accounts receivable & cash balances

AUDITINGCHAPTER 11

Accounts Receivable & Cash Balances ByDavid N. Ricchiute

GBW 8th ed. Ch. 112

TOPICS INREVENUE/RECEIPT CYCLE

Relationship assertions & audit proceduresRelationship audit risk, client strategies, substantive testsSubstantive tests for assertionsRevenue recognition, earnings manipulation, & channel stuffing Audit sampling & accounts receivableComputer-assisted audit techniques

GBW 8th ed. Ch. 113

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. 114

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. 115

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. 116

OBJECTIVES & PROCEDURES: Rights/Obligations

Objective: determine whether entity has property rights to cash, accounts receivable

Procedures Examine documentation Confirmations Inquiries

GBW 8th ed. Ch. 117

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. 118

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. 119

AUDIT RISK MODEL

AR = CR x IR x DRDetection risk (DR): likelihood that error could occur & not be detectedBased on Control risk (CR)

Likelihood of material error Inherent risk (IR)

Strategies & threats

GBW 8th ed. Ch. 1110

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. 1111

ASSERTIONS & PROCEDURESAccounts Receivable, Sales-1

ValuationVerify mathematical accuracy AR Obtain aged trial balance Foot trial balance Compare total AR per trial balance to

general ledger

GBW 8th ed. Ch. 1112

ASSERTIONS & PROCEDURESAccounts Receivable, Sales-2

Existence, rights, valuationConfirm 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. 1113

ASSERTIONS & PROCEDURESAccounts Receivable, Sales-3

Existence or occurrence, completenessTest cutoff to determine whether sales, receivables recorded in proper period FOB shipping point FOB destination

GBW 8th ed. Ch. 1114

ASSERTIONS & PROCEDURESAccounts Receivable, Sales-4

Valuation, rightsReview collectibility receivablesDetermine adequacy allowance for doubtful accounts

GBW 8th ed. Ch. 1115

ASSERTIONS & PROCEDURESAccounts Receivable, Sales-5

Existence or occurrence, completeness, valuationPerform analytical procedures for reasonableness of sales, receivables balances Collections problems Overstated sales Understated sales

GBW 8th ed. Ch. 1116

ASSERTIONS & PROCEDURESAccounts Receivable, Sales-6

Presentation & disclosureReview financial statements to determine Accounts, notes receivable properly

classified, described Disclosures adequate

GBW 8th ed. Ch. 1117

TESTING CUTOFF Sales, 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. 1118

ASSERTIONS & PROCEDURES: Cash-1

Existence, rights, valuationConfirm year end balances with all banks

GBW 8th ed. Ch. 1119

ASSERTIONS & PROCEDURES: Cash-2

ValuationVerify 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. 1120

ASSERTIONS & PROCEDURES: Cash-3

Existence, completeness, valuationTest 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. 1121

ASSERTIONS & PROCEDURES: Cash-4

Presentation & disclosureReview financial statements to determine Cash balances properly classified,

described Disclosures adequate

GBW 8th ed. Ch. 1122

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. 1123

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. 1124

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. 1125

COMMON MEANS TO MANIPULATE EARNINGS - 1

Method Revenue Recognition ErrorBill & hold

Cancelled ordersConditional salesConsignment salesContinuing involvementImproper cutoff

Shipments to 3rd party warehouses Cancelled, duplicate orders Before contingencies resolvedGoods on consignment, trialSeller involved after delivery, e.g., installationBefore title, risk ownership passed

GBW 8th ed. Ch. 1126

COMMON MEANS TO MANIPULATE EARNINGS - 2

Method Revenue Recognition Error

Kickback salesOverstated completionPartial shipmentsPre-invoicingPremature shipment

Inflated selling price for kickbackInflated % completion on construction projectsNot all goods ordered are shippedGoods still in productionGoods ordered but not authorized for shipment

GBW 8th ed. Ch. 1127

COMMON MEANS TO MANIPULATE EARNINGS - 3Method Revenue Recognition

ErrorPremature salesSham salesSide agreements

Uncertain performanceUncertain realizationUnauthorized shipment

Goods ordered but not shippedFalse shipmentsTo forestall completion earnings processSeller’s performance uncertainCollection uncertain, unlikely

Shipments not authorized

GBW 8th ed. Ch. 1128

MANIPULATED EARNINGSChannel Stuffing

Definition: incentives to induce incremental demandExamples 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. 1129

MANIPULATED EARNINGSAsset Swaps

Definition: companies trading right to use others assetExamples Global Crossing

Treated underseas cables as real estate Recognized revenue by treating swap as

sale

GBW 8th ed. Ch. 1130

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. 1131

AUDIT SAMPLING & ACCOUNTS RECEIVABLE

Update assessment of control riskPlanning 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. 1132

COMPUTER ASSISTED TESTS: AR Accuracy

Foot, crossfoot recorded amounts within master fileTotal balancesDisplay/print exceptions

GBW 8th ed. Ch. 1133

COMPUTER ASSISTED TESTS: AR Aging

Trace individual balances from master file to sales journalClassify balances by invoice dates/ageDisplay/print aged trial balances

GBW 8th ed. Ch. 1134

COMPUTER ASSISTED TESTS: AR Credit Balances

Scan master receivables file for net credit balancesDisplay/print listing credit balance accounts