A. Be related to the auditor’s business risk.

B. Be related to preliminary judgments about materiality levels.

C. Not be adjusted for qualitative factors.

The tolerable misstatement is the maximum

amount of misstatement that may exist in an
account balance without causing the financial
statements to be materially misstated.

The combined tolerable misstatement for an entire

audit should not exceed the auditor’s preliminary
estimate of materiality for the financial statements
taken as a whole.

Answer A is incorrect because, as the audit

progresses, the auditor may decide to change the
tolerable misstatement like when he/she discovers
the incorrect planning assumptions were used.

Answer B is incorrect because the auditor’s business risk is

irrelevant to the determination of tolerable misstatement.

Answer D is incorrect because qualitative factors

should be considered when determining the
tolerable misstatement for the sample. For
example, the auditor should consider the nature
and cause of misstatements and their impact on
other phases of the audit.

54. An auditor may decide to increase the risk of incorrect

rejection when
A. The cost and effort of selecting additional sample items
are low.
B. Increased reliability from the sample is desired.
C. Many differences (audit value minus recorded value) are
expected.
D. Initial sample results do not support the planned level of
control risk.
 The risk of incorrect rejection is the risk that the
sample supports the conclusion that the recorded
account balance is materially misstated, when, in
fact, it is fairly stated. This risk ordinarily result in
the performance of additional audit procedures
that will lead the auditor to the proper conclusion.
Thus, the risk of incorrect rejection affects the
efficiency, not the effectiveness of the audit. If the
cost and effort of selecting additional items are
low, the auditor may accept a higher risk of
incorrect rejection.

Answer B is incorrect because a decrease in the

risk of incorrect rejection is required if increased
reliability (confidence level) from the sample is
desired.

Answer C is incorrect because the account balance

is more likely to be misstated if many differences
are expected and therefore incorrect rejection is
less likely.

Answer D is incorrect because control risk relates

to tests of controls whereas incorrect rejection
relates to substantive testing.

55. In statistical sampling methods used in

substantive testing, an auditor most likely would
stratify a population into meaningful groups of
A. Probability-proportional-to-size (PPS) sampling is used.
B. The population has highly variable recorded amounts.
C. The standard deviation of recorded amounts is relatively
small.
 D. The auditor’s estimated tolerable misstatement is extremely
small.

Stratification involves dividing the population into

homogenous groups called strata or
subpopulations, thus reducing the effect of high
variability of amounts in the population. Because
the variability of items within each subpopulation
or stratum is reduced, the auditor will be able to
select a smaller sample for each subpopulation.

Answer A is incorrect because the population is automatically

stratified under PPS sampling.
Answer C is incorrect because the auditor would
select a sample from the total population when the
standard deviation of recorded amounts is
relatively small.

Answer D is incorrect because a relatively large

sample size will be required when the tolerable
misstatement is extremely small.

56. How would decreases in tolerable misstatement

and assessed level of control risk affect the sample
size in a substantive test of details?
Decrease in Decrease in
Tolerable Misstatement Assessed Level
Of Control Risk
A. Increase sample size Increase sample
size
B. Increase sample size Decrease sample
size
C. Decrease sample size Increase sample
size
D. Decrease sample size Decrease sample
size
The tolerable misstatement is inversely related to
the sample size – that is, as the tolerable
misstatement decreases, the sample size
 increases. Also, a decrease in the assessed level of
control risk will allow the auditor to accept a
higher level of detection risk and therefore a small
sample size for substantive testing.

57. Which of the following courses of action would an

auditor most likely follow in planning a sample of
cash disbursements if the auditor is aware of
several unusually large cash disbursements?
A. Continue to draw new samples until all the unusually large
disbursements appear in the sample.
B. Increase the sample size to reduce the effect of the
unusually large disbursements.
C. Stratify the cash disbursements population so that the
unusually large disbursements are selected.
D. Set the tolerable rate of deviation at a lower level than
originally planned.

The auditor should stratify the population to

ensure that the “unusually large disbursements”
will be tested. Sampling procedures will then be
applied to those smaller disbursements.

Answer A is incorrect because it will be inefficient

to continue to draw new samples to assure
inclusion of all unusually large disbursements.

Answer B is incorrect because the auditor will tend

to include in his/her test those disbursements
described as “unusually large.”

Answer D is incorrect because the existence of

unusually large disbursements in the population
does not affect the tolerable deviation rate in an
attribute sampling application.
58. A number of factors influence the sample size for
a substantive test of details of an account balance.
 All other factors being equal, which of the
following would lead to a larger sample size?
A. Smaller measure of tolerable misstatement.
B. Smaller expected frequency of errors.
C. Greater reliance on analytical procedures.
D. Greater reliance on internal control.

The tolerable misstatement is inversely related to

the sample size – that is, as the tolerable
misstatement decreases, the sample size
increases.

Answer B is incorrect because the expected

frequency of errors directly affects the sample size
– that is, as the expected frequency of errors
decreases, the sample size also decreases.

Answer C is incorrect because the auditor will

select a smaller sample size for a substantive test
of details if greater reliance is to be placed on
analytical procedures directed at the same
assertion.

Answer D is incorrect because as the degree of

reliance on internal control increases, the
acceptable level of detection also increases. This
means that the auditor may restrict his/her
substantive testing by selecting a smaller sample
size.

59. An auditor established a P900,000 tolerable

misstatement for an asset with an account balance of
P15,000,000. The auditor selected a sample of every
20th items from the population that represented the
asset account balance and discovered a net
overstatement of P52,500 (P55,500 overstatements
minus P3,000 understatements). Under these
circumstances, the auditor most likely would conclude
that
A. The asset account is fairly stated because the tolerable
misstatement exceeds the net of projected actual overstatements
and understatements.
B. The asset account is fairly stated because the total projected
misstatement is less than the tolerable misstatement.
C. There is an unacceptably high risk that the actual misstatements
in the population exceed the tolerable misstatement because the
total projected misstatement exceeds the tolerable misstatement.
D. There is an unacceptably high risk that the tolerable
misstatement is more than the sum of actual overstatements and
understatements.

The net overstatement of P52,500 represents 1/20

of the items in the population. Thus, the projected
misstatement will be P1,050,000 (P52,500 x 20),
which exceeds the tolerable misstatement of
P900,000. This circumstance will lead to a
conclusion that there is an unacceptably high risk
that the actual misstatements in the population
exceed the tolerable misstatement.

Answers A and B are incorrect because the

calculation above indicates that the projected
misstatement exceeds the tolerable misstatement.

Answer D is incorrect because even if the sum of

actual overstatements and understatements is to
be projected to the population, the projected
misstatement will exceed the tolerable
misstatement. Moreover, if the tolerable
misstatement exceeds the projected
misstatement, the auditor will simply accept the
account balance as fairly stated.
60. Which of the following sample selection methods is
not appropriate when using statistical sampling?
A. Random selection
B. Systematic selection
C. Monetary unit sampling
D. Haphazard selection

Haphazard selection method involves selection of

the sample without following a structured
approach. This technique is not appropriate when
using statistical sampling.

61. Which of the following sample selection methods

cannot ordinarily be used in audit sampling?
A. Value-weighted selection
B. Random selection
C. Block selection
D. Systematic selection

Block selection involves selection of a block(s) of

contiguous items from within the population. In
most populations, items in a sequence are
expected to have similar characteristics to each
other, but different characteristics from items
elsewhere in the population.

Because audit sampling involves drawing valid

conclusions about the whole population based on
the sample, block selection ordinarily cannot be
applied in audit sampling.

62. In systematic selection, the number of sampling

units in the population is divided by the sample size to
determine the
A. Sampling interval
B. Pattern that may exist in the population
 C. Sampling risk
D. Nonsampling risk

In systematic selection, the number of sampling

units in the population is divided by the sample
size to determine the sampling interval. For
example, 20 will be the sampling interval in a
population of 5,000 sampling units within which a
sample of 250 items will be selected (5,000 / 250).
After selecting a starting point within the sampling
interval of 20, the auditor will then select every
20th item.
63. In audit sampling, ____________ involves dividing the
population into discrete sub-populations which have an
identifying characteristic.
A. Value-weighted selection
B. Stratification
C. Random selection
D. Block selection

The auditor may stratify a population by dividing it

into discrete sub-populations which have an
identifying characteristic.

Stratification of the population may improve audit

efficiency because each stratum will contain
homogeneous items that will allow selection of
smaller sample size without increasing sampling
risk.

64. Which of the following statements relating to

stratification is incorrect?
A. When performing tests of details of transactions and account
balances, the population is often stratified by monetary value.
B. The results of audit procedures applied to a sample of items
within a stratum can be projected to the entire population.
 C. When verifying the valuation assertion for accounts receivable,
account balances mat be stratified by age.
D. Stratification reduces the variability of items within each stratum.

When using stratified sampling technique,

misstatement is projected for each stratum
separately. The projected misstatements are then
combined to determine the possible effect on the
entire population.

65. Audit efficiency may be improved when the sampling

unit is defined as the individual monetary units that
comprise the
population. This technique is called
A. Stratification
B. Random selection
C. Systematic selection
D. Value-weighted selection

Value-weighted selection identifies the sampling

nit as the individual monetary units that make up
the population. Under this method, audit effort
may be directed to the larger value items because
they will have a greater chance of being selected.
This can result in smaller sample sizes and may
thus improve audit efficiency.

TRUE OR FALSE

1. Nonsampling risk is the risk that audit tests will

not uncover existing exceptions in a sample.
2. For a given tolerable deviation rate, a larger
sample size should be selected as the expected
population deviation rate decreases.
3. The tolerable deviation rate for a test of controls is
generally lower than the expected rate of
deviations in the related accounting records.

4. In statistical on nonstatistical sampling methods

used in substantive testing, an auditor most likely
would stratify a population into meaningful groups
if the population contains both very high and very
low recorded amounts.

5. If sample results indicate that the control is

operating effectively, but in fact it is not, control
risk will be assessed too high.

6. To determine if a sample is truly representative of

the population, an auditor would be required to
use systematic sample selection.

7. The risk of incorrect acceptance relates to the

effectiveness of the audit.

8. One of the ways to eliminate nonsampling risk is

through the use of attributes sampling rather than
variables sampling.

9. As the amount of misstatements expected in the

population approaches tolerable misstatement, the
planned sample size will increase.

10. The auditor’s principal objective when using a

sample of test of details of balances is whether the
transactions being
audited are free of misstatements
11. The computed upper deviation rate is the sum
of the sample deviation rate and an appropriate
allowance for sampling risk.

12. When selecting a stratified sample, the sample

size is determined for each stratum and selected
randomly from the entire unstratified population.

13. Statistical sampling provides a technique for

measuring the sufficiency of evidential matter.

14. Sampling risk is the risk that audit tests will not
uncover existing exceptions in a sample.
Compare and discuss the advantages and disadvantages

of the following performance measures: ROI, EVA, and

Residual Income.
The return on investment measure is a ratio of operating

income to average operating assets. It encourages

efficiency, discourages excessive investment, forces

managers to pay attention to relationships among

variables, and allows comparison of different size

ventures. It discourages investments in ventures that

have a lower ROI than the division currently has and

encourages short-run focus.

The residual income is the excess earning over the

minimum expected return on operating assets. It has the

advantage of accepting projects that add contribution

beyond the hurdle rate. However, residual income is an

absolute measure and does not foster comparison of

different size projects. It also does not discourage myopic

behavior.

The EVA is a measure that looks at the value added by

current operations by determining the excess of after-tax

operating income over the actual cost of capital employed.

It looks at the wealth created from operations. However, it

also is subject to manipulation by managers and is an

absolute measure, making comparisons of different size

divisions difficult.

101. Provide the missing data in the following situations:

Sigma Tau Gamma

Division Division Division
Sales $ (a) $250,000 $ (g)
Operating assets $ (b) $ (d) $800,000
Net operating income $400,000 $10,000 $144,000
Margin 0.08 (e) 0.12
Turnover (c) (f) 1.5
Return on investment 16% 10% (h)
a. $400,000/a = 0.08 a = $5,000,000

b. $400,000/b = 0.16 b = $2,500,000

c. c = $5,000,000/$2,500,000 = 2.0

d. $10,000/d = 0.10 d = $100,000

e. e = $10,000/$250,000 = 4%

f. f = $250,000/$100,000 = 2.5 times

g. $144,000/g = 0.12 g = $1,200,000

h. 0.12 ´ 1.5 = 18%

102. Sprint Company has the following data for 2011:

Division A Division B
Sales $400,000 $300,000
Contribution margin 160,000 125,000
Operating income 80,000 30,000
Average operating assets 320,000 200,000
Weighted average cost of capital 15% 15%
Sprint Company has a target ROI of 20 percent.

Required:

Calculate the following amounts for each division:

a. Margin ratio
b. Turnover ratio
c. ROI
d. Residual income
e. EVA

Division A:

a. Margin ratio = $80,000/$400,000 = 20%

b. Turnover ratio = $400,000/$320,000 = 1.25

c. ROI = 0.20 ´ 1.25 = 25%

d. Residual income = $80,000 - 0.20($320,000) = $16,000

e. EVA = $80,000 - 0.15($320,000) = $32,000

15. Auditors who prefer statistical sampling to

nonstatistical sampling may do so because
 statistical sampling helps the auditor eliminate
subjectivity in the evaluation of sampling results.
16. Sampling risk is the risk than an auditor will
reach an incorrect conclusion because a sample is
not representation of the population.

17. The primary objective of using stratified

sampling in auditing is to determine the
occurrence rate for a given characteristic in the
population being studied.

18. A sample of all items of a population will

eliminate sampling risk, but increase nonsampling
risk.

19. The use of inappropriate audit procedures is a

significant cause of nonsampling risk.