In auditing accounts receivable and related revenue balances, several potential problems exist that could create material misstatements. Some of these would be errors whereas others would indicate fraud.
A set of basic internal control should be in place to prevent such erroneous or frauds from happening and a serial of substantive test to be conducted by auditors to make sure the accounts receivable’s balances are free of misstatement.
Through this post, I am going to overview accounts receivable and revenues audit. Thought this is not only useful for a junior auditors, but also a basic clue to the accountant [particularly the accounts receivables accountant or custodians] to avoid any unnecessary mistakes in accounting the accounts receivable and revenues that could lead to a long auditing drains. Enjoy!
Most Common Errors and Frauds In Accounts Receivable and Revenues
Here are most common errors and frauds in accounts receivable that potentially result in accounts receivable misstatement:
- Reported receivables and sales could be false. Amounts were recorded to manipulate reported amount of income. False sales are especially likely if: (1) income to be reported is down for the period, (2) employee compensation or bonuses are based on profits, or (3) company plans to issue capital stock or borrow money in the near future.
- Incoming cash is stolen and theft is hidden. It is done by unethical custodians by writing off the receivable as a bad debt.
- Lapping is being carried out. Cash from one receivable is stolen and covered with cash received from a second customer during the following day or two.
- The year-end cut-off of transactions is incorrect. Transactions occurring before the end of year could be recorded in the subsequent period (thus, reporting for the initial year is not complete).
- Transactions after the end of year could be recorded prematurely in the initial year (reported transactions in initial year did not actually exist at the time of the financial statements).
- Customer is billed incorrectly (because of math errors, wrong quantity, wrong price, wrong items) or customer is just not billed at all for goods that were actually shipped (inventory is gone but no collection is ever made).
- Transaction is with a related party so that disclosure is needed.
Basic Internal Control for Accounts Receivables
Company should have a system in place to record sale, make proper shipment, and control and collect receivable balance to prevent such erroneous or fraudulences. Here are a basic internal control set for accounts receivable and related revenues:
- A customer order is received. May be by mail or over telephone or given directly to company employees.
- On a pre-printed, pre-numbered sales order form, the sales department lists all relevant information: quantity, description, terms, buyer, address, method of payment, etc.
- Credit department reviews credit file (which can hold credit report, references, financial statements, payment history of client, etc.). Approval or disapproval of credit is then indicated on the sales order form.
- If approved, sales order goes to finished goods warehouse where goods are gathered and sent to shipping department. Separate departments are maintained so that goods being removed must be documented. Since asset is being transferred, shipping department should verify description and quantity against sales order form. Condition of goods should also be checked. Shipping then signs and returns a copy of sales order which is kept by warehouse as a receipt to prove that transfer was made.
- Shipping department sends goods to customer and prepares a shipping document, often known as a bill of lading. One copy goes with merchandise and a second copy is sent directly to customer.
- Copy of bill of lading [or air way bill] sent to inventory accounting department which should maintain a perpetual listing of all inventory. An entry is made to remove item from records.
- Entries are accumulated and forwarded to general accounting department for posting of the overall reduction of Inventory account.
- Copies of all documents go to billings department. Comparison is made of quantity and description. If all information agrees, a sales invoice is prepared and sent to client. It is also recorded in sales journal. Summary of sales journal is forwarded to general accounting for recording.
- Copy of sales invoice is sent to accounts receivable department. Amount is recorded in accounts receivable master file by customer name.
- Periodically, an aged accounts receivable trial balance is prepared which lists each account by age. Old accounts are turned over to a collection department.
- If balance still proves to be uncollectible, both collection and accounts receivable departments file documentation to indicate actions taken.
- Independent party reviews information before final write-off of balance is approved.
Substantive Testing Procedures for Accounts Receivable Balances
A number of substantive testing procedures should be performed to verify the assertions made by client about accounts receivable and related balances:
- Perform analytical procedures to identify areas where client figures differ from auditor expectations.
- Look at: overall balance of each account, age of receivables, gross profit percentage, sales returns as a percentage of sales, write off of accounts as compared to previous years, etc.
- Analytical procedures are required in planning stage of audit to help assess inherent risk. They are also required in final review stage of audit as a last check. Use as a substantive test of an account balance is optional.
Trace one or more transactions through the entire system to see if recording is appropriate at each step. Start with customer order and check all steps until account and collection are recorded. Auditor is especially interested that all shipments are properly billed.
- Whenever auditor starts with transactions at their inception, the completeness assertion is being tested.
- Vouch one or more entries in the T-account back through system to see if there is adequate support. Whenever auditor starts with a reported balance and seeks corroboration, the existence assertion is being tested.
- Check math and accuracy of client work where applicable. Re-add accounts receivable master file and compare it to the general ledger account. Verify that aged accounts receivable trial balance is added correctly and individual amounts agree with master file.
- For three to four days before and three to four days after year-end, verify client cut-off procedures to make sure transactions were recorded in correct period. Use the bill of lading and sales invoice to determine when receivable and sale should be recorded. Cash receipts listing provides date for removal of receivable.
- Auditor reviews any evidence generated in subsequent period (the time from the balance sheet date until the end of fieldwork). For example, cash collections prove the balance and collectibility of a receivable and sales return should be matched with sales, and bad debts written off may have been uncollectible at year’s end.
- Look for related party transactions that have to be disclosed. For example, the representation letter asks about their existence.
- Confirm balances directly with customers to prove existence assertion. Usually done early in audit unless inherent and/or control risks are high. In that case, confirmation is carried out closer to year’s end.
- All confirmations are signed by client but controlled, mailed, and responses received by auditor.
- Negative confirmations ask customer for a response only if reported balance is wrong. It is less costly but provides a poorer quality of evidence since nothing tangible is received unless a problem exists. Normally used for small balances, balances that are not old, and where risk appears low.
- Positive confirmations ask for response from customer whether balance is correct or incorrect. Because an actual response should be received in all cases, this is viewed as a better technique. Normally used for old balances, large balances, or where risk is high.
- If no response to positive request is received, a second confirmation can be sent or a direct call made. If auditor still does not get a response, alternative testing must be expanded. All documents should be compared and cash receipts should be reviewed for subsequent payment. In either type of confirmation, reported discrepancies should be investigated to determine whether a problem exists.
- Accounts which have been written off or which have a zero balance can be confirmed just to make certain that reported facts are accurate. If a confirmation is returned by e-mail or by fax, the auditor may need to call the customer or request that the confirmation be mailed to the auditor in order to get adequate support.
- Method of estimating bad debt expense should be examined. Auditor wants to make sure that no evidence exists to indicate that client’s estimation is not justified. Auditor must be aware of changes that may affect client’s previous experience.
- Auditor must ensure balance sheet presentation and disclosure is appropriate. For example, pledged accounts must be noted.