Chapter 16Completing the Tests in the Sales and

Collection Cycle: Accounts Receivable(See Phase III in Figure 16-1 on page 485)

Now is the time to test the details

of balances.

Presentation Outline

I. Analytical Procedures

II. Designing Tests of Details of Balances

III. Confirmation of Accounts Receivable

IV. Sample Audit Program

I. Analytical Procedures for Accounts Receivable

A. Analytical Procedures Defined

B. Account Receivables that Deserve Special Attention

C. Some Typical Analytical Procedures

A. Analytical Procedures Defined

When analytical procedures in the sales and collection

cycle uncover unusual fluctuations, the auditor should make additional

inquiries of client management.

Client responses should be critically evaluated to

determine their adequacy and whether they are supported by other

corroborative evidence.

B. Account Receivables that Deserve Special Attention

Large balances may be overstated.

Accounts that have been outstanding for a long period of

time may not be collectible. Receivables from affiliated companies, officers, directors, and other related parties may

need separate disclosure. Significant credit balances may

need to be reclassified as a liability.

C. Some Typical Analytical ProceduresAnalytical Procedure Possible MisstatementCompare gross margin

percentage with previous years (by product line).

Overstatement or understatement of sales and

accounts receivable.

Compare sales returns and allowances as a percentage of

gross sales with previous years (by product line).

Overstatement or understatement of sales

returns and allowances and accounts receivable.

Compare bad debt expense as a percentage of gross sales with

previous years

Uncollectible accounts receivable that have not been

provided for.

Compare allowance for uncollectible accounts as a

percentage of accounts receivable with previous years.

Overstatement or understatement of allowance for uncollectible accounts and

bad debt expense.

II. Designing Tests of Details of Balances

A. Tie-in of Aged Trial Balance

B. Existence of Accounts Receivable

C. Completeness of Accounts Receivable

D. Accuracy of Accounts Receivable

E. Proper Classification of Account Receivable

F. Correct Cutoff of Sales and Receivables

G. Realizable Value

H. Client Rights to Accounts Receivable

I. Presentation and Disclosure of Accounts Receivable

A. Tie-in of Aged Trial Balance

Most tests of accounts receivable and the allowance for uncollectible accounts are

based on the aged trial balance (See Figure 16-3 on

page 491) The aged trial balance should

be tied into the control account on the general ledger

before other tests begin, in order to ensure that the total

population is being tested.

B. Existence of Accounts Receivable

When customers do not respond to confirmations,

auditors also examine supporting documents to verify the shipment of the

goods and evidence of subsequent cash receipts to determine if accounts were

collected.These additional audit

procedures are not as imperative when customers respond to confirmations.

C. Completeness of Accounts Receivable

The understatement of sales and accounts receivable is best

uncovered by substantive tests of

transactions for shipments made but not recorded, and by

analytical procedures.

D. Accuracy of Accounts Receivable

Confirmation of individual customer accounts is the

most common test of details for balances for

accounts receivable.Supporting documentation

for shipments and cash receipts can also be examined to support individual entries to customer accounts.

E. Proper Classification of Accounts Receivable

The aged trial balance can be reviewed for material

receivables from affiliates, officers, directors, and

other related parties. Such balances often require

segregation from accounts receivable and disclosure.

Significant credit balances in accounts receivable

should be reclassified as accounts payable.

F. Correct Cutoff of Sales and Receivables

Sales cutoff – the proper cutoff of sales can be easily verified when a client uses sequential prenumbered shipping

documents.Sales returns and allowances cutoff – most companies

record sales returns and allowances in the period they occur, assuming that they occur in fairly constant amounts over

time.Cash receipts cutoff – auditor may check to see if client is

holding the cash receipts book open, by tracing recorded cash receipts to subsequent period bank deposits on the

bank statement. A delay of several days could indicate a cutoff misstatement.

G. Realizable Value

GAAP requires that accounts receivable be stated at the

amount that will ultimately be collected (total A/R less allowance for doubtful

accounts). A common method of

evaluation is to examine noncurrent accounts on the

aged trial balance. The collectibility of more current accounts must also be

assessed.

H. Client Rights to Accounts Receivable

A portion of the receivables may have been pledged as collateral, assigned to someone else, or sold at a discount.

Customer confirmations will not uncover this since customers are often unaware of the arrangements.

A review of the minutes, discussions with the client, confirmation with banks, and the examination of debt

contracts may uncover such arrangements.

I. Presentation and Disclosure of Accounts ReceivableReceivables from officers

and affiliated companies must be segregated from accounts receivable from customers if the amounts

are material.Account receivable

footnote disclosure includes information about the pledging, discounting, factoring, assignment of accounts receivable, and amounts due from related

parties.

III. Confirmation of Accounts Receivable

A. The Confirmation Requirement

B. Types of Confirmations

C. The Acceptability of Negative Confirmations

D. Follow-up of Nonresponses to Positive Confirmations

E. Analysis of Differences

F. Factors Affecting Sample Size

A. The Confirmation Requirement

Accounts receivable are immaterial

Auditor considers confirmations to be ineffective evidence

because response rates will likely be inadequate.

The combined level of inherent risk and control

risk is low and other substantive evidence can

be accumulated to provide sufficient evidence.

Although auditing standards require confirmation of

accounts receivable, there are three

situations where they are deemed

unnecessary.

B. Types of Confirmations

Positive ConfirmationsRecipient is requested to

reply to the auditor whether the balance of the

account is correct or incorrect

More reliable than negative confirmations.

See Figure 16-5 on page 498.

Negative ConfirmationsRecipient is requested to

reply to the auditor only if the balance is incorrect.

The uncertainty associated with no response makes them less reliable than positive confirmation.

See Figure 16-6 on page 499.

Note: It is also common to use a combination of confirmations,sending the positives to accounts with large balances and the

negatives to those with small balances.

C. The Acceptability of Negative Confirmations

All three of the following conditions must be met

before an auditor can use negative confirmations:

Accounts receivable is made up of a large number of small

accounts. Combined assessed control

risk and inherent risk is low. Recipients of the

confirmations are likely to give them adequate

consideration.

D. Follow-up of Nonresponses to Positive Confirmations

Failure of customers to respond to initial confirmations often results in 2nd and possibly even 3rd confirmations being sent. When positive confirmations are used, SAS 67 requires follow-up

procedures for unreturned confirmations. Alternative procedures include:

Examination for subsequent cash receipt of the receivable. This approach is generally considered to be the best alternative

procedure. Verifying the issuance of the sales invoice and date of billing. Examination of shipping documents to determine if an actual

shipment occurred. Examining correspondence of disputed amounts between the

client and their customer.

Note: In some cases auditors will assume that nonresponses are 100percent overstatement amounts.

E. Analysis of Differences

Payment has already been made – customer has made a payment before the confirmation date, but the client has not received the

payment in time for recording before the confirmation date. Goods have not been received – client records the sale at the date

of shipment and the customer records the acquisition when the goods are received.

Goods have been returned – client’s failure to record a credit memo could result from timing differences or the improper

recording of sales returns and allowances. Clerical errors and disputed amounts – customer states that there

is an error in the price charged for the goods, the goods are damaged, the proper quantity of the goods was not received, etc.

Note: The analysis of differences is important because even immaterial errors may add up to a considerable amount when

combined with other misstatements.

F. Factors Affecting Sample Size

Tolerable misstatementInherent riskControl risk

Achieved detection risk from other proceduresType of confirmation (negative form requires

more confirmations)

IV. Sample Audit Program

See Table 16-5 on page 504 for an Illustration of an Audit Program for Tests of Details of Balances for the Sales and

Collection Cycle.

Summary

Analytical Procedures and Accounts Receivable Needing Special AttentionThe 9 Test of Balances AssertionsPositive and Negative ConfirmationAlternative Procedures for Lack of

Customer Responses to Positive Confirmation.