Ch 3

Audit of the Sales and Collection Cycle

The Sales and Collection Cycle
 The Sales and Collection Cycle includes all of the
following processes:
 Receiving a customer’s order
 Approving credit for a sale
 Determining whether goods are available for sale
 Shipping the goods
 Billing the customers
 Collecting cash
 Recognizing the effect of these processes in accounting
records
YA AAUSC 1
..3.1 Audit of the Sales and Collection
Cycle

Significance of the sales and

collection cycle:
A company’s sales and collection
cycle reflects its operations.
This makes sales transactions to be
always material/significant to the
company’s financial statement
YA AAUSC 2
..3.1 Audit of the Sales and Collection
Cycle
Major Risks on which auditors focus in this
cycle
 The risk related to revenue recognition (usually
overstating revenue)
 SEC studies show, the majority of financial
statement manipulations and audit failures
involve misstatement of revenue (particularly
overstatements of revenues), which implies that
sales and collection cycle must be examined with
great care.
YA AAUSC 3
..3.1 Audit of the Sales and Collection
Cycle

The overall objective in the audit of

the sales and collection cycle:
 The objective of audit of the sales and
collection cycle is to evaluate whether
the account balances affected by the
cycle are fairly presented in
accordance with accounting standards.
YA AAUSC 4
 Classes of transactions and accounts in
Sales and Collection Cycle
Five Classes of transactions in sales and Accounts in each classes of
collection cycle transactions in sales and
collection cycle
1. Sales Transaction ( Cash and on account sales) •Cash, A/R, Sales

2. Cash Receipts Transaction: Collections from all •Cash, A/R, Sales discount,
sources, collection of AR with or with no discount; other accounts
3. Sales Returns and Allowances Transaction •Sales returns and allowances
and A/R
4. Write off of uncollectible A/R Transaction - •Allowance for Bad debt
expense, A/R

5. Estimate of Bad Debt Expense Transaction •Bad debt expense,

Allowance for uncollectible
accounts
YA AAUSC 5
Business functions and related
documents Sales and Collection Cycle

New Links\Accounts in sale

s and collection cycle.doc

YA AAUSC 6
 Receivables

Receivables are claims held against customers and others

for money, goods, or services.

Oral promises of the Written promises to pay a

purchaser to pay for goods sum of money on a specified
and services sold. future date.
Accounts Receivable Notes Receivable

YA AAUSC 7
Trade & Non Trade Receivables
Trade Receivables-these originate from Credit Sales of goods/services

Nontrade Receivables –Receivables other than credits sales

1. Advances to officers and employees.
2. Advances to subsidiaries. Auditors
3. Deposits to cover potential damages or losses. Concern
4. Deposits as a guarantee of performance or payment. Trade & Non
5. Dividends and interest receivable. Trade
6. Claims against: Receivables
a) Insurance companies for casualties sustained. must be shown
b) Defendants under suit. separately
c) Governmental bodies for tax refunds. (Presentation
d) Common carriers for damaged or lost goods. & Disclosure)
e) Creditors for returned, damaged, or lost goods.
f) Customers for returnable items (crates, containers, etc.).
YA AAUSC 8
 Business functions and related
documents Sales and Collection Cycle

Business functions and the related documents and records in

the sales and collection cycle
 Before assessing control risks and designing tests of controls
and substantive tests of transactions, auditors are required to
understand the business functions and documents and records in
a business.
New Links\Business functions and related documents.doc

YA AAUSC 9
Internal Control over Sales &
Receivables

Internal controls include:

 Controlling Customers Orders –check the
correctness of customer specification
 Credit approval: check the financial
condition of the customer before approving
credit
 Issuance of merchandise: issue merchandise
based on authorized shipping documents

YA AAUSC 10
 Internal Control over Sales &
Receivables
…Strong internal control is needed in the following area:
 The shipping function-Prepare pre-numbered shipping
documents in copies (for billing section, for gate keepers)
 Collections of Receivables: Follow up collection, check if
collection is recorded on the right customers account
 Write off of Receivables: write off should be after
adequate review by credit department
 Internal audit of Receivables:-Have an internal audit of
receivables (this applies to large organization0

YA AAUSC 11
 Internal Control over Sales &
Receivables

Indicators of weak internal control over this area:

• Shipment of merchandise to customers whose credit
standing has not been approved
• Shipment of merchandise to customers without giving
notice to the billing department (Shipment exist but no
credit sales)
• Error in recording quantity and selling price on sales
invoice
• Failure to control sales invoices by serial number, where
some may be lost without recording the accounts
receivable
YA AAUSC 12
Internal Control over Sales &
Receivables

What are the consequences of

absence/inadequate internal
control over sales and receivables?
Large losses of receivables.

YA AAUSC 13
Internal Control over Notes Receivable

Internal Control for Notes Receivable

Separation of duty
(between custodian of notes receivable and
those who handle cash and accounting
records)
Authorization of the acceptance and
renewal of notes,
Approval of the write-offs of defaulted
notes
YA AAUSC 14
Financial Statement Assertions for
Receivables
 Existence or occurrence: The recorded receivables
are valid/exist at balance sheet date (no overstatement)
 Completeness: receivables are recorded (no
understatement)
 Rights and obligations: Company has right to the
receivables as of balance sheet date
 Valuation or allocation: Valuation of receivables
approximate their realizable value
 Presentation and disclosure-receivables are properly
classified (Trade/non trade, current non current,
open/note)
YA AAUSC 15
Audit Program for Sales & Receivables

 Audit programs are prepared after assessing

risks
Inherent risk,
Fraud risk
Control risk,
New Links\Risk Assessment for Sales Transactions.d
oc
 Assessing control risk
This requires understanding internal control for this
area of audit
YA AAUSC 16
Audit Program for Sales & Receivables

Audit of Sales transaction

 Methodology for Designing Controls and
Substantive Tests of Transactions for Sales:
This involves
New Links\Methodology for designing tests of c
ontrol and substantive tests of
trnasactions for sales.doc

YA AAUSC 17
 …1. Audit of the Sales Transactions
 Auditors obtain an understanding of internal control over sales
transactions by :
1. Studying the client’s flowcharts
2. Preparing an internal control questionnaire
3. Performing walk-through tests of sales
 Flowchart shows the sequential flow of the client’s documents in
the organization.
 Since flowcharts provide a concise overview of the client’s system
(the origin, processing, control procedures and disposition of the
document), it helps auditors to identify control procedures and
deficiencies in the client’s system. Links for ch
3\Flowchart for sales and collection cycle.doc
YA AAUSC 18
 …1. Audit of the Sales Transactions
 With the help of internal control questionnaire auditors ask questions
about the controls in sales transactions and identify control deficiencies.
Links for ch 3\Internal control questionnaries
for sales and collection cycle.doc
 In a walkthrough, the auditor selects one or a few documents of sales
transaction and traces them from initiation through the entire
accounting process. This process helps auditors to identify deficiencies
in control of sales transactions
 After obtaining an understanding of internal control over sales
transactions, auditors prepare a framework to assess control risk using
the six transaction related objectives.
 Substantive tests are also performed for the six transaction-related audit
objectives
YA AAUSC 19
 ……1. Audit of the Sales Transactions
The design for the methodology for the audit of sales transactions can be
summarized in table with five columns:
Column 1:Transaction related objectives
Column 2:Key internal controls (Auditors focus on controls with the greatest effect
on the particular transaction related objective. Controls can be manual or
automated)
Column 3:Tests of controls - key controls stated in column 2 will be tested using
different procedures (documentation, observation, inquiry )to evaluate their
effectiveness in meeting the audit objectives stated in column 1
Column 4:Weaknesses (if tests of key controls show weakness, it is stated in this
column )
Column 5:Substantive tests of transactions (misstatements in transaction amounts
are checked by applying substantive tests for each transaction related objective)
Links for ch
3\Table 14-2 Designing tests of controls for sales and collection cycle.doc

YA AAUSC 20
 …1. Audit of the Sales Transactions
Column 1: Transaction related objectives
This column is used to list the six transaction-related audit objectives
for which tests of controls and substantive tests are performed
(Existence; Completeness; Accuracy; Classification; Timing ;
Posting and summarizations )
Column 2, 3 and 4: Key internal controls, tests of these controls
and recording deficiencies in tested controls
 Normally, documented internal controls exist for each audit assertion
for all classes of transactions
 However, auditors focus on key internal controls that have the
greatest effect for that audit assertion

YA AAUSC 21
 …1. Audit of the Sales Transactions
The following key internal controls are tested in assessing
control risk in sales transactions (to identify deficiencies)
a) Existence of adequate separation of duties (Key control)
Internal control requirement:
 Credit granting should be separated from sales;
 Entering sales and cash receipts transaction in
to a computer is separated from handling cash
Audit procedure for tests of control: Auditors use
observation and inquiry (eg. Auditors ask employees about
their responsibility to check if duties are separated)

YA AAUSC 22
…1. Audit of the Sales Transactions

b) Existence of proper authorization for credit limit,

shipment, price (Key Control)
Internal control requirement: Assume the sales manager
is required to put initials on all sales order over $100 to
indicate approval.

Audit procedure for Test of control : Documentation

procedure is used: eg the auditor will examine a sample of
sales orders to ensure that the sales manager’s initial is
present
YA AAUSC 23
…1. Audit of the Sales Transactions

c) Existence of adequate documents and records

(Key Control)
Internal control requirement: The occurrence of
transactions should be adequately documented

Audit procedure for Test of control: (eg.

Auditors will check if transactions are supported
by evidences using Documentation, observation)

YA AAUSC 24
…1. Audit of the Sales Transactions

d) Usage of pre-numbered documents to identify

if there are missing documents (key control)
Internal control requirement: Pre-numbered
documents must be used in recording transactions
Test of control: Auditors will check if documents
are sequential
Audit procedure used for the test: (eg.
Documentation, observation)

YA AAUSC 25
 …1. Audit of the Sales Transactions
e) The practice of sending monthly statements to customers (Key control)
Internal control requirement: statements must be send monthly to
customers
Test of control: Auditors will check if statements are sent
Audit procedure used for the test: (eg. documentation, observation)
f) Internal verification procedures (Key control)
Internal control requirement: There should be an independent person to
check numerical sequence of pre-numbered documents, the accuracy of
document preparation, and reviewing reports for unusual or incorrect
items.)
Test of control: Auditors will check if internal verification exists
Audit procedure used for the test: (eg. Observation, documentation, )

YA AAUSC 26
…1. Audit of the Sales Transactions

Column 5: Substantive tests

 This column is used for indicating the
substantive tests that will be performed for each
transaction related objective.
 Substantive tests aim at checking whether
monetary misstatements
overstatement/understatement exists).

YA AAUSC 27
…1.Audit of the Sales Transactions
Applying TOC & ST for each Audit Objective

1. Recorded Sales Exists (Existence objectives)

Internal Control:
 Sales are recorded only when shipments has occurred,
and primary revenue producing activity has been
performed
Tests of Controls: Auditors will examine sales invoices
to check if shipping document are attached or not; if it
agrees with customers orders
Substantive Tests: Auditors will examine sales invoices
to check if the following three misstatements exist:

YA AAUSC 28
 ..1. Audit of the Sales Transactions
Applying TOC & ST for each Audit Objective

(1) Sales being included in the journals for which no

shipments was made (error/fraud)
(2)Sales recorded more than once (error/fraud)
(3)Shipments made to non- existence customers (fraud)-
This is usually when the same person authorizes shipment
and record the sales)
 Improper revenue recognition is considered as fraud risk
(SAS 99).
 Many auditors do substantive tests of transactions for the
occurrence objective only if they believe that a control
deficiency exists.
YA AAUSC 29
 ..1. Audit of the Sales Transactions
Applying TOC & ST for each Audit Objective
2. Existing sales transactions are recorded (completeness)
Internal Control:
Customers must be billed for all shipments (sales invoices must be prepared for
all goods shipped to customers)
Tests of Controls: Auditors will examine sequence of shipping documents,
whether invoices are prepared for each or not
Substantive Tests: Involves tracing from shipping documents to the sales
invoice and entry in sales journal to check to check if all are billed, for the right
quantity
Direction of Tests- Failure to follow proper direction increases detection risk.
Thus, auditors are required to follow the proper direction

New Links\Direction of tests for sales transaction.doc

YA AAUSC 30
 ..1. Audit of the Sales Transactions
Applying TOC & ST for each Audit Objective

3. Sales are accurately recorded (Accuracy)

Internal Controls: Sales invoice must be prepared with
approved price list; credit must be authorized
Tests of Controls: Auditors will examine approved price list
for accuracy and proper authorization
Substantive Tests: Substantive tests of sales transactions will
be done to check the following three aspects of accuracy:
 Quantity shipped is similar to the quantity ordered
 Customers are billed for the correct quantity of goods
shipped
 Amount billed are correctly recorded in the accounting
records YA AAUSC 31
..1. Audit of the Sales Transactions
Applying TOC & ST for each Audit Objective

Accuracy objective involves the following substantive

tests:
 Comparison of prices on the copy of sales invoices
with an approved price list
 Recalculation of extensions and footings, and
 Comparisons of the details (eg. description, quantity,
and customer identification) on the invoices with
shipping records

YA AAUSC 32
..1. Audit of the Sales Transactions
Applying TOC & ST for each Audit Objective
Auditors can reduce substantive test for accuracy when:
 Sales invoices are automatically calculated and
posted by a computer,
 The auditor determines that the computer is
programmed accurately and the price list master
file is authorized and correct.
In such cases, auditors tests of controls normally
focus on the authorization and accuracy of changes
to the price list master file and substantive tests can
be reduced/eliminated
YA AAUSC 33
 … ..1. Audit of the Sales Transactions
Applying TOC & ST for each Audit Objective

 Auditors also perform some clerical accuracy tests, such

as footing the journals and tracing the totals and details to
the general ledger and the master file, to check whether
there are errors or fraud in the processing of sales
transactions.
 The extent of such tests is determined by the quality of
internal control

YA AAUSC 34
 ..1. Audit of the Sales Transactions
Applying TOC & ST for each Audit Objective

4. Recorded sales are properly classified

(classification objective)
 Internal Control: Transactions must be coded correctly
 Tests of control: Examine the sequence of sales
invoices
 Substantive Tests: Examine if cash sales are not
coded/classified as credit sales; if sales of operating
assets are not coded/classified as sales

YA AAUSC 35
..1. Audit of the Sales Transactions
Applying TOC & ST for each Audit Objective

5. Sales are recorded on the correct dates (timing

objective)
Internal Control: Sales should be billed and recorded
when ownership is transferred to the customer to
minimize omissions and misstatements
Tests of control: Examine the sequence of shipping
documents
Substantive Tests: The common procedure is to
compare the date on the copy of the sales invoice with that
of the shipment record/bill of lading

YA AAUSC 36
 ..1. Audit of the Sales Transactions
Applying TOC & ST for each Audit Objective

6. Sales transactions are properly included in the master file and

correctly summarized (posting and summarization).

Internal control: All sales transactions should be included in the

accounts receivable master file because this step affects the client’s
ability to collect outstanding receivables.
Tests of control: examine evidence that accounts receivable master
file is reconciled to the general ledger.
Substantive Tests: If financial statement is to be stated correctly, the
sales journal must be correctly totaled and posted to the general ledger.
Procedures include:
 Footing journals, master file records, and ledgers, and
 Tracing from one to the other among these three.
YA AAUSC 37
2. Audit of Sales Returns and
Allowances

2. Audit of Sales Returns and Allowances

 The objectives and methodology for auditing
sales returns and allowances is the same as for
sales
 The same procedure can be used to develop
suitable controls, tests of controls and
substantive tests of transactions to verify
amounts

YA AAUSC 38
….2. Audit of Sales Returns and
Allowances
1. Existence of sales returns and allowance
(existence objective)
 It is essential to ensure that all sales and returns
and allowances are approved by appropriate
personnel, this is because:
 A theft of cash from AR account can be covered up by a
fictitious sales return or allowance
 Thus, existence objective is an auditors focus area
 Credit memo is the main document auditors refer
for this transaction
YA AAUSC 39
….2. Audit of Sales Returns and
Allowances

2. Completeness of sales returns and allowance

(Completenes objective)
 It is essential to ensure that all sales and returns
a allowances are recorded, this is because:
 Company’s management may use unrecorded sales
return or allowance to overstate net income
 Thus, it is essential to ensure that pre-
numbered documents (Credit memos) are used
and that all are accounted for.
YA AAUSC 40
 Audit tests for the write-off of
uncollectible accounts
Audit tests for the write-off of uncollectible accounts
 The auditors primary concern is on occurrence
transaction-related audit objective-does the write-off
really occurred?
 This is due to the possibility that client personnel may
cover up an embezzlement by writing off accounts
receivable that have already been collected
Method of preventing this fraud:
 Proper authorization of write-off of A/R by the
management after a through analysis of the reason
why the customer is unable to pay
YA AAUSC 41
Completing the Audit of the Sales and
Collection Cycle : Audit of A/Receivable
New Links\Methodology for designing tests of balanc
e of AR.doc
Phase I/1 Identifying Client business risk affecting
AR
 Business risk is a risk that client's business fail to
achieve objectives (Eg. economic turn downs that
resulted in loss of customers, cash flow problems,
fraud risk etc)
 Auditors should identify business risks that
motivate the client to misstate AR balance (Eg. Cash
flow problem is a business risk that affect AR.)
YA AAUSC 42
…Completing the Audit of the Sales and
Collection Cycle : Audit of A/Receivable
Phase I/2 Setting tolerable misstatement and assessing inherent risk
for AR
Setting tolerable misstatement
Tolerable misstatement is set based on the judgment about
materiality
Assessment of client business risk affecting AR will give an idea to
the auditor about the type of misstatement in AR (eg. The auditor
expects overstatement in AR)
Once the auditor knows the type of misstatement, the next step is to
set the tolerable misstatement of AR. (the maximum misstatement
amount the auditors can tolerate)

.
YA AAUSC 43
Assessing Fraud Risk for A/Receivable

Major Fraud risk related to Receivables

Incorrect aging of accounts receivable

Lapping: Technique used to cover up embezzlement of

cash (Stealing cash collection from a customer and
crediting him from another customer's payment . This
process continues and at least one customer’s account is
always overstated. Lapping occurs when duties are
inadequately segregated

.
YA AAUSC 44
 Causes, prevention and detection
methods for Lapping of AR
Causes, prevention and detection methods for Lapping of AR

Causes: Absence of separation of duties of handling cash and entering data

to computer increases the possibility of lapping of A/R
Lapping of A/R is prevented by:
 Separating duties
 Arranging mandatory vacation policy for employees who both handle cash
and enter cash receipts into the system.
Lapping of A/R is detected by:
 Comparing the name, amount, and dates shown on remittance advices with
cash receipts journal entries and related duplicate deposit slips

.
YA AAUSC 45
 Assessing inherent risk for AR

Assessing inherent risk for AR

 For example, the following risks are inherent to AR, thus auditors
are required to identify them:
 Sales of receivables recorded as sales rather than financing transactions
 Receivables incorrectly classified as current when the likelihood of
collection during next year is low,
 Collection of receivable contingent on future events that cannot currently
be estimated,
 AR aged incorrectly and potentially uncollectible amounts are not
recognized
Presence of inherent risks increase the probability of material misstatement
Assessing inherent risks help auditors to assess control risk.

YA AAUSC 46
 Assessing control risk for the sales and
collection cycle
Assessing control risk for the sales and collection cycle
 As compared to other cycles, controls over sales and cash
receipts and the related AR is reasonably effective in most
companies since keeping accurate records helps them to
maintain good relations with customers.
Thus auditors focus on assessing risks only on the following:
1. Controls that prevent or detect embezzlements
2. Controls over cutoff (cuttoff helps to show transactions
and balances in proper period)
3. Controls related to the allowance for uncollectible
accounts
YA AAUSC 47
Phase II-Design and perform tests of controls
and substantive tests for sales and collection
cycle
Phase II-Design and perform tests of controls and
substantive tests for sales and collection cycle
 Tests of controls and substantive tests of
transactions, are conducted to ensure effectiveness
of internal controls and the monetary correctness of
transactions in the accounting system.
 These tests are performed using transaction related
objectives as a framework. (Occurrence,
completeness, accuracy, classifications timing,
posting and summarization)
YA AAUSC 48
Phase III -Design and perform
substantive tests for details of AR balance

Phase III -Design and perform substantive tests for

details of AR balance
 Substantive tests of details of balances, are
needed to determine whether the dollar amount
of an account balance is materially misstated
Substantive tests for details AR balance include
the following:
1.Analytical procedures (AP)
2.Substantive tests of balances (to check misstatements)

YA AAUSC 49
1. Analytical procedures for AR
balance
1.Analytical procedures for AR balance- It is applied to
observe if there are unusual differences or possible
misstatements
Timing (when to conduct AP?)
Most analytical procedures performed during the detailed
testing phase are done after the balance sheet date but
before tests of details of balances
Application (to which balance is AP applied?)
 Auditors perform analytical procedures for the entire
sales and collection cycle, not just accounts receivable.

YA AAUSC 50
Types of A/R that deserve auditors
attention
Types of A/R that deserve auditors attention
 In addition to analytical procedures, auditors should also
review the following: (receivables that need auditors
attention)
 Accounts receivable for large and unusual amounts, such as
large balances,
 Accounts that have been outstanding for a long time,
 Receivables from affiliated companies, officers, directors,
and other related parties, and
 Credit balances in A/R.

YA AAUSC 51
 2. Tests of details of A/Receivable
Auditors action when analytical procedures uncover
unusual fluctuations
 Auditors are required to get explanations from the
management by making additional inquiries
 They are also required to critically evaluate
management response to determine whether
fluctuations are adequately explained and supported by
other evidences

YA AAUSC 52
..2. Tests of details of A/Receivable

2. Tests of Details of AR Balances

 In many cycles, tests of details of balances focus on balance
sheet accounts
 But in the sales and collection cycle, income statements
accounts are not ignored because of there significance
Eg. Confirmation of receivables indicate an overstatement
caused by error in billing. This error overstates both A/R and
Sales balance

Framework for testing details of AR balance

 Auditors use balance related objectives as a framework in
testing details of AR balance
YA AAUSC 53
..2. Tests of details of A/Receivable
 Tests of details of balances are performed to ensure
whether the following balance related objectives are
achieved or not:
1. AR are correctly added and agree with the Master File
and the General Ledger (aged trial balance). (detail tie in
objective)
Audit Procedure: Reconciling master file with aged trial
balance
2. Recorded accounts receivable exist (existence objective)
Audit Procedure: Confirmation of AR is the most important
procedure to check existence of AR
YA AAUSC 54
 ..2. Tests of details of A/Receivable
3. Existing accounts receivable are included (Completeness Objective)
 This is relatively difficult
Audit procedure: reconciling control account with subsidiary (master
file with aged trial balance to ensure no omission of customer
balance) to see if account balance is omitted
Tests of details of AR balance may not trace omissions of receivables
due to:
 Unrecorded credit sales (omissions of transactions)
 Understated receivables due to error in billing (since customers
may not confirm when their accounts are understated)
Such errors can be detected by analytical procedures and checking
shipping documents for completeness of sales transactions

YA AAUSC 55
..2. Tests of details of A/Receivable

4. Accounts receivable are accurate (Accuracy

objective)
Audit Procedure: Confirmation of accounts
selected from the trial balance is the most common
test of details of balances for the accuracy of
accounts receivable
What if there no response?
 Auditors use alternative method (checking
documents such as sales invoice, shipment
documents and cash receipts)
YA AAUSC 56
..2. Tests of details of A/Receivable

5. Accounts receivable are properly classified (Classification

objective)
 This is relatively easier to achieve
 This objective is closely related to presentation and disclosure
 Audit Procedure: Auditors will check documents
whether the client has properly coded/ classified
receivables in terms of:
 Notes and Accounts receivable
 Current and nun current receivable
 Trade and non trade receivable (eg. Receivables from related
parties should be shown separately, disclosure is needed)
YA AAUSC 57
..2. Tests of details of A/Receivable
6. Cutoff for accounts receivable is correct (Cutoff
objective)
 Cutoff misstatements exist when current period
transactions are recorded in the subsequent period or the
reverse (it causes overstatement or understatement on
items that appear on financial statements)
 Cutoff misstatement can occur for sales, sales returns and
allowances, and cash receipts.

 To ensure that the objective is met, auditors are required

to decide on the appropriate criteria for cutoff

YA AAUSC 58
 ..2. Tests of details of A/Receivable
7. Accounts receivable is stated at realizable value (Realizable value
objective)
 Accounting standards require that companies state accounts
receivable at the amount that will ultimately be collected
Audit procedures
 Evaluating whether the client’s allowance is reasonable,
considering all available facts; (eg by looking at history of
write-offs of AR)
 Discussion with credit manager about collectability of AR;
 Checking if there are changes on economic condition; credit
policy of the company
 Review of the client’s correspondence file.
YA AAUSC 59
..2. Tests of details of A/Receivable

8. The client has rights to accounts receivable (Rights and obligation

objectives)
 A portion of the receivables may have been pledged as collateral,
assigned to someone else, factored, or sold at discount, thus
auditors have to check.
Audit procedure: The auditor is required to
▪ 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.
YA AAUSC 60
..2. Tests of details of A/Receivable
9. Accounts receivable presentation and disclosures are proper
(Presentation and Disclosure objective)
 Evaluation of this objective require the auditor to have a thorough
understanding of accounting standards and presentation and
disclosure requirements
 The auditor’s evaluation includes:
 Whether the revenue recognition policy is appropriate/not,
whether it is properly disclosed/not
 Whether related parties information are properly disclosed/not
 Whether significant receivables from related parties are
segregated or not
 Most of these tasks are usually performed while checking for
classification objectives
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 ..2. Tests of details of A/Receivable

Confirmation of Accounts Receivable

Confirmation is a direct written response from a third party
in paper or electronic form
Purpose of accounts receivable confirmation
 The primary purpose of accounts receivable confirmation
is to satisfy the existence, accuracy, and cutoff objectives.
Auditing Standards (AICPA) Requirement about
Confirmation
 When practical, auditing standards require the
confirmation of AR.

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..2. Tests of details of A/Receivable

However, auditing standards state confirmation may

not be appropriate in the following cases:
 If AR is immaterial
 If the auditor considers confirmation ineffective
because of delay and low response rate
 It the client internal control for sales and collection
cycle is effective (if The combined level of inherent
risk and control risk is low and other substantive
evidence can be accumulated to provide sufficient
evidence)
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 ..2. Tests of details of A/Receivable

Confirmation decision
1. Decision on the types of confirmation (which form of
confirmation to use?)
 Positive Confirmation (Blank, Invoice.)
 Negative Confirmation

Comparison
In terms of reliability
 A positive confirmation is more reliable because if not responded, a follow
up can be made
 In the case of negative confirmation, failure to respond may be considered as
a correct response even if it is ignored by the debtor
In terms of cost
 Negative confirmations cost less because there are no second requests and no
follow-up of non-responses.
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..2. Tests of details of A/Receivable

2. Timing decision (when to send and its effect

on reliability)
 Confirmation can be sent on interim period (due to
the need to complete the audit on time) or at time
closer to the balance sheet date
 Confirmation sent as close to the balance sheet date
as possible are more reliable than those sent in
interim period

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 ..2. Tests of details of A/Receivable
3. Sample size decision (how much should be the sample size?)
 The following factors affect sample size decisions:
▪ Tolerable misstatement (low tolerable misstatement results in larger
sample size)
▪ Inherent risk ( relative size of total accounts receivable, number of
accounts, prior-year results, and expected misstatements) (low Inherent
risk results in smaller sample size)
▪ Control risk (low control risk results in smaller sample size)
▪ Achieved detection risk from other substantive tests ( extent and results of
substantive tests of transactions, analytical procedures, and other test of
details) (low achieved detection risk results in smaller sample size)
▪ Type of confirmation ( negative confirmations normally requires a large
sample size)

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 ..2. Tests of details of A/Receivable

4. Selection of the Items for testing (How do

auditors select AR for confirmation?)
Auditors stratify/segment AR based on dollar size
of individual accounts and the length of time an
account has been outstanding.
They usually select larger and older balances since
the possibility of containing misstatements is high
However, AR in other segments are also be
included
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..2. Tests of details of A/Receivable

 Analysis of Differences
 When there is a difference between the AR balance confirmed
and that is shown on the record, auditors analyze the cause for
the difference
 Timing difference is a common cause for the difference.
Common causes of difference include:
▪ Payment Has Already Been Made: this is usually occurs when
the customer has paid before the date of the confirmation, but
the collection was not recorded by the client on the date of
confirmation
(auditors should check if there is an intent of cash theft,
lapping of AR and check also the cutoff for cash receipt)
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 ..2. Tests of details of A/Receivable
 Goods Have Not Been Received: These differences normally
result because of goods on transit.
 The client records the sale at the date of shipment and the
customer records the acquisition when the goods are received.
 The Goods Have Been Returned: Client’s failure to record a
credit memo (the improper recording of sales returns and
allowances) may cause this difference. It needs investigation
 Clerical Errors and Disputed Amounts: Customers may state
that there was an error in the price charged for the goods, the
goods are damaged, the proper quantity of goods was not received,
and so forth. These differences also require investigation

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 DOCUMENTATION REQUIREMENTS FOR
ACCOUNTS RECEIVABLE
DOCUMENTATION REQUIREMENTS FOR
ACCOUNTS RECEIVABLE
 Tests of adequacy of allowance for doubtful accounts
 Details on inquires made regarding whether receivables
are sold, pledged, or assigned
 Cutoff tests
 Evidence of roll-forward procedures if confirmations
were sent at an interim date

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 DOCUMENTATION RELATED TO THE REVENUE SUBSTANTIVE
PROCEDURES

 
 DOCUMENTATION RELATED TO THE REVENUE
SUBSTANTIVE PROCEDURES
 Substantive analytical procedures performed
 Unusual sales transactions
 Information indicating an understanding of client’s revenue
recognition policies
 Identification of specific items tests
 Relevant information on tests of details

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