11
Accounts CHAPTER Receivable, Notes Receivable, and Revenue
Review Questions 11-1 The term "customer's order" refers to the purchase order received from a customer. The term "sales order" refers to the document created upon receipt of a customer's order. The sales order is a translation of the terms of the customer's order into a set of specific instructions for the guidance of various departments, including the credit department, finished goods, stores, shipping, billing, and accounts receivable. The audit of revenue and receivables is of significant audit risk because (1) overstatement of revenue has been a factor in many instances of fraudulent financial reporting, (2) the overstatement of revenue results in a corresponding overstatement of net income, (3) the determination of the amount of revenue recognized may be determined by the application of complex accounting principles, and (4) significant accounting estimates may be involve in the determination of the financial statement presentation of receivables and revenue. Good internal control in the billing process requires that someone other than the employee preparing the invoice shall review the accuracy of prices, credit terms, and other data on the invoice before this document is released. The objective of the billing process is to notify the customer of the amount due for goods or services delivered. A most important document created by the billing department is the sales invoice. The original is sent to the customer, and copies are used to record accounts receivable and sales. The statement is incorrect. Credit memoranda are used to credit (reduce) accounts receivable when goods sold on credit are being returned, or when a defect in the goods justifies a price reduction. Credit memoranda are not issued to remove uncollectible accounts receivable from the records. Such write-off of worthless receivables is handled by a general journal entry debiting the Allowance for Doubtful Accounts and crediting Accounts Receivable.
11-2
11-3
11-4
11-5
11-6
The sales invoices (and the shipping documents as well) should be serially numbered. When each day's invoices are transmitted from the billing department to the accounts receivable department, they should be accompanied by a transmittal list showing the serial numbers of all sales invoices. Every number in the series should be accounted for. If a computer is used to record sales invoices item counts and control totals should be used to ensure that all sales are recorded. The statement is correct in suggesting that voided shipping documents should be cancelled. However, they should be retained, and not discarded so as to assure that the numerical sequence may be accounted for. All sales invoices should be serially numbered. Each day the billing department should send copies of the invoices prepared that day to the accounts receivable department accompanied by a transmittal letter specifying the invoice numbers used and the total dollar amount billed. By comparing the individual invoices with the list of serial numbers and comparing the total debits to accounts receivable with the total figure for billings, the accounts receivable department can be sure that it has received and recorded all sales invoices. Other specific procedures which contribute to good internal control over the business processes related to accounts receivable include (only three required): (1) The separation of the duties of the accounts receivable accountant from all cash handling functions. Regular balancing of the subsidiary ledger of receivables with the general ledger control account by an employee other than the accounts receivable accountant. Regular aging of accounts receivable and review by management. Periodic review of delinquent accounts by an appropriate executive. Periodic confirmation of accounts receivable by internal auditors. Serial numbering of shipping documents, sales invoices, and credit memoranda, and regular accounting for all numbers in the series.
11-7
11-8
11-9
(2)
(3) (4) (5) (6)
11-10 The auditors should confirm with the bank the loss contingency for notes receivable discounted. The auditors also should send separate confirmation requests to the makers of the notes receivable which were discounted to determine the genuineness and validity of the notes. 11-11 The write-off of small notes receivable from officers, directors, stockholders, or affiliated companies is obviously irregular and unacceptable practice. Such notes are almost always collectible by virtue of the positions held by the makers. The auditors should investigate these related party transactions fully; they will probably find that the charges to the allowance for uncollectible notes were made in error and were not authorized by management. If the amounts were large, there would be more reason to suspect an intention of self-serving activities or fraud on the part of the management. 11-12 Among the audit procedures commonly applied to notes receivable but not to accounts receivable are the following: (1) Verification of interest earned and accrued interest receivable.
(2)
Examination of the note.
11-13 The client company should request (on its letterhead) the customer to confirm the account receivable. The auditors have no authority to make such a request directly on their stationery. The return envelope should be addressed to the auditors' office to assure that the auditors have control over confirmation returns. 11-14 The audit objective of determining the existence of receivables is most directly addressed by the audit procedure of confirming accounts receivable and notes receivable by direct communication with debtors. In addition, written confirmation also addresses the completeness and valuation assertions, but less effectively because it deals only with recorded accounts and provides limited information on whether the receivable is collectible. The procedure also provides evidence of occurrence and accuracy of revenue transactions. 11-15 If the auditors find post office box addresses for many individual customers whose accounts were selected for confirmation, the auditors should consider the possibility that the customers may be fictitious, and that dishonest employees of the client company plan to "answer" the confirmation requests. 11-16 Alternative auditing procedures to verify accounts receivable when confirmation is not practicable or possible include examination of customers' purchase orders or contracts; examination of client's duplicate shipping documents and invoices; and review of payments received from customers subsequent to the balance sheet date. 11-17 Alternate auditing procedures that may be used when customers have not replied to confirmation requests include: (1) (2) Send additional requests by registered or certified mail, with return receipt requested. The auditors might telephone to ascertain the balance or the reason for failure to respond to the written request. Under some circumstances, requests may be made by fax machine. The auditors may examine any payments to the account made subsequent to the balance sheet date. The auditors may also examine the duplicate invoices, shipping records, purchase orders, etc., for transactions making up the unpaid balance.
(3) (4)
11-18 To test the client's sales cutoff at June 30, the auditors should compare shipping records with entries in the sales journal, and receiving records with entries recording sales returns, for several days prior to and subsequent to June 30. The auditors will be alert for sales and sales returns recorded in the wrong accounting period. 11-19 An unusually large number of sales transactions just prior to the balance sheet date should be fully investigated by the auditors. This situation may result from a strenuous effort made during the closing days of the period to get out shipments and meet a sales quota. On the other hand, it may reflect an improper cutoff of sales transactions at year-end, or even the recording of fictitious sales. In any event, the auditors' investigation should include matching of sales invoices with shipping documents and customers' orders, and discussions with executives. Careful analysis of sales returns during the succeeding period may also shed light on the situation.
11-20 Excessive sales returns or allowances may indicate shipments made without customers' orders, shipments of defective merchandise, a misstatement of inventory or of sales and receivables, or weaknesses in internal control. One purpose of a review of sales returns and allowances subsequent to the balance sheet date is to uncover any facts which necessitate adjustment of inventories, receivables, or sales in the statements being audited. Another purpose is to test internal control effectiveness. 11-21 The credit memoranda should bear the date and serial number of the receiving report on the return shipment. The credit memoranda selected by the auditors for testing can be compared with records of the receiving department to determine that goods were actually returned. 11-22 In testing the adequacy of the client company's allowance for doubtful accounts receivable, the auditors review the following: (1) (2) (3) Large past-due accounts not paid subsequent to the audit date. An aged trial balance of accounts receivable and comparison with those of prior years. Accounts in dispute as evidenced by confirmation exceptions or by correspondence in the client's files. Unfavorable reports of collection prospects on accounts assigned to collection agencies or attorneys. Opinions of the client's credit manager as to the collectible portion of each large past-due account. Relationship of the valuation allowance to (a) accounts receivable, (b) net credit sales, and (c) accounts written off during the year. These ratios should be compared with those prevailing in past years and industry averages. Information from a retrospective review of prior year's allowance that indicates whether management might bias its estimates.
(4)
(5)
(6)
(7)
11-23 Examples of types of receivables originating without arm's-length bargaining include loans to insiders (directors, officers, key employees) and loans to affiliated companies. These types of receivables should be shown separately with disclosure of the nature of the relationships and the amounts of the transactions. 11-24 As required by SAS No. 99 a retrospective review is an analysis of the judgments and assumptions underlying a prior year accounting estimate. With hindsight the auditors can evaluate whether there appears to be any management bias in the prior year estimate. The purpose with respect to revenue is to provide information about possible management bias to assist in the audit of the current year revenue estimates. Questions Requiring Analysis
11-25 (a)
According the SEC Staff Accounting Bulletin No. 104 the following criteria must be met for revenue to be recognized: Persuasive evidence of an arrangement (contract) exists, Delivery has occurred or services have been rendered, The seller's price to the buyer is fixed or determinable, and Collectibility is reasonably assured.
(b)
To overstate revenue the following techniques might be used by Processing Solutions' management (only two required): 1. Recording of fictitious contracts with customers. 2. Recording revenue before a contract is executed. 3. Recording revenue when the company has entered into side agreements with the customers that affect the realization of revenue (e.g., allowing liberal return privileges). 4. Allocating excessive amounts of revenue to the delivery and set-up of the system to recognized revenue early.
(c) Overstatement Technique 1. Recording of fictitious contracts with customers. Audit Procedure Confirmation of contracts with customers. Inquiries of salespeople about contracts. Confirmation of contract terms with customers. Inquiries of salespeople about contract execution dates.
2. Recording revenue before a contract is executed.
3. Recording revenue when the company has entered into side agreements with the customers that affect the recognition of revenue (e.g., allowing liberal return privileges).
Confirmation of contract terms with customers, including the existence of any side agreements. Inquiries of salespeople about oral modification of contract terms and side agreements.
4. Allocating excessive amounts of revenue to the delivery and set-up of the system to recognize revenue early.
Review of allocation of contract revenue to the multiple elements of the contract, e.g., software, setup, maintenance, etc. Revenue should be recognized on the elements based on their relative fair market values.
11-26 (a)
When a company engages in bill and hold transactions there is a possibility that the company is inappropriately recognizing revenue. The auditors must ascertain that any transactions recognized as sales meet the criteria for revenue recognition as set forth in SEC Accounting and Auditing Enforcement Release No. 108. In these circumstances, the auditors will review the provisions of sales contracts and consider confirming the terms with customers. When a company sells using a multiple element arrangement, the revenue must be allocated to the elements in relation to their fair values. Therefore, there is a possibility that management may attempted to misstate revenue by inappropriate allocation. In these situations, the auditors will review the sales contracts and evaluate the reasonableness of management's allocation of the revenue to the various elements. When a company uses the percentage-of-completion method, there is a risk that management may misestimate the amount of revenue earned on uncompleted contracts. The auditors must carefully evaluate the costs allocated to the contracts and the estimates of the percentage-ofcompletion. In some cases, the auditors may decide to engage a specialist, such as an engineer. When a company's sales agreements allow for returns, there is a risk that management may misstate the estimate of sales returns and, therefore, misstate revenue and receivables. In these situations, the auditors should carefully review the contracts to determine that revenue should be recognized at the time of sale. If revenue recognition is appropriate, they should next evaluate the adequacy of management's estimate of sales returns.
(b)
(c)
(d)
11-27 (a) Sales invoice; (b) approved sales order; (c) customer's purchase order; (d) approved sales order; (e) sales invoice. 11-28 All three generally accepted auditing standards of field work were violated in the audit of the accounts receivable of Thorne Company. The first standard of field work, which requires adequate planning of the audit and proper supervision of assistants, was obviously violated. Planning was inadequate because no audit plan, audit programs, or time budgets were prepared. Supervision was inadequate because Martin Joseph, an inexperienced staff assistant, was left on his own to audit the accounts receivable, with no guidance from the senior auditor. The second standard of field work, which requires the auditors to obtain an understanding of the entity and its environment, including existing internal control, was violated. Martin Joseph did not obtain an understanding of the internal control for the business processes related to accounts receivable, nor did he perform tests of controls over receivables and sales transactions. Obviously, the substantive tests that Joseph applied to Thorne Company's accounts receivable were merely a repetition of the preceding year's audit procedures. The third standard of field work, which requires the obtaining of sufficient competent evidence matter, was violated because no assessments of the risks of material misstatement were performed. What constitutes sufficient, competent evidence in an audit is determined principally by the assessed levels of risks of material misstatement (inherent and control risks). 11-29 (a) An audit confirmation request is a written communication received by the auditors directly from a party outside the client organization. The written communication usually affirms the existence of, and rights to, an amount recorded in the client's accounting records. To be valid evidence, an audit confirmation response must be received directly by the CPA firm from the outside party who has replied to the confirmation request.
(b)
(c)
A positive confirmation request requires a reply from the client's customer in every case. A negative confirmation request requires a reply only if the balance for which confirmation has been requested is incorrect. Negative confirmation requests may be used for situations in which (1) the combined assessed level of inherent and control risk is low; (b) a large number of small balances is involved; and (c) the auditors have no reason to believe that the recipients of the requests are not likely to give them consideration.
(d)
11-30 The confirmation requests should go to the makers of the notes regardless of whether the notes have been discounted. The act of discounting a note receivable does not reduce the importance of the note being genuine and collectible. A company which discounts its notes receivable remains in a position of sustaining a loss if the makers of the notes fail to make payment at the maturity dates. 11-31 (a) There are two forms of confirmation requests for accounts receivable: the "positive" form and the "negative" form. The positive form asks the debtor to respond whether or not the debtor is in agreement with the information on the confirmation request. A negative form asks the debtor to respond only if the debtor disagrees with the information shown on the confirmation request or monthly statement. The use of the positive form is preferable when individual account balances are relatively large, when there is reason to believe that there may be a substantial number of accounts in dispute, or with inaccuracies or fraud. The negative form is useful when internal control surrounding accounts receivable is considered to be effective, and a large number of small balances is involved, and the auditor has no reason to believe that persons receiving the requests are unlikely to give them consideration. A debtor's acknowledgement of indebtedness does not indicate whether the receivable is collectible. A good indicator of collectibility is an aging schedule. Generally the older an account is, the less likely it will be collected. Jones should review, analyze, and interpret the aging schedule to determine whether the client's allowance for doubtful accounts is adequate. If not, an adjustment by the client should be recommended. In connection with the review and interpretation of the aging schedule, Jones should investigate accounts receivable losses of preceding periods and any uncollectible accounts charged off in the current period to determine if the bad debt rate is increasing, and if charge-offs because of uncollectibility are properly approved. After a review of correspondence, minutes, and collection procedures with the appropriate officials in the client's credit and collection department, Jones should prepare an estimate of the probable collection losses and compare the estimate to the amount of the recorded allowance. If necessary, Jones should review client credit files as well as reports of external credit agencies. Jones also should examine subsequent cash receipts to ascertain what portion of amounts owing at the balance sheet date have been collected in the subsequent period.
(b)
11-32 Confirmation of accounts receivable by direct communication with debtors is usually essential to the issuance of an unqualified audit report. Confirmation of receivables is a presumed procedure, and failure to perform such a procedure when issuing an unqualified report requires justification in the working papers. The auditors must generally disclaim an opinion on the client's financial statements when they have been forbidden by the client to confirm receivables.
11-33 (a)
When confirmation requests are mailed to debtors whose accounts were written off as uncollectible, the auditors' purposes are to determine that the receivables were genuine when they were first recorded in the accounts and to determine that the accounts were not collected and the proceeds stolen. In some fraud cases, fictitious accounts receivable have been created to cover up a shortage. Eventually these fictitious receivables must be disposed of; one method is to write off the fictitious accounts as uncollectible. In other cases, valid accounts receivable have been collected, but written off as uncollectible by the employee who has procured the funds. The Solar executive appears to believe the auditors are solely concerned with the valuation or collectibility of accounts and notes receivable. In fact, the confirmation process is primarily intended to establish that the receivables are valid and that the customers (or makers of notes) exist. Other audit procedures are followed to determine proper valuation.
(b)
11-34 No. The matter remains unresolved. First, oral evidence from the client is seldom in itself sufficient; the auditors must follow up to determine the reliability of the oral evidence. Second, payment of an account receivable is not confirmation; the account might be fictitious, and the "payment" could have been made by a dishonest employee who had created the fictitious account to conceal a cash shortage. The auditors must examine the customer purchase order or contract, and copies of the sales invoice and shipping document in support of the unconfirmed receivable. They should may also determine the genuineness of the customer by reference to the telephone directory or to credit agency reports. 11-35 (a) The items to be considered in determining the adequacy of the allowance for doubtful accounts are: (1) (2) (3) (4) (5) (6) (7) (8) (9) (b) Accounts that appear to be in dispute. Unusual variations in balances. Specific overdue accounts and deterioration of aged accounts. Levels of sales and write-offs. Historical cushion in the allowance. Cash collections affecting both the company and its customers. Economic conditions affecting both the company and its customers. Evidence of the customer's inability to comply with credit terms. Unusual levels of returned products and product quality problems.
To test the completeness of sales, the auditors determine how the company ensures that all shipments are invoiced and obtain evidence that the procedures operate as prescribed. Also obtain evidence from analytical procedures and cut-off tests.
11-36 Conn should consider applying the following additional substantive audit procedures: (1) (2) (3) (4) (5) (6) (7) (8) Test the accuracy of the aged accounts receivable schedule. Send second requests for all unanswered positive confirmation requests. Perform alternative auditing procedures for unanswered second confirmation requests. Reconcile and investigate exceptions reported on the confirmations. Project the results of the sample confirmation procedures to the population and evaluate the confirmation results. Determine whether any accounts receivable are owed by employees or related parties. Test the cutoff of sales, cash receipts, and sales returns and allowances. Evaluate the reasonableness of the allowance for doubtful accounts.
(9)
(10) (11)
Perform analytical procedures for accounts receivable (e.g., accounts receivable to credit sales, allowance for doubtful accounts to accounts receivable, sales to sales returns and allowances, doubtful accounts expense to net credit sales.) Review activity after the balance sheet date for unusual transactions. Determine that the presentation and disclosure of accounts receivable is in conformity with generally accepted accounting principles, consistently applied.
11-37 In testing the aging of accounts indicated as past due, the assistant indeed verified the aging of those accounts. However, the assistant completely neglected the accounts indicated as current on the clientprepared trial balance. Any number of "current" accounts might in reality be past due. By ignoring a significant number of individual accounts, the assistant was deficient in the test and he had no basis whatsoever for reporting to the senior auditor that the client's aging work was satisfactory. The 11-38 answer to this question will vary with the nature of the company that the students select. However, almost universally these companies use the percentage-of-completion method for at least a portion of their revenues. This obviously presents the auditors with the risk that management's estimates of cost to complete a project will not be reasonable, and revenue will be prematurely recognized.
Multiple Choice Questions 11-39 (a) (4) Over-recorded sales due to a lack of control over the sales entry function relates to control risk not inherent risk. The other three replies all relate to inherent risk. Answer (4) is correct because receivables are valued at net realizable value, and assessing the allowance for uncollectible accounts for reasonableness will help the auditor determine the proper amount. Answer (1) is incorrect because the limited information in the accounts receivable ledger will not make possible tracing details to the shipping documents--also, the shipping documents may not even capture the total sales price that is included in the accounts receivable ledger. Answer (2) is incorrect because while comparing turnover ratios may provide some information on the collectibility of receivables, it is very imprecise. Answer (3) is incorrect because it relates to presentation and disclosure more directly than valuation. A sale either shouldn't be recorded, or a proper allowance for returns should be established when a customer is likely to return the goods. Thus, simply recording the sale is an example of fraudulent financial reporting when the customer is likely to record the goods. Answers (1) and (3) are examples of errors, while answer (2) is an example of misappropriation of assets. Theft of cash register sales is an example of misappropriation of assets. Answer (1) is an example of an error while answers (2) and (3) are examples of fraudulent financial reporting. A presumption that receivables will be confirmed requires a combined assessment of inherent risk and controls risk at the low level, immaterial receivables, or circumstances in which the use of confirmations would be ineffective.
(b)
(4)
(c)
(4)
(d)
(4)
(e)
(1)
(f)
(2)
Answer (2) is not among the criteria because of the portion of the answer that states "scheduled to occur in the near future." Ordinarily delivery must have occurred. Answers (2), (3) and (4) all describe circumstances required to recognize revenue. The goal is to determine the population to be sampled from to determine that all sales have been recorded; therefore, the sample should be taken from a population of source documents, here the shipping documents file. None of the other three answers represent source documents that may be sampled from to determine that all sales have been recorded. Detecting overstated sales is a primary reason the auditors' review of a client's sales cutoff. For example, shipments made in the first part of January may be improperly included in the December sales total. The objective is to determine the population the auditors would sample from to test the existence assertion for recorded receivables. The direction of testing should be from the accounts receivable subsidiary ledger to the available support, such as sales invoices, bills of lading, sales orders, and customers' orders. Comparing shipping documents to related sales invoices addresses the completeness assertion relating to sales. More specifically, it addresses whether all items that have been shipped have been recorded as sales. The auditor would send positive confirmations rather than negative confirmations because the fact that the balances are delinquent may indicate that amounts are in dispute. Examining subsequent cash receipts, answer (3), is unlikely to be effective since many of the accounts will not have been collected. Inspection of internal records, answer (4), is likely to result in less credibility evidential matter than confirming the accounts. Write-offs of receivables should be approved by a responsible officer after a review of the account by the credit department. Answer (2) is incorrect because accounts receivable, a recordkeeping function, should not authorize such entries. Answer (3) is incorrect because other procedures (e.g., a review of shipping documents) may be used to determine that the goods were received and because the shipping department would have no other information on whether the receivable is likely to be collectible. Answer (4) is incorrect because the account need not be overdue by several months as a "current" receivable may become worthless due to, for example, a bankruptcy.
(g)
(1)
(h)
(4)
(i)
(3)
(j)
(2)
(k)
(1)
(l)
(1)
Problems 11-40 SOLUTION: Halston Toy Manufacturing Co. (Estimated time: 15 minutes) (a) Due to the fact that Halston has a number of new products and a liberal return policy, it may be very difficult to estimate the allowance for sales returns. With new products it may be difficult to use prior return history to estimate the amount of returns. The auditors might consider performing the following procedures:
(b)
(1) (2) (3) (4)
Review any trade journals and industry data that might have information relevant to sales of the new products. Review trends in sales returns in prior periods, especially when new products were introduced. Make inquiries of sales personnel about customer feedback on sales of the new toys. Review sales returns given in the subsequent period and compare the amounts to prior periods.
11-41 SOLUTION: Internal Control, Tests of Controls, Substantive Testing (Estimated time: 20 minutes) (a) (1) Checking the clerical accuracy of invoices is a procedure that is designed to improve the accuracy of customer billings and, therefore, the accuracy of sales and accounts receivable. Accounting for prenumbered shipping documents is a procedure that is designed to reduce the risk of unbilled shipments to customers. Thus, the procedure serves to insure that all sales and accounts receivable are recorded. Approval of credit prior to shipment reduces the risk of sales to customers in amounts in excess of their credit limits. The procedure helps to prevent excessive credit losses. Clerical checking of invoices could be tested by examining a sample of sales invoices processed throughout the year for indication (e.g., the checker's initials) of performance of the procedure. Of course, the auditors should verify the clerical accuracy of the sample invoices themselves to obtain evidence that the checker effectively performed the procedure. Accounting for prenumbered shipping documents might be tested by reviewing the numerical file of shipping documents (typically maintained in the billing department) for missing items. Adherence to credit approval procedures could be tested by examining the documentation of a sample of transactions processed throughout the year, noting that the credit approval date is before the date of shipment. Failing to check the clerical accuracy of sales invoices results in an increased probability of errors in sales and accounts receivable. The auditors might compensate by increasing the number of accounts receivable selected for confirmation, or by shifting the confirmation date from an interim date to year-end. Also, analytical procedures applied to the client's sales or gross margin might provide evidence that sales are not materially misstated. For example, monthly sales for the year under audit could be compared to forecasted amounts, or similar amounts from prior years. Lack of control over shipping documents may result in an understatement of sales and accounts receivable. To test for this understatement the auditors could select a sample of shipping documents processed during the year and trace the details to a recorded sales transaction. Again, analytical procedures for sales or gross margin percentages might provide an indication of whether sales are understated by a material amount. When credit approval is not obtained prior to shipment of goods, the amount of uncollectible account expense as a percentage of sales is not likely to be as stable. Thus, loss percentages of prior years are less useful in testing the adequacy of the current year's allowance for doubtful accounts. To compensate, the auditors might examine more credit information for specific accounts, especially for those that are larger in amount or past due.
(2)
(3)
(b)
(1)
(2)
(3)
(c)
(1)
(2)
(3)
11-42 SOLUTION: Parktown Medical Center, Inc. (Estimated time: 25 minutes) Weakness 1. Employees who perform services are also permitted to approve credit without external credit check. Potential Misstatement Uncollectible accounts expense could be understated and accounts receivable could be overstated because of the lack of an appropriate credit check. Fees earned and accounts receivable may be understated because not all services performed might be reported for billing. Fees earned and accounts receivable may be either overstated or understated because of the use of incorrect price or service data or because of mathematical errors. 3. The employees who approve credit also approve write-offs of uncollectible accounts. Accounts receivable could be understated and uncollectible accounts expense overstated because write-offs of accounts receivable could be approved for accounts that are, in fact, collectible. Accounts receivable could be overstated and uncollectible accounts expense understated because write-offs of accounts receivable might not be initiated for accounts that are uncollectible. 4. Credit is not granted on the basis of established limits. Uncollectible accounts expense could be either understated or overstated because the lack of established credit limits may make it more difficult to identify uncollectible amounts. Fees earned and cash receipts or accounts receivable could be understated because of omitted or inaccurate billing. The cash balance per books may be overstated because not all cash is deposited. Potential Misstatement Uncollectible accounts expense could be either understated or overstated because of the lack of established write-off criteria. Any of fees earned, cash receipts, and uncollectible accounts expense could be either understated or overstated because of undetected
2.
No independent verification of billing process.
5.
The employee who initially handles cash receipts also prepares billings.
6.
7.
The employee who makes bank deposits also reconciles bank statements. Weakness Uncollectible accounts are not determined on the basis of established criteria. Trial balances of the accounts receivable subsidiary ledger are not prepared independently of, or verified
8.
and reconciled to, the accounts receivable control account in the general ledger.
differences between the subsidiary ledger and the general ledger. Fees earned and cash receipts or accounts receivable could be understated because of failure to record billings, cash receipts, or writeoffs accurately.
11-43 SOLUTION: Martin Mfg. Co. (Estimated time: 30 minutes) The journal entry recording Martin's sale of land to Ardmore is not acceptable, for it fails to recognize the discount implicit in the transaction. The fair value of the note receivable from Ardmore is not $550,000; because Ardmore refused to pay more than $770,000 principal and interest. By acquiescing to an 8 percent interest rate, Martin's management tacitly acknowledged that the fair value of the land was less than the $550,000 face amount of the note. The auditors should propose the following adjusting entry as of March 31, 200X: Gain on Sale of Land Loss on Sale of Land ($500,000 - $436,590) Discount on Note Receivable ($550,000-$436,590) 50,000 63,410 113,410
To correct entry recording sale of land to Ardmore Corp. Note receivable from Ardmore ($550,000) has a present value of $436,590 when its $770,000 maturity value is discounted at 12%; as a result a loss of $63,410 ($500,000 cost less $436,590 fair value of note) was realized on the sale. 11-44 SOLUTION: Lawrence Company (Estimated time: 40 minutes) (1) (a) (b) Examine supporting documents, including the sales invoices and applicable sales and shipping orders, for propriety of the account receivable. Review the cash receipts journal for the period after September 30, 200X, and note any collections from Moss Company. The degree of internal control over cash receipts should be an important consideration in determining the reliance that can be placed on the cash receipts entries. In addition, as there is no assurance that collections after September 30 represent the payment of invoices supporting the September 30 account balance, consideration should be given to requesting a confirmation from Moss Company of the invoices paid by its checks. The exception should be investigated thoroughly. If the credit was posted to the wrong account, it may indicate merely a clerical error. On the other had, posting to the wrong account may indicate lapping. To assure that both accounts have been properly stated, the account originally credited should be reconfirmed unless the customer has already questioned the propriety of the credit. Such a comment may also indicate a delay in recording and depositing of receipts. If, upon investigation, such is the case, the company should be informed so that they can take corrective steps.
(2)
(a)
(b)
(3)
This is a confirmation of the balance with an additional comment. As the customer has given the data, it is preferable to see that the information agrees with the company's records. Such a procedure may disclose lapping, misposting, or delay in recording of receipts. This incomplete comment should raise an immediate question: Does the customer mean paid before or paid after September 30? As it is unsafe to assume what the customer intended, this account should be reconfirmed and the customer asked to state the exact date. Upon receipt of the second confirmation, the information thereon should be traced to the cash receipts journal. A comment of this type indicates that the company may be recording sales before a sale has legally taken place. The auditors should examine the invoice and review with the appropriate officials the company's policy on shipment terms and determine if sales, cost of goods sold, inventories, and accounts receivable have to be adjusted. Follow-up for comparable cutoff problems should be made as of October 31, the balance sheet date. (a) Determine if such advance payment has been received and that it has been properly recorded. A review should be made of other advance payments to ascertain that charges against such advances have been properly handled. If the advance payment was to cover these invoices, the auditors should propose a reclassification of the $1,350, debiting the advance payment account and crediting Accounts Receivable--Trade. Examine the shipping order for indications that the goods were shipped and, if available, carrier's invoice and/or bill of lading for receipt of the goods. If it appears that goods were shipped, send all available information to the customer company and ask it to reconfirm. If the customer still insists that goods were never received, all data should be presented to an appropriate company official for a complete explanation. This may indicate that accounting for shipments is inadequate and consideration should be given to reviewing the procedures to determine if improvements can be made. If the goods were not shipped, the auditors should recommend an adjustment reducing sales, cost of goods sold, and accounts receivable, and increasing inventories.
(4)
(5)
(6)
(b)
(7)
(a) (b)
(c)
(8)
This should be discussed with the appropriate officials and correspondence with the customer reviewed and determination made if an adjustment should be made in the amount receivable, or if the allowance for doubtful accounts should be increased as of October 31. As title on any goods shipped on consignment does not pass until those goods are sold, the sales entry should be reversed, inventory charged, and Cost of Goods Sold credited. Other so-called sales should be reviewed and company officials queried to determine if other sales actually represent consignment shipments. This is a noncurrent asset and should be reclassified to either deposits or prepaid rent. A review of other accounts, especially those with round figures, may disclose other accounts that should be so reclassified. This may indicate a misposting of the credit or a delay in posting the credit. Comments under (2) above would also apply to credits.
(9)
(10)
(11)
11-45 SOLUTION: Hall Corporation (Estimated time: 20 minutes) The starting point for Chambers' examination of notes receivable was the obtaining of a list of notes receivable at December 31, prepared by the client. When the auditors make use of schedules prepared by the client, they must prove the accuracy and validity of such schedules by firsthand investigation. In this case, the auditor merely proved the footing of the list and compared the total with the general ledger control account and with the amount shown on the balance sheet. Apparently, he did not inspect the notes receivable themselves, or compare them with the list prepared by the client. Let us assume that Hall Corporation (or one of its officers or employees) had pledged the notes as collateral for a bank loan or had discounted the notes outright. The makers of the notes would not necessarily be aware of this action; therefore, Chambers' confirmation of the notes by direct communication with the makers would not disclose that the notes were missing. If Chambers had insisted on inspecting the notes, he might have been told that they had been pledged. In that case, he should have confirmed the existence and ownership of such notes by direct communication with the holders. The case as stated does not mention physical inspection of the notes by the auditor, but it does describe in detail the various auditing procedures which were employed. Since physical inspection of the notes was not mentioned, we may reasonably assume that this essential auditing procedure was omitted. All audit procedures employed and the results of such procedures should, of course, appear in the audit working papers. Under the circumstances, it appears that Chambers' audit of notes receivable did fail to meet minimum professional standards as charged in the suit filed by the creditors of Hall Corporation. 11-46 SOLUTION: Marlborough Corporation (Estimated time: 30 minutes) (a) Classifying the advance to Olds as a current asset is inappropriate. The date of repayment is not set, and it is doubtful that the funds will be available to meet obligations during the next operating cycle. Presentation as a current asset will mislead users of the financial statements; they may conclude that the company's current position is stronger than it is. Financial presentation is not adequate unless all material matters are disclosed. Olds's contention that this would "just give the raiders ammunition" implies that additional disclosure is needed to make the financial statements complete. Description of the advance as "miscellaneous accounts receivable" is inadequate. Properly it should be shown as an advance (or loan) to a company officer. In view of the materiality of the advance, the note description should identify Olds and the nature of the collateral. Under some circumstances Olds's acquisition of the stock might be considered as disguising the company's acquisition of treasury stock. Factors involved in this determination are the parties' intentions, Olds's fiscal capacity to acquire the stock, and the legal implications of the transactions. The first three actions proposed by Olds are desirable, but they have limited usefulness and are not valid alternatives to further disclosure. Specific comments on each follow: (1) (2) The Board of Directors appears to be dominated by Olds, and its post-factum approval will be perfunctory and lack independence. Execution of a demand note formalizes Olds's obligation, but it probably will not improve collectibility. The date of repayment remains uncertain and the demand designation does not justify classification as a current asset.
(b)
(3)
(4)
Endorsement of the stock will help the company establish ownership, if that should become a problem, but it appears that the collateral may be inadequate because: (a) The market price of the stock may have been artificially stimulated by the purchases of Olds and the raiders. (b) The prevailing market price often cannot be realized when large blocks of stock are sold. A written opinion from the company's attorney, will not eliminate the need for further disclosure, but it is vital and should be obtained under any circumstances. In particular, the attorney could be asked to consider whether the stock transactions might be considered an acquisition of treasury stock, if this would be a valid use of funds, and what Olds's voting rights would be in this circumstance.
(c)
If the CPA concludes that additional disclosure is essential to fair presentation of the financial statements and Marlborough refuses to disclose the additional information, the CPA should provide the necessary supplemental information in his report and express an adverse opinion, as the client's statements do not present fairly its financial position, results of operations, and cash flows in conformity with generally accepted accounting principles. If the client is unwilling to accept his report, the CPA's only alternative is to withdraw from the engagement. The effect of Olds's warning, if any, should be the opposite of his intention. The CPA must be especially careful and avoid any appearance of collusion with the client. If the raiders are successful, he probably will lose the audit engagement. He also can expect that the company's accounting and his past work will be carefully reviewed. Accordingly, he should evaluate his present actions in the light of how they must subsequently appear in a court of law. He probably should consult his own attorney concerning his risk and responsibilities.
(d)
11-47 SOLUTION: Granite Corporation (Estimated time: 15 minutes) (1) A contingent liability of $50,000 exists with respect to the discounted 60-day note from the customer of unquestioned financial standing and this contingency should be disclosed by a note to the balance sheet. The contingent liability to the bank for the $60,000 note receivable discounted should be disclosed by a note to the financial statements. This disclosure should include a statement of the intention to make an advance of $80,000 to the affiliate from which the affiliate will make payment of the present note to the bank. The disclosure should also describe the relationship between the two companies. The $20,000 note from the former executive appears to be worthless and the loss should be recognized and reflected in the financial statements. In this case, the liability to the bank is not really of a contingent nature since all available information indicates that Granite Corporation will have to make the payment. Consequently, a current liability should be included in the balance sheet to show the anticipated payment to the bank.
(2)
(3)
11-48 SOLUTION: Aerospace Contractors, Inc. (Estimated time: 20 minutes) (a) AEROSPACE CONTRACTORS, INC. Partial Balance Sheet July 31, 200X
Current Assets: Accounts receivable: Commercial, less allowance for uncollectible accounts $75,000 U.S. government, including $320,000 claims under terminated contracts Other Assets: Due from Harwood Co., investee (b)
$ 542,000 3,502,000 480,000
The claims receivable from public carriers and the trade notes receivable are immaterial, and may be included with commercial accounts receivable. The allowance for doubtful accounts and notes relates to the commercial accounts and trade notes, since receivables from the U.S. government are collectible. Receivables from the U.S. government are of sufficient materiality to warrant presentation. Since the termination claims are different from the regular receivables and are themselves material, they should be disclosed. The amount due from the investee should be shown separately because it is a related party receivable. It also may need to be classified as a noncurrent asset, since it may be collected at the convenience of the borrower.