Chapter AUDIT OF TRADE RECEIVABLES ALLOWANCE FOR DOUBTFUL accouNTS AND SALES SS Expected £ earning Outcomes After studying this chapter, you should be able to 1. Describe the auditors’ objectives for the substantive tests of details Of balances of the trade accounts and notes receivable, allowance for doubtful accounts and sales. 2. Explain the nature of the appropriate audit procedures to accomplish the objectives for the audit of trade accounts and notes receivable, allowance for doubtful accounts and sales. 3. Understand and prepare audit working papers to document audit procedures for trade receivables, allowance for doubtful accounts and sales. LUGSCHAPTER 12 CEIVABLES, RE AUDIT OF TRADSUBTFUL ACCOUNTS ALLOWANCE oA p SALES INTRODUCTION . ables from customers are so Closely relateg e sales tions and receivables from ct ¢ ely ; oe se asc msidered jointly in a discussion of auditing objectives ang the (wo can best be c audit procedures. of transactions of the revenue ang Is and substantive tests S ia oa 6. Tests of details of balances for the collection cycle are covered in Chapter 6. 7 revenue and collection cycle are studied in this Chapter. Our discussion of substantive tests of details of balances focuses on accounts and notes receivable trade, sales, and allowance for doubtful accounts. AUDIT OBJECTIVES AND PROCEDURES. The audit program and relative audit objectives for year-end substantive tests applicable to accounts and notes receivable is presented below: Assertions Audit Objectives Audit udit Procedures | [| Exslence a Occurence YA To determine that | 7. Obtain schedule af G05 ights and obligations teceivables exist and trade accounts receivable | a bona fide and notes receivable | obligations owed to the schedule and reconcile | company as of the ledgers. Statement of _financi : pearl ial | 2. Confirm receivables wil debtors. 3. Inspect notes on hand. 4. Perform analytical | Procedures to deter | whether recorded sales | and receivables balances | appear reasonable.—_— iy, Completeness | : Audit of Trade Receivables ...__ 387 To determine that transactions eceivables have bee; ded in th © proper accounting periog. em | Test cutoff of sales and | returns to | whether | ables are recorded in the proper accounting | lermine that | 6 ew colby er | mn al iew collectabiity ol Teceivables are recorded feoriae me "sd and presented at proper | determine the adequacy amounts in accordance | _of allowance for doubtful with PRS, accounts. 7. Recaloulat | | income fr receivable Pesenaon and ]D. To determine thatthe | 8. Evaluate financial | receivables are properly statement presentation | Presented and classified and disclosure of in the statement of | receivables, | financial position. 9. Obtain written dient | 1 | representations regarding | | felative to pe 7 Valuation or Allocation | | | the interes pledge, discount or | assignment of receivable, | and about receivables from officers, directors, | affliates or other related parties. Discussion of Audit Procedures 1. Obtain a schedule of aged accounts receivable and notes receivable and reconcile to ledgers. ule of trade accounts receivable at the audit date is 2 auditors by employees of the client. If may of customers’ accounts, (2) the estimating, 3) the controlling of confirmation request. ings, cross footings and aging especially ‘urrent, as well as those shown as past due. Id be traced to the subsidiary ledgers. The y client personnel should also be compared unts. Also, the balance of the subsidiary ified by footing the debit and credit columns illustrates the working papers for accounts 2. shows the working papers for notes358 Chapter 12 “sping Schedule - ts Receivable Aging Figure 12-1: Accoun i - XYZ Corporation hedule seivable ~ ne | Accounts Re pons ember 3, 2 i: — Aging Distribution _ seo) EE sienna Dt ee Subsequent | [Balance | Collection up iy | 1-60 | 61-90 |Over 90] ixy | aoe | ae Px 7 { onesies [_NCompany 7 [__ O Enterprises mx | P incorporated = =+— = —| [Balance per books Pax |v Px zn (Add (Deduct) Adjustments | 1) To reclassify account | with credit balance - | N Company xx | 2) To write-off definitely uncollectible account - P Inc. (ox) xx tas i 7 7 " Xe | Balance as adjusted Pxx Pxx Px Pxx Pxx Y Traced to the general ledger Aging distribution checked ! Official receipts inspected 7 Traced,XYZ Corporation Notes Receivable |-—____ December 31 j Note [| “Interest [nimber | “Waker ornare _| Interest 052 A Corp. | 41/302x7_| 21618 -|— 058 BCom. | 1240/x7 | 2A101x8 [060 | C Corp. “| 12/207} roa a D Corp. | 12/307x7_|~3/a0xg [Balance per ledger r |Add (Deduct) 'Adjustment [(t) To classify past due note - A Corp [Balance per audit C Confirmed by maker | Confirmation replies on separate file | Y Traced to the general ledger | | Inspected promissory note | ‘Computations verified Prepared by: _[__ Reviewed by | inital [ Date | Initial [ Date 2. Confirm receivables with debtors. debt is the most essential and conclusive step istence of accounts receivable. The following le may be confirmed by either the positive negative method or by a combination of the_ - ae tre 360 Chapter 12 fer ositive Meth are relatively large. When to use P' lances af account balar ( Individual ace elieve that there may be a substantia eason to bt b ) There is reas0 eve that with inaccurae; ( number of accounts 1 disp! uracies irregularities. (3) Internal substan (4) Internal control system | ntiating evidences are not adequate. 5 weak. when: Negative form is useful : surrounding accounts receivable j, is (1) Internal control considered to be effective. (2) A large number of small balances are involved. (3) The auditor has no reason to believe that persons receivin the requests are unlikely to give them consideration. § In many situations, a combination of two forms may be appropriat iate with the positive form used fe for large bal i ee ge balances and the negative form Figure 12-3 and 12-4 j 5 5 -4 illustrate the iti . confirmation requests, respectively. Positive and negative forms of b) Timing of confirmation Accoun: nfirmed either at confi is n i mation oo or at an interim ecessary for th ures are carried prior In the recej © auditor to review the firmation and ivables control accounts Sider confirm the statement of financial he or she 'g any accounts with large ; Considers to be unusual thatAdit of Trade Receivables esl Figure 12-3: Positive Form of Accounts ar Receivable Confirmation Request XYZ Corporation aa 1997 Star Avenue | Makati City MNO Company 222 Aquino Avenue | Parafiaque, Metro Manila | 1 | January 10, 20%8 | | Dear Sirs: | Please confirm directly to our auditors | K. B. Cabrera and Company 6705 Ayala Avenue | | Makati City | | | | the correctness of the balance of your account payable to us as shown below and on the | | enclosed statement at December 31, 20X7. If the amount is not in agreement with your | | records at that date, Please provide any information which will aid our auditors in | | reconciling the difference. | Your prompt return of this form in the enclosed stamped envelope is essential to the | completion of the auditors’ examination of our financial statements and will be | appreciated. | | XYZ Company | | By Weguet deta Crucy (Controller) BUT MERELY FOR CONFIRMATION OF YOUR ACCOUNT g a balance of P40,000 due XYZ Corporation at noted below: MNO Company By Oe a~~ eivable Confirmation cone fAccounts Receivab — Form 0 Negative west oe = Req ai ir does not agree with your records, Pleas -areful Figure 12-4: amine this statement CF Hccers differences to our auditors. KB. Cabrera and Company. 6705 Ayala Avenue Makati City for your convenience. | A business reply envelope requiring n° postage is enclosed for y‘ l THIS IS NOT A REQUEST FOR PAYMENT. c) Extent of confirmation In the audit of companies with reasonably adequate systems of internal control, the confirmation process 1s limited to a sample of the accounts receivable. The sample should be sufficiently large to account for most of the peso amount of the receivables or it should be sufficiently representative to dater the drawing of invalid inferences about the entire population of receivables. The size of the sample will depend upon (1) the materiality of account receivable in comparison with total assets. The size of the sample should be relatively large if accounts receivable are a relatively large asset; (2) the auditor s evaluation of the system of internal control. Weaknesses in internal control call for larger samples than wi iternal control is strong. of confirmation tests in prior year. Significant Prior year’s confirmations signals the need for pirmation of this year’s receivables; and F oie Positive and negative form of * the number of confirmations is ed when the Negative form is is used. 3F == ii) Sec a Audit of Trade Receivables .. 363 nd confirmation le ‘Mers to the debtors After a lapse a lapse of re request for confi ae time and no replies are received, a second inailead' se 'on Of accounts and notes receivable may be envelopes bearing the CPA y stamped business. repi firm's return address. A ¥ envelope addressed to the office of the i ith the request. The aud hould ti to include wil quest. The auditors should try the confirmation from the details of the transactions such as stat: ement of account or customer's purchase order number. iii) investi : iii) Investigate any exceptions noted b customers to recorded balances The auditor should resolve unusual or significant differences reported by customers. Other exception may be turned over to employee of the client with the request that investigation be made and explanation furnished to the auditors, When replies are not steceived on accounts with substantial balances, the auditors should verify the existence, location and credit standing of the debtor by reference to credit agencies or other sources independent of the client as well as establish the authenticity of the underlying transactions by examination of supporting document such as contract, customer purchase orders and copies of sales invoices and shipping advices. The auditor should likewise investigate thoroughly if an excessive number of confirmation request to individual debtors are returned by post office as they may represent fictitious names included by employees of the company engaged in accounts receivable fraud. iv) Prepare the summary of the results of confirmation nfirmation may be prepared (Figure 12-5) ion and conclusions of the investigation rking paper. auditors should be enclosed wi any confirmation which are not of any customers who fail to respond to uests, the auditor may perform the364 Chapter 12 ; uibsequent to the confirmation date hecks or remittance advices, ounts collected to the individual ash receipts and to the 1. Examine collections made by inspection of incoming ¢ 2. Trace invoice number nd any or count and to the recor’ customer's 4 bank deposit 3, Examine the cust records, and the : 4. Perform analytical procedures for comer's purchase order, the client's: shipping les invoice. accounts receivable. Figure 12-5: , of the Results of Confirmation XYZ Corporation Summary of Results of Positive Confirmation ‘Accounts Receivable December 31, 20%7 ae Sea ; [Amount [7 Confirming balances (CB) Prx | “Reporting differences (RD) = z Portion confirmed “Portion excepted to Returned by post office (RPO) "No replies (NR) _ Total confirmation sent Total of accounts Per Cent of Confirmations Sent to total of accounts _ aterial differences been adjusted or salisfactory ceed? ifferences nol adjusted or ar Mes on hand, should generally inspec of nd any ally inspect all of the act for the notes, prefe he actual notes and an 'S, preferably simult ig Qf ~ ) aneous, with the ing of oe di 7 counting 0! aoe of securities, However, if there are great numbe! ceivable, the auditor er eee ample te, the auditor might consider exam ining only a sample g or sa 10, if some of the n mh , oles are held by ome vison cie he 8 confirmation to the holder of thea ae ote peerAudit of Trade Receivables 36S 4. Perform analytical procedu res otermi sales, and interest revenne fo determine whether the receivables, balances appear reasonable. The auditor should s compare significant See cA Statistics related to ac Raa i able with those of the prior y highlight i et Teese ut in the client's collection efforts that may collectability of accounts receivable. This procedure may be used evaluate Y i also to evaluate the overall reasonableness of accounts receivable. These statistics include counts and This procedure can (1) Ratio of accounts receivable to sales; (2) Ratio of overdue accounts to total accounts receivable; (3) Number of average day’s sales in accounts receivable; (4) Average annual accounts receivable turnover, (5) Percentage of bad-debts expense to the total sales; (6) Ratio of the valuation allowance to accounts receivable; and (7) Ratio of interest revenue to notes receivable. 5. Test sales and sales returns cutoff to determine whether receivables are recorded in the proper accounting period. The auditor usually tests the sales cutoff by examining invoices and shipping documents for several days both before and after the year-end and by tracing such documents to the sales and account receivable fe period. This test of sales cutoff may an interim date to check the adequacy of the 1! substantial sales returns after the statement of ould also be reviewed carefully as they may corded at year-end. receivables and determine the adequacy of counts. bility of accounts receivable, and evaluating the ce for doubtful accounts, the auditors may take receivable listed in the aging schedule equent to the statement of financial366. Chapler 2.0 oo a ite. Jit ratings for delinquent and unusually large accounts, 2 credit £2 = e cree ‘ons for indication of amounts ip ible uncollectible account. (2) Determin: (3) Evaluate confirmation except clues as to poss! dispute or other clues as : hose accounts considered to be i i rth (4) Summarize in a working pape! ie preceding procedures. Lig i don pr doubtful of collection base: : auaes names, doubtful amounts and reasons, considered doubtful e credit manager the current status of each doubtful (5) Confer with the ction taken and the opinion of account ascertaining the collection a aken : the credit manager as to ultimate collectibility. Provide for the estimated losses on accounts considered by the auditors to be uncollectible. Confer with client’s legal counsel. 7. Recalculate the interest income from notes receivable. The most effective’ verification of the Interest Earned account consists of an independent computation by the auditors of the interest earned during the year on notes receivable. The interest section of working paper consists of four columns showing for ach note receivable owned during the year the following information: a) Accrued interest receivable at the beginning of the year. b) Interest collected during the year. interest receivable at the end of the year. ned during the year. mncial statement presentation and disclosure of btain written client representation: a : S regarding pledge, ‘signment of receivable, and about receivables from rs, affiliates or other related Parties, ee eae audit procedures mentioned, the auditor i of the minutes of directors’ meeting and confirm with 'ng or assigning of accounts receivable,Audit of Trade Receivables 367 IMustrative Audit Case 12.1 During the annual audit of ©, ‘okie account, entitled receivables Cor poration, y and payables ou encountered the following | Debit | Credit P16 00 vable,long-tecm, I Expected cumulative losses c on bad debts. 80,000 | Due from employee: Cash dividends payable [Special receivable, dishonored note’ Accrued wages OO Deferred rentrevenue Insurance premiums paid in advance a 2,200 | 22,000 | * Collection probable in two years. Required: 1. Give the journal entry to eliminate the above account and to set up the appropriate accounts to replace it. 2. Show how the various items should be reported on a current statement of financial position. 12-1 156,000 loans to employees _|Requirement (2) “Accounts receivable ~ trade_ Tess Allowance for doubttul a¢ “Current assets. Other assets: : [Receivables arising from dishonored note ‘Current liabilities: 62,0 Accounts payable - trade sa Cash dividends payable 3000 Wages payable 2 Rent revenue collected in advance A Long-term liabilities: Mortgage payable 40,000 Illustrative Audit Case 12-2: Sales Cut-off Examination You have been asked to audit the records of XYZ Manufacturing Company, a small manufacturer of precision tools and machines, for the year-ended December 31, 20X7. Your examination of sales transactions revealed among others the following: L Some machines have been shipped on consignment to XYZ’s regular dealers, These transactions have been recorded as ordinary sales and billed December 31, 20X7 the machines billed and in the hands of unted to P130,000. Sales price was determined by adding , Faia nachines were shipped to a customer on FOB © sales was entered in the records on January 5, was received in the amount of P13,000. Dareccn 31, 20x7 included goods sold during Bel ie ut returned on December 15, 20X7. No entry pai Ne customer * account for the goods returned. The at selling price which was 103% of cost ring Comp any, ee : 7 the above 'y. what adjusting journal entries findings?g LT, : Audit of Trade Receivabl zZ sion its le Receivables 309 ive Audit Case 12-7 phe following are the recommende " Hadjus XYZ Manufacturing Company as of yee tine shits to correct the accounts of as of December 41, 20X7 for Audit Finding No. 1 { AJE (1) | Sales i 430,000 Accounts receivable | 130,000 To reverse the entry made fo record deliveries fo consignoes which aro stil unsold as of 12/31/X7, a of sales - Inventories, 12/31/X7 fa To include goods in the hands of consignees. For Audit Finding No. 2 AJE_(3) | Accounts receivable __ [13,000 Sales [ 43,000 To record the sale of machines shipped on 12/31/X7. FOB shipping point For Audit Finding No. 3 AJE_(4) | Sales retums and allowances 6,500 ivable 6,500 turned by customer. ntories, 12/34/X7 1,500 1X7 1,500 yment of inventories.aE i lytical Procedures j it Case 12-3: Application of Analy’ fn Mlustrative Audit Case 12~! Auditing Doubtful Accounts 20N7 Annual Report follow ; the Southeast _ Titanic is the parent company : : a Region. Excerpts from Titanic , Rui of five Pharmaceutical companies in __(P-mi eres | me OXTe income Statement _____—_—\pi7 464 [Revenues Og Netincome Statement of Financial Position | Current assets fe Receivables, less allowance for uncollectibles of P338 and P308, respectively 3,052 | _P3,078 | Footnotes Provision for uncollectibles P385 P3565 Required: Answer the following questions assuming that (a) Titanic uses the allowance account to record bad debts (provision for uncollectibles) and (b) all revenues are credit sales. uncollectible. accounts increasing or decreasing as a enues? Write-offs of accounts receivable were recorded during Hlected on receivables during 20X7?solution: Mustrative Audit Case 12-3 Audit of Trade Receivables 374 Requirement () (Amount in P millions) e estimated uncollecti 7 Th ie ctible accounts are decreasii - as shown below: reasing as a percentage of revenue ———— (Estimated bad debts: |” P355 / P15,998 P385 | P17,154 Requirement (2) (Amount in P millions) Net write-offs in 20X7 are P355 as derived below: | Allowance for doubtful accounts: Beginning balance 308 | Add bad debts expense 385, P693 | Less ending balance 338 | L_ Net write-offs P355 | Requirement (3) n 20X7 is P16,795 as derived below:372_ Chapter Antowance for Doubtful Accounts of Alloy ange Corporation. Orange ras a high rate of bad debts. On adjustments, Orange's Accounts ‘Allowance for Doubtful Accounts ported in the stateme! ts will be based on the aging ive Audit Case 12-4: Audi appointed external ‘an industry thal Mustrat wditor of OF You have been Corporation operates 7 aan December 31, 20X7, before any year ene Receivable balance was P600,000 ane a balance was P25,000. The year-end bal aA scoun position for the Allowance for Doubtful Ac schedule shown as follows: ea Probability of Time Collection Outstanding | zs 98 to fe 90 - aoe eee ~ 46-60 days 10 65 61-75 days 00 I Over 75 days 10,000 e Required: As an auditor, you have to determine a) The appropriate balance for the Allowance for Doubtful Accounts of December 31, 20X7. b) How Accounts Receivables would be presented on the statement of financial position on December 31, 20X7 c) The peso effect of the year-end bad debts adjustment on the pre-tax income for 20X7. Solution: Wustrative Audit Case 12-4 for Doubtful Accounts should have a balance of P48,500 on lations are shown below: Expected Percentage Foner Uncollectible Estimated Unoolectible_| P 6,000 Amount 300,000, 200, nls in op Pitpon ates ton nd Over 75 days (P10,000) and have zero c rhe Aly immediately and not be considered when Allowance for Doubtful Accounts. have been outstandiAudi Of Trade Receivable 373 : Accounts receivable Less: Allowance for doubrfyj accounts Net accounts receivaty le ¢) The year-end bad debt adjust tme as shown below: 'ent Would dec ‘AS pretax income P33,500 for 20%5 Estimated amount Fequired in the Allo Balance in the account after w 6 for Doubitul Accounts 1d accounts but before Illustrative Audit Case 12-5; Accounts During the course of the audit of th year ended December 3], 20X7, by the following items: ¢ financial statements of Crome, Inc., for the You examined the notes receivable represented }) A four-month note dated November 30, 20X7, from the Aeon Company, P10,000; interest rate, 16 Percent; discounted on November 30, 20X7, at 16 percent. 2) A draft drawn payable 30 days after due for P45,000 by the Benton Company on the Dodge Company in favor of the Gerrad Company, endorsed to Crome, Inc., on December 2, 20X7, and accepted on December 4, 20X7. 3) A 90-day note dated November 1, 20X7, from J.C. Cruz of P25,000; interest at 16 percent; the note is for subscriptions to 250 preference shares per share. May 3, 20X7, from the National Investment rest rate, 16 percent; dishonored at maturity; tober 10, 20X7. Collection doubtful. (No interest nuary 4, 20X7, from Romeo Paz, president of st; not renewed, president confirmed eptember 14, 20X7, from the Samson Company, percent; note is held by bank as collateral. note, Interest Expense was debited foe the edited for the revenue.374 Chapter 1? Required: From the information preset a. Working papers b. All necessary audit adjustments, and prepaid Statement of financial December 31. Solution: Mustrative Requirement (a) ated, prepare th position presenta ——GRONE, INC. December 31, 20X7 ntries for interest accrue tion of the notes receivable as of ATE [Remarks Maker [oie Eamed eon Company | 130X7 fon 111300K0 at 16% | TaaIKT ‘Accepted by Dodge 7 Co.on 1a4x0 | J.C. Cruz TiHiXT ‘Subscription | | Recelvableon | | cela preference shares ‘Nabonal ‘Bu 3IXT Dishonored at | Investment Co. ‘maturity; collection | Romeo Paz “ix ay Presa | | ‘of Crome; not paid | | at maturity nor | eam | A aera ean | ny | as collateral —| | \ \ aan \ Traced to generat ledger © Traced to oficial receipt * Computation verified © Confirmed by makor eee ae eeeee Ae srirement (8) —_Audit of Trade Receivables ..__375 Adjusting Journal Entries feee(t) Subscription receivable = Notes receivable — 25,00 : 0 | 25,000 | (2)_ Accounts receivable Notes receivable ce 30,000 Interest income “800 | (3)_Advances to officers 8,000 | Notes receivable 8,000 | _(4) Prepaid interest 421 l Interest income 400 | Interest expense 421 Unearned interest 400 (6) Interest receivable 947 interest income (P1,747 - P800) aid discounted amounting to P10,000; as collateral for a loan) P51,000 25,000 8,000