Audit Sampling and Misstatement Evaluation
You are auditing the accounts receivable of RetailCo, a large retailer with 5,000 customer accounts. You designed a sample of 100 accounts using probability-proportional-to-size (PPS) sampling. The sample results show the following: 3 accounts are overstated, with errors of $500, $1,000, and $2,500. The total book value of the population is $10 million, and the sample book value is $200,000. The sampling interval is $100,000. You determined that the tolerable misstatement is $500,000 and the expected misstatement is $100,000. The risk of incorrect acceptance is 5%. After performing the sample, you projected the misstatement to the population using the Stringer bound method, resulting in an upper misstatement limit of $600,000. The client has agreed to adjust the three identified errors but refuses to adjust the projected misstatement because they believe the errors are isolated. The CFO argues that since the actual errors are only $4,000, the projected misstatement is overblown.
1. Evaluate whether the sample results support the conclusion that the accounts receivable balance is not materially misstated. What is the appropriate auditor response?
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The sample results indicate that the upper misstatement limit (UML) is $600,000, which exceeds the tolerable misstatement of $500,000. Therefore, the auditor cannot conclude that the population is not materially misstated. The UML represents the maximum misstatement in the population at the given risk level (5%). Since the UML > tolerable misstatement, there is a risk that the true misstatement exceeds tolerable misstatement. The client's argument that the errors are isolated is not supported because the projection method (Stringer bound) accounts for sampling risk and the possibility of undetected errors. The auditor should:
- Consider whether the errors are indeed anomalies. The auditor should investigate the nature and cause of the errors. If they are due to a systemic issue (e.g., a specific type of customer or a process breakdown), they are not isolated. If they are truly unique, the auditor might still need to evaluate them individually.
- Since the UML exceeds tolerable misstatement, the auditor should request that the client adjust the financial statements by the projected misstatement or perform additional audit procedures (e.g., increase sample size, perform alternative procedures) to obtain more evidence.
- If the client refuses to adjust, the auditor should consider the effect on the audit opinion. The misstatement is material if it exceeds tolerable misstatement. The auditor should aggregate the misstatement with other misstatements and evaluate materiality.
- The auditor should document the evaluation and communicate with those charged with governance.
2. How should the auditor respond to the CFO's argument that the projected misstatement is overblown?
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The CFO's argument reflects a misunderstanding of audit sampling. The projected misstatement is not simply the sum of known errors; it is an estimate of the total misstatement in the population based on the sample results, including sampling risk. The Stringer bound method provides an upper limit that considers the possibility that the sample did not include all errors. The auditor should explain that professional standards (AU-C 530) require the auditor to project misstatements found in a sample to the population and evaluate whether the projected misstatement, combined with the results of other audit procedures, indicates that the financial statements are materially misstated. The auditor should not accept the CFO's argument without sufficient evidence. The auditor should also consider whether the errors are due to fraud or error, and whether they are indicative of a systemic problem. If the client continues to refuse to adjust, the auditor should evaluate the impact on the audit opinion and consider whether to issue a qualified or adverse opinion if the misstatement is material and pervasive.