N. Wolfe, PA, is planning the audit of Goodwin Manufacturing Company’s inventory. Wolfe plans to audit the inventory by selecting a sample of items for physical observation and counting, followed by price testing. The price testing part of the work takes a large portion of the time on each sampling unit because the company’s costing method is complex. The estimated cost of auditing each sampling unit in this substantive balance-audit sample is estimated at $25.

Because this detailed substantive work is expensive, Wolfe would like to minimize the sample size by assessing a low control risk. She decided that control over accurate pricing of purchases (additions to the inventory) would be the most appropriate control attribute. The reasoning is that inventory balance misstatements could arise from either or both of miscounting or erroneous pricing and costing calculations. If the basic purchase pricing were accurate, then the inventory count accuracy and the difficult inventory costing calculations would be the remaining source for error and audit attention. The estimated cost to audit a purchase transaction for pricing accuracy is estimated to be $12. She thinks the client’s staff makes few, if any, errors in pricing the purchase transactions. 

For the audit of the inventory balance, Wolfe accepted the accounting firm’s policy of setting audit risk at 0.05. Since business activity in the client company had been hectic lately, she decided to be conservative and set inherent risk at 1.0. However, certain analytical procedures will be performed by comparing the inventory balance to prior years, the company budget, and certain historical statistics, and these procedures might have a 10% chance of detecting material misstatements of the balance.

The book-recorded amount of the inventory is $72 million, spread among 3,345 different kinds of inventory items. Purchases for the year amounted to $467 million in about 6,000 separate purchase transactions.

Wolfe believes the inventory balance can be misstated by as much as $2 million without causing the financial statements as a whole to be materially misstated. The overall materiality judgment is $8 million misstatement of operating income before taxes, and $2 million is the amount assigned to the audit of the inventory balance.

The audit staff recently attended a training session where Wolfe learned about the concepts of a smoke/fire multiplier and an incremental risk of incorrect acceptance used to judge the risk of assessing control risk too low. Inventory purchase pricing errors can be numerous yet not affect the dollar amounts very much, so Wolfe decided that a smoke/fire multiplier of 7 was appropriate. (The firm's policy is to use the multiplier to figure an anchor tolerable deviation rate for control risk = 0.05, and round the anchor up to 1% if the multiplier produces an anchor less than 1%. After that, each tolerable deviation rate is 1 percentage point higher for each control risk level increment of 0.05.) The firm's policy about an incremental risk of incorrect acceptance resulting from assessing control risk too low has not yet been published, but Wolfe thinks that a 0.02 change should not make much difference.

The problem is deciding the size of the test of controls sample for the audit of the purchasepricing transactions. Wolfe partially completed the worksheet shown in Exhibit DC 10B-2. She handed it over to you.

Required:
Copy the worksheet. Complete it and decide the size of the sample for the detail test of accuracy control over the pricing of purchases (additions to the inventory). Round the risk of incorrect acceptance and risk of assessing control risk too low probabilities to two decimal places.

RIA = Risk of incorrect acceptance for the substantive balance-audit sample.

RACRTL = Risk of assessing control risk too low.

Transcribed Image Text:

EXHIBIT DC 10B-2 TEST OF CONTROL BALANCE-AUDIT TDR N[C] CONTROL RISK CATEGORIES CR RIA RACRTL COST N[S] COST TOTAL 0.10 25 Low control risk 0.20 46 0.30 60 0.40 71 Moderate control risk 0.50 71 0.60 87 0.70 91 0.80 Control risk below maximum 96 0.90 101 Maximum risk 1.00 101