Accounts Receivable & Cash Balances By David N. Ricchiute AUDITING CHAPTER 11 Accounts Receivable & Cash Balances By David N. Ricchiute

TOPICS IN REVENUE/RECEIPT CYCLE Relationship assertions & audit procedures Relationship audit risk, client strategies, substantive tests Substantive tests for assertions Revenue recognition, earnings manipulation, & channel stuffing Audit sampling & accounts receivable Computer-assisted audit techniques GBW 8th ed. Ch. 11

ASSERTIONS & OBJECTIVES Management assertions: Recorded receivables & cash balances Exist Include all transactions (completeness) Represent rights of entity Are valued appropriately Are presented & disclosed properly GBW 8th ed. Ch. 11

OBJECTIVES & PROCEDURES: Existence/Occurrence Objective: determine whether all recorded sales, receivables, cash balances Procedures Existence Physical observation Confirmation Transactions occurred Cutoff testing for proper period GBW 8th ed. Ch. 11

OBJECTIVES & PROCEDURES: Completeness Objective: determine whether all receivables, sales, cash of period are presented in financial statements Procedures Examine documents Apply analytical procedures Cutoff bank statements, bank reconciliations, etc. GBW 8th ed. Ch. 11

OBJECTIVES & PROCEDURES: Rights/Obligations Objective: determine whether entity has property rights to cash, accounts receivable Procedures Examine documentation Confirmations Inquiries GBW 8th ed. Ch. 11

OBJECTIVES & PROCEDURES: Valuation, Allocation Objective: determine whether entity has recorded items in correct amounts, accounts, & time periods Procedures Confirm balances Verify mathematical accuracy Examine details of recording GBW 8th ed. Ch. 11

OBJECTIVES & PROCEDURES: Presentation, Disclosure Objective: determine whether recorded transactions, balances properly classified, described, disclosed Procedures Compare presentation to GAAP Annual updates of AICPA guidelines GBW 8th ed. Ch. 11

AUDIT RISK MODEL AR = CR x IR x DR Detection risk (DR): likelihood that error could occur & not be detected Based on Control risk (CR) Likelihood of material error Inherent risk (IR) Strategies & threats GBW 8th ed. Ch. 11

DETECTION RISK DR = ____AR___ IR x CR Nature, extent, timing substantive tests Nature: more/less persuasive tests Extent: larger/smaller samples Timing: balance sheet date or interim GBW 8th ed. Ch. 11

ASSERTIONS & PROCEDURES Accounts Receivable, Sales-1 Valuation Verify mathematical accuracy AR Obtain aged trial balance Foot trial balance Compare total AR per trial balance to general ledger GBW 8th ed. Ch. 11

ASSERTIONS & PROCEDURES Accounts Receivable, Sales-2 Existence, rights, valuation Confirm year-end accounts & notes receivable with debtors Positive: tell auditor if balance correct Large balances, inaccuracies Negative: tell auditor only if balance incorrect Control adequate, small balances GBW 8th ed. Ch. 11

ASSERTIONS & PROCEDURES Accounts Receivable, Sales-3 Existence or occurrence, completeness Test cutoff to determine whether sales, receivables recorded in proper period FOB shipping point FOB destination GBW 8th ed. Ch. 11

ASSERTIONS & PROCEDURES Accounts Receivable, Sales-4 Valuation, rights Review collectibility receivables Determine adequacy allowance for doubtful accounts GBW 8th ed. Ch. 11

ASSERTIONS & PROCEDURES Accounts Receivable, Sales-5 Existence or occurrence, completeness, valuation Perform analytical procedures for reasonableness of sales, receivables balances Collections problems Overstated sales Understated sales GBW 8th ed. Ch. 11

ASSERTIONS & PROCEDURES Accounts Receivable, Sales-6 Presentation & disclosure Review financial statements to determine Accounts, notes receivable properly classified, described Disclosures adequate GBW 8th ed. Ch. 11

TESTING CUTOFF Sales, Receivables At or around end each quarter, the former President directed his subordinates to hold IGI’s books open, to backdate invoices, shipping documents. This caused IGI to record out-of-period sales & to overstate revenue, net income end each quarter. Procedures Trace recorded sales to shipping documents before, after end of period GBW 8th ed. Ch. 11

ASSERTIONS & PROCEDURES: Cash-1 Existence, rights, valuation Confirm year end balances with all banks GBW 8th ed. Ch. 11

ASSERTIONS & PROCEDURES: Cash-2 Valuation Verify mathematical accuracy recorded cash balances Foot cash journals Trace totals to general ledger, year-end bank reconciliations Test cash on hand GBW 8th ed. Ch. 11

ASSERTIONS & PROCEDURES: Cash-3 Existence, completeness, valuation Test cutoff Obtain cutoff bank statement Verify accuracy Examine & trace to bank reconciliations & cash journals Proof of cash Reconcile recorded cash with bank confirmation Examine interbank, intercompany transfers GBW 8th ed. Ch. 11

ASSERTIONS & PROCEDURES: Cash-4 Presentation & disclosure Review financial statements to determine Cash balances properly classified, described Disclosures adequate GBW 8th ed. Ch. 11

TESTING CUTOFF FOR CASH Reconcile internal documents Cash journals General ledger Bank reconciliations With external documents Year-end bank statement Cutoff bank statements Bank confirmations GBW 8th ed. Ch. 11

REVENUE RECOGNITION & EARNINGS MANIPULATION Increasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding common sense business practices. Arthur Levitt, Jr., “The ‘Numbers Game.” Speech NYU, 1998. GBW 8th ed. Ch. 11

REVENUE RECOGNITION SAB 104 Criteria Persuasive evidence of arrangement exists Delivery has occurred or services rendered Seller’s price fixed or determinable Collectibility reasonably assured GBW 8th ed. Ch. 11

COMMON MEANS TO MANIPULATE EARNINGS - 1 Method Revenue Recognition Error Bill & hold Cancelled orders Conditional sales Consignment sales Continuing involvement Improper cutoff Shipments to 3rd party warehouses Cancelled, duplicate orders Before contingencies resolved Goods on consignment, trial Seller involved after delivery, e.g., installation Before title, risk ownership passed GBW 8th ed. Ch. 11

COMMON MEANS TO MANIPULATE EARNINGS - 2 Method Revenue Recognition Error Kickback sales Overstated completion Partial shipments Pre-invoicing Premature shipment Inflated selling price for kickback Inflated % completion on construction projects Not all goods ordered are shipped Goods still in production Goods ordered but not authorized for shipment GBW 8th ed. Ch. 11

COMMON MEANS TO MANIPULATE EARNINGS - 3 Method Revenue Recognition Error Premature sales Sham sales Side agreements Uncertain performance Uncertain realization Unauthorized shipment Goods ordered but not shipped False shipments To forestall completion earnings process Seller’s performance uncertain Collection uncertain, unlikely Shipments not authorized GBW 8th ed. Ch. 11

MANIPULATED EARNINGS Channel Stuffing Definition: incentives to induce incremental demand Examples Bausch & Lomb Told distributors to buy large amount of inventory to maintain distributorship B&L recognized extra $22 million Sunbeam Used price discounting to encourage customers to hold 80 weeks of inventory GBW 8th ed. Ch. 11

MANIPULATED EARNINGS Asset Swaps Definition: companies trading right to use others asset Examples Global Crossing Treated underseas cables as real estate Recognized revenue by treating swap as sale GBW 8th ed. Ch. 11

MANIPULATED EARNINGS Other Improper expense capitalization Chambers Development Capitalized landfill expenses after determining earnings necessary to meet analysts expectations MicroStrategy Recognized revenue before all services provided for software sales GBW 8th ed. Ch. 11

AUDIT SAMPLING & ACCOUNTS RECEIVABLE Update assessment of control risk Planning confirmations & selecting plan Identify population, sampling unit, anticipated error Estimate tolerable error & risk incorrect acceptance Calculate sample size Choose sample selection method Evaluate results GBW 8th ed. Ch. 11

COMPUTER ASSISTED TESTS: AR Accuracy Foot, crossfoot recorded amounts within master file Total balances Display/print exceptions GBW 8th ed. Ch. 11

COMPUTER ASSISTED TESTS: AR Aging Trace individual balances from master file to sales journal Classify balances by invoice dates/age Display/print aged trial balances GBW 8th ed. Ch. 11

COMPUTER ASSISTED TESTS: AR Credit Balances Scan master receivables file for net credit balances Display/print listing credit balance accounts GBW 8th ed. Ch. 11