What factors are considered when determining the sample size in attribute testing for internal controls?

Attribute sampling is used for internal controls and we focus on determining whether the control is operating effectively or not. Attribute sampling would focus on yes or no type attributes. There are a variety of things to consider when determining the sample size (amount of instances to test) in attribute sampling: Reliance on controls – How reliant is the audit team on the company’s internal controls. Tolerable deviation rate – What is the acceptable level of deviation rate in the population (i.e., how similar or dissimilar are items on a population). Expected population deviation rate – Before we perform any testing, what is our expectations of the population deviation rate (similar to above). One aspect that we are not concerned about is the tolerable misstatement as that would be considered when determining the sample size for substantive testing.

Internal control to test for credit approval?

For the AUD section of the CPA exam, you should understand how the audit team would test whether customer orders were properly approved to purchase on credit. For testing internal controls, we would utilize attribute sampling, which uses yes or no type of attributes. So for this situation, we would look to say “Yes, the credit was approved” or “No, the credit was not approved”. The population would be all customer orders within the given period that required credit approval, and the audit team would sample from that population.

Audit procedures to identify pending litigation?

The AUD section of the CPA exam will test your understanding of how the audit team would identify pending litigation. Pending litigation needs to be accrued for and/or disclosed if certain requirements are met. There are two main procedures the audit team would perform for every audit: 1) Inquire with Management – Performing inquiry with Management is always the first step as Management can provide useful information and direction. While we can’t rely solely on inquiry with Management, this should always be performed first. 2) Send legal letters to client’s legal counsel – This would be performed for every audit, and the audit team would send these legal letters to every external legal counsel that the client has. The audit team would ask that the legal counsel list out all pending litigation, along with any notes on the status, expected outcome, and any penalties. For the AUD section of the CPA exam, you should be familiar with these two procedures to identify pending litigation. If you are performing an audit, then make sure your audit team performs these procedures!

Who does the internal audit team report to?

The internal audit team consists of auditors who are employed by the company and they evaluate the internal controls and processes within the company. The internal audit team should report directly to the audit committee to have proper governance and communication of information.

What’s the main difference between population size and population variability?

Population size refers to volume while population variability refers to composition. For example, if we think about the population of citizens that live in New York City, population size would simply refer to the number of citizens that live in NY.  However, if we think about population variability in NYC, we would look at the different characteristics of the citizens in NYC to see just how different everyone is. We might look at race/ethnicity, we might look at job sector, we might look at house household income.  The idea is that if population variability is high, that means that the population is quite different. So for sampling purposes, it’s harder to sample a population with high population variability because the sample we test may not be representative of the overall population. 

What does it mean to reevaluate materiality?

The audit team would determine preliminary materiality during the planning stage of the audit. Preliminary materiality would be based on forecasted or estimated financial results. So if the audit team is calculating materiality based on a percentage of revenue, then revenue would be forecasted. Once the final financial results are available, the audit team would recalculate materiality based on the actual revenue for the year. They would then determine whether there was a significant change in materiality. As an example, if preliminary materiality was $50,000 and then final materiality decreased to $35,000, then the audit team would need to determine if additional audit procedures need to be performed. Certain financial statement accounts may have previously been below the materiality threshold and marked as out of scope, but now they would be in scope. Certain misstatements that were deemed immaterial (below the materiality threshold) could now be material. The audit team might have to test more samples for specific accounts. Overall, the audit team basically needs to determine what additional procedures need to be performed using the final materiality of $35,000.

Analogy for Incorrect Acceptance and Incorrect Rejection

Basics of Incorrect Acceptance and Incorrect Rejection In an audit, there are two key risks that auditors face when they conclude on sampling results. Incorrect acceptance is when the audit team concludes there is no material misstatement based on their sample testing, however, a material misstatement does actually exist in the population. Incorrect acceptance is a big risk for an audit team since they failed to properly detect a material misstatement and concluded that the financial statements were reasonably stated. Incorrect acceptance impacts the effectiveness of an audit. Incorrect rejection is when the audit team concludes that a material misstatement does exist based on their sample testing, however, a material misstatement does not actually exist in the population. This results in the audit team performing additional testing when it is not necessary. Incorrect rejection impacts the efficiency of an audit. To fully understand these topics, Universal CPA recommends that candidates develop their own analogy. Not only does thinking through these topics in your own words promote a deeper understanding, but it also helps with retention and recollection of information under pressure. A student of Universal CPA shared their analogy with the Universal CPA team and we received approval to share it with the rest of the CPA community! Analogy for Incorrect Acceptance and Incorrect Rejection Presumably you want to be married. In your search for your partner, you are probably going to go through multiple relationships. If it happens that you decide to propose your partner who later turns out to be a b*tch, you have incorrectly accepted a person. Now you have found yourself in an ineffective relationship… On the contrary, if you said goodbye to a partner and later realize that they were actually the true love, although you have incorrectly rejected the partner the first time, you can still go back to the partner and try to make it work, given that you two are still not married. That’s an inefficient use of time and money but, hey, at least you didn’t commit to the wrong partner.

Does detection risk increase or decrease when confirmation procedures are performed prior to year-end?

Let’s say that the auditors decide to perform cash or accounts receivable confirmations on September 30, Year 2 rather than December 31, Year 2. This means that they are performing substantive confirmation procedures 3 months prior to year-end. By performing substantive procedures prior to the balance sheet date, this increases the risk of material misstatement since the confirmation procedures aren’t performed as of the balance sheet date (December 31, Year 2). By doing so, the audit team is increasing the level of detection risk. This means that there is a greater chance of the audit team not identifying a material misstatement in the financial statements.