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

1. Completing the Tests in the Sales and Collection Cycle: Accounts Receivable

2. Designing Tests of Details of Balances • Audit Risk Model • Has to integrated with the design of tests • Thus need to consider • Inherent risk • the risk that the account, disclosure or financial statement note being is materially misstated • assessment of inherent risk depends on the professional judgment of the auditor, and it is done after assessing the business environment of the entity being audited. • Client controlled • Control risk • the risk that the system of internal control will not prevent or detect materially misstated • Client controlled • Detection risk • risk that auditor's procedures will fail to detect errors • Auditor controlled • Audit risk • Acceptable audit risk - indicates the auditor’s willingness to accept that the financial statements may be materially misstated after the audit is completed and an unqualified (clean) opinion was issued. • La lower audit risk means that the auditor wants to be even more certain that the financial statements are not materially misstated. • Want to always set priority at a low level (.0 1, 05, 10)

3. Types of Audit Tests and Audit Risk Model GAAS third examination standard The auditor must obtain sufficient appropriate audit evidence by performing audit procedures to afford a reasonable basis for an opinion regarding the financial statements under audit. Sufficient Appropriate Audit Evidence Audit Risk = = Risk Assessment Procedures Inherent Risk + x Procedures to understand internal control + Remember the relationship of risk to the amount of evidence. Control Risk Test of control + x Analytical Procedures + Detection Risk Test of details

4. The Audit of Accounts Receivable Must consider IR for A/R. Materiality for A/R is allocated from planning materiality. Probably want a low audit risk for A/R as it is usually material. E.g. 5% Set materiality. Assess Audit Risk for A/R. Conduct analytical procedures for planning purposes A/R is usually very material on both B/S and I/S. Even if A/R not large there are usually many sales on credit. Thus material Use last years assessed CR. If not available, estimate based on initial system review and discussions with client. Will eventually use the assessed materiality after testing. Assess Control Risk for sales and collections cycle Some parts of an audit may require additional substantive testing beyond was is normal. This could be due to increased chance of material misstatement or due to the significance of the item, E.G. intercompany A/R. i.e. Related party T/A Identify assertions where substantive testing is insufficient, and/or there is risk of material misstatement Design and perform test of control. Assess control risk Design test for those controls on which the auditor will rely. You cannot assess CR without testing e.g. Confirmations vs. Subsequent payments? e.g. Sample size will be affected by reliance on internal controls e.g. Monetary unit sampling could be used to select the actual items e.g. Low CR, could do substantive testing early Design and perform analytical procedures as substantive tests for accounts receivable balance Tests of details can be reduced if CR is low. Analytical procedures are performed as additional persuasive evidence. Amount of testing is indirectly related to DR The type of audit procedures? What is the sample size? Items to be selected? Timing – when to do the procedures? Design tests of accounts receivable balance to satisfy balance-related audit objectives.

5. Effects of Inherent and Control Risks Greater chance of missing material misstatement Thus a lot of substantive testing High Inherent or Control Risk Material misstatement will be caught by the system Thus substantive testing can be reduced, but not eliminated Low Inherent or Control Risk

6. Materiality Considerations • Accounts receivable may be one of the largest amounts on the balance sheet. • Unless the organization is highly automated (e.g. with EDI, electronic data interchange) • Sales and accounts receivable balances are normally significant. • Transactions happen continually throughout the year • They build the A/R balance • Thus typically very material

7. Inherent Risk Considerations • Inherent risk tends to be moderate to low for all assertions • What are the risk associated with Accounts Receivable? • The accounts receivable listing or individual balances may be inaccurate • Accounts receivable balances may not exist • Accounts receivable may not be collectible • Bad debts write-offs may not be valid • Sales transactions may be processed in the wrong period • High risk areas: • Realizable value • due to the judgment involved in assessing collectability • Cut-off for sales returns or allowances • in particular, warranty allowances or returns of goods on consignment • may be difficult to estimate Usually well controlled

8. Balance-Related Audit Objectives Both general and specific audit objectives or procedures. Specific audit objectives are procedures that are designed to meet general audit objectives. E.G. A/R confirmations meet the general audit objective of ownership. • Help auditor decide appropriate audit evidence • Accounts receivable exist • The A/R recorded in the accounts actually exist - existence • Accounts receivable are owned have not been sold or discounted • Right and obligations/ownership • There are no unrecorded accounts receivables • Completeness • Stated at NRV • Valuation. Thus this must include ADA • Accounts receivable are appropriately recorded and disclosed • Mathematical accuracy. I.e. Amounts to be received, adds & extensions etc. • Also allocation • Properly classified • Classification. E.g. Current vs. Long-term. Significant credit balances shown as payables • Aged trial balance agrees with the general ledger • Detail tie-in • Accounts receivable are recorded in the correct period • Cut-off More specific than general audit objectives

9. Disclosure-Related Audit Objectives • Presentation and disclosure in the financial statements • Accounts receivable transactions actually occurred • The sales transactions actually happened • Accounts receivable are amounts collectible by the client • Right and obligations/ownership • Disclosures for accounts receivables are fully included • Completeness • Accounts receivable in the financial statements are materially correct • Mathematical accuracy. I.e. Amounts to be received, adds & extensions etc. • Shown at amounts that are collectible • Valuation. Again this must include ADA • Correctly shown as current and long-term • Classification. Current means within the current fiscal year. • Both financial and non-financial is clearly disclosed • understandability

10. Relationship Between Transaction-Related and Balance-Related Audit Objectives This helps in designing dual purpose tests that can validate internal controls as well as provide substantive assurance. Also show how the test validates the transaction as well as the balance.

11. Occurrence transaction-related audit objective for sales and the Existence balance-related audit objective • For sales, the audit objective occurrence shows that • the transaction actually happened • For accounts receivable, the audit object of existence shows that • the A/R actually exists • From the point of control risk • If auditor concludes that control risk over sales is low • Auditor can also conclude that controls over balance-related audit object for A/R are effective • Tests are serving a dual purpose • Also, by performing accounts receivable confirmations • Shows existence of the A/R and occurrence of the sales

12. Completeness transaction-related audit objective for cash receipts and the Existence balance-related audit objective • For cash receipts the audit objective completeness shows that • all cash receipt transactions have been included • These are subsequent payments on A/R • For accounts receivable the audit object shows that • the A/R actually exists • From the point of control risk • If auditor concludes that control risk over cash receipts is low • Auditor can also conclude that controls over balance-related audit object for A/R are effective • Again, the tests are serving a dual purpose • Thus by performing subsequent payments • Shows existence of the A/R

13. Analytical Procedures • Analytical procedures are important • They typically supply additional supportive evidence • But remember that analytical procedures are used during three main phases of the audit: • Planning • Phase I • E.g. could reveal areas of high risk • As part of substantive testing • Phase III • The additional supportive evidence • As part of completing the audit engagement • Phase IV • Performed by manager and partner in assessing fair presentation

14. Using Analytical Review to Target Detailed Tests • Helpful analyses could include comparing: • Sales by month • Sales returns and allowances • Individual customer balances • Bad debt expense to gross sales • Number of days in A/R • Aging categories • Allowance for uncollectible accounts • To what would these items be compared? • Prior years • Budgets • Industry • What is the auditor looking for?

15. The Audit Objective and the Audit Procedure • Existence and accuracy: • Confirm accounts receivable balances • Use of MUS • performing alternative procedures for discrepancies and non-replies. • Subsequent payments • If low CR • Examine sales invoices

16. Rights and obligations: • Could also say the ownership of the asset • Confirmations and subsequent payments • But what is done about pledged or factored accounts receivable? • Review the minutes of the board of directors’ meetings for any indication of pledging or factoring

17. Valuation: • What is the important valuation account in relation to accounts receivable? • Allowance for doubtful accounts • Thus pertinent procedures for valuation? • Discuss with the credit manager the likelihood of collecting older accounts • identified by means of generalized audit software or by review of the aged accounts receivable trial balance • Examine subsequent cash receipts on these accounts and evaluate the collectability.

18. Completeness: • Trace a sample of customer details from the underlying information systems records (data files) or sales invoices to the accounts receivable trial balance. • Classification: • Review the receivables listed on the aged trail balance for notes receivable or related party transactions. • Examine listing for A/R that would be long-term

19. Cut-off: • Select the last 40 sales transactions from the current year’s sales journal and the first 40 from the subsequent year’s • Trace each to the related shipping documents, checking for the date of actual shipment and ensuring the sales were recorded in the correct period. • Detail tie-in: • Foot the customer master file • and agree to the general ledger • Presentation and disclosure: • Ensure full and complete disclosure in the financial statements • This is important when it comes to factored or pledged A/R • Theses must be disclosed as such • Enquire of management whether any receivables are pledged or factored.

20. The Power of Confirmations • A very important audit procedure • McKesson & Robbins 1937 • Fraud case • Required inventory observation and A/R confirmations • Useful for existence • If confirmed then asset exists • Also show accuracy • And cutoff. Shows if asset is recorded in the correct period. • remember must investigate timing differences • A/R confirmations come in two forms: • Negative • No response is required. If no response, assumed to be correct • Positive • A response is requested

21. Positive vs. Negative Confirmations • Positive confirmations • A more reliable form of evidence for A/R • requires the customer to respond to the auditor whether the customer's records do or do not correspond with the auditor's records. • Can use a listing of invoices • Useful if the debtor has a voucher system • if not answered • conduct alternate procedures • Subsequent payments, agree to sales invoices • When are they used? • Individual balances are • relatively large • Using MUS these balances will usually be chosen • Because they contain a lot of dollar units • And/or • Fewer debtors • Evidence or suspicion of fraud or serious error • is the more involved of the two options, so it is more likely to be used if the company's books are suspected to have errors.

22. Note there are different forms of positive confirmation. An alternative is to have it sent by the auditor instead of the client. There is an example of this in the text on page 512. • As stated on the previous slide the auditor could show a list of invoices. ABC Company Letterhead ABC Company 1234 Main Street Winnipeg, Manitoba R3R 3R3 15 January, 201Y To Whom it May Concern: This request is being sent to you to enable our independent auditors to confirm the correctness of our records. It is not a request for payment. Your prompt attention to this request will be appreciated. An stamped envelope is enclosed for your reply. Our records on December 31, 201X showed an amount of $2,987.50 receivable from you. Please confirm whether this agrees with your records on that date by signing and returning this form directly to our auditors, CHAMBERS & FORD. An addressed envelope is enclosed for this purpose. If you find any difference please report details directly to our auditors in the space provided below. Sincerely, ……………………………………Jean Fellows, Controller Confirmation The balance receivable from us for $2,987.50 as of December 31, 201X is correct except as noted below: ___________________________________________________________________________________________________________ ___________________________________________________________________________________________________________ ___________________________________________________________________________________________________________ ABC Company Date ………………………………………. By …………………………………………..

23. Negative confirmations • Failure to reply • Negative confirmation requires a response only if there is a discrepancy. • regarded as a correct response • Less expensive • When are they used? • Many homogenous balances • Small amounts owing • Internal controls strong. Great emphasis here. • No evidence/suspicion of fraud or serious error • Often used for retail stores, banks, municipalities • Here the A/.R are due from the public

24. Again there are different forms of negative confirmation. An alternative is to have it sent by the auditor instead of the client. There is an example of this in the text on page 513 ABC Company Letterhead ABC Company 1234 Main Street Winnipeg, Manitoba R3R 3R3 15 January, 201Y To Whom it May Concern: This request is being sent to you to enable our independent auditors to confirm the correctness of our records. It is not a request for payment. Our records on December 31, 201X showed an amount of $2,987.50 receivable from you. If it does NOT agree with your records, please report any exceptions directly to our auditors, CHAMBERS & FORD. An addressed envelope is enclosed for this purpose. . Sincerely, ……………………………………Jean Fellows, Controller Differences ___________________________________________________________________________________________________________ ___________________________________________________________________________________________________________ ___________________________________________________________________________________________________________ ABC Company Date ………………………………………. By …………………………………………..

25. Controlling and Managing the Confirmation Process Look at the following points: • Controlling the sending of confirmations • Procedures for those accounts the client does not want confirmed • Handling returned confirmations • Timing of alternative procedures and second requests • All of the above illustrate components that affect the cost of this audit procedure. • Auditor must also decide • which type of confirmation to use • Timing of the confirmation • Sample size • Items to be selected

26. 1. Controlling the Sending of Confirmations • The client may assist in preparing the confirmations • but the auditor must do the actual mailing • off the client premises • If the client stuffs and stamps the envelopes • this must be supervised • Return envelopes • should bear the auditor’s address, not the client’s • should be stamped for easy return

27. 2. Procedures for those Accounts the Client does not want Confirmed • If it has been selected by the auditor • this account needs to be treated like a non-response • The auditor will apply alternative procedures to the amount • Subsequent payments • Duplicate sales invoices • Shipping documents • Customer correspondence with the client • Can be used to resolve disputed items

28. 3. Handling Returned Confirmations • Confirmations should be returned directly • to the auditor’s offices • Why? • Better evidence. More objective & independent • Cannot be interfered with by the client • Differences between the client’s records and the confirmation reply • need to determine if the difference is an error • The effect of an error? • Material? • More often it is a timing difference

29. Types of differences between client and customer • Differences between the client records and the confirmation could be due to: • Payment already made by the client • A timing difference between client records and customer records • Thus customer made a payment before the confirmation date • There could be a question of a cash receipts cut-off misstatement • Goods were not received • A timing difference for goods in transit • The client records the sales on shipment but the customer records on receipt • An audit question: • Did the customer receive the goods? Needs follow up. Maybe a second confirmation. • Goods were returned • Could be a timing difference between customer and client for the return • Or the client may not have issued a credit note. • A credit not would be required • Amounts are in dispute • Damaged goods, error in prices • Need to see if this is an error

30. 4. Timing of alternative procedures and second requests • Second requests can be sent • if there is time • maybe even a third request • Control of such follow-up requests • also need to be carefully controlled by the auditor • Alternative procedures • designed to provide adequate evidence with respect to existence, accuracy and cut-off

31. Nature of Alternative Procedures • Review of subsequent cash receipts • Examine remittance advices • High quality evidence • Customer would not pay it if they did not owe it • Main difficulty: payment does not mean it was an obligation at the balance sheet date • Examination of duplicate sales invoices • Shows the date of the invoice and billing date • Good evidence if there are strong controls and thus low CR as tested • Examination of shipping documentation • Establishes if shipment was made • Good cutoff test • More reliable if controls over shipping documents are good • Review of correspondence between the client and the customer • Not usually done unless there are items in dispute • Used to determine the treatment of such item

32. Sampling and Accounts Receivable • Sampling is always used to determine which accounts receivable will be selected • The type of sampling depends on the auditor’s judgement • Statistical sampling could be used to select accounts receivable for confirmation • Common method is Monetary Unit Sampling • Or directed sampling • choosing high dollar amounts or old accounts could be used

33. How Does Monetary Unit Sampling Work? • Auditors usemonetary unit sampling, also called probability-proportional-to-size or dollar-unit sampling, to determine the accuracy of financial accounts.With monetary unit sampling, each dollar in a transaction is a separate sampling unit. A transaction for $40, for example, contains 40 sampling units. Auditors usually use monetary unit sampling to sample and test accounts receivable. • Here’s an example of how monetary unit sampling works The audit client’s accounts receivable book value is $300,000, and the sample size is set at 96 records. • Figure the sampling interval by dividing book value by sample size • (300,000/96) = 3125 • Arrange the client’s accounts receivable in an ordered list using some sort of ordering sequence. • For example, you can arrange them alphabetically by customer name or numerically by customer number. • Pick a random number between 1 and 3,125. • For this method to work correctly, the random number has to be less than the sampling interval and greater than the smallest sampling unit. Auditors usually use a random-number-generator computer program to pick the random number. The sampling unit and sampling interval limits are programmed into the software before the task is run. In this case, say the software selects the random number 556.

34. First, pick the records to test: Take the alphabetically ordered list shown in the Customer Name column, which lists every customer balance by dollar amount, and count each dollar until getting to $556. The random number generator gives the number 556 in Step 3 in the previous slide. The cumulative dollar amount for ABC Electric is under $556. That shows that the first sampling item is Best Friend Cat Care, which at a cumulative total of $1,220 is the first customer in the list with a cumulative balance over $556. Best Friend Cat Care becomes the first customer in the sample. Secondly, select the next invoice to sample: Add the sampling interval of $3,125 to the random number of $556. This equals $3,681, which is the next sampled item dollar amount. Brandy’s Grill at $2,730 cumulatively is under $3,681, thus Brandy’s is skipped. Buddy’s Gas Station has the 3,681st dollar. To pick the next sampling item: Add the sampling interval of $3,125 to the prior sampling item of $3,681, which equals $6,806, and so on until the last name in the customer list is reached. This will give the total sample size of 96. When sampling, misstatements are being looked for. If a selected customers invoice should have been entered for $986, for example, and it was entered as $896, there is a misstatement. If the total misstatements exceed the tolerable level, there may be a material misstatement.

35. Example of Misstatements from MUS • Assume that there are the following misstatements:

36. Note in the following table, the conservative approach is to associate the lowest misstatement limit (2) portion with the highest misstatement unit error (4) .The amount of error is thus maximized Overstatements * * These amounts come from the previous slide. Only overstatements.

38. Understatements

39. Offsetting Adjustments Thus the likely misstatement is between $116,900 and 117,570. Since materiality is $100,000, more work needs to be performed.

40. Problem 11-2, Page 472 Cash: Substantive Audit Procedures on Bank Reconciliation: The following auditee-prepared bank reconciliation is being examined by you during an audit of the financial statements of Cynthia Company: Required: Indicate one or more audit procedures that should be performed in gathering evidence in support of each of the items (a) through (f) above. (AICAP Adapted)

41. Basic audit procedures that should be performed in gathering evidence in support of each of the items (a) through (f) of the CYNTHIA COMPANY bank reconciliation are as follows: • Balance per bank • Confirmation by direct written communication with bank (see Standard Bank Confirmation). • Obtain and inspect a January cutoff bank statement obtained directly from the bank (examine opening balance). • Deposit in transit • Verify that the deposit was listed in the January cutoff bank statement on a timely basis. • Trace to the cash receipts journal. • Inspect the auditee's copy of the deposit slip for the date of the deposit. • Outstanding cheques • Examine cheques accompanying the January cutoff bank statement and trace all 20x0, or prior, cheques to the outstanding cheque list. • Trace outstanding cheques to the cash disbursements journal. • Examine all supporting documents for those outstanding cheques that were not returned with the cutoff bank statement. • Ascertain why cheque number 837 has been outstanding for so long. • NSF cheque return • Follow up on the ultimate disposition of the NSF cheques. • Examine all supporting documents. • Note collected • Examine the bank credit memo. • Trace to accounting records. • Balance per books • Foot the bank reconciliation to this total and compare with the general ledger balance.

42. Problem 11-4, Page 473 Alternative Accounts Receivable Procedures. Several accounts receivable confirmations have been returned with the notation “verification of vendor statements is no longer possible because our data processing system does not accumulate each vendor’s invoices.” Required: What alternative auditing procedures could be used to audit these accounts receivable? (AICPA Adapted)

43. The auditor can consider alternative confirmation methods to test the accounts receivable balance, such as confirming individual invoices in the balance. Auditing procedures other than confirmation which may be used to verify an account receivable include: • Examination of evidence of subsequent payment of the account including: • The customer's remittance advice accompanied by the payment. • The cheque sent in by the customer. • An authenticated bank deposit ticket listing a deposited cheque for the outstanding account. • An entry in the cash receipts book. • A credit posted to the customer's account. • Examination of other evidence including: • Shipping department's notice of shipment, accompanied possibly by a receipted copy of the bill of lading, the customer's purchase order, sales invoices, and any correspondence referring to the shipment of the goods. • Entries removing the goods from inventory. • Time records and work orders, if appropriate. • External inquiries as to the existence and credit rating of the debtor. • Discussion of the account with the auditee's credit manager, examination of credit department records, and records of merchandise returned, and such other investigation as may lead to better understanding of the nature of the account and its collectability.