Chapter THREE

AUDIT OF ACCOUNTS RECEIVABLE AND SALES

 Auditors select the appropriate evidence to verify the account balances in the
sales and collection cycle, after considering performance materiality, performing
risk assessment procedures to assess inherent and control risks, and
performing tests of controls and substantive tests of transactions.

SINTAYEHU T. 1
 JIMMA UNIVERSITY
COLLEGE OF BUSINESS AND ECONMICS
DEPARTMENT OF ACCOUNTING AND
FINANCE

AUDITING PRINCIPLES AND PRACTICE-

II(ACFN3162)
SINTAYEHU T. 2
 CHAPTER OVERVIEW AND LEARNING
OBJECTIVES
Upon completion of this chapter you will able to
1. Describe the methodology for designing tests of details of balances
using the audit risk model.
2. Design and perform analytical procedures for accounts in the sales
and collection cycle.
3. Design and perform tests of details of balances for accounts
receivable.
4. Obtain and evaluate accounts receivable confirmations.
5. Design audit procedures for the audit of accounts receivable, using an
evidence planning worksheet as a guide.
SINTAYEHU T. 3
Overall Audit Approach

SINTAYEHU T. 4
 Overall Audit Approach

To made the designing tests of details of balances of account

receivable:
Auditor developed the Audit Risk Model:
Thus need to consider
 Inherent risk
 Control risk
 Planned Detection risk
 Audit risk

SINTAYEHU T. 5
 Overall Audit Approach

Sufficient and Appropriate Audit Evidence Audit Risk Model

Risk Assessment Procedures Inherent Risk

Procedures to understand internal control

Control Risk
Test of control

Analytical Procedures
Planned
Detection Risk
Test of details balances of accounts

SINTAYEHU T. 6
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF BALANCES

Describe the methodology for designing tests of

details of balances using the audit risk model.
 Appropriate evidence to be obtained from tests of details of
balances must be decided on an objective-by-objective basis.
 Several interactions affect the need for evidence from test of
details of balances, this makes an audit decision can be
complex.
 In designing tests of details of balances for accounts receivable,
auditors must satisfy each of the eight balance-related audit
SINTAYEHU T. 7
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF BALANCES

 Auditor must evaluate potential for fraud and inherent risk

 Auditor must consider results of substantive tests of sales and
cash receipts.

SINTAYEHU T. 8
METHODOLOGY FOR DESIGNING TESTS OF DETAILS
OF BALANCES

 Specifically applied to accounts receivable, they are called

accounts receivable balance-related audit objectives and are as

follows:
1. Accounts receivable in aged trial balance agree with related
master file amounts, and total is correctly added and agrees
with general ledger(Detail tie-in).
2. Recorded accounts receivable exist(Existence).
3. Existing accounts receivable are included(Completeness).
4. Accounts receivable are accurate(Accuracy).
SINTAYEHU T. 9
 METHODOLOGY FOR DESIGNING
TESTS OF DETAILS OF ALANCES

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. Client has rights to accounts receivable(Rights).
 Auditor uses the factors in the rows to aid in assessing planned
detection risk for accounts receivable, by objective.
 Understanding the relationship of each part of Figure 16-1 to
designing tests of details ofSINTAYEHU
balances
T.
is mandatory for audit of10
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF ALANCES

Detail tie-in

Existence Rights

Balance of Account
Completeness Receiveable Realizable value
Audit Objectives

Accuracy Cutoff
Classification

SINTAYEHU T. 11
Methodology for Designing Tests of Details of Balances for
Accounts Receivables

SINTAYEHU T. 12
 Methodology for Designing Tests of Details of Balances for
Accounts Receivables

Phase I

Identify client Set tolerable Assess control risk

business risks misstatement and
assess inherent risk for for sales and
affecting accounts receivable collection
Auditors cycle
are especially concerned with
Accounts three aspects of internal controls:
Accounts receivable is typically one 1. Controls that prevent or detect
Receivable
Understanding of of the most material accounts in embezzlements
client’s business financial statements for companies 2. Controls over cutoff
and that sell on credit. 3. Controls related to the allowance for
industry uncollectible accounts

SINTAYEHU T. 13
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF ALANCES

Identify Client Business Risks Affecting Accounts Receivable

(Phase I):
 Tests of accounts receivable are based on the auditor’s risk
assessment procedures that provide an understanding of the
client’s business and industry.
 Auditor performs preliminary analytical procedures that may
indicate increased risk of misstatements in accounts receivable.
 Auditor's made an evaluation of inherent risk and planned
evidence for accounts receivable.
SINTAYEHU T. 14
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF ALANCES

Set Performance Materiality and Assess Inherent

Risk (Phase I):
 Auditor first decides the preliminary judgment about
materiality for the entire financial statements, and then
allocates the preliminary judgment amount to each significant
balance sheet account, including accounts receivable. This
allocation is called setting performance materiality.
 Auditors assess inherent risk for each objective for an account
such as accounts receivable, considering client business risk
SINTAYEHU T. 15
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF ALANCES

 Auditing standards indicate that auditors must normally

identify a specific fraud risk for revenue recognition. Likely
affects the Auditor’s assessment of inherent risk for the
existence, sales cutoff, and sales returns and allowances cutoff.

SINTAYEHU T. 16
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF ALANCES

Assess Control Risk for the Sales and Collection Cycle(Phase I):
 Internal controls over sales and cash receipts and the related
accounts receivable are at least reasonably effective for most
companies to maintain good relations with customers.
Auditors are especially concerned with three aspects of internal
controls:
1. Controls that prevent or detect embezzlements or
misappropration

2. Controls over cutoff

SINTAYEHU T. 17
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF ALANCES

 Auditor must relate control risk for transaction-related audit

objectives to balance-related audit objectives in deciding
planned detection risk and planned evidence for tests of details
of balances.
 Two primary classes of transactions in the sales and collection
cycle.
Two aspects of the relationships in
1. For sales, the occurrence transaction-related audit objective
affects the existence balance-related
SINTAYEHU T. audit objective. 18
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF ALANCES

2. The realizable value and rights accounts receivable balance-

related audit objectives, as well as the presentation and
disclosure-related objectives.

SINTAYEHU T. 19
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF ALANCES

SINTAYEHU T. 20
Relationship Between Transaction-Related and Balance-
Related Audit Objectives
Accounts Receivable Balance Related Accounts Receivable Presentation and Disclosure
Audit Objectives Audit Objectives

Understandable
Completeness

Completeness

Classification
Obligations

Obligations
Occurrence
Rights and

Allocation

Right and
Existence

Valuation

Accuracy

Valuation
Transaction-Related Audit
Class of Transactions Objectives
Sales Occurrence x x

Completeness x x

Accuracy x x

Cutoff x

Classification x x

Cash Receipts Occurrence x

Completeness x

Accuracy x

Cutoff

Classification

SINTAYEHU T. 21
METHODOLOGY FOR DESIGNING
TESTS OF DETAILS OF ALANCES

Phase II

Design and perform tests of controls and substantive tests of transa

the sales and collection cycle. /Determine extent to which planned
risk is satisfied for each accounts receivable balance- related audi

SINTAYEHU T. 22
METHODOLOGY FOR DESIGNING
TESTS OF DETAILS OF ALANCES

Phase III

Design and perform Design tests of details of

analytical procedures accounts receivable
balance to satisfy balance-
for accounts related objectives
receivable

Audit Sample size Items to select Timing

procedures

SINTAYEHU T. 23
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF ALANCES

Design and Perform Tests of Controls and Substantive Tests of

Transactions (Phase II):
 Deciding sample size, and evaluating the results of those tests.
 The results of the tests of controls determine whether assessed
control risk for sales and cash receipts needs to be revised.
 Auditors use the results of the substantive tests of transactions
to determine the extent to which planned detection risk is
satisfied for each accounts receivable balance-related audit
objective.
SINTAYEHU T. 24
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF ALANCES

Design and Perform Analytical Procedures (Phase III):

Design and perform analytical procedures for accounts in sales
and collection cycle.
 Analytical procedures are often done during three phases of
audit: during planning, when performing detailed tests, and as a
part of completing audit.
 Planning analytical procedures and substantive analytical
procedures done when performing detailed tests for accounts in
sales and collection cycle
SINTAYEHU T. 25
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF ALANCES

 Auditors perform analytical procedures for entire sales and

collection cycle, not just for accounts receivable
 This is necessary to show closed relationship between income
statement and balance sheet accounts.
Compare by product line:
Gross margin percentage with previous years
Sales by month overtime
Sales returns and allowances as a percentage of gross sales
with previous years SINTAYEHU T. 26
METHODOLOGY FOR DESIGNING
TESTS OF DETAILS OF ALANCES

Compare with previous years:

 Individual customer balances over a stated amount
 Bad debt expense as a percentage of gross sales
 Days that accounts receivable are outstanding
 Aging category as a percentage of receivables
 Allowance for uncollectible accounts as a percentage of
accounts receivable
 Write-off of uncollectible accounts as a percentage of total
accounts receivable 27
SINTAYEHU T.
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF ALANCES

SINTAYEHU T. 28
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF ALANCES

SINTAYEHU T. 29
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF ALANCES

SINTAYEHU T. 30
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF ALANCES

Design and Perform Tests of Details of Account Receivable Balance

(Phase III):
 Analytical procedures in sales and collection cycle uncover unusual fluctuations
auditor should make additional inquiries of management
 Management’s responses should be critically evaluated to determined adequately
explain unusual fluctuations and supported by corroborating evidence.
 Planned detection risk for each objective is an auditor decision
 Combining factors that determine planned detection risk is complex due to
measurement for each factor is imprecise and appropriate weight given to each
factor is highly subjective.

SINTAYEHU T. 31
METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF ALANCES

 Conversely, the relationship between each factor and planned

detection risk is well established.

SINTAYEHU T. 32
 Designing Tests of Detail of Balances

Design and perform tests of details of balances for accounts receivable.

 Confirmation of accounts receivable is the most important test of
details of accounts receivable
 Tests of details of balances for accounts receivable focus on balance-
related audit objectives.
We will assume two things:
1. Auditors have completed an evidence planning worksheet
2. They have decided planned detection risk for tests of details for each
balance-related audit objective.

SINTAYEHU T. 33
 Designing Tests of Detail of Balances

Accounts receivable are correctly added and agree with the Master File
and the General Ledger (aged trial balance).
 Recorded accounts receivable exist
 It is difficult for auditors to test for account balances omitted from
aged trial balance except by relying on self-balancing nature of
accounts receivable master file.
 If all sales to a customer are omitted from sales journal,
understatement of accounts receivable is almost impossible to uncover
by tests of details of balances.

SINTAYEHU T. 34
 Designing Tests of Detail of Balances

Existing accounts receivable are included;

 Accounts receivable are accurate
 Accounts receivable are properly classified
 Cutoff for accounts receivable is correct
 Accounts receivable is stated at realizable value
 The client has rights to accounts receivable
 Accounts receivable presentation and disclosure

SINTAYEHU T. 35
 Confirmation Requirements

Obtain and evaluate accounts receivable confirmations.

 Primary purpose of accounts receivable confirmation is to satisfy
existence, accuracy, and cutoff objectives
 Confirmations are one of the eight types of audit evidence
 Confirmation is a direct written response from a third party in
paper or electronic form
 They are considered to be highly reliable evidence because they
are received directly from third parties.
 Oral response provides audit evidence, it is not considered a
SINTAYEHU T. 36
confirmation.
 Confirmation Requirements

AICPA auditing standards indicate that auditors should use

external confirmations for material accounts receivable.
Confirmation may not be appropriate in the following
circumstances:
1. The auditor considers confirmations ineffective evidence
because response rates will likely be inadequate or unreliable.
In certain industries, like hospitals, response rates to
confirmations are very low.
2. The combined level of inherent risk and control risk is low and37
SINTAYEHU T.
 Confirmation Requirements

Auditing Standards Requirements

United States(GAAS) International(IASB)

Required Except Confirmations not

when: required
Expected low
response rate Alternate
Procedures
Low inherent &
control risks

SINTAYEHU T. 38
 Type of Confirmation

In performing confirmation procedures, auditor must first decide

type of confirmation to use.
 Positive confirmation is a communication addressed to debtor
requesting recipient to confirm directly whether the balance as
stated on confirmation request is correct or incorrect.
 Blank confirmation form is a type of positive confirmation that
does not state the amount on the confirmation but requests the
recipient to fill in the balance or furnish other information.

SINTAYEHU T. 39
 Type of Confirmation

 Blank forms require recipient to determine information requested, they are

considered more reliable than confirmations that include balance information.
 Blank forms are rarely used in practice because they often result in lower
response rates.
 Invoice confirmation is a type of positive confirmation in which an individual
invoice is confirmed, rather than customer’s entire accounts receivable
balance.
 Many customers use voucher systems that allow them to confirm individual
invoices but not balance information.

SINTAYEHU T. 40
 Type of Confirmation

 Negative confirmation is addressed to the debtor but requests a

response only when the debtor disagrees with the stated
amount.
A positive confirmation is more reliable evidence because
auditor can perform follow-up procedures if a response is not
received from the debtor. With a negative confirmation, failure
to reply must be regarded as a correct response, even though
the debtor may have ignored confirmation request.

SINTAYEHU T. 41
 Negative Confirmation Requirements

 Risk of material misstatement is low

 Large number of small account balances
 Expected low exception rate
 Expect adequate consideration from recipients

SINTAYEHU T. 42
Sample Positive Confirmation format

SINTAYEHU T. 43
 Sample Negative Confirmation format

Sample negative confirmation format

SINTAYEHU T. 44
 Timing

 The most reliable evidence from confirmations is obtained

when they are sent as close to the balance sheet date as
possible.
 Permits auditor to directly test accounts receivable balance on
financial statements without making any inferences about the
transactions taking place between confirmation date and
balance sheet date.
 Means of completing audit on a timely basis, it is often
necessary to confirm accounts at an interim date.
SINTAYEHU T. 45
 Sampling Decisions

Sample Size: major factors affecting sample size for confirming accounts
receivable fall into several categories and include the following:
 Tolerable misstatement
 Inherent risk (relative size of total accounts receivable, number of accounts,
prior-year results, and expected misstatements)
 Control risk
 Achieved detection risk from other substantive tests (extent and results of
substantive tests of transactions, analytical procedures, and other tests of
details)
 Type of confirmation (negatives normally require a larger sample size)

SINTAYEHU T. 46
 Sampling Decisions

Tolerable
misstatement
Inherent Risk Control Risk

Sample
Size factors

Achieved Detection risk from

Type of
Confirmation
other tests

SINTAYEHU T. 47
Verifying Addresses and Maintaining Control

 The auditor should perform procedures to verify the addresses

or email addresses used for confirmation.
 Auditors must be responsible for mailing the confirmations
and maintaining control of the confirmations until they are
returned from the customer.

SINTAYEHU T. 48
 Follow-up on Nonresponses

When positive confirmations are used, AU 330 requires follow-

up procedures for confirmations not returned by the customer.

Alternate Procedures

Subsequent Duplicate Shipping

cash receipts sales invoices documents

SINTAYEHU T. 49
 Analysis of Differences

 Payment-in-transit
 Shipment-in-transit
 The goods have been returned
 Errors and disputes

SINTAYEHU T. 50
 Drawing Conclusions

 Reevaluate internal control

 Evaluate the qualitative nature of misstatements
 Determine whether sufficient evidence was obtained

SINTAYEHU T. 51
 DEVELOPING TESTS OF DETAILS AUDIT
PROGRAM
Design audit procedures for the audit of accounts receivable,
using an evidence planning worksheet as a guide.
 Development of audit program procedures for tests of details in
sales and collection cycle
 Extent of planned tests of details of balances. The source of
each of the rows is as follows:

SINTAYEHU T. 52
 DEVELOPING TESTS OF DETAILS AUDIT
PROGRAM

 Tolerable misstatement
 Inherent risk
 Control risk
 Substantive tests of transactions results

SINTAYEHU T. 53
Evidence Planning Worksheet

SINTAYEHU T. 54
END OF CHAPTER Thtree

SINTAYEHU T. 55