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AUDITING CHAPTER 11

AUDITING CHAPTER 11. Accounts Receivable & Cash Balances By David N. Ricchiute. TOPICS IN REVENUE/RECEIPT CYCLE. Relationship assertions & audit procedures Relationship audit risk, client strategies, substantive tests Substantive tests for assertions

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AUDITING CHAPTER 11

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  1. AUDITINGCHAPTER 11 Accounts Receivable & Cash Balances By David N. Ricchiute

  2. TOPICS INREVENUE/RECEIPT CYCLE • Relationship assertions & audit procedures • Relationship audit risk, client strategies, substantive tests • Substantive tests for assertions • Revenue recognition, earnings manipulation, & channel stuffing • Audit sampling & accounts receivable • Computer-assisted audit techniques GBW 8th ed. Ch. 11

  3. ASSERTIONS & OBJECTIVES Management assertions: Recorded receivables & cash balances • Exist • Include all transactions (completeness) • Represent rights of entity • Are valued appropriately • Are presented & disclosed properly GBW 8th ed. Ch. 11

  4. OBJECTIVES & PROCEDURES:Existence/Occurrence Objective: determine whether all recorded sales, receivables, cash balances Procedures • Existence • Physical observation • Confirmation • Transactions occurred • Cutoff testing for proper period GBW 8th ed. Ch. 11

  5. OBJECTIVES & PROCEDURES:Completeness Objective: determine whether all receivables, sales, cash of period are presented in financial statements Procedures • Examine documents • Apply analytical procedures • Cutoff bank statements, bank reconciliations, etc. GBW 8th ed. Ch. 11

  6. OBJECTIVES & PROCEDURES:Rights/Obligations Objective: determine whether entity has property rights to cash, accounts receivable Procedures • Examine documentation • Confirmations • Inquiries GBW 8th ed. Ch. 11

  7. OBJECTIVES & PROCEDURES:Valuation, Allocation Objective: determine whether entity has recorded items in correct amounts, accounts, & time periods Procedures • Confirm balances • Verify mathematical accuracy • Examine details of recording GBW 8th ed. Ch. 11

  8. OBJECTIVES & PROCEDURES:Presentation, Disclosure Objective: determine whether recorded transactions, balances properly classified, described, disclosed Procedures • Compare presentation to GAAP • Annual updates of AICPA guidelines GBW 8th ed. Ch. 11

  9. AUDIT RISK MODEL AR = CR x IR x DR • Detection risk (DR): likelihood that error could occur & not be detected • Based on • Control risk (CR) • Likelihood of material error • Inherent risk (IR) • Strategies & threats GBW 8th ed. Ch. 11

  10. DETECTION RISK DR = ____AR___ IR x CR • Nature, extent, timing substantive tests • Nature: more/less persuasive tests • Extent: larger/smaller samples • Timing: balance sheet date or interim GBW 8th ed. Ch. 11

  11. ASSERTIONS & PROCEDURESAccounts Receivable, Sales-1 Valuation • Verify mathematical accuracy AR • Obtain aged trial balance • Foot trial balance • Compare total AR per trial balance to general ledger GBW 8th ed. Ch. 11

  12. ASSERTIONS & PROCEDURESAccounts Receivable, Sales-2 Existence, rights, valuation • Confirm year-end accounts & notes receivable with debtors • Positive: tell auditor if balance correct • Large balances, inaccuracies • Negative: tell auditor only if balance incorrect • Control adequate, small balances GBW 8th ed. Ch. 11

  13. ASSERTIONS & PROCEDURESAccounts Receivable, Sales-3 Existence or occurrence, completeness • Test cutoff to determine whether sales, receivables recorded in proper period • FOB shipping point • FOB destination GBW 8th ed. Ch. 11

  14. ASSERTIONS & PROCEDURESAccounts Receivable, Sales-4 Valuation, rights • Review collectibility receivables • Determine adequacy allowance for doubtful accounts GBW 8th ed. Ch. 11

  15. ASSERTIONS & PROCEDURESAccounts Receivable, Sales-5 Existence or occurrence, completeness, valuation • Perform analytical procedures for reasonableness of sales, receivables balances • Collections problems • Overstated sales • Understated sales GBW 8th ed. Ch. 11

  16. ASSERTIONS & PROCEDURESAccounts Receivable, Sales-6 Presentation & disclosure • Review financial statements to determine • Accounts, notes receivable properly classified, described • Disclosures adequate GBW 8th ed. Ch. 11

  17. TESTING CUTOFFSales, Receivables At or around end each quarter, the former President directed his subordinates to hold IGI’s books open, to backdate invoices, shipping documents. This caused IGI to record out-of-period sales & to overstate revenue, net income end each quarter. • Procedures • Trace recorded sales to shipping documents before, after end of period GBW 8th ed. Ch. 11

  18. ASSERTIONS & PROCEDURES:Cash-1 Existence, rights, valuation • Confirm year end balances with all banks GBW 8th ed. Ch. 11

  19. ASSERTIONS & PROCEDURES:Cash-2 Valuation • Verify mathematical accuracy recorded cash balances • Foot cash journals • Trace totals to general ledger, year-end bank reconciliations • Test cash on hand GBW 8th ed. Ch. 11

  20. ASSERTIONS & PROCEDURES:Cash-3 Existence, completeness, valuation • Test cutoff • Obtain cutoff bank statement • Verify accuracy • Examine & trace to bank reconciliations & cash journals • Proof of cash • Reconcile recorded cash with bank confirmation • Examine interbank, intercompany transfers GBW 8th ed. Ch. 11

  21. ASSERTIONS & PROCEDURES:Cash-4 Presentation & disclosure • Review financial statements to determine • Cash balances properly classified, described • Disclosures adequate GBW 8th ed. Ch. 11

  22. TESTING CUTOFF FOR CASH • Reconcile internal documents • Cash journals • General ledger • Bank reconciliations • With external documents • Year-end bank statement • Cutoff bank statements • Bank confirmations GBW 8th ed. Ch. 11

  23. REVENUE RECOGNITION& EARNINGS MANIPULATION Increasingly, I have become concerned that the motivation to meet Wall Street earnings expectations may be overriding common sense business practices. Arthur Levitt, Jr., “The ‘Numbers Game.” Speech NYU, 1998. GBW 8th ed. Ch. 11

  24. REVENUE RECOGNITIONSAB 104 • Criteria • Persuasive evidence of arrangement exists • Delivery has occurred or services rendered • Seller’s price fixed or determinable • Collectibility reasonably assured GBW 8th ed. Ch. 11

  25. COMMON MEANS TO MANIPULATE EARNINGS - 1 MethodRevenue Recognition Error GBW 8th ed. Ch. 11

  26. COMMON MEANS TO MANIPULATE EARNINGS - 2 MethodRevenue Recognition Error GBW 8th ed. Ch. 11

  27. COMMON MEANS TO MANIPULATE EARNINGS - 3 Method Revenue Recognition Error GBW 8th ed. Ch. 11

  28. MANIPULATED EARNINGSChannel Stuffing • Definition: incentives to induce incremental demand • Examples • Bausch & Lomb • Told distributors to buy large amount of inventory to maintain distributorship • B&L recognized extra $22 million • Sunbeam • Used price discounting to encourage customers to hold 80 weeks of inventory GBW 8th ed. Ch. 11

  29. MANIPULATED EARNINGSAsset Swaps • Definition: companies trading right to use others asset • Examples • Global Crossing • Treated underseas cables as real estate • Recognized revenue by treating swap as sale GBW 8th ed. Ch. 11

  30. MANIPULATED EARNINGSOther • Improper expense capitalization • Chambers Development • Capitalized landfill expenses after determining earnings necessary to meet analysts expectations • MicroStrategy • Recognized revenue before all services provided for software sales GBW 8th ed. Ch. 11

  31. AUDIT SAMPLING & ACCOUNTS RECEIVABLE • Update assessment of control risk • Planning confirmations & selecting plan • Identify population, sampling unit, anticipated error • Estimate tolerable error & risk incorrect acceptance • Calculate sample size • Choose sample selection method • Evaluate results GBW 8th ed. Ch. 11

  32. COMPUTER ASSISTED TESTS:AR Accuracy • Foot, crossfoot recorded amounts within master file • Total balances • Display/print exceptions GBW 8th ed. Ch. 11

  33. COMPUTER ASSISTED TESTS:AR Aging • Trace individual balances from master file to sales journal • Classify balances by invoice dates/age • Display/print aged trial balances GBW 8th ed. Ch. 11

  34. COMPUTER ASSISTED TESTS:AR Credit Balances • Scan master receivables file for net credit balances • Display/print listing credit balance accounts GBW 8th ed. Ch. 11

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