CHAPTER TWO

AUDIT OF THE SALES AND COLLECTION

CYCLE: TESTS OF CONTROLS AND
SUBSTANTIVE TESTS OF TRANSACTIONS

Auditors perform both tests of controls and tests of transactions and

balances. As a means of securing assurance from the clients system of
control, it is important for the auditors to know when they should rely
extensively on internal controls and when they should not. This
chapter studies assessing control risk and designing tests of controls
and substantive tests of transactions for each of the classes of
transactions in the sales and collection cycle. In the second part of the
chapter, discussions on designing of tests of account balances are
included.

Before studying the process of assessing control risk and designing

tests of controls and substantive tests of transactions for each class of
transactions, it is important to know the sales and collection cycle
classes of transactions and account balances. It is also important to
understand the typical documents and records used in the cycle.

I. ACCOUNTS AND CLASSES OF

TRANSACTIONS IN THE SALES AND
COLLECTION CYCLE

The overall objective in the audit of the sales and collection cycle is to
evaluate whether the account balances affected by the cycles are
fairly presented in accordance with GAAP.

ACCOUNTS IN THE SALES AND COLLECTION CYCLE includes-

Sales, A/Receivable, Cash in Bank, Cash Discounts Taken,
Allowance for Uncollectible Accounts, and Bad Debt
Expense

CLASSES OF TRANSACTIONS IN THE SALES AND

COLLECTION CYCLE are Sales (cash and sales on
account), Cash receipts, Sales returns and allowances,
Charge-off of uncollectible accounts and Estimate of bad
debt expense.

1
II. BUSINESS FUNCTIONS IN THE CYCLE AND
RELATED DOCUMENTS AND RECORDS
The Sales and Collection Cycle involves the decisions and processes
necessary for the transfer of the ownership of goods and services to
customers after they are made available for sale. It begins with a
request by a customer and ends with the conversion of material or
service into an account receivable, and ultimately into cash.

There are various Business Functions for sales and collection

cycle. They occur in every business in the recording of the five
classes of transactions.

Below you will find summary discussions of the Classes of

Transactions, Accounts, Business functions, and related Documents
and Records for the Sales and Collection Cycle.

1. SALES TRANSACTION

Accounts
Sales
Accounts receivable

Business Functions
Processing customer orders, - Customer places an order
using Customer Order document.
o This is often followed by the issuance of Sales Order.
Granting credit- a properly authorized person must approve
credit to the customer for sales on account.
o Minimizes the possibility of bad debts.
o It may be a programmed approval- based on preapproved
credit limit maintained in a customer master file.
Shipping goods
o A point at which most companies recognize sale.
o A shipping document is prepared.
o The shipping document may be a multicopy bill of lading.
o Update perpetual inventory record.
Billing customers and recording sales- Billing is a means by
which the customer is informed of the amount due for the
goods.
o All shipments should be billed and no shipment should be
billed more than once.
o Billing should consider authorized price, quantity shipped
and other terms.

2
 o Done with multicopy sales invoice and simultaneously
updating of the sales transaction file, accounts receivable
master file, and the general ledger master file for sales
and accounts receivable.

Documents and Records

Customer Order- a request for merchandise by a customer.
o It may be received in differing formats.
Sales Order- used to communicate the description, quantity
and related specification of goods ordered.
o Often used to indicate credit approval and authorization
for shipment.
Shipping Document- a document prepared to initiate shipment
of goods.
o Prepared in at lease in three copies customer, accounts,
retained
Sales invoice-a document indicating the description and
quantity of goods sold the price, freight charges, insurance,
terms, and other relevant data.
o Prepared in at least three copies.
Sales transaction file- a computer generated file that includes
all sales transactions processed by the accounting system for a
period.
o It includes all information entered into the system and
information for each transaction- customer name, date,
amount, account classifications, sales person, and
commission rate.
o The file may include returns and allowances if separate
files are not kept for those transactions.
o The information in this file is used for a variety of records,
listing, or reports- e.g. sales journal, A/R master file, and
transactions for certain account balance or division.
Sales journal or listing- a report generated from the sales
transaction file that typically includes the customer name, date,
amount, and account classification or classifications for each
transaction, such as division or product line.
o It also identifies whether the sale was for cash or credit.
Accounts receivable master file- a file used to record
individual sales, cash receipts, and sales returns and allowances
for each customer and to maintain customer account balances.
o The master file is updated from the sales, sales returns
and allowances, and cash receipts computer transaction
files.
o It is also called the A/R subsidiary ledger or subledger

3
 Accounts Receivable trial balance- a list of the amounts
owed by each customer at a point in time.
o This is prepared directly from the A/R master file.
o It is often an aged trial balance.
Monthly statements- a document sent by mail or electronically
to each customer indicating the beginning balance of A/R, the
amount and due date of each sale, cash payments received,
credit memos issued, and the ending balance due.

2. CASH RECEIPTS TRANSACTION

Accounts
Cash in bank (debits from cash receipts)
Accounts receivable

Business Functions
Processing and recording cash receipts- includes receiving,
depositing and recording cash- currency & checks.
o The possibility of theft is the most important concern
(both before and after recorded).
o All cash receipts must be deposited intact and recorded in
the cash receipts transaction file.
o Remittance advices are important for this purpose.

Documents and Records

Remittance advice- a document that accompanies the sales
invoice mailed to the customer and can be returned to the seller
with the cash payment.
o If no remittance advices are received the person opening
the mail should prepare it.
o Used to permit the immediate deposit of cash & to
improve control over custody of assets.
Prelisting of cash receipts- a list prepared when cash is
received by someone who has no responsibility for recording
sales, A/R, or cash and who has no access to accounting records.
o It is used for verifying whether cash received was
recorded and deposited.
Cash receipts transaction file- a computer generated file that
includes all cash receipts transactions processed by the
accounting system for a period.
o Used to prepare the cash receipts journal and update the
A/R and general ledger master files.

4
 Cash receipts journal or listing- a report generated from the
cash receipts transaction file that includes all transactions for
any time period.

3. SALES RETURNS AND ALLOWANCES

TRANSACTION

Accounts
Sales returns and allowances
Accounts receivable

Business Functions
Processing and recording sales returns and allowances
o When a customer is dissatisfied with the goods, the seller
often accepts the returned goods or grants a reduction in
the charges.
o It is necessary to issue a Receiving Report and return the
goods to store.
o Record the transaction promptly and accurately on the
Sales and Returns Journal & A/R master file.
o As an aid for control & to facilitate recording Credit
Memos are issued.

Documents and Records

Credit memo- a document indicating a reduction in the amount
due from a customer because of returned goods and allowances
granted.
Sales returns and allowances journal- a journal used to
record sales returns and allowances.
o Sales journal can be used instead.

4. CHARGE-OFF OF UNCOLLECTIBLE ACCOUNTS

TRANSACTION
Accounts
Accounts receivable
Allowance for uncollectible accounts

Business Functions
Charging off uncollectible accounts receivable
o When the company concludes that an amount is no longer
collectible, it must be charged off- e.g. if a customer
becomes bankrupt.
o Necessary adjusting entries are made.

5
Documents and Records
Uncollectible account authorization form- a document used
initially to indicate authority to write an account receivable off
as uncollectible.
General journal

5. BAD DEBT EXPENSE TRANSACTION

Accounts
Bad debt expense
Allowance for uncollectible accounts

Business Functions
Providing for bad debts
o The provision should be sufficient to allow for the current
period sales that the company will be unable to collect in
the future.
o Allowance method is used.

Documents and Records

General journal

III. METHODOLOGY FOR DESIGNING TESTS

OF CONTROLS AND SUBSTANTIVE TESTS
TRANSACTIONS FOR SALES

UNDERSTANDING INTERNAL CONTROLS- SALES

Typical approach- Auditor prepares an internal control
questionnaire, and performs walk-through tests of sales

ASSESS PLANNED CONTROL RISK- SALES

Information obtained in understanding internal control is used to
assess control risk.
There are four essential steps:
1. The auditor needs a framework for assessing control risk. The
framework for all classes of transactions is the six transaction-
related audit objectives.
2. Identify the key internal controls and weaknesses for sales.
3. Associate the controls and weaknesses identified with the
objectives.
4. Assess the control risk for each objective by evaluating the
controls and weaknesses for each objective.

6
Step four is critical because it affects the auditors decisions about
both tests of controls and substantive tests. It is a highly subjective
decision.

The following are key control points auditors will consider in

their evaluation of the internal control system of the client.

ADEQUATE SEPARATION OF DUTIES

Person responsible for inputting sales and cash receipts
transaction information into the computer vs. person having
access to cash.
Credit granting function vs. the sales function (to minimize the
sales people tendency to optimize volume even at the expense of
high bad debt write-offs).
Personnel responsible for doing internal comparisons vs. those
entering the original data. (E.g. comparison of batch control
totals with summary reports and comparison of A/R master file
totals with the GL balance should be done by someone
independent of those who input sales & cash receipt
transactions).
PROPER AUTHORIZATION
Three key points of authorization
Credit must be properly authorized before sales takes place,
Goods should be shipped only after proper authorization, and
Price, including freight and discount, must be properly
approved- to ensure sales is billed at the price set by co policy
ADEQUATE DOCUMENTS AND RECORDS
Documents and records used must be adequate.
Should contain sufficient information.
Most companies automatically prepare a multi-copy
prenumbered sales invoice at the time the customer places an
order. Useful for minimizing the chance of failure to bill the
customer if all invoices are accounted for periodically.
PRENUMBERED DOCUMENTS
Use of prenumbered documented prevents both the failure to
bill or record sales and the occurrence of duplicate billings and
recordings.
All should be properly accounted for.
e.g. filing, by a billing clerk, of a copy of all shipping documents
in sequential order after each shipment is billed, with someone
else periodically accounting for all numbers and investigating
the reason for any missing documents.
MONTHLY STATEMENTS

7
 Sent by someone having no responsibility for handling cash or
preparing the sales and A/R records.
Encourages response from customers if the balance is
improperly stated.
All disagreements about the balance in the account should be
directed to the independent designated official.
INTERNAL VERIFICATION PROCEDURE
For fulfilling the each of the six transactions related audit
objectives, a computer program or an independent person check
the processing and recording of sales. e.g. accounting for
numerical sequence of prenumbered documents,
Checking the accuracy of document preparation.
Reviewing reports for unusual or incorrect items.

i) DESIGN TESTS OF CONTROLS FOR SALES

For each control the auditor plans to rely onto reduce assessed
control risk, one or more tests of controls must be designed to verify
its effectiveness.
The nature of the tests of controls is determined from the nature of
the control.
Carefully Read the illustration attached in the material (Table 13-2).

ii) DESIGNING SUBSTANTIVE TESTS OF TRANSACTIONS FOR

SALES

In designing substantive tests of transactions, some procedures are

commonly used on every audit regardless of the circumstances of
tests, where as others are dependent on the adequacy of the controls
and the results of the tests of controls
The audit procedures are affected by the internal controls and
tests of controls for that objective.
Materiality and results of the prior year affect the procedures
used.
The typical substantive tests of transactions are shown in the table
provided above. (Table 13-2). Below you will find additional
procedures to be performed in relation to the transaction related
audit objectives.

RECORDED SALES EXIST

For this objective, the auditor is concerned with the possibility of
three types of misstatements.
Sales being included in the journals for which no shipment was
made,

8
 Sales recorded more than once, and
Shipments being made to nonexistent customers and recorded
as sales
Many auditors do substantive tests of transactions for
existence objective depend on where the auditor believes
the misstatements are likely to take place. The test will be
done only if they believe that a control weakness exists.
Recorded Sales for which there was No Shipment
Trace selected entries from the sales journal to make sure that
related copies of the shipping and other supporting documents
exist.
If the possibility of fictitious duplicate copy of a shipping
document, trace amounts to the perpetual inventory records.
Trace the credit in the A/r master file to its source- if collected
or goods returned, there must originally have been a sale. If
credited for bad debt or if the account was still unpaid, intensive
follow-up by examining shipping docs and customer order docs.
Sales Recorded More than Once
Duplicate sales can be determined by reviewing a numerically
sorted list of recorded sales transactions for duplicate numbers.
Also test proper cancellation of shipping documents.
Shipment Made to Nonexistent Customers
Can occur only when the person recording sales is also in a
position to authorize shipments.
If controls are weak, it is difficult to detect.
EXISTING SALES TRANSACTIONS ARE RECORDED
Normally, substantive test for completeness is less
emphasized.
But if controls are inadequate, which is likely if the client
does no independent internal tracing from shipping documents to
the sales journal, substantive testes are necessary.
Test for unbilled shipments to trace selected
shipping documents from a file in the shipping department
to related duplicate sales invoices and the sales journal.

Direction of Testing
Tracing from source documents to the
journals- a test for omitted transactions- Completeness Objective
likely starting point could be a shipping doca sample selected
and traced to sales invoices and sales journal.
Tracing from the journals back to source
documents- a test for nonexistent transactions- existence
objective.likely starting point could be the journal a sample of
invoice numbers is selected from the journals and traced to
duplicate sales invoices, shipping docs, and customer orders.

9
SALES ARE ACCURATELY RECORDED
Accurate recording of sales - shipping the amount of goods ordered,
accurate billing for the amount of goods shipped, and accurately
recording the amount billed.

Typical substantive tests include: Re computing information in the

accounting records
Start with entries in the sales journal to compare the total of
selected transactions with A/R master file entries & duplicate
sales invoices.
Compare prices on the duplicate sales invoices with an
approved price list,
Re compute extensions and footings
Compare details listed on the invoices with shipping records for
description, quantity, and customer identification
When sales invoices are automatically calculated and
posted by a computer, the auditor may be able to reduce
substantive tests of transactions for the accuracy objective.
If the auditor determines that the computer is
programmed accurately and the price list master file is authorized
and correct, detailed invoice calculations can be reduced or
eliminated. In this case, the focus will be on determining if
effective computer controls exist.

RECORDED SALES ARE PROPERLY CLASSIFIED

Sales of cash vs. credit sales
Exclude sales of operating assets such as machinery
Use of more than one sales classification.. Regular,
installment

SALES ARE RECORDED ON THE CORRECT DATES

Sales should be billed and recorded as soon after shipment
takes place as possible to prevent the unintentional omission of
transactions from the records and to make sure that sales are
recorded in the proper period.
Compare the date on selected bills of lading or other shipping
documents with the date on the related duplicate sales invoices,
the sales journal, and the A/R master file.
SALES TRANSACTIONS ARE PROPERLY INCLUDED IN THE
MASTER FILE AND CORRECTLY SUMMARIZED
Needed b/se the accuracy of these records affects the clients
ability to collect outstanding receivables.
The sales journal must be correctly totaled and posted to the GL

10
 Perform clerical accuracy tests such as footing the journals and
tracing the totals and details to the GL and the master file to
check whether there are misstatements.
The distinction between posting and summarization and
other transaction related audit objectives is that posting and
summarization includes footing journals, master file records, and
ledgers and tracing from one to the other among these three.
When footing and comparisons are restricted to these three
records, the process is posting and summarization
In contrast, accuracy involves determining the monetary
correctness of transactions and comparing amounts b/n docs
or with journals and master file records.

SALES RETURNS AND ALLOWANCES

The transaction-related audit objectives and the clients methods of
controlling misstatements are essentially the same for processing
credit memos as those described for sales.
But two important differences:
Materiality, and
Emphasis on audit objectives- primary emphasis is normally on
testing the existence of recorded transactions as a means of
uncovering any diversion of cash from collection of A/R that has
been covered up by a fictitious sales return or allowance.
Completeness objective is important especially at year-end.
Unrecorded SR/A can be material overstates net income if
unrecognized.

IV. METHODOLOGY FOR DESIGNING TESTS OF

CONTROLS AND SUBSTANTIVE TESTS OF
TRANSACTIONS FOR CASH RECEIPTS

The same methodology used for designing tests of controls and

substantive tests of transactions for sales is used for cash receipts.
Cash receipts tests of controls and substantive tests of
transactions audit procedures are developed around the same
framework used for sales.
Key internal controls for each objective are determined, tests of
controls are developed for each control, and substantive tests of
transactions for the monetary misstatements related to each
objective are developed.
The tests of controls depend on the controls the auditor has
identified and the extent they will be relied on to reduce assessed
control risk.

11
In the Table 13-3 (attached) you will find examples of key controls,
common tests of controls, and common substantive tests of
transactions to satisfy each of the transaction-related audit objectives
for cash receipts.

An essential part of the auditors responsibility in auditing cash

receipts is identification of weaknesses in internal control that
increase the likelihood of fraud.

DETERMINE WHETHER CASH RECEIVED WAS RECORDED

It is difficult to detect a cash fraud occurred before the cash is
recorded in the cash receipt journal or other cash listing.
Internal controls designed to satisfy completeness objective are
important.
Trace from prenumbered remittance advices or prelists of cash
receipts to the cash receipt journal and subsidiary A/r records
as a substantive tests of the recording of the actual cash
received effective only if a cash register tape or some other
prelisting was prepared at the time cash was received

PREPARE PROOF OF CASH

A useful audit procedure to test whether all recorded cash
receipts have been deposited in the bank account.
Total cash receipts recorded in the journal vs. actual deposits
made during the month
Helps to detect recorded cash receipts that havent been
deposited, unrecorded deposits, unrecorded loans, bank loan
deposited directly into the bank account etc.
Can not help to detect cash receipts that have not been
recorded in the journals or time lags in making deposits.
Performed only when controls are weak.

TEST TO DISCOVER LAPPING OF A/R

Lapping of A/R is the postponement of entries for the collection of
receivables to conceal an existing cash shortage.
The defalcation is perpetrated by a person who handles cash
receipts and then enters them into the computer system.
Involves differing recording the cash receipts from one
customer and covers the shortage with receipts of another. This
in turn is covered from the receipts of a third customer few days
later.
Prevention. Separate duties and mandatory vacation policy
for employees who both handle cash and enter cash receipts
into the system.

12
 Detection Compare the name, amount, and dates shown on
remittance advices with cash receipts journal entries and
related duplicate deposit slips.

V. METHODOLOGY FOR DESIGNING TESTS OF
DETAILS OF BALANCES

The methodology that auditors follow in designing the appropriate

tests of details of balances for accounts receivable involves some
major steps summarized in figure 2.1 below. These steps and related
audit work and decision involves various audit activities performed
and decisions made in the evidence planning phase of the audit,
materiality and risk considerations and tests of controls and
substantive tests of transactions discussed in this chapter of the
material.

Deciding the appropriate tests of details of balances evidence is

complicated because it must be decided on an objective-by-objective
basis, and there are several interactions that affect the evidence
decision.

For example, the auditor must consider inherent risk, which may
differ by objective, and results of substantive tests of sales and cash
receipts, which also may vary by objective. The auditor must also
consider the results of tests of controls and the related control risk
assessment.

In designing tests of details of balances for accounts receivable, it is

essential to satisfy each of the nine balance-related audit objectives.

Existence

Completeness

Accuracy

Classification

Cutoff

Realizable value

Rights and obligations

Presentation and disclosure

Figure 2.1: Designing Tests of Details of Balances
Identify client business risks
affecting accounts receivable.

Set tolerable misstatement

13
 and assess inherent risk
for accounts receivable.

Assess control risk for sales

and collection cycle.

Design and perform tests of

controls and substantive tests
of transactions for sales and
collection cycle.

Design and perform

analytical
procedures for accounts
receivable balance.

Design tests of details of Audit procedures

accounts receivable balance Sample size
to satisfy balance-related Items to select
audit objectives. Timing

Important points on the Designing Tests of Details of Balances (figure

2.1) are discussed below.

Identify Client Business Risks Affecting Accounts

Receivable
Tests of A/R are based on auditors understanding of the clients
business and industry.
As part of this understanding,
o the auditor studies the clients industry and external
environment and evaluates management objectives and
business processes to identify significant business risks
that could affect the FSs including A/Rs
o perform preliminary analytical procedures that may
indicate increased risk of misstatement in A/R.
Clients business risk affecting A/R is
considered in the auditors evaluation of inherent risk and
planned evidence for A/R

14
Set Tolerable Misstatement and Assess Inherent Risk
for Accounts Receivable
Set preliminary judgment about materiality set for the entire FS
and then allocated to each significant balance sheet accounts,
including A/R Tolerable Misstatement
A/R is one of the most material accounts in the FS for companies
that sell on credit.
Inherent risk is assessed for each objective for an account such
as A/R considering the clients business risk and the nature of the
client and industry.
For most audits, inherent risk for A/R is moderate or low except
for two objectives:
A/R is stated at net realizable value- due to
judgment involved & intentional misstatement and
Sales and sales return & allowance cutoff is correct-
due to possibility of misstatement.

Assess Control Risk for Sales and Collection Cycle

As a means to good relations with customers, mgt is concerned
with keeping accurate records.hence may have good internal
control over sales & cash receipts & A/R
Areas of concern:
Controls that prevent or detect defalcations
Controls over cutoff, and
Controls related to allowance for uncollectible accounts
(e.g. approval of credit before shipment)

The auditor must relate control risk for transaction-

related audit objective to balance-related audit objectives in
deciding planned detection risk and planned evidence for tests of
details of balances.

Example: Assume that the auditor concluded that control risk for
both sales and cash receipts transactions is low for the accuracy
transaction-related audit objective. The auditor can therefore
conclude that controls for the accuracy balance-related audit
objectives for A/R are effective b/se the only transactions
affecting A/R are sales and cash receipts.

If sales return and allowances & charge-off of uncollectible A/R

are significant, assessed CR must also be considered for these
classes of transactions.

Important point on the relationships:

15
 For sales, the existence transaction-related audit objective
affects the existence balance-related audit objective, but for
cash receipts the existence transaction-related audit objective
affects the completeness balance-related audit objective.
Three A/R balance-related audit objectives are not affected by
assessed control risk for classes of transaction--- Realizable
value, Rights & Presentation and disclosure.
To reduce assessed control risk below maximum for these three
objectives, separate controls are identified and tested.

Design and Perform Tests of Controls and Substantive

Tests of Transactions
The results of the tests of controls determine whether
assessed control risk for sales and cash receipts needs to be
revised.
The results of the substantive tests of transactions are
used to determine the extent to which planned detection risk is
satisfied for each accounts receivable balance-related audit
objective.

Design and Perform Analytical Procedures

Most analytical procedures (AP) performed during the detailed
testing phase are done after the balance sheet date but before
tests of details of balances --- since all the transactions are to be in
the record.
APs are done for the entire sales and collection cycle, not only
for A/R.---due to close r/n ship among accounts.
When APs in the sales and collection cycle uncover unusual
fluctuations, the auditor should make additional inquiries of
management.
Mgts response should be critically evaluated for adequacy of
the explanation and whether they are supported by other
corroborative evidence.
In addition to APs,
Review A/R for large and unusual amounts
Individual receivables that deserve special attention are
large balances, accounts that have been outstanding for a
long time, receivables from affiliated companies, officers,
directors, and other related parties, and creditors.

Common Examples of AP

Compare:
Gross margin percentage with previous years

16
 Sales by month over time
Sales returns and allowances as a percentage of gross sales
with previous years (by product line)
Individual customer balances over a stated amount with
previous years
Bad debt expense as a percentage of gross sales with
previous years
Days that accounts receivable are outstanding with previous
years
Aging category as a percentage of receivables with previous
years
Allowance for uncollectible accounts as a percentage of
accounts receivable with previous years
Charge-off of uncollectible accounts as a percentage of total
accounts receivable with previous years

Design And Perform Tests Of Details Of Accounts

Receivable Balance
Tests of details of balances for all cycles are directed to balance
sheet accounts, but income statement accounts are not ignored
because they are verified as a by-product of the balance sheet
accounts.
For designing tests of details of balances, the auditor needs to
decide on planned detection risk.
Basically, this decision is a result of combined consideration of
various factors such as the acceptable audit risk, inherent risk,
control risk, substantive tests of transactions and analytical
procedures decision made until this phase of the audit.
Planned detection risk for each objective is, finally, an auditor
decision, decided by subjectively combining the conclusions
reached about each of the factors.
Audit procedures selected and their sample size depends heavily
on whether planned evidence for a given objective is low,
medium, or high.
Confirmation of A/R is the most important test of details of A/R.

Designing Specific Audit Procedures and Timing of

Decisions for Accounts Receivable (Refer the attached
Table15-4 and Table 15-5)

i) Accounts Receivable Are Correctly Added And Agree

With The Master File And The General Ledger
An aged trial balance is a listing of the balances in the A/R
master file at balance sheet date.

17
 Test information on the aged trial balance for a detail tie-
in.
Test information on the aged trial balance must done
before any other tests to assure the auditor that the population
being tested agrees with the GL and A/R master file.
Must be test footed, and total on the trial balance be
compared with the GL.
Trace individual balances to supporting documents such
as sales invoices to verify customers name, balance, and proper
aging.
Sample size depends on No. of a/cs, degree of tests done
in previous phases of the audit, degree of independent
verification.
Audit software can be helpful- footing, cross-footing, &
recalculating the aging.

ii) Recorded Accounts Receivable Exist

Confirmation is the most important test of details of
balances.
If no customer response, examine supporting documents to
verify the shipment of goods and evidence of subsequent cash
collection--- Alternative evidence for nonresponse.

iii) Existing Accounts Receivable Are Included

Difficult to test account balance omitted from the aged trial
balance unless comparison with the controlling account (GL)
reveals it.
If all sales to a customer are omitted from the sales journal,
the understatement of A/R is almost impossible to uncover by
tests of details of balances.
The understatement of sales and A/R is best uncovered by
substantive tests of transactions for shipments made but not
recorded and by analytical procedures.

iv) Accounts Receivable Are Accurate

Confirm selected accounts.
For nonresponses perform alternative procedures.
Test debits and credits to individual customers balances by
examining supporting documents for shipment and cash
receipts.

v) Accounts Receivable Are Properly Classified

Review the aged trial balance for material receivables from
affiliates, officers, directors, and other related parties.
Review for any nontrade receivables.

18
 Ensure that notes receivables or accounts that should not be
classified as current asset are segregated from the regular
accounts.
If credit balances in A/R are significant, reclassify it as
accounts payable.

vi) Cutoff For Accounts Receivable Is Correct

Cutoff misstatements exist when current period transactions
are recorded in the subsequent period or subsequent period
transactions are recorded in the current period.
Objective of the test is to verify whether transactions near
the end of the accounting period are recorded in the proper
period.
Cutoff errors affect current period income.
In determining appropriate cutoff
a) Decide on the appropriate criteria for cutoff
b) Evaluate whether the client has established adequate
procedures to ensure a reasonable cutoff, and
c) Test whether a reasonable cutoff was obtained.
Sales Cutoff
Sales Return and Allowance Cutoff
Cash Receipts Cutoff
vii) Accounts Receivable Is Stated At Realizable Value
GAAP requires that A/R be stated at the amount that ultimately
be collected-Gross receivable less allowance for uncollectible
accounts.
The auditor should evaluate whether the allowance is
reasonable.
For evaluation, they prepare an audit schedule that analyses the
allowance for uncollectible accounts.
Start with review of the results of the tests of controls that are
concerned with the clients credit policy.
If the policy is unchanged and results of the tests of the credit
policy and credit approval are consistent with the preceding
year, the change in the balance must reflect only changes in
economic conditions and sales volume.
Carefully examine the noncurrent accounts on the aged trial
balance to determine which ones havent been paid subsequent
to balance sheet date.
Then, compare the size and age of unpaid balances with similar
information from previous years to evaluate whether the amount
of noncurrent receivable is increasing or decreasing over time.
Examination of credit files.
Discussion with the credit manager.
Review of the clients correspondence files.

19
viii) The Client Has Rights to Accounts Receivable
To uncover instances in which the client has limited rights to
receivables (as a result of pledging, assignment, factoring,
discounting), auditors,
Review minutes.
Discuss with the client.
Confirm with the bank.
Examine debt contracts for evidence of A/R pledged as
collateral, and
Examine correspondence files.

ix) Accounts Receivable Presentation and Disclosures Are

Proper
The auditor must decide whether the client has properly
combined the amounts and disclosed related party information
in the statements.
To evaluate adequacy of presentation and disclosure, auditors
need thorough understanding of GAAP.
Decide whether material amounts requiring separate disclosure
have actually been separated.
E.g. receivable from officers and affiliated companies
Evaluate adequacy of the footnotes.
E.g. information about pledging, discounting, factoring,
assignment of A/R, and amount due from related parties.

CONFIRMATION OF ACCOUNTS RECEIVABLE

BALANCE

Primary audit procedure for testing existence, accuracy and

cutoff.
Addresses 5 of the 8 balance-related audit objectives (not
classification, realizable value, and presentation & disclosure).
Expensive audit procedure auditor and client time but highly
reliable evidence.
Required procedure in normal circumstances.
Exceptions to Sending A/R Confirmations
1. Accounts receivable are immaterial.
2. The auditor considers confirmations ineffective evidence
because response rates will likely be inadequate or unreliable.
3. The combined level of inherent risk and control risk is low
and other substantive evidence can be accumulated to provide
sufficient evidence.
Type of Confirmation

20
 Positive confirmation confirm the printed
balance on the confirmation.
Blank confirmation form requests customer to
fill in balance amount on the confirmation.
Invoice confirmation confirm one or more
invoices instead of the total balance.
Negative confirmation respond only if balance is
incorrect.
Timing
The most reliable evidence from confirmations is obtained when
they are sent as close to the balance sheet date as possible, as
opposed to confirming the accounts several months before year-
end.

Sample Size
Factors affecting sample size includes:
Tolerable misstatement
Inherent risk
Control risk
Achieved detection risk from other substantive tests
Type of confirmation

Selection of Items for Testing

Stratification is desirable based on dollar/birr amount or
length of time outstanding. But a sample is also needed for
judging total population.
When selecting a sample of accounts receivable for
confirmation, the auditor should be careful to avoid being
influenced by the client.
If a client tries to discourage the auditor from sending
confirmation to certain customers, the auditor should consider
the possibility that the client is attempting to conceal fictitious
or known misstatements of accounts receivable.
Evaluating Returned Confirmations
Clean responses no follow up required.
Responses with disagreement follow up with the client for
reason. Reasons could be timing issues, customer cant confirm
(or wont), or errors. Customer completes the confirmation
weeks after the cutoff date and their system does not allow
them to go back to the cutoff date to accurately confirm.
No response send a second request, do follow up
procedures subsequent receipts testing
Subsequent Cash Receipts
Evidence of the receipt of cash subsequent to the confirmation
date includes examining remittance advices, entries in the cash

21
 receipts records, or perhaps even subsequent credits in the
accounts receivable master files.
If customer paid for the goods, then the sale must exist.
Duplicate Sales Invoices
These are useful in verifying the actual issuance of a sales
invoice and the actual date of the billing.
If a sales invoice was issued to a customer, then the sale most
likely exists.
Shipping Documents
These are important in establishing whether the shipment was
actually made and as a test of cutoff.

Correspondence with the Client

Usually, the auditor does not need to review correspondence as
a part of alternative procedures, but correspondence can be
used to disclose disputed and questionable receivables not
uncovered by other means.
Drawing Conclusions
Reevaluate internal control.
Evaluate the qualitative nature of misstatements.
Determine whether sufficient evidence was obtained.

22