Teaching Notes
Education Objectives of the Project
The simulation consists of 1,000 customer accounts and it creates a unique
sample for each four-digit student ID. Using customer data, the simulation creates
confirmations, responses to confirmations, invoices, bills of lading and purchase orders
in the form of *.html files which are readable with most web browsers.
The educational objectives of the project are:
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Students understand the confirmation process
Students perform alternative procedures for non-respondents
Students observe tangible examples of audit evidence
Students project sample results to the population
Students form a conclusion from their audit procedures
Students prepare audit workpapers
Availability
The following materials are available on the website: http://ar-simulation.com/
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The exercise for distribution to students which is the first portion of this paper
The complete exercise including the teaching note
Copies of last year’s workpapers
The Excel workbook which includes the simulation
The four templates which must accompany the simulation
A PowerPoint introducing the assignment
Confirmation responses for n=25 and ID 1234
A list of the discrepancies generated by the simulation
Last Year’s Workpapers
Last year’s workpapers are included with the assignment for students to use as
templates. This is consistent with practice, where auditors typically have access to the
prior year’s workpapers.
Excel Simulation and Templates
Students must be enable macros because the Excel simulation uses them
extensively. The simulation calls on the following *.html templates: TemplatePO.html
creates purchase orders; TemplateBOL.html creates bills of lading; TemplateINV.html
creates invoices; and TemplateConf.html creates confirmations and responses to
confirmations. These template files must be in the same folder as the spreadsheet
because the Excel simulation will not look to other folders for these templates.
PowerPoint files and Confirmation Responses (n=25, ID 1234)
The PowerPoint file available on the website enables you to quickly demonstrate
the assignment to students by using the following tips. From the website, you can print
out the Excel file which lists the confirmation responses for a sample of 25 using student
ID 1234. These are the results used in the PowerPoint. This will provide the amounts on
the confirmations so you won’t need to actually look at each confirmation and you can
focus on the process. When demonstrating alternative procedures, you should be aware
that the dollar amount on every purchase order and invoice always equals the book
balance and there is a bill of lading supporting every transaction. You shouldn’t tell this
to your students, but this will allow you to demonstrate the assignment much more
quickly as you won’t need to actually read from the invoices, bills of lading or purchase
orders. Each column of the results page of the simulation will auto-fill after students
enter five responses. This was done to limit the amount of time students spend on this
assignment.
2
Discrepancies
The simulation does not have a single solution. While the simulation always
generates the same discrepancy for any given customer’s confirmation response, the
discrepancies do not flow through to the alternative procedures. None of the purchase
orders, bills of lading or invoices contain discrepancies. The purchase orders, bills of
lading and invoices are always consistent with the recorded book balances.
Project Efficacy Questionnaire
During the spring term of 2011, 75 of the 91 students enrolled in our
classes responded to the following questions using SurveyMonkey. The table following
the questions summarizes their responses.
1. The Accounts Receivable Project provided a more realistic auditing experience
than is typical for accounting classes.
2. I enjoyed completing the AR Project.
3. The AR Project complimented the text and enhanced my understanding of the
accounts receivable confirmation process.
4. The AR Project complimented the text and enhanced my understanding of what it
means to perform alternate procedures for accounts receivable.
5. The AR Project helped me better understand the nature of audit evidence.
6. The AR Project helped clarify the relationship between audit evidence and
auditors’ conclusions regarding the fair presentation of account balances.
7. I am more familiar with auditors’ work papers because of the AR Project.
8. The AR Project helped me better understand how the audit risk model is used.
9. I would learn more and be better prepared for an auditing career if I were
exposed to more projects like the AR Project.
Responses to Questionnaire
number of
Strongly
repsonses
Disagree
Strongly
Disagree
Neutral
Agree
Agree
00
10
10
20
20
30
30
40
40
50
50
60
60
70
70
80
80
90
90
100
100
average
(1)
74
2
0
0
0
0
1
2
3
35
13
18
83.1
(1)
(2)
75
2
0
4
1
0
3
6
9
24
16
10
74.8
(2)
(3)
75
2
0
0
1
0
1
3
7
27
14
20
82.3
(3)
(4)
75
1
0
2
0
1
0
4
10
23
13
21
81.7
(4)
(5)
74
1
0
2
1
1
3
3
5
25
16
17
80.1
(5)
(6)
75
0
0
4
0
0
8
3
12
23
12
13
76.3
(6)
(7)
75
1
1
2
1
0
3
3
2
23
12
27
82.3
(7)
(8)
75
1
1
4
3
5
6
5
21
11
10
8
67.1
(8)
(9)
75
1
1
0
0
2
3
3
3
11
13
38
86.4
(9)
3
Implementation Guidance
Many steps in the confirmation process are mechanical. The sample size may be
given or determined from a table. The preparation and mailing of confirmations is
mechanical. Agreeing information from a confirmation or a bill of lading with a subledger
can become rote, if not mechanical. Auditors typically use last year’s workpapers as a
template for the current year. Consequently, we must continually warn students that
circumstances change from year to year and they must be vigilant and not just blindly
follow last year’s workpapers.
Prior to using this exercise, confirmation was merely a vocabulary word which
our students memorized. They had no basis to reflect on the process. A discrepancy
between a recorded balance and a confirmation, or any audit discrepancy for that
matter, was a vague concept students had difficulty visualizing. Completion of this
exercise enables students to better reflect on the confirmation process and to visualize
discrepancies.
We assign this project early in the term, after we have covered statistical
sampling but before we have covered risk, internal control, audit documentation, or
accounts receivable. Intuitively, it may seem ideal to perform the simulation while
reading the corresponding material in the text, but we did not find that to be the case.
Completing this exercise early in the term gives students a referent as topics are
covered later in the term. We continually refer back to this exercise when we discuss
risk, internal control, evidence, the confirmation process and audit documentation.
We recommend you implement the project in a manner that minimizes both class
time and student time. The available PowerPoint slides require about 20 minutes of
4
class time to introduce the assignment. Our students report that the simulation requires
approximately one hour to complete. We are not terribly concerned with how many
mistakes students make on the assignment. The benefits of the project accrue in
subsequent lectures because students have some background when we discuss risk,
internal control, evidence, the confirmation process and documentation.
We email the assignment to students and attach the first portion of this
manuscript, the Excel simulation and the four required templates. Students are
instructed to read the assignment and they must be reminded that all four templates
must be in the same directory as the Excel simulation.
Having previously covered statistical sampling, the simulation reinforces this
topic. However, most of the educational objectives relate to the confirmation of
receivables rather than statistics. You can simply instruct students to select the desired
size sample. We require our students to calculate the sample size necessary to limit the
risks of incorrect acceptance and incorrect rejection because we find this provides a
framework to discuss these risks.
You can add a time dimension to the project by assigning the simulation in
stages. Students can complete the first four steps of the simulation, which involves the
creation, printing and mailing of the confirmation requests. In order to create a time lag
between the mailing of the confirmations and responses, you can wait until the next
class to assign step 5. In this step students review the responses and record the
confirmed amounts on the results page of the workbook. Wait until the next class to
assign step 6 in which students review and record the responses to the second
5
confirmations. Finally, during the next class you can assign step 7 which covers
alternative procedures.
We remind students that the audit planning document previously established the
acceptable level of risk and the tolerable misstatement for accounts receivable. In order
to achieve the desired level of risk, every account in the sample must be audited, not
just the accounts of the customers who responded to confirmations. You may want to
explain the vouching procedure used to perform alternative procedures. We spend
minimal time explaining the mechanics of the alternative procedures because our
students have previously completed a project in which they vouched entries from a
sales journal to invoices, shipping documents and sales orders1. This allows us to focus
our discussion on risk.
Increasing the sample size does not increase the time necessary to complete the
project. Students are only required to complete each procedure five times after which
the results page of the Excel simulation auto-fills the remaining entries. For example,
once five entries are made in the column for 1st Balances, the simulation auto-fills the
remaining entries in that column. The same is true for the 2nd Balance, PO Amt, BOL
and Inv Amt columns. We wanted to limit the time students spend mechanically
inputting data. We believe five entries allows students to reflect on the documentation of
evidence without imposing a significant time burden.
1
Author, 2009.
6
We find it necessary to explain the role of the prior year’s workpapers 2. Many
students are concerned that merely updating last year’s workpapers might be cheating
or plagiarism.
Students use their sample results to conclude whether or not accounts receivable
are materially overstated. The simulation helps students see how audit procedures
generate evidence which become the basis for their conclusion. Auditing standards
state
For tests of details, the auditor is required by paragraph .13 to project
misstatements observed in an audit sample to the population in order to obtain a
likely misstatement. Due to sampling risk, this projection may not be sufficient to
determine an amount to be recorded (ASB 2011 AU-C 505.24).
… the projected misstatement is the auditor's best estimate of misstatement in
the population. As the projected misstatement approaches or exceeds tolerable
misstatement, the more likely that actual misstatement in the population exceeds
tolerable misstatement (ASB 2011 AU-C 505.27).
We require students evaluate their results and determine if the amount by which their
projected misstatement exceeds tolerable misstatement provides sufficient allowance
for sampling risk. Although standards do not require that auditors evaluate sample
results using statistics, statistics does help illustrate the relationship between the
sample results and risk.
Extension of the Project
This remaining material is provided to possibly supplement discussions of
statistics, audit risk, internal control, accounts receivable, audit sampling and audit
documentation.
2
The spreadsheet in Workpaper 3 can be replicated by having the simulation select a sample of 44 using
student ID 1123.
7
Covering Statistics Concurrently with the Simulation
Appendix A is a handout if you cover statistical sampling concurrently with the
accounts receivable simulation. Appendix A includes a sampling plan based on the
AICPA Audit Guide: Audit Sampling. It also addresses each of the issues raised in the
sampling plan.
Appendix B supplements the statistical calculation in the Workpaper 2. The first
portion of Appendix B provides a legend for the terms used in the sample size
calculation. The second portion illustrates the use of a hypothesis test to evaluate the
sample results. The final section compares the projected misstatement from the sample
with the tolerable misstatement and evaluates whether the allowance for sampling risk
is adequate. This second approach is consistent with terminology used in auditing
standards.
Subsequent Discussions of Audit Risk
When teaching the audit risk model, we refer to the simulation. We ask students
to consider the effect on the required sample size (1) if we had instead taken a primarily
substantive approach, or (2) if we had determined internal controls were moderately
effective rather than very effective.
Subsequent Discussions of Internal Control
As the project is written, the audit team previously evaluated the internal controls
to be very effective and assessed control risk as low. However, the simulation is seeded
with a large number of discrepancies, making it likely that all students will encounter
discrepancies. This leads to discussions about the possible need to reassess control
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risk. The question we pose to students is: “How can we find a significant number of
discrepancies if the controls are effective?”
We discuss possible causes of the observed discrepancies. Workpaper 3
illustrates two possible discrepancies. The first is an order which was billed even though
a portion of the order remained on backorder as of Dec. 31 (see footnote #1 of
Workpaper 3). While obtaining an understanding of the billing process, auditors need to
ensure the client only bills for goods that have actually been shipped. Otherwise, the
auditor may need to extend procedures to audit items on backorder. The second
discrepancy involves a sales return which was in transit as of year-end (footnote #2 of
Workpaper 3). Because the audit will occur after year-end, the auditor will likely be able
to exam returned merchandise.
Other examples of overstatements in the simulation could result from: (1) billing
customers for sales that did not occur, or at least for sales that had not occurred as of
December 31st; (2) billing customers for more products than were actually shipped or
billing at higher prices than those on the approved price list; (3) shipping more goods
than the customer ordered; and (4) shipping products to customers who never ordered
the products.
Finally, we discuss controls which might prevent such errors; controls such as
having the shipping department verify that a customer purchase order exists for every
shipment and that the quantity shipped agrees with the quantity ordered. In the billing
department, controls should be in place to verify that a bill of lading exists before an
invoice is created and also to agree the prices on the invoice with the official price list.
9
Subsequent Discussions of Accounts Receivable
By the time the textbook we use covers accounts receivable our students have a
better background about auditing procedures. We again discuss conditions which might
explain discrepancies between the recorded balance and a customer’s response to the
confirmation. We also explain that auditors do not automatically accept the customer’s
response as correct. For such discrepancies, auditors examine source documents to
determine whether the amount the customer confirmed or the recorded balance is
correct. One method of auditing discrepancies is to vouch from the accounts receivable
subsidiary ledger to the invoice, bill of lading and purchase order. This is an opportunity
to reinforce that vouching to the invoice provides evidence the customer was billed for
the recorded amount; the bill of lading provides evidence the goods were actually
shipped to the customer; and the purchase order provides evidence the customer
actually ordered the goods.
This naturally leads to a discussion of alternative procedures. Rather than
vouching to the supporting documents, some auditors might prefer auditing subsequent
cash receipts.
Subsequent Discussions of Audit Sampling
In order to provide a framework to discuss the relationship between the quantity
of evidence and the risk of an incorrect conclusion, we cover audit sampling early in the
term. Later, when the text covers account receivable confirmations, we refer to the
simulation and again discuss the evaluation of sample results. Because this comes
toward the end of the term, we discuss possible implications of any material
10
misstatements detected by our substantive procedures. We ask students to consider if it
will be necessary to reassess control risk and extend our substantive tests.
Although Charles Cabinets is a private company, we discuss the implications
detection of material misstatements would have if this were an integrated audit for a
public company. For a public company, the existence of a material misstatement would
likely result in an adverse opinion regarding internal controls, even if the client agrees to
correct the misstatement.
Subsequent Discussions of Audit Documentation
Our students have difficulty grasping the importance of good audit
documentation. By including workpapers, the project exposes students to workpapers.
We frame discussions regarding audit documentation in terms of litigation. In case they
are ever required defend their conclusion to a jury, we stress that their documentation
may need to persuade a suspicious jury that they actually performed the procedures
and obtained sufficient evidence. PCAOB inspection reports substantiate the need for
proper documentation. A word search of one recent PCAOB inspection report revealed
seven instances where the PCAOB found no evidence in the audit firm’s documentation
that they had performed a required procedure.
Subsequent Discussions of Fraud
If you want to discuss fraud in accounts receivable, students can read the article
“Detecting Circular Cash Flow” in the Journal of Accountancy (Monhemius and
Durkin 2009). This article discusses how companies use receivables as collateral to
obtain loans which may create incentive to inflate receivables. It also illustrates the
limitations of confirmation procedures to detect sophisticated schemes used to inflate
11
receivables. In addition, the article points out various red flags that may indicate
fraudulent activities and helps students understand the need to be vigilant during the
confirmation process.
Grading
Grades in this course are based on 500 total points of which students can earn
25 points for successfully completing this project. The rubric in Appendix C was
developed from shortcomings we observed in student workpapers. The rubric is
segmented into five equally weighted components: timeliness, the material at the top of
the workpapers which is common to all three workpapers, and the procedural material
on Workpaper 1, Workpaper 2, and Workpaper 3. Students can earn up to 5 points for
each segment. We encourage students to think about what they are doing as they
complete the project because many of the procedures and concepts incorporated in the
project will be included on the exams.
12
Appendix A
Sampling Plan (AICPA Audit Guide: Audit Sampling)
The AICPA Audit Guide for audit sampling suggests the following questions be
addressed when planning a sampling procedure.
“2.30 The following questions apply to planning any audit sampling procedure, whether
it is nonstatistical or statistical:
• What is the test objective and relevant assertion? (What does the auditor want to
learn or be able to infer about the population? What assertions are being tested?)
• What is the auditor looking for in the sample? (How is a misstatement or
deviation defined?)
• What is to be sampled? (How is the population defined?)
• How is the population to be sampled? (What is the sampling plan, what is the
sampling unit, and what is the method of selection?)
• How much is to be sampled? (What is the sample size?)
• What do the results mean? (How are the sample results evaluated and
interpreted?)”
What is the test objective?
What assertions are being tested?
How is a misstatement defined?
How is the population defined?
What is the sampling unit?
What is the sample size?
What is the method of selection?
How are the sample results (to be)
evaluated?
What do the results mean?
Determine whether the accounts receivable
balance is materially overstated.
Materiality is defined as 10% of the accounts
receivable balance.
Existence; valuation and allocation
When the audited value for a customer’s
account as determined by confirmation or
alternative procedures does not agree with the
amount recorded in the accounts receivable
subsidiary ledger
All customer accounts included in the accounts
receivable subledger, which has been agreed to
the general ledger balance
Customer accounts in the accounts receivable
subsidiary ledger
Must be determined
Random sampling
Send positive confirmations to selected
customers
Perform alternative procedures for customers
who do not respond to confirmation requests
Perform a hypothesis test to statistically
generalize the sample results to the accounts
receivable balance.
Conclude on whether the accounts receivable
balance is materially overstated
13
Appendix B
Sample Size calculation
$2,371,983.60 BV book value
$2,550.52 ̅̅̅̅
𝐵𝑉 average book value
$237,198.36 TM tolerable misstate
$255.05 ̅̅̅̅̅
𝑇𝑀 average tolerable misstate
$2,134,785.24 BV - TM
$2,295.47 μ = ̅̅̅̅
𝐵𝑉 − ̅̅̅̅̅
𝑇𝑀 hypothetical mean
806.81 Sx standard deviation
Sx/√n
std error of the means
930
items in population
0.30 risk of incorrect rejection
1.04 Zα/2 number of std dev
0.15 risk of incorrect acceptance
1.04 Zβ number of std dev
̅̅̅̅
𝑇𝐸 = Zβ* Sx/√n + Zα/2* Sx/√n
(Zα
⁄2
√𝒏 = [
+ Zβ
) × sx
̅̅̅̅̅
𝑇𝑀
√𝒏 = 𝟔. 𝟓𝟖𝟎
rearrange the equation to solve for n
]
√𝒏 = [
(1.04 + 1.04 ) × $806.81
]
$255.05
𝒏 = 𝟒𝟑. 𝟐
Evaluation of Sample Results using a Hypothesis Test
During the planning phase, the standard deviation of the recorded values would be the
only value available to calculate the required sample size. If the sample results indicate
the standard deviation might actually be greater, we should consider using the standard
deviation of the sample results.
1.04
x 209.56
$ 217.95
+ 2,295.47
$ 2,513.42
Zβ number of std dev
Sx/√n std error of the means
allowance for sampling risk
μ hypothetical mean
Critical value
0.15 risk of incorrect acceptance
1,390.09 Sx std deviation of sample
44
sample size
$ 2,425.57 sample mean
The hypothetical mean is the book value less tolerable misstatement. We need
evidence indicating there is a low probability the true value is less than the hypothetical
mean. The critical value is calculated by adding an allowance for sampling risk to the
hypothetical mean.
In this example the $2,425 sample mean is less than the critical value indicating there is
unacceptable risk that accounts receivable might be is overstated. This indicates that
we need to obtain more evidence before we can conclude on the account.
If our sample mean exceeded the critical value we could conclude that the account is
not materially overstated. There is less than a 15% probability of selecting a sample
with a $2,513 mean from population with a $2,134,785 balance.
14
Evaluation by Comparing the Projected Sample Results to Tolerable
Misstatement
$ 2,550.52 ̅̅̅̅
𝐵𝑉 ave. book value
- 2,425.57 sample average
$ 124.95 average misstatement
0.15
1.04
x 209.56
$ 217.95
$ 2,371,983.60
- 2,255,775.24
$ 116,208.36
237,198.36
risk of incorrect acceptance $ 120,990.00
Zβ number of std dev
Sx/√n std error of the means
allowance for sampling risk
202,693.50
book value
projected value
projected misstatement
TM tolerable misstatement
allowance for sample risk
desired allowance
for sample risk
Alternatively, we reach the same conclusion by projecting the estimated misstatement
from our sample results to population. Although the $116,208 projected misstatement is
less than tolerable misstatement, accounting standards require us to add an allowance
for sampling risk. The difference between the projected misstatement and tolerable
misstatement results in a $120,990 allowance for sampling risk. A $202,693 allowance
for sampling risk would be necessary to achieve 15% Beta risk.
15
Appendix C
rubric for the simulation workpapers
1 Workpapers are turned in on time
2 Each workpaper includes the appropriate common information:
client name, transaction cycle, account, nature of test, objective,
s
assertions and tolerable error
s sign-off and date should be updated for each work paper
3 Workpaper 3
s
s
s
a dollar amount from a confirmation response or the results of the
alternative procedures, for each item in the sample
a tick mark for each discrepancy
sum, mean and standard deviation calculated from sample results
4 Workpaper 2
s
s
s
the required sample size calculation reflect this year’s population and
risk parameters
Zβ = 0.84, Zα/2 = 1.28, population size = 1,000, tolerable error
$290,814.44, and standard deviation = $1,204.33
critical value is calculated from sample results in workpaper 3
the conclusion is appropriate for the critical value
5 Workpaper 1
s sample size and dates in the procedure description are appropriate
s the conclusion is consistent with workpaper 2
16
References
AICPA Audit Sampling Guide Task Force. 2008 AICPA. Audit Guide: Audit Sampling,
2.30. New York: American Institute of Certified Public Accountants.
Auditing Standards Board. 2011. Statements on Auditing Standards 122-124,
York: American Institute of Certified Public Accountants.
New
Author 2009.
Monhemius, J., and Durkin, K. 2009. Detecting Circular Cash Flow. Journal of
Accountancy Vol. 208(6): 23-30. Retrieved from
http://www.journalofaccountancy.com/Issues/2009/Dec/20091793
Securities and Exchange Commission, 1940. Accounting Standards Release No. 19.
Dec, 5. In the Matter of McKesson & Robbins, Section 1, Summary of Findings and
Conclusions. Retrieved from http://sechistorical.org/museum/papers/1940/
17