Question

in the dialogue between the kingston auditors, Fred said, "our analytical procedures related to receivable didn't show much (APR 100%). the total is down, consistent with the sales with the sales decline, so the turnover is up a little. if any misstatement in the receivable total, it may be too small to be obvious in the ratio"

Jill replied, " that is the good news if the problems are immaterial. too bad we can't say analytical procedures reduce our audit risk. what about internal control?"

Fred responded: " i'd say it is about a 50-50 proposition (50%). sometimes control seemed to work well; sometimes it didn't. i noticed a few new people doing the invoice processing last week when we were here for a conference. incidentally, i lump the inherent risk problems and internal control risk problems together when i think aobut internal control risk. therefore (IR100%). anyway, firm policy is to plan a sample for a low overall audit risk (1%) for the receivable."

a. based on this dialogue information, use the expanded risk model to determine a test of detail risk

b. relate this risk to sample size determination. what type of relationship does the Risk of incorrect acceptance have with the amount of evidence required?

Answer 1

Solution: (a)

The auditor tests the controls and also does substantive test of samples, to understand the risk in the internal control. The auditor has to decide whether the sampling test can be applied. When used the expandable risk model, it is been observed that there is absence of internal control system and the inherent risk is at 100%. The analytical procedure show that total of account receivables balance is fairly stated and is consistent with the sales revenue. This shows the auditors failure to discover material misstatement in the account receivables balance. The deviation of internal control is higher when an expandable risk model is used.

Solution: (b)

Need to decide the objective of audit test. Here the audit sampling applies because the auditor needs to reach conclusion about the population of accounts receivables. When an auditor does sample the auditor is accepting risk. The risk needs to be measured by the auditor. The measurement of risk is called as acceptable risk of overreliance (ARO). If ARO is more than the auditor need to do substantive testing that means the acceptable risk of incorrect acceptance (AIRA) should be less. The acceptable risk of incorrect acceptance (AIRA) is the risk taken in arriving at a sample to supports the conclusion, that the recorded account balance is not materially misstated.

Here the control risk is 100%. It is very important that the AIRA should be lower. Needs to do a substantive testing or more of sample testing. The misstatement is determined based on the tolerance limit designed for the misstatement amount. If the account is important then the tolerance limit can be lower and if the account is not important then the tolerance limit can be higher. The total account receivables are stratified into three groups based on the dollar amount to determine sampling. Stratification helps the auditor in arriving samples for smaller size accounts receivables, so that more accounts are considered for substantive testing.