Trade Receivables

1 The relevant assertions

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If you want to audit the receivables balance you have to find ways of testing each assertion that the receivables balance makes: existence, rights and obligations, completeness, accuracy, valuation and allocation, classification and presentation.

2 External confirmation

Assuming trade receivables are material, it’s almost universal to use external confirmation procedures (a 'receivables circularisation') to obtain audit evidence. This involves asking customers to respond directly to the auditor to confirm what they owe. This provides good evidence about the existence of a receivable and its accuracy, but it says very little about the valuation of a receivable. It could well be that a customer who is in trouble will verify that the receivable exists to play for time: they don’t want to arouse suspicions. Quite a separate valuation exercise has to be done later.

There are two types of confirmation request:

• Positive - requests a reply from everyone who has been written to, whether or not they agree with the balance. This is most suitable where the risk of misstatement is high (e.g. weak internal controls, errors expected or suspicion of irregularity or disputed amounts).
  

• Negative - requests a reply only if the customer does not agree with the balance that they have been asked to confirm. But if you don’t get a reply how do you know whether that person agrees with the balance or whether they simply haven’t bothered replying? This type is appropriate when control risk is low (i.e. errors are not expected), there is a large proportion of smaller balances and customers are not expected to ignore the request.
  

A request for confirmation will usually include management's authorisation or encouragement for the customer to disclose confidential information to the auditor. The auditor must have control over sending the requests and receive responses directly. You may remember when we looked at the reliability of audit evidence that auditor-directly obtained evidence is more reliable than client-obtained evidence. Here, if the customers replied to the client, the client could simply throw away those letters which show disagreement and pass on only those letters which show agreement. That would give the auditor quite a wrong impression of the accuracy of the receivables.

Very often stratification will allow a very large percentage of the receivables balance to be covered by requesting relatively few confirmations. Perhaps the key accounts of the client will account for 80% of the receivables balance.

In addition some of the balances will be selected at random for confirmation, together with those balances which have not moved for some time, credit balances and perhaps nil balances.

The auditor has to keep a careful schedule of customers written to, replies received, where replies agree and where they don’t agree.

Disagreements, which may be due to timing differences or errors (the client's or the customer's), will need to be reconciled. Timing differences arising at the confirmation date may include:

• Cash-in-transit (i.e. payments by customers not received by the client);
  

• Goods-in-transit (i.e. goods sent and invoiced by the client not received/recorded by the customer).
  

If some of the client’s customers don’t reply, then it’s normal for the auditor to follow-up the original request with an additional request. If the auditor is really worried about the balance for which there is no confirmation received, the auditor might, as a last resort, phone that customer. However this can only be done with the client’s permission, to avoid damaging the relationship between client and customer.

3 Other work on receivables

• Agree the sum of list of individual customers' balances to the trade receivables account balance in the general ledger. If they do not agree, reconcile. Agree the general ledger balance to the financial statements.
  

• Aged listings. These are essential for receivable valuations. The older the debt, the greater the risk of non-payment. A general allowance for irrecoverable debts is calculated based on the age of the debts (e.g. increasing percentages applied to balances more than 30/60/90/120 days overdue).
  

• Correspondence with customers should be scrutinised. It may become clear that a customer disputes an invoice and it will be difficult ever to receive that amount of money; they might be denying the goods were received; they might be disputing the quality of the goods.
  

• Scrutiny of board minutes. Large receivables which look as though they might be going bad should be reflected in board discussions and there should be records of that in the board minutes.
  

• Collection period, that is a number of days' sales in receivables. It is calculated as receivables divided by sales per day. It is usually regarded as an indicator of the recoverability of receivables and also the efficiency of the credit control operation. There may, of course, be good reasons why the collection period increases: the company might have extended credit terms to be competitive or it may be making a greater proportion of sales abroad where usually the collection period is longer. But all other things being equal, an increase in the collection period is usually regarded as bad news.
  

• On a test basis, trace items outstanding on customer’s accounts to the copy invoice, copy dispatch note and order received from the customer. This provides evidence that the amount is a genuine receivable.
  

• On a test basis, test recent orders in the order file to dispatch notes and to copy invoices and to the trade receivables account to obtain evidence of completeness of amount owing.
  

• Trace amounts showing as having been paid in customers’ accounts to Dr entries in the bank ledger account ("cash book") to verify that they have indeed been paid and should not be in receivables.
  

• Examine after-date cash receipts. An absolute proof that a receivable is good is if it is received after year end. If an amount is not received maybe after two or three months, then there may be serious doubt as to the recoverability of that amount against which a specific allowance should be made for irrecoverability.

• Scrutiny of credit notes issued after year end is very important. It is possible for a company to debit a receivable account and credit sales just before year end, and then very early in a new year to reverse that transaction by issuing a credit note. This gives a mechanism for the company to boost its income and profit for the year which is then quietly reversed out.
  

The tests above fall into two types of substantive procedure:

• Analytical procedures: collection period, compare receivables to last year etc.
  

• Tests of detail: where the auditor traces and inspects the details which provide evidence that an amount is free from material misstatement