What is Accounts Receivable Confirmation?

Overview

In this article, we will cover the accounts receivable confirmation. Before, we understand such confirmation, let’s get some overview about the auditing and why do we need to do the accounts receivable confirmation.

Auditing is the process of reviewing and examining the financial statements of a business without any bias to express an opinion on them. Auditing is a major part of accounting. Usually the term auditing refers to the external auditing of the financial statements of a business. However, auditing can have many more applications. Auditing can also be internal. For most businesses, external audit of their financial statements, is required by law. Similarly, some companies might also be required by law to have an internal audit function.

The external auditing process starts with a general planning regarding the procedures that should be undertaken to enable the auditors to form an opinion about the financial statements of the business. This may also be paired with a test of controls of the business internal controls to determine the level of substantive procedures that a business must perform in order to form an opinion regarding the financial statements. The substantive procedures and test of controls are done in accordance with the relevant auditing standards.

For the financial statements of a business, auditors must also ensure the financial statements are prepared in accordance with the relevant financial reporting standards. These standards may be the international accounting standards or the accounting standards set by the country in which the business operates. The balance sheet and income statement of a business are the main focus of auditing procedures.

Auditors must perform a range of tests to verify the assertions made in the financial statements of the business. Assertions are claims or presentations made by the business regarding the financial statements of the business. For balance sheet auditors must test assertions regarding the existence, completeness, accuracy, rights and obligations, valuation and allocation, and presentation and classification of balances.

One of the prominent balances in the balance sheet of a business is the accounts receivable balances. Like all other balances in the balance sheet, the same assertions apply to the accounts receivable balances. This means that the auditor must check the existence, completeness, accuracy, rights and obligations, valuation and allocation, and presentation and classification of the accounts receivable balances presented in the financial statements.

Accounts Receivable Balance

The accounts receivable balance of a business consists of the balances owed from its trade debtors. Trade debtors are customers of the business to whom credit sales are made. All the amounts owed from the trade debtors of the business are aggregated into one balance presented as either “Accounts receivable” or “Trade Debtors” on the balance sheet of the business. For businesses that make credit sales to their customers, the accounts receivable balance will form a major part of the current liabilities in their balance sheets.

When the accounts receivable balances of a business are being tested, the auditors focus on two assertions, valuation and existence. This means that the auditors, when checking accounts receivable balances, focus on whether the balances are valued properly and according to the standards, and whether these balances exist or not. This, however, does not mean the other assertions are not tested.

One of the major tools at the discretion of auditors to confirm both these assertions is the accounts receivable confirmation. This is also known as circularization of accounts receivable balances. Accounts receivable confirmations are a form of high-quality evidence.

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Accounts Receivable Confirmations

Accounts receivable confirmation is one of the audit procedures of the accounts receivable. It is a document sent to external parties, in this case the customers of the business being audited, to confirm their balances. Before being sent, these confirmations are signed by the management of the auditee business to give permissions for the information to be disclosed to the auditor. Customers confirm these balances by looking at their ledgers and checking whether the balances on their ledger is the same as the balance stated on the confirmation sent by the auditors. Once the accounts receivable balances are confirmed by customers, the confirmations are sent back directly to the auditors.

Businesses may have different number of credit customers and, therefore, different personal accounts receivable ledger balances. The number of customers that a business has depends on the size of the business, its operations and the credit terms that the business provides. For example, a small business with more favorable credit terms may have more credit customers than a large business that mainly offers only cash sales.

This means that the accounts receivables balance on the balance sheet may be composed of only one customer balance or hundreds or even thousands of customers’ balances. To test the accounts receivable balance on the balance sheet, auditors must first determine whether the accounts receivable balance is material. Regardless of whether it is the accounts receivable balance or not, auditors always determine whether the balance or transactions are material or not first before testing their assertions.

If the auditors determine the accounts receivable balance is material, then further actions are taken. The first thing that auditors do after considering the materiality is breakup up the accounts receivable balance into individual customer balances. This will give the auditors a better view of the accounts receivable balance of the business. In case there are a small number of customers, the auditor may send accounts receivable confirmations to all the customers if they deem necessary. In case of a high number of customers, the auditor may not send confirmations to all customers.  

In that case, the auditor must pick a sample size of customers, from the list of individual accounts receivable balances, based on different sampling techniques. The number of customers to be selected is based on the materiality and risks of the accounts receivable balance. For each customer, the auditors must send a separate accounts receivable confirmation. This confirmation can either be positive or negative depending on the auditor’s understanding of the risk of material misstatement of the accounts receivable balance.

Once the confirmations are received back, the auditors must check whether the balances are confirmed by the customer. In case the balances are not confirmed, the auditor must discuss it with the auditee business’ management and determine the cause of differences between the balances. This can be done by inspecting recent statement of accounts and remittance advices sent by the customers. Any unexplained differences should be noted.

Purpose of Accounts Receivable Confirmation

The accounts receivable confirmation is sent to the customers of the auditee business to mainly test the existence and valuation of the accounts receivable balance. The existence assertion test is done to check that the accounts receivable balance in the balance sheet actually exists. For example, some businesses may create ghost customers to boost their sales and assets in their balance sheets. By sending these confirmations, auditors can confirm that these customers and the related balances actually exist.

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The valuation assertion check is done to ensure that the accounts receivable balance is valued at the correct amount and all the related adjustments related to accounts receivable balances have been recorded. The accounts receivable confirmation is sent to the customers to confirm whether the balances on the auditee business’ ledgers match the balances on the customer’s ledgers. In case these balances do no match, the valuation on the ledgers should be questioned.

While these are the two major assertions that are confirmed by the accounts receivable confirmations, other assertions such as the assertion of accuracy, and rights and obligations are also confirmed by the confirmations. When customers confirm the accounts receivable balance in the accounts receivable confirmation, it is proven that the balance is accurate and that the auditee business has rights and obligations to future receipts against those balances.

Difficulty in Obtaining Accounts Receivable Confirmation

Accounts receivable confirmations can sometimes be difficult to obtain as they depend on third-party responses. If the customers do not send the confirmations on time, or don’t send them at all, alternative procedures need to be performed by the auditor. In case of nonresponses, specially in case of positive accounts receivable confirmation nonresponses, the auditor cannot assume the balances are properly stated.

Sometimes auditors may also be limited by the management of the auditee business when sending these confirmations. These may have other implications on the audit process. The auditors must challenge the reasons provided by the management to assess whether the reasons provided are valid. Auditors must gather additional evidence to form an opinion about the validity and reasonability of the management’s request. Auditors may also need to assess whether a limitation of audit scope is being imposed by the management.

Types of Accounts Receivable Confirmations

There are two main types of accounts receivable confirmations. These are positive accounts receivable confirmations and negative accounts receivable confirmations.

Positive Accounts Receivable Confirmations

Positive accounts receivable confirmations are confirmations sent to customers with a requirement to respond to the auditor’s request for information. In this type of confirmation, the auditor mentions the accounts receivable balance of a customer in the auditee business’ ledgers and asks them to confirm whether the balance matches the balance payable to the auditee business in the customer’s ledgers. The customer is also requested to mention the balance on their ledgers in case the balances do not match.

Positive accounts receivable confirmations are superior to negative accounts receivable confirmations. It is also recommended by standards to use positive accounts receivable confirmations unless the risk of material misstatements of the balance is low or the sample population is made up of many small balances. In case positive accounts receivable confirmations are not returned by the customers, alternative auditing procedures must be applied to test the assertions on the accounts receivable balance. However, nonresponses cannot be used as an audit evidence, either positively or negatively.

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Negative Accounts Receivable Confirmations

The negative accounts receivable confirmation does not require the customer to respond to the auditor when the balances match. In a negative accounts receivable confirmation, the customer is only required to respond if the balance on their ledger does not match the balance on the auditee business’ ledgers. The negative accounts receivable confirmation is only sent when the auditors determine the risk of material misstatement is low for the accounts receivable balance.

This type of accounts receivable confirmation assumes that the balances stated in the business’ ledgers are valued properly unless otherwise stated by the customers. However, in case the balances do not agree and the confirmation is not returned to the auditor, by the customer, for any reason, the balance will still be considered correct.

Alternative Procedure when the Confirmation Cannot be Obtained

As mentioned above, when confirmation cannot be obtained, auditors need to perform alternative procedures if they deem necessary. If the aggregate nonresponses amount is immaterial or the risks of material misstatement in the accounts receivable is perceived to be low, the auditors may choose not to perform any alternative procedures. Auditors can also choose not to perform alternative procedures unless they identify similar characteristics or patterns in the nonresponses. However, auditors may also choose to perform alternative procedures for confirmed balances if auditors deem the response to be unreliable. The type of alternative procedure will ultimately depend on the assertion that is being tested.

The most commonly used alternative procedure when confirmation cannot be obtained is checking the subsequent transactions of a nonresponse balance. It is assumed that the auditee business will have had some transactions with its customers after the year end. Auditors check those subsequent records to check if any or all of the remaining receivable balance has been recovered. This will involve checking for subsequent cash or bank receipts and matching them to the invoices being paid for. This will also confirm the same assertions as the accounts receivable confirmation, although, this procedure is not considered as high-quality.

Other alternative procedures may include checking the signed purchases orders of the customers for the related balances and tracking them to the invoices sent for the orders. Another alternative procedure is to check the goods delivery notes of the order and checking if the goods were delivered on time and signed by the customer. Auditors can also confirm that the documentation for the sale exists and is accurate.

Conclusion

Accounts receivable confirmations are a high-quality audit evidence when it comes to auditing accounts receivable balances. Accounts receivable confirmations are sent by the auditor to the customers of the auditee business. Accounts receivable confirmations can confirm the existence, valuation, accuracy, and rights and obligations assertions of the accounts receivable balances. There are two main types of accounts receivable confirmations, positive and negative accounts receivable confirmations. In case of nonresponses to accounts receivable confirmations or if the auditors deem necessary, alternative procedures must be applied to confirm accounts receivable balances.

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