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Chapter 14Completing the Tests in the Sales and Collection Cycle: Accounts Receivable

Review Questions

14-1 Tests of details of financial balances are designed to determine thereasonableness of the balances in sales, accounts receivable, and other accountbalances which are affected by the sales and collection cycle. Such tests includeconfirmation of accounts receivable, and examining documents supporting the balancein these accounts.

Tests of controls for the sales and collection cycle are intended to determine theeffectiveness of internal control and to test the substance of the transactions which areproduced by this cycle. Such tests would consist of examining sales invoices in supportof entries in the sales journal, reconciling cash receipts, or reviewing the approval ofcredit.

The results of the tests of controls will be used to affect the procedures, sample size,timing and particular items selected for the tests of details of financial balances (i.e.,effective internal control will result in reduced testing when compared to the tests ofdetails of balances required in the case of inadequate internal control).

14-2 The CICA Assurance Handbook Section 5303 par. 26 - 28 deals with theconfirmation of accounts receivable.

The procedures suggested in the section are both positive and negative confirmations.Negative confirmations suffer from the fact that they do not always receiveconsideration from the debtor, and consequently a failure to reply does not necessarilysignify agreement. Positive confirmations are preferred for individual balances ofrelatively large amounts, when there are a few debtors, or when there is evidence orsuspicion of fraud or serious error.

Cynthia Robert’s approach is questionable from the standpoint that the non-replies havenot necessarily proved that internal control is effective although replies indicatingmisstatements in the account balances would be confirmation that internal control wasineffective. Her confirmation at an interim date requires her to assume an assessedcontrol risk less than maximum, but she has not tested the related internal control forthe period from the confirmation date until year end.

14-3 The following are analytical procedures for the sales and collection cycle, andpotential misstatements uncovered by each procedure. Each ratio should be comparedto previous years. The question asked for five analytical procedures.

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AnalyticalProcedure

Potential Misstatement

1. Gross margin byproduct line

Including in the physical inventory items for which thecorresponding liability had not yet been recorded.

2. Sales returns andallowances as apercentage of grosssales by product lineor segment

All returns were not recorded, or shipments to customers werenot in accordance with specifications and were returned (thiscould result in significant operating problems).

3. Trade discountstaken as a percentageof net sales

Discounts that were taken by customers and allowed by thecompany were not recorded.

4. Bad debts as apercentage of grosssales

Allowance for doubtful accounts misstated.

5. Days sales inreceivablesoutstanding.

A problem with collections, and understatement of bad debtsand allowance for doubtful accounts.

6. Aging categoriesas a percentage ofaccounts receivable

Collection problems and understatement of bad debts andallowance for doubtful accounts.

7. Allowance foruncollectible accountsas a percentage ofaccounts receivable

Allowance for doubtful accounts misstated.

8. Comparison of thebalances in individualcustomer’ accountsover a stated amountwith their balances inthe previous year

A problem with collections, and therefore, a misstatement ofthe allowance for doubtful accounts.

14-4 The following are the nine balance-related audit objectives and related auditprocedures for the audit of accounts receivable.

Balance-related AuditObjective

Audit Procedure

1. Accounts receivable inthe aged trial balanceagree with relatedmaster file amounts,the total is correctly

a. Trace twenty accounts from the trial balance to therelated accounts on master file.b. Foot two pages of the trial balance, and total all

pages.

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added and agrees withthe general ledger.

2. The accountsreceivable in the agedtrial balance exist.

Confirm accounts receivable using positive confirmations.Confirm all amounts over $5,000 and a nonstatisticalsample of the remainder.

3. Existing accountsreceivable areincluded in the agedtrial balance.

Trace ten accounts from the accounts receivable masterfile to the aged trial balance.

4. Accounts receivable inthe trial balance areowned.

Review the minutes of the board of directors for anyindication of pledged or factored accounts receivable.

5. Accounts receivable inthe trial balance areaccurately recorded.

Confirm accounts receivable using positive confirmations.Confirm all amounts over $5,000 and a nonstatisticalsample of the remainder.

6. Accounts receivable inthe aged trial balanceare properly classified.

Review the receivables listed on the aged trial balance fornotes and related party receivables.

7. Transactions in thesales and collectioncycle are recorded inthe proper period.

Select the last 10 sales transactions from the currentyear’s sales journal and the first 10 from the subsequentyear’s and trace each one to the related shippingdocuments, checking for the date of actual shipment andthe correct recording.

8. Accounts in the salesand collection cycleare properly presentedand disclosed.

Review the minutes of the board of directors for anyindication of pledged or factored accounts receivable.

9. Accounts receivable inthe trial balance arestated at realizablevalue.

Discuss with the credit manager the likelihood of collectingolder accounts. Examine subsequent cash receipts andthe credit file on older accounts to evaluate whetherreceivables are collectible.

14-5 The most important objectives satisfied by confirmations are existence, rights,and accuracy. In extreme cases, confirmations are also useful tests for cutoff.Sometimes confirmations may also help the auditor satisfy the completeness objective.

14-6 The purpose of the accuracy tests of gross accounts receivable is to determinethe correctness of the total amounts receivable from customers based on total sales.These tests normally consist of confirmation of accounts receivable or examination ofshipping documents in support of the shipment of goods to customers.

The purpose of the test of the realizable value of receivables is to estimate the amountof the accounts receivable balance that will not be collected. To estimate this amount,the auditor normally reviews aging of the accounts receivable, analyzes subsequent

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cash payments by customers, discusses the collectibility of individual accounts withclient personnel, and examines correspondence and financial statements of significantcustomers.

14-7 In most audits it is more important to carefully test the cutoff for sales than forcash receipts because sales cutoff misstatements are more likely to affect net earningsthan are cash receipt cutoff misstatements. Cash receipt cutoff misstatementsgenerally lead to a misclassification of accounts receivable and cash and, therefore, donot affect income.

To perform a cutoff test for sales, the auditor should obtain the number of the last salesinvoice issued before year-end and examine shipping documents representingshipments before and after year-end to determine that the proper shipments wererecorded in the appropriate period. The reconciliation of the bank confirmation willestablish the propriety of the cash receipts cutoff.

14-8 It is acceptable to confirm accounts receivable prior to the balance sheet date ifinternal control is adequate and can provide reasonable assurance that sales, cashreceipts and other credits are properly recorded between the date of the confirmationand the end of the accounting period. Other factors the auditor is likely to consider inmaking the decision are the materiality of accounts receivable and the auditor’sexperience in prior years. If the decision is made to confirm accounts receivable prior toyear end, it is necessary to test the transactions occurring between the confirmationdate and the balance sheet date by examining internal documents and performinganalytical procedures at year end.

14-9 The most important factors affecting the sample size inconfirmations of accounts receivable are:

1. Materiality2. Inherent risk (relative size of total accounts receivable, number of

accounts, prior year results, and expected misstatements)3. Control risk4. Achieved detection risk from other substantive tests (extent and results of

substantive tests of transactions, analytical procedures, and other tests ofdetails)

5. Type of confirmation (negatives normally require a larger sample size)

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14-10 In most confirmations of accounts receivable, some type of stratification isdesirable. A typical approach to stratification is to consider both the size of theoutstanding balance and the length of time an account has been outstanding as a basisfor selecting the balances for confirmation, since large accounts and long outstandingaccounts are more likely to include a significant misstatement. It is also important tosample some items from every material stratum of the population. Utilizing thisapproach, the auditor will pay particular attention to the accounts in which errors aremost likely and will follow the guidelines set forth in chapter 11 regarding the need toobtain a representative sample of the population.

14-11 TER = 4%, EPER 0%, ARIA 10% Sample size = 57

14-12 Alternative procedures are procedures performed on a positive confirmation notreturned by the debtor using documentation evidence to determine whether therecorded receivable exists and is collectible. It is common to send second requests forconfirmations and sometimes even third requests. Even with these efforts, somecustomers do not return the confirmation, so it is necessary to follow up with alternativeprocedures. The objective of the alternative procedures is to determine by a meansother than confirmation whether the non-confirmed account existed and is properlystated at the confirmation date. For any confirmation not returned, the followingdocumentation can be examined to verify the existence and accuracy of individual salestransactions making up the ending balance in accounts receivable.

1. Subsequent cash receipts. Evidence of the receipt of cash subsequentto the confirmation date includes examining remittance advice, entries inthe cash receipts records, or perhaps even subsequent credits in theaccounts receivable subsidiary records. The examination of evidence ofsubsequent cash receipts is a highly useful alternative procedure becauseit is reasonable to assume that a customer would not make a paymentunless it was a valid receivable. On the other hand, the fact of paymentdoes not establish whether there was an obligation on the date of theconfirmation. In addition, care should be used to match each unpaid salestransaction with evidence of its payment as a test for disputes ordisagreements over individual outstanding invoices.

2. Duplicate sales invoices. These are useful to verify the actual issuanceof a sales invoice and the actual date of the billing.

3. Shipping documents. These are important to establish whether theshipment was actually made and as a test of cutoff.

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4. Correspondence with the client. Usually it is unnecessary to reviewcorrespondence as a part of alternative procedures, but it can be used todisclose disputed and questionable receivables not uncovered by othermeans.

The extent and nature of the alternative procedures depends primarily upon themateriality of the unconfirmed accounts, the nature and extent of the misstatementsdiscovered in the confirmed responses, the subsequent cash receipts of theunconfirmed accounts and the auditor’s evaluation of the effectiveness of internalcontrol. It is normally desirable to account for all unconfirmed balances with alternativeprocedures, even if the amounts are small, as a means of properly generalizing from thesample to the population.

14-13 Confirmation of accounts receivable is normally performed on only a sample ofthe total population. The purpose of the confirmation is to obtain outside verification ofthe balance of the account and to obtain an indication of the rate of occurrence ofmisstatements in the accounts. Most misstatements that are indicated by thedifferences on the confirmation replies will not be material; however, each differencemust be analyzed to determine the effect of that difference and all others consideredtogether on the accounts receivable balance. Though the individual differences may notbe material, they may indicate a material problem when extended for the entirepopulation, and with regard to the internal controls over the accounts receivable.

14-14 Three differences that may be observed on the confirmation of accountsreceivable that do not constitute misstatements and an audit procedure that would verifyeach difference are as follows:

1. Payment has been made by the customer but not received by the client atthe confirmation date. The subsequent payment should be examined asto date deposited.

2. Merchandise shipped by the client has not been received by the customer.The shipping documents should be examined to verify that the goods wereshipped prior to confirmation date.

3. Merchandise has been returned but has not been received by the client atthe confirmation date. Receiving documents and the credit memo shouldbe examined.

Multiple Choice Questions

14-15 a. (4) b. (4) c. (3)

14-16 a. (2) b. (1) c. (4) d. (2)

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Discussion Questions and Problems

14-17 1. Detail tie-in 2. Detail tie-in 3. a. Existence

b. Accuracyc. Realizable value (if cash receipts relate to older accounts).

4. a. Existenceb. Accuracy

5. a. Existenceb. Accuracyc. Realizable value (if cash receipts relate to older accounts).

6. a. Cutoff7. a. Rights

b. Presentation and disclosure.8. Classification

14-18 a. b. c.Balance-relatedAudit Objective Preventive

Internal ControlTest of Details of Balances AuditProcedures

1. Transactionsare recorded inthe properperiod (cutoff)

Company policy should statethat the cash cutoff at end of amonth should be achieved byonly recording the amountsreceived prior to the monthend in the current month.

The auditor should be present at theclient’s facility at the end of the lastworking day of the year, should obtainthe amount of the last deposit to bemade from current year receipts, andshould determine in the auditprocedures that this was, indeed, thelast deposit recorded during the currentyear.

The auditor should compare thedeposits in transit shown on the bankreconciliation to the date that depositsreached the bank to determine that thelag is reasonable.

2. Accountsreceivable arestated atrealizable value(realizablevalue)

The client should perform ananalysis of the collectibility ofaccounts receivable at the endof the year and shouldcommunicate with itscustomers to determine thelikelihood of the collectibility ofindividual accounts.

The auditor should keep informed ofcurrent economic conditions andconsider their effect on collectibility ofaccounts receivable for his or herclients.

The auditor may compare cashcollections after year end to thecollections of the similar period of the

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previous year and consider anychanges as to their effect on thecollectibility of the accounts receivable

3. Accountsreceivable arestated at thecorrectamounts(accuracy)

The client should recordclaims for defectivemerchandise as soon aspossible after the claim isreceived to keep accountsreceivable balances asaccurate as possible.

The auditor should review the client’scorrespondence files from customers.

The auditor should note any replies tothe confirmation of accounts receivableconfirmations which indicate disputesbetween a customer and client.

4. Accountsreceivablepresentationand disclosuresare proper(presentationand disclosure)

The controller should maintaina schedule containing allrequired disclosureinformation. This scheduleshould be updated each timean event occurs which affectsthis information.

The auditor’s standard bankconfirmation should contain an inquiryas to assets pledged for loans fromthat institution.

Where loan confirmations are sent bythe auditor, they should contain aninquiry as to any assets pledged for theindebtedness.

5. Transactionsare recorded inthe properperiod (cut-off)

The client should follow apolicy of holding open thebooks to record any returns inthe subsequent period whichapply to goods shipped andsales recorded in the currentperiod.

The auditor should review returnsrecorded in the subsequent period todetermine if they apply to goodsshipped and sales recorded prior toyear end.

The auditor should perform ananalytical test to determine whether ornot returns in the first month of the nextyear are similar in magnitude to thoseexperienced in the same period ofprevious years.

6. Accountsreceivable areproperlyclassified(classification)

The client should maintainseparate accounts for therecording of receivables duefrom affiliated companies.

The auditor should review the trialbalance of accounts receivable todetermine whether or not accountsfrom affiliated companies are includedin the customer accounts.

The auditor should be aware ofaffiliated companies and thetransactions between them and theclient, and should inquire and follow upto determine that accounts receivablefrom affiliates are not included in theaccounts receivable from customers.

7. Accountsreceivable in

The client should total the trialbalance of accounts

The auditor should foot the trialbalance of accounts receivable and

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the aged trialbalance agreewith relatedmaster fileamounts, andthe total iscorrectly addedand agreeswith thegeneral ledger(detail tie-in)

receivable and reconcile thetotal to the balance in thegeneral ledger.

reconcile it to the balance per thegeneral ledger.

14-19 a. A shipment should be recorded as a sale at the date of shipment orthe passing of title, whichever occurs first. Ordinarily, a shipment isconsidered a sale when it is shipped, picked up, or delivered by acommon carrier.

b. The sales invoice number can be ignored, except to determine the shippingdocument number.

Invoice # Shipping Misstatement in Sales Overstatement or ShippingDocument # Cutoff Error in Understatement of

Aug. 31 Sales

August sales4326 2164 none4329 2169 1,914.30 overstatement4327 2165 none4328 2168 620.22 overstatement4330 2166 none

2,534.52

September sales4332 2163 2,641.31 understatement4331 2167 106.39 understatement4333 2170 none4335 2171 none4334 2172 none

2,747.70Net understatement 213.18

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Adjusting entryAccounts receivable 213.18

Sales 213.18

c. After making the type of cutoff adjustments shown in part b, currentyear sales would be overstated by:

Amount of sale2168 620.222169 1,914.302170 852.062171 1,250.502172 646.58

5,283.66

The best way to discover the misstatement is to be on hand on the balance sheet dateand record in the audit working papers the last shipping document issued in the currentperiod. Later, the auditors can examine shipping documents before and after thebalance sheet date to determine if they were correctly dated.

An alternative, if there are perpetual records, is to follow up differences betweenphysical inventory counts and perpetual record balances to determine if the cause wasend of the period cutoff errors. Assume, for example, that there were 626 units of partx263 on hand August 31, but the perpetual records showed a total of 526, and ashipment of 100 units included on the perpetual August 31, that is a likely indication of aSeptember shipment that had been dated August 31.

d. The following procedures are usually desirable for sales cutoff:

1. Be present during the physical count on the last day of the accountingperiod to determine the shipping document number for the lastshipment made in the current year. Record that number in the workingpapers.

2. During year-end field work, select a sample of shipping documentspreceding and succeeding those selected in procedure 1. Shippingdocuments with the same or with a smaller number than the onedetermined in procedure 1 should be included in current sales. Thosewith document numbers larger than that number should have beenexcluded from current sales.

3. During year-end field work, select a sample of sales recorded in the lastfew days of the sales journal and a sample of those recorded for thefirst few days in the subsequent period. Trace sales recorded in the

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current period to related shipping documents to make sure each onehas a number equal to or smaller than the one in procedure 1.Similarly, trace sales recorded in the subsequent period to make sureeach sale has a related shipping document number greater than theone in procedure 1.

e. The following are effective controls to prevent cutoff errors and related tests ofcontrols.

Control Test of Controls(1) Policy requiring the use of

prenumbered shipping documents.

(2) Policy requiring the issuance ofshipping documents sequentially.

(3) Policy requiring recording salesinvoices in the same sequence asshipping documents are issued.

(4) Policy requiring dating of shippingdocuments, immediate recording ofsales, and dating sales on the samedate as the shipment.

(5) Use of perpetual inventory records andreconciliation of differences betweenphysical and perpetual records.

Examine several documents forprenumbering

Observe issuance of documents, examinedocument numbers and enquiry

Observe recording of documents, examinedocument numbers and enquiry.

Observe dating of shipping documents andsales invoices, and timing of recording.

Examine worksheets reconciling physicaland perpetual counts.

14-20 a. The two types of confirmations used for confirming accounts receivableare “positive” and “negative” confirmations. A positive confirmation is a communicationaddressed to the debtor requesting him or her to confirm directly whether the balanceas stated on the confirmation is correct or incorrect. A negative confirmation requests aresponse from the debtor only when he or she disagrees with the stated amount.

When deciding which type of confirmation to use, the auditor should consider theassessed control risk in the sales and collections cycle, the make-up of the population,cost/benefit relationship, and any information about the validity of the accounts.Positive confirmations are more reliable but more expensive than negativeconfirmations. Positive confirmations should be used for individual balances ofrelatively large amounts, when there are few debtors, when there is evidence orsuspicion of fraud or serious error or when required by regulatory agencies. Whennegative confirmations are used, the auditor has normally assessed control risk belowmaximum and tested the internal controls for effectiveness. Negative confirmations are

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often used when accounts receivable are comprised of a large number of smallaccounts from the general public.

b. When evaluating the collectibility of accounts receivable, the auditor may reviewthe aging of accounts receivable, analyze subsequent cash payments bycustomers, discuss the collectibility of individual accounts with client personnel,and examine correspondence and financial statements of significant customers.Changes in the aging of receivables should be analyzed in view of any changesin the client’s credit policy and the current economic conditions.

c. When customers fail to respond to positive confirmation requests, the publicaccountant may not assume with confidence that these customers checked therequest, found no disagreement, and therefore did not reply. Some busycustomers will not take the time to check confirmation requests and will notrespond, hence obvious exceptions may exist without being reported to thepublic accountant. In the case of fraud or embezzlement, the perpetrators couldperhaps prevent exceptions from being reported and prevent letters addressed tofictitious addresses from being returned from the post office as undeliverable.Confirmations returned as undeliverable by the post office will require appropriateaction to obtain better addresses.

Follow-up is necessary when customers do not reply because the public accountant hasselected the positive confirmation route for certain receivables, and the most logicalstep to follow first is to mail second requests.

d. When no response is received to the second request for positive confirmation,the auditor should use alternative procedures. These normally includeexamination of customers’ formal remittance advice and cash receipts journals.This is often a simple and effective check where collections have been madesubsequent to the balance sheet date. Correspondence in the client’s files willalso sometimes offer satisfactory evidence. The auditor should also examineshipping documents, sales invoices, contracts, or other documents tosubstantiate that the charges were proper.

In unusual cases, the public accountant should mail a third request and possibly maketelephone calls in an effort to get a reply directly from the customer. The publicaccountant may find it necessary where significant amounts are involved andcircumstances are not clear to investigate the existence and/or financial status of acustomer.

14-21 a. Yes, it is acceptable for the controller to review the list of accounts theauditor intends to confirm. The confirmations will be sent to the company’s customers,and the auditor must be sensitive to the client’s concern with the treatment of theircustomers. At the same time, if the client refuses permission to confirm receivables, the

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auditor must consider the effect on her audit opinion. If the restriction is material, aqualified or denial of opinion may be needed.

b. The auditor should be willing to perform special procedures which the clientrequests if the client is in agreement that these procedures may not necessarilybe considered within the scope of the auditor’s engagement. In the case of the20 additional confirmations which the controller requested that the auditor send,the auditor should be willing to send the confirmations; however, theseconfirmations should not be considered in the evaluation of the results of theaccounts receivable confirmation sent by the auditor.

c. If the auditor complies with the controller’s request to eliminate six of theaccounts from the confirmation, the auditor must perform alternative procedureson the six accounts and decide whether or not this omission is significant to thescope of her examination. If the auditor believes that the impact of omitting theseaccounts is significant, she must qualify the auditor’s report to indicate therestriction of scope imposed by the client.

14-22 a.

Random NumberTable Item

Random Dollar PopulationItem

1000 70,399 81001 51,458 81005 102,032 201006 100,596 201008 9,545 21010 101,882 201011 100,140 201012 160.232 301014 175,103 321015 133,735 27

Note: Random dollar items are matched with population item numbers by computingcumulative book values of the population according to the chart which follows:

Pop’n Recorded Cumulative Pop’n Recorded Cumulative Item Amount Amount Item Amount Amount

1 1,410 1,410 21 4,865 117,385* 2 9,130 10,540 22 770 118,155

3 660 11,200 23 2,305 120,4604 3,355 14,555 24 2,665 123,1255 5,725 20,280 25 1,000 124,125

* 6 8,210 28,490 * 26 6,225 130,3507 580 29,070 27 3,675 134,025

* 8 44,110 73,180 28 6,250 140,275

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9 825 74,005 29 1,890 142,16510 1,155 75,160 * 30 27,705 169,87011 2,270 77,430 31 935 170,80512 50 77,480 32 5,595 176,40013 5,785 83,265 33 930 177,33014 940 84,205 34 4,045 181,37515 1,820 86,025 35 9,480 190,85516 3,380 89,405 * 36 360 191,215

* 17 530 89,935 37 1,145 192,36018 955 90,890 38 6,400 198,76019 4,490 95,380 39 100 198,860

* 20 17,140 112,520 40 8,435 207,295

Interval = Population total / Number of items selected= 207,295 / 10 = 20,729 IntervalUsing 1857 as a starting point, we have:

Systematic Dollar Population Item No.1 1,857 22 22,586 63 43,315 8 (counts as 2 items)4 64,044 85 84,773 156 105,502 207 126,231 268 146,960 30 (counts as 2 items)9 167,689 30

10 188,418 35

All items larger than the interval will be automatically included. If the interval is 20,729item 30 will be included at least once, and item 8 at least twice.

b. Monetary unit sampling would be used because (1) it is efficient and (2) itfocuses on large dollar items.

14-23 a. The differences that were uncovered include only five misstatementsrather than seven misstatements. Items 2 and 7 are not misstatements, but only timingdifferences. Therefore, only the five "misstatements" are summarized in order tocompute the upper and lower misstatement bounds. These misstatements aresummarized below.

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_______________________________________________________________Recorded Audited Misstate- Misstatement /

Item Value Value ment Recorded Value_______________________________________________________________

1 $2,728.00 $2,498.00 $230.00 .0843 3,890.00 1,190.00 2,700.00 .6944 791.00 815.00 (24.00) (.030)5 548.00 1,037.00 (489.00) (.892)6 3,115.00 3,190.00 (75.00) (.024)

Upper misstatement bound before adjustment:

No. ofMisstate-ments

RecordedValue

x CUERPortion

x Misstatement%Assumption

= Misstatement Bound Portion

0 $1,975,000 .023 1.000 $45,4251 1,975,000 .015 .694 20,5602 1,975,000 .014 .084 2,323

.052 $68,308Lower misstatement bound before adjustment:

No. ofMisstate-ments

RecordedValue

x CUERPortion

x Misstatement%Assumption

= Misstatement Bound Portion

0 $1,975,000 .023 1.000 $45,4251 1,975,000 .015 .892 26,4262 1,975,000 .014 .030 8303 1,975,000 .014 .024 664

.066 $73,345

Adjustment of upper misstatement bound:

Point estimate for understatement misstatements = sum of misstatement prorations xrecorded value / sample size

= (.892 + .030 + .024) x (1,975,000 / 100)

= .946 x 19,750

= 18,684

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Adjusted bound = initial bound - point estimate for understatement misstatements

= 68,308 - 18,684

= 49,624

Adjustment of lower misstatement bound:

Point estimate for overstatement misstatements = Sum of misstatement prorations xRecorded value / sample size

= (.694 + .084) x (1,975,000 / 100)

= .778 x 19,750

= 15,366

Adjusted bound = Initial bound - point estimate for overstatements

= 73,345 - 15,366

= 57,979

b. The population is not acceptable as stated because the lower misstatementbound exceeds materiality. (Note that although the upper misstatement bounddoes not exceed materiality, it is quite close.)

In this situation, the auditor has the following options:

1. Increase the sample size.2. Segregate a specific type of misstatement and test it separately. The

sample would then not include the specified type of misstatement since itis being tested separately.

3. Expand other areas in the audit of accounts receivable.

Of these options, segregating a particular type of misstatement may prove the mostbeneficial. In this problem, items 3 and 5 are cut-off misstatements. Segregating theseitems and eliminating them from the sample would result in the following bounds:

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Upper misstatement bound:

No. ofMisstate-ments

RecordedValue

x CUERPortion

x Misstatement%Assumption

= Misstatement Bound Portion

0 $1,975,000 .023 1.000 $45,4251 1,975,000 .015 .084 2,489

.038 $47,914Less adjustment [(.030 + .024) (19, 750)] (1,067)

$46,847

Lower misstatement bound:

No. ofMisstate-ments

RecordedValue

x CUERPortion

x Misstatement%Assumption

= Misstatement Bound Portion

0 $1,975,000 .023 1.000 $45,4251 1,975,000 .015 .030 8892 1,975,000 .024 664

---------$46,978

Less adjustment [(.084) (19, 750)] (1,067)$45,319

It can be seen that both misstatement bounds are now within materiality after "cut-off"misstatements were segregated. These misstatements were significant in two ways.Their existence increased the overall estimated misstatement rate, and their magnitudecontributed to the amount of estimated misstatements in the portion of the populationrepresented by the misstatements in the sample.

14-24 a. The audit approach of testing all three account balances is acceptable.This approach is also desirable when the following conditions are present:

1. The auditor can obtain valid, reliable information to perform the requiredtests in all of the areas.

2. Internal control for each of the three areas are comparable.

3. Misstatements are expected to occur evenly over the entire population.For instance, the auditor does not expect a large number of misstatementsin accounts receivable and very few, if any, in inventory.

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b. The required sample size for all three accounts is:

Tolerable misstatement / Recorded population value 100,000 / 10,000,000 = .01

From the attributes table sample size n cannot be determined, but using interpolation itis approximately 114 + (114 - 76) = 152. (This is not an appropriate method todetermine sample size in practice. Normally, computer software would be used.)

c. The required sample sizes if each account is tested separately are:Approximate

Account Factor Sample Size

Accounts receivable n = 100,000 \ 3,600,000 = .028 76

Inventory n = 100,000 \ 4,800,000 = .020 114

Marketable securities n = 100,000 \ 1,600,000 = .060 38

The important point is that sample size under b is much smaller than for the combinedsamples in c.

d. The population would be arranged so that all accounts receivable would be first,followed by inventory and marketable securities. The items would be identified bythe cumulative totals. In the example, the number 4,627,871 would relate to aninventory item since it is between the cumulative totals of $3,600,000 and$8,400,000. Accordingly, for this number the inventory audit procedures would beperformed.

e. The misstatement data are as follows:

Recorded Audited Misstatement /Amount Amount Difference Recorded Amount

$987.12 $887.12 $100.00 10.1%

Assuming a 100% average misstatement in the population when there are nomisstatements found and an ARIA of 10%, the misstatement bounds are:

Upper misstatement bound:$10,000,000 x .011 x 1.0 = $110,000

$10,000,000 x .008 x .101 = 8,080$118,080

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Lower misstatement bound:

Before adjustment:

$10,000,000 x .011 x 1.0 = $110,000

Adjustment:$10,000,000 ( 200 = (5,050)

$104,950Based on the sample results and the materiality level of $100,000, the populationshould not be accepted as stated without further testing:

14-25 For all of the exceptions, the auditor is concerned about four principal things:

(a) Whether there is a client misstatement. Many times the confirmationresponse differences are due to timing differences for deposits in the mailand inventory in transit to the customer. Sometimes customersmisunderstand the confirmation or the information requested. The auditormust distinguish between those and client misstatements.

(b) The amount of the client misstatement if any.

(c) The cause of the misstatement. It could be intentional, amisunderstanding of the proper way to record a transaction, or abreakdown of internal control.

(d) Potential misstatements in the sample not tested. The auditor mustestimate the misstatements in the untested population, based on theresults of the tests of the sample.

Suggested steps to clear each of the comments satisfactorily are:

1. (a) Examine supporting documents, including the sales invoices andapplicable sales and shipping orders, for propriety and valuation of thesales.

(b) Review the cash receipts books for the period after December 31, 2001,and note any collections from Duck Lake Inc. The degree of internalcontrol over cash receipts should be an important consideration indetermining the reliance that can be placed on the cash receipts entries.In addition, as there is no assurance that collections after December 31represent the payment of invoices supporting the December 31 trialbalance, consideration should be given to requesting a confirmation fromDuck Lake Inc. of the invoices paid by their cheques.

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2. (a) The cause should be investigated thoroughly. If the credit was posted tothe wrong account, it may indicate merely a clerical error. On the otherhand, posting to the wrong account may indicate lapping.

(b) Such a comment may also indicate a delay in posting and depositing ofreceipts. If upon investigation such is the case, the company should beinformed immediately so that it can take corrective steps.

3. This is a confirmation of the balance with an additional comment. Sincethe customer has given us the data, it is preferable to check to see thatthe information agrees with the company’s records. Such a proceduremay disclose misposting or delay in recording receipts.

4. This incomplete comment should raise an immediate question: does thecustomer mean paid before or paid after December 31? Because thecustomer’s intent is unknown, this account should be reconfirmed and thecustomer asked to state the exact date. Upon receipt of the secondconfirmation, the information thereon should be traced to the cash receiptsbook.

5. The auditor should first evaluate how long it takes to ship goods to thecustomer in question. If it ordinarily takes more than five days, there is noindication of misstatement.

A comment of this type may indicate that the company may be recordingsales before an actual has taken place. The auditor should examine theinvoice and review with the appropriate officials the company’s policy onshipment terms and determine if sales, cost of sales, inventories andaccounts receivable need to be adjusted.

6. (a) Determine if such advance payment has been received and that it hasbeen properly recorded. A review should be made of other advancepayments to ascertain that charges against such advances have beenproperly handled.

(b) If the advance payment was to cover these invoices, the auditor shouldpropose a reclassification of the $1,350, debiting the advance paymentaccount and crediting accounts receivable—trade.

7. (a) Examine the shipping order for indications that the goods were shippedand, if available, carrier’s invoice and/or bill of lading for receipt of thegoods.

(b) If it appears that goods were shipped, send all available information to thecustomer and ask the customer to reconfirm. If the customer still insiststhat goods were never received, all data should be presented to an

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appropriate company official for a complete explanation. This mayindicate that accounting for shipments is inadequate and considerationshould be given to reviewing the procedures to determine if improvementscan be made.

(c) If the goods were not shipped, the auditor should recommend anadjustment reducing sales, cost of sales, and accounts receivable, andincreasing inventories.

8. This should be discussed with the appropriate officials and correspondence withthe customer should be reviewed to allow determination whether an adjustmentshould be made in the amount receivable or if an allowance for doubtful accountsshould be set up.

9. As title on any goods shipped on consignment does not pass until those goodsare sold, the sales entry should be reversed, inventory charged, and cost of salescredited if it is actually a consignment sale. Other so-called sales should bereviewed and company officials queried to determine if other sales actuallyrepresent consignment shipments; if so, the adjustment set forth in the precedingsentence should be made for all consignment shipments.

10. This is a noncurrent asset and should be reclassified to either deposit or prepaidrent. A review of other accounts, especially those with round numbers, maydisclose other accounts that should be so reclassified.

11. This may indicate a misposting of the credit or a delay in posting the credit.Comments under 2 above would also apply to credits.

14-26 Additional audit procedures necessary for testing the balances in the salesand collection cycle from August 31 to year end are as follows:

1. Compare sales and accounts receivable balances at year end to thebalances at August 31 and obtain and verify an explanation for anysignificant unexpected differences. If either balance appears to besignificantly out of line at year end, consider performing unexpectedconfirmation procedures again at year-end.

2. Obtain reconciliations of the sales and accounts receivable accountsfrom August 31 to year end. Trace reconciling items to supportingjournals produced by the system. Obtain explanation and verify theexplanation for any unusual transactions.

3. Examine the trial balance of accounts receivable at year end. Considerconfirmation of any accounts which have large balances and were notincluded in the circularization at August 31.

4. Compute the gross margin percent on a monthly basis for the year anddetermine if the ratios for the months after the confirmation aresignificantly different that before.

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5. Compute the ratio of sales returns and allowances to sales on a monthlybasis as in 4.

6. Internal controls should be tested for the period August 31 to December31. The extent of testing should depend on the results of procedures 1through 5.

14-27 a. If called upon to evaluate the adequacy of the sample size, the type ofconfirmation used, and the percentage of accounts confirmed, the following additionalinformation would be required:

1. The number of accounts that had positive balances at 12/31/01.2. The materiality of total accounts receivable.3. The distribution and size of the accounts receivable.4. The assessment of control risk based on the understanding obtained of the

control structure and tests of controls.5. The results of the confirmation tests in previous years.6. The risk of exposure to bankruptcy and similar risks. (audit risk)7. Expected misstatements.

b. If the amounts are material, it is necessary to perform follow-up procedures forpositive confirmations not returned by the debtor. It is common to send secondrequests for confirmations and sometimes even third requests. Even with these efforts,some customers do not return the confirmation, so it is necessary to follow up on allnon-responses with a method referred to as “alternative procedures.”

c. The alternative procedures used for verifying the two non- responses do notappear to be adequate. In recording information about the subsequent cash receipts,for confirmation request no. 9, the auditor should have indicated which invoices thepayments applied to and whether or not the invoices were included in the balance at12/31/01. In addition, the auditor should have examined copies of cheques if they wereavailable or traced the amounts into the bank deposit and to the bank statement. Thecash receipts listed for confirmation request no. 9 total in excess of the balance due atthe 12/31/01. The auditor should have indicated what portion of this balance applies tothe balance at 12/31/01.

The alternative procedures for confirmation request no. 26 show a payment for which noindication of the invoice to which it applies is given. The auditor examined a duplicatesales invoice which may or may not support the balance at 12/31/01. The auditor mustdetermine which sales invoices are represented by the $2,500 balance at 12/31/01 andthen examine a shipping document to support the shipment of goods to the customer.The even amount of the balance and periodic payments also raise a question about thepossibility of a note outstanding rather than an account receivable.

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14-28Investigation of credit and collection problems1. Obtain:

• Aged accounts receivable trial balances (current date).• Analysis of bad debt expenses.• Analysis of doubtful accounts.

2. Ascertain policies in force.

3. Obtain explanations from credit manager for unfavorable results.

4. Consider the following factors:• Economic situation• Effect of competition• Sales policies.

5. Identify variances in policies and procedures between subsidiary and parentcompany.

6. Method of granting credit: Is there an acceptable credit granting system?• Outside sources (such as trade credit agencies).• Internal sources – payment history.• Credit limits established.

7. Follow-up on collections: Is there an adequate system for follow-up?• Invoices and statements mailed promptly.• Aged list of accounts reviewed and old accounts contacted by

reminders, advices, correspondence, etc.

8. Are records up-to-date?

9. Check compliance with procedures.• Have there been changes?

10. Review status of overdue accounts per aged list of accounts and ascertain whetherproper action has been taken.• Follow-up by credit manager.• Approval of credit on specific sales.• Credit limit exceeded – should be cut off.• Explanation of delays in payment.• Perform similar analysis of accounts written off as to causes, by checking:• original credit approval,• follow-up.

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11. Determine that current allowance is adequate by reviewing collectibility of overdueaccounts.• Form opinion on written off items.

12. Ensure that write-offs are appropriate and that collection efforts are continued wherepossible.• Form opinion on written off items.

13. Assess competence of credit manager.

Case

14-29a.

Information hoped to be obtained ReasonIndependent addition of:• Amounts outstanding – in total (need $

amount outstanding)• Aged totals• Total service charges

Mechanical accuracy

To assist in verifying the revenue figure

Selection of accounts for circularization:account data that would be placed on aconfirmation: account number, name,address, balances, open items bytransaction

To establish circularization basis (for astatistical sample, if selection is on arandom basis)

Accounts lacking valid customer (creditcard) number

To locate invalid account, i.e., customercould not be located.

Accounts lacking customer name Same as aboveAccounts lacking customer address Same as aboveAccounts with duplicate names To locate double active accountsAccounts where the aggregate balanceoutstanding exceeds the credit limit

Verify similar report by credit departmentand related reports

A list of bad debt write offs, by customer Same as aboveAccounts showing balances 60 days orolder

Same as above

Accounts which have been inactive for 90days or more.

Same as above

Accounts in credit balance Identify unusual credit balancesAccounts over stated amount Identify unusual customersOver valid information Same as above

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b. Control over programmer• Obtain master file layout and relate it to the program.• Run program and compare with predetermined output.• If in doubt, have program checked by an expert.• Check constants (limit) in the program.• Check logic of program: ensure all items have an equal chance of being

drawn: ensure no specific account is mentioned in program.• Ensure with operator that proper file is used: be present when file is used:

check instructions to operate.