Chapter Three

3. Audit of Accounts Receivables and sales

3.1. Audit of Receivable

In this section you will deal with audit of account receivable. The section contains the internal
control over accounts receivables, the test of control and substantive test of balance that
auditor perform during the audit of accounts receivable. For many business sales are made on
credit and thus auditors usually make a due attention in an audit of account receivable as they
can have evidence about the assets reported in the balance sheet as receivable as well as about
the sales revenue reported in the income statement. Like those of other accounts, the auditor
approaches an audit of receivable in two procedures; first it conducts assessment of internal
control or transaction test and performs an audit of balance to substantiate the validity of
audit objectives. In the process of conducting audit of accounts receivable, the auditor checks
the sales and receivable cycle, collection, the discount, allowance and returns offered to
customer as well as the process of determining bad debt expense or written-off debt that is
proved to be uncollectable.

In attaining the overall audit objective, the auditor design and implement transactions and audit
related audit objectives substantiate the effectiveness of the internal control system as well as to
substantiate the validity of expressed and implied assertion concerning balance of accounts
receivable.
3.1.1. Evaluating Internal Control over Accounts Receivable
Good internal control for receivables includes:
 Any person who handles or has access to collect from customers should have no other
responsibility relating to account receivable.
 Responsibility for approval of credit to customers, account for returned goods, and
allowance for uncollectible accounts should be given to the general manager or high
ranking officers.
 A person authorized to approve non cash credit should under no circumstance have
access to cash collection.
 The handling of cash should be separated from the preparation of the accounting
records.

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  A person who opens a mail should make a record in 3 copies of all cash received, retain
one copy for himself, send the cash and the second copy to the cashier and send the
third copy to accounting department. The cashier will deposit the cash in a bank and
send the deposit slip to accounting department. The accounting department will control
the cash by comparing the third copy with the deposit slip sent to it.
 Granting credit, collecting delinquent account, making records (accounting) and
cashiering, all should not be granted to a single individual.
 Using two types of account (subsidiary ledger and general ledger) and assigning
recoding in the two accounts to different employees.
3.1.2. Test of Control for Account Receivable
Test of control should be designed to check that the control procedures are being applied and the
objectives are being acceded. In relation to accounts receivable, the following tests can be
performed on a sample basis:

 Cary out sequence test checks on invoices, credit notes, shipping/dispatch notes orders
to ensure that all items are included and that there are no omissions or duplications.
 Check authorization for the:
 Acceptance of the order
 Dispatch of goods
 Raising of the invoice or credit notes
 Pricing and discounts
 Write-off of bad debts

In this procedure, the auditor checks that the relevant signature exists and that the control has
been applied in the process of credit sales and subsequent cash collection.

 Seek evidence of checking of the arithmetic accuracy of invoices, credit notes and sales
tax.
 Check dispatch notes and goods returned notes to ensure that they are referenced to
invoices and credit notes and vice versa.
 Check that control account reconciliations have been performed and reviewed.
 Ensure that batch total control have been applied by seeking signatures and tracing
batches from inputs to output.

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In all the above cases, the auditor attempts to get satisfaction on the proper application of the
control procedure.
3.1.3. Test of Balance of Accounts Receivables
Once the auditor appraises and tests the system of internal control in order to ascertain that the
system of internal control over receivable is adequate, he/she further carries out substantive tests
in an attempt to ensure that, the transactions, sales, cash receipt, discounts, return and allowance
and bad debts in the accounts receivable subsidiary ledgers and controlling account, are in fact
completely and accurately recorded or the balance is not materially misstated.
In audit of accounts receivable balance the audit program includes the following balance related
objectives:

i. Accounts receivable in the aged trial balance agree with related master files
amounts, and the total is correctly added and agrees with the general ledger
(detail tie-in)
ii. Recorded account receivable exist(existence)
iii. Existing accounts receivable are included(completeness)
iv. Accounts receivable are accurate( accuracy)
v. Cutoff for accounts receivable is correct( cut off)
vi. Accounts receivable are properly classified(classification)
vii. Accounts receivable are stated at realizable value(realizable value)
viii. The client has right to accounts receivable(rights)
ix. Accounts receivable presentation and disclosure are proper(presentation)

The followings are substantive audit test for account balance of accounts receivable:

Accuracy: is discussed first because the auditor must establish that the detailed record that
support the account to be audited agree with the general ledger account. The amounts
continued in the financial statements are derived from the general ledger balances. To test the
fairness of a financial statement amount, the auditor tests the general ledger account by
examining the amount or estimates that compose the balance. For many account, the general
ledger balance is supported by a subsidiary ledger or listing of the details that make up the
balance. Normally, the auditor performs a number of accuracy tests of the subsidiary ledger or
listing before conducting other tests of the account balance. This process is followed when

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accounts receivable are audited. For example, the auditor agrees the accounts receivable
subsidiary ledger of customers accounts to the general ledger account receivable (control)
account. This is typically accomplished by obtaining a copy of the aged trial balance of
accounts receivable and comparing the total balance with the general ledger accounts
receivable account balance. An aged trial balance of the subsidiary ledger is used because the
auditor will need this type of data to examine the allowance for uncollectible accounts. The
auditor must also have assurance that the details making up the aged trial balance is accurate.
This can be accomplished in a number of ways. One approach involves mainly manual audit
procedures. First, the aged trial balance is footed and cross footed. Footing and cross footing
mean that each column of the trial balance is added, and the column totals are then added to
ensure that they agree with the total balance for the account. Then a sample of customer
accounts included in the aged trial balance is selected for testing. For each selected customer
account, the auditor traces the customer’s balance back to the subsidiary ledger detail and
verifies the total amount and the amounts included in each column for proper aging. A second
approach involves the use of computer-assisted audit techniques. If the general controls over IT
are adequate, the auditor can use a generalized audit software package to examine the accuracy
of the aged trial balance generated by the client’s accounting system

Validity: The validity of accounts receivable is one of the more important audit objectives
because the auditor wants assurance that this account balance is not overstated through the
inclusion of fictitious customer accounts or amounts. The major audit procedure for testing
the validity objective for accounts receivable is confirmation from customers. If some
customers’ dose not respond to the auditor’s confirmation request, additional audit procedures
may be necessary. There are two types of confirmation called positive confirmation and negative
confirmation. Basically positive confirmations are letters sent to debtors asking them to confirm
directly to the auditor the amount of the balance in their respective accounts. The auditor wants a
response regardless of whether the customer agrees or disagrees with the stated balance. The
confirmation usually includes the amount from the client books, but it is possible to send a blank
confirmation and ask the clients to fill in the correct amount. The blank type of confirmation is
very good evidence because the customer has to actually look up the information on his or her
records and writes it down. But the response rate is usually lower because of the amount of work
involved for the customers. Negative confirmation on the other hand asks for a response only if

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the debtor disagree with the recorded amount. Negative confirmation request are often simply
stamped or glued on to the clients regular monthly statements to the customer before it is sent
out. Positive confirmations are more reliable, partly because the auditor will follow up
confirmations which are not returned. If a negative confirmation is not returned, the auditor
assumes it is because the debtor agrees with the balance. Since negative confirmation are often
simply ignored by the receipt that assumption may not be correct. Negative confirmation are less
reliable, but are cheaper to send. A formal letter is not required, and no time is spent following
up.

SAMPLE POSITIVE CONFIRMATION LEETER

KK Company
Addis Ababa, Ethiopia
Control number: KK/108/2011
Date:2/01/2011
To: BB Company
Dire Dawa, Ethiopia
Dear Sir:
Our auditor, Birhanu& Co., is conducting an audit of our financial statements. Please examine
the accompanying statement and either confirm its correctness or report any differences to our
auditors.
Your prompt attention to this request will be appreciated. An envelope is enclosed for your
reply.
Very truly yours,

[Client signature and title]

The replay from the client may be written as follows:

The balance receivable from us of Br.20, 000 as of 2/01/2011 is correct except as noted
below:

[Debtor name]
Date
By

Completeness: The auditor’s concern with completeness is whether all accounts receivable
have been included in the accounts receivable subsidiary ledger and the general accounts

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receivable account, the reconciliation of the aged trial balance to the general ledger account
should detect an omission of a receivable from either the accounts receivable subsidiary ledger or
the general ledger account. If the client’s accounting system contains proper control totals and
reconciliations, such errors should be detected and corrected by the relevant internal control
procedures. Personnel in the billing department would be responsible for reconciling the two
totals. If such control procedures do not exist in a client’s accounting system, or if they are not
operating effectively, the auditor will have to trace a sample of shipping documents to sales
invoices, the sales journal, and the accounts receivable subsidiary ledger to ensure that the
transactions were included in the accounting records.

Cutoff: The cutoff objective attempts to determine whether all revenue transactions and
related accounts receivable are recorded in the proper period. On most audits, sales cutoff is
coordinated with inventory cutoff because the shipment of goods normally indicates that the
earnings process is complete. The auditor wants assurance that if goods have been shipped in the
current period, the resulting sale has been recorded, and also that if the sales have been
recorded, the corresponding inventory has been removed from the accounting records. In
addition, the auditor needs to determine if there is proper cutoff for sales returns.

Sales Cutoff: If there is no proper cutoff of revenue transactions, both revenue and accounts
receivable will be misstated for the current and following years. In most instances, errors related
to sales cutoff are due to delays in recognizing the shipment of goods or recognizing revenue
transactions in the current period in the next period or may recognize sales from the next period
in the current period. The first situation can occur by the revenue transactions not being recorded
in the sales journal until the next period. For example, sales that take place on the last two days
of the current year are recorded as sales in the next year by delaying entry until the current- year
sales journal is closed. The second situation is generally accomplished by leaving the sales
journal “Open” and recognizing sales from the first few days of the next period as current-period
sales.

The test of sales cutoff is straightforward. The auditor first identifies the number of the last
shipping document issued in the current period. Then a sample of sales invoices and their related
shipping documents is selected for a few days just prior to, and subsequent to, the end of the

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period. Assuming that sales are recorded at the time of shipment (FOB- shipping point), sales
invoices representing goods shipped prior to year-end should be recorded in the current period,
and invoices for goods shipped subsequent to year- end should be recorded as sales in the next
period. Any transaction recorded in the wrong period should be corrected by the client. For
example, suppose the last shipping document issued in the current period was numbered 10,540,
and none of the recorded revenue transactions sampled from a few days prior to year- end should
have related shipping document numbers higher than 10,540. And none of the sampled revenue
transactions recorded in the first few days of the subsequent period should have related shipping
document numbers lower than 10,540. In a computerized system such tests are still necessary
because a delay in entering data may occur, or management may manipulate the recognition of
the transactions.

Sales Returns Cutoff: The processing of sales returns may differ across entities. When sales
return are not material, or if they occur irregularly, the entity may recognize a sales return at the
time the goods are returned when sales return represent a material amount, the auditor needs to
test for proper cutoff. Using the procedures similar to sales cutoff, the auditor selects a sample of
receiving documents for few days prior to and subsequent to the end of the period. The receiving
documents are traced to the related credit memorandum. Sales return recorded in the wrong
period should be corrected if material.

Ownership: The auditor determines whether the account receivables are owned by the entity
because accounts receivable that have been sold should not be included in the entity’s financial
statement. For most audit engagements, this doesn’t represent a problem because the client owns
all the receivables. However, in some instances client may sell its account receivable. The
auditor can detect such an action by reviewing bank confirmation. Cash receipt for payments
from organization that factor accounts receivable, or corporate minutes for authorization of the
sales or assignment of receivables.

Valuation: Two major valuation issues are related to accounts receivable. The first issue relates
to the valuation of the revenue and cash receipts transactions that make up the details of the
gross amount of account receivables. The concern her is with the quantity and pricing of the
items included on the sales invoices and the proper recording of cash received including any
discount. This affects the gross amount of accounts receivable as well as sales. Test of control

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and substantive test of transaction normally provides evidence about these types of pricing
errors. Pricing errors, especially when the consumer has been overcharged or proper payment
hasn’t been recorded may also be detected via confirmation.

The second valuation issue relates to the net realizable value of accounts receivable. The
auditor is concerned with determining that the allowance for uncollectible accounts, and thus
bad debt expense, is fairly stated. The allowance for uncollectible account is affected by internal
factors such the client’s credit granting and cash collection policies and external factors such as
the state of the economy, condition in the clients industry, and the financial strength of the clients
customer. In verifying the adequacy of the allowance for uncollectible accounts, the auditor
starts by assessing the client’s policies for granting credit and collecting cash. If the client
establishes strict standards for granting credit, the likely hood of a large number of bad debts is
reduced. The second step in assessing the adequacy of the allowance account involves
examining the client’s prior experience with bad debts.

Classification: The major issues related to the classification objectives are

 Identifying and reclassifying any material credits contained in accounts receivable

 Segregating short term and long term receivables
 Ensuring that different types of receivables are properly classified.
In many entities, when a customer pays in advance or a credit is issued, the amount is credited to
the customer’s accounts receivable account. The auditor should determine the amount of such
credits and if material, reclassify them as either a deposit or another type of labiality. The second
issue requires that the auditor identify and separate short term receivable from long term
receivables, should not be included with trade accounts receivable. The auditor must also ensure
that non trade receivables are properly separated from trade accounts receivable

Disclosure: Disclosure is an important audit objective for accounts receivables and related
accounts. While management is responsible for the financial statements, the auditor must ensure
that all necessary disclosures are made. Examples of disclosure items for receivables are:

 Short and long term receivables

 Pledged or discounted receivables
 Receivable from related parties
 Receivables by type (trade, officer, employee, affiliated, and as on)

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3.2. Revenue Recognition

3.2.1. Overview of Revenue Process

Three types of transactions are typically processed by the revenue process

 The sales of goods or rendering of service for cash or credit

 The receipt of cash from the customers in payment for the goods or services
 The return of good by the customers for the credit or cash
The following list shows the most important document and records that are normally contained
in the revenue process. However, in advanced IT system, some of these documents and records
may exist for only a short period of time or may be maintained only in machine readable form.

 Customer’s sales order  Accounts receivable subsidiary ledgers

 Credit approval form  Aged trail balance of accounts
 Open order report receivable
 Shipping documents  Remittance advice
 Sales invoice  Cash receipt journal
 Sales journal  Credit memorandum
 Customer’s statement  Write off authorization

3.2.2. Evaluating Internal Control for Revenue

The followings are some the internal controls that should exist in the revenue process.

 The credit function should be segregated from the billing function. If one individual has
the ability to grant credit to a customer and also has responsibility for billing those
customers, it is possible for sales to be made to customers who are not creditworthy.
This can result in bad debt expense.
 The shipping function should be segregated from the billing function. If one individual
who is responsible for shipping goods is also involved in the billing function, it is
possible for unauthorized shipments to be made and for the usual billing procedures to
be circumvented. This can result in unrecorded sales transaction and theft of goods.
 The cash receipts function should be segregated from the accounts receivable function.
If one individual has access to both the cash receipt and the accounts receivable records,
it is possible for cash to be diverted and the shortage of cash in the accounting records to
be covered. This can result in theft of the entity’s cash.
 Customers order and shipping documents should be approved before revenue is
recognized and recorded.

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  Accounting for the numerical sequence of shipping document and sales invoices,
matching shipping documents with sales invoice, reconciling the sales invoice to the
daily sales report.
 There should be proper verification of the information contained, shipped, price and
terms. The sales invoices should also be verified for mathematical accuracy before being
sent to the customer

3.2.3. Substantive Test of Revenue Transactions

Validity: Auditors are concerned about the validity objective for revenue transaction because
clients are more likely to overstate sales than to understate them. Sales to factious customers
and recording of revenue when goods have not been shipped or services have not been
performed. In order to test this, the auditor can observe and evaluate the segregation of duties
and can also examine a sample of sales invoice for the presence of an authorized customers order
and shipping document.

Completeness: The major misstatement that concern the auditor is that goods are shipped or
services are performed and no revenue is recognized. Failure to recognize revenue means that
the customer may not be billed for goods or services and the client doesn’t receive payment. The
audit procedure to test this is that the auditor selects a sample of bills of lading and traces each
one to its respective sales invoice and to the sales journal. If all bills of lading are recorded in the
sales journal, the auditor would have evidence that all goods shipped are being billed

Cutoff: If the client doesn’t have adequate control to ensure that revenue transactions are
recorded on timely basis, sales may be recorded in the wrong accounting period. The auditor can
test this objective by comparing the date on bill of lading with the date on the respective sales
invoices and the date the sales invoices was recorded in the sales journal.

Valuation: Revenue transactions that are not properly valued results in misstatement that
directly affect the amount reported in the financial statement. The audit procedure for this
objective is comparison of prices and terms on sales invoices to authorized prices list and
terms of trade.

Classification: The use of chart of account and proper codes for recording transactions should
provide adequate assurance about these objectives. The auditor can review the sales journal and

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general ledger for proper classification, and can test sales invoice for proper classification by
examining programmed control to ensure that sales invoices are coded by the type of product or
service.

Posting and summarization: In any accounting system, there is always a possibility that
transaction are not properly summarized from source document or posted properly from journals
to the subsidiary and general ledgers. In the revenue process control totals should be utilized to
reconcile sales invoices to the daily sales report and the daily recording in the sales journal
should be reconciled with the posting to the accounts receivables subsidiary ledger.

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