An audit of trade receivables involves a systematic process to ensure that the amounts customers owe a business are accurately recorded, properly valued, and genuinely collectible. This crucial procedure helps verify the existence, valuation, rights and obligations, completeness, and presentation of accounts receivable on a company's financial statements.
Why Audit Trade Receivables?
Trade receivables, representing money owed by customers for goods or services delivered, often constitute a significant portion of a company's current assets. Auditing them is essential to:
- Verify Existence: Confirm that the receivables genuinely exist and are owed by real customers.
- Assess Valuation: Ensure that the amounts are recorded correctly and that adequate provision is made for uncollectible accounts.
- Confirm Rights and Obligations: Ascertain that the company has a legal right to collect these amounts.
- Ensure Completeness: Verify that all receivables that should be recorded are included.
- Evaluate Presentation and Disclosure: Check that receivables are classified and disclosed appropriately in the financial statements according to accounting standards like IFRS or GAAP.
Key Steps in Auditing Trade Receivables
Auditing trade receivables involves a combination of substantive procedures and tests of controls. The following steps outline a comprehensive approach:
1. Understand Internal Controls
Before diving into balances, auditors assess the client's internal control system related to sales, billing, cash receipts, and adjustments. Strong controls reduce the risk of material misstatement and can influence the extent of substantive testing required. Key areas include:
- Segregation of duties (e.g., order entry, shipping, billing, cash collection).
- Authorization processes for credit sales and write-offs.
- Reconciliation procedures for accounts receivable subsidiary ledgers.
2. Initial Reconciliation and Verification
This phase focuses on ensuring the mathematical accuracy and consistency of the receivable records.
- Trace Receivable Report to General Ledger: Verify that the total balance of the accounts receivable aging report (subsidiary ledger) agrees with the control account balance in the general ledger. Any discrepancy needs immediate investigation.
- Calculate the Receivable Report Total: Independently re-perform the summation of balances in the accounts receivable aging report to confirm its mathematical accuracy.
- Investigate Reconciling Items: Thoroughly examine and understand any differences found between the subsidiary ledger and the general ledger, or any discrepancies in totals, ensuring they are valid and properly recorded.
3. Substantive Testing of Balances and Transactions
These procedures directly test the balances reported in the financial statements.
- Confirm Accounts Receivable: This is often considered the most effective procedure for verifying the existence and accuracy of receivables. Auditors send direct confirmations to a sample of customers, asking them to verify their outstanding balances.
- Positive Confirmations: Customers are asked to reply directly to the auditor, indicating whether they agree or disagree with the balance.
- Negative Confirmations: Customers are only asked to reply if they disagree with the balance. Used for low-risk, small balance accounts.
- Test Invoices Listed in Receivable Report: Select a sample of outstanding invoices from the aging report.
- Trace these invoices back to supporting documentation such as sales orders, shipping documents (e.g., bills of lading), and sales invoices to verify the legitimacy, amount, and terms of the sale.
- Match Invoices to Shipping Log: For a sample of recorded sales or outstanding receivables, verify that the goods or services were actually delivered.
- Compare sales invoice dates and quantities with corresponding entries in the shipping log or proof of delivery documents. This confirms the occurrence of the transaction and proper revenue recognition.
4. Assessing Collectibility
Auditors evaluate the adequacy of the allowance for doubtful accounts, which estimates the portion of receivables unlikely to be collected.
- Assess the Allowance for Doubtful Accounts:
- Review the client's methodology for calculating the allowance (e.g., aging analysis, historical write-off rates).
- Examine subsequent cash receipts for specific large balances to gauge collectibility.
- Discuss specific long-outstanding or high-risk accounts with management and review credit files.
- Consider current economic conditions and industry trends that might impact collectibility.
5. Review Subsequent Cash Receipts
- Review Cash Receipts (Post Period-End): Examine cash receipts recorded shortly after the balance sheet date. This helps verify the valuation and existence of receivables at year-end, as cash collected post-period-end for prior period sales confirms those receivables were valid. It also aids in cut-off testing.
6. Perform Cut-off Procedures
- Sales Cut-off Test: Ensure that sales transactions are recorded in the correct accounting period. Examine sales invoices and shipping documents for a period just before and after the year-end to confirm that revenue recognition criteria are met in the appropriate period.
- Cash Receipts Cut-off Test: Similarly, ensure cash receipts are recorded in the correct period to avoid misstating receivables.
7. Analytical Procedures
- Analyze Trends and Ratios: Compare current year receivables balances, sales, and related ratios (e.g., days sales outstanding (DSO), accounts receivable turnover) to prior periods, budgeted figures, and industry averages. Significant fluctuations warrant further investigation.
8. Review Presentation and Disclosure
- Evaluate Financial Statement Disclosure: Confirm that trade receivables are properly classified (e.g., current assets) and that all required disclosures are made in the financial statements and accompanying notes, such as details of the allowance for doubtful accounts, related party receivables, and any pledged receivables.
Audit Objectives and Procedures Summary
| Audit Objective | Description | Key Audit Procedures |
|---|---|---|
| Existence | Do the receivables genuinely exist? | Confirm accounts receivable directly with customers. Match invoices to shipping log. Test invoices listed in receivable report. |
| Completeness | Are all legitimate receivables recorded? | Review sales cut-off procedures. Trace a sample of shipping documents to sales invoices and the accounts receivable ledger. Perform analytical procedures (e.g., compare sales to prior years). |
| Valuation & Allocation | Are receivables recorded at the correct amount and collectible? | Assess the allowance for doubtful accounts. Review cash receipts (subsequent period). Trace receivable report to general ledger. Calculate the receivable report total. Test invoices listed in receivable report (for accuracy of amount). |
| Rights & Obligations | Does the entity own the rights to the receivables? | Inquire about pledged, factored, or discounted receivables. Review loan agreements. |
| Presentation & Disclosure | Are receivables properly classified and disclosed in financial statements? | Review financial statements for proper classification (e.g., current vs. non-current) and adequate disclosures regarding the allowance for doubtful accounts, related party transactions, or any receivables used as collateral. Ensure compliance with relevant accounting standards. |
By systematically following these procedures, auditors can form an opinion on the fairness and accuracy of the trade receivables balance presented in the financial statements.
