Exercise based on AICPA Guide- Audit Sampling- Chapter 5 Nonstatistical Sampling Case Study

5.01

This chapter provides a case study illustrating the design and use of a nonstatistical sample.

5.02

Sarah Jones of Jones & Co., CPAs, designed a nonstatistical sample to test the existence and gross valuation of the December 31, 20XX, accounts-receivable balance of Short Circuit Inc., a privately owned electrical supply company that is a continuing client of Jones & Co. For the year ended December 31, 20XX, Short Circuit had sales of approximately $25 million. As of December 31, there were 905 accounts receivable, with debit balances aggregating $4.25 million. These balances ranged from $10 to $140,000. There were also 40 credit balances aggregating $5,000.^{fn 1}

5.03

In planning her audit, Sarah Jones updated her understanding of the client and its environment, including its internal control. She also understood that the entitys revenue recognition policy was to recognize revenue upon shipment. She also understood that cash sales are prohibited, and the entry for all sales transactions involves a debit to accounts receivable. In addition, all cash receipts are through the banks lock box, and there are no credits to income in the cash receipts journal. The only general journal entries affecting receivables and revenue involve minor write-offs of bad debts and setting up an allowance for doubtful accounts at the end of each quarter. All of the preceding were true in prior audits, and inquiry of client management indicates no changes from prior periods.

5.04

Jones made the following judgments in planning her procedures for revenue and receivables:

Because this is not a first audit and because of some past errors in accounts receivables, her assessment of the risks of material misstatement in receivables did not support an assessment much below high for the assertions of existence and gross valuation of accounts receivable.

Fraud risk related to revenue and receivables is low. There is little incentive to misstate revenue or receivables. The lock box system significantly reduces the risk of misappropriation of cash. The companys revenue recognition policy was appropriate in the circumstances. There was minimal risk of channel stuffing or other revenue recognition issues.

The confirmation process would test existence and gross valuation of receivables. It would not provide much evidence about completeness, net valuation of receivables, presentation, and disclosure. Other procedures will be performed on the account that will address these assertions and provide some evidence on existence and valuation.

The confirmation process would provide some evidence of the occurrence and gross valuation of sales transactions. This was because if receivables did not exist, the sales transaction did not occur. It also would provide some evidence about receivables cutoff because customers would report items included in receivables that were not shipped by year-end. The confirmation process would not provide evidence of completeness of revenue.

5.05

Sarah Jones made the following judgments in designing the confirmation sample:

Her limited tests of controls supported an assessed level of risk of material misstatement (inherent and control risk) of high for the assertions of existence and gross valuation of accounts receivable.

The preliminary assessment of overall materiality is $200,000.

Tolerable misstatement for this test was set at $150,000, which is 75 percent of the materiality for the financial statements as a whole and less than the performance materiality set for the overall engagement. This judgment was based on the fact that most other accounts could be estimated to a significant precision and that the client would adjust for factual misstatements and follow up appropriately on projected misstatement issues, and this account had a higher expected error rate than other account balances.^{fn 2}

She expects a possible $15,000 misstatement in accounts receivable, which is a realistic, or if anything, a somewhat conservative estimate based on the results of prior years testing.

The credit balances in accounts receivable would be tested separately.

The balance for each selected customer would be confirmed.

As a percent of account receivables what does the $15,000 represent as %? What term from the power point presentation is most closely defined by this number (the%)?