Accounts Receivable: An Audit Simulation
ABSTRACT: This easy-to-use simulation allows students to confirm accounts
receivables electronically. It 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. For those customers who do not respond,
the simulation creates invoices, bills of lading and purchase orders necessary for
students to perform alternative procedures.
Although the simulation requires little class time, students perform several audit
procedures which provides helpful background for subsequent lectures. 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 objective of the auditor is to design and perform audit procedures that enable the auditor to obtain sufficient
appropriate audit evidence to be able to draw reasonable conclusions on which to base the auditor’s opinion.”
(Auditing Standards Board 2011 AU-C Section 500.03)
Introduction
This is your first week on the job at DC&H, LLP and today’s training will cover the
accounts receivable confirmation process. This exercise uses data from Charles
Cabinets which is a client of the firm. Although there may be situations when accounts
receivable are understated, this exercise focuses on overstatement which will typically
be our primary concern for accounts receivable. The related financial statement
assertions are existence, and valuation and allocation.
The Securities Exchange Commission (SEC 1940 page 7) investigation of the
McKesson & Robbins, Inc. fraud found that the auditors had failed to detect $19 million
in fictitious receivables and inventory. Auditing standards, at that time, did not require
the confirmation of receivables. The SEC’s findings 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 includes a hands-on Excel simulation and covers auditing
standards relating to the confirmation process, audit sampling, evaluation of results, and
audit documentation. 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 often performed when customers do not
return confirmations;
the relationship between samples size and detection risk;
how to evaluate the audit evidence generated by substantive procedures; and
how to prepare audit workpapers for accounts receivable.
External Confirmations (Auditing Standards Board 2011 AU-C Section 505)
Accounts receivable are addressed by AU-C 505, External Confirmations.
Confirmation of accounts receivable is a generally accepted auditing
procedure. As discussed in paragraph .02, it is generally presumed that
“audit evidence is more reliable when it is obtained from independent
sources outside 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:
 The overall account balance is immaterial.
 External confirmation procedures would be ineffective, or
 The auditor’s assessed level of risk of material misstatement at the
relevant assertion level is low, and the other planned substantive
procedures address the assessed risk. (ASB 2011 AU-C Section
505.03)
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Audit Sampling (Auditing Standards Board 2011 AU-C Section 530)
The first step in the confirmation process is to determine how many customer
accounts must be audited in order to provide sufficient evidence and then determine
which customers to confirm. Although not required by auditing standards, statistical
sampling provides auditors with an objective method to determine the sufficiency of the
evidence. This will help if the client is selected for peer review, PCAOB inspection or is
involved in litigation.
On most audits, DC&H uses dollar-unit-sampling which is a form of probabilityproportional-to-size sampling which you may have discussed in a statistics course.
However, statistics courses typically introduce confidence intervals and hypothesis tests
using mean-per-unit (MPU) sampling. So, this exercise uses MPU sampling.
Statistical sampling illustrates how we can 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 a material misstatement exists when, in fact, it does not. The risk of incorrect
acceptance is the risk that the sample supports the conclusion that a material
misstatement does not exist when, in fact, it does. (ASB 2011 AU-C Section 530.05)
Table 1 shows the four possible outcomes. When accounts receivable are fairly
presented, we may correctly conclude such or incorrectly conclude they are materially
misstated. When accounts receivable are materially overstated, we may correctly
conclude such or incorrectly conclude they are fairly presented.
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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 accounts receivable are materially overstated and the sample size is too small,
then the risk of incorrect acceptance will be unacceptably high. This increases the
probability of issuing an unmodified opinion on materially misstated financial statements
which would expose DC&H to legal liability to investors.
If the accounts receivable are fairly presented and the sample size is too small,
then 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 its opinion.
Such a conclusion will lead to inefficiency and may harm the firm’s relationship with the
client.
When samples are larger than necessary we perform excessive procedures
which reduces the engagement’s profitability and also imposes an inconvenience on the
client. At the extreme, firms that consistently perform excessive procedures price
themselves out of the market.
Charles Cabinet’s has 1,000 customers with receivables balances totaling
$2,908,144.44. The standard deviation of these 1,000 accounts, as recorded, is
$1,204.33. It is important to understand that if our audit procedures result in changes to
the recorded balances this will also change the standard deviation. The standard
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deviation is a critical element in determining the appropriate sample size If we use the
incorrect standard deviation to calculate the required sample size, then the achieved
level of sampling risk will differ from the planned risk of incorrect acceptance.
Although professional standards do not require the use of statistical sampling,
those standards do provide the following guidance.
— The auditor's desired level of assurance (complement of risk of incorrect
acceptance) that tolerable misstatement is not exceeded by actual misstatement
in the population; the auditor may decide the desired level of assurance based on
the following:
• The auditor's assessment of the risk of material misstatement
• The assurance obtained from other substantive procedures directed at the
same assertion
• Tolerable misstatement
• Expected misstatement for the population
• Stratification of the population when performed
• For some sampling methods, the number of sampling units in each
stratum
The decision whether to use a statistical or nonstatistical sampling approach is a
matter for the auditor's professional judgment; however, sample size is not a
valid criterion to use in deciding between statistical and nonstatistical
approaches. An auditor who applies statistical sampling may use tables or
formulas to compute sample size based on the factors in paragraph .A13. An
auditor who applies nonstatistical sampling exercises professional judgment to
relate the same factors used in statistical sampling in determining the appropriate
sample size. Ordinarily, this would result in a sample size comparable with the
sample size resulting from an efficient and effectively designed statistical sample,
considering the same sampling parameters. This guidance does not suggest that
the auditor using nonstatistical sampling also compute a corresponding sample
size using an appropriate statistical technique. (ASB 2011 AU-C
Section 530.A13)
In this exercise, the audit team previously performed tests of controls. Based on
their test results they concluded controls over credit sales transactions were very
effective and assessed control risk as low. Because sales are always significant,
DC&H’s policies require auditors to assess inherent risk as high for sales transactions.
Table 2 from DC&H’s audit manual specifies the appropriate risk of incorrect
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acceptance to calculate the sample size. Auditing literature refers to the combination of
inherent risk and control as the risk of material misstatement (RMM).
Table 2
Appropriate level for Risk of Incorrect Acceptance (RoIA)
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
External Confirmations (Auditing Standards Board 2011 AU-C Section 505)
First you determine the required sample size and then select a random sample of
customers from Charles Cabinets' accounts receivable subsidiary ledger. You will
provide their controller with a list of customers from which they will prepare confirmation
requests using DC&H's template for positive confirmations. In this exercise, once you
determine the appropriate sample size the Excel simulation will randomly select a
sample of customers.
Although the client may assist with the confirmation process, auditors are
required to review the confirmation requests and oversee them being placed in
envelopes. It is essential that the confirmations are mailed from a public post office or
from DC&H’s office. Confirmations 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.
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You can simulate this process by going to the Summary Tab in the Excel
workbook and entering the desired sample size in the designated cell. Clicking the
“Generate” button will randomly select the desired number of customers. Next, click the
“Create” button to prepare confirmations for those customers. You can review these
confirmations in your web browser by pressing the red “Confirms” link. The simulation
will electronically mail the confirmations to the selected customers.
After one week, you would go to DC&H’s office and pick up the confirmation
responses that have been returned.
In the simulation, you retrieve the first round of confirmations by clicking the
“First” button which 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 the corresponding information from the accounts receivable subsidiary ledger
which is accessible under the “Results” tab. The “Results” page is designed to help
organize your audit results and facilitate the preparation of your workpapers. The
“Results” page has a column to record the amount confirmed by the customer.
For this exercise, whenever the confirmed amount disagrees with the accounts
receivable subsidiary ledger you are to assume the amount confirmed by the customer
is correct. On actual engagements, you would investigate such discrepancies because
they are not always errors. For example, customer payments which are in transit on
December 31st can create discrepancies, as can shipments which are in route to
customers as of December 31st. Again, for today’s exercise you should assume the
amount reported by the customer is correct.
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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 should be able to mail a second round of
confirmations. Approximately one week after mailing the first confirmation requests, you
will mail a second confirmation request to those customers who have not yet
responded. In the simulation your do this 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 perform
alternative procedures for customers who do not return their confirmations. One
alternative procedure might be to investigate subsequent cash receipts. When
customers pay their account in early January it provides evidence that those accounts
existed. However, subsequent cash receipts may not establish that the balance existed
as of December 31st. 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. A purchase order provides external evidence that there was an
agreement between the customer and Charles Cabinets. The bill of lading provides
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evidence that the goods were shipped and the revenue earned as of December 31st.
The invoice provides 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 returned
their confirmations. You can view these invoices in your web browser by clicking the
green “Invs” 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 allows you to view the 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.
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Evaluation of Results
Auditing standards require auditors to project sample results to the population
and compare the projected misstatement to tolerable misstatement. Even when the
projected misstatement is less than tolerable misstatement, the level of risk may be
unacceptable if the difference between the projected misstatement and tolerable
misstatement is small (ASB 2011 AU-C Section 530.A26). In such circumstances
additional audit procedures are necessary to reduce the level of audit risk to an
acceptable level. Although statistical sampling does not replace auditor judgment, it
does provide a useful tool to evaluate the results of the 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, if
substantive procedures reveal either a large discrepancy or a significant number of
discrepancies, then we would reconsider our assessment of control risk, regardless of
the results from the previous tests of controls. However, an extensive discussion of
internal controls is beyond the scope of this exercise.
Audit Documentation (Auditing Standards Board 2011 AU-C Section 230)
AU_C Section 230.02 Audit Documentation states the following:
Audit documentation that meets the requirements of this section and the specific
documentation requirements of other relevant AU-C sections provides
a. evidence of the auditor's basis for a conclusion about the achievement of
the overall objectives of the auditor;1 and
b. evidence that the audit was planned and performed in accordance with
generally accepted auditing standards (GAAS) and applicable legal and
regulatory requirements.
Auditing standards require documentation to include the name of the auditor who
performed the work and the date the work was completed. Audit documentation must be
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in sufficient detail to allow auditors who are new to the engagement to understand the
procedures performed in the prior audit. Last year’s workpapers are included as an
attachment and you should use them for guidance as you perform the procedures in the
current engagement.
DC&H utilizes the workpaper template shown in Table 4.
Table 4
Workpaper (reference number)
Client name
Transaction cycle
Class of transactions or Account
performed by:
date:
Nature of test: 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 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
Hands-On Training Assignment
General Instructions
You are required to complete the same workpapers that are provided from last
year’s audit.
The simulation uses four *.html templates to create files. These templates must
be placed in the same folder as the excel simulation. You will probably need to enable
macros for Excel to run the simulation. If your computer’s security settings are too
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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 also on the “ReadMe” tab at the bottom of the
spreadsheet.
The “Results” page of the spreadsheet is designed to organize information for
your workpapers. It may be easiest to imbed an Excel spreadsheet in your workpapers
so the “Results” page can be copied from the simulation and pasted into your
workpapers.
Project Deliverables
You are to use your sample results to test the hypothesis that accounts
receivable are materially overstated. Tolerable misstatement is $290,814.44, which is
10 percent of the book value. Both the risk of incorrect acceptance and the risk of
incorrect rejection are 20 percent unless your instructor indicates otherwise. The
hypothesis test needs to evaluate whether the actual balance is less than
$2,617,330.00 ($2,908,144.44 - $290,814.44). If you use statistical sampling you will
need to calculate the critical value for your test and compare your sample results to the
critical value in order to 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 should prepare audit documentation that is sufficient to enable an
experienced auditor, having no previous connection with the audit, to understand
a. the nature, timing, and extent of the audit procedures performed to comply
with GAAS and applicable legal and regulatory requirements;
b. the results of the audit procedures performed, and the audit evidence
obtained; and
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c. significant findings or issues arising during the audit, the conclusions
reached thereon, and significant professional judgments made in reaching
those conclusions. (ASB 2011 AU_C Section 230.08)
You don’t 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 workpapers1. However, don’t let yourself become mechanical
because 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.
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
Nature of test: Test of details
performed by: John
date:
2/28/14
Objective:
The objective of this procedure is to determine if the accounts
receivable account is overstated.
Assertion(s):
Existence; Valuation & Allocation
Tolerable error: For accounts receivable tolerable misstatement 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, 2014, a confirmation letter was sent
to each customer in the sample. On Feb. 17, 2014 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: John
date:
2/28/14
Nature of test: Test of details
Objective:
The objective of this procedure is to determine if the accounts
receivable account is overstated.
Assertion(s):
Existence; Valuation & Allocation
Tolerable error: For accounts receivable tolerable misstatement 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 $2,371,983.60 / N = 930
Tolerable misstate
237,198.36
Standard deviation
806.81
average = $2,550.52
=
255.05
Ho: μ > 2,550.52 – 255.05 tolerable misstatement = 10% of the recorded balance
α = 0.30
Zα/2 = 1.04 risk of incorrect rejection
β = 0.15
Zβ = 1.04 risk of incorrect acceptance
TM
= 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
2.295.47 + 1.04 * 1,390.09 / √ 44
2,513.42
We are unable to conclude that Accounts Receivable is not materially overstated
because the sample mean of $2,425.56 is less than the $2,513.42 critical value.
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Attachment 3: Workpaper 3
Charles Cabinets
Revenue Collection cycle
Accounts Receivable
performed by: John
date:
2/28/14
Nature of test: Test of details
Objective:
The objective of this procedure is to determine if the accounts
receivable account is overstated.
Assertion(s):
Existence; Valuation & Allocation
Tolerable error: For accounts receivable tolerable misstatement 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. 2015
#2 items were returned prior to 12/31/14
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Attachment 4: Workpaper 2 alternate
Charles Cabinets
Revenue Collection cycle
Accounts Receivable
performed by: John
date:
2/28/14
Nature of test: Test of details
Objective:
The objective of this procedure is to determine if the accounts
receivable account is overstated.
Assertion(s):
Existence; Valuation & Allocation
Tolerable error: For accounts receivable tolerable misstatement 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 $2,371,983.60 / N = 930
Tolerable misstate
237,198.36
Standard deviation
806.81
average = $2,550.52
=
255.05
Ho: μ > 2,550.52– 255.05 tolerable misstatement =10% of the recorded balance
α = 0.30
Zα/2 = 1.04 risk of incorrect rejection
β = 0.15
Zβ = 1.04 risk of incorrect acceptance
TM
= 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 desired allowance for sampling risk
exceeds the $237,198.36 tolerable misstatement.
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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. 2011. Statements on Auditing Standards 122-124,
York: American Institute of Certified Public Accountants.
New
Author 2009.
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
Securities and Exchange Commission, 1940. Accounting Standards Release No. 19.
Dec, 5. In the Matter of McKesson & Robbins, Section 1, Summary of Findings and
Conclusions. Retrieved from http://sechistorical.org/museum/papers/1940/
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