Audit of Receivables and Sales PDF

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TABLE OF CONTENTS Primary Substantive Procedures 1 Reconciliation of Subsidiary Ledger with General Ledger 1 Confirmation of Receivables and Review of Subsequent Cash Receipt 1 Evaluating the Adequacy of the Allowance for Doubtful Accounts 1 Expected Credit Loss 1 Accounts Receivable and Sales Cutof...

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TABLE OF CONTENTS

1. Primary Substantive Procedures 1.1 Reconciliation of Subsidiary Ledger with General Ledger 1.2 Confirmation of Receivables and Review of Subsequent Cash Receipt 1.3 Evaluating the Adequacy of the Allowance for Doubtful Accounts 1.4 Expected Credit Loss 1.5 Accounts Receivable and Sales Cutoff 1.6 Investigate Any Transactions with or Related Party Receivables. 1.7 Analyzing Credit Balances and Unusual Items. 1.8 Ascertaining Whether Any Receivables Have been Pledged or Assigned 1.9 Performing Analytical Procedures. 2. Other Substantive Procedures 2.1 Bill and Hold Transaction 2.2 Multiple Element Arrangement 2.3 Percentage of Completion Method 2.4 Sales Returns 2.5 Receivables Denominated in Foreign Currency 2.6 Analysis of Notes Receivable and Related Interest 3. Situational Problems 3.1 Palisades, Inc. - Unreplied Confirmation Letter 3.2 Lakeside Company - Forbidden Communication with Customers 3.3 Thorne Company - Three GAAS in Fieldwork 3.4 Solar Technologies Inc. - Confirmation Request 3.5 Halston Toy Manufacturing Co. - Sales Returns 4. Problem Solving 4.1 Audit of Trade Receivables 4.2 Estimation of Bad Debt Expense 4.3 Receivable Financing ( Assignment And Factoring) 4.4 Discounting Of Note Receivable 4.5 Audit of Note Receivable 4.6 Audit of Loans Receivable 4.7 Reversal Impairment of Loans receivable 4.8 Audit of Sales

Primary Risks for Accounts Receivable and Revenues The main risks are:  The company intentionally overstates accounts receivable and revenue  Company employees steal collections  Without proper cutoff, an overstatement of accounts receivables and revenue occurs  Allowances are understated PRIMARY SUBSTANTIVE TEST 1. Reconciliation of Subsidiary Ledger with General Ledger An aged trial balance of trade accounts receivable at the audit date is commonly prepared for the auditors by employees of the client, often in the form of computer printout. The client-prepared schedule is a multi-purpose form designed for the aging of the customers’ accounts, the estimating of probable credit losses, and the controlling of confirmation requests. The inclusion of so many phases of the examination of receivables in a single working paper is practicable only for small concerns with a limited number of customers. When trial balances are furnished to auditors by the client’s employees, some independent verification is essential. Determination of the proper extent of testing should be made in relation to the adequacy of the internal controls over receivables. The auditor should test the footings, crossfootings and agings.

2. Confirmation of Receivables and Review of Subsequent Cash Receipt The primary audit procedure to verify the existence and gross valuation of receivable is through confirmation. In accordance with PSA 505 Revised and Redrafted, when using confirmation, the auditor can use either the positive and negative confirmation, or a combination of the two methods to produce more effective procedures. a. Positive Confirmation It is sent to customer of the client by the auditor requesting a response directly as to whether the stated amount owed is correct or incorrect, or to request the customer to provide specific information, such as their account balance with the entity, which is referred to as “blank form”. Positive confirmation is considered to provide more reliable audit evidence; however, it is more costly compared to negative confirmation. b. Negative Confirmation It is sent to customer of the client by auditor requesting a response only if the customer disagrees with the amount stated on the confirmation. When to use Negative Method:  The receivables comprise a large number of small balances.  Internal control surrounding receivables is considered to be effective.  The auditor reasonably believes that recipients of negative confirmation requests will give the requests adequate consideration. Negative confirmation provides audit evidence that is less reliable and less costly as compared to positiveconfirmation. Non-response of the customer may either indicate that the customer agrees with the information in the confirmation request or the customers just ignore the confirmation letter. Other Audit Considerations When Using Confirmation:  The confirmation request should be described that it is not a request for payment, but merely to confirm the account.  The confirmation request should be prepared and sent to the customer under the control of the auditor.  The auditor may include in the confirmation request the details of the transactions, such as customer’s purchase order numbers to improve the response rate.  The confirmation request should be mailed in envelopes bearing the CPA firm’s return address.  Receipt of reply to confirmation request should be under the control of the auditor.

3. Evaluating the Adequacy of the Allowance for Doubtful Accounts\ As part of risk in conducting a business, some customers may default from their payment. Since receivables need to be valued at net realizable value, the company needs to make a reliable estimate of bad debts or doubtful accounts in its financial statements. In some circumstances, receivables are proven to be worthless are written off.An important part of obtaining evidence about the proper valuation of accounts receivable is the auditor's evaluation of the adequacy of the allowance for uncollectible accounts. Since this account is a management estimate, it is typically audited by one or a combination of the following procedures: 1. Evaluating management process of developing the estimate. The auditor's evaluation ordinarily includes: Obtaining a general understanding of the process used in developing the estimate a) Considering the reasonableness of the entity's policies regarding additions to the allowance and writeoffs of doubtful accounts b) Discussing with management the key assumptions regarding collectability and evaluating the reasonableness of the assumptions c) Considering the effectiveness of the controls over the data used in the process d) Evaluating the entity's method of calculating the allowance 2. Reviewing subsequent transactions. Since the best evidence of collectability of receivable is payment by the debtors subsequent to the reporting date, the auditor may review subsequent payment and ascertain the appropriateness of the provisions for bad debts recorded. 3. Developing auditor's independent estimate. Based on the knowledge gained by the auditor regarding the credit and collection process and management process in developing the estimate, the auditor may come up with its independent estimate and compare it with the management estimate. Any significant difference should be investigated and resolved with the management (e.g., credit manager). 4. Expected Credit Losses General Model: Three Stages Stage 1: Insignificant Deterioration Estimate the probability of default in the first 12 months. Ex. On Jan. 1, 2019, Zoom Bank provided a loan of 4M to D Company. Under the loan agreement, the effective interest rate is 10% and that D Company is to pay the annual interest every Dec. 31. The principal amount of the loan is due on Dec. 31, 2023. Jan. 01, 2019 Loan Receivable 4,000,000 Cash 4,000,000 On Dec. 31, 2019, Zoom Bank needs to measure the 12-month expected credit loss for the loan. Zoom Bank determined that the probability of default over the next 12 months is 1%. Dec. 31, 2019 Cash 400,000 Interest Income 400,000 Carrying Amount, 12/31/2019 P4,000,000 PV of Expected CF (4M x 0.683) (2,185,600) Expected Credit Loss 1,814,400 Probability Of Default x 1% 12-month ECL P18,140 Impairment Loss 18,140 Allowance for Credit Loss 18,140 Stage 2: Significant Deterioration Review macro-economic factors, industry information, and reassessing risk in general. Estimate the probability of default for the remaining life of loan. Continuation of example On Dec. 31, 2020, Zoom Bank has determined that there is a significant increase in credit risk of the loan receivable. The probability of the loan being default over the life of the loan is 10%. Dec. 31, 2020 Cash 400,000 Interest Income 400,000

Carrying Amount, 12/31/2020 P4,000,000 PV of Expected CF (4M x 0.7513) (2,253,900) ECL 1,746,100 Probability f Default x 10% 12-month ECL 174,610 ECL allowance, 12/31/2019 (18,140) Impairment Loss P156,470 Impairment Loss 156,470 Allowance for Credit Loss 156,470 Stage 3: Credit Impaired Estimate the probability of default over the loan’s remaining life and records a loss provision. Continuation of example During 2021, D Company began to face financial difficulties. At year-end, Zoom Bank considered the loan impaired. Interest for that year was collected. However, only 40% of the principal amount is expected to be received on due date. Dec. 31, 2021 Cash 400,000 Interest Income 400,000 Carrying Amount, 12/31/2021 P4,000,000 PV of Expected CF (4M x 40% x .8264) (1,322,240) ECL 2,677,760 Allowance for CL12/31/2020 (174,610) Impairment loss P2,503,150 Impairment Loss 2,503,150 Allowance for Credit Loss 103,150 Loan receivable 2,400,000 5. Accounts Receivable and Sales Cutoff The auditor usually tests the sales cutoff by examining invoices and shipping documents for several days both before and after the year-end and by tracing such documents to the sales and accounts receivable records for the appropriate period. This test of sales cutoff may occasionally be made at an interim date to check the adequacy of the company’s procedures. All substantial sales returns after the statement of financial position date should be reviewed carefully as they may represent fictitious sales recorded at year-end. 6.Investigate any transactions with or related party receivables. The auditor must determine the existence of related parties and identify significant related party transactions including those not recognized in the accounting records. These related party relationships can provide opportunities for individuals to act in a way that creates confusion to shareholders. There are many related party transaction risks that materially affects the amount of receivables and sales that appears in the financial statements of an entity. These include all of the contracts entered with related parties that have substantially different terms than those similar transactions entered with unrelated parties. However, the auditors should be concerned more with the possibility that an undisclosed relationship with a party to a material transaction has been used to fabricate transactions. After a related party receivable is identified and considered as material, the auditor should apply substantive tests to that transaction by performing the following steps: 1. Recalculate the total balance of receivables in the subsidiary ledger and determine that it agrees with the balance in the general ledger. 2. Review the list for potential problem accounts or large amounts and obtain an understanding of these transactions and their potential collectibility. 3. If the balances are significant, consider confirmation of several selected individual balances with the related parties involved and reconcile replies. The auditor may also examine the invoices, executed copies of contracts and other documents to support the balances. 4. Determine whether the transaction has been approved by the appropriate officials. 5. Determine the nature of any related party receivable that were written off during the audit period but subsequently reinstated to the general ledger. 6. Determine the adequacy of disclosure in the notes of the transaction, balance of receivable and any amount written off. 7. Analyzing credit balances and unusual items. Customer's credit balances are credit balances in accounts receivable resulting from overpayments, returns and allowances, advance payments from customers, or any unusual items caused by errors or irregularities in the

accounts. These credit balances are classified as current liabilities and not deducted from the debit balance of customer accounts, except when the same is not material in which case only the net accounts receivable may be presented. The auditors should identify and review the listings of credit balances for large or unsual items and test its completeness. If the credit balance appearing on the customer's account is caused by a return of goods purchased, the documents supporting such return of goods, such as credit memo and sales returns and allowances journal, must be reviewed. It should be noted that the auditors must obtain an understanding of these credit transactions and their impact on year-end receivables. 8. Ascertaining whether any receivables have been pledged or assigned. Pledging of receivable happens when a client uses its receivables as collateral on a loan. Accounts receivable that have been pledged are usually labeled by inserting an identifying code in the receivable records or stamping on a copy of sales invoice that such receivable was pledged. But the auditors cannot proceed on the assumption that all pledged receivables have been labeled in that effect and they must be alert to detect any suggestions of unrecorded pledging of accounts receivable. Receivables that were pledged or assigned must be disclosed in the notes to inform the reader of financial statements that there is a contingent liability attached with such receivables. The auditors must review the footnotes regarding the disclosures made for any factored, assigned or pledged receivables. Bank confirmation requests and inquiry may also be used as a medium in gathering evidence of the pledging of receivables. 9. Performing analytical procedures. During an audit, a variety of analytical procedures might be employed, depending on the circumstances and the nature of the business. The auditors must first establish a threshold (it can be a percentage or an amount or both) in performing analytical procedures, to determine the transactions that needs a thorough investigation. Typical analytical procedures for sales include the following: 1. Compare sales for the last month of the fiscal to sales for the rest of the year and the first month after year end. 2. Compare monthly sales returns and credit memos for the last few months of the fiscal year to the first few months following year end. Other analytical procedures can be perform by the auditors are trend analysis, comparison among sales units, receivables turnover, days’ sales in receivables, amount of past due receivables, gross margin ratio, and sales/asset ratios to historical data and industry statistics. Account interrelationships can also be used. For any significant difference or fluctuations noted, investigate the nature and cause of differences and consider whether additional procedures are needed.

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OTHER SUBSTANTIVE PROCEDURES ON AUDIT OF RECEIVABLES AND SALES Bill and Hold Transaction. When a company engages in bill and hold transactions there is a possibility that the company is inappropriately recognizing revenue. The auditors must ascertain that any transactions recognized as sales meet the criteria for revenue recognition as set forth in SEC Accounting and Auditing Enforcement Release No. 108. In these circumstances, the auditors will review the provisions of sales contracts and consider confirming the terms with customers. Multiple Element Arrangement. When a company sells using a multiple element arrangement, the revenue must be allocated to the elements in relation to their fair values. Therefore, there is a possibility that management may attempted to misstate revenue by inappropriate allocation. In these situations, the auditors will review the sales contracts and evaluate the reasonableness of management’s allocation of the revenue to the various elements. Percentage of Completion Method. When a company uses the percentage-of-completion method, there is a risk that management may misestimate the amount of revenue earned on uncompleted contracts. The auditors must carefully evaluate the costs allocated to the contracts and the estimates of the percentage-of-completion. In some cases, the auditors may decide to engage a specialist, such as an engineer. Sales Returns. When a company’s sales agreements allow for returns, there is a risk that management may misstate the estimate of sales returns and, therefore, misstate revenue and receivables. In these situations, the auditors should carefully review the contracts to determine that revenue should be recognized at the time of sale. If revenue recognition is appropriate, they should next evaluate the adequacy of management’s estimate of sales returns. Receivables Denominated in Foreign Currency. Portion of the receivables of an entity may be denominated in foreign currency as a result of sales, loan or other transaction in that foreign currency. As required by the PAS 21 The Effects of Changes in Foreign Exchange Rates, these receivables should be translated using the closing rate at the reporting date. The auditor ordinarily obtains the closing rate and reperforms the translation of the

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foreign currency denominated receivables. The auditor should also ensure that any foreign currency transaction gain or loss should be reported as part of profit or loss. Analysis of Notes Receivable and Related Interest An analysis of notes receivable supporting the general leger control account may be prepared for the auditor by the client’s staff. The information in the analysis ordinarily includes the name of the maker, date, maturity, amount and interest rate. In addition to identifying the accuracy of the analysis prepared by the client, the auditors should trace items to the accounting records and to the note themselves. After ensuring the accuracy of the items included in the analysis of notes receivable, the most effective verification of the Interest Earned account consists of an independent computation by the auditors of the interest earned during the year on notes receivable. The interest section of working paper consists of four columns showing for each note receivable owned during the year the following information:  Accrued interest receivable at the beginning of the year.  Interest collected during the year.  Accrued interest receivable at the end of the year.  Interest earned during the year. If the interest earned for the year as computed by the auditor does not agree with the interest earned as shown in the accounting records, the auditor should investigate any difference as there may be unrecorded interest receipt or notes that was not included in the analysis prepared by the client.

SITUATIONAL PROBLEMS SITUATIONAL PROBLEM 1 Your regular annual audit of Palisades, Inc., included in the confirmation of accounts receivable. You decided to use the positive form of confirmation request. Satisfactory replies were received from all but one of the large amounts. You sent a second and third request to this customer, but received no reply. At this point an employee of the client company informed you that a check had been received for the full amount of the receivable. Would you regard this as a satisfactory disposition of matter? Answer:No. The matter remains unresolved. First, oral evidence from the client is seldom in itself sufficient; the auditors must follow up to determine the reliability of the oral evidence. Second, payment of an account receivable is not confirmation; the account might be fictitious, and the "payment" could have been made by a dishonest employee who had created the fictitious account to conceal a cash shortage. The auditors must examine the customer purchase order or contract, and copies of the sales invoice and shipping document in support of the unconfirmed receivable. They should may also determine the genuineness of the customer by reference to the telephone directory or to credit agency reports. SITUATIONAL PROBLEM 2 Lakeside Company has retained you to conduct an audit so that it will be able to support its application for a bank loan with audited financial statements. The president of Lakeside states that you will have unlimited access to all records of the company and may carry out any audit procedures you consider necessary, except that you are not to communicate w...