized and, if necessary, that an opinion of an attorney has been obtained
regarding the legality of the debt.

c. Other typical substantive audit procedures for long-term debt

Review disclosures for compliance with applicable financial reporting

framework.
Inquire of management concerning pledging of assets related to debt.
Review debt agreements for details on pledged assets and for events that may
result in default on the loan.
Obtain and inspect copies of debt agreements to verify whether provisions
have been met and disclosed.
Trace receipt of funds (and payments) to the bank account and to the cash
receipts journal to verify that the funds were properly received (or disbursed)
by the company.
Review the cutoff of cash receipts and disbursements around year-end to
verify that transactions affecting debt are recorded in the proper period.
Perform analytical procedures to verify the overall reasonableness of long-
term debt and interest expense.
Inquire of management as to the completeness of debt.
Review bank confirmations for any indication of unrecorded debt.
Foot summary schedules of long-term debt to test clerical accuracy.
Reconcile summary schedules of long-term debt to the general ledger to verify
clerical accuracy.
Vouch entries in long-term debt accounts to test existence, obligation, and
accuracy of debt.
Recalculate interest expense and accrued interest payable to determine
accuracy of the amounts.

1.3 Substantive Procedures to Audit Shareholder’s Equity Accounts

a. Confirm shares authorized, issued, and outstanding with the independent registrar
and stock transfer agent (if applicable).

Large clients usually engage a registrar and a stock transfer agent to manage the
company’s stock transactions. The primary responsibility of the registrar is to
verify that stock which is issued is properly authorized. Stock transfer agents
maintain detailed stockholder records and carry out transfers of stock ownership.

The number of shares authorized, issued, and outstanding will usually be confirmed
to the auditor directly by the registrar and stock transfer agent.

b. Reconcile the stock certificate book to transactions recorded in the general ledger
(for a corporation that acts as its own stock registrar and transfer agent).

A stock certificate book may be used which summarizes shares issued through use
of “stubs” which remain after a certificate has been removed. The certificates for
outstanding shares are held by the shareholders; canceled certificates (for
repurchased share or received when a change in stock ownership occurs) are held
by the client. When a stock certificate book is used, auditors reconcile outstanding
shares, par value, etc., with the “stubs” in the book.

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 c. Vouch all entries affecting retained earnings.

Little effort will be exerted in auditing the retained earnings of a continued client.
The audit procedures for dividends will allow the auditor to verify the propriety of
that debit to retained earnings. The entry to record the year’s net income (loss) is
readily available. Finally, the nature of any prior period adjustments is examined
to determine whether they meet the criteria for an adjustment to retained
earnings. The type of adjustment typically encountered is a correction of prior
years’ income.

d. Other typical substantive audit procedures for shareholders’ equity

Review disclosures for compliance with applicable financial reporting

framework.
Review Articles of Incorporation, bylaws, and minutes for provisions relating
to stock options, and dividends restriction.
Vouch transactions and trace receipt of funds (and payment) to the bank
account and to the cash receipts journal to verify that the funds were properly
received (or disbursed) by the company.
Review minutes of the board of directors’ and/or shareholders’ meetings to
verify that stock transactions and dividends have been properly authorized.
Inquire of the client’s legal counsel to obtain information concerning any
unresolved legal issues.
Review the Articles of Incorporation and bylaws for the propriety of equity
transactions.
Perform analytical procedures to test the reasonableness of dividends.
Inspect treasury stock certificates to verify that transactions have been
completely recorded and that client has control of certificates.
Agree amounts that will appear on the financial statements to the general
ledger.
Vouch dividend payments to verify that amounts have been paid.
Recalculate treasury stock transactions.

1.4 Substantive Procedures to Audit Revenue and Expenses

Substantive Procedures to Audit Revenue

a. Verification of revenue accounts in relation with the audit of a related asset or

liability account.

Most revenue accounts are verified in conjunction with the audit of a related asset
or liability account. For example:

Statement of Financial Position Income Statement

Account Account
Accounts receivable Sales
Notes Receivable Interest income
Investments Interest, dividends, gains on sales
Property, plant and equipment Rent, gains on sale

Most frequently sales are recorded during the period in which title has passed, or
services have been rendered to customers who have made firm, enforceable
commitments to purchase such goods or services.

However, there are potential problem areas for revenues. These are:

 Bill and hold transactions. Transactions in which a customer agrees to

purchase goods but the seller retains physical possession until the customer
requests shipment to designated locations. Because delivery has not yet
occurred, such transactions do not ordinarily qualify. The primary
requirements to qualify for revenue recognition are that the buyer make an
absolute commitment to purchase, has assumed the risks and rewards of
the product, and is unable to accept delivery because of some compelling
reason.

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  Side agreements. Agreements used to alter the terms and conditions of
recorded sales transactions, often to convince customers to accept delivery
of goods and services. Side agreements are frequently hidden from the
board of directors and may create obligations that relieve the customer of
the risks and rewards of ownership. Accordingly, side agreement terms
may not result to revenue recognition.

 Channel stuffing (trade loading). A marketing practice that suppliers

sometimes use to boost sales by inducing distributors to buy substantially
more inventory than they can promptly resell. Inducements may range from
deep discounts on the inventory to threats of losing the distributorship if
inventory is not purchased. Channel stuffing may result in the need to
increase the level of anticipated sales returns.

 Related-party transactions. A variety of potential misstatements may

occur due to transactions with related parties. For example, sales of the
same inventory back and forth among affiliated companies may “freshen”
receivables.

b. Other substantive procedure approach for revenues not verified in the audit of
balance sheet accounts

Perform analytical procedures related to revenue accounts.

Obtain or prepare analyses of selected revenue accounts.
Vouch selected transactions and determine that they represent proper revenue
for the period.

Substantive Procedures to Audit Expenses

a. Verification of expense accounts in relation with the audit of a related asset or

liability account.

Most expense accounts are verified in conjunction with the audit of a related asset
or liability account. For example

Statement of Financial Position Income Statement

Account
Accounts receivable
Inventories
Property, plant and equipment
Accrued liabilities
Account
Uncollectible accounts (bad debts)
Purchases, cost of goods sold, payroll
Depreciation, repairs and maintenance
Commissions, fees, product warranty expenses

b. Substantive procedure approach for expenses not verified in the audit of

balance sheet accounts

Perform analytical procedures related to the expense accounts.

Obtain or prepare analyses of selected expense accounts.
Vouch selected transactions.

Exercises:

Choose the correct answer:

1. The following are the auditor’s principal objectives in the audit of revenues, except

a. To determine whether all cash owned by the entity at the reporting date is included
on the reporting date.
b. To determine whether earned revenue has been recorded and recorded revenue
has been earned.
c. To determine whether revenues are reported in the income statement at the
appropriate amounts.
d. To determine whether revenues are properly classified, described, and disclosed in
the financial statements, including notes, in conformity with an applicable financial
reporting framework.

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2. An auditor confirms a representative number of open accounts receivable as of
December 31 and investigates respondents’ exceptions and comments. By this
procedure, the auditor would be most likely to learn of which the following?

a. One of the cashiers has been covering a personal embezzlement by lapping.

b. One of the sales clerks has not been preparing charge slips for credit sales to family
and friends.
c. One of the computer control clerks has been removing all sales invoices applicable
to his account form the data file.
d. The credit manager has misappropriated remittances from customers whose
accounts have been written off.

3. In the audit of which of the following general ledger accounts will test of controls be
particularly appropriate?

a. Bank charges. c. Bonds payable.

b. Equipment. d. Sales.

4. If the objective of a test of details is to detect overstatements of sales, the auditor

should compare transactions in the

a. Cash receipts journal with the sales journal.

b. Sales journal with the cash receipts journal.
c. Source documents with the accounting records.
d. Accounting records with the source documents.

5. Which of the following might be detected by an auditor’s review of the client’s sales
cutoff?

a. Excessive goods returned for credit.

b. Unrecorded sales discount.
c. Lapping of year-end accounts receivable.
d. Inflated sales for the year.

6. Which of the following procedures would an auditor most likely perform for year-end
accounts receivable confirmations when the auditor did not receive replies to second
requests?

a. Review the cash receipts journal for the month prior to year-end.
b. Intensify the study of the internal control structure concerning the revenue cycle.
c. Increase the assessed level of detection risk for the existence assertion.
d. Inspect the shipping records documenting the merchandise sold to the debtors.

7. Which statement regarding external confirmation is incorrect?

a. External confirmation of an account receivable provides strong evidence regarding

its valuation.
b. External confirmation on goods held on consignment is likely to provide strong
evidence to support the existence and rights assertions.
c. Unreturned negative confirmation requests rarely provide significant explicit
evidence.
d. Auditors may use positive or negative forms of confirmation or a combination of
both.

8. Negative confirmation requests is least likely used when

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

b. A large number of small balances is involved.
c. A substantial number of errors is expected.
d. The auditor has no reason to believe that respondents will disregard these
requests.

9. The confirmation of customers’ accounts receivable rarely provides reliable evidence

about the valuation assertion because

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 a. Customers may not be inclined to report understatement errors in their accounts.
b. Auditors typically select many accounts with low recorded balances to be
confirmed.
c. It is not practicable to ask the customer to confirm detailed information relating to
its ability to pay the account.
d. Recipients usually respond only if they disagree with the information on the
request.

10. The primary purpose of sending a standard confirmation requests to financial

institutions with which the client has done business during the year is to

a. Detect kiting activities that may otherwise not be discovered.

b. Corroborate information regarding deposit and loan balances.
c. Provide the date necessary to prepare a proof of cash.
d. Requests information about contingent liabilities and secured transactions.

11. An auditor should test bank transfers for the last part of the audit period and first part
of the subsequent period to detect whether

a. The cash receipts journal was held open for a few days after year-end.
b. The last checks recorded before year-end were actually mailed by year-end.
c. Cash balances were overstated because of kiting.
d. Any unusual payments to or receipts from related parties occurred.

12. Which of the following is a substantive procedure that an auditor most likely would
perform to verify the existence and valuation of recorded accounts payable?

a. Investigating the open purchase order file to ascertain that prenumbered purchase
orders are used and accounted for.
b. Receiving the client’s mail; unopened, for a reasonable period of time after year-
end to search for unrecorded vendor’s invoices.
c. Vouching selected entries in the accounts payable subsidiary ledger to purchase
orders and receiving reports.
d. Confirming accounts payable balances with known suppliers who have zero
balances.

13. An entity’s internal control structure requires that an approved voucher, a

prenumbered purchase order, and a prenumbered receiving report accompany every
check request. To determine whether checks are being issued for unauthorized
expenditures, an auditor most likely would select items for testing from the population
of all

a. Purchase orders. c. Canceled checks.

b. Receiving reports. d. Approved vouchers.

14. When auditing inventories, an auditor would least likely verify that

a. All inventory owned by the client is on hand at the time of the count.
b. The client has used proper inventory pricing.
c. The financial statement presentation of inventories is appropriate.
d. Damaged goods and obsolete items have been properly accounted for.

15. If the perpetual inventory records show lower quantities of inventory than the physical
count, an explanation of the difference might be unrecorded

a. Sales. c. Purchases.
b. Sales discounts. d. Purchase discounts.

16. In testing for unrecorded retirements of equipment, an audit most likely would

a. Select items of equipment from the accounting records and them locate them
during the plant tour.
b. Compare depreciation journal entries with similar prior-year entries in search of
fully depreciated equipment.
c. Inspect items of equipment observed during the plant tour and then trace them to
the equipment subsidiary ledger.

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 d. Scan the general ledger for unusual equipment additions and excessive debits to
repairs and maintenance expense.

17. In establishing the existence and ownership of a long-term investment in the form of
publicly traded stock, an auditor should inspect the securities or

a. Correspond with the investee company to verify the number of share owned.
b. Inspect the audited financial statements of the investee company.
c. Confirm the number of shares owned that are held by an independent custodian.
d. Determine that the investment is carried at fair value.

18. A client has a large and active investment portfolio that is kept in a bank safe deposit
box. If the auditor is unable to count the securities at the balance sheet date, the
auditor most likely would

a. Request the bank to confirm to the auditor the contents of the safe deposit box at
the balance sheet date.
b. Examine supporting evidence for transactions occurring during the year.
c. Count the securities at a subsequent date and confirm with the bank whether
securities were added or removed since the balance sheet date.
d. Request the client to have the bank seal the safe deposit box until the auditor can
count the securities at a subsequent date.

19. An auditor’s program to audit long-term debt should include steps that require

a. Examining bond trust indentures.

b. Inspecting the accounts payable subsidiary ledger.
c. Investigating credits to the bond interest income account.
d. Verifying the existence of the bondholders.

20. In auditing payroll, an auditor most likely would

a. Verify that checks representing unclaimed wages are mailed.

b. Trace individual employee deductions to entity journal entries.
c. Observe entity employees during a payroll distribution.
d. Compare payroll costs with entity standard or budgets.

END OF TOPIC 1

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Topic 2: AUDIT SAMPLING

LEARNING OBJECTIVES:

At the end of this topic, the students are expected to

1. Understand the basic audit sampling concepts;

2. Understand and explain the general approaches to audit sampling;
3. Explain the types of sampling risks;
4. Elaborate on the different methods in selecting samples; and
5. Identify the usage of sampling.
6. Understand the two types of sampling plan;
7. Enumerate and explain the steps involved in attributes and variables sampling;
8. Identify and explain the factors affecting sample size for tests of controls;
9. Identify and explain the factors affecting sample size for substantive tests of
details; and
10.Describe the audit techniques used in variable sampling.

NOTES:

2.1 Audit Sampling Concepts

As defined in PSA 530 (Redrafted), “Audit Sampling”, audit sampling involves the
application of audit procedures to less than 100% of the items within a population of
audit relevance such that all sampling units have a chance of selection in order to
provide the auditor with a reasonable basis on which to draw conclusions about the
entire population.

Sampling is a process of selecting a subset of a population of items for the purpose of

making inferences to the whole population. Detailed or 100% examination of all
accounts in the financial statements is almost impossible.

Population refers to the entire set of data from which a sample is selected and about
which the auditor wishes to draw conclusions.

A sampling unit is defined as the individual items constituting a population.

Audit sampling can be used in tests of controls and substantive procedures. In relation
to substantive procedures, sampling can only be used in performing substantive tests
of details because substantive analytical procedures should be applied to a complete
set of data or information so that the relationships generated by computing ratios and
trend analysis are realistic.

Procedures that do not involve sampling:

a. Inquiry and observation

 Interview management and employees
 Obtain an understanding of internal control
 Obtain written representations from management
 Scan accounting records for unusual items
 Observe behavior of personnel and functioning of business operations
 Observe cash-handling procedures
 Inspect land and buildings
b. Analytical procedures
c. Procedures applied to every item in a population (e.g., some audit plans include
the audit of all “large” accounts
d. Tests of controls where application is not documented (e.g., no audit trail exists)
e. Procedures that depend on segregation of duties or that otherwise provide no
documentary evidence

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 f. Procedures from which the auditor does not intend to extend a conclusion to the
remaining items in the account (e.g., walkthrough test or procedure which involve
tracing several transactions through accounting system to obtain understanding)
g. Untested balances

2.2 General Approaches to Audit Sampling

When examining account balances or classes of transactions using audit sampling, an

auditor uses either one of two approaches, namely:

a. Statistical sampling.

Statistical sampling is a sampling approach that involves the random selection of

a sample for inspection and uses probability theory to evaluate sample results and
measure sampling risk. In statistical sampling, each item in the population has a
calculable chance of being selected.

An auditor must use professional judgment even when using statistical sampling,
especially in considering and specifying in advance factors such as materiality, the
expected error rate or amount, the risk of over-reliance and the risk of incorrect
acceptance, audit risk, inherent risk, control risk, and population size, before the
sample size can be determined.

Statistical sampling permits an auditor’s judgment to be concentrated on those

areas of the audit where it is most needed. It allows the auditor to:

 Quantify sampling risk.

 Design an efficient sample.
 Measure the sufficiency of the audit evidence gathered.
 Objectively evaluate the sample results.

Costs of statistical sampling include:

 Training auditors
 Designing samples
 Selecting items to be tested

b. Nonstatistical or judgmental sampling.

Nonstatistical sampling is a selection process where the auditor decides which

items are to be audited. It involves a subjective selection of items for testing and
a subjective evaluation of the results. This approach relies on intuition and non-
quantitative methods in the evaluation process.

The reliability of the sample results obtained using judgmental sampling cannot be
estimated because the probability of selection of the individual items in the
population cannot be ascertained.

Judgmental sampling is an acceptable means of gathering audit evidence

concerning the fairness of the financial statements provided the auditor is satisfied
that the sample is not unrepresentative of the entire population.

Furthermore, nonstatistical sampling is often cheaper and less time-consuming to

perform compared to statistical sampling.

Both statistical and nonstatistical sampling:

a. Involve judgment in planning, executing the sampling plan, and evaluating the
results of the sample
b. Can provide sufficient appropriate audit evidence

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2.3 Uncertainty and Risks

In obtaining audit evidence, the auditor should use professional judgment in assessing
audit risk and in designing audit procedures to ensure that such risk is reduced to an
acceptably low level.

Audit risk is the risk that the auditor may unknowingly fail to appropriately modify
his opinion on financial statements that are materially misstated. It can be expressed
as:

AUDIT RISK = IR x CR x DR

or

AUDIT RISK = IR x CR x (AP x TD)

Where: IR = Inherent risk

CR = Control risk
DR = Detection risk
AP = Analytical procedures risk and other relevant
substantive procedures
TD = Test of details allowable risk of incorrect
acceptance for this substantive procedure

For sampling purposes, audit risk can be affected by sampling and nonsampling risks.

Nonsampling risk arises from factors that cause the auditor to reach an erroneous
conclusion for any reason not related to the size of the sample. It results from human
errors. For instance, the auditor may:

a. Fail to select appropriate audit procedures.

b. Fail to recognize misstatements in documents examined.
c. Misinterpret the results of audit tests.

Nonsampling risk exists regardless of the number of items selected from a population
for testing.

Nonsampling risk is a risk that is attributable to the auditor; hence, it can never be
eliminated. However, it can be appropriately reduced through proper
engagement planning, supervision, and review of the audit work.

Sampling risk is the probability that a properly drawn sample may not be representa-
tive of the population; that is, the auditor’s conclusion based on a sample may be
different from the conclusion reached if the entire population were subjected to the
same audit procedure.

Sampling risk can be reduced by increasing sample size. It can be eliminated if

the auditor will examine all items in the population.

2.4 Types of Sampling Risk

The two types of sampling risk are:

a. Tests of control sampling risks.

b. Substantive procedure sampling risks.

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Test of control sampling risks may be classified into:

a. Risk of assessing control risk too high.

It refers to the risk that sample does not support the auditor’s planned degree of
reliance on the control when the true compliance rate supports such reliance. In
other words, the risk of assessing control risk too high is the risk that the assessed
level of control risk based on the sample is greater than the true operating
effectiveness of the control structure policy or procedure.

This type of risk pertains to audit efficiency and is likely to result in greater audit
effort. The over-assessment of control risk may result to an unnecessary increase
or extension of the auditor’s substantive procedures.

For instance, when an auditor concludes that control risk is high, he ordinarily sets
a lower acceptable level of detection risk and expands the scope of his substantive
procedures in order to compensate for the perceived control deficiency or
weakness. Such additional effort is unwarranted and would only result to
inefficiencies in the audit because more substantive procedures will be performed
than necessary.

The risk of assessing control risk too high is also termed a type 1 error, alpha
risk, or the risk of under-reliance.

b. Risk of assessing control risk too low.

It refers to the risk that sample supports the auditor’s planned degree of reliance
on the control when the true compliance rate does not justify such reliance. Simply
stated, the risk of assessing control risk too low is the risk that the assessed level
of control risk based on the sample is less than the true operating effectiveness of
internal control.

This type of risk relates to audit effectiveness and could lead to audit failure.
The auditor`s under-assessment of control risk may result to an unjustified
reduction in the scope of substantive procedures which, in turn, results in obtaining
insufficient audit evidence.

For instance, if an auditor erroneously concludes that the controls are effective,
control risk would be assessed at a low level and the auditor will subsequently
reduce or restrict the extent and scope of his substantive procedures. Thus, the
substantive procedures performed may not be effective or enough in detecting
material misstatements that otherwise may exist in the population.

The risk of assessing control risk too low is also referred to as type 2 error, beta
risk, or the risk of over-reliance.

The risk of assessing control risk too low is more important to auditors than the
risk of assessing control risk too high.

Substantive procedure sampling risks may be classified into:

a. Risk of incorrect rejection. It refers to the risk that the sample supports the
conclusion that the recorded account balance is materially misstated when in fact,
it is not materially misstated.

This type of risk relates to the audit efficiency. Because of the risk involved in
sampling, an auditor might select a sample containing disproportionately more
misstatements than the population contains. However, the audit client would likely
maintain that the balance is properly stated. The auditor would then perform
additional procedures and gather additional evidence to confirm or dispel his
previous findings; thus, resulting to additional effort and extra spending.

The risk of incorrect rejection is also called type 1 error or alpha risk. This risk is
similar to the risk of assessing control risk too high for tests of control.

Page 20 of 46
 b. Risk of incorrect acceptance. It refers to the risk that the sample supports the
conclusion that the recorded account balance is not materially misstated when in
fact, it is materially misstated.

This type of risk relates to audit effectiveness. Owing to sampling risk, an

auditor might select a sample containing disproportionately less misstatements
than what the population contains. If the auditor incorrectly accepts a materially
misstated account balance as fairly stated, this would cause the auditor to express
an unmodified opinion on financial statements which actually departs from PFRSs.
Ultimately, audit ineffectiveness results to audit failure.

The risk of incorrect acceptance is also called type 2 error or beta risk. This risk is
similar to the risk of assessing control risk too low for tests of control.

The risk of incorrect acceptance is far more consequential to the auditor than the
risk of incorrect rejection.

The confidence (reliability) level is the complement of sampling risk. Hence, for a
test of control, if the risk of assessing control risk too low is 10%, the auditor’s
confidence level would be 90% (100% - 10%). For a substantive procedure, if the
risk of incorrect acceptance is 15%, the auditor`s confidence level would be 85%
(100% - 15%).

2.5 Methods in Selecting Samples

The auditor should select items for the sample with the expectation that all sampling
units in the population have a chance of selection. The auditor may use sample
selection methods such as random sampling, systematic sampling, stratified sampling,
haphazard sampling, and block sampling.

Random or Probability Sampling

This method involves selecting items from the population so that each item has an
equal or known chance of being selected. Random selection requires the use of
random number tables or random number generators.

A random number table is composed of a list of randomly selected number which may
be used by the auditor.

Random number generators are computer programs that generate random numbers.

The auditor should make sure that the sample being selected is representative of the
population from which it is drawn. Random sampling typically involves relating
identifying numbers (or letters) to sampling units in the population, and deriving a
random sample from the population with the aid of a random number table or a random
number generator.

The sampling unit may be in physical terms. Examples of physical identifiers are check
number, invoice number, page number, and warehouse row.

Random sampling may be restricted or unrestricted.

In unrestricted or simple random sampling with replacement, a fixed number of

items are selected. Each time an item is selected, any item on the frame can be
selected into the sample once again. This means that a sample item can be selected
into the sample multiple times.

In restricted or simple random sampling without replacement, a fixed number

of items are selected each time. An item can be selected into the sample only once;
therefore, the sample contains unique items. Only items not selected earlier can be
selected into the sample.

Random sampling can be used for both statistical and nonstatistical sampling
approaches.

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Systematic or Interval Sampling

Systematic sampling involves selecting every nth item from the population

This method consists of sequencing all items of the population. Sampling units are
put in numerical order. The auditor divides the population into intervals of equal sizes
based on the number of sampling units that must be chosen for the sample (n). He
then chooses a sampling unit from each of the derived intervals. The selection interval
can be determined by dividing the population size (N) by the required sample size (n).

For instance, if the population is composed of 1,000 units and the desired sample size
is 100 units, the auditor selects a random starting point between one and the sampling
interval of 10 (1,000/100). He then randomly chooses the first sampling unit from the
first interval. After including the random start unit (e.g., 4) as part of the sample, the
auditor then sequentially selects every 10 th item of the population (e.g., 14th, 24th,
34th,…). This approach usually results in a true random sample.

However, bias may result if a pattern in the population exists that coincides with the
selection interval. For instance, if every 10th sampling unit or multiples of 10 happens
to be a departmental manager, then based on the random start, the sample derived
may yield either all departmental managers or none. Nonetheless, the possibility of
introducing a bias into the sample as a result of a pattern in the population can be
minimized by having multiple starting points in the selection process or by using an
interval that does not coincide with the said pattern.

Under systematic sampling, there is no need to establish correspondence between

population items and random numbers.

Systematic sampling applies to both statistical and nonstatistical sampling approaches.

Stratified Sampling

Stratification simply involves subdividing the population into subpopulations or

strata, each of which is a group of sampling units which have similar characteristics.
Stratification of accounting population is usually based on the recorded book value
amounts of the line items wherein the population is divided into strata according to
their book values and a sample is selected independently from each stratum.

Stratified sampling enables the auditor to direct his effort on items which contain the
greatest potential misstatement (e.g., the auditor will focus his attention in auditing
larger value items to detect material errors and fraud).

Stratified sampling is used when a population has a high variability, that is, certain
parts of the population are distinct from the other parts. For instance, some accounts
in the population are stated in terms on millions, while others, only in thousands or
hundreds.

Stratified sampling may be used for both statistical and nonstatistical sampling
approaches.

Haphazard Sampling

This method involves selecting items from the population without following a
structured technique. Simply stated, the auditor must select sample items without
regard to their size, shape, location, or other physical features. In using haphazard
sampling, the auditor should avoid any conscious bias in the selection of population
items, for example, by selecting only unusual or physically small items, or omitting
the first or last items in a population. Due care must be exercised in selecting
representative samples using this method.

Haphazard selection is not appropriate when using statistical sampling because it does
not allow the auditor to measure the probability of selecting a given combination of
sampling units.

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 Block or Cluster Sampling

This method involves selecting items from the population in contiguous groups (or
blocks).

A block sample is obtained by selecting several items in sequence. Once the first item
in the block is selected, the remainder of the block is chosen automatically. For
instance, the sample may consist of all vouchers processed during a two-week period
or all vouchers processed on specific days. Block samples could theoretically be
representative samples but are rarely used because they are inefficient. The time and
expense to select sufficient blocks so that the samples could be considered
representative of the total population is absurd.

Block sampling is considered the least desirable for use by the auditor and, like
haphazard sampling, is also inappropriate for statistical sampling.

2.6 Usage of Sampling

Sampling may be used in:

a. Tests of controls (attributes sampling). It is directed towards the design or

operation of a control to assess its effectiveness in preventing, detecting and
correcting material misstatements in a financial statement assertion.

b. Substantive procedures (variables sampling). It is used to obtain evidence

about the validity and propriety of the accounting treatment of transactions and
balances.

c. Dual-purpose tests. It is used to test a control and to serve as a substantive

procedure of a recorded balance or class of transactions.

When a dual-purpose test is used, auditors select the sample size as the higher of
that required for the two purposes. For instance, if the test of control test required
45 items, and the substantive test required 50, both tests would be performed
using the 50 items.

2.7 Types of Sampling Plan

Sampling plan may either be attributes sampling or variables sampling.

Attributes sampling is a statistical approach used with tests of controls. In testing

for attributes, the auditor is typically concerned with the qualitative characteristics or
attributes of the population, and is used to estimate the proportion of deviations
associated with a particular set of controls.

For example, the issuance of checks must be authorized, and attributes sampling is
used to estimate the proportion of times or percentage that such documents have not
been authorized. Based on the deviation or occurrence rate computed in the sample,
the auditor evaluates if control risk can be assessed at below the maximum level.

Variables sampling, on the other hand, is used by the auditor when performing
substantive tests of details. It is a form of sampling that provides a numerical
estimate (peso amounts or in units) of a population. It is used to determine whether
account balances in the entity’s books are fairly stated.

Variables sampling is used to detect material misstatements in the financial

statements.

2.8 Steps Involved in Attributes Sampling

The auditor should follow the following steps in performing attributes sampling:

Page 23 of 46
 a. Determining the objectives of the test. Tests of controls are designed to
provide reasonable assurance that internal control is operating effectively.
Attributes sampling is usually used when there is a trail of documentary evidence.

b. Defining the attribute and deviation conditions. The auditor should identify
characteristics or attributes that would indicate operation of the internal controls.
The auditor then defines the possible deviation conditions. For instance, a control
procedure requires that each check be signed by the treasurer before given to a
payee. Hence, an issued check that was not signed, or signed by an employee
other than the treasurer, constitutes a deviation.

c. Defining the population. For tests of controls, the population is the class of
transactions being tested. The population must be:

 Appropriate to the objective of the sampling procedure. The direction of testing

must be considered. For example, if the auditor’s objective is to test for
overstatement of accounts payable, the population should be the accounts
payable listing. Conversely, when testing for understatement of accounts
payable, the population should be subsequent disbursements, unpaid invoices,
or unmatched receiving reports.

 Complete. For example, if the auditor intends to select payment vouchers from
a file, conclusions cannot be drawn about all vouchers for the period unless the
auditor is satisfied that all vouchers have in fact been filed.

d. Determining the method of selecting the sample. The most common methods
for selecting samples are random sampling and systematic sampling.

Audit samples are usually designed using a fixed-size approach. However, the
following techniques, which do not use fixed sample size, may also be applied:

 Sequential or stop-or-go sampling is a sampling technique wherein the

auditor chooses a single or a group of items in a given time interval, conducts
his examination, analyzes the results, then audits another group of items if
needed, and so on. It involves a sampling plan for which the sample is selected
in several steps, with the need to perform each step conditional on the results
of the previous steps.

 Discovery sampling is a sampling plan which selects a sample of a given size,

accepts the population if the sample is free of error, and rejects the population
if it contains at least one error. It is often used in situations where the expected
population deviation rate is zero or near zero, and hence, a single error is very
critical. If a deviation is detected, the auditor must either use an alternative
approach, or if the deviation is of sufficient importance, audit all transaction.

e. Determining the sample size. Determining the appropriate sample size is very
important. If sample items chosen to be tested are very few in relation to the
entire population, there is a high probability that existing deviations in the client’s
internal control will not be detected while performing tests of controls.

f. Performing the sampling plan. The auditor should apply appropriate audit
procedures to all items in the sample to determine if there are any deviations from
the prescribed control procedures.

g. Evaluating the sample results. The auditor should interpret the sampling
results carefully and make conclusions with respect to the population from which
the samples are taken.

h. Documenting the sampling procedure. Each of the prior 7 steps and the
conclusions reached should be documented in the audit working papers.

2.9 Factors Affecting Sample Size for Tests of Controls

The following table presents the factors and their corresponding effects on the sample
size for tests of controls:

Page 24 of 46
 ATTRIBUTES SAMPLING (TESTS OF CONTROLS)
SUMMARY OF RELATIONSHIPS OF FACTORS TO SAMPLE SIZE

Conditions leading to Conditions leading to larger

Factors
smaller sample size sample size
Intended reliance on Lower reliance on internal Higher reliance on internal
internal control control control
Tolerable deviation
Higher TDR Lower TDR
rate (TDR)
Expected population
Lower EDR Higher EDR
deviation rate (EDR)
Acceptable (allowable) Higher acceptable risk of Lower acceptable risk of
risk of assessing assessing control risk too assessing control risk too
control risk too low low low
Required confidence Low required confidence High required confidence
level level level
Number of sampling
Negligible effect on sample size unless population is small
units in the population

Tolerable deviation rate represents the maximum deviation rate from a prescribed
control procedure that an auditor is willing to accept without modifying the planned
assessed level of control risk.

Expected population deviation rate (expected rate of occurrence) is the rate of

deviation from the prescribed control procedure the auditor expects to find in the
population.

The auditor’s required confidence level is the mathematical complement of

sampling risk (the risk in assessing control risk too low in the case of tests of controls).

2.10 Procedures in Evaluating Sample Results for Tests of Controls

The auditor should apply audit procedures to examine the samples chosen. If the
audit procedure is not applicable to the selected item, the auditor shall perform the
procedure on a replacement item.

For instance, when a voided check is selected while testing for evidence of payment
authorization, such is not considered a deviation if the check has been properly voided
to the auditor’s satisfaction. Consequently, the auditor should perform the procedure
on an appropriately chosen replacement item.

If the auditor is unable to perform the planned audit procedures to a selected item
because documentation pertaining to that item has been lost or apparently destroyed,
the auditor shall treat such item as a deviation from the prescribed control in the case
of tests of controls (or a misstatement in the case of substantive tests of details),
provided that alternative procedures are not available.

The procedures to evaluate sample results for tests of controls include:

a. Calculating the sample deviation rate (the auditor’s estimate of the true but
unknown population deviation rate).

Sample Number of deviations observed

=
Deviation Rate Sample size

b. Determining the maximum population deviation rate (upper deviation limit, upper
occurrence limit, achieved upper precision limit).

Maximum Population Sample Allowance for

= +
Deviation Rate Deviation Rate Sampling Risk

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c. Comparing the maximum population deviation rate to the tolerable rate specified
in designing the sample.

d. Considering the qualitative aspects of the deviations discovered.

The auditor should investigate the nature (whether intentional or unintentional)

and causes of any deviations identified, and evaluate their possible effect(s) on the
purpose of the audit procedure and on other areas of the audit.

When the auditor considers a deviation discovered in a sample to be an anomaly,

the auditor should obtain a high degree of certainty that such deviation is not
representative of the population. The auditor should consider performing
additional audit procedures to obtain sufficient appropriate audit evidence that the
deviation does not affect the remainder of the population.

e. Reaching a conclusion.

The auditor should evaluate the sample results to determine whether the
preliminary assessment of the relevant characteristic of the population is confirmed
or needs to be revised.

If the maximum population deviation rate is greater than the tolerable deviation rate,
this may indicate a higher risk of material misstatement than originally planned. The
auditor should, therefore, increase the planned assessed level of control risk, and
consequently increase the scope of his substantive procedures.

If the maximum population deviation rate is lower than the tolerable deviation rate,
this may indicate a lower risk of material misstatement than originally planned. The
auditor should accept the sample results as support to the planned assessed level of
control risk, and the scope of his substantive procedures need not be modified.

Illustration 1:

Illustrate the procedures to evaluate sample results for tests of controls given the
following information:

Allowable risk of assessing control risk too low 5.0%

Tolerable deviation rate 6.0%
Expected population deviation rate 2.5%

The auditor discovered 6 deviations while examining the samples.

By referencing to the sample table shown below:

Statistical Sample Sizes for Tests of Controls at 5% Risk of Assessing

Control Risk Too Low (with allowable number of deviations in
parenthesis)

Source: AICPA, Audit Guide, Audit Sampling

Sample size must consist of 150 units.

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 Since the auditor discovered 6 deviations, then the sample deviation rate must be
6/150 or 4%.

Based on a 5% risk of assessing control risk too low and 6 deviations found, the
maximum population deviation rate can be determined using the following table:

Statistical Sampling Results Evaluation for Tests of Controls: Achieved

Upper Deviation Rate at 5% Risk of Assessing Control Risk Too Low

Source: AICPA, Audit Guide, Audit Sampling

The maximum population deviation rate is equal to 7.8%. The allowance for sampling
risk` can be computed as 7.8% - 4% or 3.8%.

Based on the sample results, there is a 5% chance of the true population deviation
rate being greater than or equal to 7.8%.

Since the maximum population deviation rate (7.8%) exceeds the tolerable rate
(6%), the sample results indicate that control risk for the control procedure being
tested is higher than planned, and therefore, the scope of resulting substantive
procedures must be increased.

2.11 Steps Involved in Variables Sampling

The auditor should perform the following steps involved in variables sampling:

a. Determine the objectives of the test. Variables sampling is used primarily for
substantive testing and that its conclusion is generally stated in terms of pesos and
quantities.

b. Define the population. The population should consist of the items constituting
the account balance or class of transaction of interest. Items that are individually
significant for which sampling risk is not justified should be tested separately and
not be subjected to sampling.

c. Select an audit sampling technique. The auditor may select either the:

 Value weighted selection or probability proportional to size sampling; or

 Classical variables sampling

d. Determine the sample size (n). The auditor should consider the factors that
affect the sample size for substantive procedures.

e. Determine the method of selecting the sample. Usually, random number or

systematic sampling is used.

f. Perform the sampling plan. The auditor should perform appropriate audit
procedures to determine an audit value for each sample size.

g. Evaluate the sample results. The auditor should project the results of the
sample to the population.

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 h. Document the sampling procedure. Each of the prior 7 steps and the
conclusions reached should be documented in the working papers.

2.12 Factors Affecting Sample Size for Substantive Tests of Details

The following table presents the factors and their corresponding effects on the sample
size for substantive tests of details:

VARIABLES SAMPLING (SUBSTANTIVE TESTS OF DETAILS)

SUMMARY OF RELATIONSHIPS OF FACTORS TO SAMPLE SIZE

Conditions leading to Conditions leading to larger

Factors
smaller sample size sample size
Assessed level of risks of
material misstatement Lower assessment level of Higher assessment level of
(inherent risk and risks of material risks of material
control risk) misstatement misstatement
Reliance on other
substantive procedures Higher reliance to be Lower reliance to be placed
directed at the same placed on other on other substantive
financial statement substantive procedures procedures
assertion
Required confidence Low required confidence High required confidence
level level level
Tolerable misstatement Higher amount of Lower amount of tolerable
(error) tolerable misstatement misstatement
Expected amount of Lower expected amount Higher expected amount of
misstatement of misstatement misstatement
Stratification of the No stratification of the
Stratification
population (if appropriate) population
Number of sampling
Negligible effect on sample size unless population is small
units in the population

Tolerable misstatement is an estimate of the maximum monetary misstatement

that may exist in an account balance or class of transaction, when combined with
misstatements in other accounts, without causing the financial statements to be
materially misstated.

The expected amount of misstatement is the amount of misstatement the auditor

expects to find in the population.

2.13 Procedures in Evaluating Sample Results for Substantive Tests of Details

For substantive procedures, the auditor should project monetary errors found in the
sample to the population, and consider the effect of the projected error on the
particular test objective and on other areas of the audit. The auditor projects the total
error to the population so as to obtain a broad view of the scale of errors, and compare
it to the tolerable error.

For substantive procedures, the tolerable misstatement will be an amount less than or
equal to the auditor’s preliminary estimate of materiality used for the individual
account balances being audited.

When an error has been established as an anomaly, it may be excluded when

projecting sample errors to the population. The effect of any such error, if uncorrected,
still needs to be considered in addition to the projection of the non-anomalous errors.
If an account balance or class of transactions has been divided into strata, the error is
projected for each stratum separately.

Projected errors plus anomalous errors for each stratum are then combined when
considering the possible effect of errors on the total account balance or class of

Page 28 of 46
 transactions. If the total amount of projected error plus anomalous error is less than
but close to that which the auditor deems tolerable, the auditor:

a. Considers the persuasiveness of the sample results in the light of other audit
procedures.
b. May consider it appropriate to obtain additional audit evidence.

The total of projected error plus anomalous error is the auditor’s best estimate of error
in the population. However, sampling results are affected by sampling risk. Thus when
the best estimate of error is close to the tolerable error, the auditor recognizes the risk
that a different sample would result in a different best estimate that could exceed the
tolerable error. Considering the results of other audit procedures helps the auditor to
assess this risk.

Qualitative factors should also be considered. For instance, if fraud has been
discovered, a simple projection of them will not ordinarily be sufficient as the auditor
will need to obtain a thorough understanding of their causes and their likely effects on
the financial statements.

2.14 Audit Sampling Techniques Used in Variables Sampling

Variables sampling may use either the value-weighted selection approach, or the
classical sampling techniques.

Classical sampling techniques includes difference estimation, ratio estimation,

and mean-Per-Unit (MPU) estimation.

Value weighted selection

This technique identifies the sampling unit as the individual monetary units that make
up the population. This approach to defining the sampling unit ensures that audit
effort is directed to the larger value items because they have a greater chance of
selection, and can result in smaller sample sizes.

A common type of value weighted selection approach is the monetary or peso unit
sampling. Monetary unit (MU) sampling views the population, not as a population
of accounts of different sizes, but as a population of monetary units. The size of the
population is taken to be the total number of monetary units in all the accounts and
each monetary unit is selected with equal probability.

Monetary unit sampling is also known as probability-proportional-to-size

sampling or PPS sampling because in this technique, each peso in the population
has an equal chance of being selected, but the likelihood of selecting any one logical
unit for testing is directly proportional to its size.

Monetary unit sampling is most often used when one or a few population errors are
expected, but it is most appropriate when no errors are expected. This method is
more likely to detect overstatements (normally for assets and income) rather than
understatements.

Classical Variables Sampling

When using classical variables sampling, auditors treat each individual item in the
population as a sampling unit. It uses normal distribution theory to evaluate audit
samples. This method is appropriate when the auditor’s objective is to estimate the
true but unknown monetary balance.

The three common types of classical variables sampling are:

a. Ratio estimation. It is a classical variables sampling technique that uses the ratio
of audited amounts to recorded amounts in the sample in order to estimate the
total peso amount of the population and an allowance for sampling risk.

This method is most appropriate when the size of misstatements is directly

proportional to the book values of the items.

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 Ratio estimation involves the following steps:

 Determining the audited values for each sample item.

 Calculating the ratio between the sum of sample audited values and sample
book values.
 Determining the estimated population value by multiplying the total
population book value by the ratio computed.

b. Difference estimation. It is a classical variables sampling technique that uses

the average difference between audited amounts and individual recorded amounts
in order to estimate the total audited amount of a population and an allowance for
sampling risk.

This method is most appropriate when the size of misstatements does not vary
significantly in comparison to book value.

Difference estimation involves the following steps:

 Determining the audited values for each sample item.

 Calculating the difference between the audited value and book value for
each sample item.
 Calculating the average difference.
 Determining the estimated population value by multiplying the average
difference by the total population units and adding or subtracting this value
from the recorded book value.

c. Mean-per-unit (MPU) sampling. It is a classical variables sampling technique

that projects the sample average (mean) to the total population by multiplying the
sample average by the number of items in the population.

This method is appropriate when the individual population items do not have
recorded values. For instance, the statement of financial position shows a total for
accounts receivable, but the individual invoices supporting the balance are not
available.

MPU estimation involves the following steps:

 Determining the audited values for each sample item.

 Calculating the average audited amount.
 Multiplying the average audited amount by the number of units in the
population to obtain the estimated population value.

Both the difference and ratio estimation techniques can only be used under the
following instances:

 Each population item must have a recorded book value.

 Total population book value must be known and must correspond to the sum
of all individual population items.
 Differences between audited and recorded book values are frequent.

Illustration 2:

The following information pertains to an entity’s accounts receivable:

Sample Population

Number of accounts 100 10,000

Book values P1,000 P120,000
Audited values P1,200 ?

Compute the estimated total audited value (ETAV) of the population and the projected
misstatement using (a) ratio estimation, (b) difference estimation, and (c) mean-per-
unit estimation techniques.

Page 30 of 46
 ETAV Projected
misstatement
Ratio estimation
(P1,200 / P1,000) x P120,000 P144,000
P1440,000 – P120,000 P24,000 understatement

Difference estimation
[(P1,200 – P1,000) / 100] x 10,000 P20,000 understatement
P120,000 + P20,000 P140,000

Mean-per-unit estimation
(P1,200 / 100) x 10,000 P120,000
P120,000 – P120,000 P0

Comparison of Value Weighted Sampling to Classical Sampling

Advantages
Value It is generally easier to use.
weighted It automatically results in a
selection stratified sampling, that is,
the probability of selection
of an item is directly
proportional to the size or
value of the item.
It usually results in a
smaller sample size if only
few or no misstatements
are expected.
Disadvantages
It requires more samples if
many differences between
the book and audited values
are expected.
It requires special sample
design considerations when
zero and negative balances
are selected.

Classical It may result to a smaller It is generally considered

variables sample size if many more complex than value
sampling differences between the weighted selection.
book and audited values The population standard
are expected. deviation must be computed
It does not require special in determining sample size.
sample design
considerations when zero
and negative balances are
selected.

Exercises:

Choose the correct answer:

1. It is appropriate to apply 100% examination of all the items making up a class of

transactions or account balances under the following instances, except

a. When the population constitutes a small number of large value items.

b. When the population constitutes a large number of small value items.
c. When the risk of material misstatement is significant and other means do not
provide sufficient appropriate audit evidence.
d. When the repetitive nature of a calculation or other process performed by a
computer information system (CIS) makes a 100% examination cost effective.

2. Which of the following procedures constitutes audit sampling?

a. Selecting and examining specific items to determine whether or not a particular

procedure is being performed.

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 b. Applying audit procedures to less than 100% of items within an account balance
or class of transactions such that all sampling units have a chance of selection.
c. Examining items to obtain information about matters such as the client’s business
and the nature of transactions.
d. Examining items whose values exceed a certain amount so as to verify a large
proportion of the total amount of an account balance or class of transactions.

3. Auditors who prefer statistical to non-statistical sampling believe that the principal
advantage of statistical sampling flows from its unique ability to achieve the following,
except

a. Provide a mathematical measurement of uncertainty.

b. Measure the sufficiency of the audit evidence obtained.
c. Aids in the design of an efficient sample.
d. Establish conclusive audit evidence with decreased audit effort.

4. Which of the following is an element of sampling risk?

a. Choosing an audit procedure that is inconsistent with the audit objective.

b. Concluding that no material misstatement exists in a materially misstated
population based on taking a sample that includes no misstatement.
c. Failing to detect an error on a document that has been inspected by an auditor.
d. Failing to perform audit procedures that are required by the sampling plan.

5. Which of the following is correct about sampling risk and nonsampling risk?

a. Sampling risk can be reduced by decreasing sample size.

b. Sampling risk can be eliminated.
c. Nonsampling risk arises from the possibility that the auditor’s conclusion, based on
a sample may be different from the conclusion reached if the entire population
were subjected to the same audit procedure.
d. Non-sampling risk can be eliminated by proper planning, supervision and review.

6. Which statement about sampling is correct?

a. The risk of incorrect acceptance and the likelihood of assessing control risk too low
relate to the effectiveness of the audit.
b. Variables sampling is most appropriate when performing tests of controls.
c. When the auditor goes through a population and selects items for the sample
without regard to their size, source, or other distinguishing characteristics, it is
called random sampling.
d. The primary objective of using stratification as a sampling method in auditing is to
decrease the effect of variance in the total population.

7. When performing a test of control with respect to control over cash receipts, an auditor
may use a systematic sampling technique with a start at any random selected item.
The biggest disadvantage of this type of sampling is that the items in the population

b. Must be systematically replaced in the population after sampling.

c. May systematically occur more than once in the sample.
d. Must be recorded in a systematic pattern before the sample can be drawn.
e. May occur in a systematic pattern, thus destroying the sample randomness.

8. Which of the following is correct if certain forms are not consecutively numbered?

a. Systematic sampling may be appropriate.

b. Selection of a random sample probably is not possible.
c. Random number tables cannot be used.
d. Stratified sampling should be used.

9. Attribute sampling is

a. An inferential technique adopted in auditing as a test basis examination approach

to assess the occurrence rates of compliance-type errors in population of
accounting transactional data.

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 b. A technique used if an auditor, planning to use statistical sampling, is concerned
with the number of a client’s sales invoice that contain mathematical errors.
c. Either A or B.
d. Neither A nor B.

10. For which of the following audit tests would an auditor most likely use attribute
sampling?

a. Selecting accounts receivable for confirmation of accounts receivable.

b. Making an independent estimate of the amount of a FIFO inventory.
c. Examining invoices in support of the valuation of fixed asset additions.
d. Inspecting employee time cards for proper approval of supervisors.

11. When using statistical sampling, which of the following need not be known to evaluate
the results of an attribute sample?

a. Sample size.
b. Number of deviations found in the sample.
c. Risk of assessing control risk too low.
d. Number of deviations in the population.

12. Which statement is correct concerning statistical sampling in tests of controls?

a. Increases in both allowable risk of assessing control risk too low and tolerable
deviation rate will increase the sample size for tests of controls.
b. Deviations from control procedures at a given rate usually result in misstatements
at a lower rate.
c. As the population size doubles, the sample size for tests of controls should increase
proportionately.
d. There is an inverse relationship between the sample size and the expected
population deviation rate.

13. An auditor is testing internal control procedures that are evidence on an entity’s
vouchers by matching random numbers with voucher numbers. If a random number
matches the number of a voided voucher, the voucher ordinarily should be replaced
by another voucher in the random sample if the voucher

a. Constitutes a deviation.
b. Has been properly voided.
c. Cannot be located.
d. Represents an immaterial peso amount.

14. This is a type of attribute sampling procedure which is sometimes adopted where
intentional or unintentional errors of high materiality are believed to be remotely
possible in populations of accounting data.

a. Discovery sampling. c. Difference estimation sampling.

b. Stratified sampling. d. Judgmental sampling.

15. As a result of sampling procedures applied as tests of controls, an auditor incorrectly

assesses control risk lower than appropriate. Which of the following is the most likely
explanation for this situation?

a. The deviation rate in the auditor’s sample exceeds the tolerable rate, but the
deviation rate in the population is less than the tolerable rate.
b. The deviation rate in the auditor’s sample is less than the tolerable rate, but the
deviation rate in the population exceeds the tolerable rate.
c. The deviation rates of both the auditor’s sample and the population are less than
the tolerable rate.
d. The deviation rates of both the auditor’s sample and the population exceed the
tolerable rate.

16. While performing a substantive test of detail during an audit, an auditor determined
that the sample results supported the conclusion that the recorded account balance
was materially misstated. It was, in fact, not materially misstated. The situation
illustrates the risk of

Page 33 of 46
 a. Assessing control risk too high. c. Assessing control risk too high.
b. Incorrect rejection. d. Incorrect acceptance.

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

Increase in tolerable error Increase in assessed level of control risk

a. Increase sample size Increase sample size
b. Increase sample size Decrease sample size
c. Decrease sample size Increase sample size
d. Decrease sample size Decrease sample size

18. Which of the following must be known to estimate the appropriate sample size needed
in variables sampling?

a. The estimated population value.

b. The estimated population deviation rate.
c. The acceptable level of risk.
d. The qualitative aspect of misstatements.

19. In applying variables sampling, an auditor attempts to

a. Predict a monetary population value within a range of precision.

b. Estimate a qualitative characteristic of interest.
c. Determine various rates of occurrence for specified attributes.
d. Discover at least one instance of a critical deviation.

20. In selecting a sample using PPS sampling, the peso is the sampling unit. Thus, if the
300th peso of invoices is selected

a. Only that peso is audited.

b. Only an invoice with exactly P300 is audited.
c. An invoice of less than P300 cannot be selected.
d. The invoice containing the 300th peso is audited.

END OF TOPIC 2

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Topic 3: COMPLETING THE AUDIT

LEARNING OBJECTIVES:

At the end of this topic, the students are expected to

2. Understand the importance of analytical procedures performed at the

completion stage of the audit;
3. Identify and explain the auditor’s responsibility in relation to related party
transactions;
4. Understand an audit letter of inquiry;
5. Explain the auditor’s responsibilities in relation to subsequent events;
6. Explain the audit procedures in assessing the client’s ability to continue as a
going concern; and
7. Identify the importance of obtaining written representations from
management.

NOTES:

3.1 Analytical Procedures at the Completion Stage

PSA 520 (Redrafted), Analytical Procedures, requires the auditor to design and perform
analytical procedures near the end of the audit to assist the auditor in forming an
overall conclusion as to whether the financial statements are consistent with the
auditor’s understanding of the entity.

Analytical procedures performed as an overall review in the completion stage of an

audit usually involves reading the financial statements and:

a. Consider unusual or unexpected account balances or relationships that were not

previously identified during the audit.
b. Consider the adequacy of audit evidence regarding previously identified unusual or
unexpected balances.
c. Assess the conclusions reached and evaluate the overall financial statement
presentation.

3.2 Related Party Transactions

Parties are considered to be related parties if one party has the ability to control the
other party, the ability to exercise significant influence over the other party, or has
joint control over another entity.

Related party transactions involve a transfer of resources or obligations between

related parties, regardless of whether a price is charged. Common examples include
sales or purchase transactions between a parent company and its subsidiary,
exchanges of equipment between two companies owned by the same person, and
loans to officers.

Management is responsible to identify and disclose related parties and transactions

with such parties. When there have been transactions between related parties, PAS
24 requires disclosure of the nature of the related party relationship as well as
information about the:

a. Amount of the transaction.

b. Amount of outstanding balance, the terms and conditions, whether secured or
unsecured, and nature of consideration to be provided in settlement.
c. Allowance for doubtful accounts related to the outstanding balance.
d. Expense recognized during the period in respect of doubtful accounts due from
related parties.

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Auditor’s Responsibilities

In relation to the audit of related party transactions, the auditor should:

a. Perform audit procedures to identify, assess and respond to the risks of material
misstatement arising from the entity’s failure to appropriately account for or
disclose related party relationships, transactions or balances in accordance with
the requirements of the applied framework.
b. Obtain an understanding of the entity’s related party relationships and
transactions.

An ordinary audit, however, cannot be expected to provide assurance that all related
party transactions will be detected. Nevertheless, an auditor should be aware of the
possibility that material related party transactions may exist.

The existence of related parties and transactions between such parties are important
to the auditor because:

a. PFRSs require disclosure in the financial statements of certain related party

relationships and transactions.

b. The existence of related parties or related party transactions may affect the
financial statements. For example, the entity's tax liability and expense may be
affected by tax laws which require special consideration when related parties exist.

c. The source of audit evidence affects the auditor's assessment of its reliability. A
greater degree of reliance may be placed on audit evidence that is obtained from
or created by unrelated third parties.

d. A related party transaction may be motivated by other than ordinary business

considerations. In the absence of evidence to the contrary, related party
transactions should not be assumed to be outside the ordinary course of business.
However, the auditor should be aware of the possibility that transactions with
related parties may have been motivated by conditions that are considered outside
the ordinary course of business.

Such conditions include:

 Lack of sufficient working capital or credit to continue business.

 An urgent desire for a continued favorable earnings record in the hope of
supporting the price of the company’s stock.
 Dependence on a single or relatively few products, customers, or transactions
for the ongoing success of the venture.
 Overly optimistic earnings forecast.
 Declining industry characterized by a large number of business failures.
 Excess capacity.
 Significant litigation, especially litigation between shareholders and
management.
 Significant danger of obsolescence.

The auditor should be alert of transactions which appear unusual in the circumstances
and that may indicate the existence of previously unidentified related parties.
Examples include:

a. Transactions which have abnormal terms of trade (e.g., unusual prices, interest
rates, absence of guarantees, and repayment terms).
b. Transactions which lack an apparent logical business reason for their occurrence.
c. Transactions in which substance differs from form.
d. Transactions processed in an unusual manner.
e. High volume or significant transactions with certain customers or suppliers.
f. Unrecorded transactions such as the receipt or provision of management services
at no charge.

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 Auditor’ Reporting Responsibility

If the auditor is unable to obtain sufficient appropriate audit evidence concerning

related parties and transactions with such parties, the auditor will issue either a
qualified opinion or a disclaimer of an opinion, depending on materiality and/or
pervasiveness.

If the auditor concludes that disclosure in the financial statements of related party and
related party transactions is inadequate, this will result to material misstatements and
will lead to the issuance of either a qualified or an adverse opinion, also, depending on
materiality and/or pervasiveness.

3.3 Letter of Inquiry

Litigation and claims involving an entity may have a material effect on the financial
statements, and thus, may be required to be recognized or disclosed in the financial
statements. The auditor should carry out procedures in order to become aware of any
litigation and claims involving the entity which may give rise to a material
misstatement. Since management is the primary source of information about such
contingencies, the auditor’s procedures should include:

a. Making appropriate inquiries of management including obtaining representations.

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

Moreover, the auditor may seek direct communication with the entity’s external lawyers
through a letter of inquiry.

The letter of inquiry corroborates the information furnished by management about

litigation, claims and assessment. It should be prepared by management but sent
by the auditor and request the client’s external lawyers to communicate directly with
the auditor. The letter would ordinarily specify:

a. A list of litigation and claims.

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

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

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

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

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

3.4 Subsequent Events

Subsequent events are events occurring between the date of the financial
statements and the date of the auditor’s report, and facts that become known to the
auditor after the date of the auditor’s report. The two types of subsequent events are:

a. Type 1 Subsequent Events. They relate to conditions existing at the end of the
reporting period that are inherent in the process of preparing financial statements.
These events require adjustment to the financial statements. Examples consist of:

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  Resolution after the reporting period of a court case because it confirms that
the entity already had a present obligation.
 Bankruptcy of a customer which occurs after the reporting period.
 The discovery of fraud or errors that show the financial statements were
incorrect.
 Sale of inventories after the reporting period may give evidence about the net
realizable value at reporting date.

b. Type 2 Subsequent Events. They relate to conditions that did not exist at or
before the date of the financial statements, but are disclosed because they may be
of such significance that the financial statements would be misleading if the events
are not disclosed. These events do not require adjustment to the financial
statements. Examples of these events include:

 Business combinations after the reporting period.

 Plan to discontinue an operation.
 Issuance of new notes, bonds, or other indebtedness after the reporting period.
 Damage from fire, flood, or other casualty.

The date of the financial statements refers to the date of the end of the latest
period covered by the financial statements. It is sometimes referred to as the balance
sheet date or the reporting date.

The date of approval of the financial statements is the date on which all the
statements that comprise the financial statements have been prepared and those with
the recognized authority have asserted that they have taken responsibility for those
financial statements.

The date of the auditor’s report is the date the auditor dates the report on the
financial statements.

The date the financial statements are issued refers to the date that the auditor’s
report and audited financial statements are made available to third parties.

Auditor’s Responsibility

An auditor should perform audit procedures designed to obtain sufficient appropriate

audit evidence that all events occurring between the date of the financial statements
and the date of the auditor’s report that require adjustment of, or disclosure in, the
financial statements have been identified. The auditor is not, however, expected to
perform additional audit procedures on matters to which previously applied audit
procedures have provided satisfactory conclusions.

The auditor has no obligation to perform any audit procedures regarding the financial
statements after the date of the auditor’s report. However, when, after the date of
the auditor’s report but before the date the financial statements are issued, a fact
becomes known to the auditor that, had it been known to the auditor at the date of
the auditor’s report, may have caused the auditor to amend the auditor’s report, the
auditor should:

a. Discuss the matter with management and, where appropriate, those charged with
governance (TCWG).
b. Determine whether the financial statements need amendment.
c. Inquire how management intends to address the matter in the financial
statements.

If amendment of the financial statements is necessary and management agrees to

such amendment, the auditor should:

a. Carry out the necessary audit procedures on the amendment.

b. Extend the audit procedures to the date of the new auditor’s report,
c. Provide a new auditor’s report on the amended financial statements, and this
new auditor’s report should not be dated earlier than the date of approval of the
amended financial statements.

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 Nevertheless, the auditor may dual date his auditor’s report by amending the
auditor’s report to include an additional date restricted to such amendment that
indicates that the auditor’s procedures on subsequent events are restricted solely to
the amendment of the financial statements described in the relevant note to the
financial statements.

In dual dating, the original date of the auditor’s report remains unchanged because it
informs the reader as to when the audit work on those financial statements was
completed. However, an additional date is included in the auditor’s report to inform
users that the auditor’s procedures subsequent to that date were restricted to the
subsequent amendment of the financial statements.

“(Date of auditor’s report), except as to Note X, which is as of (Date of completion of

audit procedures restricted to amendment described in Note X).”

Alternatively, the auditor may provide a new or amended auditor’s report with an
Emphasis of Matter paragraph or Other Matter(s) paragraph which states that the
auditor’s procedures on subsequent events are restricted solely to the amendment of
the financial statements as described in the relevant note to the financial statements.

On the other hand, when management does not amend the financial statements in
circumstances where amendment is necessary, the auditor should do either of the
following:

a. Modify his opinion and issue the auditor’s report (if such report has not yet been
provided to the entity);
b. Notify management and TCWG not to issue the financial statements to third parties
before the necessary amendments have been made (if the auditor’s report has
already been provided to the entity); or
c. Take appropriate action to prevent reliance on the auditor’s report, which includes
seeking legal advice (if the financial statements are nevertheless subsequently
issued without the necessary amendments).

3.5 Going Concern Problem

Management should make an explicit and specific assessment of an entity’s ability to

continue as a going concern. In assessing whether the going concern assumption is
appropriate, the management takes into account all available information for the
foreseeable future, which should be at least twelve months from the balance sheet
date. If there is a history of profitable operations and a ready access to financial
resources, management may not make its assessment with detailed analysis.

Management should take note that the degree of uncertainty associated with the
outcome of an event or condition increases significantly the further into the future of
judgment being made about the outcome of an event or condition.

The following are examples of events or conditions that may cast significant doubt
about the going concern assumption:

Financial

 Net liability or net current liability position.

 Negative operating cash flows indicated by historical or prospective financial
statements.
 Adverse key financial ratios.
 Fixed-term borrowings approaching maturity without realistic prospects of renewal
or repayment; or excessive reliance on short-term borrowings to finance long-term
assets.
 Indications of withdrawal of financial support by creditors.
 Substantial operating losses or significant deterioration in the value of assets used
to generate cash flows.
 Arrears or discontinuance of dividends.
 Inability to pay creditors on due dates.
 Inability to comply with the terms of loan agreements.
 Change from credit to cash-on-delivery transactions with suppliers.

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 Inability to obtain financing for essential new product development or other
essential investments.

Operating

 Management intentions to liquidate the entity or cease operations.

 Loss of key management without replacement.
 Loss of a major market, key customer(s), franchise, license, or principal suppliers.
 Labor difficulties.
 Shortages of important supplies.
 Emergence of a highly successful competitor.

Others

 Non-compliance with capital or other statutory requirements.

 Pending legal or regulatory proceedings against the entity that may, if successful,
result in claims that the entity is unlikely to be able to satisfy.
 Changes in law or regulation or government policy expected to adversely affect the
entity.
 Uninsured or underinsured catastrophes when they occur.

Auditor’s Responsibility

With respect to a client’s ability to continue as a going concern, PSA 570 (Revised),
Going Concern, states that the auditor should obtain sufficient appropriate audit
evidence about the appropriateness of management’s use of the going concern
assumption in the preparation and presentation of the financial statements. Based on
the audit evidence obtained, the auditor should assess whether a material uncertainty
exists related to events or conditions that may cast significant doubt on the entity’s
ability to continue as a going concern, and determine its effect on the auditor’s report.

Material uncertainties refer to uncertainties related to events or conditions which

may cast significant doubt on the enterprise’s ability to continue as a going concern
that should be disclosed in the financial statements.

The auditor cannot predict future events or conditions that may cause an entity to
cease to continue as a going concern. The absence of any reference to going concern
uncertainty in an auditor’s report cannot be viewed as a guarantee as to the entity’s
ability to continue as a going concern.

When events or conditions have been identified that may cast significant doubt on the
entity’s ability to continue as a going concern, the auditor should obtain sufficient
appropriate audit evidence to determine whether or not a material uncertainty exists
through performing additional audit procedures, and consider management’s plans to
mitigate such doubt, such as the following:

a. Plans to dispose of assets.

b. Plans to borrow money or restructure debt.
c. Plans to reduce or delay expenditures.
d. Plans to increase ownership equity.

Auditor’s Reporting Responsibility

When the auditor concludes that the use of the going concern assumption is
appropriate in the circumstances but a material uncertainty exists, the auditor shall
determine whether the financial statements adequately disclose the principal events
or conditions that give rise to uncertainty as well as the management’s plans for future
actions.

If adequate disclosure is made in the financial statements in relation to a going concern

problem, the auditor should express an unmodified opinion and include a separate
section under the heading “Material Uncertainty Related to Going Concern” to highlight
and draw attention to the note in the financial statement regarding the uncertainty,
and state that these events or conditions indicate that a material uncertainty exists
that may cast significant doubt on the entity’s ability to continue as a going concern
and that the auditor’s opinion is not modified in respect of the matter.

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 If adequate disclosure is not made in the financial statements in relation to a going
concern problem, this will result to material misstatements in the financial statements
that would necessitate the issuance of either a qualified or adverse opinion.

If in the auditor’s judgment, the use of the going concern assumption is not
appropriate, but the financial statements have still been prepared on a going concern
basis, the auditor should express an adverse opinion.

If management is unwilling to make or extend its assessment when requested to do

so by the auditor, the auditor should consider the need to issue a qualified opinion or
disclaim an opinion as a result of the limitation on the scope of the auditor’s work.

3.6 Management Written Representations

Written representations from management shall be in the form of a representation

letter. A management representation letter is a letter written by the management
to the auditor confirming all the representations made to him during the course of his
audit.

The purpose of the management representation letter is to emphasize that the financial
statements are management's representations, and thus management has the primary
responsibility for their accuracy. Also, such letter provides supplementary audit
evidence of an internal nature by giving formal management replies to auditor
questions regarding matters that did not come to the auditor's attention in performing
audit procedures. Management representation letter prevents or minimizes any
misunderstanding between the auditor and his client.

When requesting a management representation letter, the auditors would request that
it be addressed to the auditors, contain specified information and be appropriately
dated and signed. A management representation letter would ordinarily be dated the
same date as the auditors' report, that is, the completion date of the audit.

A management representation letter would ordinarily be signed by the members of

management who have primary responsibility for the entity and its financial aspects,
ordinarily the senior executive officer and the senior financial officer. Nevertheless, in
certain circumstances, the auditors may wish to obtain representation letters from
other members of management.

Auditor’s Responsibility

An auditor obtains numerous representations from management during the course of

an audit, some written while most of them are oral representations. While written
representations are tangible, oral representations are not, thereby requiring that an
auditor obtain some form of written representation from his client. As required by PSA
580 (Revised and Redrafted), Written Representations, the auditor should request
written representations from management with appropriate responsibilities for the
financial statements and knowledge of the matters concerned.

The auditor should request management to issue written representations about its
responsibilities:

a. For the preparation and presentation of the financial statements in accordance with
the applicable financial reporting framework, including the design, implementation
and maintenance of internal control relevant to the preparation and presentation
of financial statements that are free from material misstatement, whether due to
fraud or error.

b. To provide the auditor with:

 All information, such as records and documentation, and other matters that are
relevant to the preparation and presentation of the financial statements.
 Any additional information that the auditor may request from management.
 Unrestricted access to those within the entity from whom the auditor
determines it necessary to obtain audit evidence.

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 If management does not provide one or more of the requested written representations,
the auditor should:

a. Discuss the matter with management.

b. Re-evaluate the integrity of management and evaluate the effect that this may
have on the reliability of representations (oral or written) and audit evidence in
general.
c. Take appropriate actions, including determining the possible effect on the opinion
in the auditor’s report.

The auditor should disclaim an opinion on the financial statements when:

a. The auditor concludes that there is sufficient doubt about the integrity of
management such that the written representations regarding management’s
responsibilities are unreliable.
b. Management does not provide the written representations regarding
management’s responsibilities.

The aforementioned circumstances are tantamount to a scope limitation that is both

material and pervasive.

Exercises:

Choose the correct answer:

1. Analytical procedures used in the overall review stage of an audit generally include

a. Considering unusual or unexpected account balances that were not previously

identified.
b. Performing tests of transactions to corroborate management’s financial statement
assertions.
c. Gathering evidence concerning account balances that have not changed form the
prior year.
d. Obtaining an understanding of the entity’s internal control system.

2. Which of the following are transactions which appear unusual in the circumstances and
may indicate the existence of related parties?

a. Making a loan without scheduled terms for repayment of the funds.

b. Low volume transactions with certain customers.
c. Selling real estate at a price which differs significantly from its book value.
d. Borrowing a large sum of money at a variable rate of interest.

3. Which of the following auditing procedures least likely would assist an auditor in
identifying the existence of related party transactions?

a. Reviewing minutes of meetings of shareholders and directors.

b. Vouching accounting records for recurring transactions recorded just after the
reporting date.
c. Reviewing confirmations of loans receivable and payable and confirmations from
banks for indications of guarantees.
d. Reviewing accounting records for large or unusual transactions or balances.

4. Which of the following statements concerning related party transactions is correct?

a. In the absence of evidence to the contrary, related party transactions should be

assumed to be outside the ordinary course of business.
b. The audit procedures directed toward identifying related party transactions should
include considering whether transactions are occurring but are not being given
proper accounting recognition.
c. An auditor should determine whether a particular transaction would have occurred
if the parties had not been related.

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 d. An auditor should substantiate that related party transactions were consummated
on terms equivalent to those that prevail in arm’s-length transactions.

5. After determining that a related party transaction has, in fact, occurred, an auditor
should

e. Obtain an understanding of the business purpose of the transaction.

f. Substantiate that the transaction was consummated on terms equivalent to an
arm’s-length transaction.
g. Add a separate paragraph to the auditor’s report to explain the transaction.
h. Perform analytical procedures to verify whether similar transactions occurred, but
were not recorded.

6. The primary source of information to be reported about litigation, claims and

assessments is the

a. Independent auditor. c. Client’s management.

b. Court records. d. Client’s lawyers.

7. The primary reason an auditor requests that letters of inquiry be sent to client’s
attorney is to provide the auditor with

a. Corroborative evidence of information furnished by management about litigation,

claims, and assessments.
b. The probable outcome of asserted claims and pending or threatened lawsuits.
c. A description and evaluation of litigation, claims and assessments that existed at
the balance sheet date.
d. The lawyer’s opinion of the client’s historical experiences in recent similar litigation.

8. The appropriate date for the client to specify as the effective date in the audit inquiry
to a lawyer is the expected

a. Date of the completion of audit field work.

b. Balance sheet date.
c. Date of approval of the financial statements.
d. Date of issuance of the financial statements.

9. The letter of inquiry should be

a. Prepared and sent by the auditor.

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

10. Statement 1: The procedures to identify events that may require adjustments of, or
disclosure in, the financial statements would be performed up to the date of the
auditor’s report.

Statement 2: The procedures that are designed to obtain sufficient appropriate audit
evidence that all events up to the date of the audit report that may require adjustment
of, or disclosure in, the financial statements are in addition to routine procedures which
may be applied to specific transactions,

a. Statement 1 is correct. c. Both statements are correct.

b. Statement 2 is correct. d. Both statements are incorrect.

11. Which of the following procedures should an auditor perform regarding subsequent
events?

a. Review of cutoff statements for several months after the year-end.

b. Compare the latest available interim financial statements with the financial
statements under audit.
c. Send second requests to the client’s customers who failed to respond to initial
accounts receivable confirmation requests.
d. Communicate material weaknesses in internal control to the client’s audit
committee.

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12. Which of the following statements best expresses the auditor’s responsibility with
respect to facts which become known to the auditor after the date of the auditor’s
report but before the date the financial statements are issued?

a. The auditor should amend the financial statements.

b. If the facts discovered will materially affect the financial statements, the auditor
should issue a new report which contains either a qualified opinion or an adverse
opinion.
c. The auditor should consider whether the financial statements need amendment,
discuss the matter with management, and taking the action appropriate in the
circumstances.
d. The auditor should withdraw from the engagement.

13. When a fact is discovered after the date of the report but before the financial
statements are issued, and the client amends the financial statements as deemed
necessary, which actions may be made by the auditor?

a. Amend the auditor’s report to include an additional date (dual date).

b. Provide a new or amended auditor’s report that includes a statement in an
Emphasis of Matter paragraph or Other Matter(s) paragraph.
c. Either A and B.
d. Neither A nor B.

14. After issuing a report, an auditor has no obligation to make continuing inquiries or
perform other procedures concerning the audited financial statements, unless

a. Final determinations are made of contingencies that had been disclosed in the
financial statements.
b. Information about an event that occurred after the date of the auditor’s report
comes to the auditor’s attention.
c. The control environment changes after issuance of the auditor’s report.
d. Information, which existed at the report date and may affect the report, comes to
the auditor’s attention.

15. Which of the following is correct about the auditor’s responsibility with respect to the
entity’s ability to continue as a going concern?

a. The auditor is responsible to make a specific assessment of the entity’s ability to

continue as a going concern.
b. The auditor’s responsibility is to consider the appropriateness of the management’s
use of the going concern assumption in the preparation of the financial statements.
c. The auditor can predict future events or conditions that may cause an entity to
cease to continue as a going concern.
d. The absence of any reference to going concern uncertainty in an auditor’s report
can be viewed as a guarantee as to the entity’s ability to continue as a going
concern.

16. Which of the following conditions or events most likely would cause an auditor to have
substantial doubt about an entity’s ability to continue as a going concern?

a. Cash flows from operating activities are negative.

b. Stock dividends replace annual cash dividends.
c. Significant related party transactions are pervasive.
d. Research and development projects are postponed.

17. The entity’s inability to make its normal debt repayments may be counter balanced by
the following plans, except

a. Disposal of assets. c. Rescheduling of loan repayments.

b. Obtaining additional capital. d. Purchasing equipment currently leased.

18. Which statement is false regarding management representation letter?

a. It would ordinarily be addressed to the auditor and signed by the senior executive
officer and senior financial officer.

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 b. It would ordinarily be dated as of the date the financial statements were approved
by the client management.
c. If management refuses to provide a representation that the auditor considers
necessary, this will not constitute a scope limitation.
d. A purpose of a management representation letter is to reduce the possibility of a
misunderstanding concerning management’s responsibility for the financial
statements.

19. Which of the following is true regarding a client representation letter?

a. It is essential for the preparation of the audit program.

b. It is a substitute for testing.
c. It does not reduce the auditor’s responsibility.
d. It reduces the auditor’s responsibility only to the extent it is relied upon.

20. When considering the use of management’s written representations as audit evidence
about the completeness assertion, an auditor should understand that such
representations

a. Complement, but do not replace, substantive tests designed to support the

assertion.
b. Constitute sufficient evidence to support the assertions when considered in
combination with a sufficiently low assessed level of control risk.
c. Are not part of the audit evidence considered to support the assertion.
d. Replaced a low assessed level of control risk as evidence to support the assertion.

END OF TOPIC 3

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References:

1. Chen, Harvey S., CPA, MBA (2021-2022). Auditing Theory – Volume 1

2. Chen, Harvey S., CPA, MBA (2021-2022). Auditing Theory – Volume 2

3. Gleim, Irvin. Auditing & Systems

4. PSA 500 (redrafted) – Audit Evidence

5. PSA 501 (Redrafted) – Audit Evidence – Additional Considerations on Specific Items

6. PSA 505 (Revised and Redrafted) – External Confirmations

7. PSA 510 (Redrafted) – Initial Audit Engagements-Opening Balances

8. PSA 520 (Redrafted) – Analytical Procedures

9. PSA 530 (Redrafted) – Audit Sampling

10. PSA 550 (Revised and Redrafted) – Related Parties

11. PSA 560 (Redrafted) – Subsequent Events

12. PSA 570 (Redrafted) – Going Concern

13. PSA 580 (Revised and Redrafted) – Written Representations

14. Whittington, O. Ray, CPA, PhD (2016). Wiley CPA Excel Exam Review Study Guide

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