CHAPTER

8
8-1.

SUBSTANTIVE TESTS OF RECEIVABLES AND SALES

Tests of details of financial balances are designed to determine the reasonableness of the balances in sales, accounts receivable, and other account balances which are affected by the sales and collection cycle. Such tests include confirmation of accounts receivable, and examining documents supporting the balance in these accounts. Tests of transactions for the sales and collection cycle are intended to determine the effectiveness of internal control structure and to test the substance of the transactions which are produced by this cycle. Such tests would consist of examining sales invoices in support of entries in the sales journal, reconciling cash receipts, or reviewing the approval of credit. The results of the tests of transactions will be used to affect the procedures, sample size, timing and particular items selected for the tests of details of financial balances (i.e., an effective internal control structure will result in reduced testing when compared to the tests of details required in the case of an inadequate internal control structure .

8-2.

There are two common types of confirmations used for confirming accounts receivable! "positive# confirmations and "negative# confirmations. $ positive confirmation is a communication addressed to the debtor requesting him to confirm directly whether the balance as stated on the confirmation request is correct or incorrect. $ negative confirmation is also a communication addressed to the debtor, but it requests a response only when the debtor disagrees with the stated amount. $ positive confirmation is more reliable evidence because the auditor can perform follow%up procedures if a response is not received from the debtor. &ith a negative confirmation, failure to reply must be regarded as a correct response even though the debtor may have ignored the confirmation request. 'ffsetting the reliability disadvantage, negative confirmations are less expensive to send than positive confirmations, and thus more of them can be distributed for the same total cost. The determination of which type of confirmation to be sent is an auditor(s decision, and it should be based on the facts in the audit. The

8-2

Solutions Manual to Accompany Applied Auditing, 2006 Edition following are the most important circumstances where positive confirmations should be used! ). *. +. There are a small number of large accounts which account for a significant portion of total accounts receivable. There are suspected conditions of dispute, inaccuracy, or irregularity. This would be the case when internal controls are considered inadequate or if prior year(s audit test results are unsatisfactory. The rules of certain regulatory agencies require them. This is the case for bro,ers and dealers in securities.

&hen the above conditions do not exist, it is acceptable to use negative confirmations, but negative confirmations should not be used if the auditor believes the customer is li,ely to ignore the confirmation. Typically, when negative confirmations are used, the auditor is using a reduced control ris, assessment in the audit of accounts receivable. -t is also common to use negative confirmations for audits of hospitals, retail stores, and other industries where the receivables are due from the general public. -n these cases, far more assurance is obtained from tests of internal control than from confirmations. -t is also common to use a combination of negative and positive confirmations by sending the positives to accounts with large balances and negatives to those with small balances. 8-3. -t is acceptable to confirm accounts receivable prior to the balance sheet date if the internal control structure is adequate and can provide reasonable assurance that sales, cash receipts and other credits are properly recorded between the date of the confirmation and the end of the accounting period. 'ther factors the auditor is li,ely to consider in ma,ing the decision are the materiality of accounts receivable and the auditor(s experience in prior years. -f the decision is made to confirm accounts receivable prior to year end, it is necessary to test the transactions occurring between the confirmation date and the balance sheet date by examining internal documents and performing analytical procedures at year end. South Technologies, Inc. (a &hen confirmation requests are mailed to debtors whose accounts were written off as uncollectible, the auditors( purpose is to determine that the receivables were genuine when they were first recorded in the accounts. -n some fraud cases, fictitious accounts receivable have been created to cover up a shortage. .ventually these fictitious receivables must be disposed of/ one method is to write off the fictitious accounts as uncollectible. (b The South executive appears to believe the auditors are solely concerned with the collectibility of accounts and notes receivable. -n fact, the confirmation process is primarily intended to establish that the receivables are genuine and

8-4.

Substantive Tests of Receivables and Sales

8-3

that the customers (or ma,ers of notes exist. 'ther audit procedures are followed to determine collectibility. 8-5. The confirmation requests should go to the ma,ers of the notes regardless of whether the notes have been discounted. The act of discounting a note receivable does not reduce the importance of the note being genuine and collectible. $ company which discounts its notes receivable remains in a position of sustaining a loss if the ma,ers of the notes fail to ma,e payment at the maturity dates. (a &hen customers fail to respond to positive confirmation requests the 01$s may not assume with confidence that these customers reviewed the requests and found no disagreement and therefore did not reply. Some busy customers will not ta,e the time to review confirmation requests and will not respond/ hence, obvious exceptions may exist without being reported to the 01$s.

8-6.

(b -f there is no response to a second request, the 01$s may mail a third request and possibly ma,e telephone calls in an effort to get a reply directly from the customer. &hen it becomes apparent that the confirmation program will not produce further evidence, the 01$s should consider each remaining customer as to the size, nature, and age of the balance and the apparent reason for the lac, of a reply before they decide what additional wor, is necessary in the circumstances. The 01$s should carry out the alternative audit procedures of examining customers( purchase orders or contracts, shipping documents and sales invoices of the client, and remittances by nonconfirming customers received by the client subsequent to the balance sheet date. The auditors may also verify the existence, location, and credit standings of the nonconfirming customers by reference to credit agencies or other sources independent of the client. 8-7. North, Inc. 2o, the matter remains unresolved. 3irst, oral evidence from the client is never 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 also determine the genuineness of the customer by reference to the telephone directory or to credit agency reports. 8-8. Montys Meat, Inc. a. The wor,paper does not include a description of the auditing procedures performed in confirming the accounts. The wor,paper is also incomplete in the following respects!

8-4

Solutions Manual to Accompany Applied Auditing, 2006 Edition ) * + 9 : < The wor,paper does not state whether the auditor traced the $40 5rocery remittance of 1+,666 to 2ovember cash receipts. The wor,paper does not state whether the auditor examined the 2ovember * credit memo issued to Sari%Sari Store. The wor,paper does not state whether the auditor traced the 7ucena(s 8eat 8ar,et remittance to 2ovember cash receipts. The wor,paper does not state whether and how the auditor obtained satisfaction regarding confirmation requests not returned. The wor,paper does not state whether the auditor examined documentation for the ;iana(s Supper 0lub order returned and received on 'ctober +). =ather than summarizing the confirmations returned without exception, as was done at the bottom of &or,ing 1aper ), these confirmations should have been listed separately. Sales $ccounts receivable -nventory 0ost of goods sold To reverse *66? sale recorded in *66<. * $llowance for uncollectible accounts $ccounts receivable To write off uncollectible account. + Sales returns and allowances $ccounts receivable To record return of spoiled meat and recognize loss in period in which incurred. 8eat not restored to inventory, inasmuch as it was spoiled. 9 Sales $ccounts receivable To correct error in recording customer remittance as a sale. : Sales =eturns $ccounts receivable -nventory 0ost of goods sold ++9 ++9 *:6 *:6 )+,666 )+,666 +,<+9 +,<+9 ),*?? ),*?? 1)),)66 1)),)66 >,<66 >,<66

b.

Substantive Tests of Receivables and Sales

8-5

c. Exhibit 1.1

To record return and restore meat to inventory because meat returned in good condition. (See completed .xhibits ).) and ).* reproduced below and on the following page.

Montys Meat, Inc. Accounts Receivable - Trade Aging Analysis October 31, 200 Conf. No. 1060 1061 1064 1602 1603 160% 160$ 1612 10/31 10/31 Customer Culleys Meats Jolly Roger Restaurant ABC Grocery ( t!er" Ru&ys 'el( General )oo&s Grocers *(+s )res! Meats '(lls '(scount Grocery '(anas ,u--er Clu. Balance -er le&ger Au&(t A&0ust+ents Au&(te& .alance Cas! rece(-ts 11/1 2 11/2% 11/2% utstan&(ng 4st(+ate& -ercent uncollect(.le 10/31 4st(+ate& uncollect(.le P 24,4$% P Balance P 1,330 466 4,256 32#,433 3%$ 13,46$ 2,334 12,46# $66 P365,000 P (2#,345" P335,655 1 P Current 1,330 P 3,000 2$0,%63 13,000 1,0%4 12,46# 334 P 311,#%0 P (2$,06$" P 2$3,#02 P(210,113" P %3,%$# 105 %,3%# 466 1,256 33,46% 1,260 P 36,44# P 36,44# P (13,353" P 23,0#6 255 P 5,%%4 532 P13,234 P 3,34% P(1,2%%" P13,234 P 2,0%0 P 0 P 0 3 P12,324 P 2,$%# 3%$ 46$ 1-30 Past Due (Days) 31-60 Over 60

P13,234 P 2,0%0 %05 1005

P #,264 P 2,0%0

3 1

6race& su.se7uent collect(ons to 8o9e+.er re+(ttance a&9(ces: .ta(ne& .alances ;ro+ su.s(&(ary le&ger a;ter agree(ng to general le&ger control account:

Pre-are& .y< >n(t(al 'ate

Re9(e=e& .y< >n(t(al 'ate

8-6

Solutions Manual to Accompany Applied Auditing, 2006 Edition

Exhibit 1.2
Montys Meat, Inc. Accounts Receivable - Trade Allo!ance "or #oubt"ul Accounts October 31, 200 11/1/05 11/1 ? 10/31 11/1 ? 10/31 10/31/06 Balance -er general le&ger Mont!ly -ro9(s(on @r(te?o;;s Balance -er general le&ger AJ4 2 AJ4 6 10/31/06 Au&(te& .alance AJ4 6 Ba& &e.ts eC-ense Allo=ance ;or &ou.t;ul accounts P10,%%% P10,%%% P2$,000 1 24,000 3 (3%,000" A P15,000 (1,2%%" P13,%23 P10,%%% P24,500 B

6o a&0ust allo=ance ;or &ou.t;ul accounts to a+ount cons(&ere& reasona.le (n t!e c(rcu+stances:

1 3 A B

6race& to last years @6B ? au&(te& .alance 6race& to stan&ar& 0ournal entr(es 4Ca+(ne& &ocu+entat(on an& &(scusse& =(t! cre&(t +anager an& legal counsel >n l(g!t o; ag(ng analys(s, t!e a.o9e .alance, as a&0uste&, a--ears to .e a&e7uate:

Pre-are& .y< >n(t(al 'ate

Re9(e=e& .y< >n(t(al 'ate

Substantive Tests of Receivables and Sales

8-7

8-9.

Makati Com any 3or all of the exceptions, the auditor is concerned about four principal things. (a &hether there is a client error. 8any times the confirmation response differences are due to timing differences for deposits in the mail and inventory in transit to the customer. Sometimes customers misunderstand the confirmation or the information requested. The auditor must distinguish between those and client errors. (b The amount of the client error if any. (c The cause of the error. -t would be intentional, a misunderstanding of the proper way to record a transaction, or a brea,down of internal control. (d 1otential errors in the sample not tested. The auditor must estimate the error in the untested population, based on the results of the tests of the sample. Suggested steps to clear each of the comments satisfactorily are! ). (a (b .xamine supporting documents, including the sales invoices and applicable sales and shipping orders, for propriety and valuation of the sales. =eview the cash receipts boo,s for the period after ;ecember +), *66:, and note any collections from the 1;@ 0ompany. The degree of internal control over cash receipts should be an important consideration in determining the reliance that can be placed on the cash receipts entries. -n addition, as there is no assurance that collections after ;ecember +) represent the payment of invoices supporting the ;ecember +) trial balance, consideration should be given to requesting a confirmation from the 1;@ 0ompany of the invoices paid by their chec,s.

*.

(a

The cause should be investigated thoroughly. -f the credit was posted to the wrong account, it may indicate merely a clerical error. 'n the other hand, posting to the wrong account may indicate lapping. (b Such a comment may also indicate a delay in posting and depositing of receipts. -f upon investigation such is the case, the company should be informed immediately so that it can ta,e corrective steps. This is a confirmation of the balance with an additional comment. Since the customer has given us the data, it is preferable to chec, to see that the information agrees with the company(s records. Such a procedure may disclose misposting or delay in recording receipts. This incomplete comment should raise an immediate question! does the customer mean paid before or paid after ;ecember +)A 4ecause the customer(s intent is un,nown, this account should be reconfirmed and the customer as,ed to state the exact date. Bpon receipt of the second

+.

9.

8-8

Solutions Manual to Accompany Applied Auditing, 2006 Edition confirmation, the information thereon should be traced to the cash receipts boo,. The auditor should first evaluate how long it ta,es to ship goods to the customer in question. -f it ordinarily ta,es more than five days, there is no indication of error. $ comment of this type may indicate that the company may be recording sales before an actual sale has ta,en place. The auditor should examine the invoice and review with the appropriate officials the company(s policies. Sales, cost of sales, inventories and accounts receivable may have to be adjusted if title has not passed to the buyer as of ;ecember +), *66:. <. (a ;etermine if such advance payment has been received and that it has been properly recorded. $ review should be made of other advance payments to ascertain that charges against such advances have been properly handled. -f the advance payment was to cover these invoices, the auditor should propose a reclassification of the 1),+:6, debiting the advance payment account and crediting accounts receivable%%trade. .xamine the shipping order for indications that the goods were shipped and, if available, carrier(s invoice andCor bill of lading for receipt of the goods. -f it appears that goods were shipped, send all available information to the customer and as, the customer to reconfirm. -f the customer still insists that goods were never received, all data should be presented to an appropriate company official for a complete explanation. This may indicate that accounting for shipments is inadequate and consideration should be given to reviewing the procedures to determine if improvements can be made. -f the goods were not shipped, the auditor should recommend an adjustment reducing sales, cost of sales, and accounts receivable, and increasing inventories.

:.

(b

?.

(a (b

(c

>.

This should be discussed with the appropriate officials and correspondence with the customer should be reviewed to allow determination whether an adjustment should be made in the amount receivable or if an allowance for doubtful accounts should be set up. $s title on any goods shipped on consignment does not pass until those goods are sold, the sales entry should be reversed, inventory charged, and cost of sales credited if it is actually a consignment sale. 'ther so%called sales should be reviewed and company officials queried to determine if other sales actual represent consignment shipments/ if so, the adjustment set forth in the preceding sentence should be made for all consignment shipments.

D.

)6. This is a noncurrent asset and should be reclassified to either deposit or prepaid rent. $ review of other accounts, especially those with round numbers, may disclose other accounts that should be so reclassified.

Substantive Tests of Receivables and Sales

8-9

8-10.

)). This may indicate a misposting of the credit or a delay in posting the credit. 0omments under * above would also apply to credits. !en Com any Re uirement !a"
Een 0ompany $ccounts =eceivable $ging Schedule 8ay +), *66< $roportion of Total .<>6 .):6 .6>6 .6:6 .6*: .6): ).666 Amount in #ategory 1 >)<,666 )>6,666 D<,666 <6,666 +6,666 )>,666 1),*66,666 $robability of %on&#ollection .6)6 .6+: .6:6 .6D6 .966 .D66 Estimated 'ncollectibl e Amount 1 >,)<6 <,+66 9,>66 :,966 )*,666 )<,*66 1:*,><6

Age #ategory 2ot yet due 7ess than +6 days past due +6 to <6 days past due <) to )*6 days past due )*) to )>6 days past due 'ver )>6 days past due

Re uirement !b" Een 0ompany $nalysis of $llowance for ;oubtful $ccounts 8ay +), *66< Fune ), *66: balance 4ad debt expense accrual (+,666,666 x .69 4alance before write%offs of bad accounts &rite%offs of bad accounts 4alance before year%end adjustment .stimated uncollectible amount $dditional allowance needed (ebit 4ad ;ebts .xpense $llowance for ;oubtful $ccounts Re uirement !c"
Steps to )mprove t*e Accounts Receivable Situation .stablish more selective credit%granting policies, such as more restrictive credit requirements or more thorough credit rating investigation. .stablish a more rigorous collection policy either through external collection agencies ). *. Ris+s and #osts )nvolved This policy could result in lost sales and increased costs of credit evaluation. Een may be all but forced to adhere to the prevailing credit%granting policies of the office equipment and supplies industry. This policy may offend current customers and thus ris, future sales. -ncreased

1 +6,*:6 )*6,666 1):6,*:6 )6>,?:6 1 9),:66 :*,><6 1 )),+<6 #redit )),+<6 )),+<6

8-10

Solutions Manual to Accompany Applied Auditing, 2006 Edition

or by Een(s own personal. 0harge interest on overdue accounts. -nsist on cash on delivery (0'; or cash on order (0'' for new customers or poorer credit ris,s. collection costs could result from this policy. This policy may offend current customers and thus ris, future sales. This policy could result in lost sales and increased administrative costs.

8-11.

"emo Inc. #$MO I%&. Accounts Receivable 12-31-0'

Balance Per General Per Ee&ger ,u.s(&(ary AG>8G '>,6R>BD6> 8 Mont!s utstan&(ng 0?1 1?3 3?6 o9er 6 P#3,240 P%6,$20 P22,1$0 P6,000

Re uirement !a"

Dna&0uste& Balances A&& ('e&uct" A&0ust+ents< AJ4 (2" to correct un&erstate+ent o; accounts =r(tten o;; on cto.er 31: (3" to =r(te o;; &e;(n(tely uncollect(.le accounts (4" to reclass(;y a&9ances ;ro+ custo+ers (5" to reclass(;y accounts =(t! cre&(t .alances (6" to a&0ust general le&ger .alance to agree =(t! su.s(&(ary .alance Balances as a&0uste&

P1#%,000

P1#$,240

(200" (1,000" 2,000 500 (1,000" 2,000 500 2,000 500 (1,000"

1,440 P1##,%40

FFFFFFF P1##,%40

FFFFFF F P#5,240

FFFFFFF P%%,320

FFFFFFF P22,1$0

FFFFFF P5,000

#$MO I%&. Allo!ance "or #oubt"ul Accounts 12-31-0' Balance -er Ee&ger A&& ('e&uct" A&0ust+ents< AJ4 (1" to correct error (n recor&(ng .a& &e.ts reco9ery P12,000:00 324:00

Substantive Tests of Receivables and Sales (2" to correct un&erstate+ent o; accounts =r(tten o;; (3" to =r(te o;; &e;(n(tely uncollect(.le accounts (4" to a&0ust allo=ance to re7u(re& .alance (,c!e&ule 1" Balance as a&0uste& Sche !"e 1# C$%&!'(')$* $+ Re,!)-e A""$.(*ce Account #lassification 6%) month outstanding )%+ months outstanding +%< months outstanding over < months outstanding Totals Ad,usted Total 1 D:,*96 ??,+*6 **,)>6 :,666 HHHHHHH 1)DD,?96 Re uired . ) * + 1*,666%:6G 1+,666%*6G

8-11

( 200:00" ( 1,000:00" ( 6,35#:$0" P 4,%64:20 Allo-ance Amount 1 D:*.96 ),:9<.96 <<:.96 ),666.66 <66.66 19,?<9.*6

Re uirement !b" $djusting Fournal .ntries )*%+)%6: () (* (+ (9 (: (< (? 4ad ;ebts $llowance for ;oubtful $ccounts $llowance for ;oubtful $ccounts $ccounts =eceivable $llowance for ;oubtful $ccounts $ccounts =eceivable $ccounts =eceivable $dvances from 0ustomers $ccounts =eceivable 0ustomers( accounts with credit balances $ccounts =eceivable Sales $llowance for ;oubtful $ccounts 4ad ;ebts .xpense +*9.66 +*9.66 *66.66 *66.66 ),666.66 ),666.66 *,666.66 *,666.66 :66.66 :66.66 ),996.66 ),996.66 <,+:D.>6 <,+:D.>6

8-12.

Tri oli Com any Re uirement !/" $ccounts receivable, trade.............................................. $dvances to suppliers..................................................... ;ue from officers............................................................ Subscriptions receivable I share capital......................... .xpense advances to salespeople.................................... $ccounts payable, trade (1)D,*:6 I 19:6 J............ 96,666 9:6 *,:66 9,<66 ),666 )D,*:6

8-12

Solutions Manual to Accompany Applied Auditing, 2006 Edition $dvances from customers on sales contracts........... Salaries payable....................................................... $llowance for doubtful accounts............................. =eceivables (to close permanently ......................... 0ustomers( credit balances...................................... Re uirement !2" 0urrent assets! $ccounts receivable, trade....................................... 7ess allowance for doubtful accounts...................... 0reditors( debit balances.......................................... ;ue from officersJJ................................................. Subscriptions receivable I ordinary sharesJJ.......... .xpense advances to salespeople............................. 0urrent liabilities! $ccounts payable, trade........................................... 0ustomers( credit balances...................................... 0ash advances from customers on sales (not yet shipped ................................................... Salaries payable....................................................... J 96,666 :66 9:6 +,+66 :66 *+,6:6 *,666

1+D,:66 9:6 *,:66 9,<66 ),666 )D,*:6 *,666 9:6 +,+66

These amounts are netted against normal balances to reflect control balances/ but if material in amount, they s*ould be reported separately on the balance sheet as indicated in =equirement *. $ll items are

JJ 0onsidered as current assets only if currently collectible. assumed to be material in amount. 8-13. #earl Cor oration /.

.stimated bad debt percentage based on year%end accounts receivable! *>.:GK $ctual bad debts 0redit Sales 'utstanding receivables (year%end 1ercentage of outstanding receivables
a b c

2000 1 +,+66a 1D6,666 1 D,:66b 6.+9?

2001 1 :,?66c 1):>,666 1 )D,D66d 6.*><

2002 1 ?,>66e 1*)6,666 1 *D,:66f 6.*<9

2006 1 )<,>66 19:D,666 1 :>,D66 6.*>:K

1*,:66 L 1:66 L 1+66 M 1+,+66 6 L 1D6,666 % 1?>,666 % 1*,:66 M 1D,:66 19,<66 L 1?66 L 1966 M 1:,?66

Substantive Tests of Receivables and Sales

d e

8-13

1D,:66 L 1):>,666 % 1>,:66 % 1)+9,666 % 1:66 % 19,<66 M 1)D,D66 .stimated. The bad debts written off in the third year following the sale have averaged about ?.>G N(1+66 L 1966 (1+,+66 L 1:,?66 O of the total actual bad debts in the previous * years. Therefore, the bad debts on *66: sales of 1<,*66 and 1),666 are about D*.*G of the total bad debts expected on *66: sales. 1)D,D66 L 1*)6,666 % 1*66 % 1)9,*66 % 1)?>,>66 % 1+66 % 1?66 % 1<,*66 M 1*D,:66

2.

4ad debts estimated as a percentage of year%end accounts receivable 1*D,:66 L 1*+:,666 % 1+66 % 1)D,:66 % 1966 % 1),666 % 1*66,666 M 19+,+66 19+,+66 x 6.*>: M 1)*,+96.:6, or approximately 1)*,+66. 0riteria for recognition of bad debts or impairment of receivables under 1$S +D should be applied.

8-14.

$lores Cor oration Re uirement !/"

3lores 0orporation $nalysis of 0hanges in the $llowance for ;oubtful $ccounts 3or the Pear .nded ;ecember +), *66< 4alance at Fanuary ), *66< 1rovision for doubtful accounts (1D,666,666 x *G =ecovery in *66< of bad debts written off previously ;educt write%offs for (1D6,666 L 1<6,666 4alance at ;ecember +), *66<, before additional impairment loss -ncrease in estimated uncollectible accounts during *66< (1*+:,+66 % 1)?:,666 4alance at ;ecember +), *66<, adjusted (Schedule ) 1)+6,666 )>6,666 ):,666 1+*:,666 ):6,666 1)?:,666 <6,+66 1*+:,+66

Sche !"e 1# 0omputation of $llowance for ;oubtful $ccounts at ;ecember +), *66< $ging category 2ovember%;ecember *66< Fuly%'ctober Fanuary%Fune 1rior to )C)C6<
a

4alance 1),)96,666 <66,666 966,666 ?6,666 a

1ercent * )6 *: ?:

;oubtful accounts 1 **,>66 <6,666 )66,666 :*,:66 1*+:,+66

1)+6,666 % 1<6,666 3lores 0orporation Fournal .ntry ;ecember +), *66<

Re uirement !2"

4ad ;ebt .xpense

<6,+66

8-14

Solutions Manual to Accompany Applied Auditing, 2006 Edition $llowance for ;oubtful $ccounts To increase the allowance for doubtful accounts at ;ecember +), *66<, resulting from evaluation of collectibility of remaining receivables. <6,+66

8-15.

%isayas Com any Re uirement !a" Qisayas 0ompany $ccounts =eceivable )*.+).6< 4alance, )*.+).6: $dd! Sales on account for the year Total 7ess! 0ollections during the year % with discount () % without discount (* $ccounts written off 0redit memo for sales returns R allowances 4alance, )*.+).6< Total collections 7ess! $ccts paid wC discount $ccts paid by customers wCo discount Re uirement !b" $F. () ;oubtful accounts expense $llowance for doubtful accounts Supporting Analysis3 G allowance to $= )*.+).6: =equired G allowance to $= )*.+).6< =equired allowance )*.+).6< *G x 1*)9,::: 1 )<,+D* 1:9<,966 *C+ x +G 19,*D) 1 )<,+D* )>,?66 M M +G *G <,:DD <,:DD 1*,>:?,D<6 *,66D,>9* 1 >9>,))> 1 :9<,966 *,<**,>+* 1+,)<D,*+* 1*,6:6,>:D >9>,))> )>,?66 +?,666

*,D:9,<?? 1 *)9,:::

( D>G M 1*,6:6,>:D () (*

$llowance for doubtful accounts balance, )*.+).6: 7ess! $ccounts written off

Substantive Tests of Receivables and Sales

8-15

1( *,+6> =equired balance, )*.+).6< .stimated bad debts expense for )*.+).6< 8-16. Charry Com any Re uirement !a" $djusting Fournal .ntries () $ccounts =eceivable 0ustomers( accounts with credit balances (1:66 L 1:,666 Sales $ccounts =eceivable Subscriptions =eceivable $ccounts =eceivable ;eposit on 0ontract $ccounts =eceivable 0laims =eceivable $ccounts =eceivable $dvances to .mployees $ccounts =eceivable $dvances to $ffiliated 0ompany $ccounts =eceivable $dvances to Supplier $ccounts =eceivable :,:66 :,:66 :,666 :,666 ):,666 ):,666 ):,666 ):,666 :66 :66 :66 :66 )6,666 )6,666 :,666 :,666 9,*D) 1 <,:DD

(* (+ (9 (: (< (? (>

Re uirement !b" 4alance Sheet 1resentation )*%+)%6< 0urrent $ssets $ccounts =eceivable % Trade 0laims =eceivable $dvances to .mployees $dvances to Supplier -nvestments $dvances to $ffiliated 0ompany 'ther $ssets 1:D,:66 :66 :66 :,666 )6,666

8-16

Solutions Manual to Accompany Applied Auditing, 2006 Edition ;eposit on 0ontract Shareholders( .quity Subscribed Share 0apital (net of subscriptions receivable of 1):,666 Supporting Analysis3 0harry 0ompany $ccounts =eceivable %Trade )*%+)%6< 4alance per ledger $dd (;educt $djustments! $F. () To reclassify accounts with credit balances (* To reverse entry for consignment deliveries (+ To reclassify subscriptions receivable (9 To reclassify deposit on contract (: To reclassify balance of claims from carrier for shipping damages (< To reclassify employee(s -'B(s (? To reclassify advances to affiliate (> To reclassify advances to supplier 2et adjustments 4alance as adjusted 1)6:,666 :,:66 ( :,666 ( ):,666 ( ):,666 ( :66 ( :66 ( )6,666 ( :,666 ( 9:,:66 1 :D,:66 ):,666

xxx

-f correct entries were made for the transactions given, the $ccounts =eceivable account would show the following postings! Acc$!*'/ Rece)0(1"e Fan. ) 4alance 0harge Sales =ecoveries of accounts written off 1 :<,666 <*:,666 ),666 HHHHHHHH 1<>*,666 HHHHHHHH 1<>*,666 8-17. The #reston Com anies (amounts in 1 millions Re uirement !/" 0ollections &rite offs 8erchandise returns $llowance for shipping damages 4alance ;ec. +) 1<):,666 +,:66 *,:66 ),:66 1<**,:66 :D,:66 1<>*,666

Substantive Tests of Receivables and Sales (a

8-17

1reston(s earnings would have increased () I 6.96 1)6: million or 1<+ million in *66<. 2et accounts receivable and total assets would have been 1)6: million higher than actually reported in *66<. -gnoring differences between tax and financial reporting, income tax payable would have increased by 16.96 (1)6: million or 19* million, and retained earnings would be greater by 1<+ million. This example illustrates the material effect estimated bad debts can have on reported earnings and total assets.

(b Bnder the allowance method, failure to write off an account has no effect on earnings (assuming a sufficient balance exists in the allowance account , or any net balances in the balance sheet. 'nly the components of net accounts receivable would be affected. 4oth gross accounts receivable and the allowance for doubtful accounts would be overstated 16.< million. Re uirement !2" 4eginning allowance balance 4ad debt expense .nding allowance balance &rite%offs of accounts Re uirement !0" (a The ratio of bad debt expense to operating revenue for the two years is! *66<, 1)6:C1+,?*D M *.>G/ *66:, 1>)C1+,:+9 M *.+G. This ratio appears relatively stable although is increasing. /445 1)>+ )6: (*)* 1 ?<

(b The composite rate of uncollectible accounts as a percentage of gross accounts receivable M ending allowance balanceCending accounts receivable. The ratio for *66< is 1*)* C (1D:) L 1*)* M )>.*G, and for *66: is 1)>+ C (1D?* L 1)>+ M ):.>G. This ratio is less stable and also is increasing. (c 4ad debt expense is considerably higher than the write%offs in *66<. The firm has experienced an increase in expected write%offs. $pparently the firm expects an increase in bad debts, which is partially an estimate of future write%offs.

8-18.

&ain Com any Re uirement !/" 1resent value of the note! 1):6,666 x (1Q), )*G, + (6.?))?> M 1)6<,?<?

8-18

Solutions Manual to Accompany Applied Auditing, 2006 Edition

Re uirement !2" 0orrection and 0ollection Schedule!

Date 1?1?2005 12?31?2005 12?31?2005 12?31?2006 12?31?200% 12?31?200% J =ounded. !"#lanation an$ %nterest Revenue Recor&e& or(g(nally at ;ace a+ount Correct(on to restate to -resent 9alue 6o accrue (nterest, P106,%6% C 125 G P12,$12 6o accrue (nterest, P11#,5%# C 125 G P14,34# 6o accrue (nterest, P133,#2$ C 125 G P16,0%2I Collect(on on ;ace a+ount, &e.(t Cas! Note Receiva le C&an'e Balance P150,000 P 43,233 106,%6% 12,$12 11#,5%# 14,34# 133,#2$ 16,0%2 150,000 150,000 0

2 H H H 2

8-19. ). d. The Fosefina note is a short%term note and is reported at face value although the note can be recorded at present value. The 2icole note is reported at present value! N(1*6,666 L :(6.+ (1*6,666 O (1Q), >G, : M 1*+,666 (6.<>6:> M 1):,<:+ The annual payment is computed as! 1)6,666 (1Q$, >G, : M 1)6,666 C +.DD*?) M 1*,:6:. ;iscounting this stream of payments at DG yields cash proceeds of! 1*,:6: (1Q$, DG, : M 1*,:6: (+.>>D<: M 1D,?99. Total interest equals total payments less proceeds M : (1*,:6: I 1D,?99 M 1*,?>). +. 9. b. c. -nterest receivable is recorded for one month. 8aturity value..................................................................... 1)66,666 ;iscount 1)66,666 (6.)6 (<C)* ......................................... (:,666 1roceeds............................................................................... 1 D:,666

*.

c.

8-20.

'uce Com any () $F. ! Sales returns and allowances -nventory )*.+).6< $ccounts receivable 0ost of sales -ncome will decrease by 1<,666 if the above $F. is made. +6,666 *9,666 +6,666 *9,666

Substantive Tests of Receivables and Sales $ns. (* $F. ! (c) Sales $ccounts receivable -ncome was overstated by 1)6,666 $ns. (+ (a) $ctual number of units sold to 8r. 7azo was +*6. $ns. (9 (b) 1 +*,666 9>,666 1 )<,666 )6,666

8-19

)6,666

19>,666 1):6

0orrect receivable from 8r. 7azo ! +*6 x 1)66 1er client 'verstatement $ns. (*)

(:

$ccounts receivable from 8r. Sia is correctly stated because the goods are considered sold in *66<. $ns. (a) $ns. (*)

(< 8-21.

ETC Co. $djusting Fournal .ntries $F. ). *. +. 9. 0ash 'ther 0urrent 7iabilities (B014 'verdraft $ccounts =eceivable 0ash 0ash $ccounts 1ayable 2otes 1ayable -nterest .xpense 0ash 0ash I 41'ther 0urrent 7iabilities (B014 'verdraft 0ash I S4T0 $ccounts =eceivable #as* 2.0/.06 **:,666 **:,666 +?,:66 +?,:66 *>,?6D *>,?6D <?,:66 )<,*66 >+,?66 *:,666 *:,666 ?+,<D6 ?+,<D6

:. <.

8-20

Solutions Manual to Accompany Applied Auditing, 2006 Edition 1er boo,s 1 ):,>*:,666 $F. ). **:,666 *. (+?,:66 +. *>,?6D 9. (>+,?66 :. *:,666 <. ?+,<D6 $djusted balance #1+,,-+,1.. Accounts Receivable 2.0/.06 Subsidiary 7edger 1>,69?,6:9 +?,:66 (+?:,*): )**,:66 1?,>+),>+D 5eneral 7edger 1?,><>,6*D +?,:66 (?+,<D6 #/,011,01. (* (b)

() (c)

$F. *. <.

Allo-ance for (oubtful Accounts Aging (istributio n 0urrent 1ast due! ) I +6 +) I <6 <) I D6 'ver D6 Amount Estimated to be 'ncollectible

Subsidiary 6edger

1),?+?,<D6.66 L 1)**,:66 M 1),><6,)D6.66 x * M 1 +?,*6+.>6 1),<)?,+96.66 1),9+?,?6<.:6 1),9?9,9:6.66 1),??D,><?.:6 L 1+?,:66 HHHHHHHHHHH I 1+?:,*): 1>,69?,6:9.66 M ),<)?,+96.66 x : M >6,><?.66 M ),9+?,?6<.:6 x )6 M )9+,??6.?6 M ),9?9,9:6.66 x ): M **),)<?.:6 M ),99*,):*.:6 x *6 M *>>,9+6.:6 1?,>+),>+D.66 #//1,21..-, (+ (a)

8-22.

'ing, Inc. Re uirement !/" 7-25, -20. 7ong%term =eceivables Section of 4alance Sheet ;ecember +), *66: DG note receivable from sale of division, due in annual installments of 1:66,666 to 8ay ), *66?, less current installment >G note receivable from officer, due ;ecember +), *66?,

1 :66,666 N)O

Substantive Tests of Receivables and Sales collaterized by )6,666 shares of 7ing, -nc., ordinary shares with a fair value of 19:6,666 2on%interest%bearing note from sale of patent, net of ):G imputed interest, due $pril ), *66? -nstallment contract receivable, due in annual installments of 1:6,666 to Fuly ), *66D, less current installment Total long%term receivables

8-21

966,666 >9,)6: N*O ))*,966 N+O 1),6D<,:6:

Re uirement !2" 7-25, -20. Selected 4alance Sheet 4alances ;ecember +), *66: 0urrent portion of long%term receivables! 2ote receivable from sale of division -nstallment contract receivable Total $ccrued interest receivable! 2ote receivable from sale of division -nstallment contract receivable Total Re uirement !0" 7-25, -20. -nterest -ncome from 7ong%Term =eceivables and 5ains =ecognized on Sale of $ssets 3or the Pear .nded ;ecember +), *66: -nterest income! 2ote receivable from sale of division 2ote receivable from sale of patent 2ote receivable from officer -nstallment contract receivable from sale of land Total interest income for year ended )*C+)C6: 5ains recognized on sale of assets! 1atent 7and Total gains recognized for year ended )*C+)C6: Ex lanation o3 amounts4 1)6:,666 >,:6: +*,666 )),*66 1):<,?6: N<O N*O N?O N:O 1:66,666 N)O *?,<66 N+O 1:*?,<66 1 <6,666 N9O )),*66 N:O 1 ?),*66

1 +?,<66 N>O :6,666 NDO 1 >?,<66

8-22

Solutions Manual to Accompany Applied Auditing, 2006 Edition N)O 7ong%term 1ortion of DG 2ote =eceivable at )*C+)C6:

Substantive Tests of Receivables and Sales 3ace amount, :C)C66 7ess! installment received :C)C6: 4alance, )*C+)C6: 7ess! installment due :C)C6< 7ong%term portion, )*C+)C6:

8-23

1),:66,666 (:66,666 1),666,666 (:66,666 1 :66,666

N*O 2on%interest%bearing 2ote, 2et of -mputed -nterest at )*C+)C6: 3ace amount, 9C)C6: 1 )66,666 7ess! imputed interest N1)66,666 I (1)66,6666 x 6.?:< O (*9,966 4alance, 9C)C6: 1 ?:,<66 $dd! interest earned to )*C+)C6: (1?:,<66 x ):G x DC)* >,:6: 4alance, )*C+)C6: 1 >9,)6: N+O 7ong%term 1ortion of -nstallment 0ontract =eceivable at )*C+)C6: 0ontract selling price, ?C)C6: 1 *66,666 7ess! down payment, ?C)C6: (<6,666 4alance, )*C+)C6: 1 )96,666 7ess! installment due ?C)C6< N1:6,666 I (1)96,666 x )<G O (*?,<66 7ong%term portion, )*C+)C6: 1 ))*,966 N9O $ccrued -nterest I 2ote =eceivable, Sale of ;ivision, at )*C+)C6: -nterest accrued from :C) to )*C+)C6: (1),666,666 x DG x >C)* 1 <6,666 N:O $ccrued -nterest I -nstallment 0ontract at )*C+)C6: -nterest accrued from ?C) to )*C+)C6: (1)96,666 x )<G x S

)),*66

N<O -nterest -ncome I 2ote =eceivable, Sale of ;ivision, for *66: -nterest earned from )C) to :C)C6: (1),:66,666 x DG x 9C)* 1 9:,666 -nterest earned from :C) to )*C+)C6: (1),666,666 x DG x >C)* <6,666 -nterest income 1 )6:,666 N?O -nterest -ncome I 2ote =eceivable, 'fficer, for *66: -nterest earned )C) to )*C+)C6: (1966,666 x >G N>O 5ain =ecognized on Sale of 1atent Stated selling price 7ess! imputed interest 1 +*,666

1 )66,666 (*9,966

8-24

Solutions Manual to Accompany Applied Auditing, 2006 Edition $ctual selling price (1)66,666 x 6.?:< 7ess! cost of patent (net 0arrying value )C)C6: 7ess amortization )C) to 9C)C6< (1>,666 x T 5ain recognized NDO 5ain =ecognized on Sale of 7and Sale of price 7ess! cost 5ain recognized 1 196,666 (*,666 1 (+>,666 +?,<66 N*O ?:,<66

1 *66,666 ():6,666 1 :6,666

8-23.

5ran*e Com any Re uirement / 1$S +D, paragraph <+ will be applied in this case. 'n ;ecember +), *66<, 5rande 0ompany should record the *66< accrued interest and the impairment! 2otes C -nterest =eceivable (6.6< ()66,666 -nterest -ncome 4ad ;ebts .xpense $llowance for decline in note value J 0arrying value of note and interest ()66,666 L <,666 1resent value C 2ew carrying value of note (discount rate I <G 1rincipal! ;ue on )*.+).6> (1+6,666 x 6.>D666 1*<,?66 ;ue on )*.+).)6 (1+6,666 x 6.?D*6D *+,?<+ -mpairment write%down Re uirement 2 The entries with the corresponding computations follow! Effective Interest Method December 31, 2007 Allo=ance ;or &ecl(ne (n note 9alue >nterest (nco+e (0:06" (50,463" December 31, 2008 Allo=ance ;or &ecl(ne (n note 9alue >nterest (nco+e (0:06" (50,463 H 3,02$" 3,02$ 3,02$ 3,20# 3,20# <,666 <,666 ::,:+? J ::,:+? 1)6<,666

:6,9<+ 1 ::,:+?

Substantive Tests of Receivables and Sales Cas! 8otes rece(9a.le December 31, 2009 Allo=ance ;or &ecl(ne (n note 9alue >nterest (nco+e (0:06" (50,463 H 3,20$ H 3,20# 2 30,000" December 31, 2010 Allo=ance ;or &ecl(ne (n note 9alue >nterest (nco+e I 0:06 (26,%00 H 1,602" Cas! 8otes rece(9a.le Allo=ance ;or &ecl(ne (n note 9alue 8otes rece(9a.le 6o close re+a(n(ng .alance (n notes rece(9a.le an& allo=ance
7 At t*is point, t*e amorti8ed cost of t*e notes receivable is 8ero. Notes Receivable 100,000 30,000 6,000 30,000 106,000 60,000 46,000 .al llo!ance for Decline in Note "al#e 3,02$ 55,53% 3,20# 1,602 1,6#$ #,53% 55,53% 46,000

8-25

30,000 30,000 1,602 1,602 1,6#$I 1,6#$ 30,000 46,000 46,000

30,000

8-24.

6my Cor oration Re uirement / $ccounts =eceivable (Trade $ccounts =eceivable ('fficer 'rdinary Shares Subscriptions =eceivable $dvances to .mployees 2otes =eceivable (Trade ;eposit to 5uarantee 0ontract 1erformance Btility ;eposit =eceivables Re uirement 2 ):,:66 +,<66 )*,666 ),>66 <,666 :,666 :66 99,966

8-26

Solutions Manual to Accompany Applied Auditing, 2006 Edition $ccounts receivable (trade %%current asset, trade receivable $ccounts receivable (officer %%normally current nontrade receivable 'rdinary shares subscription receivable%%current or noncurrent asset, depending on due date/ nontrade receivable $dvances to employees%%current asset, nontrade receivable 2otes receivable (trade %%noncurrent asset, trade receivable ;eposit to guarantee contract performance%%separately classify, could be current or noncurrent asset, depending on the length of the contract/ nontrade receivable Btility deposit%%separately classify, probably noncurrent nontrade receivable 7anes "e artment Store Re uirement / $ge Bnder +6 days +6% <6 days <)%)*6 days )*)%*96 days *9)%+<6 days 'ver +<6 days Re uirement 2 a. b. c. 4ad ;ebt .xpense $llowance for ;oubtful $ccounts 4ad ;ebt .xpense (1+:,>*9 L 1+,666 $llowance for ;oubtful $ccounts 4ad ;ebt .xpense (1+:,>*9 I 1*,>66 $llowance for ;oubtful $ccounts +:,>*9 +:,>*9 +>,>*9 +>,>*9 ++,6*9 ++,6*9 4alance 1)D+,666 ))9,666 ?+,666 9),666 *:,666 )D,666 19<:,666 .stimated 1ercentage Bncollectible 6.66> 6.6*6 6.6:6 6.*66 6.+:6 6.<66 .stimated $mount Bncollectible 1 ),:99 *,*>6 +,<:6 >,*66 >,?:6 )),966 1+:,>*9

8-25.

8-26.

8lue Cor oration Re uirement / 2002 ;ec. ) 0ash N(1)?:,666 x 6.>6 I 1),966O )+>,<66 $ssignment Service 0harge .xpense (1)?:,666 x 6.>6 x 6.6) ),966 2otes 1ayable (1)?:,666 x 6.>6 $ccounts =eceivable $ssigned $ccounts =eceivable )?:,666 )?:,666

)96,666

;ec.

Substantive Tests of Receivables and Sales )) +) +) Sales =eturns and $llowances $ccounts =eceivable $ssigned 0ash $ccounts =eceivable $ssigned 2otes 1ayable -nterest .xpense (1)96,666 x 6.)* x )C)* 0ash 0ash $ccounts =eceivable $ssigned 2otes 1ayable (1)96,666 I 1><,666 -nterest .xpense (1:9,666 x 6.)* x )C)* 0ash $ccounts =eceivable $ccounts =eceivable $ssigned (1)?:,666 I 1),666 I 1><,666 I 1<6,666 ),666 ),666 ><,666 ><,666 ><,666 ),966 >?,966 <6,666 <6,666 :9,666 :96 :9,:96 *>,666 *>,666

8-27

2006 Fan. *D *D

*D

Re uirement 2 'n the ;ecember +), *66: balance sheet of the 4lue 0orporation, the assigned accounts receivable and the remaining liability would be reported as follows! 0urrent $ssets! $ccounts receivable assigned 0urrent 7iabilities! 2ote payable 8-27. Tan*y Shoes Sept. ): $ccounts =eceivable 0redit 0ard .xpense (1*,)66 x 6.6: Sales Sales =eturns and $llowances $ccounts =eceivable 0redit 0ard .xpense (1*66 x 6.6: ),DD: )6: *,)66 *66 )D6 )6 1>>,666 1:9,666

*)

8-28

Solutions Manual to Accompany Applied Auditing, 2006 Edition *D 0ash $ccounts =eceivable ),>6: ),>6:

8-28.

5abe Com any 5$4. 0'81$2P -ncome Statement .ffect 3or the Pear .nded ;ecember +), *66: .xpenses resulting from accounts receivable assigned (Schedule ) .xpenses resulting from accounts receivable sold (1+66,666 I 1*<6,666 Total expenses

1):,)66 96,666 1::,)66

Sc*edule /! 0omputation of .xpenses for $ccounts =eceivable $ssigned $ssignment expense! $ccounts receivable assigned $dvance by 4elle 1*66,666 x >:G 1)?6,666 x +G 1 :,)66 )6,666 1 ):,)66

-nterest expense Total expenses