8.2 Audit of Receivable PDF

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8.2 Audit of Receivables Inherent risk of Receivables balance Inherent risk of Receivables balance Receivables tends to be a material balance in most sets of accounts and an area auditors focus on as a higher risk balance. Areas of potential higher risk for Receivables are: 

 

The adequacy of the provision for bad and doubtful debts (VALUATION). Many entities have large amounts of trade receivables, and without adequate credit control and credit limit procedures, there can be considerable potential for bad debts if receivables prove to be uncollectible. Overstatement of Sales and receivables (EXISTENCE): Because of the direct impact on profit of sales/receivables there is a higher risk of receivables being overstated Sales/ receivables cut-off errors (CUT-OFF) : Because of the direct impact on profit of sales/receivables there is a risk of recording sales/receivables in the wrong period

In exam questions students should be aware that situations where, poor credit control exists or there are significant increases in receivable days would be an indicator that the provision of bad and doubtful debts is an area of high inherent risk. In addition situations where bonus schemes are based on the absolute level of sales rather than on a combination of sales and collections that this would be an indicator that the existence of sales and sales cut-off are areas of higher inherent risk because of the obvious incentive to maximise sales, potentially not always be legitimate means.

Extent of substantive testing for Receivables Because of the nature of directional testing the completeness of receivables will primarily be covered by our audit procedures on sales which will focus on completeness. As with any substantive procedures the extent of audit procedures (and sample sizes) will depend on the auditors assessment and testing of the internal control system and systems relevant to the balance. The primary systems that are relevant to the receivables balance are the Sales and Cash receipts systems.

Key documents for the audit of Receivables Documents and supporting information that will be used in the audit of receivables For Receivables and prepayments, auditors will normally use the following sources of information and documentation as part of their audit:  Nominal Ledger/trial balance  Summary aged trade receivables listing  Detailed trade receivables Ledger  Detailed bad debt provision  Detailed doubtful debt provision  Detailed list of prepayments Aged receivables listing

The aged receivables listing is a critical source of audit evidence and information. The aged receivable listing will show a list of all outstanding customer balances outstanding aged by the date of the invoices included in the balance, this is an invaluable source of evidence for assessing the likelihood of bad debts. Generally, the longer an invoice/balance has been outstanding then there is an increase in the risk of bad debts Example Aged Receivables Listing A critical audit test will be to:    

Ensure that the aged receivables listing agrees to the trial balance for receivables and detailed receivables ledger; and Check that the aged receivables listing adds up; and To test the ageing of a sample of invoices for accuracy; and Ensure that any foreign currency balances are correctly translated at the year end rate

These tests establish the reliability of the aged receivables listing as a basis for audit testing.

Risk assessment task and analytical review for receivables TASK - You are an audit senior on the audit of Raincover plc a Company that manufactures and sells Umbrellas You are auditing receivables and have been given the following information

a) risk

Perform analytical review procedures to identify the areas of higher audit

b) Identify the additional information you will need to audit the receivables balance

Trade Receivables Substantive Testing

Main Trade Receivables Substantive Procedures Receivables substantive procedures will focus on the Existence, Valuation, Rights and obligations and cut-off assertions. The major substantive procedures will include:  Analytical Review procedures (e.g receivables days compared with last year and industry) (assists the auditor in identifying areas of higher risk and gives some assurance against all audit assertions)  External confirmation of outstanding trade receivables with confirmations received direct from customers (Provides a strong source of audit evidence for the existence and rights and obligations assertion)  Review of subsequent cash receipts (Provides audit evidence for the existence and valuation assertions)  Performance of cut-off testing (provides audit evidence for the cut-off assertion)  Review of aged receivables listing (provides audit evidence for the valuation assertion)  Review of adequacy of bad and doubtful debts provision (provides audit evidence for the valuation assertion)

Receivable Confirmations Receivable confirmations involve the auditor obtaining direct confirmation from customers of the amounts that they owe the audit client. it provides a strong source of audit evidence and is a crucial audit test for the Receivables balance. Objective of Receivables confirmations To receive external confirmation of outstanding trade receivables customer balances and gain evidence as to the existence of the stated receivables balance. Receivables confirmations represent confirmation from a sample of customers of the balance they owe the Company and form a strong form of audit evidence regarding the Existence and Rights and obligations assertions. ISA 505: External Confirmations defines external confirmation as Audit evidence obtained as a direct written response to the auditor from a third party and notes that depending on the circumstances of the audit, audit evidence in the form of external confirmations received directly by the auditor from confirming parties may be more reliable than evidence generated internally by the entity.

What Receivable balances will the auditor seek to confirm? The auditor will generally seek confirmation of:   

All balances greater than the tolerable misstatement (linked to performance materiality) ; Any unusual balances (e.g customers paying their balance with round sum amounts) A statistical sample of the remaining trade receivables population

Process Receivables confirmations process

Issuing the confirmation letter

The receivables confirmation letters will be prepared on Clients headed notepaper, signed by the client and attached will be a statement from the client, it is vital that the auditor ensures strict control over the preparation and dispatch of the confirmation letters in order to reduce the risk of fraudulent manipulation. The auditor also needs to ensure that all replies are sent directly to the auditor. The process can be summarised as follows:

Timing Receivables confirmations should generally be carried out based on Year-end balances. However, if timing is tight at year end because the company has a very fast reporting deadline requiring a quick audit sign off, there may not be enough time to perform the procedure at year end (for example Apple reports its consolidated results within 4 weeks of year-end). In such cases it is possible to carry out receivables confirmations in advance of year-end, but no more than 3 months before year end provided:  

Internal controls are strong; and Roll-forward testing of sales and cash receipts is carried out

Types of Receivable Confirmations The Receivables confirmation can seek either positive or negative confirmation:  

Positive confirmation: Customer requested to confirm the accuracy of the balance or state any disagreed amounts Negative confirmation: Customer to reply only if in disagreement with the amount stated

The Positive confirmation method is used almost exclusively and is generally preferable because it gives positive assurance. The negative confirmation method is rarely used and should not be used unless controls are extremely strong, there are few large balances and the auditor expects a very low exception rate. This is because the auditor cannot be sure if the non-reply is just because the customer can’t be bothered to reply, or is actually a confirmation of the balance.

Procedures for non-replies Follow-up procedures

Any non-replies to a receivables confirmation will need to be followed up and ultimately alternative audit evidence will need to be gained over the existence of the receivable balance in order to be able to evaluate the sample. An auditor will have to follow up and gain evidence on 100% of the sample balance selected if a confirmation is not received. In most cases the auditor will try to get a reply if at all possible before performing the more time consuming alternative procedures. So the follow up procedures will be as follows: Send out a repeat confirmation letter If there is still no reply received then the auditor will need to perform the following alternative procedures: 1. Firstly the auditor will agree the unconfirmed customer balance to cash receipts received from the customer subsequent to the date of the receivables confirmation. The fact that a customer has paid outstanding invoices is good evidence that the receivable did exist. 2. For any outstanding invoices in the customer balance not subsequently paid, the auditor will need to perform procedures checking the validity of the sale, this will generally involve  Agreeing the unpaid sales invoice to a sales order and dispatch note to prove that the customer ordered the related goods and that they were dispatched by the client prior to the date of the receivables confirmation  The auditor will also check with the client to see if there is any correspondence from the customer disputing the balance or individual invoices  

It is critical that the auditor performs alternative procedures on all non-replies to Receivable Confirmation letters in order to be able to evaluate the sample that the auditor has picked. This can prove to be a time consuming activity, particularly if the customer has not subsequently paid the outstanding invoices.

Disputed replies to receivable confirmations and evaluating the sample results Disputed/disagreed balances It is very important that the auditor follows up both non replies and disputes/nonagreement. If a reply is received disputing the balance then again follow up procedures are required. Differences may relate to timing issues such as  Sales cut-off (where the client despatched good prior to the date of the receivables confirmation but not received by the customer until after the date of the confirmation)  Cash-in-transit (can occur where the customer has sent out a cash payment prior to the receivable confirmation date (for example by cheque) but the cash receipt has not been recorded by the client until after the confirmation date. In such cases the auditor will reconcile the differences and then check that the timing differences are valid differences between the clients receivable balance and the customers confirmed balance. An example of a reconciliation is shown as follows:

The auditor would need to check that the reconciling items were valid timing differences by:  

For cash in transit, check to ensure that the cash/cheque is received by the client and clears it's bank statement within a short period after the circularisation date For goods despatched by the client but not delivered to the customer the auditor should check to source documents such as goods despatch note to ensure that the goods were despatched prior to the circularisation date

The auditor should attempt to reconcile and follow up on any further information provided by the customer. If differences are unexplained after follow up, then they should be treated as an error and evaluated as part of the sample and considered for evidence of wider problems e.g (Teeming and Lading, theft of cash, cut-off issues, product returns).

Audit of bad debt provisions Audit risk The key audit risk in the audit of bad debt provisions is that adequate provision has been made for all potential bad debts. Whilst this can be judgmental the auditor is often able to gain a good deal of assurance based on the timing of audit procedures. In most cases the audit will be carried out some period after the end of the year so the auditor will have the benefit of being able to see what has happened in terms of cash collected from customers after the end of the year. Clearly the best evidence that a bad debt provision is not required is that a customer has subsequently paid the invoice/balance. The audit work on bad debt provisions therefore focusses on two key areas:  

Review of post year end cash receipts to establish which receivable balances/invoices are still unpaid at the date of the audit; and Review of the aged receivables listing for older outstanding balances that remain unpaid

Focus on these two tests enables the auditor to identify older receivables which remain unpaid at the date of the audit work being carried out. These balances are the highest risk for bad debts and the auditor will then focus on other procedures, such as discussion with management, review of correspondence with the customer to establish whether a bad debt provision is required for the outstanding balance. Audit work on specific bad debts/provisions for doubtful debts

An area of high inherent risk, so assessing the adequacy of provisions for bad and doubtful debts is an important audit process. Processes include:        

Compare balance with prior year and sales Calculate receivables days and investigate significant changes Test accuracy of clients provision list and ensure it agrees to the trial balance Review for after date cash receipts of outstanding receivables Review aged receivables listing and for un-provided overdue balances: Discuss old outstanding balances with client management Review correspondence files with customers/lawyers Review after-date credit notes/sales returns/ bad debt write-off

Tests for general provisions for doubtful debts include: Checking:   

Reasonable formula based on previous experience Computation correct Exclusion of balances provided for as part of the specific bad debts provision to avoid over-provision

Sales/Receivable cut-off testing Ensuring that sales/receivables have been recorded in the correct accounting period is another area of potential higher risk when auditing sales/receivables. Clearly one way of inflating profits for an accounting period is to include sales/receivables that relate to the following accounting period. In order to gain assurance that this has not occurred auditors will perform the following tests: In order to ensure sales and receivables are recorded in the correct period:   

For a sample of sales invoices recorded before and after the year end check the date of despatch and ensure that the sales/receivables are recorded in the correct period For a sample of dispatches before and after the year end ensure that the sales/receivables are recorded in the correct period

Prepayments AUDIT OF PREPAYMENTS Prepayments will generally not be a material balance, but the auditor will generally carry out the following audit tests on prepayments: The extent of audit work on prepayments will depend on the materiality of the balances, but audit procedures would normally include:   

Test accuracy of clients prepayments list Ensure list ties in to nominal ledger Compare the balance with previous years

 

Agree significant balances to invoice/payment check calculation and that cost should be prepaid Review other audit work e.g review of expenses, cash payments for evidence of any balances that should be prepaid

Audit of Sales/Revenue Sales audit work There is often a heavy reliance on systems/control work so the extent of audit work on sales will vary dependent on the testing of controls. However, generally substantive audit procedures will be carried out as follows: Directional testing: test a sample of dispatches etc through to invoice to ensure all sales invoiced, invoices are accurate, classified correctly and that all sales are recorded in the accounting system.  Sales cut-off testing  Analytical review procedures eg:  Compare sales by product type with prior years and budget, compare sales quantities and prices  Compare gross margin by product with prior years  Compare levels of sales returns etc Contract Revenue 

The auditor will also need to consider whether contract revenue is being recognised in accordance with IAS15. The work would include:      

Agreeing total contract value to original contract Reviewing the contract to ensure that it meets the conditions for revenue to be recognised over time Agreeing stage of completion to third party expert if the output method is being used for contract revenue recognition Agreeing total costs to date to source documentation e.g purchase invoice, timesheets etc Reviewing estimated amount of costs to complete Discussion of contract progress with client management

SUMMARY Receivables, (particular existence and valuation), is often a material balance and identified as areas of high inherent risk. It is therefore balances that auditors focus on. The balance can be difficult to audit because it can comprise outstanding amounts from many different customers. The critical audit test for the existence of receivables is the receivables confirmation, this provides valuable third party external confirmation but has limitations, where there are non-replies and the confirmation does not provide any evidence regarding valuation. The extent of testing and size of receivables confirmation sample will depend on the auditors’ assessment and testing of controls in the sales and cash receipts system....