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					Lesson Exercise 2. Audit Risk Model as a Planning Tool

You are beginning an audit engagement concerning a small firm in the metal
subcontracting industry. The firm is a subcontractor for several firms that
are purchasing components. The managing director is the main owner of this
small firm. Besides him there are two other owners, who all are the founding
persons of the firm.

Suppose that you are using the audit risk model quantitatively in assessing
the detection risk and necessary amount of substantive tests in order to
keep the overall audit risk low (5 %) in financial statement auditing.

You have the working papers of the previous audit of the selling activity and
accounts receivable; in this previous audit the following risk levels were set
for the accounts receivable in the financial statement for the firm.

Accounts receivable
A = Audit Risk 0,05 (5 %)
IR = Inherent Risk 0,50 (50 %)
CR = Control Risk 0,40 (40 %)

DR = Auditor’s Detection Risk - Calculate

After this previous audit following has happened: The market situation has
worsened in the subcontracting branch in question. Some end-product
producers are anticipated to fall in troubles and are already experiencing
worsening liquidity and troubles in paying bills. The three owners are old and
are willing to retire. They had decided to sell their company for investors
and this decision was made during the accounting period under audit. The
owners wants to get as a good selling price as possible.

a) Based on this explained changed situation, would you change the risks (IR,
CR) used in the previous audit. If you change risks, calculate again the
detection risk (DR).

b) Justify and explain why you possibly changed the assessed risks.
Lesson Exercise 3. Flowchart and Risk – Control assessment

This audit is targeted to a factory’s salary payment function. In the
preliminary study the auditor decided to make a flowchart of the salary
payment process in question. Based on observing and interviews the auditor
formed the following description of the payroll process. The personnel
department kept the personnel register and a personnel secretary’s task was
to keep and update the register. The factory had a clock cards system and
workers had to clock in and clock out. The IT-department is responsible of
the time control devices and computer system and its maintenance. If workers
were doing overtime, this had to be based on overtime authorizations decided
by the supervisors. Based on a personnel register, working time data and
overtime authorizations data pay masters calculate the salaries and a
computer salary run is made once a month. According to this payroll, the
bookkeeper makes corresponding entries to the wages account in the journal.
Chief accountant signs the bank payments transactions transmission and the
pay lists are sent to workers.       The bank after getting the approved
transmission data pays the salaries to workers’ accounts. Once a month the
bank sends a bank account statement to the firm. The bookkeeper makes a
reconciliation between the bank statement and the wages account.

a) Draw a flowchart of the salary payment process.

b) Think about the possible relevant risks in the salary payment process and
list 5-8 risks. Point these risks to the flowchart.

c) Think about the possible effective controls to these risks, and point them
also to the flowchart.
Lesson Exercise 4. Analytical methods

Sawyer’s Internal Auditing

Part 3/Scientific Methods, Multiple Choice Questions

21. What form of analytical review might uncover the existence
of obsolete merchandise ?

  a)   Inventory turnover rates.
  b)   Decrease in the ratio of gross profit to sales.
  c)   Ratio of inventory to accounts payable
  d)   Comparison of inventory values to purchase invoices.

22. Which of the following analytical audit findings would most
likely indicate a possible problem ?

  a)   A   material decrease in the receivables turnover.
  b)   A   material increase in inventory turnover.
  c)   A   material decrease in days-sales-outstanding
  d)   A   material increase in the acid-test ratio.
Lesson Exercise 5. Control Testing with Sampling

A government agency that controls environmental emissions and gives firms and
other corporations permissions is a target of an audit. During the audit planning
and preliminary study the auditor assessed the control environment and control
activities in the agency and decided to do a statistical sampling of agency’s
permission decision activity. The auditor took a statistically determined sample
of 100 of total 10 000 permission decisions. The sample was randomly selected
without replacement (once included in the sample, the item cannot be selected

When evaluating the sample the auditor observed that one written permission of
100 was not properly justified for the applicant (an industrial firm). The written
permission decision lacked references to environmental laws and also the appeal
directions, which, according to regulations, should be included into the official
decision document sent to the client.

a) Use the table attached below and assess with a 95 % confidence and with 5 %
risk of assessing the control risk too low, what is the rate of errors in the
population (10 000 permission decisions). The auditor has set a tolerable rate of
control deviations to 5 % - compare the achieved upper precision limit on
deviation rate to this tolerable rate of deviations.

b) How critical do you deem the deviation and what are your conclusions based on
this audit sampling ? What would be the auditor’s assessment of the functioning
of the control activities in the government environmental agency ?
A part from a statistical table, look in details Glezen & Taylor 1997, page 304.
Evaluation of sample results (estimation sampling for attributes)

Sample size 100          Chosen Risk level 10%, 5% or 1%,
                         and the achieved upper precision
                         limit on deviation rate (achieved
                         tolerable rate) in the population

                                Risk level
Number of deviations     10 %       5 %         1 %
found in the sample      Achieved upper precision
                         %          %           %
0                        2,28       2,95        4,50
1                        3,83       4,66        6,45
2                        5,23       6,16        8,14
3                        6,56       7,56        9,70
4                        7,83       8,92        11,17
5                        9,08       10,23       12,58
6                        10,29      11,50       13,95
7                        11,49      12,75       15,29
8                        12,67      13,97       16,59
9                        13,83      15,18       17,87
10                       14,99      16,37       19,13
.. etc.
Lesson Exercise 6. Attribute sampling (test of controls)

The basic sample size formula for attribute sampling is following:

n= C       pq

n = sample size
C = confidence coefficient (e.g., at a 95 % confidence level it
equals 1,96)
p = expected deviation rate
q = 100 %-p
P = precision (if, for instance, ± 2 %, you get 0,02)

Sample size adjustment to population formula
n’ = final sample size
N = population
n' = n/(1 +(n/N)

An auditor is planning to use attribute sampling to test the
effectiveness of a specific internal control related to approvals
of invoices for payments. The population is 1000, The expected
error rate was 5 %, and the desired precision is 2 %. The auditor
wanted to have a 95 % confidence level.

  a) What is the statistical sample size ?
  b) The auditor finds 15 deviations in the sample taken
     according to a) What are the conclusions of the control ?
  c) What if the auditor finds 22 deviations, what would be the
     new sample size with this deviation rate ?
  d) Or what would be the achieved precision if the sample size
     is kept and not risen up with these 22 deviations ?