Chapter Three

Auditing Receivables and sales

Learning Objectives:
After studying this chapter, students should be able to:
 Describe the sources and nature of receivable
 Illustrate financial reporting standards for receivables and sales
 Understand audit Program for receivables and sales Transactions
 Describe audit objectives for the receivables and sales
3.1. 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.
It is important to differentiate the origin and nature of receivables to ensure their appropriate
classification and valuation. Hence, receivable involves an account expected to be collected from
customers by selling/ providing goods or service on credit.
3.2. Financial Reporting Standards
Financial reporting standards for receivables require:
1 Separation of trade from non – trade receivables.
2 Establishment of genuine of trade receivables transactions ensuring “arms length deal”,
and terms of sales.
3 Assurance of ownership disclosure.
4 Assurance of collectability of receivables.
5 Assurance of consideration for returns and allowances.
3.3. Audit Program for Receivables and Sales Transactions
The following audit procedures are typical work done in the verification of notes, accounts
receivable, and sales transaction.
A. Consider internal control for receivables and sales.
sales.
1. Obtain an understanding of internal control for receivables and sales. This 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 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 obtaining an understanding of the client’s internal control for receivables and sales
transactions, the auditors perform their initial assessment of control risk for the variant
financial statement assertions.

3. Perform additional tests and controls:

controls:
Tests directed towards the effectiveness of control help to evaluate the client’s internal

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 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. examines significant aspects of a sample of sales transactions.
B. compare a sample of shipping documents to related sales invoices.
C. reviews the use and authorization of credit memoranda.
D. reconciles selected cash register tapes and sales invoices with sales journals .
4. Re-Assess 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.
3.4. Audit Objectives
The audit objectives for receivables and sales related to obtain sufficient and competent evidence
about each significant financial statement assertion pertaining 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 to:
1. Consider internal control over receivables and sales transactions.
2. Determine the existence of receivables, the clients’ ownership of these assets,
and the occurrence of sales transactions.
3. Establish the completeness of receivables and sales transactions.
4. Establish the clerical accuracy of records and supporting schedules of
receivables and sales.
5. Determine that the valuation of receivables is at appropriate net realizable
values.
6. Determine that the statement presentation of receivables and sales is
adequate.

3.4.1. Selected Specific Audit Objectives for Receivables and Sales

a. Validity
The validity of accounts receivable is one of the more important audit objectives because the
auditor wants assurance that this account balance is not overstated through the inclusion of
fictitious customer' accounts or' amounts, The major audit procedure for the validity objective
for accounts receivable is confirmation of customers' account balances, If a customer does not
respond to the auditor’s confirmation request, additional audit procedures may be necessary.
b. Completeness
The auditor's test whether all accounts receivable have been completely included in the accounts
receivable subsidiary ledger and the general ledger accounts receivable account. The
reconciliation of the aged trial balance to the general ledger account should detect an omission
of a receivable from either the accounts receivable subsidiary ledger or the general ledger
account. If the client's accounting system contains proper control totals and reconciliations, such
errors should be detected and corrected by the relevant control procedures, For example, in the

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sales system control totals exist for daily shipping and billing, Personnel in the Billing
Department would be responsible for reconciling the two totals. If such control procedures do
not exist in a client's accounting system or if they are not operating effectively, the auditor will
trace a sample of shipping documents to sales invoices, the sales journal and the accounts
receivable subsidiary ledger to ensure that the transactions were included in the accounting
records.
c. Cutoff
The cutoff objective attempts to determine whether all sales transactions and elated accounts
receivable are recorded in the proper period. On most audits, sales cutoff is coordinated with
inventory cutoff because the shipment of goods normally indicates that the earnings process is
complete. The auditor wants assurance that if goods have been shipped in the current period, the
resulting sale has been recorded and also that if the sales have been recorded, the corresponding
inventory has been removed from the accounting records. In addition, the auditor needs to
determine if there is proper cutoff for sales returns.
d. Sales Returns Cutoff
The processing of sales returns may differ across entities. When sales returns are not material,
or if they occur on a regular basis, the entity may recognize a sales return at the time the goods
are returned. However, for other entities, sales returns may represent a material amount or may
occur on an irregular basis. In this instance, the client may estimate an allowance for sales
returns. When sales returns represent a material amount, the auditor needs to test for proper
cutoff.
Analytical procedures may be used to test cutoff for sales returns. The ratio of sales returns to
sales may indicate to the auditor that ·sales returns are consistent with expectations and
therefore that the sales returns cutoff is adequate. If the auditor decides to conduct more detailed
tests, the receiving documents used to acknowledge receipt of the returned goods must be
examined. Using procedures similar to those for testing sales cutoff, a sample of receiving
documents for a few days prior to and subsequent to the end of the period is selected. The
receiving documents are traced to the related credit memoranda. Sales returns recorded in the
wrong period should be corrected if material.
e. Ownership
The auditor must determine whether the accounts receivable are owned by the entity. For most of
audit engagements, this does not represent a problem since 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 payments from organizations that
factor accounts receivable, or corporate minutes for authorization of the sale or assignment of
receivables.
f. Valuation
There are two major valuation issues related to accounts receivable. The first issue relates to the
valuation of the revenue and cash receipts transactions that make up· the details of the gross
amount of accounts receivable. The concern here is with the quantity and pricing of the items
included on the sales invoices and the proper recording of cash received, including any
discounts. This affects the gross amount of accounts receivable as well as sales. Tests of
controls' and substantive tests of transactions are normally used to provide evidence about these
types of pricing errors. Pricing errors, especially when the customer has been overcharged or
proper payment has not been recorded, may also be detected via confirmations.
The second valuation issue relates to the net realizable value of accounts receivable. The auditor
is concerned with determining that the allowance for uncollectible accounts, and thus bad-debt

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expense, is fairly stated. The allowance for uncollectible accounts is affected toy internal factors
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
customer's.
g. Classification
The major issues related to classification objective are:
(1) Identifying and reclassifying any material credits contained in accounts receivable,
(2) Segregating shot-term and long-term receivables and
(3) Ensuring that different types of receivables are properly classified.
The auditor should determine the amount of such credits and, if material, reclassify them as
either a deposit or, another type of liability. The second issue requires that the auditor ratify
and separate short-term receivables from long-term receivables. Long-term receivables should
not be included with trade accounts receivable; the auditor must also ensure that no trade
officers’ employees or related parties should not be included with trade accounts receivable
because users might be misled if such receivable are combined. The last two issues are also
related to the disclosures audit objective.
h. Disclosure
Disclosure is an important audit objective for revenue-related accounts. While management
responsible for financial statements, the auditor must ensure that all necessity’s discourses are
made. Disclosure is normally included in a footnote, which describes significant recounting
policies. Most public accounting firms use some type of financial statement reporting checklist to
ensure that all necessary disclosures are made for each account.
Table: Example of Disclosure Items for the Sales and Receivable Cycle
 Sales revenue recognition basis
 Sales revenue recognized under the percentage-of-completion method
 Long-term sales contracts
 Sales revenue by reportable segment of the business
 Sales and receivables from related parties
 Receivables by type (trade officer, employee, affiliate, etc.)
 Short and long-term receivables
 Pledged or discounted receivables