Chapter 16 Completing the Tests in the Sales and Collection Cycle: Accounts Receivable

aged trial balance

- a listing of the balances in the accounts receivable master file at the balance sheet date broken down according to the amount of time passed between the date of sale and the balance sheet date - auditors test the information for detail tie-in before any other tests to verify that the population being tested agrees with the general ledger and accounts receivable master file - auditor's should trace a sample of individual balances to supporting documents, to verify the customer's name - audit software is often used to perform tests

invoice confirmation

- a type of positive confirmation in which an individual invoice is confirmed, rather than the customer's entire accounts receivable balance - many customers use voucher systems that allow them to confirm individual invoices but not balance information - may improve confirmation response rates - also result in fewer timing differences and other reconciling items than balance confirmation - have the disadvantage of not confirming ending balances

evidence planning worksheet

- an aid for the auditor to decide the extent of planned tests of details of balances - rows: o performance materiality o acceptable audit risk o inherent risk o control risk o substantive tests of transactions results o substantive analytical procedures o planned detection risk and planned audit evidence - columns = tests of details of balance objectives

design and perform tests of details of accounts receivable balance

- appropriate tests depends on the factors listed in the evidence planning worksheet - task of combining factors that determine planned detection risk is complex because the measurement is imprecise and the appropriate weight given to each factor is highly subjective - the relationship between each factor and planned detection risk is well established

setting performance materiality

- auditor first decides the preliminary judgement about materiality for the entire financial statements - then allocates the preliminary judgement amount to each significant balance sheet account

accounts receivable presentation and disclosure

- auditor must have a thorough understanding of accounting standards and presentation and disclosure requirements - auditor must understand and evaluate the appropriateness of the client's revenue recognition policy to determine whether it's properly disclosed in financial statements - auditor must also decide whether the client has properly aggregated amounts and disclosed related party information in the statements - an important part of the evaluation involves deciding whether the client has separated material amounts requiring separate disclosure in the statements

positive confirmation

- communication addressed to the debtor, requesting that the recipient indicate directly on the letter whether the stated account balance is correct or incorrect and, if incorrect, by what amount - nonresponses do not provide audit evidence - it's necessary to follow up on nonresponses with alternative procedures

negative confirmations

- communication, addressed to the debtor, requesting a response only if the recipient disagrees with the amount of the stated account balance - failure to reply must be regarded as a correct response, even though the debtor may have ignored the confirmation request - are less expensive to send - cost less because there are no second requests and no follow-up of nonresponses - auditor puts considerable emphasis on the effectiveness of internal controls, substantive tests of transactions, and substantive analytical procedures - often used for audits of hospitals, retail stores, banks, and other industries in which the receivables are due from the general public

blank confirmation form

- communication, addressed to the debtor, requesting the recipient to fill in the amount of the accounts receivable balance - considered a positive confirmation - more reliable than confirmations that include balance information - rarely used in practice because they often result in lower response rates

accounts receivable are accurate

- confirmation of accounts selected from the trial balance is the most common test of details of balances - when customers do not respond to confirmation requests, auditors examine supporting documents - auditors perform tests of of the debits and credits to individual customers' balances by examining supporting documentation for shipments and cash receipts

recorded accounts receivable exists

- confirmation of customers' balances is the most important test of balances for determining the existence of recorded accounts receivable - auditors will also examine supporting documents to verify the shipment of goods and evidence of subsequent cash receipts to determine whether the accounts were collected

verification of addresses and maintaining control

- confirmations sent by mail, the auditor must maintain control of the confirmations until they are returned from the customer - client may assist with preparing the confirmations, but the auditor must be responsible for mailing them outside the client's office

designing tests of details of balances

- even though auditors emphasize balance sheet accounts in tests of details of balances they are not ignoring income statement accounts because the income statement accounts are tested as a by-product of the balance sheet tests - the audit procedures selected and their sample size will depend heavily on whether planned evidence for a given objective is low, medium, or high - most tests of accounts receivable and the allowance for uncollectible accounts are based on the aged trial balance

confirmation of accounts receivable

- is the most important test of details of accounts receivable - the primary purpose is to satisfy the existence, accuracy, and cutoff objectives - can be a direct written response from a third party in paper or electronic form - can be a response through a third-party confirmation service provider - may also include information the auditor is able to obtain through direct access provided by a third party to information held by the third party - oral responses are not a confirmation

existing accounts receivable are included

- it's difficult for auditors to test for account balances omitted from the aged trial balance except by relying on the self-balancing nature of the accounts receivable master file - if all sales to a customer are omitted from the sales journal, the understatement of accounts receivable is almost impossible to uncover by tests of details of balances - unrecorded sales to a new customer are difficult to identify for confirmation because the customer is not included in the accounts receivable master file - understatement of sales and accounts receivable is best uncovered by substantive tests of transactions for shipments made but not recorded

follow-up of nonresponses

- it's inappropriate to regard confirmations mailed but not returned by customers as significant audit evidence - for negative confirmations, the auditor should not conclude that the recipient received the confirmation request and verified the information request - auditing standards require follow-up procedures for confirmations not returned by the customer when positive confirmation are used

cutoff misstatements

- misstatements that take place as a results of current period transactions being recorded in a subsequent period, or subsequent period transactions being recorded in the current period - objective is to verify whether transactions near the end of the accounting period are recorded in the proper period - can occur for sales, sales returns and allowances, and cash receipts

timing

- most reliable evidence from confirmations is obtained when they are sent as close to the balance sheet date as possible - permits the auditor to directly test the accounts receivable balance without making any inferences about the transactions taking place between the balance sheet date and confirmation date - often necessary to confirm the accounts at an interim date - if the decision is made to confirm accounts receivable before year end, the auditor typically prepares a roll-forward that reconciles the accounts receivable balance at the confirmation date to accounts receivable at the balance sheet date

design and perform substantive analytical procedures

- most substantive analytical procedures performed during the detailed testing phase are done before tests of details of balances since the results of the substantive analytical procedure affect the extent of detail testing - auditors perform both planning and substantive analytical procedures for the entire sales and collection cycle, not just accounts receivable - auditor's conclusions for the sales and collection cycle are incorporated in the evidence-planning worksheet - if results are favorable o they reduce the extent to which the auditor needs to perform detailed tests of balances - if the results uncover unusual fluctuations o the auditor should make additional inquiries of management

accounts receivable are properly classified

- normally can evaluate easily by reviewing the aged trial balance for material receivables from affiliates, officers, directors, or other related parties or by using audit software to identify related party balances - auditors should verify that notes and accounts receivables that should be classified as noncurrent assets are separated from regular accounts - significant credit balances in accounts receivable are reclassified as accounts payable - auditor must make sure that the classifications are properly presented by determining whether related party transactions are properly aggregated and correctly shown in the financial statements to satisfy the presentation objective

the client has rights to accounts receivable

- ordinarily cause no audit problems because the receivables usually belong to the client - to uncover instances in which the client has limited rights to receivables, the auditor may review the minutes, discuss with the client, confirm with banks, examine debt, contracts for evidence of accounts receivable pledged as collateral, and examine correspondence files

methodology for designing tests of details of balances for accounts receivable

- phase I o identify significant risks and assess risk of material misstatements for accounts receivable o set performance materiality for accounts receivable o assess control risk for sales and collection cycle - phase 2 o design and perform tests of controls and substantive tests of transactions for sales and collection cycle, including disclosures - phase 3 o design and perform substantive analytical procedures for accounts receivable balance o design tests of details of accounts receivable balances and related disclosures to satisfy balance-related audit objectives

design and performs tests of controls and substantive tests of transactions

- results of the tests of controls determine whether assessed control risk for sales and cash receipts needs to be revised - auditors use the results of the substantive tests of transactions to determine the extent to which planned detection risk is satisfied for each AR balance-related audit objective

identify significant risks and assess the risk of material misstatement for accounts receivable

- tests are based on the auditor's risk assessment procedures that provide an understanding of the client's business and industry - auditor evaluates management objectives and business processes to identify significant client business risk that could affect the financial statements - auditors assess inherent risk for each objective for an account, considering client business risk and nature of the client and industry - auditor performs preliminary analytical procedures that may indicate increased risk of misstatements - as part of assessment of the risk of material misstatement, the auditor determines whether any risks identified are a significant risk

realizable value of accounts receivable

- the amount of the outstanding balance in accounts receivable that will ultimately be collected - auditor reviews the results of the tests of controls that are concerned with the client's credit policy - auditors often examine the noncurrent accounts on the aged trial balance to determine which ones have not been paid subsequent to the balance sheet date - auditors also gain insights into the collectibility of the accounts by examining credit records, discussions with the credit manager, and review of the client's correspondence file

drawing conclusions

- when all differences have been resolved, the auditor must reevaluate internal controls - each client misstatement must be analyzed to determine whether it was consistent or inconsistent with the original assessed level of control risk - if a significant number of misstatements are inconsistent with the assessment of control risk, it's necessary to revise the assessment and consider the effect of the revision on the audit - auditor should always evaluate the qualitative nature of the misstatements found in the sample - final decision about accounts receivable and sales is whether sufficient appropriate evidence has been obtained through tests of controls and substantive tests of transactions, substantive analytical procedures, cutoff procedures, confirmation, and other substantive tests

accounts receivable balance-related audit objectives

1. accounts receivable in the aged trial balance agree with related master file amounts, and the total is correctly added and agrees with the general ledger (detail tie-in) 2. recorded accounts receivable exist (existence) 3. existing accounts receivable are included (completeness) 4. accounts receivable are accurate (accuracy) 5. cutoff for accounts receivable is correct (cutoff) 6. accounts receivable are stated at realizable value (realizable value) 7. accounts receivable are correctly classified (classification) 8. the client has rights to accounts receivable (rights) 9. accounts receivable are appropriately aggregated and clearly described, and related disclosures are relevant and understandable (presentation)

aspects auditors are concerned with of internal controls

1. controls that prevent or detect embezzlements 2. controls over cutoff 3. controls related to the allowance for uncollectible accounts

approach to determine reasonableness of cutoff

1. decide on the appropriate criteria for cutoff 2. evaluate whether the client has established adequate procedures to ensure a reasonable cutoff 3. test whether the cutoff was correct

balanced-related audit objectives

1. detail tie-in 2. existence 3. completeness 4. accuracy 5. cutoff 6. realizable value 7. classification 8. rights 9. presentation

what auditors should review accounts receivable for

1. large and unusual amounts, such as large balances 2. accounts that have been outstanding for a long time 3. receivables from affiliated companies, officers, directors, and other related parties 4. credit balances

differences in confirmations

1. payment has already been made 2. goods have not been received 3. the goods have been returned 4. clerical error and disputed amounts

factors affecting sample size for confirming accounts receivable

1. performance materiality 2. inherent risk 3. control risk 4. achieved detection risk from other substantive tests 5. types of confirmation

types of confirmation

1. positive confirmation 2. negative confirmation

what do auditor's test of details of balances for accounts receivable include

1. recorded accounts receivable exist 2. existing accounts receivable are included 3. accounts receivable are accurate 4. cutoff for accounts receivable is correct 5. accounts receivable is stated at net realizable value 6. accounts receivables are properly recorded 7. the client has rights to accounts receivable 8. accounts receivable presentation and disclosure

circumstances to use negative confirmations as sole substantive audit procedure

1. the auditor has assessed the risk of material misstatement as low and has obtained sufficient appropriate evidence regarding the design and operating effectiveness of controls relevant to the assertion being tested by the confirmation procedure 2. the population of items subject to negative confirmation procedures is made up of a large number of small, homogeneous account balances, transactions, or other items 3. the auditor expects a low exception rate 4. the auditor reasonably believes that recipients of negative confirmation requests will give the requests adequate considerations

external confirmations are not appropriate for accounts receivable

1. the overall accounts receivable balance is immaterial 2. the auditor considers confirmation ineffective evidence because response rates will likely be inadequate or unreliable 3. the auditor's assessed level of the risk of material misstatement is low and other substantive evidence can be accumulated to provide sufficient evidence

timing difference

a reported difference in a confirmation from a debtor that is determine to be a timing difference between the client's and debtor's records and therefore not a misstatement

possible misstatement: uncollectible accounts receivable that have not been provided for

analytical procedures: - compare bad debt expense as a percentage of gross sales with previous years

possible misstatement: overstatement of understatement of sales and accounts receivable

analytical procedures: - compare gross margin percentage with previous years (by product line) - compare sales by month (by product line) over time

possible misstatement: misstatements in accounts receivable and related income statement accounts

analytical procedures: - compare individual customer balances over a stated amount with previous years

possible misstatement: overstatement or understatement of allowance for uncollectible accounts and bad debt expense

analytical procedures: - compare number of days that accounts receivable are outstanding with previous years and related turnover of accounts receivable - compare aging categories as a percentage of accounts receivable with previous years - compare allowance for uncollectible accounts as a percentage of accounts receivable with previous years - compare write-off of uncollectible accounts as a percentage of total accounts receivable with previous years

possible misstatement: overstatement or understatement of sales returns and allowances and accounts receivable

analytical procedures: - compare sales returns and allowances as a percentage of gross sales with previous years (by product line)

significant risk

represents an identified and assessed risk of material misstatement that, in the auditor's professional judgement, requires special audit consideration

developing tests of details audit program

the determination of the development of audit program procedures is based on the tests of controls and substantive tests of transactions

alternative procedures

the follow-up of a positive confirmation not returned by the debtor with the use of documentation evidence to determine whether the recorded receivables exist and was properly stated at the confirmation date