Completing the Tests in the Sales and Collection Cycle: Accounts Receivable

1. Completing the Tests in theSales and Collection Cycle:Accounts Receivable Chapter 16

2. Learning Objective 1 Describe the methodology for designing tests of details of balances using the audit risk model.

3. Accounts Receivable Balance-Related Audit Objectives Detail tie-in Accuracy Realizable value Existence Classification Rights and obligations Completeness Cutoff

4. Methodology for Designing Tests ofBalances – Accounts Receivable Identify client business risks affecting sales and collection cycle and set audit risk (ch. 8). Set tolerable misstatement for A/R and assess inherent risk for sales and collection cycle (ch. 9). Potential FR – improper rev recognition (ch. 11) Assess control risk for sales and collection cycle (ch. 10).

5. Methodology for Designing Tests ofBalances – Accounts Receivable Design and perform tests of controls and substantive tests of transactions for sales and collection cycle (ch.13, 14 and 15). Design and perform analytical procedures for sales and collection cycle balances (e.g., sales, BDE) (ch. 8, 13 and 16).

6. Methodology for Designing Tests ofBalances – Accounts Receivable Design tests of details of accounts receivable balance to satisfy balance-related audit objectives. Audit procedures/staffing Sample size/budget Items to select Timing

7. Relationship Between Sales and Accounts Receivable: dr. A/R (inc), cr. Sales (inc) Accounts Receivable Balance-Related Audit Objectives → Detail tie-in Existence Accuracy Cutoff Completeness Classification Realizable value Rights Transaction-Related Audit Objectives Sales ↓ Occurrence × Completeness × Accuracy × Classification × Timing × Posting/Summary ×

8. Relationship Between Collections and Accounts Receivable: dr. cash (inc), cr. A/R (dec) Accounts Receivable Balance-Related Audit Objectives Detail tie-in Existence Accuracy Cutoff Completeness Classification Realizable value Rights Transaction-Related Audit Objectives Cash receipts Occurrence × Completeness × Accuracy × Classification × Timing × Posting/Summary ×

9. Say what??? • Recording a cash receipt that did not occur (cash – occurrence violation) violates completeness objective for A/R – there is an open A/R not in the accounting records (A/R reduced with false j/e). Cash is overstated and AR is understated • Failure to record a cash receipt (cash – completeness violation) means violation of existence for A/R – A/R should be reduced – does not exist. Cash is understated and AR is overstated

10. Learning Objective 2 Design and perform analytical procedures for accounts in the sales and collection cycle.

11. Analytical Procedures for the Sales and Collection Cycle Compare Gross margin percentage with previous years Sales by month over time Sales returns and allowances as a percentage of gross sales with previous years Sales growth vs. related NFM growth by product line

12. Analytical Procedures for the Sales and Collection Cycle Compare Individual customer A/R balances over a stated amount Bad debt expense as a percentage of gross sales Days that accounts receivable are outstanding with previous years

13. Analytical Procedures for the Sales and Collection Cycle Compare Aging category as a percentage of receivables Allowance for uncollectible accounts as a percentage of accounts receivable Charge-off of uncollectible accounts as a percentage of total accounts receivable with previous years

14. Selected Comparative Information Percent Percent 2008 Change 2007 Change 2006 (000) 08-07 (000) 07-06 (000) Sales 144.39.4 132.0 6.5 124.0 Gross margin 39.8 9.3 36.4 7.1 34.0 Accounts receivable 20.2 7.4 18.8 13.9 16.5 Bad debt expense 3.3 (2.9) 3.4 9.7 3.1 Total assets 61.4(7.0) 66.0 8.0 61.1 Net earnings 5.7 21.3 4.7 38.2 3.4 Number of accounts receivable 258 16.7 221 5.7 209

15. Analytical ProceduresSales and Collection Cycle 200820072006 Gross margin/net sales 27.8% 27.7% 27.5% Sales R&A/gross sales .9% .9% .8% Bad debt expense/net sales 2.3% 2.6% 2.4% Allowance for uncollectible accounts/accounts receivable 6.1% 8.2% 8.4% Number of days receivables outstanding 51.5 52.3 51.2 Net accounts receivable/ current assets 37.2% 38.6% 36.0%

16. Analytical Procedures for Gross Margin: Sales – CGS / Sales Gross Margin Percent 20082007 Client Industry Client Industry Hardwood 36.3 32.4 36.4 32.5 Softwood 23.9 22.0 20.3 22.1 Plywood 40.3 50.1 44.2 54.3

17. Learning Objective 3 Design and perform tests of details of balances for accounts receivable for each balance- related audit objective.

18. Design and Perform Tests of Detailsof A/R Balance (Phase III) Planned detection risk for each objective is an auditor’s decision. Combining the factors that determine planned detection risk and reacting to DR is complex. Research – better at assessment than response

19. Designing Tests ofDetail of Balances Aged A/R master file / subsidiary ledger (realizable value): BDE and Allowance Recorded accounts receivable exist (confirm) Existing accounts receivable are included (completeness) – Less of a concern – covered w/ Sales (cash) ToT of completeness (existence). Accounts receivable are accurate (confirm and ToT) Accounts receivable are properly classified – reclassify notes receivable, credits, plus ToT

20. Designing Tests ofDetail of Balances Cutoff for accounts receivable is correct – ToT (timing) The client has rights to accounts receivable: factoring? discussions, BOD minutes Extra: Accounts receivable and Sales presentation and disclosures are proper – SOX: exec loans, more than 5%, Rev Recognition policy

21. Learning Objective 4 Obtain and evaluate accounts receivable confirmations.

22. AICPA Requirements: When confirmation NOT required 1. Accounts receivable are immaterial. OR 2. The auditor considers confirmations ineffective evidence because response rates will likely be inadequate or unreliable. OR 3. The combined level of inherent risk and control risk is low (DR high) and other substantive evidence can be accumulated to provide sufficient evidence (ToT and AP). MUST DOCUMENT – story time, did not / could not document #2 above. #1 and #3 not an option.

23. Type of Confirmation Positive confirmation: non responses must be followed up. Negative confirmation: all: (1) many small balances (coverage) (B2C) AND (2) IR and CR are low AND (3) high response rate to positive confirms in PY

24. 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. Consider earnings release dates in light of risks – can you get it done?? SEC / LAFs : 90 → 60 days

25. Sample Size (firm specific) AUDIT SOFTWARE COMBINES ALL THIS Tolerable misstatement - indirect Inherent risk - direct Control risk - direct Assurance re: objectives from other substantive tests (ToT, AP) - indirect Type of confirmation – more with negative Dollar A/R balance – Not “large” so typically part of process - direct

26. Selection of Itemsfor Testing When selectinga sample of accounts receivable for confirmation, the auditor should be careful to avoid being influenced by the client.

27. Selection of Itemsfor Testing 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. Scope limitation???? Disclaimer of opinion??? Parmalat and cash confirms, Satyam

28. Subsequent Cash Receipts Follow up: Evidence of the receipt of cash subsequent to the confirmation date includes examining remittance advices, entries in the cash receipts records, or perhaps even subsequent credits in the accounts receivable master files. Monday Morning QB: Evaluate 12/31 balance with Post 12/31 info

29. Duplicate Sales Invoices These are useful in verifying the actual issuance of a sales invoice and the actual date of the billing: Cutoff

30. Shipping Documents These are important in establishing whether the shipment was actually made (existence and completeness) and as a test of cutoff.

31. End of Chapter 16