Substantive Year End Testing in Sales and Collection Cycle

1. Substantive Year End Testing in Sales and Collection Cycle Donald K. McConnell Jr.

2. Accounts Receivable Confirmation Issues • External evidence • Best suited for identifying overstated or invalid account balances • Exhibit an “overstatement bias” • First Auditing Standard (1939: SAP I) made A/R confirmation a requirement, along with inventory observation • AU 330 issues: • Presumption: still must confirm AR • However, presumption overcome if one or more AU 330.34 conditions exist

3. Implementing A/R Confirmation Theory in Practice • Confirm as soon as possible after year end ordinarily • Verify A/R master files tie to G/L control • Confirm all A/R exceeding TM 100% • Sample confirm from remaining A/R in master files • Auditor must control mailing confirmation • Return envelope should be provided • Investigating confirmation exceptions: • Who does actual investigative work? • Auditor must be satisfied with documentation that exceptions are actually timing differences

4. Clearing up Confirmation Timing Differences: Common Practice Examples • “We paid this.” • “We paid this on January 4.” • “We don’t owe this, as we had not received shipment.” • “Due to nature of our system, we are unable to confirm this balance.” • “Due to nature of our system, we are unable to confirm this balance; however, we are willing to verify a few open items.” • Reconcilable timing differences are not misstatements for purposes of projecting likely error

5. Alternative Procedures • Required for non responding positives unless Au 330.31 conditions met • First examine for subsequent cash collection • Be sure collections apply to receivables in question! • If no collections, examine documentation: • Customer P.O.s • Shipping documentation • Sales invoices • Contracts • May do both, if concerns about cut-offs

6. Alternative Procedures Issues • How could performance of alternative procedures identify misstatements? • What is the issue? • Receipt of an A/R confirmation provides external information about possible misstatements • Alternative procedures are performed on documents provided by client!

7. Examples of Misstatements Potentially Identifiable in Performing Alternative Procedures • No purchase orders exist! What might this suggest? • Shipping document date is in early January. What might this suggest?

8. Alternative Procedures May Be Omitted for Nonresponding Positive Confirmations if: • Auditor has not identified unusual qualitative factors or systematic characteristics relating to the nonresponding A/R. [There is no identifiable nonresponse bias.] • When the aggregate nonresponses, projected as being 100 percent misstated, added to the sum of other unadjusted audit differences, would not materially affect the financial statements [Summed, they aren’t material.] • Both of these conditions must be met! (Au 330.31)

9. Examples of Au 330.31 Theory • Assume TM = $100,000 • Non responding positives, no ID’d bias = $50,000 • Other Audit AJE’s passed, dr. effect = $10,000 • Conclusion? • No need to apply alternative procedures

10. Examples of Au 330.31 Theory (con.) • Assume TM = $100,000 • Non responding positives, no ID’d bias = $50,000 • Other Audit AJE’s passed, dr. effect = $70,000 • Conclusion? • Must do alternative procedures

11. Examples of Au 330.31 Theory (con.) • Assume TM = $100,000 • Non responding positives=$50,000 • All are new customers • Other Audit AJE’s passed, dr. effect = $10,000 • Conclusion? • Must apply alternative procedures • Why?

12. A classic example of confirmations being ineffective (Au 330.34) What would auditor do? A/R assertions must be directly verified by other audit procedures: Performing alternative procedures Analytical review Where impracticable to confirm, if alternatively satisfied, no reference to alternative procedures in audit report U.S. Government and Some Companies Will Not Respond to Confirmation Requests