Chapter Two

Audit of Receivables and Sales

Receivables are a product of the sales cycle and therefore the control objectives of the sales cycle
are relevant. Receivable is a general term that may refer to many types of receivables whose
origin and nature may be different.
Receivables include amounts due from customers, employees, and affiliates on open accounts,
notes, and loans and accrued interest on such balances.

Sources and Nature of Receivable

The sales and collection cycle including the receiving of orders from customers are delivery and
billing of merchandise to customers, and the recording and collection of receivables.
Receivables from customers include both accounts receivable and various types of notes
receivable.
Financial reporting standards for receivables require:
 Separation of trade from non–trade receivables.
 Establishment of genuine of trade receivables transactions ensuring “arms length deal”,
and terms of sales.
 Assurance of ownership disclosure.
 Assurance of collectability of receivables.
 Assurance of consideration for returns and allowances.
 Appropriate classification of current and non - current.

AUDIT OBJECTIVES
The audit objectives for the receivables and sales relate to obtain to sufficient competent
evidence about each significant financial statement assertion that pertain to receivables and sales
transactions and balances.
To achieve each of these specific audit objectives, the auditors employ various parts of the audit
planning and audit testing methodology.
The auditors’ objectives in the examination of receivables and sales are:
1. To consider internal control over receivables and sales transactions.
2. To determine the existence of receivables, the clients ownership of these assets, and the
occurrence of sales transactions.

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 3. To establish the completeness of receivables and sales transactions.
4. To establish the clerical accuracy of records and supporting schedules of receivables and
sales.
5. To determine that the valuation of receivables is at appropriate net realizable values.
6. To determine that the statement presentation of receivables and sales is adequate.

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Figure 3.1 Selected specific audit objectives for receivables and sales

Assertion Transaction class Account balance

Category Audit objective Audit objective
Recorded sales transactions represent Accounts receivable include all
Category Existence goods shipped during the period. amounts owed by the customers
or Occurrence Recorded cash receipts transactions exists at the balance sheet date.
represent cash received during the
period.

All sales, cash receipts sales adjustments Accounts receivable include all
Completeness that occurred during the period have claims on customers at the
been recorded. balance sheet date.

The entity has rights to the receivables Accounts receivable at the

Rights and and cash resulting from sales balance sheet date represents
Obligations transactions. legal claims of the entity.

Valuation All sales, cash receipts and sales Accounts receivable represent
adjustments transactions are correctly gross claims, On customers at the
journalized, summarized, and posted. balance sheet date.
The allowances for uncollectible
accounts represent a reasonable
estimate.

Presentation and The details of sales, cash receipts and Accounts receivables are
disclosure sales adjustments support their properly identified and classified.
presentation in the financial statements.

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Category Existence or Occurrence
The existence of accounts receivable is one of the more important assertions because the auditor
wants assurance that this account balance is not overstated through the inclusion of fictitious
customer accounts or amounts. The major audit procedures for testing the existence assertion for
accounts receivable are confirmation of customers’ account balances and examination of
subsequent cash receipts. If a customer does not respond to the auditor’s confirmation request,
additional audit procedures may be necessary.
The possible misstatement that concern the auditor when considering the occurrence assertion is
that cash receipts are recorded but not deposited in the client’s bank account. In order to commit
such a fraud, an employee needs access to both the cash receipts and the accounts receivable
records; segregation of duties normally prevents this type of defalcation. Thus, proper
segregation of duties between the cash receipts function and the accounts receivable function is
one control procedure that can prevent such misstatements.
Completeness
A major misstatement related to the completeness assertion is that cash or checks are stolen or
lost before being recorded in the cash receipts records. Proper segregation of duties and a
lockbox system are strong controls for ensuring that this assertion is met. When a lockbox
system is not used, checks should be restrictively endorsed when received, and a daily cash
listing should be prepared. An additional control is reconciliation of the daily cash receipts with
the amounts posted to customers’ accounts in the accounts receivable subsidiary ledger.
When the client does not have adequate segregation of duties or if collusion is suspected, the
possibility of defalcation is increased. An employee who has access to both the cash receipts and
the accounts receivable records has the ability to steal cash and manipulate the accounting
records to hide the misstatement.
Rights and Obligations
The auditor must determine whether the accounts receivable are owned by the entity because
accounts receivable that have been sold should not be included in the entity’s financial
statements. For most audit engagements, this does not represent a problem because the client
owns all the receivables. However, in some instances a client may sell its accounts receivable.
The auditor can detect such an action by reviewing bank confirmations, cash receipts for

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payments from organizations that factor accounts receivable, or corporate minutes for
authorization of the sale or assignment of receivables.
Valuation
The major valuation issue related to accounts receivable is concerned with thenet 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 accounts is affected by internalfactors such as the client’s credit-granting and cash
collection policies and external factors such as the state of the economy, conditions in the client’s
industry,and the financial strength of the client’s customers.In verifying the adequacy of the
allowance for uncollectible accounts, the auditor starts by assessing the client’s policies for
granting credit and collectingcash. If the client establishes strict standards for granting credit, the
likelihood ofa large number of bad debts is reduced. Generally, the auditor assesses the adequacy
of the allowance account by first examining the aged trial balance foramounts that have been
outstanding for a long time. The probability of collectingthese accounts can be assessed by
discussing them with the credit manager, examining the customers’ financial statements,
obtaining credit reports, or reviewing the customers’ communications with theclient related to
payment.The second step in assessing the adequacy of the allowance account involvesexamining
the client’s prior experience with bad debts. The problem with examining only delinquent
accounts is that no consideration is given to accounts thatare current but that may result in bad
debts. By maintaining good statistics onbad debts, the client can determine what percentage of
each aging category willbecome uncollectible. The auditor can test these percentages for
reasonableness.
Presentation and disclosure
The major issues related to the presentation and disclosure assertion about classification are;
(1) Identifying and reclassifying any material credits contained inaccounts receivable,
(2) Segregating short-term and long-term receivables, and
(3) Ensuring that different types of receivables are properly classified.
In manyentities, when a customer pays in advance or a credit is issued, the amount iscredited to
the customer’s accounts receivable account. The auditor should determine the amount of such
credits and, if material, reclassify them as either adeposit or another type of liability. The second
issue requires that the auditor identify and separate short-term receivables from long-

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termreceivables. Long-term receivables should not be included with trade accounts receivable.
The auditor must also ensure that nontrade receivables are properly separated fromtrade accounts
receivable. For example, receivables from officers, employees, orrelated parties should not be
included with trade accounts receivable becauseusers might be misled if such receivables are
combined.
Disclosure is important for accounts receivable and related accounts. While management is
responsible for the financial statements, the auditor must ensure that all necessary disclosures are
made. Most public accounting firms use some type of financial statement reporting checklist to
ensure that all necessary disclosures are made for each account (completeness).
2.1. Internal control over Sales transactions, and Accounts Receivable

The objectives of internal controls over receivables are to ensure:

a. All goods dispatched are invoiced.
b. Invoicing is at correct price and discount.
c. Goods are only dispatched on credit to approved customers.
d. Invoices are recorded and related to subsequent cash receipts.
e. Receivables are controlled and bad debts pursued.
f. Credit notes approved.

In addition the internal over receivables should be such that the possibility of any falsification of
the receivables accounts is eliminated. An important part of the controls would be to ensure that
the cashier does not have access to the sales ledger, and the sales ledger clerk does not have
access to cash received. Control procedures, over sales and receivables include the following.

a. Orders.
- The orders should be checked against the customer’s account.
- All orders received should be recorded on pre – numbered sales order documents.
- All orders should be authorized before goods are dispatched.

b. Dispatch.
- Dispatch notes should be pre - numbered and a register kept of them to relate to sales
invoices and orders.
- Goods dispatch notes should be authorized as goods leave.

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 c. Invoicing
- Sales invoices should be authorized by a responsible official.
- Sales invoices should be checked for prices and calculations by a person other than
the one preparing the invoice.
- All invoices should be pre – numbered consecutively.
- Copies of cancelled invoices should be retained.
c. Receivables.
- A receivable ledger control account should be prepared and checked to individual
sales ledger balances.
- Receivables ledger personnel should be independent of dispatch and cash receipt
functions.
- Statements should be sent regularly to customers.

e. Bad debts.
- The authority to write off a bad debt should be given in writing and adjustments
made to the accounts receivable ledger.
- The use of court action or write – off of a bad debt should be authorized by an
official independent of the cash receipts function.

2.2 Audit program for Receivables and Sales

The following audit procedures are typical of the work done in the verification of notes,
accounts receivable, and sales transaction.
A. Consider internal control for receivables and sales.
1. Obtain an understanding of internal control for receivables and sales. The auditors’
consideration of internal controls over receivables and sales may begin with the
preparation of a written narrative or flow chart and the completion of an internal control
questionnaire. As the auditors’ confirm their understanding of the sales and collection
cycle, they will observe whether there is appropriate segregation of duties, and enquire as
to who performed various functions throughout the year.
2. Assess control risk and design additional tests of controls for receivables and sales. After
obtain an understanding of the client’s internal control for receivables and sales

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 transactions, the auditors perform their initial assessment of control risk for the variant
financial statement assertions.
3. Perform additional tests and controls: Tests directed towards the effectiveness of
control help to evaluate the client’s internal control, and determine the extent to which
the auditors are justified in reducing their assessed levels of control risk for the
assertion about the receivables and sales accounts. The following are examples of
additional tests:
A. Examine significant aspects of a sample of sales transactions.
B. Compare a sample of shipping documents to related sales invoices.
C. Review the use and authorization of credit memoranda.
D. Reconcile selected cash register tapes and sales invoices with sales
journals.
4. Reassess control risk and design substantial tests. When auditors have completed the
procedures described in the preceding sections, they should assess the extent of control
risk for each financial statement assertions regarding receivables and sales transactions.
The assessment will determine the nature, extent, and timing of auditors’ substantive
tests for receivables and sales.

B. Substantive tests
1. Obtain an aged trail balance of trade accounts receivable and analyses of other
accounts receivable and reconcile to ledgers. When trial balances or analyses of
accounts receivable are furnished to the auditors by the client’s employees, some
independent verification of the listings is essential.
2. Obtain analyses of notes receivable and related interest.
3. Inspect notes on hand and confirm those not on hand with holders.
4. Confirm receivables with debtors.
5. Receive the year-end cutoff of sales transactions.
6. Perform analytical procedures for accounts receivable, sales, notes receivable, and
interest revenue.
7. Verify interest earned on notes and accrued interest receivable.
8. Evaluate the propriety of the client’s accounting for receivables and sales.

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 9. Determine adequacy of allowance for uncollectible accounts.
10. Ascertain whether any receivables have been pledged.
11. Investigate fully any notes or accounts receivable from related parties.
12. Evaluate financial statement presentation and disclosure.

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