1. Copyright © 2007 Pearson Education Canada 1 Chapter 14: Completing the Tests in the Sales and Collection Cycle: Accounts Receivable

2. Copyright © 2007 Pearson Education Canada 14-2 Chapter 14 objectives  Describe the process for designing tests of details of balances for accounts receivable  Explain the relationship between transaction- related and balance-related audit objectives  Discuss analytical procedures for accounts receivable  Link detailed audit tests to audit assertions  Explain how sampling is used for tests of details

3. Copyright © 2007 Pearson Education Canada 14-3 Methodology for designing tests of details of balances for accounts receivable

4. Copyright © 2007 Pearson Education Canada 14-4 Audit tests to be performed are based upon assessed risks

5. Copyright © 2007 Pearson Education Canada 14-5 Effects of inherent and control risks

6. Copyright © 2007 Pearson Education Canada 14-6 Materiality considerations  Unless the organization is highly automated (e.g. with EDI, electronic data interchange), accounts receivable may be one of the largest amounts on the balance sheet  Transactions throughout the year that build the sales and accounts receivable balances are also normally significant

7. Copyright © 2007 Pearson Education Canada 14-7 Inherent risk considerations  Inherent risk tends to be moderate to low for all assertions except: – Realizable value (due to the judgment involved in assessing collectability) and – Cut-off for sales returns or allowances (in particular, warranty allowances or returns of goods on consignment may be difficult to estimate)

8. Copyright © 2007 Pearson Education Canada 14-8 Figure 14-1 and figure 14-2  14-1: After procedures to obtain an understanding and tests of controls we do tests of details  14-2: Designing tests of details rests on the previous work that has been done in the cycle

9. Copyright © 2007 Pearson Education Canada 14-9 Consider the relationship between transaction- related and balance-related audit objectives  Figure 14-3 shows how these audit assertions are related  This helps in designing dual purpose tests that can validate internal controls as well as provide substantive assurance  Pay special attention to occurrence/existence, completeness/existence (p. 420)

10. Copyright © 2007 Pearson Education Canada 14-10 Analytical procedures  Completed during three phases of the audit: – Planning (Phase I) – As part of substantive testing (Phase III) – As part of completing the audit engagement (Phase IV)

11. Copyright © 2007 Pearson Education Canada 14-11 Using analytical review to target detailed tests (see table 14-1)  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

12. Copyright © 2007 Pearson Education Canada 14-12 Examples of audit procedures by audit objective (assertion), Table 14-4  Detail tie-in: Add (foot) open-item file (sales, credit and cash receipts transactions) or the customer master file, and agree to the general ledger  Accuracy and existence: Confirm accounts receivable balances, performing alternative procedures for discrepancies and non- replies.

13. Copyright © 2007 Pearson Education Canada 14-13 Examples of audit procedures by audit objective (assertion), Table 14-4 (cont’d)  Completeness: Agree a sample of customer details from the underlying information systems records (data files) to the accounts receivable trial balance.  Classification: Review the receivables listed on the aged trail balance for notes receivable or related party transactions.

14. Copyright © 2007 Pearson Education Canada 14-14 Examples of audit procedures by audit objective (assertion), Table 14-4 (cont’d)  Cut-off: Select the last 40 sales transactions from the current year’s sales journal and the first 40 from the subsequent year’s, and trace each to the related shipping documents, checking for the date of actual shipment and ensuring the sales were recorded in the correct period.

15. Copyright © 2007 Pearson Education Canada 14-15 Examples of audit procedures by audit objective (assertion), Table 14-4 (cont’d)  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.

16. Copyright © 2007 Pearson Education Canada 14-16 Examples of audit procedures by audit objective (assertion), Table 14-4 (cont’d)  Rights and obligations: Review the minutes of the board of directors’ meetings for any indication of pledged or factored accounts receivable.  Presentation and disclosure: Enquire of management whether any receivables are pledged or factored.

17. Copyright © 2007 Pearson Education Canada 14-17 Practice problem 14-25 (p. 450)  A company is having collection problems  What would you do to investigate the causes?

18. Copyright © 2007 Pearson Education Canada 14-18 The power of confirmations  Useful for existence, accuracy and cutoff  A/R confirmations come in several forms: – Negative – Positive Individual item Balance owing

19. Copyright © 2007 Pearson Education Canada 14-19 Practice problem 14-24 (p. 450)  Confirmations have been returned with answers that do not match the records – what do you do?

20. Copyright © 2007 Pearson Education Canada 14-20 Positive vs. negative confirmations  Positive confirmations – More reliable evidence – Possible to conduct follow up if not answered  Use When – Individual balances relatively large – Fewer debtors – Evidence or suspicion of fraud or serious error

21. Copyright © 2007 Pearson Education Canada 14-21 Positive vs. negative confirmations  Negative confirmations – Failure to reply must be regarded as a correct response – Less expensive  Used When – Many homogenous balances – Small amounts owing – Internal controls strong – No evidence/suspicion of fraud or serious error

22. Copyright © 2007 Pearson Education Canada 14-22 Controlling and managing the confirmation process  1. Controlling the sending of confirmations  2. Procedures for those accounts the client does not want confirmed  3. Handling returned confirmations  4. Timing of alternative procedures and second requests  (All of the above illustrate components that affect the cost of this audit procedure.)

23. Copyright © 2007 Pearson Education Canada 14-23 1. Controlling the sending of confirmations  The client may assist in preparing the confirmations, but the auditor must due 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

24. Copyright © 2007 Pearson Education Canada 14-24 2. Procedures for those accounts the client does not want confirmed  Where the client does not want to have an account confirmed that has been selected by the auditor, this account needs to be treated like a non-response  This means that the auditor will apply alternative procedures to the amount

25. Copyright © 2007 Pearson Education Canada 14-25 3. Handling returned confirmations  Confirmations should be returned directly to the auditor’s offices  Differences between the client’s records and the confirmation reply need to be assessed to determine whether the difference is an error

26. Copyright © 2007 Pearson Education Canada 14-26 Types of differences  Differences between the client records and the confirmation could be due to: – Payment already made by the client (a potential cut- off error or simply due to the postal service) – Goods were not received (a cut-off error, a potential credit note, or timing difference) – Goods were returned (requiring a credit note) – Amounts are in dispute (perhaps requiring an allowance)

27. Copyright © 2007 Pearson Education Canada 14-27 4. Timing of alternative procedures and second requests  Second (or even third) requests can be sent if there is time  Such follow-up requests also need to be carefully controlled by the auditor  Alternative procedures are designed to provide adequate evidence with respect to existence, accuracy and cut-off

28. Copyright © 2007 Pearson Education Canada 14-28 Nature of alternative procedures  Review of subsequent cash receipts  Examination of duplicate sales invoices  Examination of supporting shipping documentation  Review of correspondence between the client and the customer

29. Copyright © 2007 Pearson Education Canada 14-29 Sampling and accounts receivable  Sampling is used to select the transactions that will be tested  For example, statistical sampling could be used to select accounts receivable for confirmation  In addition, directed sampling (choosing high dollar amounts or old accounts) would be used

30. Copyright © 2007 Pearson Education Canada 14-30 Practice problem 14-23 (p. 450)  Evaluate the sampling approach  Select the sample size  Evaluate results