©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Completing the Tests in the Sales and Collection Cycle: Accounts Receivable Chapter 16

Learning Objective 1 Describe the methodology for designing tests of details of balances using the audit risk model.

Accounts Receivable Balance- Related Audit Objectives Detail tie-in Completeness ClassificationExistence Accuracy Cutoff Realizable value Rights and obligations

Methodology for Designing Tests of Balances – Accounts Receivable Identify client business risks affecting sales and collection cycle and set audit risk (ch. 8). Set tolerable misstatement for A/R and assess inherent risk for sales and collection cycle (ch. 9). Potential FR – improper rev recognition (ch. 11) Assess control risk for sales and collection cycle (ch. 10).

Methodology for Designing Tests of Balances – Accounts Receivable Design and perform tests of controls and substantive tests of transactions for sales and collection cycle (ch. 14 and 15). Design and perform analytical procedures for sales and collection cycle balances (e.g., sales, BDE) (ch. 8 and 16).

Methodology for Designing Tests of Balances – Accounts Receivable Design tests of details of accounts receivable balance to satisfy balance-related audit objectives. Audit procedures/staffing Sample size/budget Items to select Timing

Relationship Between Sales and Accounts Receivable: dr. A/R (inc), cr. Sales (inc) Occurrence Completeness Accuracy Classification Timing × Detail tie-in ExistenceCompletenessAccuracyClassificationCutoff Realizable value Rights Posting/Summary Accounts Receivable Balance-Related Audit Objectives → Transaction-Related Audit Objectives Sales ↓ × × × × ×

Relationship Between Collections and Accounts Receivable: dr. cash (inc), cr. A/R (dec) Occurrence Completeness Accuracy Classification Timing Detail tie-in ExistenceCompletenessAccuracyClassificationCutoff Realizable value Rights Posting/Summary Accounts Receivable Balance-Related Audit Objectives Transaction-Related Audit Objectives Cash receipts × × × × × ×

Say what??? Recording a cash receipt that did not occur (cash – occurrence violation) violates completeness objective for A/R – there is an open A/R not in the accounting records (A/R reduced with false j/e). Failure to record a cash receipt (cash – completeness violation) means violation of existence for A/R – A/R should be reduced – does not exist.

Learning Objective 2 Design and perform analytical procedures for accounts in the sales and collection cycle.

Analytical Procedures for the Sales and Collection Cycle Gross margin percentage with previous years Sales by month over time Sales returns and allowances as a percentage of gross sales with previous years Sales growth vs. related NFM growth

Analytical Procedures for the Sales and Collection Cycle Individual customer A/R balances over a stated amount Bad debt expense as a percentage of gross sales Days that accounts receivable are outstanding

Analytical Procedures for the Sales and Collection Cycle Aging category as a percentage of receivables Allowance for uncollectible accounts as a percentage of accounts receivable Charge-off of uncollectible accounts as a percentage of total accounts receivable

Selected Comparative Information Percent 2008Change2007Change2006 (000) 08-07(000) 07-06(000) Sales Gross margin Accounts receivable Bad debt expense 3.3(2.9) Total assets 61.4(7.0) Net earnings Number of accounts receivable

Analytical Procedures Sales and Collection Cycle Gross margin/net sales27.8%27.7%27.5% Sales R&A/gross sales.9%.9%.8% Bad debt expense/net sales 2.3% 2.6% 2.4% Allowance for uncollectible accounts/accounts receivable 6.1% 8.2% 8.4% Number of days receivables outstanding Net accounts receivable/ current assets37.2%38.6%36.0%

Analytical Procedures for Gross Margin: Sales – CGS / Sales Gross Margin Percent Client Industry Client Industry Hardwood Softwood Plywood

Learning Objective 3 Design and perform tests of details of balances for accounts receivable for each balance- related audit objective.

Design and Perform Tests of Details of A/R Balance (Phase III) Planned detection risk for each objective is an auditor’s decision. Combining the factors that determine planned detection risk and reacting to DR is complex. Research – better at assessment than response

Designing Tests of Detail of Balances Aged A/R master file / subsidiary ledger (realizable value): BDE and Allowance Recorded accounts receivable exist (confirm) Existing accounts receivable are included (completeness) – Less of a concern – covered w/ Sales (cash) ToT of completeness (existence). Accounts receivable are accurate (confirm and ToT) Accounts receivable are properly classified – reclassify notes receivable, credits

Designing Tests of Detail of Balances Cutoff for accounts receivable is correct – ToT (timing) The client has rights to accounts receivable: factoring? discussions, BOD minutes Extra: Accounts receivable and Sales presentation and disclosures are proper – SOX: exec loans, more than 5%, Rev Recognition policy

Learning Objective 4 Obtain and evaluate accounts receivable confirmations.

AICPA Requirements: When confirmation NOT required 1. Accounts receivable are immaterial. OR 2. The auditor considers confirmations ineffective evidence because response rates will likely be inadequate or unreliable. OR 3. The combined level of inherent risk and control risk is low (DR high) and other substantive evidence can be accumulated to provide sufficient evidence (ToT and AP). MUST DOCUMENT – story time

Type of Confirmation Positive confirmation: non responses must be followed up. Positive confirmation: non responses must be followed up. Negative confirmation: all: (1) many small balances (coverage) (B2C) AND (2) IR and CR are low AND (3) high response rate to positive confirms in PY Negative confirmation: all: (1) many small balances (coverage) (B2C) AND (2) IR and CR are low AND (3) high response rate to positive confirms in PY

Timing The most reliable evidence from confirmations is obtained when they are sent as close to the balance sheet date as possible, as opposed to confirming the accounts several months before year-end. Consider earnings release dates in light of risks – can you get it done?? SEC / LAFs : 90 → 60 days

Sample Size (firm specific) Tolerable misstatement - indirect Inherent risk - direct Control risk - direct Assurance re: objectives from other substantive tests (ToT, AP) - indirect Type of confirmation – more with negative Dollar A/R balance – Not “large” so typically part of process - direct

Selection of Items for Testing When selecting a sample of accounts receivable for confirmation, the auditor should be careful to avoid being influenced by the client.

Selection of Items for Testing If a client tries to discourage the auditor from sending confirmation to certain customers, the auditor should consider the possibility that the client is attempting to conceal fictitious or known misstatements of accounts receivable. Scope limitation???? Disclaimer of opinion??? Parmalat and cash confirms, Satyam

Subsequent Cash Receipts Follow up: Evidence of the receipt of cash subsequent to the confirmation date includes examining remittance advices, entries in the cash receipts records, or perhaps even subsequent credits in the accounts receivable master files. Monday Morning QB: Evaluate 12/31 balance with Post 12/31 info

Duplicate Sales Invoices These are useful in verifying the actual issuance of a sales invoice and the actual date of the billing: Cutoff

Shipping Documents These are important in establishing whether the shipment was actually made (existence and completeness) and as a test of cutoff.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley End of Chapter 16