Statements on Auditing Standards in the section on internal control (Section 320B.35) is the following formula:

where:
S = reliability level for substantive tests 

R = combined reliability level desired 

C = reliance assigned to internal accounting control and other relevant factors
For purposes of this problem, assume the following:

1. 1 minus reliability equals risk.

2. Substantive tests are the same as direct tests of balances.

3. Internal control reliance and other relevant factors are the same as tests of transactions and analytical tests.

Required:

a. Explain what the formula means in terms of overall level of assurance, tests of transactions, analytical tests, and direct tests of balances.

b. Which of the factors in the formula is equivalent to the overall level of assurance? Restate the formula so that it emphasizes the overall level of assurance, assuming that all other factors are known.

c. Assume that the auditor has decided that an overall level of assurance of 99% is appropriate for a given audit. Explain what a 99% overall level of assurance means. What factors would affect the decision to use a 99% assurance level?

d. Assume the auditor has performed analytical tests, evaluated the system of internal control, and tested the system of internal control. The level of reliability gained from these tests is 40%. Given the overall level of assurance of 99% in part c, what is the appropriate risk the auditor should be willing to take that direct tests of balances will fail to uncover material errors?

Transcribed Image Text:

S s = 1-=-=- R) - C)