Auditing – Lecture 8

Part III. Audit process

by cycle: Sales and
collection cycle
Content

 Accounts and classes of transactions

 Business functions
 Tests of transactions for sales, cash receipts and write-offs
 Effect of tests of transactions
 Tests of details of balances
 Recommended reading

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Accounts and classes of tran-ns
 Accounts and classes of transactions - the overall objective in
the audit of the sales and collection cycle is to evaluate whether
the account balances affected by the cycle are fairly presented
in accordance with accounting standards. The nature of the
accounts may vary, of course, depending on the industry and
client involved. There are differences in the nature and account
titles for a service industry, a retail company, and an insurance
company, but the key concepts remain the same. To provide a frame
of reference for understanding the material in this lecture, let’s
assume we’re dealing with a wholesale merchandising company.
There are five classes of transactions in the sales and
collection cycle:
 sales (cash and sales on account)

 cash receipts;

 sales returns and allowances;

 write-off of uncollectible accounts;

 estimate of bad debt expense.

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Accounts and classes of tran-ns

Nov 9, 2015 4
Business functions
 Before auditors can assess control risk and design tests of
controls and substantive tests of transactions, they need to
understand the business functions and documents and records
in a business. Business functions in 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. There are eight business functions
for the sales and collection cycle are: processing customer
orders, granting credit, shipping goods, billing customers and
recording sales, processing and recording cash receipts, processing
and recording sales returns and allowances, writing off uncollectible
accounts receivable, providing for bad debts. They occur in every
business in the recording of the five classes of transactions in
the sales and collection cycle.
 Processing сustomer orders - legally, it is an offer to buy

goods under specified terms. The receipt of a customer

order often results in the immediate creation of a sales order.
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Business functions

Nov 9, 2015 6
Business functions
 Customer order - a request for merchandise by a
customer. It may be received by telephone, letter, a
printed form that has been sent to prospective and
existing customers, through salespeople, electronic
submission of the customer order through the Internet.
 Sales order - a document for communicating the

description, quantity, and related information for

goods ordered by a customer. This is often used to
indicate credit approval and authorization for shipment.
 Granting credit - before goods are shipped, a properly
authorized person must approve credit to the customer for
sales on account. Weak practices in credit approval often
result in excessive bad debts and accounts receivable that
may be uncollectible. In some companies, the computer
automatically approves a credit sale based on preapproved
credit limits maintained in a customer master file. The
computer allows the sale to proceed only when the
proposed sales order total plus the existing customer
Nov 9, 2015 7
balance is less than the credit limit in the master file.
Business functions
 Shipping goods - this critical function is the first point in the
cycle at which the company gives up assets. Most
companies recognize sales when goods are shipped. The
shipping document, which is often a multicopy bill of
lading, is essential to the proper billing of shipments to
customers. A shipping document is prepared to initiate
shipment of the goods, indicating the description of the
merchandise, the quantity shipped, and other relevant
data. The company sends the original to the customer and
retains one or more copies. The shipping document serves
as a signal to bill the customer and may be in electronic or
paper form.
One type of shipping document is a bill of lading, which is a
written contract between the carrier and the seller of goods.
Often, bills of lading include only the number of boxes or
pounds shipped, rather than complete details of quantity and
description. It is often transmitted electronically, once goods
have been shipped, and automatically generates the related
Nov 9, 2015 8
sales invoice as well as the entry in the sales journal.
Business functions
 Billing customers and recording sales - because billing
customers is the means by which the customer is informed
of the amount due for the goods, it must be done correctly
and on a timely basis. The most important aspects of billing
are:
 all shipments made have been billed (completeness).

 no shipment has been billed more than once

(occurrence).
 each one is billed for the proper amount (accuracy).

Billing the proper amount is dependent on charging the

customer for the quantity shipped at the authorized price,
which includes consideration for freight charges, insurance,
and terms of payments.
In most systems, billing of the customer includes preparation of
an electronic record or a multicopy sales invoice and real-
time updating of the sales transactions file, accounts
receivable master file, and general ledger master file for
Nov 9, 2015 sales and accounts receivable. It is used to create a 9
Business functions
sales journal and, along with cash receipts and
miscellaneous credits, to prepare the accounts receivable
trial balance.
 Processing and recording cash receipts - the four sales
transaction functions are necessary for getting the goods
into the hands of customers, correctly billing them, and
reflecting the information in the accounting records. The
remaining four functions involve the collection and
recording of cash, sales returns and allowances, write-off
of uncollectible accounts, and providing for bad debt
expense. Processing and recording cash receipts includes
receiving, depositing, and recording cash. Cash includes
currency, checks, and electronic funds transfers. The most
important concern is the possibility of theft. It is important
that all cash receipts are deposited in the bank at the
proper amount on a timely basis and recorded in the cash
receipts transaction file. This file is used to prepare the
cash receipts journal and update the accounts receivable
Nov 9, 2015 10
and general ledger master files.
Business functions
 Processing and recording sales returns and allowances -
when a customer is dissatisfied with the goods, the seller
often accepts the return of the goods or grants a reduction
in the charges. The company prepares a receiving report for
returned goods and returns them to storage. Returns and
allowances are recorded in the sales returns and
allowances transaction file, as well as the accounts
receivable master file. Credit memos are issued for returns
and allowances to aid in maintaining control.
 Writing off uncollectible accounts receivable - regardless of
the diligence of credit departments, some customers do not
pay their bills. After concluding that an amount cannot be
collected, the company must write it off. Typically, this
occurs after a customer files for bankruptcy or the account
is turned over to a collection agency.
 Providing for bad debts - because companies cannot expect
to collect on 100% of their sales, accounting principles require
them to record bad debt expense for the amount they do
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not expect to collect.
Tests of trans-s for sales

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Tests of trans-s for sales
 Methodology for designing TT for sales
 Understanding IC - How do auditors obtain an understanding

of internal control? Using one typical approach for sales,

auditors study the client’s flowcharts, make inquiries of the
client using an internal control questionnaire, and perform
walkthrough tests of sales.
 Assessment of planned control risk - the auditor uses the

information obtained in understanding internal control to

assess control risk. There are four steps for this:
 1. step - the auditor needs a framework for assessing

control risk. The six transaction-related audit objectives

provide this framework. These objectives are the same
for all sales and collection cycles in all companies.
 2. step - the auditor must identify the key internal

controls and deficiencies for sales. These will differ for

every audit because every client has different internal
controls.
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Tests of trans-s for sales
 3. step - after identifying the controls and deficiencies,
the auditor associates them with the objectives.
 4. step - the auditor assesses control risk for each

objective by evaluating the controls and deficiencies

for each objective. This step is critical because it affects
the auditor’s decisions about both tests of controls
and substantive tests. It is a highly subjective decision.
 Determining the extent of testing controls - after auditors
identify the key internal controls and control deficiencies, they
assess control risk. For audits of accelerated filer public
companies, the auditor must perform extensive tests of key
controls and evaluate the impact of the deficiencies on the
auditor’s report on internal control over financial reporting. The
extent of testing of controls in audits of nonaccelerated filers
and nonpublic companies depends on the effectiveness of
the controls and the extent to which the auditor believes
they can be relied on to reduce control risk. In determining
Nov 9, 2015 the extent of reliance to place on controls, the auditor also 14
Tests of trans-s for sales
considers the cost of the increased tests of controls
compared to the potential reduction in substantive tests. A
lower assessed level of control risk will result in increased
testing of controls to support the lower control risk, with a
corresponding increase in detection risk and decrease in
the amount of substantive tests.
 Design of tests of controls for sales and STT for sales –
 For each key control, one or more tests of controls

must be designed to verify its effectiveness. In most

audits, it is relatively easy to determine the nature of the
test of the control from the nature of the control. For
example, if the internal control is to initial customer orders
after they have been approved for credit, the test of control
is to examine the customer order for proper initials. For
example, one key internal control for the occurrence
objective is “sales are supported by authorized
shipping documents and approved customer orders.”
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The test of control is to “examine sales invoice for 15
Tests of trans-s for sales
supporting bill of lading and customer order.” For this
test, the auditor should start with sales invoices and
examine documents in support of the sales invoices
rather than going in the opposite direction. If the
auditor traced from shipping documents to sales
invoices, it is a test of completeness. As for the
completeness objective, a common test of control for
sales is to account for a sequence of various types of
documents. For example, accounting for a sequence of
shipping documents and tracing each one to the
duplicate sales invoice and recording in the sales
journal provides evidence of completeness. To
simultaneously provide evidence of both the
occurrence and completeness objectives, an auditor
can check the sequence of sales invoices selected
from the sales journal and watch for duplicate and
omitted numbers or invoices outside the normal
sequence. Assume the auditor selects sales invoices
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#18100 to #18199. The completeness objective for this 16
Tests of trans-s for sales
procedure will be satisfied if all 100 sales invoices are
recorded. The occurrence objective will be satisfied if there
is no duplicate.
 In deciding substantive tests of transactions, auditors
commonly use some procedures on every audit
regardless of the circumstances, whereas others are
dependent on the adequacy of the controls and the
results of the tests of controls. The substantive tests
of transactions are related to the transaction-related
audit objectives and are designed to determine
whether any monetary misstatements for that
objective exist in the transaction. The audit procedures
used are affected by the internal controls and tests of
controls for that objective. Materiality and results of the
prior year also influence the procedures used.
Determining the proper substantive tests of
transactions procedures for sales is relatively difficult
Nov 9, 2015
because they vary considerably depending on the 17
circumstances.
Tests of trans-s for sales
The following paragraphs discuss substantive tests of
transaction audit procedures that are done only when
there are specific circumstances that require special
audit attention, such as when there is a deficiency in
internal control.
 Recorded sales occurred - for this objective, the
auditor is concerned with the possibility of three types
of misstatements: (1) sales included in the journals for
which no shipment was made; (2) sales recorded
more than once; (3) shipments made to nonexistent
customers and recorded as sales. The first two
types of misstatements can be due to an error or
fraud. The last type is always a fraud. The potential
consequences of all three are significant because they
lead to an overstatement of assets and income.
Unintentional overstatements of sales are typically
more easily discovered than fraudulent
overstatements. An unintentional overstatement
Nov 9, 2015 normally also results in an overstatement of 18
Tests of trans-s for sales
accounts receivable, which the client can detect by
sending monthly statements to customers. With
fraudulent overstatements, the perpetrator will
attempt to conceal the overstatement, making it more
difficult for auditors to find. Substantive tests of
transactions may be necessary to discover
overstated sales in these circumstances.
The appropriate substantive tests of transactions for
testing the occurrence objective depend on whether
the auditor believes misstatements are likely. Many
auditors do substantive tests of transactions for the
occurrence objective only if they believe that a
control deficiency exists.
• Recorded sale for which there was no
shipment - the auditor can vouch selected entries
in the sales journal to related copies of shipping
and other supporting documents to make sure they
Nov 9, 2015 occurred. If the auditor is concerned about the 19
Tests of trans-s for sales
possibility of a fictitious duplicate copy of a
shipping document, it may be necessary to trace
the amounts to the perpetual inventory records as
a test of whether inventory was reduced.
• Sale recorded more than once - duplicate sales
can be determined by reviewing a numerically
sorted list of recorded sales transactions for
duplicate numbers. The auditor can also test for
the proper cancellation of shipping documents.
• Shipment made to nonexistent customers - this
type of fraud normally occurs only when the
person recording sales is also in a position to
authorize shipments. Deficient internal controls
make it difficult to detect fictitious shipments, such
as shipments to other locations of the company. To
test for nonexistent customers, the auditor can
trace customer information on the sales invoice to
Nov 9, 2015
the customer master file. These revenue frauds 20
are often referred to as “sham sales.”
Tests of trans-s for sales
 Existing sales transactions are recorded - in many
audits, no substantive tests of transactions are done
for the completeness objective. This is because
overstatements of assets and income from sales
transactions are more likely than understatements,
and overstatements also represent a greater source of
audit risk. To test for unbilled shipments, auditors can
trace selected shipping documents from a file in the
shipping department to related duplicate sales
invoices and the sales journal. To conduct a meaningful
test using this procedure, the auditor must be confident
that all shipping documents are included in the file.
This can be done by accounting for a numerical sequence
of the documents. Generalized audit software tools, such
as ACL or IDEA, can be used to efficiently identify
duplicates and gaps in the numerical sequence of
electronic records.

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Tests of trans-s for sales
Direction of tests - auditors need to understand the
difference between tracing from source documents to
the journals and vouching from the journals back to
source documents. The former tests for omitted
transactions (completeness objective); the latter tests
for nonexistent transactions (occurrence objective).
To test for the occurrence objective, the auditor starts by
selecting a sample of invoice numbers from the journal
and vouches them to duplicate sales invoices, shipping
documents, and customer orders. In testing for the
completeness objective, the auditor typically starts by
selecting a sample of shipping documents and traces
them to duplicate sales invoices and the sales journal
as a test of omissions.
 Sales are accurately recorded - the accurate recording of
sales transactions concerns:
 Shipping the amount of goods ordered

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Tests of trans-s for sales

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Tests of trans-s for sales
 Accurately billing for the amount of goods shipped
 Accurately recording the amount billed in the

accounting records
Auditors typically do substantive tests of transactions in
every audit to ensure that each of these three aspects
of accuracy are done correctly by recalculating
information in the accounting records and comparing
information on different documents. Auditors commonly
compare prices on duplicate sales invoices with an
approved price list, recalculate extensions and
footings, and compare the details on the invoices with
shipping records for description, quantity, and
customer identification. Often, auditors also examine
customer orders and sales orders for the same
information.
 Sales transactions are correctly included in the master
file and correctly summarized - the proper inclusion of all
Nov 9, 2015 sales transactions in the accounts receivable master file 24
Tests of trans-s for sales
is essential because the accuracy of these records
affects the client’s ability to collect outstanding
receivables. Similarly, the sales journal must be correctly
totaled and posted to the general ledger if the financial
statements are to be correct. In most engagements,
auditors perform some clerical accuracy tests, such as
footing the journals and tracing the totals and details to the
general ledger and the master file, to check whether there
are errors or fraud in the processing of sales transactions.
The extent to which such tests are needed is determined
by the quality of internal controls. Generalized audit
software allows for efficient testing of the accuracy of
electronic journals and records.
Posting and summarization tests differ from those for
other transaction-related audit objectives because they
include footing journals, master file records, and ledgers,
and tracing from one to the other among these three.
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Tests of trans-s for sales
 Recorded sales are correctly classified - although it is
less of a problem in sales than in some transaction cycles,
auditors must still be concerned that transactions are
charged to the correct general ledger account. With
cash and credit sales, company personnel should not
debit accounts receivable for a cash sale or credit
sales for collection of a receivable. They should also not
classify sales of operating assets, such as buildings,
as sales. For those companies using more than one sales
classification, such as companies issuing segmented
earnings statements, proper classification is essential.
Auditors commonly test sales for proper classification
as part of testing for accuracy. They examine supporting
documents to determine the proper classification of a given
transaction and compare this with the actual account to
which it is charged.

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Tests of trans-s for sales
 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. Timely
recorded transactions are also less likely to contain
misstatements. When auditors do substantive tests of
transactions procedures for accuracy they commonly
compare the date on selected bills of lading or other
shipping documents with the date on related duplicate
sales invoices, the sales journal, and the accounts
receivable master file. Significant differences indicate
potential cutoff problems in the test of year-end balances.

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Tests of trans-s for cash receipts
 Methodology for designing ToC and ST for cash receipts -
auditors use the same methodology for designing tests of
controls and substantive tests of transactions for cash receipts
as they use for sales. Cash receipts tests of controls and
substantive tests of transactions audit procedures are
developed around the same framework used for sales, but of
course the specific objectives are applied to cash receipts.
Given the transaction-related audit objectives, the auditor follows
this process:
 Determine key internal controls for each audit objective

 Design tests of control for each control used to support a

reduced control risk

 Design substantive tests of transactions to test for

monetary misstatements for each objective

As in all other audit areas, the tests of controls depend on the
controls the auditor identifies, the extent they will be relied on
to reduce assessed control risk, and whether the company
Nov 9,being
2015 audited is publicly traded. 28
Tests of trans-s for cash receipts
Because the methodology for cash receipts is similar to that for
sales, our discussion is not as detailed as our discussion of the
internal controls, tests of controls, and substantive tests of
transactions for the audit of sales. Instead, we focus on the
substantive audit procedures that are most likely to be
misunderstood. An essential part of the auditor’s responsibility in
auditing cash receipts is to identify deficiencies in internal
control that increase the likelihood of fraud. It is done by
means of the following actions:
 Determining whether cash receipt was recorded - the most

difficult type of cash embezzlement for auditors to detect

is when it occurs before the cash is recorded in the cash
receipts journal or other cash listing, especially if the sale
and cash receipt are recorded simultaneously. For
example, if a grocery store clerk takes cash and intentionally
fails to record the sale and receipt of cash on the cash register,
it is extremely difficult to discover the theft. To prevent this
type of fraud, special internal controls are implemented by
Nov 9, 2015 many companies. The type of control will, of course, depend 29
Tests of trans-s for cash receipts
on the type of business. For example, the controls for a retail
store in which the cash is received by the same person
who sells the merchandise and enters cash receipts in a
cash register should be different from the controls for a
company in which all receipts are received through the
mail several weeks after the sales have taken place. It is
normal practice to trace from prenumbered remittance
advices or prelists of cash receipts to the cash receipts
journal and subsidiary accounts receivable records as a
substantive test of the recording of actual cash received.
This test will be effective only if a cash register tape or
some other prelisting was prepared at the time cash was
received.
 Preparing proof of cash receipt - a useful audit procedure to
test whether all recorded cash receipts have been
deposited in the bank account is a proof of cash receipts.
In this test, the total cash receipts recorded in the cash
receipts journal for a given period, such as a month, are
Nov 9, 2015 30
Tests of trans-s for cash receipts
reconciled with the actual deposits made to the bank
during the same period. A difference in the two may be the
result of deposits in transit and other items, but the
amounts can be reconciled and compared. This procedure
is not useful in discovering cash receipts that have not been
recorded in the journals or time lags in making deposits, but it
can help uncover recorded cash receipts that have not
been deposited, unrecorded deposits, unrecorded loans,
bank loans deposited directly into the bank account, and
similar misstatements. Ordinarily, this somewhat time-
consuming procedure is used only when the controls are
deficient.
 Testing to discover lapping of accounts receivable -
lapping of accounts receivable is the postponement of
entries for the collection of receivables to conceal an
existing cash shortage. The embezzlement is perpetrated
by a person who handles cash receipts and then enters
them into the computer system. He or she defers recording
Nov 9, 2015 31
Tests of trans-s for cash receipts
the cash receipts from one customer and covers the
shortages with receipts of another. These in turn are
covered from the receipts of a third customer a few days
later. The employee must continue to cover the shortage
through repeated lapping, replace the stolen money, or find
another way to conceal the shortage.
This embezzlement can be easily prevented by separation
of duties and a mandatory vacation policy for employees
who both handle cash and enter cash receipts into the
system. It can be detected by comparing the name, amount,
and dates shown on remittance advices with cash receipts
journal entries and related duplicate deposit slips. Because
this procedure is relatively time-consuming, it is ordinarily
performed only when specific concerns with
embezzlement exist because of a deficiency in internal
control.

Nov 9, 2015 32
Tests of trans-s for write-offs
 Audit tests for write-offs - the same as for sales returns and
allowances, the auditor’s primary concern in the audit of the write-
off of uncollectible accounts receivable is the possibility of
client personnel covering up an embezzlement by writing off
accounts receivable that have already been. The major control
for preventing this fraud is proper authorization of the write-off of
uncollectible accounts by a designated level of management
only after a thorough investigation of the reason the customer
has not paid.
Normally, verification of the accounts written off takes
relatively little time. Typically, the auditor examines approvals
by the appropriate persons. For a sample of accounts written off,
it is also usually necessary for the auditor to examine
correspondence in the client’s files establishing their uncollectibility.
In some cases, the auditor also examines credit reports. After the
auditor has concluded that the accounts written off by general
journal entries are proper, selected items should be traced to the
accounts receivable master file to test whether the write-off
Nov 9,was
2015 properly recorded. 33
Effect of tests of trans-s
 The results of the tests of controls and substantive tests of
transactions have a significant effect on the remainder of the
audit, especially on substantive tests of details of balances.
The parts of the audit most affected by the tests of controls and
substantive tests of transactions for the sales and collection cycle
are the balances in accounts receivable, cash, bad debt
expense, and allowance for doubtful accounts.
Furthermore, if the test results are unsatisfactory, it is
necessary to do additional substantive testing of sales, sales
returns and allowances, write-off of uncollectible accounts, and
processing cash receipts. Auditors of accelerated filer public
companies must also consider the impact of the unsatisfactory test
results on the audit of internal control over financial reporting.
At the completion of the tests of controls and substantive tests
of transactions, auditors must analyze each exception, for both
public and nonpublic audits, to determine its cause and the
implication of the exception on assessed control risk, which
may affect the supported detection risk and related remaining
Nov 9, 2015 34
substantive tests.
Tests of details of balances

Nov 9, 2015 35
Tests of details of balances
 The appropriate evidence to be obtained from tests of details of
balances must be decided on an objective-by-objective basis.
Because several interactions affect the need for evidence from test
of details of balances, this audit decision can be complex. For
example, the auditor must evaluate the potential for fraud and
also consider inherent risk, which may vary by objective, as well
as the results of tests of controls and the related control risk
assessment, which also may vary by objective. The auditor must
also consider the results of substantive tests of sales and cash
receipts. In designing tests of details of balances for accounts
receivable, auditors must satisfy each of the eight balance-
related audit objectives. These eight general objectives are the
same for all accounts. Specifically applied to accounts receivable,
they are called accounts receivable balance-related audit objectives
and are as follows:
 Accounts receivable in the aged trial balance agree with

related master file amounts, and the total is correctly

Nov 9, 2015
added and agrees with the general ledger. (Detail tie-in) 36
Tests of details of balances
 Recorded accounts receivable exist. (Existence)
 Existing accounts receivable are included. (Completeness)

 Accounts receivable are accurate. (Accuracy)

 Accounts receivable are correctly classified. (Classification)

 Cutoff for accounts receivable is correct. (Cutoff)

 Accounts receivable are stated at realizable value.

(Realizable value)
 The client has rights to accounts receivable. (Rights)

 The methodology for designing TDB for accounts receivable

include the following actions undertaken by the auditor:

 Identifying the client business risk affecting accounts

receivable - tests of accounts receivable are based on the

auditor’s risk assessment procedures that provide an
understanding of the client’s business and industry. As
part of this understanding, the auditor studies the client’s
industry and external environment and evaluates
Nov 9, 2015 management objectives and business processes to 37
Tests of details of balances
identify significant client business risks that could affect
the financial statements, including accounts receivable. As
part of gaining this understanding, the auditor also performs
preliminary analytical procedures that may indicate
increased risk of misstatements in accounts receivable.
Client business risks affecting accounts receivable are
considered in the auditor’s evaluation of inherent risk and
planned evidence for accounts receivable. For example, as
a result of adverse changes in the industry’s economic
environment, the auditor may increase inherent risk for net
realizable value of accounts receivable.
 Setting of tolerable misstatement and assessing of IR -
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 tolerable
Nov 9, 2015 misstatement. Accounts receivable is typically one of the 38
Tests of details of balances
most material accounts in the financial statements for
companies that sell on credit. For even small accounts
receivable balances, the transactions in the sales and
collection cycle that affect the balance in accounts receivable
are almost certain to be highly significant.
Auditors assess inherent risk for each objective for an
account such as accounts receivable, considering client
business risk and the nature of the client and industry. ISA
indicate that auditors must normally identify a specific
fraud risk for revenue recognition. This likely affects the
auditor’s assessment of inherent risk for the following
objectives: existence, sales cutoff, and sales returns and
allowances cutoff. It is common for clients to misstate cutoff
either by error or through fraud. It is also common for clients
to unintentionally or fraudulently misstate the allowance
for uncollectible accounts (realizable value) because of the
difficulty of the judgments to determine the correct
Nov 9, 2015
balance. 39
Tests of details of balances
 Assessing control risk for S&C cycle - internal controls
over sales and cash receipts and the related accounts
receivable are at least reasonably effective for most
companies because management is concerned with keeping
accurate records to maintain good relations with customers.
Auditors are especially concerned with three aspects of
internal controls:
 Controls that prevent or detect embezzlements

 Controls over cutoff

 Controls related to the allowance for uncollectible

accounts
The 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. For the most part, this
relationship is straightforward. For example, assume the
auditor concluded that control risk for both sales and cash
Nov 9, 2015 receipts transactions is low for the accuracy transaction-related40
Tests of details of balances
audit objective. The auditor can therefore conclude that
controls for the accuracy balance-related audit objective for
accounts receivable are effective because the only
transactions that affect accounts receivable are sales and cash
receipts. Of course, if sales returns and allowances and write-
off of uncollectible accounts receivable are significant,
assessed control risk must also be considered for these two
classes of transactions.
 Design and performance of ToC and STT – it includes
designing audit procedures for tests of controls and
substantive tests of transactions, 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.
Nov 9, 2015 41
Tests of details of balances
 Design and performance of TD of accounts receivable
balance - when analytical procedures in the sales and
collection cycle uncover unusual fluctuations, however,
the auditor should make additional inquiries of
management. Management’s responses should be
critically evaluated to determine whether they adequately
explain the unusual fluctuations and whether they are
supported by corroborating evidence.
The task of combining the factors that determine planned
detection risk is complex because the measurement for
each factor is imprecise and the appropriate weight given
to each factor is highly subjective. Conversely, the
relationship between each factor and planned detection risk is
well established. For example, auditors know that a high
inherent risk or control risk decreases planned detection risk
and increases planned substantive tests, whereas good results
of substantive tests of transactions increase planned detection
risk and decrease other planned substantive tests. As we’ve
Nov 9, 2015 42
Tests of details of balances
discussed, planned audit evidence is the inverse of
planned detection risk. After deciding whether planned
audit evidence for a given objective is high, medium, or
low, the auditor must then decide on the appropriate audit
procedures, sample size, items to select, and timing.
For our discussion of tests of details of balances for accounts
receivable, we will focus on balance-related audit
objectives. The audit procedures selected and their
sample size will depend heavily on whether planned
evidence for a given objective is low, medium, or high.
 Account receivable are correctly added and agree with

MF and GL - most tests of accounts receivable and the

allowance for uncollectible accounts are based on the
aged trial balance. An aged trial balance lists the
balances in the accounts receivable master file at the
balance sheet date, including individual customer
balances outstanding and a breakdown of each
Nov 9, 2015
balance by the time passed between the date of sale 43
and the balance sheet date. Ordinarily, auditors test the
Tests of details of balances
information on the aged trial balance for detail tie-in
before any other tests to verify that the population
being tested agrees with the general ledger and
accounts receivable master file. The total column and
the columns depicting the aging must be test footed
and the total on the trial balance compared with the
general ledger. In addition, auditors should trace a sample
of individual balances to supporting documents such as
duplicate sales invoices to verify the customer’s name,
balance, and proper aging. The extent of the testing for
detail tie-in depends on the number of accounts involved,
the degree to which the master file has been tested as a
part of tests of controls and substantive tests of
transactions, and the extent to which the schedule has
been verified by an internal auditor or other independent
person before it is given to the auditor. Auditors often use
audit software to foot and cross-foot the aged trial balance
and to recalculate the aging.
Nov 9, 2015 44
Tests of details of balances
 Recorded amounts receivable exist - confirmation of
customers’ balances is the most important test of
details of balances for determining the existence of
recorded accounts receivable. When customers do not
respond to confirmations, auditors also examine supporting
documents to verify the shipment of goods and evidence of
subsequent cash receipts to determine whether the
accounts were collected. Normally, auditors do not
examine shipping documents or evidence of subsequent
cash receipts for any account in the sample that is
confirmed, but they may use these documents extensively
as alternative evidence for nonresponses.
 Existing accounts receivable are included - it is
difficult for auditors to test for account balances
omitted from the aged trial balance except by relying
on the self-balancing nature of the accounts receivable
master file. For example, if the client accidentally
excluded an account receivable from the trial balance, the
Nov 9, 2015 45
only likely way it will be discovered is for the auditor to foot
Tests of details of balances
accounts receivable trial balance and reconcile the balance
with the control account in the general ledger. If all sales
to a customer are omitted from the sales journal, the
understatement of accounts receivable is almost
impossible to uncover by tests of details of balances.
For example, auditors rarely send accounts receivable
confirmations to customers with zero balances, in part
because research shows that customers are unlikely to
respond to requests that indicate their balances are
understated. In addition, unrecorded sales to a new
customer are difficult to identify for confirmation because
that customer is not included in the accounts receivable
master file. The understatement of sales and accounts
receivable is best uncovered by substantive tests of
transactions for shipments made but not recorded and
by analytical procedures.
 Accounts receivable are accurate - confirmation of
accounts selected from the trial balance is the most
Nov 9, 2015 common test of details of balances for the accuracy of46
Tests of details of balances
accounts receivable. When customers do not respond to
confirmation requests, auditors examine supporting
documents in the same way as described for the existence
objective. Auditors perform tests of the debits and credits
to individual customers’ balances by examining supporting
documentation for shipments and cash receipts.
 Accounts receivable are properly classified - normally,
auditors can evaluate the classification of accounts
receivable relatively easily, by reviewing the aged trial
balance for material receivables from affiliates,
officers, directors, or other related parties. Auditors
should verify that notes receivable or accounts that should
be classified as noncurrent assets are separated from
regular accounts, and significant credit balances in
accounts receivable are reclassified as accounts payable.
 Account receivable are stated at RV - accounting
standards require that companies state accounts
receivable at the amount that will ultimately be
Nov 9, 2015
collected. The realizable value of accounts receivable 47
Tests equals
of details of balances
gross accounts receivable less the allowance
for uncollectible accounts. To calculate the allowance,
the client estimates the total amount of accounts
receivable that it expects to be uncollectible. Obviously,
clients cannot predict the future precisely, but it is
necessary for the auditor to evaluate whether the
client’s allowance is reasonable, considering all
available facts.
 Bad debt expense - after the auditor is satisfied with the
allowance for uncollectible accounts, it is easy to verify bad
debt expense. Assume that:
 The beginning balance in the allowance account was

verified as a part of the previous audit.

 The uncollectible accounts written off were verified as

a part of the substantive tests of transactions.

 The ending balance in the allowance account has

been verified by various means.

Nov 9, 2015
Bad debt expense is then simply a residual balance 48
that can be verified by recalculation.
Recommended reading

 Arens et al. (2015) – chosen chapters will be uploaded to IS

 Ch. 14-17 (whole)

Oct 12, 2015 49