Audit Procedures for Accounts Receivable

Introduction

In this article, we will cover the detailed audit procedures for accounts receivable. This includes the objectives, the key assertions as well as the audit procedures in response to those assertions. It is very essential to perform proper audit procedures for accounts receivable in order to obtain sufficient appropriate evidence. Accounts receivable are material items on the Balance Sheet and auditors should be more concerned about these items during the audit. Audits perform audit procedures on accounts receivable by testing the various audit assertions.

Objectives of Accounts Receivable Audit

The main objective of an accounts receivable audit is to determine whether there are adequate controls and procedures to ensure the proper recording of accounts receivable. The overall objective of the accounts receivable audit is to ensure they are presented fairly in the financial statements.

Why Do We Need to Audit the Accounts Receivable?

Commonly, we audit the accounts receivable because it is the big item in the Balance Sheet and there are many risks associated with those accounts receivable. Below are the main risks associated with the accounts receivable:

  • An entity or management may intentionally account for or overstate the accounts receivable and revenue in order to look good. This is also called window dressing.
  • There is a possibility of un-reported collection by staff that has to keep the accounts receivable in the book.
  • The proper calculation of the allowance for the doubtful account might not be correct resulting in the understatement of provision or allowance recorded in the book.

In addition to the risk on the accounts receivable, the auditor wants also to test if there are any control deficiencies. The control deficiencies give rise to possible fraud as well as other problems that result in the misstatement of accounts receivable presented in the Balance Sheet.

The above problems both on risk and control deficiencies answer the reason why auditors shall need to audit the accounts receivable.

In the later section, we will cover the key assertions as well as the audit procedures for the audit of accounts receivable.   

Key Assertions of Accounts Receivable Audit

As mentioned above, the audit on accounts receivable is very important as it is the key and material item in the financial statements. In order to audit the accounts receivable, it requires to use the combination of analytical procedures and tests of detail or substantive tests. Typically, we perform the audit of accounts receivable in conjunction with the audit of sales. Thus, in this section, we will take some assertions that we usually test in combination with accounts receivable. Below are the key audit assertions for accounts receivable and we will group these assertions into 3 main types:

Financial Statements AssertionsAudit Objective in Relation to the Assertions
Assertion about classes of transactionsOccurrence: This is to ensure that all revenue transactions arising from the sales of goods and provision of services are actually incurred and related to the entity.
Completeness: This is to ensure that all revenue transactions arising from sales of goods or provision of services that should have been recorded have been actually recorded.
Accuracy: This is to ensure that all revenue transactions have been appropriately recorded at the correct amount.
Cut-Off: This is to ensure that all transactions have been recorded in the correct accounting period.
Classification: This is to ensure that all transactions have been recorded and classified properly.
Assertions about the account balance as at the year-endExistence: This assertion means that the accounts receivable balance recognized in the financial statements actually exists at the end of the period.
Rights and Obligations: This assertion means that the accounts receivable included in the financial statements at the reporting date belong to the entity.
Completeness: This is to ensure that the accounts receivable reported on the Balance Sheet includes all accounts receivable transactions occurring during the period.
Valuation and Allocation: This is to ensure that the amount of accounts receivable included in the financial statement is mathematically correct.
Assertions about presentation and disclosureThe combination of Occurrence, Rights, and Obligations: For all these assertions, we want to ensure that the entity being audited has properly disclosed all events and transactions relating to the accounts receivable and those that have actually incurred and pertain to the entity.
Completeness: This is to ensure that the entity has included all required disclosures.
Classification and Understandability: This is to ensure that all accounts receivable are properly presented and all required disclosures have been clearly expressed.
Accuracy and Valuation: This is to ensure that all financial and other information have been disclosed fairly at the appropriate amounts.

Key Audit Procedures for Accounts Receivable Audit

In the below section set out the key detail practical audit procedures for accounts receivable. All those procedures are in response to the assertions as mentioned in the above section.

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Review Accounts Receivables Process

The first thing is the auditor should review a company’s accounts receivables process to investigate the original information. The auditor can test a sample of customers from the company’s receivables ledger as per the process to verify the original information. In this procedure, the auditor wants to ensure the existence and completeness of the accounts receivable.

Confirm Accounts Receivables

ISA 505 – External Confirmation covers the confirmation of accounts receivable.

Auditors need to confirm accounts receivables balance by directly contacting customers for unpaid receivables balance at the end of the period. This procedure is for large account balances but sometimes includes a few random customers. We commonly call it accounts receivable circularization.

In this procedure, the purpose is also to ensure the existence as well as the Rights and Obligations of accounts receivable that have been recorded in the accounting book.

If there is any discrepancy or there is no response from the account receivable confirmation, the auditor shall need to do a follow-up where necessary.

In addition, the auditor may also perform alternative procedures in case there is an exception as a result of the confirmation or in case it is impossible to get the confirmation. These alternative procedures that auditor can carry out are as follow:

  • Review the subsequent receipt after the year-end by inspecting the bank statements and receipt vouchers relating to that account receivable.
  • In case the account receivable is still outstanding at the date of the review, the auditor may perform the examination on the customers’ account and any other related correspondence in order to assess such outstanding amount is correct or not and pertain to the invoice being tested.
  • The auditor may also perform the inquiry from management for the explanation of any invoices that remained unpaid while the subsequent invoices have been paid for.
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We commonly divide the accounts receivable confirmation into two types; positive and negative confirmation.

Positive confirmation typically requires the confirming party to respond directly to the auditor whether they agree or disagree with the amount stated in the confirmation letter. If they disagree, they can write down the reason for such disagreement.

In contrast, negative confirmation typically requires the confirming party to respond to the auditor only when they disagree with the number provided in the confirmation letter.

In practice, we rarely use the negative confirmation as it is difficult to ensure that the confirming party has actually received such a confirmation letter. The letter may lose on the way and does not reach the confirming party. In this case, if there is any disagreement that the confirming party fails to respond to, then the auditor might treat it as correct.

Testing Invoices from Receivables Report

The auditor should select a sample of invoices from the accounts receivables aging report and test the supporting documents of those invoices. For the selected invoices, the auditor shall perform the review and compare to the authorized price list and other relevant trade documents or contract to ensure that the price charge on the invoice is correct.

The auditor may also test the discount by performing the recalculation to ensure the mathematical accuracy of such a discount.

In addition, the auditor shall also perform the recalculation of tax to ensure that the amount on the invoice is correct.

 All these procedures on those selected invoices are performed so that auditors are able to ensure the accuracy of the accounts receivable.

Verify Shipping Documents

The auditor should inspect the shipping documents to verify the sales period. The auditor will examine the invoices, match the invoice dates to the shipment dates to ensure sales are recorded in the correct accounting period. This is to ensure the cut-off of the accounts receivable has been properly recorded in the correct period.

In addition, the auditor shall trace the sample of shipping documents to the sales invoices as well as to the sales ledger and account receivable ledger in order to ensure the completeness of the accounts receivable.

Review Credit Memos and Cash Receipts

The auditor should review a sample of credit memos and cash receipt copies or vouchers to check whether they were properly authorized and issued in the correct period. For the credit memo, the auditor shall perform the recalculation to see if such credit notes have been properly applied for those selected samples.

This is to ensure both accuracy and cut-off of the receivables.

In addition, perform the review of the selected credit memo after the year-end and verify if the allowance has been provided against the current period’s balances. The auditor performs this procedure to ensure the proper valuation and allocation assertion.

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The auditors should collectively review a list of the company’s current related parties and associated transactions. They should identify how the related party transactions are identified and recorded in the company’s system. The auditor should analyze the presentation of related party transactions in the company’s financial statements.

In this procedures, auditor wants to ensure the proper presentation and disclosure of the related party transactions.

Trend Analysis

The auditor should perform a trend analysis of the aged analysis of accounts receivables account or sales account or perform a comparison of the two overtime to see whether there are any unusual trends. If there are any unusual trends, the auditor should make inquiries about the reasons for those unusual trends.

In this trend analysis, the auditor shall also perform the comparison of key ratios relating to account receivable to previous years or industry data. Those key ratios are the account receivable turnover and account receivable days. Sometimes, we call account receivable days as average daily sales outstanding or days sales outstanding (DSO).

This is part of the analytical procedures to gain an understanding of the trend so that author is able to spot any unusual fluctuation and perform any substantive audit procedures accordingly.

This analysis is part of the audit procedures to ensure the proper valuation and allocation of accounts receivable.

GAAP Considerations

The auditor should perform the review of whether an entity being audit has applied the appropriate accounting policies and procedures related to accounts receivable in accordance with GAAP. They should review the presentation, disclosure, and notes for accounts receivable balance and ensure proper accounting policies and procedures are applied.

Cut-off Analysis

The cut-off is the process to ensure accounts receivables are recorded in the right accounting period. Auditors should follow procedures, review, and confirm to ensure that the entity properly recorded the accounts receivables in the correct accounting period to which they belong.

Assessing the Allowance for Doubtful Accounts

The auditor should review the process that a company follows to make an allowance for doubtful accounts. The auditor will compare the method used this year with the method of last year to determine whether the method is appropriate for the business.

In addition, the auditor may also discuss with management in order to review the adequacy of the allowance for doubtful debt or uncollectible accounts receivable.

In the above procedures, the auditor wants to ensure the valuation and allocation assertion. This means that the allowance for doubtful accounts shall be properly calculated and recorded in the accounting book.

Assess Bad-debt Write-offs

The auditor will calculate the proportion of bad-debt expense to sales for this year and compare it with that of the prior year to see the reasonableness of the expense. They will analyze the necessary disclosure for bad debts and other significant events that are appropriately presented in the notes to the company’s financial statements.

Similar to the allowance for doubtful account, the assessment of bad-debt write-offs is to ensure the correct valuation and allocation as well as the presentation and disclosure.

Investigate Reconciling Items

The auditor should compare general ledger balances to actual receivables listing to confirm their accuracy. The auditor should review the justification for large amounts and the journal entries should be fully documented.

This is to ensure the accuracy and Completeness assertion.

Other Audit Procedures that Auditor should also Performs during the Course of the Audit

Below are the other audit procedures that auditor may carry out on the audit of accounts receivable:

  • The auditor shall need to complete the disclosure checklist in order to ensure that an entity being audited has provided all relevant disclosures relating to the accounts receivable.
  • Before selecting the sample for testing, the auditor shall ensure that he/she has properly cross-checked or performed the casting between the aged receivables sub-ledger or listing to General Ledger (GL) as well as the Trial balance
  • The auditor shall do an inquiry from management to see if there is any evidence of receivables have been sold. In addition, the auditor may also obtain the loan agreements as well as the board minutes and perform the review to see any evidence of those receivables have been sold or not.

In other word, we usually call as accounts receivable factoring. Meaning that an entity sells the receivables to third parties or factoring companies.

Key notes

In best practice, auditors shall perform the test of control first before they perform the tests of detail or substantive audit testing. After the control testing, if the auditor found any big or major risks and control deficiencies, they can perform an in-depth test of detail.

However, if there are minimal risks and there is a strong control measure in place within the company being audited, the auditor may consider reducing the level of testing in the substantive test procedures.

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