Auditing: The Art and Science of Assurance Engagements Chapter 15: Completing the Tests in the Sales and Collection Cycle: Accounts Receivable Copyright © 2011 Pearson Canada Inc.

Chapter 15 Learning Objectives Identify and describe the process for designing tests of details of balances for accounts receivable. Explain when and why analytical review procedures are completed as part of the audit of sales and accounts receivable. Describe the accounts receivable audit tests that would be completed for each audit assertion. Describe the execution and evaluation of monetary unit sampling(MUS). Copyright © 2011 Pearson Canada Inc.

Integration of Audit Risk Model and Types of Audit Tests 15-3 Copyright © 2011 Pearson Canada Inc.

Designing Tests of Details of Balances 15-4 Copyright © 2011 Pearson Canada Inc.

Effects of Inherent and Control Risks 15-5 Copyright © 2011 Pearson Canada Inc.

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. 15-6 Copyright © 2011 Pearson Canada Inc.

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) 15-7 Copyright © 2011 Pearson Canada Inc.

Relationship Between Transaction-related and Balance-related Audit Objectives Figure 15-3, p.501 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. 15-8 Copyright © 2011 Pearson Canada Inc.

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) 15-9 Copyright © 2011 Pearson Canada Inc.

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 15-10 Copyright © 2011 Pearson Canada Inc.

Examples of Audit Procedures by Audit Objective (Assertion) 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. (Continued) 15-11 Copyright © 2011 Pearson Canada Inc.

Examples of Audit Procedures by Audit Objective (Assertion) (Continued) 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. (Continued) 15-12 Copyright © 2011 Pearson Canada Inc.

Examples of Audit Procedures by Audit Objective (Assertion) (Continued) 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. (Continued) 15-13 Copyright © 2011 Pearson Canada Inc.

Examples of Audit Procedures by Audit Objective (Assertion) (Continued) 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. (Continued) 15-14 Copyright © 2011 Pearson Canada Inc.

Examples of Audit Procedures by Audit Objective (Assertion) (Continued) Rights and obligations: Review the minutes of the board of directors’ meetings for any indication of pledged or factored accounts receivable. (Continued) 15-15 Copyright © 2011 Pearson Canada Inc.

Examples of Audit Procedures by Audit Objective (Assertion) (Continued) Presentation and disclosure: Enquire of management whether any receivables are pledged or factored. 15-16 Copyright © 2011 Pearson Canada Inc.

Discussion Problem 15-30, p. 534 A company is having collection problems What would you do to investigate the causes? 15-17 Copyright © 2011 Pearson Canada Inc.

The Power of Confirmations Useful for existence, accuracy and cutoff A/R confirmations come in several forms: Negative Positive Individual item 15-18 Copyright © 2011 Pearson Canada Inc.

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 (Continued) 15-19 Copyright © 2011 Pearson Canada Inc.

Positive vs. Negative Confirmations (Continued) Failure to reply must be regarded as a correct response Less expensive Use when Many homogenous balances Small amounts owing Internal controls strong No evidence/suspicion of fraud or serious error 15-20 Copyright © 2011 Pearson Canada Inc.

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.) 15-21 Copyright © 2011 Pearson Canada Inc.

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. 15-22 Copyright © 2011 Pearson Canada Inc.

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. 15-23 Copyright © 2011 Pearson Canada Inc.

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. 15-24 Copyright © 2011 Pearson Canada Inc.

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) 15-25 Copyright © 2011 Pearson Canada Inc.

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. 15-26 Copyright © 2011 Pearson Canada Inc.

Discussion Question 15-26, p. 533 Confirmations have been returned with answers that do not match the records – what do you do? 15-27 Copyright © 2011 Pearson Canada Inc.

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 15-28 Copyright © 2011 Pearson Canada Inc.

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. 15-29 Copyright © 2011 Pearson Canada Inc.

Discussion Problem 15-28, p. 534 Evaluate the sampling approach Select the sample size Evaluate results 15-30 Copyright © 2011 Pearson Canada Inc.