CONFIRMATION OF ACCOUNTS RECEIVABLE

Objective 16-4
Obtain and evaluate accounts receivable confirmations.
Most typically, a confirmation is a direct written response from a third party in paper
or electronic form, but it may also include information the auditor is able to obtain through
direct access provided by a third party to information that is held by the third party, such as
direct access to a supplier’s vendor management system. Confirmations are considered to be
highly reliable evidence because they are received directly from third parties. Although an oral
response provides audit evidence, it is not considered a confirmation.

Auditing Standards requirements

U.S. auditing standards indicate that auditors should use external confirmations for
accounts receivable. Confirmation may not be appropriate in the following circumstances:
1. The overall accounts receivable balance is immaterial. Some clients, such as fast-food
restaurants, may generate sales mostly on a cash basis, resulting in a negligible accounts
receivable balance.
2. The auditor considers confirmations ineffective evidence because response rates will likely
be inadequate or unreliable. In certain industries, such as hospitals, response rates to
confirmations are very low.
3. The auditor’s assessed level of the risk of material misstatement (represented by the
combined level of inherent risk and control risk) is low and other substantive evidence can be
accumulated to provide sufficient evidence. If a client has effective internal controls and low
inherent risk for the sales and collection cycle, the auditor should often be able to satisfy the
evidence requirements by tests of controls, substantive tests of transactions, and substantive
analytical procedures.

Types of Confirmation
In performing confirmation procedures, the auditor must first decide the type of
confirmation to use.
A positive confirmation is a communication addressed to the debtor requesting the
recipient to confirm directly whether the balance as stated on the confirmation request is correct
or incorrect. Figure 16-5 illustrates a positive confirmation in the audit of Hillsburg Hardware
Co. Notice that this confirmation is for one of the largest accounts on the aged trial balance in
Figure 16-3 (p. 532).
A blank confirmation form is a type of positive confirmation that does not state the
amount on the confirmation but requests the recipient to fill in the balance or furnish other
information. Because blank forms require the recipient to determine the information requested,
they are considered more reliable than confirmations that include balance information. Blank
forms are rarely used in practice because they often result in lower response rates.
An invoice confirmation is another type of positive confirmation in which an
individual invoice is confirmed, rather than the customer’s entire accounts receivable balance.
Many customers use voucher systems that allow them to confirm individual invoices but not
balance information. As a result, the use of invoice confirmations may improve confirmation
response rates. Invoice confirmations also result in fewer timing differences and other
reconciling items than balance confirmations. However, invoice confirmations have the
disadvantage of not directly confirming ending balances.
Negative Confirmation A negative confirmation is also addressed to the debtor but
requests a response only when the debtor disagrees with the stated amount. Figure 16-6 (p.
540) illustrates a negative confirmation in the audit of Hillsburg Hardware Co. that has been
attached to a customer’s monthly statement.

Timing
The most reliable evidence from confirmations is obtained when they are sent as close
to the balance sheet date as possible. This permits the auditor to directly test the accounts
receivable balance on the financial statements without making any inferences about the
transactions taking place between the confirmation date and the balance sheet date. However,
as a means of completing the audit on a timely basis, it is often necessary to confirm the
accounts at an interim date. This is permissible if internal controls are adequate and can provide
reasonable assurance that sales, cash receipts, and other credits are properly recorded between
the date of the confirmation and the end of the accounting period. The auditor is likely to
consider other factors in making the decision, including the materiality of accounts receivable
and the auditor’s exposure to lawsuits because of the possibility of client bankruptcy and
similar risks.
Sampling Decisions
Sample Size The major factors affecting sample size for confirming accounts receivable fall
into several categories and include the following:
• Performance materiality
• Inherent risk (relative size of total accounts receivable, number of accounts, prior-year results,
and expected misstatements)
• Control risk
• Achieved detection risk from other substantive tests (extent and results of substantive tests of
transactions, substantive analytical procedures, and other tests of details)
• Type of confirmation (negatives normally require a larger sample size)

Selection of the Items for Testing

Some type of stratification is desirable with most confirmations. In a typical approach
to stratification for selecting the balances for confirmation, an auditor considers both the dollar
size of individual accounts and the length of time an account has been outstanding. In most
audits, the emphasis should be on confirming larger and older balances because these are most
likely to include a significant misstatement. But it is also important to sample some items from
every material segment of the population. In many cases, the auditor selects all accounts above
a certain dollar amount and selects a random sample from the remainder.
Management may refuse to allow the auditor to send confirmation requests to certain
customers. The auditor must inquire about the reason for the client’s request, which is often
due to litigation or negotiations between the client and customer. The auditor should obtain
evidence to evaluate the reasonableness of the client’s request, and evaluate whether the request
indicates a potential fraud risk or increased risk of material misstatement.

Verification of Addresses and Maintaining Control

The auditor should perform procedures to verify the addresses or email addresses used
for confirmation. For example, auditors should consider performing additional procedures
when the address is a post office box or when an email address is inconsistent with the
customer’s Web site address.
For confirmations sent by mail, the auditor must maintain control of the confirmations
until they are returned from the customer. The client may assist with preparing the
confirmations, but the auditor must be responsible for mailing the confirmation outside the
client’s office. A return address must be included on all envelopes to make sure that undelivered
mail is received by the CPA firm. Similarly, self-addressed return envelopes accompanying the
confirmations must be addressed for delivery to the CPA firm’s office. These procedures are
designed to ensure that responses will be received directly by the auditor.

Follow-Up on Nonresponses
For negative confirmations, the auditor should not conclude that the recipient received
the confirmation request and verified the information requested. Negative confirmations do,
however, provide some evidence of the existence assertion.
When positive confirmations are used, auditing standards require follow-up procedures
for confirmations not returned by the customer. It is common to send second and sometimes
even third requests for confirmations. Even with these efforts, some customers do not return
the confirmation, so it is necessary to follow up with alternative procedures. For any positive
confirmation not returned, auditors can examine the following documentation to verify the
existence and accuracy of individual sales transactions making up the ending balance in
accounts receivable:
 Subsequent Cash receipts Evidence of the receipt of cash subsequent to the
confirmation date includes examining remittance advices, entries in the cash receipts
records, or perhaps even subsequent credits in the accounts receivable master file. On
the one hand, the examination of evidence of subsequent cash receipts is a highly useful
alternative procedure because it is reasonable to assume that a customer would not have
made a payment unless it was an existing receivable. On the other hand, payment does
not establish whether an obligation existed on the date of the confirmation. In addition,
auditors should take care to match each unpaid sales transaction with evidence of its
subsequent payment as a test for disputes or disagreements over individual outstanding
invoices.
 Duplicate Sales Invoices These are useful in verifying the actual issuance of a sales
invoice and the actual date of the billing.
 Shipping Documents These are important in establishing whether the shipment was
actually made and as a test of cutoff.
 Correspondence with the Client Usually, the auditor does not need to review
correspondence as a part of alternative procedures, but correspondence can be used to
discover disputed and questionable receivables not uncovered by other means.
Analysis of Differences
When the confirmation requests are returned by the customer, the auditor must
determine the reason for any reported differences. In many cases, they are caused by timing
differences between the client’s and the customer’s records. It is important to distinguish
between timing differences and exceptions, which represent misstatements of the accounts
receivable balance. The most commonly reported types of differences in confirmations include:
 Payment Has Already Been Made Reported differences typically arise when the
customer has made a payment before the confirmation date, but the client has not
received the payment in time for recording before the confirmation date. Such instances
should be carefully investigated to determine the possibility of a cash receipts cutoff
misstatement, lapping, or a theft of cash.
 Goods Have Not Been Received
These differences typically result because the client records the sale at the date of
shipment and the customer records the acquisition when the goods are received. The
time that the goods are in transit is often the cause of differences reported on
confirmations. These should be investigated to determine the possibility of the customer
not receiving the goods at all or the existence of a cutoff misstatement on the client’s
records.
 The Goods Have Been Returned
The client’s failure to record a credit memo could have resulted from timing differences
or the improper recording of sales returns and allowances. Like other differences, these
must be investigated.
 Clerical Errors and Disputed Amounts
The most likely types of reported differences in a client’s records are when the customer
states that there is an error in the price charged for the goods, the goods are damaged,
the proper quantity of goods was not received, and so forth. These differences must be
investigated to determine whether the client is in error and the amount of the error.

Drawing Conclusions
When all differences have been resolved, including those discovered in performing
alternative procedures, the auditor must reevaluate internal control. Each client misstatement
must be analyzed to determine whether it was consistent or inconsistent with the original
assessed level of control risk. If a significant number of misstatements occurred that are
inconsistent with the assessment of control risk, it is necessary to revise the assessment and
consider the effect of the revision on the audit. Auditors of public companies must also consider
implications for the audit of internal control over financial reporting.
The final decision about accounts receivable and sales is whether sufficient appropriate
evidence has been obtained through tests of controls and substantive tests of transactions,
substantive analytical procedures, cutoff procedures, confirmation, and other substantive tests
to justify drawing conclusions about the correctness of the stated balance.

DEVELOPING TESTS OF DETAILS AUDIT PROGRAM

Objective 16-5
Design audit procedures for the audit of accounts receivable, using an evidence-planning
worksheet as a guide
We use Hillsburg Hardware Co. to illustrate the development of audit program
procedures for tests of details in the sales and collection cycle. The determination of these
procedures is based on the tests of controls and substantive tests of transactions, as illustrated
in Chapters 14 and 15, and the analytical procedures described earlier in this chapter.
Fran Moore, the audit senior, prepared the evidence-planning worksheet in Figure 16-7 as an
aid to help her decide the extent of planned tests of details of balances.
The source of each of the rows is as follows:
• Performance materiality. The preliminary judgment of materiality for the financial statements
as a whole was set at $442,000 (approximately 6 percent of earnings from operations of
$7,370,000). She allocated $265,000 as performance materiality to the audit of accounts
receivable (see Figure 8-7 on p. 240).
• Acceptable audit risk. Fran assessed acceptable audit risk as medium because the company is
publicly traded, but is in good financial condition, and has high management integrity.
Although Hillsburg is a publicly traded company, its stock is not widely held or extensively
followed by financial analysts.

• Inherent risk. Fran assessed inherent risk as medium for existence and cutoff because of
concerns over revenue recognition identified in auditing standards. Fran also assessed inherent
risk as medium for realizable value. In past years, the client made audit adjustments to the
allowance for uncollectible accounts because it was found to be understated. Inherent risk was
assessed as low for all other objectives.
• Control risk
• Substantive tests of transactions results
• Substantive analytical procedures
• Planned detection risk and planned audit evidence. These two rows are decided for each
objective based on the conclusions in the other rows.