a2m2 auditing accounts receivable accounts... · – cash management and operational...

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Auditing Accounts Receivable

A2M2/15/01


Learning Objectives

• Discuss typical audit risks and special considerations.

• Explain how to tailor a detailed audit plan to audit risk.

• Evaluate confirmation responses for propriety.

• Evaluate allowance for doubtful accounts for proper valuation.

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Receivables Defined

• Trade -- Claims for goods or services sold in the ordinary course of business.

• Non-trade -- Sale of assets, tax refund claims, dividends receivable, etc.

• Related party -- Due from employees, stockholders, officers, management, or affiliates.

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Trade Accounts Receivable

• Extension of short-term credit.

• Unsecured open accounts.

• Generally due within 30-90 days.

• Classified as notes receivable if formal written promise.

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Current vs. Long-Term

• Collectible within one year or the normal operating cycle, whichever is longer.

• All trade A/R considered current.

• Non-trade requires specific analysis.

• Notes receivable may be trade in nature, and current.

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A/R Related Fraud

• Fraudulent financial reporting:

– Lack of economic substance.

– Shipping goods to unauthorized parties.

– Manipulating shipping/billing records or other support.

– Revenue recognition criteria not met.

• Misappropriation of assets:

– Lapping.

– Fictitious customers.

– False credits, discounts, and other write-offs.

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Primary Assertions

1. Existence -- Authentic obligations.

2. Completeness -- All amounts included.

3. Rights -- Pledged/discounted/assigned.

4. Valuation -- Allowance adequate.

5. Accuracy or classification -- Related party.

6. Cut-off.

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Exhibit 1: Typical A/R AuditProcedures Case Study

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Converting A/R to Cash

• Sale of receivables (with or without recourse):

1. Transferred assets isolated, and not accessible by creditors.

2. Transferee has right to pledge or exchange assets.

3. Transferor does not maintain effective control over the assets through either:

• An agreement to repurchase before maturity, OR

• Ability to cause the transferee to return specific assets.

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Converting A/R to Cash

• A/R factoring (sale without recourse):

– Buyer assumes collectability risk.

– Buyer becomes the “factor” and assumes credit, billing and collection functions.

• Secured borrowing:

– When the above “sale” conditions are not met.

– Loans where A/R are simply assigned or pledged as security.

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Sales with Recourse

• Seller estimates the value of the recourse obligation as a liability.

• Estimate the amount that will be paid to the purchaser as a result of default of sold receivables:

– Recourse obligation is always exactly equal to the allowance for bad debts.

• Fee paid to factor is lower when sold with recourse.

• Recourse provisions may leave transferor with such significant control over assets (or retain large amount of risk) that transferred A/R may remain on the books of the transferor.

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Example Journal Entry –Sale with Recourse

• Dr. Cash – Amount actually received

• Dr. Receivable from Factor – Any amount withheld by the purchaser of the receivables.

• Dr. Allowance for Bad Debts – Amount of any previously established allowance related to receivables sold.

• Dr. Loss on Sale of Receivables – Difference.

• Cr. Accounts Receivable – Amount of receivables sold.

• Cr. Recourse Obligation – Amount of estimated liability.

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Factoring, Without Recourse

• Financial institution assumes the credit and collection function:

– Factor grants/denies credit.

– Factor handles A/R records.

– Factor bills customers.

– Factor makes collections.

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Cost of Factoring

• Charges generally exceed interest charges on loans:

– May charge 10-30 percent of net A/R purchased.

– May charge 3-5 percent of credit card A/R purchased.

– A/R generally used as collateral.

• Factor may withhold portion of purchase price for possible future charges for customer returns and other adjustments:

– Final settlement is made after A/R collected.

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Example Journal Entry –Factoring A/R

• Dr. Cash – Amount received from financing institution

• Dr. Receivable from Factor – Amount of any purchase price withheld (cash will be debited later when received)

• DR. Allowance for Bad Debts – Amount of any allowance previously established for factored receivables

• Dr. Loss from Factoring Receivables – Difference between net book value and total proceeds to be received

• Cr. Accounts Receivable – Amount of receivables factored

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Secured Borrowing

• Written note that provides for either general assignment of A/R or an assignment of specific A/R.

• Assignment of A/R -- No special accounting for the A/R itself on part of the borrower.

• Report note payable to lender – No special accounting.

– Any finance charge in addition to interest is recognized as expense at time of recognition of the liability.

• Disclose amount and nature of A/R pledged to secure obligation.

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Notes Receivable

• Unconditional written promise to pay a certain amount at a certain time, usually with interest charged:

– Implied interest if non-interest-bearing.

• Trade notes receivable -- Negotiable short-term instruments:

1. High dollar sale with extended credit terms.

2. Accounts receivable past due.

• Initial recognition -- Discounted PV method.

• When exchanged for non-cash items:

– PV equals current selling price of the items exchanged.

– Difference with amount to be collected at maturity = interest.

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Notes Receivable -- Non-Cash Exchange

• Valuation issues:

1. No stated interest rate.

2. Stated rate does not seem reasonable, given nature of transaction and surrounding circumstances.

3. Stated face amount significantly different from current cash equivalent sales price of non-cash items or similar notes.

• Record note at either:

– FV of non-cash items exchanged.

– FV of the note, if more clearly determinable.

• Difference between face of note and recorded value is a premium/discount that is amortized over life of note.

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External Confirmation Defined

• Audit evidence obtained as a direct written response to the auditor from a confirming third party:

– Either in paper form, electronic, or other medium.

– Oral response is considered to be alternative audit evidence.

• Management refusal is a scope limitation:

– Validity and reasonableness of basis for refusal.

– Implications on ability to gather sufficient appropriate evidence.

– Consult those with governance, as appropriate.

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Presumption of Confirmation

• Confirm existence of A/R presumed, unless:

– Total A/R is immaterial.

– Use of confirmations would be ineffective.

– Risk of material misstatement is “low” and other substantive procedures adequate to meet audit objective.

– Receivables are “non-trade” in nature.

• Must document if confirmations not used as an audit procedure.

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Selecting Items for Confirmation

• Confirm individual invoices or total customer balance outstanding.

• Individually significant items (quantitatively and qualitatively):

– Based on professional judgment.

• Coverage of population, using scope:

– Based on performance materiality/tolerable misstatement.

• Sampling (statistical or non-statistical method):

– Random, haphazard, or systematic.

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Positive vs. Negative Confirmation

• Positive:

– Statement whether agree or disagree with information provided.

• Negative:

– Ask for reply only if disagree with information provided.

– Used only if all criteria are met:

• Risk of material misstatement is “low.”

• Large number of small balances.

• Auditor believes confirmee will consider the request.

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Exhibit 2: Accounts Receivable Confirmation Case Study


A/R Valuation

• Value at net realizable value (NRV):

– Net of estimated uncollectible items.

• Direct write-off method:

– Debit bad debt expense and credit A/R at time deemed uncollectible.

– Not generally accepted since violates matching concept.

– Generally required by IRS in computing taxable income.

• Allowance method:

– Debit bad debt expense and credit allowance.

– Credit represents estimated future uncollectible accounts.

– Debit represents verified uncollectible accounts.

– Specific account write-offs applied against allowance.

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Methods for A/R Valuation

• Percentage of sales:

– Amount of uncollectible in past years relative to total credit sales.

– Percentage of estimated uncollectible.

– Modified for current period experience.

• Accounts receivable outstanding balance:

– Percentage of total A/R outstanding.

– Aging A/R most common method.

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Misstatements of A/R Valuation

• If provision too large… earnings and A/R understated:

– May be inadequate or excessive.

• Allowance should follow actual credit experience of business.

• Effect of change in accounting estimate made through bad debt expense.

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Monitoring Accounts Receivable

• Average collection period:

– Average A/R Outstanding/Average Daily Sales.

– Average Daily Sales = Net Sales/365.

– E.g., 102 days.

– $397,500/($1,425,000/365) = $397,000/$3,904.

• Average receivable turnover:

– Net Sales/Average A/R Outstanding.

– E.g., 3.6 times.

– $1,425,000/ $397,000 = 3.6 .

• Multiple internal control objectives:

– Cash management and operational effectiveness/efficiency.

– Reliable internal and external financial reporting.

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Exhibit 3: Valuation ofA/R Case Study

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