Distinguish between accuracy tests of gross accounts receivable and tests uncollectible accounts resulting from the inability
ility to locate the customer.
of the realizable value of receivables.
The purpose of the accuracy tests of gross accounts receivable is to
determine the correctness of the total amounts receivable from
customers. These tests normally consist of confirmation of accounts
receivable or examination of shipping documents in support of the
shipment of goods to customers.
The purpose of the test of the realizable value of receivables is to
estimate the amount of the accounts receivable balance that will not be
collected. To estimate this amount, the auditor normally reviews the aging
of the accounts receivable, analyzes subsequent cash payments by
customers, discusses the collectibility of individual accounts with client
personnel, and examines correspondence and financial statements of
significant customers.
Evaluate the following statement: “In many audits in which accounts
receivable is material, the requirement of confirming customer balances
is a waste of time and would not be performed by competent auditors if
it were not required by auditing standards. When internal controls are
excellent and there are a large number of small receivables from
customers who do not recognize the function of confirmation, it is a
meaningless procedure. Examples include well-run utilities and retail
stores. In these situations, tests of controls and substantive tests of
transactions are far more effective than confirmations.”
The value of accounts receivable confirmation as evidence can be
visualized more clearly by relating it to tests of controls and substantive
tests of transactions. If the beginning balance in accounts receivable can
be assumed to be correct and careful tests of the controls have been
performed, the auditor should be in an excellent position to evaluate the
fairness of the ending balance in accounts receivable.
Confirmations are typically more effective than tests of controls
and substantive tests of transactions for discovering certain types of
misstatements. These include invalid accounts, disputed amounts, and
Although confirmations cannot guarantee the discovery of any of these
types of misstatements, they are more reliable than tests of controls and
substantive tests of transactions, because tests of controls and substantive
tests of transactions rely upon internally created documents, whereas
confirmations are obtained from independent sources.
There are two instances in which confirmations are less likely to
uncover omitted transactions and amounts than tests of controls and
substantive tests of transactions. First, in order to send a confirmation, it is
necessary to have a list of accounts receivable from which to select.
Naturally, an omitted account will not be included in the population from
which the auditor is selecting the sample. Second, if an account with an
omitted transaction is confirmed, customers are less likely to respond to
the confirmation, or, alternatively, will state that it is correct. Tracing
shipping documents or sales orders to the related duplicate sales invoice
and the accounts receivable master file is an effective method of
discovering omitted transactions.
Clerical errors in billing customers and recording the amounts in
the accounts can be effectively discovered by confirmation, tests of
controls, or substantive tests of transactions. Confirmations are typically
more effective in uncovering overstatement of accounts receivable than
understatements, whereas tests of controls and substantive tests of
transactions are effective for discovering both types. The important
concept in this discussion is the existence of both a complementary and a
substitute relationship between tests of controls and substantive tests of
transactions, and confirmations. They are complementary in that both
types of evidence, when combined, provide a higher level of overall
assurance of the fair presentation of sales, sales returns and allowances,
and accounts receivable than can result from either type considered
separately. The strengths of tests of controls and substantive tests of
transactions combined with the strengths of confirmation result in a highly
useful combination. The two types of evidence are substitutes in the sense
that the auditor can obtain a given level of assurance by decreasing the
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tests of controls and substantive tests of transactions if there is an
offsetting increase in the confirmation of accounts receivable. The extent
to which the auditor should rely upon the tests of controls and substantive
tests of transactions is dependent upon his or her evaluation of the
effectiveness of internal controls. If the auditor has carefully evaluated
internal control, tested internal controls for effectiveness, and concluded
that the internal controls are likely to provide correct results, it is
appropriate to reduce the confirmation of accounts receivable. On the
other hand, it would be inappropriate to bypass confirmation altogether.
In the situation being addressed in this problem, the auditor will
want to put more emphasis on tests of controls and substantive tests of
transactions than confirmations because of the nature of the customers
and the effectiveness of internal control. Nevertheless, both types of tests
should be used.
Explain why the emphasis in auditing property, plant, and equipment is
on the current period acquisitions and disposals rather than on the
balances in the account carried forward from the preceding year. Under
what circumstances will the emphasis be on the balances carried
forward?
The reason for the emphasis on current period acquisitions in
auditing property, plant, and equipment is that there is an expectation that
permanent assets will be kept and maintained on the records for several
years. The assets carried over from the preceding years can be assumed to
have been verified in the prior years' audits.
If tests of controls and substantive tests of transactions do not
show that all disposals have been recorded, additional testing of the prior
balance could be required. A first year audit also necessitates tests of the
beginning balance.
Define monetary unit sampling and explain its importance in auditing.
How does it combine the features of attributes and variables sampling?
Monetary unit sampling is a method whereby the population is
defined as the individual dollars (or other currency) making up the account
balance. A random sample is drawn of these individual monetary units and
the physical audit units containing them are identified and audited. The
results of auditing the physical audit units are applied, pro rata, to the
random monetary units, and a statistical conclusion about all population
monetary units is derived.
Monetary unit sampling is the most commonly used method of
statistical sampling for tests of details of balances. This is because it uses
the simplicity of attributes sampling yet still provides a statistical result
expressed in dollars. It does this by using attribute tables to estimate the
total proportion of population dollars misstated, based on the number of
sample dollars misstated, and then modifies this amount by the amounts
of misstatements found. This latter aspect gives monetary unit sampling its
"variables" dimension, although normal distribution theory is not used;
rather an arbitrary rule of thumb is applied to make the adjustment.
What audit procedures are most likely to be used to verify accounts
receivable written off as uncollectible? State the purpose of each of
these procedures.
The audit procedures most likely to be used to verify accounts
receivable charged off as uncollectible and the purpose of each procedure
are as follows:
a. Examine approvals by the appropriate persons of individual
accounts charged off. The purpose is to determine that charge-offs
are approved.
b. Examine correspondence in client's files that indicates the
uncollectibility of the accounts for a selected number of write-offs.
The purpose is to determine that the account appears to be
uncollectible.
c. Examine Dun and Bradstreet credit records as an indication of the
uncollectibility of an account. The purpose is the same as the
previous procedure.
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 d. Consider the reason for the charge-off compared to the company
policy for writing off uncollectible accounts. The purpose is to
determine whether or not company policy is being followed.
Evaluate the following comment by an auditor: “My job is to determine
whether the payroll records are fairly stated in accordance with
accounting standards, not to find out whether they are following proper
hiring and termination procedures. When I conduct an audit of payroll, I
keep out of the human resources department and stick to the time cards,
journals, and payroll checks. I don’t care whom they hire and whom they
fire, as long as they properly pay the ones they have.”
The auditor should be concerned with whether the human
resources department is following the proper hiring and termination
procedures. An obvious reason for this would be to ensure that there are
adequate safeguards against hiring and retaining incompetent and
untrustworthy people. The ramifications of hiring such people can range
from simple inefficiency and waste to outright fraud or theft. More
importantly, though, it is necessary for the auditor to assure himself or
herself that the client is hiring and terminating according to operations
standards and procedures. It is necessary to see if the internal controls are
working as planned before they can be effectively evaluated. To say that
the auditor doesn't care who is hired and who is fired is to suggest that he
or she doesn't care if the internal controls work according to any
standards. Failure to follow proper termination procedures could lead to
fraudulent payments for work not performed.
What is meant by an attribute in sampling for tests of controls and
substantive tests of transactions? What is the source of the attributes
that the auditor selects?
An attribute is the definition of the characteristic being tested and
the exception conditions whenever audit sampling is used. The attributes
of interest are determined directly from the audit program. In a test of
control, that attribute is evidence of the operation of the control
consistent with the design. In a substantive test, the attribute is the
absence of monetary misstatement.
In connection with his audit of the financial statements of Knutson
Products Co., an assembler of home appliances, for the year ended May
31, 2011, Ray Abel, CPA, is reviewing with Knutson’s controller the plans
for a physical inventory at the company warehouse on May 31, 2011.
Finished appliances, unassembled parts, and supplies are stored in the
warehouse, which is attached to Knutson’s assembly plant. The plant will
operate during the count. On May 30, the warehouse will deliver to the
plant the estimated quantities of unassembled parts and supplies
required for May 31 production, but there may be emergency
requisitions on May 31. During the count, the warehouse will continue to
receive parts and supplies and to ship finished appliances. However,
appliances completed on May 31 will be held in the plant until after the
physical inventory.
The following procedures should be established to insure that the
inventory count includes all items that should be included and that nothing
is counted twice:
1. All materials should be cleared from the receiving area and stored
in the appropriate space before the count.
2. Incoming shipments of unassembled parts and supplies should be
held in the receiving area until the end of the day and then
inventoried.
3. If possible, the day's shipments of finished appliances should be
taken to the shipping area before the count. (Unshipped items
remaining in the shipping area should be inventoried at the end of
the day.)
4. Great care must be exercised over goods removed from the
warehouse itself. These may be unassembled parts and supplies
requisitioned on an emergency basis or unscheduled shipments of
finished appliances. Alternative methods for recording these
removals are:
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 a. Keep a list of all items removed and indicate on the list whether
the item had been counted.
b. Record the removal on the inventory tag if the item has been
inventoried.
c. Indicate on the material requisition or the shipping order that
the item had been inventoried. For any of these alternatives, a
warehouse employee or the perpetual inventory clerk must
adjust the recorded counts.
5. The finished appliances remaining in the warehouse should be
inventoried at the end of the day.
6. The warehouse should be instructed to date all documents as of
the day the materials are received, issued, or shipped.
7. The inventory clerk should post the May 31 production and
shipment of finished goods to the inventory record based upon the
dates shown on the plant production report and the shipping
report. This will provide a proper cutoff because provisions have
been made to adjust all counts for goods manufactured and
shipped on May 31.
8. The listing of inventory differences should be reviewed by the
controller and warehouse supervisor prior to booking the
adjustment. Abnormal differences should be investigated, and
recounts (with appropriate reconciliation) should be made where
appropriate.