question archive Cloud 9 - Continuing Case Ian Harper (first-year audit staff) asks Suzie Pickering (experienced audit staff) to coffee
Cloud 9 - Continuing Case Ian Harper (first-year audit staff) asks Suzie Pickering (experienced audit staff) to coffee
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Cloud 9 - Continuing Case
Ian Harper (first-year audit staff) asks Suzie Pickering (experienced audit staff) to coffee. He wants her to explain how to plan audit tests and write a detailed audit program, including instructions on when to use audit data analytics versus audit sampling, how to select a sample for a substantive test, and when the results of one audit test will influence the work on other audit tests. It all seems a bit circular to him and he is finding it difficult to grasp.
Suzie meets Ian that afternoon in the staff room. “The types of tests we do, tests of controls and substantive tests, and when and how we do them, depends on the quality of the client's system of internal control and accounting records. However, before we talk about that, we probably should talk about when we use audit data analytics versus audit sampling, and how we take samples. Do you have a feel for when we use audit data analytics versus audit sampling?” Ian is not sure.
Cloud 9 - Continuing Case
Suzie and Ian are discussing the use of ADA versus audit sampling. Suzie illustrates with a discussion of their audit of inventory. “Let me illustrate with a discussion of how we might audit two different assertions for inventory. When testing the existence assertion, professional standards require that we physically inspect inventory. We will focus on Cloud 9's distribution centers, and we will select a sample of inventory at each distribution center. Electronic data is not available that proves the existence of inventory. In this case sampling is both appropriate and an effective audit technique to draw a conclusion about the existence of inventory.
On the other hand, we are thinking about using ADA to audit inventory obsolescence. Cloud 9 has a large amount of inventory. Most of it turns over pretty fast, but we need to be alert to slow-moving inventory. Cloud 9 has good data on inventory quantities sold and on hand for each location. ADA may be a way to investigate a large amount of inventory, to look at how much inventory is on hand for each item in inventory, and to see how fast each inventory item is being sold. This can be an effective way to identify slow-moving inventory or inventory with lower-of-cost-or-net-realizable-value problems.”
Cloud 9 - Continuing Case
Ian and Suzie are talking about sampling risk. Ian is a bit disappointed. “I thought that if you took a random sample and did not find any misstatements, you could conclude that there was definitely no misstatement in the overall population. But you are saying that there is still a risk that the population is misstated.”
“That's right,” says Suzie. “Unless you test every item in the population, you will still have a statistical chance of making the wrong conclusion simply because you took a sample. Also, if you take a sample in a way that is biased, it is difficult to conclude that the sample results say anything at all about the population. That's why it is so important junior staff don't just take the nearest, or most convenient, sample of items in inventory to test. Another big trap is that conditions may change during the accounting period when transactions are being tested. Perhaps a key member of the client's staff is on leave. The auditor should select a sample from both times when that key member is present and when that key member is on leave. We know that Cloud 9 opened a new San Francisco store on the first of June. Obviously, inventory levels will be different around this time, so we have to plan to handle these different conditions with our sampling.”
Cloud 9 - Continuing Case
“We are going to use random selection for sales invoices and cash receipts at Cloud 9,” Suzie tells Ian. “We will select our sample from the entire year because we do not expect different conditions in sales made to department stores during different times of the year. Obviously, part of the sampling process includes processes to protect against any potential bias in the sample selection.”
Cloud 9 - Continuing Case
Suzie and Ian are discussing how sample size might change from the prior year when performing substantive tests of transactions related to total sales. At an interim date when Suzie and Ian are planning the audit, Cloud 9 has increased its revenues by approximately 10%. Ian notes that he expects that the increase in revenue will cause an increase in sample size. However, Suzie observes that the increase in the total revenues also caused an increase in the auditor's level of tolerable misstatement. As a result, these two changes may offset each other and have little effect on sample size.
Ian also asserts that because top-line revenues are so important to many financial statement users, the auditor should want a high level of assurance that tolerable misstatement is not exceeded by expected misstatement. Suzie responds with a question. “Based on our planning work, how strong are internal controls? And how will our control risk assessment affect the assurance that we need from substantive tests of revenues?” As Ian attempts to answer this question, he suggests, “Inherent risk is probably maximum for sales revenues, but internal controls are expected to be strong, so overall risk of material misstatement is low. Because risk of material misstatement is low, we can allow ourselves to obtain a higher detection risk that the actual misstatements do not exceed tolerable misstatement, which allows for a smaller sample size for substantive tests of revenue transactions.” Suzie likes Ian's reasoning.
Now she asks, “Is there anything else we need to consider?” Ian thinks for a minute and then suggests that they also need to consider the expected amount of misstatement in the population: “If internal controls are good, then the expected amount of misstatement should be fairly low. I now see that good internal controls are really important to our audit strategy, and we will need to emphasize testing controls, and strong controls will allow us to minimize the sample sizes we need for substantive testing.”
Finally, Suzie asks Ian if they should stratify their sample selection regarding sales. Ian suggests that before answering that question, he really needs to understand the variation in the size of sales made to various customers. Suzie likes the fact that this needs to be determined based on Cloud 9's sales history. However, she notes that, based on prior experience, some large customers have many stores, but the average invoice for each store is relatively similar. Suzie suggests that stratification may be more important for testing accounts receivable than for testing sales. They agree to quickly investigate this more and then reach a final conclusion.
