Accounts Receivable: An Audit Simulation
“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.” (AICPA 2010a)
THE AUDIT SIMULATION
This is your first week on the job as a new hire at the CPA firm, DC&H, LLP. During
today’s training we will learn how to confirm accounts receivables. This training is based on a
client of the firm. Although there may be situations when accounts receivable is understated, our
primary concern for accounts receivable is typically overstatement and this exercise will focus
on overstatement. The related financial statement assertions are existence, and valuation and
allocation.
In 1938, the Securities Exchange Commission (SEC 1940) 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. It includes a hands-on Excel
simulation. After completing this project you should understand


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.
The Confirmation Process (AICPA 2010 AU 330)
Accounts receivable are addressed by AU 330, The Confirmation Process (AICPA
2010b).
“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:
 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.”
Audit Sampling (AICPA 2010 AU 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 beneficial during peer reviews, PCAOB inspections or litigation.
On most audits, DC&H uses dollar-unit-sampling (DUS) to calculate the sample size,
select the sample and analyze the results. DUS is a form of probability-proportional-to-size
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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, because college
curricula typically use classical variables sampling to introduce confidence intervals and
hypothesis tests. So, you should be somewhat familiar with classical variables sampling.
Classical variables sampling allows us to illustrate how sample size can be used to
manage risk during audit planning. 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.” (AICPA 2010c)
If our primary concern is that accounts receivable may be overstated, there are four
possible outcomes as shown in Table 1. 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.
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 rejection
β risk or Type II risk
incorrect rejection
α risk or Type I risk
correct conclusion
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If the accounts receivable are materially overstated and the sample size is to small, 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 issue an
unqualified opinion on financial statements that are materially misstated which exposes DC&H
to legal liability to investors.
If the accounts receivable are fairly presented and the sample size is to small, 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 expand the
scope of the audit or attempt to modify their opinion. Such a conclusion will lead to inefficiency
or even damage the firm’s relationship with the client.
When sample sizes are larger than necessary we perform excessive procedures which
reduces the engagement’s profitability and inconveniences the client. At the extreme, firms that
consistently perform excessive procedures price themselves out of the market.
Charles Cabinet’s accounts receivable has a $2,908,144.44 balance which includes 1,000
customers. 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 the
standard deviation will change if there are any discrepancies between the audited balances and
the recorded balances. If the incorrect standard deviation is used to calculate the required sample
size, then sampling risk will differ from the planned risk of incorrect acceptance.
Although professional standards do not require auditors to use statistical sampling, they
do state that “an auditor who applies nonstatistical sampling uses professional judgment to relate
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these factors1 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.” (AICPA 2010d)
In this exercise, the audit team previously performed tests of controls and concluded that
controls over credit sales transactions were very effective. Based on their test results, control risk
was assessed as low for credit sales transactions. Because they are such a significant class of
transactions, DC&H’s policies require that we always assess inherent risk as high for credit sales
transactions. Table 2 is from DC&H’s audit manual and it specifies the appropriate risk of
incorrect acceptance to calculate the required sample size. The risk of material misstatement
(RMM) is the combination of internal risk and control risk. 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
DR = .20
DR = .30
RoIA = .30
RMM = low
analytical
procedures
The Confirmation Process Continued (AICPA 2010 AU 330)
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To determine the number of items to be selected in a sample for a particular test of details, the auditor should
consider tolerable misstatement and expected misstatement, the audit risk, the characteristics of the population, and
the assessed risk for other substantive procedures related to the same assertions.
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After you determine the required sample size, you select a random sample of customers
from Charles Cabinets' accounts receivable subsidiary ledger. You will provide their controller a
list of customers to be confirmed and provide her or him with DC&H's template for positive
confirmations on which they can prepare the confirmation requests. The Excel simulation will
select the sample of customers in this exercise.
Although the client prepares the confirmations, we must review the confirmation requests
and oversee them being placed in envelopes. It is essential that we mail the confirmations from a
public post office or from DC&H’s office but they cannot be mailed from the client’s mail room.
The confirmation will include a return envelope that is pre-addressed to DC&H’s office.
In the Excel 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. By pressing the red “Confirms” link you can review these confirmations in your web
browser. Next, the simulation will electronically mail the confirmations to the selected
customers.
After five days, you would go to DC&H’s office and pick up the responses from those
customers who have returned their confirmations.
In the simulation, you retrieve the first round of confirmations by clicking the “First”
button. This is equivalent to picking up the mail from DC&H’s office. You can observe these
responses in your web browser by clicking the green “Firsts” link. You will need to agree the
customer name, address and balance on the confirmation response with information from the
accounts receivable subsidiary ledger which will be available under the “Results” tab. The
“Results” page is designed to accumulate your sample results and facilitate the preparation of
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your workpapers. The “Results” page has a column to record the amount reported by the
customer.
If there is a discrepancy between the amount reported by the customer and the accounts
receivable subsidiary ledger, assume the amount reported by the customer is correct. On actual
engagements, you would perform additional procedures to investigate such discrepancies. 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
today’s exercise you should assume the amount reported by the customer is correct.
Unfortunately, not all customers respond to confirmation requests. Last year’s
workpapers indicate that only 22 out of 44 customers responded. If confirmations are scheduled
early in the audit process we may be able to mail a second round of confirmations. One week
after mailing the first confirmation requests, you will mail a second confirmation request to those
customers who have not yet responded. This can be simulated 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 viewed using the green “Seconds”
link. The process is the same as for the first round of confirmations. The “Results” page of the
workbook has a “2nd Balance” column to record the amounts confirmed by these customers.
Alternative Procedures
In order to limit the risk of incorrect acceptance to the desired level we must audit every
account in the sample. Alternative procedures must be performed for customers who do not
respond to the confirmations. One alternative procedure might be to investigate subsequent cash
receipts. When customers pay their account in early January this provides evidence that those
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accounts existed. However, subsequent cash receipts may not establish that the balance existed
as of December 31st. In this exercise, the audit program shown 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 that there was 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
da te
workpa per
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
Clicking the “Alternative” button in the simulation retrieves file copies of the invoices,
bills of lading and purchase orders for those customers who have not responded to the
confirmation requests. You can view these invoices in your web browser by clicking the green
“Ins” link. You need to 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 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
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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.
Evaluation of Results
Auditing standards require us to project our sample results to the population. In order to
conclude that accounts receivable are not materially overstated the projected error must be
significantly less than tolerable misstatement. Otherwise, the sample results do not provide
sufficient evidence for us to conclude that accounts receivable are fairly presented. If the
projected error is only slight less than tolerable misstatement there may be an unacceptable level
of risk (AU 350 AICPA 2010e). In such circumstances additional audit procedures will be
necessary to reduce the level of audit risk to the acceptable level. Statistical sampling does not
replace auditor judgment, but it does provide a valuable tool to evaluate the results of the firm’s
confirmation procedures.
Unexplained discrepancies should cause us to reconsider our assessment of control risk.
In this exercise, control risk was previously assessed as low. However, a significant number of
discrepancies or significantly large discrepancies are revealed by our substantive tests, the
effectiveness of internal controls needs 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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Audit Documentation (AICPA 2010 AU 339)
AU 339 Audit Documentation (AICPA 2010f) 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 the auditor who performed the work to document her or his
name 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 template shown in Table 4.
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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Hands-On Training Assignment
General Instructions
You are required to complete the same workpapers as provided from last year’s audit.
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. When Excel
opens the simulation, 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.
Instructions for the simulation are on the “ReadMe” tab at the bottom of the spreadsheet.
The “Results” page of the spreadsheet is designed to accumulate information for your
workpapers. It may be easiest to imbed an Excel spreadsheet in your workpapers. The “Results”
page can then be copied from the simulation and pasted into your workpapers.
Project Deliverables
Use your sample results to test the hypothesis that accounts receivable is materially
overstated. 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.” (AICPA 2010f)
There is no need to reinvent the wheel. Last year’s workpapers (Attachments 1 to 4)
should help you understand the work to be performed and serve as a guide for preparing this
year’s workpapers2. However, don’t let yourself become mechanical as circumstances will
change from year to year. It is essential that you (1) understand why you are performing the
procedures, (2) objectively evaluate the results of your procedures, and (3) update the
workpapers accordingly.
2
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
2/29/11
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 and Valuation
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, 2011, a confirmation letter was sent to each
customer in the sample. On Feb. 17, 2011 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
2/29/11
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 and Valuation
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
2/29/11
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 and Valuation
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. 2011
#2 items were returned prior to 12/31/10
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Attachment 4: Workpaper 2 alternate
Charles Cabinets
Revenue Collection cycle
Accounts Receivable
performed by:
date:
John
2/29/11
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 and Valuation
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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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, AU 150.02
Generally Accepted Auditing Standards. New York: American Institute of Certified Public
Accountants.
Auditing Standards Board. 2010b. Codification of Statements on Auditing Standards, AU 330.34
The Confirmation Process. New York: American Institute of Certified Public Accountants.
Auditing Standards Board. 2010c. Codification of Statements on Auditing Standards, AU 350.12
Audit Sampling. New York: American Institute of Certified Public Accountants.
Auditing Standards Board. 2010d. Codification of Statements on Auditing Standards, AU
Section 350.23 Audit Sampling. New York: American Institute of Certified Public Accountants.
Auditing Standards Board. 2010e. Codification of Statements on Auditing Standards, AU
Section 350.26 Audit Sampling. New York: American Institute of Certified Public Accountants.
Auditing Standards Board. 2010f. Codification of Statements on Auditing Standards, AU Section
339.10. Audit Documentation. New York: American Institute of Certified Public Accountants.
Auditing Standards Board. 2010g. Codification of Statements on Auditing Standards, AU
Section 339.03. Audit Documentation. 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.
Securities and Exchange Commission, Accounting Standards Release No. 19. Dec, 5, 1940. In
the Matter of McKesson & Robbins.
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