If you selected options “a” or “b” in question 1, assume now that the client has decided that they will make an adjustment of up to $250,000 to their financial statements. Please decompose the total adjustment you would recommend into the individual account classifications included on the Summary of Unadjusted Misstatements in the space provided below (e.g., what adjustment would you

Question

require for warranty expense, repair and maintenance expense, etc? The dollar values of your individual account adjustments should sum to no more than $250,000).

If you selected item “c” in question 1, what is the minimum total adjustment that you would require before issuing a clean opinion? $ _______________. Please decompose this total adjustment into the individual account classifications included on the Summary of Unadjusted Misstatements in the space provided below (e.g., what adjustment, if any, would you require for warranty expense, repair and maintenance expense, etc? The dollar values of your individual account adjustments should sum to your
required minimum adjustment).

Warranty expense ____________
Repair and maintenance expense __________
Litigation expense __________
Accounts Receivables/Sales __________
Total ______________

Answer 1

Please briefly explain your decisions:
Student responses will vary. To properly evaluate the potential misstatements in accounts receivable, students need to project the sample misstatements to the population. It is very common in practice for
auditors to take a random sample, project the sample findings to the population and then evaluate the results judgmentally or using rules of thumb provided by the firm. We have found that even students who have had relatively little training in sampling understand the need to project misstatement to the population. Projection using ratio estimation is a relatively intuitive concept and it is common in practice. That said, in our experience even students that have had relatively extensive training in audit
sampling have difficulty applying their knowledge of sampling risk associated with projections. Given that materiality is $625,000, the level of potential aggregate misstatement including upper bound (sampling
risk) suggests a significant adjustment would be required to reduce audit risk to an acceptable level. The auditor’s alternative courses of action can be discussed (e.g., increase materiality, take another sample, have client extensively test accounts receivable, book an adjustment).
The sum total or aggregation of known non-sampling misstatement and projected sampling misstatement is less than 2% below materiality. Exhibit A at the end of these teaching notes can be used as an overhead when debriefing the case. Therefore, students understanding the need to project should also consider the uncertainty surrounding the misstatement projection due to sampling risk (AU-C 530, Audit Sampling). While we do not anticipate students will calculate the statistically derived upper confidence bound, they should be aware that aggregate misstatement including an upper confidence bound will exceed materiality. While many students do calculate projected misstatement, many do not consider
sampling risk. It is common for students to require no adjustments to the financial statements even when aggregate projected misstatement is just barely below materiality. With respect to the amount of the
adjustment, a formal evaluation of the aggregate misstatements suggests an upper bound about $310,000 above materiality. Thus an adjustment of around $310,000 can be justified. Assuming the auditor chooses
not to increase their acceptable audit risk or materiality, and assuming the auditor chooses to not conduct any additional tests, then the total adjustment to the financial statements might be comprised of the
following components:

Repair and maintenance expense 200,000
Warranty expense 70,000
Accounts receivables/sales 40,000
Total $310,000

Projected Misstatement and Upper Limit Calculation. As noted previously, the projected misstatement reported in the case extension is based on ratio projection. Projected misstatement based on difference projection is also provided below.

Projected Misstatement Point Estimate—Ratio Projection
Projected Misstatement = $8,662 (known sample error)
$12,600,000 (population) $326,096 (total tested)
Projected Misstatement = $ 334,690

Projected Misstatement Point Estimate—Difference Projection
$8,662 (known sample error) X 1,545 (number of accounts) = $334,570
40 (sample size)

Upper Limit
CPI = NZA
(SD/SQRT(n)) (SQRT ((N-n)/N))

Where:
CPI = computed precision interval N = population size
ZA
= confidence coefficient for ARIA SQRT = square root
SD = population standard deviation n = sample size
(SQRT ((N-n)/N)) = finite correction factor
CPI = 1,545 x 1.96 *(758/SQRT(40))*(SQRT(1,505/1,545)) = $358,202.
Therefore the upper 95% confidence bound using ratio projection is $692,892 ($334,690 + $358,202)

The case requires students to decide which of the individual adjustments to make and in what amount. Some students select proposed adjustments that are less subjective while others simply select one of the largest misstatements to correct. These differences lead to good class discussions about the differences in “hard” and “soft” proposed adjustments. After seeing the upper bound, some students may question whether a larger adjustment is required to accounts receivable because according to the case tolerable misstatement for any account cannot exceed $468,750 (75% of materiality). Tolerable misstatement is more of a scoping tool than it is an evaluation tool; however, some auditors may require a larger adjustment and that decision will likely be dependent on how important the assertions associated with the accounts receivable account are to the financial statement users. In the final evaluation of likely Unadjusted Misstatements and proposed adjustments, most auditors will focus more on the best
estimate of misstatement, projected error, which for accounts receivable is below tolerable even before the $40,000 adjustment proposed above. The auditor does want ample margin for error between the unadjusted most likely aggregate misstatements and materiality to provide an appropriate allowance for sampling risk and other potential undetected misstatements. The proposed adjustments above appear to about the minimum level required to provide sufficient margin for error.