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SUBSTANTIVE TESTS
8 OF RECEIVABLES AND SALES
8-1. Tests of details of financial balances are designed to determine the reasonableness of
the balances in sales, accounts receivable, and other account balances which are
affected by the sales and collection cycle. Such tests include confirmation of
accounts receivable, and examining documents supporting the balance in these
accounts.
Tests of transactions for the sales and collection cycle are intended to determine the
effectiveness of internal control structure and to test the substance of the
transactions which are produced by this cycle. Such tests would consist of
examining sales invoices in support of entries in the sales journal, reconciling cash
receipts, or reviewing the approval of credit.
The results of the tests of transactions will be used to affect the procedures, sample
size, timing and particular items selected for the tests of details of financial
balances (i.e., an effective internal control structure will result in reduced testing
when compared to the tests of details required in the case of an inadequate internal
control structure).
8-2. There are two common types of confirmations used for confirming accounts
receivable: positive confirmations and negative confirmations. A positive
confirmation is a communication addressed to the debtor requesting him to
confirm directly whether the balance as stated on the confirmation request is
correct or incorrect. A negative confirmation is also a communication addressed
to the debtor, but it requests a response only when the debtor disagrees with the
stated amount.
A positive confirmation is more reliable evidence because the auditor can perform
follow-up procedures if a response is not received from the debtor. With a
negative confirmation, failure to reply must be regarded as a correct response even
though the debtor may have ignored the confirmation request.
When the above conditions do not exist, it is acceptable to use negative confirmations,
but negative confirmations should not be used if the auditor believes the customer
is likely to ignore the confirmation. Typically, when negative confirmations are
used, the auditor is using a reduced control risk assessment in the audit of
accounts receivable. It is also common to use negative confirmations for audits of
hospitals, retail stores, and other industries where the receivables are due from the
general public. In these cases, far more assurance is obtained from tests of
internal control than from confirmations.
8-3. It is acceptable to confirm accounts receivable prior to the balance sheet date if the
internal control structure is adequate and can provide reasonable assurance that
sales, cash receipts and other credits are properly recorded between the date of the
confirmation and the end of the accounting period. Other factors the auditor is
likely to consider in making the decision are the materiality of accounts receivable
and the auditors experience in prior years. If the decision is made to confirm
accounts receivable prior to year end, it is necessary to test the transactions
occurring between the confirmation date and the balance sheet date by examining
internal documents and performing analytical procedures at year end.
(a) When confirmation requests are mailed to debtors whose accounts were
written off as uncollectible, the auditors purpose is to determine that the
receivables were genuine when they were first recorded in the accounts. In
some fraud cases, fictitious accounts receivable have been created to cover up
a shortage. Eventually these fictitious receivables must be disposed of; one
method is to write off the fictitious accounts as uncollectible.
(b) The South executive appears to believe the auditors are solely concerned with
the collectibility of accounts and notes receivable. In fact, the confirmation
process is primarily intended to establish that the receivables are genuine and
Substantive Tests of Receivables and Sales 8-3
that the customers (or makers of notes) exist. Other audit procedures are
followed to determine collectibility.
8-5. The confirmation requests should go to the makers of the notes regardless of whether
the notes have been discounted. The act of discounting a note receivable does not
reduce the importance of the note being genuine and collectible. A company
which discounts its notes receivable remains in a position of sustaining a loss if
the makers of the notes fail to make payment at the maturity dates.
8-6. (a) When customers fail to respond to positive confirmation requests the CPAs
may not assume with confidence that these customers reviewed the requests
and found no disagreement and therefore did not reply. Some busy customers
will not take the time to review confirmation requests and will not respond;
hence, obvious exceptions may exist without being reported to the CPAs.
(b) If there is no response to a second request, the CPAs may mail a third request
and possibly make telephone calls in an effort to get a reply directly from the
customer. When it becomes apparent that the confirmation program will not
produce further evidence, the CPAs should consider each remaining customer
as to the size, nature, and age of the balance and the apparent reason for the
lack of a reply before they decide what additional work is necessary in the
circumstances. The CPAs should carry out the alternative audit procedures of
examining customers purchase orders or contracts, shipping documents and
sales invoices of the client, and remittances by nonconfirming customers
received by the client subsequent to the balance sheet date. The auditors may
also verify the existence, location, and credit standings of the nonconfirming
customers by reference to credit agencies or other sources independent of the
client.
No, the matter remains unresolved. First, oral evidence from the client is never in
itself sufficient; the auditors must follow up to determine the reliability of the oral
evidence. Second, payment of an account receivable is not confirmation; the
account might be fictitious, and the payment could have been made by a
dishonest employee who had created the fictitious account to conceal a cash
shortage. The auditors must examine the customer purchase order or contract, and
copies of the sales invoice and shipping document, in support of the unconfirmed
receivable. They should also determine the genuineness of the customer by
reference to the telephone directory or to credit agency reports.
1) The workpaper does not state whether the auditor traced the ABC
Grocery remittance of P3,000 to November cash receipts.
2) The workpaper does not state whether the auditor examined the
November 2 credit memo issued to Sari-Sari Store.
3) The workpaper does not state whether the auditor traced the Lucenas
Meat Market remittance to November cash receipts.
4) The workpaper does not state whether and how the auditor obtained
satisfaction regarding confirmation requests not returned.
5) The workpaper does not state whether the auditor examined
documentation for the Dianas Supper Club order returned and received
on October 31.
6) Rather than summarizing the confirmations returned without exception,
as was done at the bottom of Working Paper 1, these confirmations
should have been listed separately.
b. 1) Sales P11,100
Accounts receivable P11,100
Inventory 8,600
Cost of goods sold 8,600
To reverse 2007 sale recorded in 2006.
4) Sales 13,000
Accounts receivable 13,000
To correct error in recording customer
remittance as a sale.
Inventory 250
Cost of goods sold 250
Substantive Tests of Receivables and Sales 8-5
To record return and restore meat to inventory
because meat returned in good condition.
c. (See completed Exhibits 1.1 and 1.2 reproduced below and on the following
page.)
Exhibit 1.1
Exhibit 1.2
AJE 2 (1,277)
P13,723
AJE 6 P10,777
AJE 6
For all of the exceptions, the auditor is concerned about four principal things.
(a) Whether there is a client error. Many times the confirmation response
differences are due to timing differences for deposits in the mail and
inventory in transit to the customer. Sometimes customers misunderstand the
confirmation or the information requested. The auditor must distinguish
between those and client errors.
(b) The amount of the client error if any.
(c) The cause of the error. It would be intentional, a misunderstanding of the
proper way to record a transaction, or a breakdown of internal control.
(d) Potential errors in the sample not tested. The auditor must estimate the error
in the untested population, based on the results of the tests of the sample.
Requirement (a)
Ken Company
Accounts Receivable Aging Schedule
May 31, 2006
Requirement (b)
Ken Company
Analysis of Allowance for Doubtful Accounts
May 31, 2006
June 1, 2005 balance P 30,250
Bad debt expense accrual (3,000,000 x .04) 120,000
8-10 Solutions Manual to Accompany Applied Auditing, 2006 Edition
Requirement (c)
1. Steps to Improve the 2. Risks and Costs
Accounts Receivable Situation Involved
Establish more selective credit-granting This policy could result in lost sales and
policies, such as more restrictive credit increased costs of credit evaluation. Ken
requirements or more thorough credit rating may be all but forced to adhere to the
investigation. prevailing credit-granting policies of the
office equipment and supplies industry.
Establish a more rigorous collection policy This policy may offend current customers
either through external collection agencies and thus risk future sales. Increased
or by Kens own personal. collection costs could result from this
policy.
Charge interest on overdue accounts. This policy may offend current customers
and thus risk future sales.
Insist on cash on delivery (COD) or cash on This policy could result in lost sales and
order (COO) for new customers or poorer increased administrative costs.
credit risks.
Requirement (a)
DEMO INC.
Accounts Receivable
12-31-05
DEMO INC.
Allowance for Doubtful Accounts
12-31-05
Balance per Ledger P12,000.00
Add (Deduct) Adjustments:
AJE (1)to correct error in recording bad debts recovery 324.00
(2)to correct understatement of accounts written off ( 200.00)
(3)to write off definitely uncollectible accounts ( 1,000.00)
(4)to adjust allowance to required balance ( 6,359.80)
(Schedule 1)
Balance as adjusted P 4,764.20
Schedule 1: Computation of Required Allowance
Adjusted Required Allowance
Account Classification Total % Amount
0-1 month outstanding P 95,240 1 P 952.40
1-3 months outstanding 77,320 2 1,546.40
3-6 months outstanding 22,180 3 665.40
over 6 months outstanding 5,000 P2,000-50% 1,000.00
_______ P3,000-20% 600.00
Totals P199,740 P4,764.20
8-12 Solutions Manual to Accompany Applied Auditing, 2006 Edition
Requirement (1)
Current assets:
Accounts receivable, trade....................................... 40,000
Less allowance for doubtful accounts...................... 500 P39,500
Creditors debit balances.......................................... 450
Due from officers**................................................. 2,500
Subscriptions receivable ordinary shares**.......... 4,600
Expense advances to salespeople............................. 1,000
Substantive Tests of Receivables and Sales 8-13
Current liabilities:
Accounts payable, trade........................................... 19,250
Customers credit balances...................................... 2,000
Cash advances from customers on sales
(not yet shipped)................................................... 450
Salaries payable....................................................... 3,300
* These amounts are netted against normal balances to reflect control balances;
but if material in amount, they should be reported separately on the balance
sheet as indicated in Requirement 2.
** Considered as current assets only if currently collectible. All items are
assumed to be material in amount.
a
P2,500 + P500 + P300 = P3,300
b
0 + P90,000 - P78,000 - P2,500 = P9,500
c
P4,600 + P700 + P400 = P5,700
d
P9,500 + P158,000 - P8,500 - P134,000 - P500 - P4,600 = P19,900
e
Estimated. The bad debts written off in the third year following the sale have
averaged about 7.8% [(P300 + P400) (P3,300 + P5,700)] of the total actual bad
debts in the previous 2 years. Therefore, the bad debts on 2005 sales of P6,200 and
P1,000 are about 92.2% of the total bad debts expected on 2005 sales.
f
P19,900 + P210,000 - P200 - P14,200 - P178,800 - P300 - P700 - P6,200 = P29,500
2. Bad debts estimated as a percentage of year-end accounts receivable
P29,500 + P235,000 - P300 - P19,500 - P400 - P1,000 - P200,000
= P43,300
P43,300 x 0.285 = P12,340.50, or approximately P12,300. Criteria for
recognition of bad debts or impairment of receivables under PAS 39
should be applied.
Requirement (1)
Flores Corporation
Analysis of Changes in the
Allowance for Doubtful Accounts
For the Year Ended December 31, 2006
Schedule 1:
Computation of Allowance for Doubtful Accounts
at December 31, 2006
Aging category Balance Percent Doubtful accounts
November-December 2006 P1,140,000 2 P 22,800
July-October 600,000 10 60,000
January-June 400,000 25 100,000
Prior to 1/1/06 70,000 a 75 52,500
P235,300
a
P130,000 - P60,000
Requirement (2)
Flores Corporation
Journal Entry
December 31, 2006
Requirement (a)
Visayas Company
Accounts Receivable
12.31.06
Requirement (b)
Supporting Analysis:
Current Assets
Accounts Receivable - Trade P59,500
Claims Receivable 500
Advances to Employees 500
Advances to Supplier 5,000
Investments
Advances to Affiliated Company 10,000
Other Assets
Deposit on Contract 15,000
Shareholders Equity
Subscribed Share Capital (net of subscriptions
receivable of P15,000) xxx
Supporting Analysis:
Charry Company
Accounts Receivable -Trade
12-31-06
If correct entries were made for the transactions given, the Accounts
Receivable account would show the following postings:
Accounts Receivable
Jan. 1 Balance P 56,000 Collections P615,000
Charge Sales 625,000 Write offs 3,500
Recoveries of Merchandise returns 2,500
accounts written off 1,000 Allowance for shipping
________ damages 1,500
P682,000 P622,500
________ Balance Dec. 31 59,500
P682,000 P682,000
Requirement (1)
(a) Prestons earnings would have increased (1 0.40) P105 million or P63
million in 2006. Net accounts receivable and total assets would have been
P105 million higher than actually reported in 2006. Ignoring differences
between tax and financial reporting, income tax payable would have
increased by P0.40 (P105 million) or P42 million, and retained earnings
would be greater by P63 million. This example illustrates the material effect
estimated bad debts can have on reported earnings and total assets.
(b) Under the allowance method, failure to write off an account has no effect on
earnings (assuming a sufficient balance exists in the allowance account), or
any net balances in the balance sheet. Only the components of net accounts
receivable would be affected. Both gross accounts receivable and the
allowance for doubtful accounts would be overstated P0.6 million.
8-18 Solutions Manual to Accompany Applied Auditing, 2006 Edition
Requirement (2)
1998
Beginning allowance balance P183
Bad debt expense 105
Ending allowance balance (212)
Write-offs of accounts P 76
Requirement (3)
(a) The ratio of bad debt expense to operating revenue for the two years is: 2006,
P105/P3,729 = 2.8%; 2005, P81/P3,534 = 2.3%. This ratio appears relatively
stable although is increasing.
(c) Bad debt expense is considerably higher than the write-offs in 2006. The
firm has experienced an increase in expected write-offs. Apparently the firm
expects an increase in bad debts, which is partially an estimate of future
write-offs.
Requirement (1)
Requirement (2)
Correction and Collection Schedule:
Note Receivable
Date Explanation and Interest Revenue Chang Balance
e
1-1-2005 Recorded originally at face amount P150,00
0
12-31- Correction to restate to present P 106,767
Substantive Tests of Receivables and Sales 8-19
2005 value 43,233
12-31- To accrue interest, P106,767 x + 12,812 119,579
2005 12% = P12,812
12-31- To accrue interest, P119,579 x + 14,349 133,928
2006 12% = P14,349
12-31- To accrue interest, P133,928 x + 16,072 150,000
2007 12% = P16,072*
12-31- Collection on face amount, debit 150,00 0
2007 Cash 0
* Rounded.
8-19.
1. d. The Josefina note is a short-term note and is reported at face value
although the note can be recorded at present value. The Nicole note is
reported at present value: [(P20,000 + 5(0.3) (P20,000)] (PV1, 8%, 5) =
P23,000 (0.68058) = P15,653
2. c. The annual payment is computed as: P10,000 (PVA, 8%, 5) = P10,000 /
3.99271 = P2,505.
Discounting this stream of payments at 9% yields cash proceeds of:
P2,505 (PVA, 9%, 5) = P2,505 (3.88965) = P9,744.
Total interest equals total payments less proceeds = 5 (P2,505) P9,744
= P2,781.
3. b. Interest receivable is recorded for one month.
4. c. Maturity value..................................................................... P100,000
Discount P100,000 (0.10) (6/12)......................................... (5,000)
Proceeds............................................................................... P 95,000
(3) Actual number of units sold to Mr. Lazo was 320. P48,000
P150
Ans. (b)
(4) Correct receivable from
Mr. Lazo : 320 x P100 P 32,000
Per client 48,000
Overstatement P 16,000
Ans. (d)
(5) Accounts receivable from Mr. Sia is correctly stated because the goods
are considered sold in 2006.
Ans. (a)
(6) Ans. (d)
Requirement (1)
LING, INC.
Long-term Receivables Section of Balance Sheet
December 31, 2005
Requirement (2)
LING, INC.
Selected Balance Sheet Balances
December 31, 2005
Requirement (3)
LING, INC.
Interest Income from Long-Term Receivables
and Gains Recognized on Sale of Assets
For the Year Ended December 31, 2005
Interest income:
Note receivable from sale of division P105,000 [6]
Note receivable from sale of patent 8,505 [2]
Note receivable from officer 32,000 [7]
Installment contract receivable from sale of land 11,200 [5]
Total interest income for year ended 12/31/05 P156,705
Explanation of amounts:
Requirement 1
PAS 39, paragraph 63 will be applied in this case. On December 31, 2006,
Grande Company should record the 2006 accrued interest and the impairment:
Notes / Interest Receivable (0.06) (100,000) 6,000
Interest Income 6,000
Bad Debts Expense 55,537 *
Allowance for decline in note value 55,537
* Carrying value of note and interest (100,000 + 6,000) P106,000
Present value / New carrying value of
note (discount rate 6%)
Principal:
Due on 12.31.08 (P30,000 x 0.89000) P26,700
Due on 12.31.10 (P30,000 x 0.79209) 23,763 50,463
Impairment write-down P 55,537
Requirement 2
The entries with the corresponding computations follow:
Effective Interest
Method
December 31, 2007
Allowance for decline in note 3,028
value
Interest income (0.06) 3,028
(50,463)
Cash 30,000
Substantive Tests of Receivables and Sales 8-25
Notes receivable 30,000
Cash 30,000 *
Notes receivable 30,000
Requirement 1
8-26 Solutions Manual to Accompany Applied Auditing, 2006 Edition
Requirement 2
Accounts receivable (trade)--current asset, trade receivable
Accounts receivable (officer)--normally current nontrade receivable
Ordinary shares subscription receivable--current or noncurrent asset, depending
on due date; nontrade receivable
Advances to employees--current asset, nontrade receivable
Notes receivable (trade)--noncurrent asset, trade receivable
Deposit to guarantee contract performance--separately classify, could be current
or noncurrent asset, depending on the length of the contract; nontrade
receivable
Utility deposit--separately classify, probably noncurrent nontrade receivable
8-25. Janes Department Store
Requirement 1
Estimated Estimated
Percentage Amount
Age Balance Uncollectible Uncollectible
Under 30 days P193,000 0.008 P 1,544
30- 60 days 114,000 0.020 2,280
61-120 days 73,000 0.050 3,650
121-240 days 41,000 0.200 8,200
241-360 days 25,000 0.350 8,750
Over 360 days 19,000 0.600 11,400
P465,000 P35,824
Requirement 2
Requirement 1
2005
Dec. 1 Cash [(P175,000 x 0.80) P1,400] 138,600
Assignment Service Charge Expense
(P175,000 x 0.80 x 0.01) 1,400
Notes Payable (P175,000 x 0.80) 140,000
31 Cash 86,000
Accounts Receivable Assigned 86,000
Requirement 2
On the December 31, 2005 balance sheet of the Blue Corporation, the assigned
accounts receivable and the remaining liability would be reported as follows:
Current Assets:
Accounts receivable assigned P88,000
Current Liabilities:
Note payable P54,000
8-28 Solutions Manual to Accompany Applied Auditing, 2006 Edition
29 Cash 1,805
Accounts Receivable 1,805
GABE COMPANY
Income Statement Effect
For the Year Ended December 31, 2005