Accounts Receivable: An Audit Simulation
ABSTRACT: The project is an easy-to-use simulation allowing students to observe and
participate in the accounts receivable confirmation process. The simulation contains 1,000
customer accounts from which students select a random sample. Confirmations are created in
viewable *html documents which are electronically mailed to customers. Some customers return
their viewable confirmation documents with discrepancies which students must identify. For
customers who do not respond, the simulation creates the invoices, bills of lading and purchase
orders necessary for students to preform alternative procedures.
Although the simulation requires little class time, students develop a familiarity which is
beneficial in subsequent lectures. After downloading the Excel spreadsheet, students report that
the project requires approximately one hour to complete.
Students gain an understanding of (1) the confirmation process; (2) alternative procedures for
receivables; (3) evaluation of audit evidence; (4) preparation of work papers; and (5) statistical
sampling as a tool to manage risk.
“The auditor must obtain sufficient appropriate audit evidence by performing audit procedures
to afford a reasonable basis for an opinion regarding the financial statements under audit.”
(Auditing Standards Board 2010 AU Section 150.02)
1. Introduction
This is your first week on the job as a new hire at the CPA firm, DC&H, LLP and you are
participating in training for new hires. Today’s training covers the confirmation of accounts
receivable and uses data from one of the firm’s clients, Charles Cabinets. In addition to the
confirmation of accounts receivable, you will also cover learn how to vouch from the sales
journal to source documents which is often called the three-way match, and how to prepare
workpapers. Although there are situations when management may have incentive to understate
sales and accounts receivable, for example to minimize income taxes, our primary concern for
these accounts is typically overstatement. Consequently, this exercise will focus on
overstatement of accounts receivable. When auditing balances, as opposed to transactions, the
related financial statement assertion is existence.
In 1938, the Securities Exchange Commission (SEC 1940 page 7) investigated the
McKesson & Robbins, Inc. fraud and found that the auditors had failed to detect $19 million in
fictitious receivables and inventory. At that time, auditing standards did not require the
confirmation of receivables. In their findings the SEC stated “The facts of this case, however,
demonstrate the utility of circularization and the wisdom of the profession in subsequently
adopting confirmation of accounts and notes receivable as a required procedure whenever
practicable and reasonable, and where the aggregate amounts of notes and accounts receivable
represents a significant proportion of the current assets or of the total assets of a concern.”
(Securities and Exchange Commission)
This exercise covers auditing standards relating to the confirmation process, audit
sampling, evaluation of results, and audit documentation. You will also perform a hands-on
training exercise using an Excel simulation. After completing this project you should understand
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the confirmation process used to audit accounts receivable;
one type of alternative audit procedure that can be performed for customers who do not
respond to confirmations;
how statistical sampling can be used to control detection risk;
how to evaluate the audit evidence generated by the audit procedures; and
how to prepare audit workpapers for accounts receivable.
2. The Confirmation Process (Auditing Standards Board 2010 AU Section 330)
Accounts receivable are addressed in The Confirmation Process (ASB 2010
AU Section 330.34).
“Confirmation of accounts receivable is a generally accepted auditing procedure.
As discussed in paragraph .06, it is generally presumed that evidence obtained
from third parties will provide the auditor with higher-quality evidence than is
typically available from within the entity. Thus, there is a presumption that the
auditor will request the confirmation of accounts receivable during the audit
unless one of the following is true:
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 Accounts receivable are immaterial to the financial statements.
 The use of confirmations would be ineffective.
 The auditor’s combined assessed level of inherent risk and control risk is
low, and the assessed level, in conjunction with the evidence expected to be
provided by analytical procedures or other substantive tests of details, is
sufficient to reduce audit risk to an acceptably low level for the applicable
financial statement assertions. In many situations, both confirmation of
accounts receivable and other substantive tests of details are necessary to
reduce audit risk to an acceptably low level for the applicable financial
statement assertions.”
3. Audit Sampling (Auditing Standards Board 2010 AU Section 350)
The first step in the confirmation process is to determine how many customer accounts
must be confirmed in order to provide sufficient evidence and then determine which customers to
confirm. Although auditing standards permit the use of non-statistical sampling, statistical
sampling provides auditors with an objective method to determine the sufficiency of the
evidence. This can be very beneficial if DC&H needs to substantiate its position during peer
review, PCAOB inspections or litigation.
On most audits, DC&H uses monetary-unit-sampling (MUS) to calculate the sample size,
select the sample and analyze the results. MUS is a form of probability-proportional-to-size
sampling which may have been discussed in your college statistics course. However, today’s
exercise uses mean-per-unit (MPU) sampling, a classical variables approach. We use MPU
sampling in this exercise because college curricula typically use classical variables sampling to
introduce confidence intervals and hypothesis tests. So, you should be familiar with classical
variables sampling. This exercise builds on that knowledge and demonstrates a practical
application for confidence intervals and hypothesis tests which are two statistical procedures
with which you are familiar.
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Perhaps the most important reason to use classical variables sampling is to illustrate how
sample size can be used in audit planning to manage detection risk. In statistics, alpha (or type I)
risk is associated with confidence intervals and beta (or type II) risk is associated with hypothesis
testing. In auditing literature, these correspond with the risk of incorrect rejection (alpha risk)
and the risk of incorrect acceptance (beta risk).
“The risk of incorrect rejection is the risk that the sample supports the conclusion
that the recorded account balance is materially misstated when it is not materially
misstated.
The risk of incorrect acceptance is the risk that the sample supports the conclusion
that the recorded account balance is not materially misstated when it is materially
misstated.” (ASB 2010 AU Section 350.12)
If our primary concern is that accounts receivable may be overstated, there are four
possible outcomes. If accounts receivable are in fact fairly presented, we may correctly conclude
they are fairly presented or incorrectly conclude they are materially overstated. If accounts
receivable are materially overstated, we may correctly conclude accounts receivable are
materially overstated or incorrectly conclude they are fairly presented. These outcomes are
illustrated in Table 1.
Table 1
If accounts receivable
are actually
fairly presented
materially overstated
and the auditor concludes
accounts receivble are
fairly presented
materially overstated
correct conclusion
incorrect acceptance
β risk or Type II risk
incorrect rejection
α risk or Type I risk
correct conclusion
If the accounts receivable are materially overstated and the sample size is not large
enough, then the risk of incorrectly concluding the balance is fairly presented (i.e., the risk of
incorrect acceptance) will be unacceptably high. This increases the probability that DC&H might
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issue an unqualified opinion on financial statements that are materially misstated. Audit risk will
be unacceptably high, which exposes DC&H to legal liability.
If the accounts receivable are fairly presented and the sample size is not large
enough, then the risk of incorrectly concluding the balance is materially overstated (i.e., the risk
of incorrect rejection) will be unacceptably high. This increases the probability that DC&H will
perceive a need to expand the scope of the audit or even attempt to modify their opinion on
financial statements that are fairly presented. Such a conclusion will lead to inefficiency or even
damage the firm’s relationship with the client and may result in losing the client.
Sample sizes that are larger than necessary reduce the profitability of the engagement and
inconvenience the client by performing excessive procedures. At the extreme, firms that
consistently perform excessive procedures price themselves out of the market and find it difficult
to obtain or retain clients.
Charles Cabinet’s accounts receivable has a $2,908,144.44 balance which includes 1,000
customers with active accounts. The standard deviation of these 1,000 accounts is $1,204.33. The
standard deviation is a critical element in determining the appropriate sample size. It is important
to realize that if any of the customers’ audited balances differ from their recorded balances, the
standard deviation will change. If the actual standard deviation differs from that used to calculate
the required sample size, sampling risk will differ from the planned risk of incorrect acceptance.
Although professional standards do not require auditors to use statistical techniques to
determine sample size, those standards do provide the following guidance.
“To determine the number of items to be selected in a sample for a particular test of
details, the auditor should consider the tolerable misstatement and the expected
misstatement, the audit risk, the characteristics of the population, the assessed risk of
material misstatement (inherent risk and control risk), and the assessed risk for other
substantive procedures related to the same assertion. An auditor who applies statistical
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sampling uses tables or formulas to compute sample size based on these judgments. An
auditor who applies nonstatistical sampling uses professional judgment to relate these
factors in determining the appropriate sample size. Ordinarily, this would result in a
sample size comparable to the sample size resulting from an efficient and effectively
designed statistical sample, considering the same sampling parameters.” (ASB 2010
AU Section 350.23)
In this exercise, the audit team has already performed tests of controls and the results of
those tests provide evidence that controls over credit sales transactions are very effective. On this
basis, control risk was assessed as low for credit sales transactions. Because credit sales are such
a significant class of transactions, DC&H’s policies require that inherent risk always be assessed
as high for credit sales transactions. The risk of material misstatement (RMM) is the the auditor’s
combined assessment of internal risk and control risk. Table 2 provides guidance to determine
the acceptable level for risk of incorrect acceptance. In this example, Table 2 indicates the
required sample size should be calculated using a 20 percent risk of incorrect acceptance. Any
deviation from this firm guidance requires the engagement partner’s approval.
Table 2
Appropriate level for Risk of Incorrect Acceptance
Inherent
Risk
High
Moderate
Low
Effectiveness of Controls
less effective
effective
very effective
CR = high
CR = moderate
CR = low
RMM = high
RMM = high
RMM = high
RoIA = .05
RoIA = .10
RoIA = .20
RMM = high
RMM = mod
RMM = mod
RoIA = .10
RoIA = .25
RMM = mod
RMM = mod
RoIA = .20
RoIA = .30
RoIA = .30
RMM = low
analytical
procedures
4. The Confirmation Process Continued (Auditing Standards Board 2010 AU Section 330)
In an actual audit, after you determine the required sample size, an auditor with
specialized IT skills would select a random sample of customers from Charles Cabinets' accounts
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receivable subsidiary ledger. You would then inform the firm’s controller which customers
should be confirmed and provide him or her with DC&H's positive confirmation template from
which to prepare the confirmation requests. However, in this training session, the Excel
simulation will select the sample of customers.
Although we have the client prepare the confirmations, we must review the confirmation
requests and oversee the confirmations being placed in the envelopes. Confirmation requests
must not be mailed from the client’s mail room. It is essential to mail the confirmations from a
public post office or from DC&H’s office. The confirmation mailed to customers will include a
return envelope that is pre-addressed to DC&H’s office.
After ten days, you would go to DC&H’s office and pick up the responses from those
customers who have returned their confirmations.
The Excel workbook you have been provided contains the simulation. Go to the
Summary Tab and enter the required sample size in the designated cell and click the “Generate”
button to select a random sample of customers. Next, click the “Create” button and the
simulation will prepare confirmations for those customers in the sample. The red “Confirms”
link allows you to review these confirmations in your web browser. Next, the simulation will
electronically mail the confirmations to the selected customers.
In order to retrieve the first round of confirmations returned by customers, click the
“First” button. This is equivalent to picking up the mail from DC&H’s office. The green “Firsts”
link allows you to observe these responses in your web browser. You will need to agree the
customer name, address and balance on the confirmation response with the accounts receivable
subsidiary ledger. The information from the subsidiary ledger is included on the “Results” tab of
the workbook. The “Results” page of the workbook has a column to record the amount reported
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by the customer. The “Results” page is designed to be used when you prepare the workpapers
and evaluate the evidence obtained.
In this simulation you should assume the amount reported by the customer is the correct
amount. On actual engagements, you would perform additional procedures to investigate
discrepancies between the amount reported by the customer and the balance in the receivables
subsidiary ledger. For example, payments from customers which are in transit on December 31st
can create discrepancies, as can shipments to customers which are in route as of December 31st.
Again, for this simulation assume that the amount reported by the customer is correct.
Unfortunately, many customers do not respond to confirmation requests. Last year’s
workpapers indicate that only 22 out of 44 customers responded to the confirmations.
Confirmations should be scheduled early in the audit process to permit the mailing of a second
round of confirmations. One week after mailing the first confirmation requests, you mail a
second confirmation request to customers who have not yet responded. In the simulation this is
done by clicking the “Second” button, which electronically mails confirmations to those
customers who have not yet responded.
Responses to the second confirmation request can be retrieved and observed using the
green “Seconds” link. The process is the same as used for previous confirmations. The “Results”
page of the workbook has a “2nd Balance” column to record the amounts confirmed by these
customers.
5. Alternative Procedures
In order to achieve the desired level of detection risk, every customer account in the
sample must be audited. Alternative procedures are performed for customers who do not respond
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to the confirmations. One alternative procedure might be to investigate subsequent cash receipts.
When a customer pays its account balance in the first few days of January, it provides evidence
that the account existed. However, subsequent cash receipts do not establish that the balance
existed as of December 31st. In this exercise, the audit program in Table 3 instructs you to vouch
from the accounts receivable subsidiary ledger to the invoice, bill of lading and customer’s
purchase order. The purchase order will provide external evidence of an agreement between the
customer and Charles Cabinets. The bill of lading will provide evidence that the goods were
shipped and the revenue earned as of December 31st. The invoice will provide evidence that
Charles Cabinets has billed the customer.
Table 3
audit program for accounts receivable
performed
by
workpa per
da te
reference
Confirm accounts receivable
determine appropriate sample size
send first confirmation requests
send second confirmation requests
Perform alternate procedures for customers who do not respond to
confirmations
vouch account balance to invoice(s)
vouch invoice to bill of lading
vouch bill of lading to purchase order
Evaluate results of confirmation and alternative procedures
Conclude on accounts receivable
Click the “Alternative” button in the simulation to retrieve file copies of the invoices,
bills of lading and purchase orders for customers who have not responded to the confirmation
requests. The green “Invs” link allows you to view these invoices in your web browser. You will
agree the customer’s name, address, amount and date on the invoice with the information on the
accounts receivable subsidiary ledger. The amount on the invoice should be entered in the
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appropriate column of the “Results” page of the workbook. The green “BOLs” link enables
viewing of bills of lading and the green “POs” link enables viewing of purchase orders. You will
agree the information on these source documents with the accounts receivable subsidiary ledger
and document your observations in the appropriate columns of the “Results” page of the
workbook.
6. Evaluation of Results
Auditing standards require auditors to project sample results to the population. The
projected misstatement should be compared to tolerable error. Even when the projected
misstatement is less than tolerable error, there may be an unacceptable level of risk if the
difference between the projected misstatement and tolerable error is small (ASB 2010
AU Section 350.26). In such circumstances additional audit procedures are necessary to reduce
the level of audit risk to the acceptable level. Although statistical sampling does not replace
auditor judgment, it does provide a valuable tool to help evaluate the results of the confirmation
procedures.
On actual engagements, unexplained discrepancies would cause us to reconsider our
assessment of control risk. In this exercise, control risk was previously assessed as low.
Whenever substantive tests reveal a significant number of discrepancies or significantly large
discrepancies, the effectiveness of internal controls would need to be reviewed, regardless of the
results from previous tests of controls. However, an extensive discussion of internal controls is
beyond the scope of this exercise.
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7. Audit Documentation (Auditing Standards Board 2010 AU Section 339)
AU Section 339 Audit Documentation (ASB 2010 AU Section 339.10) states the following:
“.10 The auditor should prepare audit documentation that enables an experienced
auditor, having no previous connection to the audit, to understand:
a. The nature, timing, and extent of auditing procedures performed to comply
with SASs and applicable legal and regulatory requirements;
b. The results of the audit procedures performed and the audit evidence obtained;
c. The conclusions reached on significant matters; and
d. That the accounting records agree or reconcile with the audited financial
statements or other audited information.”
Auditing standards require documentation of the auditor who performed the work and the
date the work was completed. Audit documentation must be in sufficient detail to allow auditors
who are new to the engagement to understand the procedures performed in the prior audit and
must also provide guidance on how to perform the procedure in the current engagement.
DC&H policy requires that workpapers utilize the following template.
Table 4
Workpaper (reference number)
Client name
Transaction cycle
Class of transactions or Account
Nature of test:
performed by:
date:
analytical procedure, test of controls, test of details, substantive analytical
procedure
Objective:
Assertion(s):
Tolerable error: Either a dollar amount or a percentage of the account balance
Procedure:
Description of the procedure performed be in sufficient detail to allow auditors
who are new to the engagement to understand the procedures performed in the
prior audit and must also provide guidance on how to perform the procedure in
the current engagement
Conclusion:
Evaluation of the results of the procedure or a conclusion regarding the account
or class of transactions
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8. Assignment Hands-On Training
8.1. General Instructions
You are required to complete three workpapers similar to those provided from last year’s
audit.
The simulation uses macros. When Excel opens the file, you will probably need to enable
macros. If your computer’s security settings are too restrictive, it may not allow you to enable the
macros, in which case you will need to relax the security settings on the computer.
The simulation uses four *.html templates to create certain files. You will need to
download these templates and place them in the same folder as the spreadsheet.
Instructions for the simulation are on the “ReadMe” tab at the bottom of the spreadsheet.
You need to include the information from the “Results” tab of the spreadsheet in your
workpapers.
8.2. Project Deliverables
Use your sample results to perform a hypothesis test evaluating whether the actual
balance is materially overstated, given the acceptable level of risk of incorrect acceptance.
Tolerable error should be $290,814.44, which is 10 percent of the book value. The risk of
incorrect acceptance is 20 percent, and the risk of incorrect rejection is also 20 percent. The
hypothesis test needs to evaluate whether the actual balance is less than $2,617,330.00
($2,908,144.44 - $290,814.44). Calculate the critical value for your test. Compare your sample
results to the critical value and determine whether you will (1) accept, or (2) fail to accept, that
the recorded book value is not materially overstated. Present your answers in the form of
working papers, as required by auditing standards:
“The auditor must prepare audit documentation in connection with each engagement in
sufficient detail to provide a clear understanding of the work performed (including the
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nature, timing, and extent, and results of audit procedures performed), the audit evidence
obtained and its source, and the conclusions reached.” (ASB 2010 AU Section 339.03)
Last year’s working papers are included to assist you in understanding the work to be
performed. Use last year’s workpapers (Attachments 1 to 4) as a guide for this year1. There is no
need to reinvent the wheel. However, don’t let yourself become mechanical as circumstances
change from year to year. It is essential that you (1) understand why you are performing the
procedures, (2) objectively evaluate the results your procedures generate, and (3) update the
workpapers accordingly.
1
Two examples of workpaper 2 are included. In the first example, a hypothesis test is used to evaluate the sample
results. In the alternate presentation of workpaper 2, the sample results are projected to the account balance and the
projected overstatement is compared with the tolerable misstatement for accounts receivable.
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Attachment 1: Workpaper 1
Charles Cabinets
Revenue Collection cycle
Accounts Receivable
performed by:
date:
John
2/29/12
Nature of test:
Test of details
Objective:
The objective of this procedure is to determine if the accounts receivable
account are overstated.
Assertion(s):
Existence; Valuation and Allocation
Tolerable error: For accounts receivable tolerable error has been set at 10% of the account
balance
Procedure:
DC&H, LLP selected a random sample of 44 entries from the accounts
receivable sub-ledger. On Feb. 10, 2012, a confirmation letter was sent to each
customer in the sample. On Feb. 17, 2012 a second confirmation letter was
sent to each customer in the sample who had not responded to the first letter.
For each customer who did not respond to either confirmation, we vouched
from the account balance on the schedule in Workpaper 3, which was selected
from the accounts receivable sub-ledger, to the invoice, bill of lading and sales
order. We agreed the date, customer name, address, PO number, and amount
from the schedule with the invoice. We then agreed the date, customer name,
address, and PO number on the invoice with the bill of lading. Finally, we
agreed the date, customer name, address, PO number, and amount from the
invoice with customer purchase order.
Workpaper 2 shows how the appropriate sample size was calculated and the
evaluation of the sample results. Workpaper 3 shows the sample results.
Conclusion:
Based on the sample results we are unable to conclude that accounts
receivable are not materially overstated. More extensive substantive tests of
details need to be performed to reduce the risk of incorrect acceptance to the
desired level.
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Attachment 2: Workpaper 2
Charles Cabinets
Revenue Collection cycle
Accounts Receivable
performed by:
date:
John
2/29/12
Nature of test:
Test of details
Objective:
The objective of this procedure is to determine if the accounts receivable
account are overstated.
Assertion(s):
Existence; Valuation and Allocation
Tolerable error: For accounts receivable tolerable error has been set at 10% of the account
balance $237,198.36 ( 10% x $2,371.983.60 )
Procedure:
Sample size calculation and evaluation of sample results
Account balance
Tolerable error
Standard deviation
$2,371,983.60 / N = 930
237,198.36
806.81
Ho: μ > 2,550.52 – 255.05
α = 0.30
Zα/2 = 1.04
β = 0.15
Zβ = 1.04
average = $2,550.52
= 255.05
tolerable error is 10% of the recorded balance
risk of incorrect rejection
risk of incorrect acceptance
TE
= Zβ* Sx/√n
+
Zα/2* Sx/√n
255.05 = 1.04*806.81/√n + 1.04*806.81/√n
√n
= 2.08*806.81 / 255.05
255.05 = 2.08*806.81/√n
n = 43.29
=> n = 44
Evaluation of Sample Results
Critical Value = μ + Zβ* Sx/√n
2,550.52 + 1.04 * 1,390.09 / √ 44
2,768.47
We are unable to conclude that Accounts Receivable is not materially overstated because the
sample mean of $2,425.56 is less than the $2,768.47 critical value.
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Attachment 3: Workpaper 3
Charles Cabinets
Revenue Collection cycle
Accounts Receivable
performed by:
date:
John
2/29/12
Nature of test:
Test of details
Objective:
The objective of this procedure is to determine if the accounts receivable
account are overstated.
Assertion(s):
Existence; Valuation and Allocation
Tolerable error: For accounts receivable tolerable error has been set at 10% of the account
balance
Procedure:
Results of confirmations and alternative procedures
#1 part of the order was backordered and not shipped until Jan. 2012
#2 items were returned prior to 12/31/11
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Attachment 4: Workpaper 2 alternate
Charles Cabinets
Revenue Collection cycle
Accounts Receivable
performed by:
date:
John
2/29/12
Nature of test:
Test of details
Objective:
The objective of this procedure is to determine if the accounts receivable
account are overstated.
Assertion(s):
Existence; Valuation and Allocation
Tolerable error: For accounts receivable tolerable error has been set at 10% of the account
balance $237,198.36 ( 10% x $2,371.983.60 )
Procedure:
Sample size calculation and evaluation of sample results
Account balance
Tolerable error
Standard deviation
$2,371,983.60 / N = 930
237,198.36
806.81
Ho: μ > 2,550.52 – 255.05
α = 0.30
Zα/2 = 1.04
β = 0.15
Zβ = 1.04
average = $2,550.52
= 255.05
tolerable error is 10% of the recorded balance
risk of incorrect rejection
risk of incorrect acceptance
TE
= Zβ* Sx/√n
+
Zα/2* Sx/√n
255.05 = 1.04*806.81/√n + 1.04*806.81/√n
√n
= 2.08*806.81 / 255.05
255.05 = 2.08*806.81/√n
n = 43.29
=> n = 44
Projection of Sample Results to the population
sample
results
sample
n=
mean
106,724.85
44
= 2,425.56
x 930
2,371,983.60
2,255,775.24
116,208.36
= Zβ
* Sx /√n
= 217.95
x 930
202,690.25
1.04
1,390.09
√44
N=
318,898.62
Book value
projected balance
projected overstatement
allowance for sampling risk
projected error plus allowance for sampling risk
We are unable to conclude that Accounts Receivable is not materially overstated because the
projected overstatement plus the allowance for sampling risk exceeds the $237,198.36 tolerable
error.
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TEACHING NOTE
1. Educational Objectives of the Project
This accounts receivable confirmation simulation consists of 1,000 customer accounts. It
creates a unique sample for each four-digit student ID. Using customer data, the simulation
creates confirmations, responses to confirmations, invoices, bills of lading and purchase orders
in the form of *.html files which are readable with most web browsers.
The educational objectives of the project are:
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
Allow students to complete the confirmation process
Allow students to complete alternative procedures for non-respondents
Provide tangible examples of audit evidence
Require students to project sample results to the population
Require students to form a conclusion from their audit procedures
Familiarize students with workpapers
1.1. Availability
The following materials are available at the following website: http://ar-simulation.com/.
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The exercise for distribution to students which is the first portion of this paper
The complete exercise including the teaching note
Copies of last year’s workpapers
The Excel workbook which includes the simulation
The four templates which must accompany the simulation
Powerpoint introducing the assignment
Confirmation responses for n=25 and ID 1234
A list of the discrepancies generated by the simulation
1.1.1. Last Year’s Workpapers
Last year’s workpapers are included with the assignment for students to use as templates.
We believe this is consistent with practice, where auditors typically have access to the prior
year’s workpapers.
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1.1.2. Excel Simulation and Templates
The Excel simulation makes extensive use of macros, which must be enabled. The
simulation calls on the following html templates to create document files: TemplatePO.html
creates the file containing purchase orders; TemplateBOL.html creates the file containing bills of
lading; TemplateINV.html creates the file containing invoices; and TemplateConf.html creates
files containing confirmations and responses to confirmations. These template files must be in
the same folder as the spreadsheet. The Excel simulation will not look to other folders for these
templates.
1.1.3. PowerPoint files and Confirmation Responses (n=25, ID 1234)
The PowerPoint file may be useful to explain the assignment to students. The
confirmation responses for a sample of 25 using student ID 1234 are also available. The
demonstration goes quickly if you already know the confirmation responses. This allows you to
focus on your explanation of the process without searching for the amounts on each
confirmation. The demonstration can go quickly for two reasons. First, the simulation auto-fills
after you enter five responses. Second, you already know that the dollar amount on the purchase
order and invoice always equals the book balance and there is a bill of lading supporting each
invoice.
1.1.4. Discrepancies
The simulation does not have a single solution. While the simulation always generates the
same discrepancy for any given customer’s confirmation response, the discrepancies do not flow
through to the alternative procedures. None of the purchase orders, bills of lading or invoices
contain discrepancies. The purchase orders, bills of lading and invoices are consistent with the
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recorded book balances. This project design results in a unique solution for each four-digit
student ID.
2. Project Efficacy Questionnaire
During the spring term of 2011, we asked students to respond to the following
questions using SurveyMonkey. Seventy-five out of the 91 students enrolled in our classes
responded to the survey. The table following the questions shows the responses to the questions.
1. The Accounts Receivable Project provided a more realistic auditing experience than is
typical for accounting classes.
2. I enjoyed completing the AR Project.
3. The AR Project complimented the text and enhanced my understanding of the accounts
receivable confirmation process.
4. The AR Project complimented the text and enhanced my understanding of what it means
to perform alternate procedures for accounts receivable.
5. The AR Project helped me better understand the nature of audit evidence.
6. The AR Project helped clarify the relationship between audit evidence and auditors’
conclusions regarding the fair presentation of account balances.
7. I am more familiar with auditors’ work papers because of the AR Project.
8. The AR Project helped me better understand how the audit risk model is used.
9. I would learn more and be better prepared for an auditing career if I were exposed to
more projects like the AR Project.
Responses to Questionnaire
number of
Strongly
repsonses
Disagree
Strongly
Disagree
Neutral
Agree
Agree
00
10
10
20
20
30
30
40
40
50
50
60
60
70
70
80
80
90
90
100
100
average
(1)
74
2
0
0
0
0
1
2
3
35
13
18
83.1
(1)
(2)
75
2
0
4
1
0
3
6
9
24
16
10
74.8
(2)
(3)
75
2
0
0
1
0
1
3
7
27
14
20
82.3
(3)
(4)
75
1
0
2
0
1
0
4
10
23
13
21
81.7
(4)
(5)
74
1
0
2
1
1
3
3
5
25
16
17
80.1
(5)
(6)
75
0
0
4
0
0
8
3
12
23
12
13
76.3
(6)
(7)
75
1
1
2
1
0
3
3
2
23
12
27
82.3
(7)
(8)
75
1
1
4
3
5
6
5
21
11
10
8
67.1
(8)
(9)
75
1
1
0
0
2
3
3
3
11
13
38
86.4
(9)
20
3. Implementation Guidance
Many steps in the accounts receivable process are mechanical. The sample size may be
given or determined from a matrix, while the preparation and mailing of confirmations is
mechanical. Agreeing information from a confirmation or a bill of lading with a subledger can
become rote, if not mechanical. Although it may encourage mechanical behavior, we understand
that auditors still typically use last year’s workpapers as a template for the current year.
Consequently, we warn students that circumstances change from year to year and we encourage
them to be vigilant and not blindly follow last year’s workpapers.
Prior to using this exercise, we found that confirmation was a word students memorized.
They had no basis to reflect on the process. A difference between a recorded balance and
confirmation, or any audit difference for that matter, was a vague concept they tried to grasp but
had difficulty visualizing. Completion of this exercise enables students to better reflect on the
confirmation process and to visualize a discrepancy.
Our preference is to assign this project in an auditing course early in the term, after we
cover statistical sampling but before we cover risk, internal control, audit documentation, or
accounts receivable. Although it may seem ideal to perform the simulation while reading the
corresponding material in the text, we have not found this to be the case. By completing this
exercise early in the term, students have a referent for many subsequent discussions and are
better prepared to engage in the discussions when topics are covered later in the term. We
continually refer back to this exercise when we discuss risk, internal control, evidence, audit
documentation, vouching and confirmations.
We recommend that the simulation be implemented in a manner that minimizes both
class time and student time. We spend approximately 20 minutes introducing the assignment in
21
class and students report that the simulation requires an hour or less to complete. 2 It may seem
logical to expand the assignment to cover multiple topics such as statistical sampling, accounts
receivable, vouching and audit documentation. In fact, we have taught each of those topics as
part of the assignment. However, we have enjoyed the most success by covering these topics as
they appear on the syllabus and referring back to the simulation as we discuss each of these
topics. We are not terribly concerned with how well students complete the assignment. The
benefits of the simulation continue to accrue by providing a referent as we discuss each of the
topics in subsequent lectures.
Having previously covered statistical sampling, we use the simulation to reinforce audit
sampling. However, you will note that the objectives relate to the confirmation of receivables,
and not statistics. You can assign this simulation prior to coverage of statistical sampling. If so,
simply provide students with the required sample size for the simulation which is 78.
We email the assignment to students and attach the first portion of this manuscript, the
Excel simulation and the four templates used by the Excel simulation. Students are instructed to
read the assignment and they are reminded that all four templates must be in the same directory
as the Excel simulation. Students can also download the components of the simulation from our
website. However, the simulation cannot be run from a website. It must be downloaded to the
computer where the Excel program resides.
As previously stated, we have already covered statistical sampling and require our
students to calculate the sample size necessary to limit the risk of incorrect acceptance and the
risk of incorrect rejection. The simulation provides a framework to discuss the risks of incorrect
acceptance and incorrect rejection.
2
The PowerPoint slides we use to introduce the assignment are available at http://ar-simulation.com/
22
In order to add a time dimension to the simulation, you may have students complete the
simulation in stages. Students complete the first four steps of the simulation, which takes them
through the creation, printing and mailing of the confirmation requests. In order to create a time
lag between the mailing of the confirmations and responses, we wait until the next class to assign
step 5 of the deliverables. In this step students review the responses and record the confirmed
amounts on the results page of the workbook. We create another time lag by waiting until the
next class to assign step 6. In this step students review and record the responses to the second
confirmations. Finally, during the next class we assign step 7 which covers alternative
procedures.
Depending on the order in which you cover topics, it may be necessary to explain the
vouching procedure used to perform alternative procedures. We spend minimal time explaining
the mechanics of the alternative procedures because our students have previously completed the
“Vouch and Trace” project where they vouched entries from a sales journal to invoices, shipping
documents and sales orders.3 This allows us to focus our discussion on risk. We remind students
that the audit planning document has already established the acceptable level of risk and the
tolerable misstatement for accounts receivable. In order to achieve the desired level of risk, every
account selected in the sample must be audited, not just the accounts of customers who
responded to the confirmation.
Increasing the required sample size does not increase the time required to complete the
project. The results page of the Excel workbook only requires students to complete each
procedure five times before the simulation auto-fills the remainder of the entries. For example,
once five entries are made in the column for 1st Balances, the simulation auto-fills the remaining
3
Miller, C. and Savage, A. (2009). “Vouch or Trace: A Revenue Recognition Audit Simulation.” Issues in
Accounting Education 24(1): 93-103. The vouch and trace project covers revenues and the use of vouching to audit
transactions.
23
entries in that column. The same is true for the 2nd Balance, PO Amt, BOL and Inv Amt
columns. We did not want students spending significant time mechanically inputting data. We
believe five entries allow students to reflect on the documentation of evidence without imposing
a significant time burden.
We find it necessary to explain the role of the prior year’s workpapers.4 Many students
are reluctant to merely update last year’s workpapers. They are concerned that this might be
cheating or plagiarism.
Students use their sample results to conclude whether or not accounts receivable are
materially overstated. The simulation helps students see how audit procedures generate evidence,
which become the basis for their opinion.
Auditing standards state that “The auditor should project misstatement results of the
sample to the items from which the sample was selected. … This total projected misstatement
should be compared with the tolerable misstatement for the account balance or class of
transactions, and appropriate consideration should be given to sampling risk (ASB 2010
AU Section 350.26).” Having covered statistical sampling, we require students use statistics to
evaluate their results and determine if the allowance for sampling risk is adequate. Although
standards do not require that auditors evaluate sample results using statistics, statistics can help
illustrate the relationship between the sample results and risk.
4
The spreadsheet in Workpaper 3 can be replicated by having the simulation select a sample of 44 using student ID
1123.
24
3.1. Extension of the Project
For instructors who wish to extend the project for more coverage and/or post-project
discussions of statistics, audit risk, internal control, accounts receivable, audit sampling
and audit documentation, we provide additional implementation guidance.
3.1.1. Covering Statistics Concurrently with the Simulation
Appendix A is available as a handout if you prefer to cover statistical sampling
concurrently with the accounts receivable simulation. Appendix A includes a sampling plan
based on the AICPA Audit Guide: Audit Sampling. It also addresses each of the issues raised in
the sampling plan.
Appendix B is provided as a handout to supplement the statistical calculation in the
Workpaper 2. The first portion of Appendix B provides a legend for the terms used in the
calculation of the required sample size. The second portion of Appendix B discusses the use of a
hypothesis test to evaluate the sample results. The final section of Appendix B evaluates the
sample results incorporating the terminology used in auditing standards. The projected error is
compared with the tolerable error to determine if the allowance for sampling risk is adequate.
3.1.2. Subsequent Discussions of Audit Risk
When teaching the audit risk model, we refer to the simulation. Students are asked (1) to
consider the effect on the required sample size if we took a primarily substantive approach, and
(2) to consider the effect on the required sample size if we determined internal controls were
moderately effective rather than very effective.
3.1.3. Subsequent Discussions of Internal Control
Control risk was assessed as low in the simulation because internal controls had
previously been found to be very effective. However, the simulation is seeded with a significant
number of discrepancies, making it likely that all students will encounter discrepancies. This
25
leads to discussions about the possible need to reassess control risk. The question we pose to
students is: “Why are we finding a significant number of discrepancies if the controls are very
effective?”
We discuss the possible causes of the observed discrepancies. Because discrepancies
were only detected on returned confirmations and none were detected by alternative procedures,
we can conclude that these are not sales to fictitious customers. Workpaper 3 illustrates two
possible discrepancies. The first is an order which was billed even though a portion of the order
remained on backorder as of Dec. 31 (see footnote #1 of workpaper 3). In their understanding of
the billing process, auditors need to ensure that the client only bills for goods that have been
shipped. Otherwise, the auditor may need to extend procedures to include items on backorder.
The second discrepancy involves a sales return which was in transit as of year-end (footnote #2
of workpaper 3). The audit will occur after year-end, enabling the auditor to exam returned
merchandise.
Other examples of overstatements in the simulation could result from: (1) billing
customers for sales that did not occur, or at least the sales had not occurred by December 31st; (2)
billing customers for more products than were actually shipped or billing at higher prices than
those on the approved price list; (3) shipping the customer more goods than ordered; and (4)
shipping products to customers who never ordered the products.
Next we discuss controls which might prevent such errors, controls such as having
someone in the shipping department verify that a customer purchase order exists for every
shipment and that the quantity shipped agrees with the quantity ordered. In the billing
department, controls should be in place to verify that a bill of lading exists before an invoice is
created and also to agree the prices on the invoice with the official price list.
26
3.1.4. Subsequent Discussions of Accounts Receivable
By the time we actually cover accounts receivable, students have a better background in
auditing. We discuss conditions which might explain discrepancies between the recorded balance
and amount confirmed by the customer. The customer may have made a payment which is still in
transit to the client on December 31st. The audit client may have recorded a receivable for goods
shipped but still in transit to the customer.
In an actual audit, auditors would not automatically accept the customer’s response as
correct. For discrepancies, the auditor examines source documents to determine which balance is
correct. One method of auditing discrepancies is to vouch from the accounts receivable
subsidiary ledger to the invoice, bill of lading and purchase order. This is an opportunity to
reinforce that vouching to the invoice provides evidence that the audit client billed the customer
for the recorded amount; vouching to the bill of lading provides evidence the goods were
actually shipped to the customer; and vouching to the purchase order provides evidence the
customer actually ordered the goods.
This naturally leads to discussion of alternative procedures. Rather than vouching to the
supporting documents, some auditors might prefer auditing subsequent cash receipts as an
alternative procedure.
3.1.5. Subsequent Discussions of Audit Sampling
Although the text we use covers audit sampling after the chapter on accounts receivable
confirmations, we cover audit sampling earlier in the class. We do this to provide a framework to
discuss the relationship between the quantity of evidence and the risk of an incorrect conclusion.
When the text covers account receivable confirmations, we refer to the simulation and again
discuss the evaluation of sample results. As this comes toward the end of the audit, we discuss
27
the possible implications if we had detected a material misstatement in accounts receivable. Will
it be necessary to reassess control risk and extend our substantive tests?
Although Charles Cabinets is a private company, we discuss the implications the
detection of a material misstatement would have if we were performing an integrated audit of a
public company. The existence of a material misstatement would likely result in an adverse
opinion regarding internal controls, even if the client corrects the misstatement.
3.1.6. Subsequent Discussions of Audit Documentation
Students appear to have difficulty grasping the necessity for good audit documentation.
By including workpapers in this assignment, our students obtain some basic familiarity with the
nature of workpapers. We frame discussions regarding audit documentation in terms of
litigation. If it becomes necessary for the auditors to defend their position to a jury, we stress the
need for persuasive documentation to prove that they actually did perform the procedures and did
obtain sufficient evidence to support their opinion. You might also refer to problems noted in
PCAOB inspection reports. A word search of one recent inspection report revealed seven
instances where the PCAOB found no evidence in the audit documentation that the audit firm
had performed a required procedure.
3.1.7. Subsequent Discussions of Fraud
If you want to discuss fraud, consider having students read the article “Detecting Circular
Cash Flow” in the Journal of Accountancy (Monhemius and Durkin 2009). This article illustrates
potential weaknesses of confirmation procedures to detect sophisticated schemes used to inflate
receivables. Companies such as the one in the article use receivables as collateral to obtain loans
and may have incentive to inflate receivables. In addition, the article points out various red flags
that may indicate fraudulent activities. This article helps students understand the need to exercise
judgment in the confirmation process.
28
4. Grading
Grades in this course are based on 550 total points of which students can earn up to 25
points for successfully completing this project. The rubric in Appendix C was developed from
shortcomings we observed in student workpapers. The rubric is segmented into five equally
weighted components: timeliness, the material at the top of the workpapers which is common to
all three workpapers, and the procedural material on Workpaper 1, Workpaper 2, and
Workpaper 3. Students can earn up to 5 points for each segment. We also encourage students to
think about what they are doing as they complete the project because many of the procedures and
concepts incorporated in the project will be included on the exams.
29
Appendix A
Sampling Plan (AICPA Audit Guide: Audit Sampling)
The AICPA Audit Guide for audit sampling suggests the following questions be addressed when
planning a sampling procedure.
“2.30 The following questions apply to planning any audit sampling procedure, whether it is
nonstatistical or statistical:
• What is the test objective and relevant assertion? (What does the auditor want to learn or
be able to infer about the population? What assertions are being tested?)
• What is the auditor looking for in the sample? (How is a misstatement or deviation
defined?)
• What is to be sampled? (How is the population defined?)
• How is the population to be sampled? (What is the sampling plan, what is the sampling
unit, and what is the method of selection?)
• How much is to be sampled? (What is the sample size?)
• What do the results mean? (How are the sample results evaluated and interpreted?)”
What is the test objective?
What assertions are being tested?
How is a misstatement defined?
How is the population defined?
What is the sampling unit?
What is the sample size?
What is the method of selection?
How are the sample results (to be) evaluated?
What do the results mean?
Determine whether the accounts receivable
balance is materially overstated.
Materiality is defined as 10% of the accounts
receivable balance.
Existence; valuation and allocation
When the audited value for a customer’s
account as determined by confirmation or
alternative procedures does not agree with the
amount recorded in the accounts receivable
subsidiary ledger
All customer accounts included in the accounts
receivable subledger, which has been agreed to
the general ledger balance
Customer accounts in the accounts receivable
subsidiary ledger
Must be determined
Random sampling
Send positive confirmations to selected
customers
Perform alternative procedures for customers
who do not respond to confirmation requests
Perform a hypothesis test to statistically
generalize the sample results to the accounts
receivable balance.
Conclude on whether the accounts receivable
balance is materially overstated
30
Appendix B
Sample Size calculation using the information in sample workpaper 2
The book value, standard deviation, tolerable error and risk factors in the sample
workpapers differ from those in the current assignment.
$2,371,983.60
$237,198.36
$2,134,785.24
806.81
930
0.30
0.15
BV book value
TE tolerable error
BV - TE
Sx standard deviation
items in population
risk of incorrect rejection
risk of incorrect acceptance
̅̅̅̅ = Zβ* Sx/√n + Zα/2* Sx/√n
𝑇𝐸
(Zα
√𝒏 = [
√𝒏 = 𝟔. 𝟓𝟖𝟎
⁄2
+ Zβ
) × sx
̅̅̅̅
𝑇𝐸
$2,550.52
$255.05
$2,295.47
Sx/√n
1.04
1.04
̅̅̅̅ average book value
𝐵𝑉
̅̅̅̅
𝑇𝐸 average tolerable error
̅̅̅̅ − 𝑇𝐸
̅̅̅̅ hypothetical mean
μ = 𝐵𝑉
std error of the means
Zα/2 number of std dev
Zβ number of std dev
rearrange the equation to solve for n
]
√𝒏 = [
(1.04 + 1.04 ) × $806.81
]
$255.05
𝒏 = 𝟒𝟑. 𝟐
Evaluation of Sample Results using a Hypothesis Test
During the planning phase, the standard deviation of the recorded values would be the only value
available to calculate the required sample size. If the sample results indicate the standard
deviation might actually be greater, we should consider using the standard deviation of the
sample results.
1.04
x 209.56
$ 217.95
+ 2,295.47
$ 2,513.42
Zβ number of std dev
Sx/√n std error of the means
allowance for sampling risk
μ hypothetical mean
Critical value
0.15
1,390.09
44
$ 2,425.57
risk of incorrect acceptance
Sx std deviation of sample
sample size
sample mean
The hypothetical mean is the book value less tolerable error. We need evidence indicating there
is a low probability the true value is less than the hypothetical mean. The critical value is
calculated by adding an allowance for sampling risk to the hypothetical mean.
In this example the $2,425 sample mean is less than the critical value indicating there is
unacceptable risk that accounts receivable might be is overstated. This indicates that we need to
obtain more evidence before we can conclude on the account.
31
If our sample mean exceeded the critical value we could conclude that the account is not
materially overstated. There is less than a 15% probability of selecting a sample with a $2,513
mean from population with a $2,134,785 balance.
Evaluation by Comparing the Projected Sample Results to Tolerable Error
$ 2,550.52 ̅̅̅̅
𝐵𝑉 ave. book value
- 2,425.57 sample average
$ 124.95 average error
0.15
1.04
x 209.56
$ 217.95
risk of incorrect acceptance
Zβ number of std dev
Sx/√n std error of the means
allowance for sampling risk
$ 2,371,983.60
- 2,255,775.24
$ 116,208.36
237,198.36
$ 120,990.00
202,693.50
book value
projected value
projected error
TE tolerable error
allowance for sample risk
desired allowance for sample
risk
Alternatively, we reach the same conclusion by projecting the estimated error from our sample
results to population. Although the $116,208 projected error is less than tolerable error,
accounting standards require us to add an allowance for sampling risk. The difference between
the projected error and tolerable error results in a $120,990 allowance for sampling risk. A
$202,693 allowance for sampling risk would be necessary to achieve 15% Beta risk.
32
Appendix C
rubric for the simulation workpapers
the risk factors, tolerable error and standard deviation in the assignment
differ from those in the sample workpapers
1 Workpapers are turned in on time
2 Each workpaper includes the appropriate common information:
client name, transaction cycle, account, nature of test, objective,
s
assertions and tolerable error
s sign-off and date should be updated for each work paper
3 Workpaper 3
s
s
a dollar amount from a confirmation response or the results of the
alternative procedures, for each item in the sample
sum, mean and standard deviation calculated from sample results
4 Workpaper 2
s
s
s
s
the required sample size calculation reflect the current year’s
population and risk parameters:
Zβ = 0.84, Zα/2 = 1.28, population size = 1,000, tolerable error
$290,814.44, and standard deviation = $1,204.33
critical value is calculated from sample results in workpaper 3
the conclusion is appropriate for the critical value
5 Workpaper 1
s sample size and dates in the procedure description are appropriate
s the conclusion is consistent with workpaper 2
33
References
AICPA Audit Sampling Guide Task Force. 2008 AICPA. Audit Guide: Audit Sampling, 2.30.
New York: American Institute of Certified Public Accountants.
Auditing Standards Board. 2010a. Codification of Statements on Auditing Standards Generally
Accepted Auditing Standards. New York: American Institute of Certified Public Accountants.
Miller, C., and Savage, A. 2009. Vouch or Trace: A Revenue Recognition Audit Simulation.
Issues in Accounting Education 24(1): 93-103.
Monhemius, J., and Durkin, K. 2009. Detecting Circular Cash Flow. Journal of Accountancy
Vol. 208(6): 23-30. Retrieved from
http://www.journalofaccountancy.com/Issues/2009/Dec/20091793.htm
Securities and Exchange Commission, 1940. Accounting Standards Release No. 19. Dec, 5. In
the Matter of McKesson & Robbins, Section I, Summary of Findings and Conclusions.
Retrieved from
http://www.sechistorical.org/museum/papers/1940/
34