Auditing Accounts Receivable (AR)
Accounts Receivable (AR) represents amounts owed to a company by its customers, making it a critical asset to audit. The Auditing and Attestation (AUD) section of the U.S. CPA exam often features questions on auditing AR, and candidates are expected to master various procedures associated with this area. Three fundamental audit procedures concerning AR are Receivables Confirmation, Aging Analysis, and Bad Debt Assessment.
Receivables Confirmation
Receivables Confirmation is the process of verifying the accuracy of accounts receivable balances by directly contacting the debtor to confirm the amounts owed. For the CPA exam, it’s crucial to understand that this is a primary substantive procedure for obtaining audit evidence. The idea is to assess whether the AR is both accurate and legitimate. Confirmations may be either positive, requiring a response whether the debtor agrees or disagrees with the balance, or negative, requiring a response only if the debtor disagrees with the balance.
Example: Suppose you are auditing a software company with a major client that shows an outstanding balance of $50,000 on the accounts receivable ledger. You send a positive confirmation to this client, asking them to confirm the amount. The client replies, confirming the balance. This evidence strongly supports the recorded AR balance. If there's a discrepancy, it’s a red flag requiring additional investigation.
Aging Analysis
Aging Analysis involves breaking down AR balances by the length of time they have been outstanding. This is crucial for assessing the collectability of receivables and is a common area tested in the CPA exam. The older the receivable, the less likely it is to be collected. This analysis aids in the valuation of the AR and in the estimation of the allowance for doubtful accounts.
Example: Continuing with the software company, you perform an aging analysis and discover that $20,000 of the AR is over 90 days old. In comparison to prior years, this is unusually high for the company, which usually sees only about $5,000 over 90 days old. This might require you to reassess the adequacy of the allowance for doubtful accounts and could impact your audit opinion.
Bad Debt Assessment
The Bad Debt Assessment is the procedure to evaluate whether the client has made adequate provision for uncollectible accounts. The auditor needs to assess the adequacy of the allowance for doubtful accounts, a contra-asset account that reduces the AR to its net realizable value. On the CPA exam, candidates might have to calculate or evaluate bad debt expense and its impact on financial statements.
Example: During your audit, you review the software company’s method for estimating bad debts and find it historically accurate. However, given the aging of AR this year, you discuss with management whether a larger allowance is needed. After your discussion, they adjust the allowance from $8,000 to $15,000. This exercise showcases the importance of auditors not only in confirming data but also in advising clients to make prudent financial decisions.