Audit II Chapter 3 - Audit of Sales and Collection Cycle PDF

# CHAPTER THREE ## AUDIT OF THE SALES AND COLLECTION CYCLE: TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS Auditors perform both tests of controls and tests of transactions and balances. As a means of securing assurance from the clients system of control, it is important for the auditors...

# CHAPTER THREE ## AUDIT OF THE SALES AND COLLECTION CYCLE: TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS Auditors perform both tests of controls and tests of transactions and balances. As a means of securing assurance from the clients system of control, it is important for the auditors to know when they should rely extensively on internal controls and when they should not. This chapter studies assessing control risk and designing tests of controls and substantive tests of transactions for each of the classes of transactions in the sales and collection cycle. In the second part of the chapter, discussions on designing of tests of account balances are included. Before studying the process of assessing control risk and designing tests of controls and substantive tests of transactions for each class of transactions, it is important to know the sales and collection cycle classes of transactions and account balances. It is also important to understand the typical documents and records used in the cycle. ## I. ACCOUNTS AND CLASSES OF TRANSACTIONS IN THE SALES AND COLLECTION CYCLE The overall objective in the audit of the sales and collection cycle is to evaluate whether the account balances affected by the cycles are fairly presented in accordance with IFRS. ### ACCOUNTS IN THE SALES AND COLLECTION CYCLE includes * Sales * A/Receivable * Cash in Bank * Cash Discounts Taken * Allowance for Uncollectible Accounts * Bad Debt Expense ### CLASSES OF TRANSACTIONS IN THE SALES AND COLLECTION CYCLE are * Sales (cash and sales on account) * Cash receipts * Sales returns and allowances * Charge-of of uncollectible accounts * Estimate of bad debt expense ## II. BUSINESS FUNCTIONS IN THE CYCLE AND RELATED DOCUMENTS AND RECORDS The Sales and Collection Cycle involves the decisions and processes necessary for the transfer of the ownership of goods and services to customers after they are made available for sale. It begins with a request by a customer and ends with the conversion of material or service into an account receivable, and ultimately into cash. There are various Business Functions for sales and collection cycle. They occur in every business in the recording of the five classes of transactions. Below you will find summary discussions of the Classes of Transactions, Accounts, Business functions, and related Documents and Records for the Sales and Collection Cycle. ### 1. SALES TRANSACTION #### Accounts * Sales * Accounts receivable #### Business Functions * **Processing customer orders**- Customer places an order using Customer Order document. This is often followed by the issuance of Sales Order. * **Granting credit** - A properly authorized person must approve credit to the customer for sales on account. Minimizes the possibility of bad debts. * It may be a programmed approval- based on preapproved credit limit maintained in a customer master file. * **Shipping goods** - A point at which most companies recognize sale. A shipping document is prepared. * The shipping document may be a multicopy bill of lading. * Update perpetual inventory record. * **Billing customers and recording sales** - Billing is a means by which the customer is informed of the amount due for the goods. All shipments should be billed and no shipment should be billed more than once. Billing should consider authorized price, quantity shipped and other terms. * Done with multicopy sales invoice and simultaneously updating of the sales transaction file, accounts receivable master file, and the general ledger master file for sales and accounts receivable. #### Documents and Records * **Customer Order** - A request for merchandise by a customer. * It may be received in differing formats. * **Sales Order** - Used to communicate the description, quantity and related specification of goods ordered. * Often used to indicate credit approval and authorization for shipment. * **Shipping Document** - A document prepared to initiate shipment of goods. Prepared in at lease in three copies - customer, accounts, retained * **Sales invoice** - A document indicating the description and quantity of goods sold the price, freight charges, insurance, terms, and other relevant data. * Prepared in at least three copies. * **Sales transaction file** - A computer generated file that includes all sales transactions processed by the accounting system for a period. * It includes all information entered into the system and information for each transaction - customer name, date, amount, account classifications, sales person, and commission rate. * The file may include returns and allowances if separate files are not kept for those transactions. * The information in this file is used for a variety of records, listing, or reports - e.g. sales journal, A/R master file, and transactions for certain account balance or division. * **Sales journal or listing** - A report generated from the sales transaction file that typically includes the customer name, date, amount, and account classification or classifications for each transaction, such as division or product line. * It also identifies whether the sale was for cash or credit. * **Accounts receivable master file** - A file used to record individual sales, cash receipts, and sales returns and allowances for each customer and to maintain customer account balances. * The master file is updated from the sales, sales returns and allowances, and cash receipts computer transaction files. * It is also called the A/R subsidiary ledger or subledger * **Accounts Receivable trial balance** - A list of the amounts owed by each customer at a point in time. * This is prepared directly from the A/R master file. * It is often an aged trial balance. * **Monthly statements** - A document sent by mail or electronically to each customer indicating the beginning balance of A/R, the amount and due date of each sale, cash payments received, credit memos issued, and the ending balance due. ## 2. CASH RECEIPTS TRANSACTION #### Accounts * Cash in bank (debits from cash receipts) * Accounts receivable #### Business Functions * **Processing and recording cash receipts** - Includes receiving, depositing and recording cash - currency & checks. * The possibility of theft is the most important concern (both before and after recorded). * All cash receipts must be deposited intact and recorded in the cash receipts transaction file. * Remittance advices are important for this purpose. #### Documents and Records * **Remittance advice** - A document that accompanies the sales invoice mailed to the customer and can be returned to the seller with the cash payment. If no remittance advices are received the person opening the mail should prepare it. Used to permit the immediate deposit of cash & to improve control over custody of assets. * **Prelisting of cash receipts** - A list prepared when cash is received by someone who has no responsibility for recording sales, A/R, or cash and who has no access to accounting records. * It is used for verifying whether cash received was recorded and deposited. * **Cash receipts transaction file** - A computer generated file that includes all cash receipts transactions processed by the accounting system for a period. * Used to prepare the cash receipts journal and update the A/R and general ledger master files. * **Cash receipts journal or listing** - A report generated from the cash receipts transaction file that includes all transactions for any time period. ## 3. SALES RETURNS AND ALLOWANCES TRANSACTION #### Accounts * Sales returns and allowances * Accounts receivable #### Business Functions * **Processing and recording sales returns and allowances** - When a customer is dissatisfied with the goods, the seller often accepts the returned goods or grants a reduction in the charges. * It is necessary to issue a Receiving Report and return the goods to store. * Record the transaction promptly and accurately on the Sales and Returns Journal & A/R master file. As an aid for control & to facilitate recording Credit Memos are issued. #### Documents and Records * **Credit memo** - A document indicating a reduction in the amount due from a customer because of returned goods and allowances granted * **Sales returns and allowances journal** - A journal used to record sales returns and allowances. Sales journal can be used instead. ## 4. CHARGE-OFF OF UNCOLLECTIBLE ACCOUNTS TRANSACTION #### Accounts * Accounts receivable * Allowance for uncollectible accounts #### Business Functions * **Charging off uncollectible accounts receivable** - When the company concludes that an amount is no longer collectible, it must be charged off - e.g. if a customer becomes bankrupt. * Necessary adjusting entries are made. #### Documents and Records * **Uncollectible account authorization form** - A document used initially to indicate authority to write an account receivable off as uncollectible. * **General journal** ## 5. BAD DEBT EXPENSE TRANSACTION #### Accounts * Bad debt expense * Allowance for uncollectible accounts #### Business Functions * **Providing for bad debts** - The provision should be sufficient to allow for the current period sales that the company will be unable to collect in the future. * Allowance method is used. #### Documents and Records * **General journal** ## III. METHODOLOGY FOR DESIGNING TESTS OF CONTROLS AND SUBSTANTIVE TESTS TRANSACTIONS FOR SALES ### UNDERSTANDING INTERNAL CONTROLS - SALES * Typical approach - Auditor prepares an internal control questionnaire, and performs walk-through tests of sales. ### ASSESS PLANNED CONTROL RISK - SALES Information obtained in understanding internal control is used to assess control risk. There are four essential steps: 1. The auditor needs a framework for assessing control risk. The framework for all classes of transactions is the six transactionrelated audit objectives. 2. Identify the key internal controls and weaknesses for sales. 3. Associate the controls and weaknesses identified with the objectives. 4. Assess the control risk for each objective by evaluating the controls and weaknesses for each objective. Step four is critical because it affects the auditor's decisions about both tests of controls and substantive tests. It is a highly subjective decision. The following are key control points auditors will consider in their evaluation of the internal control system of the client. ### ADEQUATE SEPARATION OF DUTIES * Person responsible for inputting sales and cash receipts transaction information into the computer vs. person having access to cash. * Credit granting function vs. the sales function (to minimize the sales people tendency to optimize volume even at the expense of high bad debt write-offs). * Personnel responsible for doing internal comparisons vs. those entering the original data. (E.g. comparison of batch control totals with summary reports and comparison of A/R master file totals with the GL balance should be done by someone independent of those who input sales & cash receipt transactions). ### PROPER AUTHORIZATION Three key points of authorization * Credit must be properly authorized before sales takes place. * Goods should be shipped only after proper authorization. * Price, including freight and discount, must be properly approved- to ensure sales is billed at the price set by co policy ### ADEQUATE DOCUMENTS AND RECORDS * Documents and records used must be adequate. * Should contain sufficient information. * Most companies automatically prepare a multi-copy prenumbered sales invoice at the time the customer places an order. - Useful for minimizing the chance of failure to bill the customer if all invoices are accounted for periodically. ### PRENUMBERED DOCUMENTS * Use of prenumbered documented prevents both the failure to bill or record sales and the occurrence of duplicate billings and recordings. * All should be properly accounted for. * e.g. filing, by a billing clerk, of a copy of all shipping documents in sequential order after each shipment is billed, with someone else periodically accounting for all numbers and investigating the reason for any missing documents. ### MONTHLY STATEMENTS * Sent by someone having no responsibility for handling cash or preparing the sales and A/R records. * Encourages response from customers if the balance is improperly stated. * All disagreements about the balance in the account should be directed to the independent designated official. ### INTERNAL VERIFICATION PROCEDURE * For fulfilling the each of the six transactions related audit objectives, a computer program or an independent person check the processing and recording of sales. e.g. accounting for numerical sequence of prenumbered documents, Checking the accuracy of document preparation. * Reviewing reports for unusual or incorrect items. ### i) DESIGN TESTS OF CONTROLS FOR SALES For each control the auditor plans to rely onto reduce assessed control risk, one or more tests of controls must be designed to verify its effectiveness. The nature of the tests of controls is determined from the nature of the control. Carefully Read the illustration attached in the material (Table 13-2). ### ii) DESIGNING SUBSTANTIVE TESTS OF TRANSACTIONS FOR SALES In designing substantive tests of transactions, some procedures are commonly used on every audit regardless of the circumstances of tests, where as others are dependent on the adequacy of the controls and the results of the tests of controls * The audit procedures are affected by the internal controls and tests of controls for that objective. * Materiality and results of the prior year affect the procedures used. The typical substantive tests of transactions are shown in the table provided above. (Table 13-2). Below you will find additional procedures to be performed in relation to the transaction related audit objectives. ### RECORDED SALES EXIST For this objective, the auditor is concerned with the possibility of three types of misstatements. * Sales being included in the journals for which no shipment was made, * Sales recorded more than once, and * Shipments being made to nonexistent customers and recorded as sales Many auditors do substantive tests of transactions for existence objective depend on where the auditor believes the misstatements are likely to take place. The test will be done only if they believe that a control weakness exists. ### Recorded Sales for which there was No Shipment * Trace selected entries from the sales journal to make sure that related copies of the shipping and other supporting documents exist. * If the possibility of fictitious duplicate copy of a shipping document, trace amounts to the perpetual inventory records. * Trace the credit in the A/r master file to its source- if collected or goods returned, there must originally have been a sale. If credited for bad debt or if the account was still unpaid, intensive follow-up by examining shipping docs and customer order docs. ### Sales Recorded More than Once * Duplicate sales can be determined by reviewing a numerically sorted list of recorded sales transactions for duplicate numbers. * Also test proper cancellation of shipping documents. ### Shipment Made to Nonexistent Customers * Can occur only when the person recording sales is also in a position to authorize shipments. * If controls are weak, it is difficult to detect. ### EXISTING SALES TRANSACTIONS ARE RECORDED * Normally, substantive test for completeness is less emphasized. * But if controls are inadequate, which is likely if the client does no independent internal tracing from shipping documents to the sales journal, substantive testes are necessary. * Test for unbilled shipments to trace selected shipping documents from a file in the shipping department to related duplicate sales invoices and the sales journal. ### Direction of Testing * Tracing from source documents to the journals- a test for omitted transactions Completeness Objective... likely starting point could be a shipping doc...a sample selected and traced to sales invoices and sales journal. * Tracing from the journals back to source documents- a test for nonexistent transactions- existence objective....likely starting point could be the journal... a sample of invoice numbers is selected from the journals and traced to duplicate sales invoices, shipping docs, and customer orders. SALES ARE ACCURATELY RECORDED ### Accurate recording of sales - shipping the amount of goods ordered, accurate billing for the amount of goods shipped, and accurately recording the amount billed. Typical substantive tests include: Re computing information in the accounting records * Start with entries in the sales journal to compare the total of selected transactions with A/R master file entries & duplicate sales invoices. * Compare prices on the duplicate sales invoices with an approved price list, * Re compute extensions and footings * Compare details listed on the invoices with shipping records for description, quantity, and customer identification When sales invoices are automatically calculated and posted by a computer, the auditor may be able to reduce substantive tests of transactions for the accuracy objective. If the auditor determines that the computer is programmed accurately and the price list master file is authorized and correct, detailed invoice calculations can be reduced or eliminated. In this case, the focus will be on determining if effective computer controls exist. ### RECORDED SALES ARE PROPERLY CLASSIFIED * Sales of cash vs. credit sales * Exclude sales of operating assets such as machinery * Use of more than one sales classification..... Regular, installment... ### SALES ARE RECORDED ON THE CORRECT DATES * Sales should be billed and recorded as soon after shipment takes place as possible to prevent the unintentional omission of transactions from the records and to make sure that sales are recorded in the proper period. * Compare the date on selected bills of lading or other shipping documents with the date on the related duplicate sales invoices, the sales journal, and the A/R master file. ### SALES TRANSACTIONS ARE PROPERLY INCLUDED IN THE MASTER FILE AND CORRECTLY SUMMARIZED * Needed b/se the accuracy of these records affect's the client's ability to collect outstanding receivables. * The sales journal must be correctly totaled and posted to the GL Perform clerical accuracy tests such as footing the journals and tracing the totals and details to the GL and the master file to check whether there are misstatements. * The distinction between posting and summarization and other transaction related audit objectives is that posting and summarization includes footing journals, master file records, and ledgers and tracing from one to the other among these three. * When footing and comparisons are restricted to these three records, the process is posting and summarization. In contrast, accuracy involves determining the monetary correctness of transactions and comparing amounts b/n docs or with journals and master file records. ### SALES RETURNS AND ALLOWANCES The transaction-related audit objectives and the client's methods of controlling misstatements are essentially the same for processing credit memos as those described for sales. But two important differences: * Materiality, and * Emphasis on audit objectives- primary emphasis is normally on testing the existence of recorded transactions as a means of uncovering any diversion of cash from collection of A/R that has been covered up by a fictitious sales return or allowance. Completeness objective is important especially at year-end. Unrecorded SR/A can be material... overstates net income if unrecognized. ## IV. METHODOLOGY FOR DESIGNING TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS FOR CASH RECEIPTS The same methodology used for designing tests of controls and substantive tests of transactions for sales is used for cash receipts. Cash receipts tests of controls and substantive tests of transactions audit procedures are developed around the same framework used for sales. Key internal controls for each objective are determined, tests of controls are developed for each control, and substantive tests of transactions for the monetary misstatements related to each objective are developed. The tests of controls depend on the controls the auditor has identified and the extent they will be relied on to reduce assessed control risk. In the Table 13-3 (attached) you will find examples of key controls, common tests of controls, and common substantive tests of transactions to satisfy each of the transaction-related audit objectives for cash receipts. An essential part of the auditor's responsibility in auditing cash receipts is identification of weaknesses in internal control that increase the likelihood of fraud. ### DETERMINE WHETHER CASH RECEIVED WAS RECORDED It is difficult to detect a cash fraud occurred before the cash is recorded in the cash receipt journal or other cash listing. * Internal controls designed to satisfy completeness objective are important. * Trace from prenumbered remittance advices or prelists of cash receipts to the cash receipt journal and subsidiary A/r records as a substantive tests of the recording of the actual cash received... effective only if a cash register tape or some other prelisting was prepared at the time cash was received ### PREPARE PROOF OF CASH * A useful audit procedure to test whether all recorded cash receipts have been deposited in the bank account. * Total cash receipts recorded in the journal vs. actual deposits made during the month... * Helps to detect recorded cash receipts that haven't been deposited, unrecorded deposits, unrecorded loans, bank loan deposited directly into the bank account etc. * Can not help to detect cash receipts that have not been recorded in the journals or time lags in making deposits. Performed only when controls are weak. ### TEST TO DISCOVER LAPPING OF A/R Lapping of A/R is the postponement of entries for the collection of receivables to conceal an existing cash shortage. * The defalcation is perpetrated by a person who handles cash receipts and then enters them into the computer system. * Involves differing recording the cash receipts from one customer and covers the shortage with receipts of another. This in turn is covered from the receipts of a third customer few days later. * **Prevention....** Separate duties and mandatory vacation policy for employees who both handle cash and enter cash receipts into the system. * **Detection...** Compare the name, amount, and dates shown on remittance advices with cash receipts journal entries and related duplicate deposit slips. ## V. METHODOLOGY FOR DESIGNING TESTS OF DETAILS OF BALANCES The methodology that auditors follow in designing the appropriate tests of details of balances for accounts receivable involves some major steps summarized in figure 2.1 below. These steps and related audit work and decision involves various audit activities performed and decisions made in the evidence planning phase of the audit, materiality and risk considerations and tests of controls and substantive tests of transactions discussed in this chapter of the material. Deciding the appropriate tests of details of balances evidence is complicated because it must be decided on an objective-by-objective basis, and there are several interactions that affect the evidence decision. For example, the auditor must consider inherent risk, which may differ by objective, and results of substantive tests of sales and cash receipts, which also may vary by objective. The auditor must also consider the results of tests of controls and the related control risk assessment. In designing tests of details of balances for accounts receivable, it is essential to satisfy each of the nine balance-related audit objectives. * Existence * Completeness * Accuracy * Classification * Cutoff * Realizable value * Rights and obligations **Figure 2.1: Designing Tests of Details of Balances Identify client business risks affecting accounts receivable.** * Set tolerable misstatement and assess inherent risk for accounts receivable. * Assess control risk for sales and collection cycle. * Design and perform tests of controls and substantive tests of transactions for sales and collection cycle. * Design and perform analytical procedures for accounts receivable balance. * **Design tests of details of accounts receivable balance Sample size to satisfy balance-related Items to select audit objectives.** * **Timing** Important points on the Designing Tests of Details of Balances (figure 2.1) are discussed below. ### Identify Client Business Risks Affecting Accounts Receivable Tests of A/R are based on auditors understanding of the client's business and industry. As part of this understanding, * the auditor studies the client's industry and external environment and evaluates management objectives and business processes to identify significant business risks that could affect the FSs including A/Rs. * perform preliminary analytical procedures that may indicate increased risk of misstatement in A/R. * Client's business risk affecting A/R is considered in the auditor's evaluation of inherent risk and planned evidence for A/R ### Set Tolerable Misstatement and Assess Inherent Risk for Accounts Receivable * Set preliminary judgment about materiality set for the entire FS and then allocated to each significant balance sheet accounts, including A/R... Tolerable Misstatement * A/R is one of the most material accounts in the FS for companies that sell on credit. * Inherent risk is assessed for each objective for an account * such as A/R considering the client's business risk and the nature of the client and industry. * For most audits, inherent risk for A/R is moderate or low except for two objectives: * A/R is stated at net realizable value- due to judgment involved & intentional misstatement and * Sales and sales return & allowance cutoff is correctdue to possibility of misstatement. ### Assess Control Risk for Sales and Collection Cycle As a means to good relations with customers, mgt is concerned with keeping accurate records....hence may have good internal control over sales & cash receipts & A/R Areas of concern: * Controls that prevent or detect defalcations * Controls over cutoff, and * Controls related to allowance for uncollectible accounts (e.g. approval of credit before shipment) The auditor must relate control risk for transactionrelated audit objective to balance-related audit objectives in deciding planned detection risk and planned evidence for tests of details of balances. **Example:** Assume that the auditor concluded that control risk for both sales and cash receipts transactions is low for the accuracy transaction-related audit objective. The auditor can therefore conclude that controls for the accuracy balance-related audit objectives for A/R are effective b/se the only transactions affecting A/R are sales and cash receipts. If sales return and allowances & charge-off of uncollectible A/R are significant, assessed CR must also be considered for these classes of transactions. **Important point on the relationships:** * For sales, the existence transaction-related audit objective affects the existence balance-related audit objective, but for cash receipts the existence transaction-related audit objective affects the completeness balance-related audit objective. * Three A/R balance-related audit objectives are not affected by assessed control risk for classes of transaction--Realizable value, Rights & Presentation and disclosure. To reduce assessed control risk below maximum for these three objectives, separate controls are identified and tested. ### Design and Perform Tests of Controls and Substantive Tests of Transactions * The results of the tests of controls determine whether assessed control risk for sales and cash receipts needs to be revised. * The results of the substantive tests of transactions are used to determine the extent to which planned detection risk is satisfied for each accounts receivable balancerelated audit objective. ### Design and Perform Analytical Procedures * Most analytical procedures (AP) performed during the detailed testing phase are done after the balance sheet date but before tests of details of balances since all the transactions are to be in the record. * APs are done for the entire sales and collection cycle, not only for A/R.---due to close r/n ship among accounts. * When APs in the sales and collection cycle uncover unusual fluctuations, the auditor should make additional inquiries of management. * Mgt's response should be critically evaluated for adequacy of the explanation and whether they are supported by other corroborative evidence. In addition to APs, * Review A/R for large and unusual amounts Individual receivables that deserve special attention are large balances, accounts that have been outstanding for a long time, receivables from affiliated companies, officers, directors, and other related parties, and creditors. **Common Examples of AP** * Gross margin percentage with previous years * Sales by month over time * Sales returns and allowances as a percentage of gross sales with previous years (by product line) * Individual customer balances over a stated amount with previous years * Bad debt expense as a percentage of gross sales with previous years * Days that accounts receivable are outstanding with previous years * Aging category as a percentage of receivables with previous years * Allowance for uncollectible accounts as a percentage of accounts receivable with previous years * Charge-off of uncollectible accounts as a percentage of total accounts receivable with previous years ### Design And Perform Tests Of Details Of Accounts Receivable Balance * Tests of details of balances for all cycles are directed to balance sheet accounts, but income statement accounts are not ignored because they are verified as a by-product of the balance sheet accounts. * For designing tests of details of balances, the auditor needs to decide on planned detection risk. Basically, this decision is a result of combined consideration of various factors such as the acceptable audit risk, inherent risk, control risk, substantive tests of transactions and analytical procedures decision made until this phase of the audit. * Planned detection risk for each objective is, finally, an auditor decision, decided by subjectively combining the conclusions reached about each of the factors. * Audit procedures selected and their sample size depends heavily on whether planned evidence for a given objective is low, medium, or high. * Confirmation of A/R is the most important test of details of A/R. ### Designing Specific Audit Procedures and Timing of Decisions for Accounts Receivable (Refer the attached Table15-4 and Table 15-5) i) **Accounts Receivable Are Correctly Added And Agree With The Master File And The General Ledger** * An aged trial balance is a listing of the balances in the A/R master file at balance sheet date. * Test information on the aged trial balance for a detail tiein. * Test information on the aged trial balance must done before any other tests to assure the auditor that the population being tested agrees with the GL and A/R master file. * Must be test footed, and total on the trial balance be compared with the GL. * Trace individual balances to supporting documents such as sales invoices to verify customer's name, balance, and proper aging. * Sample size depends on No. of a/cs, degree of tests done in previous phases of the audit, degree of independent verification. * Audit software can be helpful- footing, cross-footing, & recalculating the aging. ii) **Recorded Accounts Receivable Exist** * Confirmation is the most important test of details of balances. * If no customer response, examine supporting documents to verify the shipment of goods and evidence of subsequent cash collection--- Alternative evidence for nonresponse. iii) **Existing Accounts Receivable Are Included** * Difficult to test account balance omitted from the aged trial balance unless comparison with the controlling account (GL) reveals it. * If all sales to a customer are omitted from the sales journal, the understatement of A/R is almost impossible to uncover by tests of details of balances. * The understatement of sales and A/R is best uncovered by substantive tests of transactions for shipments made but not recorded and by analytical procedures. iv) **Accounts Receivable Are Accurate** * Confirm selected accounts. * For nonresponses perform alternative procedures. * Test debits and credits to individual customer's balances by examining supporting documents for shipment and cash receipts. v) **Accounts Receivable Are Properly Classified** * Review the aged trial balance for material receivables from affiliates, officers, directors, and other related parties. * Review for any nontrade receivables. * Ensure that notes receivables or accounts that should not be classified as current asset are segregated from the regular accounts. * If credit balances in A/R are significant, reclassify it as accounts payable. vi) **Cutoff For Accounts Receivable Is Correct** * Cutoff misstatements exist when current period transactions are recorded in the subsequent period or subsequent period transactions are recorded in the current period. * Objective of the test is to verify whether transactions near the end of the accounting period are recorded in the proper period. * Cutoff errors affect current period income. * In determining appropriate cutoff * a) Decide on the appropriate criteria for cutoff * b) Evaluate whether the client has established adequateprocedures to ensure a reasonable cutoff, and * c) Test whether a reasonable cutoff was obtained. * Sales Cutoff * Sales Return and Allowance Cutoff * Cash Receipts Cutoff vii) **Accounts Receivable Is Stated At Realizable Value** * IFRS requires that A/R be stated at the amount that ultimately be collectedGross receivable less allowance for uncollectible accounts. * The auditor should evaluate whether the allowance is reasonable. * For evaluation, they prepare an audit schedule that analyses the allowance for uncollectible accounts. * Start with review of the results of the tests of controls that are concerned with the client's credit policy. * If the policy is unchanged and results of the tests of the credit policy and credit approval are consistent with the preceding year, the change in the balance must reflect only changes in economic conditions and sales volume. * Carefully examine the noncurrent accounts on the aged trial balance to determine which ones haven't been paid subsequent to balance sheet date. * Then, compare the size and age of unpaid balances with similar information from previous years to evaluate whether the amount of noncurrent receivable is increasing or decreasing over time. * Examination of credit files. * Discussion with the credit manager. * Review of the client's correspondence files. viii) **The Client Has Rights to Accounts Receivable** * To uncover instances in which the client has limited rights to receivables (as a result of pledging, assignment, factoring, discounting...), auditors, □ Review minutes. * Discuss with the client. * Confirm with the bank. * Examine debt contracts for evidence of A/R pledged as collateral, and • * Examine correspondence files. ix) **Accounts Receivable Presentation and Disclosures Are Proper** * The auditor must decide whether the client has properly combined the amounts and disclosed related party information in the statements. * To evaluate adequacy of presentation and disclosure, auditors need thorough understanding of IFRS. * Decide whether material amounts requiring separate disclosure have actually been separated. * E.g. receivable from officers and affiliated companies * Evaluate adequacy of the footnotes. * E.g. information about pledging, discounting, factoring, assignment of A/R, and amount due from related parties. ### CONFIRMATION OF ACCOUNTS RECEIVABLE BALANCE * Primary audit procedure for testing existence, accuracy and cutoff. * Addresses 5 of the 8 balance-related audit objectives (not classification, realizable value, and presentation & disclosure). * Expensive audit procedure – auditor and client time – but highly reliable evidence. * Required procedure in normal circumstances. ### Exceptions to Sending A/R Confirmations 1. Accounts receivable are immaterial. 2. The auditor considers confirmations ineffective evidence because response rates will likely be inadequate or unreliable. 3. The combined level of inherent risk and control risk is low and other substantive evidence can be accumulated to provide sufficient evidence. ### Type of Confirmation * **Positive confirmation** - confirm the printed balance on the confirmation. * **Blank confirmation form** – requests customer to fill in balance amount on the confirmation. * **Invoice confirmation** – confirm one or more invoices instead of the total balance. * **Negative confirmation** – respond only if balance is incorrect. ### 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 yearend. ### Sample Size Factors affecting sample size includes: * Tolerable misstatement * Inherent risk * Control risk * Achieved detection risk from other substantive tests * Type of confirmation ### Selection of Items for Testing * Stratification is desirable – based on dollar/birr amount or length of time outstanding. But a sample is also needed for judging total population. * When selecting a sample of accounts receivable for confirmation, the auditor should be careful to avoid being influenced by the client. * 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. ### Evaluating Returned Confirmations * **Clean responses** no follow up required. * **Responses with disagreement** - follow up with the client for reason. Reasons could be timing issues, customer can't confirm (or won't), or errors. Customer completes the confirmation weeks after the cutoff date and their system does not allow them to go back to the cutoff date to accurately confirm. * **No response** - send a second request, do follow up procedures - subsequent receipts testing Subsequent Cash Receipts 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. * If customer paid for the goods, then the sale must exist. ### Duplicate Sales Invoices * These are useful in verifying the actual issuance of a sales invoice and the actual date of the billing. * If a sales invoice was issued to a customer, then the sale most likely exists. ### Shipping Documents These are important in establishing whether the shipment was actually made and as a test of cutoff. ### Correspondence with the Client * Usually, the auditor does not need to review correspondence as a part of alternative procedures, but correspondence can be used to disclose disputed and questionable receivables not uncovered by other means. ### Drawing Conclusions * Reevaluate internal control. * Evaluate the qualitative nature of misstatements. * Determine whether sufficient evidence was obtained.