Risk of Material Misstatement for Accounts Receivable
Risk of material misstatement for accounts receivable is the risk that can occur in accounts receivable and internal control procedures related to accounts receivable cannot prevent or detect such risk.
In general, risk of material misstatement is the combination of inherent risk and control risk, in which inherent risk is the risk that material misstatement can happen before consideration of internal control; while control risk is the risk that the control procedures cannot prevent or detect material misstatement that can occur in financial statements.
In auditing, when inherent risk for accounts receivable is high, auditors usually perform the test of controls on accounts receivable if they believe internal control procedure can reduce the risk of material misstatement for accounts receivable.
In this case, the test of control is required to prove that the internal control is strong and effective in preventing or detecting material misstatement. In other words, auditors perform the test of control to obtain the evidence that internal controls are effective before they can rely on internal control to reduce their substantive tests.
Inherent Risk for Accounts Receivable
Inherent risk is the risk that relates to nature, size, and complexity of the client’s business. Usually, the more complex the business is the higher the inherent risk is.
In this case, inherent risk for accounts receivable is the risk that accounts receivable can contain material misstatement regardless of internal control in place. It is the susceptibility of accounts receivable to misstatement.
The primary inherent risk for accounts receivable is related to existence assertion of accounts receivable on the balance sheet.
Some examples of inherent risk for accounts receivable include:
- Receivables on specific transactions may not exist, e.g. fictitious invoices are made to increase sale or sales and receivables are recorded on the current year when they are actually made after the year-end
- Receivables do not reflect their economic value, e.g. allowance for doubtful accounts are not properly made
- Company has no control on receivables, e.g. due to they are pledged as collateral for loans from the bank
- Receivables are based on contingent events that should not be allowed if the company properly follows applicable accounting standards, such as IFRS or US GAAP.
- Receivable aging is not correct regarding the collectability of receivables
Control Risk for Accounts Receivable
Control risk is the risk that internal control cannot prevent or detect material misstatement in financial statements. In this case, control risk for accounts receivable is the risk that control procedures related to accounts receivable cannot prevent or detect misstatement that can occur in accounts receivable.
When inherent risk for accounts receivable is high, auditors usually assess internal control procedures related accounts receivable to make sure if the control risk is low; hence it can reduce the risk of material misstatement for accounts receivable.
However, auditors are required to perform the test of controls to obtain sufficient appropriate audit evidence to support their assessment if they assess that control risk is low. On the other hand, if they assess that the control risk is high, they don’t need to perform the test of controls; they will just go directly to substantive tests (but more works or bigger sample size may be required).
Example of control procedures that can reduce control risk include:
- Accounts receivable can only be recorded when there are sufficient supporting documents including customer purchase order, shipping document and sale invoice to ensure the existence
- Regularly reconciliation by tracing shipping document and sale invoices to accounts receivable ledger to ensure completeness
- Documents such as customer purchase order, shipping document, and sale invoice are prenumbered and are used in numerical sequence to prevent or detect the omission of transactions.
- Allowance for doubtful accounts are properly and regularly made based on the collectability of each receivable