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.

1. Introduction

Today’s assignment covers the confirmation of accounts receivable and uses data from

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. Our primary concern is typically that accounts

receivable are overstatement. Consequently, you should focus on the overstatement of accounts

receivable. When auditing balances, as opposed to transactions, the related financial statement

assertion is existence.

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

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:

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, this

exercise uses classical mean-per-unit (MPU) sampling. MPU sampling incorporates confidence

intervals and hypothesis tests with which you should be familiar. This exercise demonstrates a

practical application for confidence intervals and hypothesis tests which you learned in statistics.

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)

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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

and the auditor concludesIf accounts receivable accounts receivble are

are actually fairly presented materially overstated

fairly presented correct conclusionincorrect rejection

α risk or Type I risk

materially overstatedincorrect acceptance

correct conclusionβ risk or Type II risk

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 of issuing an

unmodified 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 we will expand

the scope of the audit or even attempt to modify our 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.

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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 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, auditors typically assess inherent risk 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 is from the firm’s audit manual which indicates the

required sample size should be calculated using a 20 percent risk of incorrect acceptance. Table 2

Appropriate level for Risk of Incorrect Acceptance

Effectiveness of ControlsInherent less effective effective very effectiveRisk CR = high CR = moderate CR = low

High RMM = high RMM = high RMM = highRoIA = .05 RoIA = .10 RoIA = .20

Moderate RMM = high RMM = mod RMM = modRoIA = .10 RoIA = .25 RoIA = .30

LowRMM = mod RMM = mod RMM = low

analyticalRoIA = .20 RoIA = .30 procedures

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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

receivable subsidiary ledger. You would then inform the firm’s controller which customers to

confirm and provide her with a 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 seven days, you would go to DC&H’s office and pick up the responses from those

customers who have returned their confirmations.

In the Excel simulation you go to the Summary Tab and enter the required sample size in

the designated cell and then 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

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 any

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

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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

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.

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Table 3audit program for accounts receivable

performed workpaper

by date reference

Confirm accounts receivabledetermine appropriate sample sizesend first confirmation requestssend second confirmation requests

vouch account balance to invoice(s)vouch invoice to bill of ladingvouch bill of lading to purchase order

Evaluate results of confirmation and alternative proceduresConclude on accounts receivable

Perform alternate procedures for customers who do not respond to confirmations

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

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.

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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.

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; andd. 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.

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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

Table 4Workpaper (reference number)

Client name

performed by:Transaction cycle

date: Class of transactions or Account

Nature of test: analytical procedure, test of controls, test of details, substantive analytical procedure

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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 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 performed by: JohnRevenue Collection cycle date: 2/29/12Accounts Receivable

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 performed by: JohnRevenue Collection cycle date: 2/29/12Accounts Receivable

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 $2,371,983.60 / N = 930 average = $2,550.52Tolerable error 237,198.36 = 255.05Standard deviation 806.81

Ho: μ > 2,550.52 – 255.05 tolerable error is 10% of the recorded balanceα = 0.30 Zα/2 = 1.04 risk of incorrect rejectionβ = 0.15 Zβ = 1.04 risk of incorrect acceptance

TE = Zβ* Sx/√n + Zα/2* Sx/√n 255.05 = 1.04*806.81/√n + 1.04*806.81/√n 255.05 = 2.08*806.81/√n √n = 2.08*806.81 / 255.05 n = 43.29 => n = 44

Evaluation of Sample Results

Critical Value = μ + Zβ* Sx/√n 2,295.47 + 1.04 * 1,390.09 / √ 44 2513.42

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 performed by: JohnRevenue Collection cycle date: 2/29/12Accounts Receivable

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 performed by: JohnRevenue Collection cycle date: 2/29/12Accounts Receivable

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 $2,371,983.60 / N = 930 average = $2,550.52Tolerable error 237,198.36 = 255.05Standard deviation 806.81

Ho: μ > 2,550.52 – 255.05 tolerable error is 10% of the recorded balanceα = 0.30 Zα/2 = 1.04 risk of incorrect rejectionβ = 0.15 Zβ = 1.04 risk of incorrect acceptance

TE = Zβ* Sx/√n + Zα/2* Sx/√n 255.05 = 1.04*806.81/√n + 1.04*806.81/√n 255.05 = 2.08*806.81/√n √n = 2.08*806.81 / 255.05 n = 43.29 => n = 44

Projection of Sample Results to the populationsample sample

results n = mean N =

2,371,983.60 Book value106,724.85 44 = 2,425.56 x 930 2,255,775.24 projected balance

116,208.36 projected overstatement

1.04 1,390.09 = 217.95 x 930 202,690.25 allowance for sampling risk√44

318,898.62 projected error plus allowance for sampling risk

= Zβ * Sx/√n

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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