Audit Accounts Receivable

Overview

Accounts receivable are usually material items on the balance sheet; hence to audit accounts receivable, it is very important to perform proper audit procedures in order to obtain sufficient audit evidence for making appropriate conclusion on receivables.

In the audit of accounts receivable, the inherent risk of accounts receivable involves more on the existence of their balances. This is due to the client’s accounts receivable usually expose to the risk that is related to the intentional manipulation of sales in order to reach the target sales or an actual fraud to steal the products.

An example of accounts receivable manipulation would be the client’s personnel may persuade or collude with the customers to buy the products on credit and promise to have them return products to the company after year-end to increase sales at year-end in order to achieve the target sales. In this case, the accounts receivable balance here should not exist in the first place as the customers will return the goods after the year-end.

As auditors, we usually perform audit procedures on accounts receivable by testing the audit assertions such as existence, valuation, completeness, and right and obligation. Also, accounts receivable are usually tested together with the sale revenue transactions in the client’s account.

Audit Assertions for Accounts Receivable

In the audit of accounts receivable, we usually test the audit assertions included in the table below:

Audit assertions for accounts receivable
Existence The accounts receivable that are shown on the balance sheet at the reporting date really exist.
Valuation The amount of receivables recorded in the client’s account is mathematically correct and their balances reflect the actual economic value.
Completeness All accounts receivable transactions that should have been recorded have been recorded.
Right and obligation The client has the right of controls on the accounts receivable included in the financial statements.

Audit Procedures for Accounts Receivable

Existence

Existence assertion tests whether the accounts receivable on the balance sheet actually exist. Similar to other asset items, the existence is usually the major auditing issue for us when we perform the audit of accounts receivable.

This is due to receivable is likely to be a material area and its inherent risk is usually related to fraud and sales revenue manipulation. In order to test existence on accounts receivable, the confirmation is usually made by sending the letter to the client’s customers asking them to confirm whether they really owe such amount to the client.

As the process of confirmation procedures, from preparation confirmation letter until receiving back the confirmation letter, usually takes some time especially after the letter was sent out, we usually perform the accounts receivable confirmation at the early of the audit fieldwork.

In the audit of accounts receivable, we can achieve two objectives in performing the receivable confirmation. First, we can verify the existence of the customer’s balances; second, we can ensure the correctness of those balances.

There are two types of confirmation, positive confirmation and negative confirmation, as included in the table below:

Two types of confirmation
Positive confirmation Positive confirmation is the confirmation sent to customers asking them to sign on the letter and mail back directly to us, auditors. The letter is needed to be sent back regardless of the amount is correct or not.

In the case that the amount is incorrect, in which the customer’s account is not agreed to the client’s account, the customer still needs to indicate the correct amount on the letter and send it back to us. We will make further investigation on the issue.

Also, if we do not receive the confirmation letter back from the client’s customers, we will need to perform follow-up procedures in order to confirm the existence of the client’s accounts receivable.

Negative confirmation Negative confirmation is the confirmation sent to customers asking them to reply and mail directly back to us only when they disagree with the balance stated in the confirmation letter.

We usually only perform this type of receivable confirmation when the assessed level of risk of material misstatement on accounts receivable and related accounts are low and there is a large number of small customers in the accounts receivable balance.

In this case, when there is no response from the client’s customers, we will take it as they agree with the balance stated in the confirmation letter. We do not perform follow-up procedures, hence the cost of administering the negative confirmation is lower compared to positive confirmation.

Valuation

Valuation assertion tests whether the accounts receivable recorded in the client’s accounts reflect their actual economic value. Though the receivable confirmation in the audit of accounts receivable mentioned above can ensure the existence and the accuracy of customers’ balances, it cannot provide evidence on the correctness of accounts receivable valuation.

For example, the client’s customers may confirm on the letter that they really owe such amount to the client. However, they may not have sufficient resources to pay the debt that they owe at all.

We usually test valuation by performing both substantive analytical procedures and tests of details. In substantive analytical procedures, we usually compare figures and ratios with the previous year and industry average.

Example: test of valuation in the audit of accounts receivable

  • Compare the irrecoverable debt expense as percentage of sales with the previous year and the industry average
  • Compare the allowance for irrecoverable debts as percentage of accounts receivable with the previous year and the industry average
  • Compare accounts receivable turnover and receivables days with the previous year and the industry average
  • Obtain and agree the detailed aged receivables listing to trial balance
  • Select a sample of old debts on detailed aged accounts receivable to discuss the recoverability with management and further review on customers’ responses
  • Review and discuss with management on allowance for doubtful accounts
  • Determine the reasonableness of allowance for doubtful accounts
  • Examine credit notes issued after year-end that should be made against current period balances 

Completeness

Completeness assertion tests whether all accounts receivable have been recorded. Lack of completeness usually results in the understatement of the accounts and balance; in this case, as we audit accounts receivable, the lack of completeness means the understatement of accounts receivable balances.

Example: test of completeness in the audit of accounts receivables

  • Select a sample of shipping documents such as bill and lading and trace back to sale invoices and then to sales and accounts receivable ledger account.
  • Agree individual balance on detailed aged receivables listing to the sales ledger account
  • Agree total balance of detailed aged receivables listing to the sales ledger account

Right and obligation

Right and obligation assertion tests whether the client has the right of control on all accounts receivable show on its financial statement. The concern in the audit of accounts receivable is usually on the factoring of the receivables in which the client should no longer have the right of control to receivables.

This is because the control should have been transferred when the company sold or factored its receivable. Hence, the factored receivables should be removed from the balance sheet.

We usually test the right and obligation assertion on accounts receivable by making inquiries of management on factoring matter, reviewing the loan agreement and reviewing board minutes for any evidence that receivables have been sold or factored.

Summary

All in all, accounts receivable’ existence and valuation are the primary concerns for us as auditors. The existence of accounts receivable itself is the high-risk area as the misstatement in this area could be due to fraud or manipulation of sales.

On the other hand, misstatement occurred in the area of valuation usually tends to be an overstatement of net receivables as the client might forget to make sufficient allowance for receivables or they are perhaps not willing to make sufficient allowance as the bigger allowance means the bigger expense, hence the lower profit.