Accounts Receivable-Aud Theory

AUDITING CHAPTER 11 Accounts Receivable & Cash Balances By David N. Ricchiute

TOPICS IN REVENUE/RECEIPT Relationship assertions & audit CYCLE procedures Relationship audit risk, client strategies, substantive tests Substantive tests for assertions Revenue recognition, earnings manipulation, & channel stuffing Audit sampling & accounts receivable Computer-assisted audit techniques

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ASSERTIONS & OBJECTIVES Management assertions: Recorded receivables & cash balances  

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Exist Include all transactions (completeness) Represent rights of entity Are valued appropriately Are presented & disclosed properly

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OBJECTIVES & PROCEDURES: Objective: determine whether all recorded Existence/Occurrence sales, receivables, cash balances Procedures 

Existence  Physical observation  Confirmation

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Transactions occurred  Cutoff testing for proper period

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OBJECTIVES & PROCEDURES: Completeness Objective: determine whether all receivables, sales, cash of period are presented in financial statements Procedures   

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Examine documents Apply analytical procedures Cutoff bank statements, bank reconciliations, etc.

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OBJECTIVES & PROCEDURES: Rights/Obligations Objective: determine whether entity has property rights to cash, accounts receivable Procedures   

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Examine documentation Confirmations Inquiries GBW 8th ed. Ch. 11

OBJECTIVES & PROCEDURES: Valuation, Allocation

Objective: determine whether entity has recorded items in correct amounts, accounts, & time periods Procedures   

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Confirm balances Verify mathematical accuracy Examine details of recording

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OBJECTIVES & PROCEDURES: Presentation, Disclosure

Objective: determine whether recorded transactions, balances properly classified, described, disclosed Procedures  

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Compare presentation to GAAP Annual updates of AICPA guidelines GBW 8th ed. Ch. 11

AUDIT RISK MODEL AR = CR x IR x DR Detection risk (DR): likelihood that error could occur & not be detected Based on 

Control risk (CR)  Likelihood of material error

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Inherent risk (IR)  Strategies & threats

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DETECTION RISK DR =

____AR___ IR x CR Nature, extent, timing substantive tests   

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Nature: more/less persuasive tests Extent: larger/smaller samples Timing: balance sheet date or interim GBW 8th ed. Ch. 11

ASSERTIONS & PROCEDURES Accounts Receivable, Sales-1 Valuation Verify mathematical accuracy AR   

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Obtain aged trial balance Foot trial balance Compare total AR per trial balance to general ledger

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ASSERTIONS & PROCEDURES Accounts Receivable, Existence, rights, valuation Sales-2 Confirm year-end accounts & notes receivable with debtors 

Positive: tell auditor if balance correct  Large balances, inaccuracies

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Negative: tell auditor only if balance incorrect  Control adequate, small balances

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ASSERTIONS & PROCEDURES Accounts Receivable, Sales-3

Existence or occurrence, completeness Test cutoff to determine whether sales, receivables recorded in proper period  

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FOB shipping point FOB destination

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ASSERTIONS & PROCEDURES Accounts Receivable, Sales-4 Valuation, rights Review collectibility receivables Determine adequacy allowance for doubtful accounts

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ASSERTIONS & PROCEDURES Accounts Receivable, Sales-5 Existence or occurrence, completeness, valuation Perform analytical procedures for reasonableness of sales, receivables balances   

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Collections problems Overstated sales Understated sales

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ASSERTIONS & PROCEDURES Accounts Receivable, Sales-6 Presentation & disclosure Review financial statements to determine 

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Accounts, notes receivable properly classified, described Disclosures adequate

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TESTING CUTOFF Sales, Receivables At or around end each quarter, the former President directed his subordinates to hold IGI’s books open, to backdate invoices, shipping documents. This caused IGI to record out-of-period sales & to overstate revenue, net income end each quarter. Procedures 

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Trace recorded sales to shipping documents before, after end of period

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ASSERTIONS & PROCEDURES: Cash-1 Existence, rights, valuation Confirm year end balances with all banks

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ASSERTIONS & PROCEDURES: Cash-2 Valuation Verify mathematical accuracy recorded cash balances  

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Foot cash journals Trace totals to general ledger, yearend bank reconciliations Test cash on hand

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ASSERTIONS & PROCEDURES: Cash-3 Existence, completeness, valuation Test cutoff 

Obtain cutoff bank statement  Verify accuracy  Examine & trace to bank reconciliations & cash journals  Proof of cash

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Reconcile recorded cash with bank confirmation Examine interbank, intercompany transfers

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ASSERTIONS & PROCEDURES: Cash-4 Presentation & disclosure Review financial statements to determine 

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Cash balances properly classified, described Disclosures adequate

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TESTING CUTOFF FOR CASH Reconcile internal documents   

Cash journals General ledger Bank reconciliations

With external documents   

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Year-end bank statement Cutoff bank statements Bank confirmations

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REVENUE RECOGNITION & EARNINGS MANIPULATION Increasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding common sense business practices.

Arthur Levitt, Jr., “The ‘Numbers Game.” Speech NYU, 1998.

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REVENUE RECOGNITION SAB 104 Criteria 

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Persuasive evidence of arrangement exists Delivery has occurred or services rendered Seller’s price fixed or determinable Collectibility reasonably assured

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COMMON MEANS TO MANIPULATE EARNINGS 1Method Revenue Recognition BillError & hold Cancelled orders Conditional sales Consignment sales Continuing involvement Improper cutoff

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Shipments to 3rd party warehouses Cancelled, duplicate orders Before contingencies resolved Goods on consignment, trial Seller involved after delivery, e.g., installation Before title, risk ownership passed

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COMMON MEANS TO MANIPULATE EARNINGS 2Method Revenue Recognition Error

Kickback sales Overstated completion Partial shipments Pre-invoicing Premature shipment 26

Inflated selling price for kickback Inflated % completion on construction projects Not all goods ordered are shipped Goods still in production Goods ordered but not authorized for shipment

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COMMON MEANS TO MANIPULATE EARNINGS M Revenue Recognition 3ethod

Error sales Premature Sham sales Side agreements Uncertain performance Uncertain realization Unauthorized shipment 27

Goods ordered but not shipped False shipments To forestall completion earnings process Seller’s performance uncertain Collection uncertain, unlikely Shipments not authorized

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MANIPULATED EARNINGS Channel Stuffing Definition: incentives to induce incremental demand Examples 

Bausch & Lomb  Told distributors to buy large amount of

inventory to maintain distributorship  B&L recognized extra $22 million 

Sunbeam  Used price discounting to encourage

customers to hold 80 weeks of inventory

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MANIPULATED EARNINGS Asset Swaps Definition: companies trading right to use others asset Examples 

Global Crossing  Treated underseas cables as real estate  Recognized revenue by treating swap as

sale

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MANIPULATED EARNINGS Other Improper expense capitalization 

Chambers Development  Capitalized landfill expenses after

determining earnings necessary to meet analysts expectations 

MicroStrategy  Recognized revenue before all services

provided for software sales

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AUDIT SAMPLING & ACCOUNTS Update assessment of control risk RECEIVABLE

Planning confirmations & selecting plan 

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Identify population, sampling unit, anticipated error Estimate tolerable error & risk incorrect acceptance Calculate sample size Choose sample selection method Evaluate results GBW 8th ed. Ch. 11

COMPUTER ASSISTED TESTS: AR Accuracy Foot, crossfoot recorded amounts within master file Total balances Display/print exceptions

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COMPUTER ASSISTED TESTS: AR Aging Trace individual balances from master file to sales journal Classify balances by invoice dates/age Display/print aged trial balances

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COMPUTER ASSISTED TESTS: AR Credit Balances Scan master receivables file for net credit balances Display/print listing credit balance accounts

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