COMPLETING THE

TESTS IN THE SALES

AND COLLECTIONS CYCLE:
ACCOUNTS RECEIVABLE
CHAPTER 16

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 CHAPTER 16 LEARNING OBJECTIVES
16-1 Describe the methodology for designing tests of details of
balances using the audit risk model.
16-2 Design and perform substantive analytical procedures for
accounts in the sales and collection cycle.
16-3 Design and perform tests of details of balances for accounts
receivable.
16-4 Obtain and evaluate accounts receivable confirmations.
16-5 Design audit procedures for the audit of accounts receivable,
using an evidence-planning worksheet as a guide.

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 OBJECTIVE 16-1
Describe the methodology for
designing tests of details of
balances using the audit risk model.

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 METHODOLOGY FOR DESIGNING TESTS
OF DETAILS OF BALANCES
The appropriate evidence to be obtained from tests of details
of balances must satisfy the eight balance-related objectives:
1. Detail tie-in
2. Existence
3. Completeness
4. Accuracy
5. Classification
6. Cutoff
7. Realizable value
8. Rights
The methodology for designing these tests is illustrated in Figure 16-1.

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 Substantive Tests of AR balance
The objectives of auditing the AR balance are:
1. Accounts receivable in the aged trial balance agree with related master file amounts,
and the total is correctly added and agrees with the general ledger (Detail tie-in)
2. Recorded accounts receivable exist. (Existence)
3. Existing accounts receivable are included. (Completeness)
4. Accounts receivable are accurate. (Accuracy)
5. Accounts receivable are correctly classified. (Classification)
6. Cutoff for accounts receivable is correct. (Cutoff)
7. Accounts receivable is stated at realizable value. (Realizable value)
8. The client has rights to accounts receivable. (Rights)

In Addition to proper presentation and disclosure.

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 METHODOLOGY FOR DESIGNING TESTS
OF DETAILS OF BALANCES (CONT.)
Identify Significant Risks and Assess the Risk of Material
Misstatement for Accounts Receivable (Phase I):
• Tests are based on the auditor’s risk assessment.
• As part of the assessment of risk of material misstatement, the
auditor determines whether any of the risks are a significant risk.
• For most audits, revenue recognition is considered a significant
risk.

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 METHODOLOGY FOR DESIGNING TESTS
OF DETAILS OF BALANCES (CONT.)
Set Performance Materiality for Accounts Receivable (Phase I):
• The auditor makes a preliminary judgment about materiality for
the entire financial statement, then allocates the amount to each
significant balance sheet account.
• Accounts receivable is typically one of the most material accounts
for companies that sell on credit.
• Even when the ending balance in accounts receivable is small, the
transactions occurring throughout the year in the sales and
collection cycle are almost certain to be highly significant.

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 METHODOLOGY FOR DESIGNING TESTS
OF DETAILS OF BALANCES (CONT.)
Assess Control Risk for the Sales and Collection Cycle (Phase I):
• Internal controls over sales and cash receipts and related accounts receivable
are reasonably effective for most companies because they want to maintain
good relations with customers.
• Auditors are especially concerned with three aspects of internal controls:
1. Controls that prevent or detect embezzlement
2. Controls over cutoff
3. Controls related to the allowance for uncollectible accounts

The primary classes of transactions in the sales and collection cycle are shown
in Figure 16-2.

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Copyright ©2017 Pearson Education, Inc. 16-10
 METHODOLOGY FOR DESIGNING TESTS
OF DETAILS OF BALANCES (CONT.)
Design and Perform Tests of Controls and Substantive Tests of
Transactions (Phase II):
• Chapters 14 and 15 covered designing audit procedures for
tests of controls and substantive tests of transactions, including
deciding sample size and evaluating results.
• Auditors use results of substantive tests of transactions to
determine the extent to which planned detection risk is
satisfied for each accounts receivable balance-related audit
objective.
Figure 16-7 shows three rows for control risk, two for substantive
tests of transactions, one for sales, and one for cash receipts.

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 OBJECTIVE 16-2
Design and perform substantive
analytical procedures for accounts in
the sales and collection cycle.

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 a. Design & Perform Analytical Procedures
Analytical procedures are often done during three phases of the audit: during planning,
when performing detailed tests, and as a part of completing the audit.

Some considerations related to Analytical procedures during detailed tests:

• Most analytical procedures performed during the detailed testing phase are done after the
balance sheet date but before tests of details of balances.
• Auditors perform analytical procedures for the entire sales and collection cycle, not just AR.
because of the close relationship between income statement and balance sheet accounts. If
there is misstatement in sales or sales returns and allowances using analytical procedures, AR
will likely be the offsetting misstatement
• It may focus on the comparison of current year results with previous years, budgets and
industry trends.
 Examples for Analytical procedures related to AR and sales cycle:

1. Compare gross margin percentage with previous years.

2. Compare sales by month over time.
3. Compare sales returns and allowances as a percentage of gross sales with previous years.
4. Compare individual customer balances over a stated amount with previous years.
5. Compare bad debt expense as a percentage of gross sales with previous years.
6. Compare number of days that accounts receivable are outstanding with previous years and
related turnover of accounts receivable.
7. Compare aging categories as a percentage of accounts receivable with previous years.
8. Compare allowance for uncollectible accounts as a percentage of accounts receivable with
previous years.
9. Compare write-off of uncollectible accounts as a percentage of total accounts receivable with
previous years.
In addition, auditors should also review accounts receivable for large and unusual
amounts, such as large balances, accounts that have been outstanding for a long time,
receivables from affiliated companies, officers, directors, and other related parties,
and credit balances.

Because analytical procedures are substantive tests, they reduce the extent to which
the auditor needs to perform detailed tests of balances,
if the analytical procedure results are favorable.
 OBJECTIVE 16-3
Design and perform tests of details of
balances for accounts receivable.

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 1- detail tie-in:
• The Summation of Accounts Receivable Agrees with the Master File and the
General Ledger
Most tests of accounts receivable and the allowance for uncollectible
accounts are based on the aged trial balance.
The aging
-Lists the balances in the accounts receivable master file at the balance sheet
date for each individual customer
-Categorizes the balances due based on the time passed between the sale and
the balance sheet date.
• substantive tests of transactions.
 DESIGNING TESTS OF DETAILS OF BALANCES
• Before any other tests, auditors test the information on the aged trial
balance for detail tie-in, to verify that the population being tested
agrees with AR master file and the general ledger.
• In addition, auditors should trace a sample of individual balances to
supporting documents such as sales invoices to verify the customer’s
name, balance, and proper aging.
• The extent of the testing for detail tie-in depends on the number of
accounts involved, the degree to which the master file has been
tested as a part of tests of controls and Most tests of accounts
receivable and the allowance for uncollectible accounts are
based on the aged trial balance.

A typical aged trial balance is shown in Figure 16-3.

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Copyright ©2017 Pearson Education, Inc. 16-20
 2- Existence:
• Confirmation of customers’ balances is the most important test of details of
balances for determining the existence of recorded AR.
• When customers do not respond to confirmations, auditors also examine
supporting documents to verify the shipment of goods and evidence of
subsequent cash receipts to determine whether the accounts were
collected.
• Normally, auditors do not examine shipping documents or evidence of
subsequent cash receipts for any account in the sample that is confirmed,
but they may use these documents as alternative evidence for
nonresponses.
 3- Completeness
• It is difficult for auditors to test for account balances omitted. If all sales
to a customer are omitted from the sales journal, the understatement of
accounts receivable is almost impossible to uncover by tests of details of
balances.

• However the auditor can trace the shipping documents to the journal
entries and subsidiary ledger. Also By examining the movement of
inventory and tracing them to the sales invoices, he can discover any
unrecorded sales and omitted AR.
 4- Accuracy

• Confirmation of accounts selected from the trial balance is the most

common test of details of balances for the accuracy of accounts
receivable.
• When customers do not respond to confirmation requests, auditors
examine supporting documents in the same way as described for the
existence objective.
 5- Classification
• There is a close relationship between the classification objective and presentation and
disclosure objective.
• To satisfy the classification objective, the auditor must determine whether the client has
correctly separated different classifications of AR. For example, the auditor will determine
whether receivables from related parties have been separated on the aged trial balance.
• To satisfy the objective for presentation and disclosure, the auditor must make sure that the
classifications are properly presented by determining whether related party transactions are
correctly shown in the financial statements.
• The auditor should assure that the company doesn't deduct (offset) the negative balance of a
customer (credit balance) from the debit balances of the other customers. Because the credit
balance of a customer should be classified and presented as current liability in the Balance
Sheet
 6- Cutoff
• Cutoff misstatements exist when current period transactions are recorded in the
subsequent period or vice versa.
• The objective of cutoff tests, regardless of the type of transaction, is to verify
whether transactions near the end of the accounting period are recorded in the
proper period.
• Cutoff misstatements may occur for sales, sales return and allowances, cash
receipts.
• Auditors may rely on the confirmation of accounts receivable to uncover cutoff
misstatements, However, timing difference due to shipments and payments in
transit at year end, may require additional investigation, such as inspection of
supporting documents.
Cutoff for Accounts Receivable is Correct: Cutoff misstatements
exist when current period transactions are recorded in the
subsequent period or vice versa.
Cutoff misstatements can occur for sales, sales returns, and
allowances and cash receipts. For each, auditors require a
threefold approach to determine the reasonableness of cutoff:
1. Decide on the appropriate criteria for cutoff.
2. Evaluate whether the client has established adequate
procedures to ensure a reasonable cutoff.
3. Test whether the cutoff was correct.

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 7- Realizable value
• Realizable value of AR (good debts) = gross AR -AFDA.
• it is necessary for the auditor to evaluate whether the client’s allowance is reasonable.
• To begin the evaluation of the AFDA, the auditor reviews the results of the tests of
controls that are concerned with the client’s credit policy. If the client’s credit policy
has remained unchanged, the change in the balance of AFDA should reflect only
changes in economic conditions and sales volume. However, if the client’s credit policy
or the degree to which it correctly operates has significantly changed, auditors must
take great care to consider the effects of these changes.
• The size and age of unpaid balances can be compared with similar information from
previous years to evaluate whether the amount of noncurrent receivables is increasing
or decreasing over time.
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 8- Rights

The auditor can review client’s rights to accounts receivable

using confirmation.
However, in some cases, a portion of the receivables may
have been pledged as collateral, assigned to someone else, or
sold at discount, so the confirmation of receivables will not
bring them to light. The auditor may review the minutes,
discuss with the client, confirm with banks, examine debt
contracts for evidence of accounts receivable pledged as
collateral, and examine correspondence files.
 OBJECTIVE 16-4
Obtain and evaluate accounts receivable
confirmations.

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 CONFIRMATION OF ACCOUNTS RECEIVABLE
Auditing Standards Requirements:
Auditors should use external confirmations for accounts
receivable unless:
1. The overall accounts receivable balance is immaterial.
2. The auditor considers confirmations ineffective evidence
because response rates will likely be inadequate or
unreliable.
3. The auditor’s assessed level of the risk of material
misstatement is low and other evidence can be accumulated
to provide sufficient evidence.
If the auditor decides not to confirm accounts receivable that
are material, the justification must be documented in the
audit files.

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 CONFIRMATION OF ACCOUNTS RECEIVABLE
(CONT.)
Types of Confirmations:
Positive Confirmation: A communication addressed to the debtor
requesting the recipient to confirm directly whether the balance as
stated is correct or incorrect. Figure 16-5 is an example of a
positive confirmation request.
Negative Confirmation: A communication addressed to the debtor,
but requests a response only when the debtor disagrees with the
stated amount. Figure 16-6 is an example of a negative
confirmation.

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 CONFIRMATION OF ACCOUNTS RECEIVABLE
(CONT.)
Types of Confirmations (Cont):
Positive confirmations are more reliable, but negative confirmations are
less costly.
Negative confirmations are acceptable as the sole substantive audit
procedure only when all of the following circumstances are present:
1. The auditor has assessed the risk of material misstatement as low.
2. The population of items is made up of a large number of small,
homogenous account balances.
3. The auditor expects a low exception rate.
4. The auditor reasonably believes that recipients of negative confirmation
requests will give the requests adequate consideration.

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 CONFIRMATION OF ACCOUNTS RECEIVABLE
(CONT.)

Timing: The most reliable evidence from confirmations is obtained

when they are sent as close to the balance sheet date as possible.
- To complete an audit in a timely manner, confirmation at an interim
date is permissible if internal controls are adequate.
If the auditor decides to confirm accounts receivable before year-
end, the auditor typically prepares a roll-forward schedule to
reconcile accounts receivable at the confirmation date to accounts
receivable at the balance sheet date.

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 CONFIRMATION OF ACCOUNTS RECEIVABLE
(CONT.)
Sampling Decisions:
• Sample size is based on the following factors:
• Performance materiality
• Inherent risk
• Control risk
• Achieved detection risk from other substantive tests
• Type of confirmation
Selection of the Items for Testing: Some type of stratification is
desirable with most confirmations.

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 CONFIRMATION OF ACCOUNTS RECEIVABLE
(CONT.)
Verification of Addresses and Maintaining Control:
• The auditor should perform procedures to verify the addresses
or email addresses used for confirmation.
• For confirmations sent by mail, the auditor must maintain
control of the confirmations until they are returned from the
customer.
• The client may assist in preparing the confirmations, but the
auditor must be responsible for mailing and the return address
should be the auditor’s to ensure that undeliverable
confirmations are returned to the auditor, not the client.

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 CONFIRMATION OF ACCOUNTS RECEIVABLE
(CONT.)
Follow-Up on Nonresponses: Nonresponses to positive confirmations
provide no audit evidence, though nonresponses to negative
confirmations provide some evidence of the existence assertion. When
positive confirmations are used, auditing standards require follow-up
procedures. Documents and procedures may include:
• Subsequent Cash Receipts—Evidence of the receipt of cash for payment
subsequent to the confirmation.
• Duplicate Sales Invoices—Examining duplicate sales invoices are useful in
verifying the actual issuance of an invoice as well as verifying the date.
• Shipping Documents—These help to determine that a shipment was made to
test cutoff.
• Correspondence with the Client—Can be used to discover any disputed
balances.

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 CONFIRMATION OF ACCOUNTS RECEIVABLE
(CONT.)
Analysis of Differences: The most commonly reported types of differences
in confirmations include:
• Payment Has Already Been Made—The customer has made payment prior to
the confirmation date, but the client has not recorded it. These should be
carefully investigated for cutoff misstatements, lapping, or theft of cash.
• Goods Have Not Been Received—Typically because the client records the sale
on the ship date, but the customer may not have received the goods yet.
• The Goods Have Been Returned—The client may have failed to record a credit
memo for a sales return.
• Clerical Errors and Disputed Amounts—Normally, the auditor will ask the
client to reconcile the differences.

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 CONFIRMATION OF ACCOUNTS RECEIVABLE
(CONT.)
Drawing Conclusions:
When all differences have been resolved, the auditor must
reevaluate internal control.
The misstatements must be analyzed to determine whether it was
consistent or inconsistent with the original assessed level of control
risk.
If a significant number of misstatements occurred that are
inconsistent with the assessment of control risk, it is necessary to
revise the assessment and consider the effect of the revision on the
audit.

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