7055 Accounts receivable confirmations—Specific considerations

Jun-2020

In This Section

Confirming accounts receivable

Assessment of effectiveness

Combined assessed level of inherent and control risk is normal

Documentation examples for each situation where accounts receivable will not be confirmed

Alternative procedures

Considerations specific to smaller entities

Practice aids

Overview

This topic explains:

• OAG Policy for sending accounts receivable confirmations
• Assessment of effectiveness of confirmations
• Impact of combined assessed level of inherent and control risk on need for confirmations
• Documentation examples for each situation where accounts receivable will not be confirmed
• Application of alternative procedures

OAG Guidance

The following templates are recommended to assist teams in addressing all of the elements relevant to the control, design and execution of accounts receivable confirmation requests:

• Example confirmation letters:
  • Accounts Receivable Confirmation—Balance
  • Accounts Receivable Confirmation—Specific Transaction
• Test of Details Template Menu—Accounts Receivable Confirmation Log Documentation Sheet

OAG Guidance

A conclusion that confirmation procedures would be ineffective may be justified when previous attempts to confirm accounts receivable on an audit client or on audits of similar clients have resulted in inadequate response rates or unreliable responses. However, whether that conclusion is justified will vary based upon the circumstances of the engagement. For example:

• An historical response rate of 35% by number may be considered inadequate if confirmations are consistently not returned by customers with high balances.

• A response rate of 15% by number could be considered adequate if the accounts confirmed provide significant monetary coverage over accounts receivable. [Note: The 35% and 15% are illustrative, not “bright line” cut-offs.]

• Historically confirmation of balances has been requested however the customer may be only able to confirm individual invoices therefore an alternative approach to the confirmation may be required.

• Inadequate or unreliable responses may be due to the nature and policies of the customers. For example, governmental entities may prohibit responses or a client may have a customer base that comprises certain types of commercial customers who have established policies not to respond to requests for confirmations and have communicated such policies to the client.

• Accounts receivable may not be made up of homogeneous customers or balances; therefore, the assertion that confirmations would be ineffective may only apply to certain classes of receivables. Do not “opt out” of confirmation procedures entirely without giving careful consideration to the nature and type of receivables within the account. If it is expected that adequate response rates would be achieved for a material class of receivables, these receivables will be subject to confirmation unless another exception applies.

To be justified in maintaining an approach of not requesting confirmations, keep up to date the evidence supporting the assessment that confirmation procedures would be ineffective. Evidence would ordinarily be obtained periodically (e.g., every three years) or when circumstances change. When we decide to send confirmations with the principal objective of reaffirming our belief that a confirmation procedure would be ineffective, the timing and extent of our work may differ from procedures we would perform if our objective were to obtain substantive audit evidence. For example, we may send confirmations at an early date and fewer requests (i.e., choose a smaller sample or define a smaller target population). Any exceptions noted would need to be properly evaluated, their implications identified and the need for further testing considered.

OAG Guidance

We may be able to justify not sending confirmations when the combined assessed level of inherent risk and control risk for the applicable financial statement assertion(s) is normal, and audit risk can be reduced to an acceptably low level through the performance of substantive analytical procedures or alternative tests of details. In order to conclude that the combined level of inherent and control risk is low, consider the relative risk associated with both inherent and control risk related to each applicable financial statement assertion. For example, inherent risk may be assessed within the normal risk continuum (i.e., not a significant risk), and control risk may be assessed at low (i.e., high controls reliance), resulting in a combined assessed risk of low.

For example, on a large public utility where we have gained significant assurance from controls, we might conclude that confirmation procedures need not be performed for residential customer receivables. Inherent accounts receivables risk will generally not be significant due to factors such as a large number of customers with individually small account balances, simple revenue calculations (customer revenue is a function of the volume used multiplied by the regulated rate per kilowatt) and a highly regulated environment (meter accuracy is closely monitored by a third party local commission which requires periodic calibration).

OAG Guidance

Potential rationale for not sending accounts receivable confirmations	Explanation
Accounts receivable are immaterial to the financial statements	Accounts receivable confirmations have not been sent due to accounts receivable balance of ($x) being immaterial as compared to our assessed level of performance materiality of ($x). Based on our knowledge of the client and the results of our risk assessment analytics, we expect the accounts receivable balance to be immaterial.
The use of confirmations would be ineffective.	Accounts receivable confirmations have not been sent as we know from past experience (confirmations having been sent during the 2003 and 2006 audits), that we have not received more than 8% responses to the confirmations, generally as a result of the fact that most customers are major retailers that do not respond to confirmations as a matter of policy. There are no changes to circumstances this year to indicate that the response rate would improve.
Based on our assessment of risk and assurance from controls testing, the combined assessed level of inherent and control risk over the applicable assertions is acceptably low to allow alternative forms of substantive testing.	The level of inherent risk associated with the existence of accounts receivable was determined to be low as there is no history of material misstatement due to fraud, the revenue and receivables process is primarily automated and consists of routine transactions, and few adjustments were noted during the current and the prior year. The level of control risk associated with the existence of accounts receivable was deemed low as the evaluation of design and testing of operating effectiveness of internal controls relating to the existence of accounts receivable provided a high level of assurance that these controls were operating effectively during the period under audit. Based upon the evaluation above, we assess that the combined level of inherent risk and control risk associated with the existence of accounts receivable is low. The alternative procedures to be performed include the examination of subsequent cash receipts, shipping documents and customer purchase orders. These procedures, when combined with other planned testing will be sufficient to reduce audit risk to an acceptably low level and accounts receivable confirmation requests were not sent.

OAG Guidance

There is no requirement to use confirmations as evidence for the entire account. The testing strategy may combine confirmations and alternative procedures.

The same alternative procedures can be used in the absence of a confirmation request as well as for non-responses to confirmation requests.

When performing alternative procedures, teams need to be aware of the potential fraud risk associated with the client creating fictitious remittances. Therefore testing involves:

• Tracing subsequent cash remittances credited to accounts to remittance advices or deposit slips and bank statements and ascertaining that payments relate to the account balances existing at year end.

• Examining documentation such as shipping documents, copies of sales invoices, customer sales orders and other relevant correspondence supporting the paid and unpaid portion of the account balances. In this scenario it is necessary to exercise professional judgment as to the sufficiency of such procedures recognizing that inspection of information not obtained directly from a third party is not as reliable.

• Considering whether it is necessary to verify further the existence of the customer.

Normally, we perform alternative testing where a response to a confirmation is not received on the full amount that was subject to confirmation. Note: eliminating insignificant invoices (in aggregate do not exceed SUM de minimis level) from follow up may be acceptable.

The extent of alternative testing and the conclusions that we can draw will depend on our risk assessment and materiality to the financial statements as a whole, taking into account aggregation risk, i.e. the risk that differences, which in the disaggregated components/balances are not individually material, aggregate to a material misstatement in the financial statements as a whole. Where alternative procedures are to be applied as a substitute for performing confirmations, selections of individual account balances or individual invoices to confirm can be made by targeted testing and/or use of non-statistical or statistical sampling (see below).

The method of selecting the account balances or individual invoices for confirmation purposes will determine the approach to be taken for performing alternative procedures where confirmation requests are not returned. We need to consider which sampling unit leads to a more effective and efficient sampling application in the circumstances and select the sampling unit that we believe customers will be most likely to confirm.

Targeted testing

When the confirmation request was a targeted test, normally alternative testing would be performed on the full amount that was subject to confirmation, subject to elimination of insignificant invoices. For example:

• If an accounts receivable balance of $100,000 was selected for confirmation using targeted testing and a response to the confirmation request was not received alternative procedures in respect of the balance will need to be performed. If, in this example, the balance is comprised of ten invoices which amount to $75,000 and performance materiality is $250,000 then we can exclude the remaining invoices from the alternative procedures on the basis that the remaining amount is clearly immaterial.

As part of the planning for the test it is useful to determine the threshold of invoices to be subjected to alternative testing. It is recommended that the threshold for not following up on individual invoices be set low enough so there is not a significant impact on the overall level of coverage needed. Therefore, such an approach is generally appropriate where the balance is primarily made up of large invoices and only a limited amount contained in small invoices. Alternatively we may scan the invoices comprising the items not confirmed to identify and test all material or unusual items. When insignificant invoices are excluded from follow up, we evaluate the level of evidence obtained through the reduced targeted testing to verify that we have sufficient evidence to achieve our test objectives.

If alternative procedures are performed on less than 100% of all invoices that make up the balance the coverage achieved from the performance of the test will be reduced to only include those items tested. Using the example above we have obtained audit evidence on $75,000 only and not the original amount selected for confirmation of $100,000.

Non-statistical and statistical sampling

When the confirmation request was a non-statistical or a statistical sampling test, normally alternative testing would be performed on the full amount that was subject to confirmation. In order to design an efficient and effective test it is preferable that the ease in applying alternative procedures be considered. For example:

• Individual transactions defined as sampling unit—it is generally recommended as being more efficient to define the sampling unit as an individual transaction, such as invoices comprising a customer account, as alternative procedures will be performed on the selected invoice and not the entire balance.

• Customer balance defined as the sampling unit—full alternative procedures would normally be applied to the entire customer balance. However this may not be necessary if the timing of the audit allows for sufficient audit evidence to be obtained from subsequent receipts testing of the customer balance.

Accounts receivable confirmation

To further clarify, accounts receivable confirmations are primarily an existence test on accounts receivable. In order to obtain evidence that the accounts receivable balance existed as at the balance sheet date, we need to obtain sufficient evidence that the client has fulfilled the relevant revenue recognition criteria and therefore is entitled to receive the accounts receivable amount.

Generally speaking, cash is not considered sufficient evidence that the accounts receivable existed on or before the balance sheet date and therefore the accounts receivable existed as at the balance sheet date. We expect teams to vouch to other documents such as shipping documents. If you determine that vouching to cash is appropriate, you should document you rationale in your file.

OAG Guidance

For smaller entities the audit may commence well after the entity’s year end and therefore customer remittances for accounts receivable balances outstanding at year end may have already been received. It may be that this is a relevant consideration in addition to the factors for rebutting the presumption that accounts receivable confirmation requests will be sent as described in the guidance above.

Alternative procedures can be performed instead of obtaining confirmations, but on the basis that, in combination with other audit procedures, they will be effective in addressing the risk of material misstatement for all relevant assertions. Therefore, in the absence of substantive evidence of existence, accuracy and completeness that can otherwise be obtained from confirmation of accounts receivable (invoices or balances), the nature and extent of alternative procedures will need to be sufficient to obtain the desired level of audit evidence for each relevant assertion. We need to document the rationale for not requesting accounts receivable confirmations and the basis on which we will obtain sufficient appropriate audit evidence for each relevant assertion.

Take particular care where there are identified significant risks in the area, either due to fraud or error at the assertion level. If we identify a significant risk, our substantive procedures need to be specifically responsive to the risk at the assertion level (as required by CAS 330.21) and confirmations may be the most appropriate response in such situations.

Example

Note: The following example illustrates an approach that may be appropriate in the circumstances explained below. This example is for illustrative purposes only. To the extent that facts and circumstances of a particular audit engagement differ from those in the illustrative example, including additional facts and circumstances, the appropriate judgments of the engagement team may differ from those applied in this illustration. Our audit documentation needs to reflect the specific engagement circumstances and the rationale for the judgments made.

The entity is a smaller entity. The prior year’s financial statements indicate that accounts receivable turn over approximately every 43 days, based on $565,000 of accounts receivable outstanding at year end and $4,800,000 in sales for the previous year. We have been auditing the entity for several years; there are no higher risks identified in revenue or receivables; and the entity’s customer base is very stable with no significant changes year to year. We plan to begin our year end audit work 90 days after year end, and sufficient evidence of settlement of customer accounts receivable is expected to be available because all customer balances, with the exception of delinquent accounts, are expected to be paid or otherwise settled by the time we commence our year end audit work. Based on these factors, and considering the guidance provided earlier in this section regarding timing of the audit, we have determined that confirmations will not be requested on this engagement in the current year. Because the risk for the accuracy and existence assertions in accounts receivable is assessed at the lower end of the normal risk continuum, a low level of planned substantive evidence is considered appropriate. This will be obtained by agreeing customer balances receivable at year end to appropriate evidence, such as shipping documents, sales invoices and tracing cash remittances to customer remittance advices or deposit slips and bank statements and ascertaining that the payment relates to account balances existing at year end by identifying corresponding invoice or order numbers. Customer invoices will be selected for testing using a combination of targeted testing and non-statistical sampling. Our testing strategy for revenue and receivables will also include procedures to address other relevant assertions over accounts receivable (e.g., completeness, cut-off) and also to separately test the entity’s allowance for bad debts. We document the rationale for our decision not to request accounts receivable confirmations and the basis on which we will obtain sufficient appropriate audit evidence for all relevant assertions.

The following templates are recommended to assist teams in determining and documenting the targeted testing, the non-statistical or statistical sampling approach to accounts receivable confirmations and alternative procedures:

• Test of Details Template Menu—Targeted testing or Non-statistical sampling
• Test of Details Template Menu—Accounts Receivable Confirmation Log Documentation Sheet