Effective Test Design for Accounts Receivable Balances Audit

1. Completing the Testsin the Sales 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 1. Detail tie-in 5. Classification 2. Existence 6. Cutoff 3. Completeness 7. Realizable value 4. Accuracy 8. Rights

4. Methodology for Designing Testsof Details of Balances for A/R Identify client business risks affecting accounts receivable Phase I Set tolerable misstatement and assess inherent risk for accounts receivable Phase I Assess control risk for sales and collection cycle Phase I

5. Methodology for Designing Testsof Details of Balances for A/R Design and perform tests of controls and substantive tests of transactions for the sales and collection cycle Phase II

6. Methodology for Designing Testsof Details of Balances for A/R Design and perform analytical procedures for accounts receivable balance Phase III Phase III Design tests of details of accounts receivable balance to satisfy balance-related audit objectives Audit procedures Sample size Items to select Timing

7. Relationship Between Sales and Accounts Receivable ACCOUNTS RECEIVABLE BALANCE-RELATED AUDIT OBJECTIVES Detail tie-in Completeness Classification Realizable value Rights Existence Accuracy Cutoff Translation-related audit objectives Sales Occurrence × Completeness × Accuracy × Posting and summarization × Classification × Timing ×

8. Relationship Between Sales and Accounts Receivable ACCOUNTS RECEIVABLE BALANCE-RELATED AUDIT OBJECTIVES Detail tie-in Completeness Classification Realizable value Rights Existence Accuracy Cutoff Translation-related audit objectives Cash receipts Occurrence × Completeness × Accuracy × Posting and summarization × Classification × Timing ×

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

10. Analytical Procedures for the Sales and Collection Cycle Compare by product line: • Gross margin percentage with previous years • Sales by month over time • Sales returns and allowances as a percentage of gross sales with previous years

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

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

13. Selected Comparative Information 12/31/07 ($000) Percent change 2006- 2007 12/31/06 ($000) Percent change 2005- 2006 12/31/05 ($000) Sales Gross margin Accounts receivable Bad debt expense Total current assets Total assets Net earnings Number of accounts receivable Number of accts. rec. with balances over $100,000 144,328 39,845 20,197 3,323 51,027 61,367 5,681 258 37 9.0 9.6 7.3 (2.1) 14.0 (7.0) 21.9 16.7 15.6 132,421 36,350 18,827 3,394 44,779 66,021 4,659 221 32 7.0 7.0 14.1 7.3 6.6 8.0 39.0 5.7 6.7 123,737 33,961 16,505 3,162 41,989 61,147 3,351 209 30

14. Analytical Procedures: Sales and Collection Cycle 12/31/07 12/31/06 12/31/05 Gross margin/net sales Sales returns and allowances/ gross sales Bad debt expense/net sales Allowance for uncollectible accounts/accounts receivable Number of days receivables outstanding Net accounts receivable/ current assets 27.85% 0.90% 2.30% 6.10% 48.09 37.20% 27.70% 0.90% 2.60% 7.50% 47.96 32.50% 27.68% 0.90% 2.60% 6.40% 49.32 32.30%

15. Design and Perform Tests of Details of A/R Balance (Phase III) • Planned detection risk for each objective is an auditor decision • Combining the factors that determine • planned detection risk is complex

16. Analytical Procedures for Gross Margin Gross margin percent 2007 2006 2005 Great Western Industry Great Western Industry Great Western Industry Hardwood Softwood Plywood 36.3 23.9 40.3 32.4 22.0 50.1 36.4 20.3 44.2 32.5 22.1 54.3 36.0 20.5 45.4 32.3 22.3 55.6

17. Learning Objective 3 Design and perform tests of details of balances for accounts receivable.

18. Designing Tests of Detailof Balances Accounts receivable are correctly added and agree with the Master File and the General Ledger (aged trial balance). • Recorded accounts receivable exist • Existing accounts receivable are included

19. Designing Tests of Detailof Balances • Accounts receivable are accurate • Accounts receivable are properly classified • Cutoff for accounts receivable is correct

20. Designing Tests of Detailof Balances • Accounts receivable is stated at • realizable value • The client has rights to accounts receivable • Accounts receivable presentation and • disclosure

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

22. Auditing Standards Requirements 1. Accounts receivable are immaterial. 2. The auditor considers confirmations ineffective evidence because response rates will likely be inadequate or unreliable. 3. The combined level of inherent risk and control risk is low and other substantive evidence can be accumulated to provide sufficient evidence.

23. Type of Confirmation • Positive confirmation • Blank confirmation form • Invoice confirmation • Negative confirmation

24. Timing The most reliable evidence from confirmations is obtained when they are sent as close to the balance sheet date as possible.

25. Sample Size • Tolerable misstatement • Inherent risk • Control risk • Achieved detection risk from • other substantive tests • Type of confirmation

26. Maintaining Control After the items for confirmation have been selected, the auditor must maintain control of the confirmations until they are returned from the customer.

27. Follow-up on Nonresponses When positive confirmations are used, SAS 67 requires follow-up procedures for confirmations not returned by he customer. Alternative procedures

28. Subsequent Cash Receipts 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 file.

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

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

31. Analysis of Difference • Payment has already been made • Goods have not been received • The goods have been returned • Clerical errors and disputed accounts

32. Drawing Conclusions • Reevaluate internal control • Evaluate the qualitative nature of • misstatements • Determine whether sufficient evidence • was obtained

33. Learning Objective 5 Design audit procedures for the audit of accounts receivable, using an evidence planning worksheet as a guide.

34. Source of Each Row in the Evidence Planning Worksheet • Tolerable misstatement • Acceptable audit risk • Inherent risk • Control risk • Substantive tests of transactions results • Analytical procedures • Planned detection risk and planned audit evidence

35. End of Chapter 16