Trade receivables, prepayments and confirmations (ISA 505)

A distributor in Kano shows trade receivables of ₦1.25 billion at the year end. The balance is mostly made up of a few large customers and hundreds of small ones. Is the money really owed? Will it be paid? The best evidence is a letter from the customer, sent to the auditor, saying "yes, we owe you this".

That letter is a confirmation, and it is the standard way to test receivables. The auditor also tests whether doubtful debts have been provided for, whether sales were recorded in the right year and whether prepayments are right.

This topic covers the risks for receivables, direct confirmation under ISA 505, planning the exercise, positive and negative confirmation, selecting the sample, handling replies and non-replies, summarising and extrapolating the results, other procedures on irrecoverable debts and cut-off, and the audit of prepayments. The previous topics dealt with inventory, and the next deals with bank and cash.

Key terms in plain English

Syllabus check

This topic is in syllabus area C, audit evidence and substantive procedures (25% of marks). It covers:

• substantive procedures for trade receivables and prepayments
• external confirmations (ISA 505)
• the audit of accounting estimates

CAMA 2020 and receivables

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria. The sections below apply to this topic.

The rules in more depth

Principal risks

Trade receivables are usually material, so a significant amount of work is needed. The principal risks are:

• receivables that are irrecoverable (valuation);
• receivables contested by customers (existence, and rights and obligations); and
• wrong cut-off between goods outward and recording of receivables. Cut-off is an income statement assertion that affects the receivables audit.

Because assets are normally tested for overstatement, completeness is less relevant. Nil balances may be checked for completeness, as shown later.

Confirmation of balances

Direct confirmation (also called circularisation) means asking customers to confirm their balance in writing, directly to the auditor. Written confirmation from customers is normally high-quality evidence, because it is external and in writing. Its reliability depends on two things that the auditor does not fully control: a large proportion of customers must reply, since they are not obliged to; and some may confirm without checking the details.

Because the auditor is concerned about overstatement, the exercise starts with the client's own list of receivables ledger balances. The confirmation tests:

• Existence: the receivables exist and there is no overstatement;
• Rights and obligations: the client has the legal right to the amounts;
• Valuation: the receivables are at the appropriate amount; and
• Cut-off: transactions are recorded in the right period.

ISA 505: external confirmations

ISA 505 says that confirmations received directly by the auditor are likely to be more reliable than evidence generated by the client. Where it is reasonable to expect customers to reply, direct confirmation will normally be part of the testing. The auditor must keep control over the requests, by:

• deciding what information to confirm or request;
• selecting the confirming party, for example the finance director or controller of the customer;
• designing the request, including an instruction that replies go directly to the auditor; and
• sending the requests personally.

The letter, though sent by the auditor, carries the client's authorisation for the customer to give the information to the auditor.

If management refuses to let the auditor send a request, the auditor must enquire into and validate the reasons, consider the effect on the risk assessment and other procedures, and perform alternative procedures. A refusal without good reason raises the risk of fraud and may lead to a limitation of scope.

Results. The auditor must:

• obtain more evidence if there are doubts about the reliability of a response, and consider the effect on risk assessment if a response is found not to be reliable;
• perform alternative procedures for any non-response; for a non-response to a vital positive request the auditor considers the effect on the report;
• investigate all exceptions, which could be a misstatement, fraud, a breakdown in control or just a timing difference; and
• evaluate the results as a whole to decide whether they give relevant and reliable evidence or whether more is needed.

Planning the confirmation exercise

• Timing. Ideally after the year end and based on balances at the year end. To ease pressure at the final stage, it is often done at an interim date, normally no more than three months before the year end. The auditor then checks the changes in the balances between the confirmation date and year end, mainly by checking control account entries to books of prime entry.
• Number of balances. Usually a sample, since the cost of confirming all customers outweighs the benefit. A representative sample allows a reasonable conclusion.
• Method. A positive or a negative request.

Positive or negative confirmation?

ISA 505 permits negative confirmation as the sole procedure only if all these hold:

• the risk of material misstatement is low and controls have been tested
• the population has a large number of small balances
• a very low exception rate is expected
• the auditor knows of no circumstance that would lead recipients to ignore the request

A sample positive confirmation letter

The letter appears to come from the client and says, in substance: In accordance with the request of our auditors, we ask you to confirm to them directly your indebtedness to us at (date), which according to our records is ₦(amount), as shown by the enclosed statement. If this agrees with your records, please sign below and return this letter direct to our auditors in the enclosed stamped addressed envelope.

If it does not agree, please tell our auditors directly the amount shown by your records and, if possible, give details of the difference on the back. The reply slip has a confirmation number, an account number, a statement that the amount is or is not in agreement with the customer's records at the date, a signature, date and position, and a note that the customer's own position is attached if it differs.

The auditor posts or e-mails the letters directly, so that the auditor is sure they are sent to the selected customers.

Sample selection and performing the exercise

1. Obtain or prepare an aged list of receivables ledger balances at the chosen date.
2. If the client prepared the list, check its completeness and accuracy, and the total, against the receivables control account and a sample of balances in the ledger.
3. Choose a suitable sampling method that makes the sample representative of the population.
4. If the population is not homogeneous, use stratified sampling.

Consider including these accounts in the sample:

• overdue accounts;
• credit balances, where the client owes the customer after issuing credit notes;
• accounts with round-sum payments, such as ₦500, ₦1,000 or ₦3,000, instead of payments of specific invoices;
• nil balances, which check completeness of receivables; and
• individually material balances.

In an IT system, audit software can select, for example, every 500th ₦ or all balances over a set amount, plus nil and credit balances. If the client refuses permission for a request to a particular customer, the auditor looks for the reason and performs alternative work on that balance.

If no reply arrives within a reasonable time, the auditor sends second and third requests or asks the client to contact the customer.

After the replies arrive

Check that each reply is signed by a responsible official and file it. Classify the sample:

• Balance agreed. No further work.
• Balance not agreed. Ask the client to reconcile its records to the customer's balance and check the reconciliation, looking for errors in the client's figures. Many differences are timing differences, such as an invoice, credit note or cash recorded by one party and not yet by the other. If the auditor is confident that they are timing differences, they are not errors.
• No reply. The auditor cannot ignore these accounts, as they were chosen as part of a representative sample. Alternative procedures are needed.

Alternative procedures for non-replies. If the customer has since paid the amount due at the confirmation date, that is strong evidence of the receivable.

If there has been no payment, or only part-payment, the auditor examines, for each invoice outstanding at the confirmation date, (a) a signed customer purchase order, (b) signed delivery documentation, with the customer's signature on the delivery note, and (c) a sales invoice addressed to the customer.

Summary and conclusion

When the exercise is complete, the auditor prepares a summary of responses showing the amount of balances for which no supporting evidence has been found. Those amounts are misstatements, and may show irrecoverable debts. The auditor concludes on the likely misstatement in the whole population from the sample result.

Total receivables are ₦1,248,900. Extrapolating the unresolved 2.5% gives a potential error of 1,248,900 × 2.5% = ₦31,222, which is carried to the cumulative errors schedule, the auditor's list of items where the auditor's view differs from the client's records. The schedule is used when reaching the final opinion.

Other procedures: irrecoverable receivables

• Review the company's procedures for identifying irrecoverable and doubtful receivables.
• Review the aged listings: write-offs and allowances should relate to overdue accounts, and the auditor asks whether overdue accounts are collectable.
• Review correspondence with customers, lawyers and collection agencies about unpaid or disputed debts.
• Review the calculation of any allowance for doubtful receivables.
• Examine credit notes issued after the year end, which can show that some balances were overstated at the year end.
• Review the confirmation replies for signs that balances may not be collectable.

Under IFRS 9 the allowance is based on expected credit losses. For trade receivables, entities usually apply the simplified approach, with a provision matrix by age, adjusted for current conditions and forecasts. The auditor tests the data in the matrix, the loss rates and the adjustments, and compares past estimates with actual write-offs.

Cut-off, presentation and disclosure

The work after the inventory count gives evidence on sales cut-off.

Further work includes analytical procedures to see that inventory levels, cost of sales and gross margins can be explained by known facts; checking that invoices and credit notes dated shortly before and after the year end are in the right year; and reviewing control account entries around the year end for unusual items and asking the client to explain them.

For presentation and disclosure, the auditor checks that the list of balances agrees to the financial statements and that receivables are correctly classified and disclosed, for example the split between trade and other receivables and amounts due from related parties.

Example: which balances to test

At Mike's Manufacturing, performance materiality is ₦5,000. The balances (20X4, 20X3) are Jones 2,500 (2,400); Smith 6,000 (3,000); Brown 2,000 (2,000); White 1,000 (1,100); Crane 20,500 (18,900); other customers, each under ₦1,000, 16,600 (7,400). Total 48,600 (34,800). Brown went into liquidation during the year. The minimum selection is:

• Smith: above performance materiality, and the balance doubled.
• Brown: below performance materiality but probably irrecoverable.
• Crane: individually material.
• A sample of the other customers: each is small, but together they are material and the total more than doubled, which could mean a deliberate overstatement of small balances or fictitious customers to avoid detection.

The audit of prepayments

Prepaid expenses are often estimated amounts, so they may not lend themselves to precise checking, and they are often not material. Procedures include:

• obtain or prepare a list of prepayments with supporting calculations
• check the calculations if the client prepared the list
• use analytical procedures, such as comparing balances with the previous year
• review the list for obvious errors or omissions using knowledge of the business

For larger items, such as annual insurance or rent, the auditor agrees the payment to the invoice and the contract, and recalculates the portion that relates to the next period.

Further points on confirmations

Electronic confirmation, through e-mail or a secure portal, needs extra care. The auditor checks that the reply truly comes from the customer, for example by confirming the sender's address or by telephone to a known number, because a fraudster can intercept replies.

Where the customer is a government body that will not reply to confirmation requests, the auditor relies on alternative procedures, such as inspecting contracts and certificates of work done and later receipts. Confirmations are less useful for the completeness of receivables, since a customer may confirm only the balance it is told about.

Factored or discounted receivables need special attention, since the auditor must decide whether the client has transferred substantially all the risks and rewards, and so whether the receivable should still appear on the statement of financial position.

Testing the allowance for expected credit losses

A provision matrix groups receivables by age and applies a loss rate to each group. Suppose receivables are ₦100 million: current ₦60 million at 1%, 1 to 30 days overdue ₦20 million at 3%, 31 to 90 days ₦12 million at 10% and over 90 days ₦8 million at 40%. The allowance is 0.6 + 0.6 + 1.2 + 3.2 = ₦5.6 million.

The auditor tests:

• that the ageing is accurate, by checking a sample of invoices to dates
• that the loss rates are based on the client's own history of non-payment
• that they have been adjusted for current conditions, such as a downturn or a customer's financial difficulty
• that specific, known problem accounts, such as a customer in liquidation, are provided for separately and not left in the matrix

The auditor compares last year's allowance with the actual write-offs in the year to judge whether management's estimates have been reliable and whether there is bias, as ISA 540 requires.

Write-offs and recoveries

Write-offs should be authorised by someone senior who is not responsible for collecting the debt or recording cash. The auditor looks at a sample of write-offs for authority and supporting evidence, such as a liquidator's notice or a letter from a lawyer, and checks for later receipts on accounts written off. A debt written off and then paid to an employee, who keeps the money, is a known fraud.

A large write-off just before the year end may also show earlier overstatement of sales.

Related parties and unusual customers

The auditor watches for balances due from directors, shareholders and other related parties, which need disclosure and may not be recoverable. Large sales to a new customer near the year end, to a customer in a country with weak enforcement, or on unusual terms such as extended payment or a right to return, suggest a risk of fictitious or premature revenue.

Confirmations to these customers should ask about terms and side agreements as well as the balance. The auditor also checks that sales with a right of return are recognised only to the extent the client expects not to be reversed.

Keeping a confirmation log

The auditor keeps a log of every request: the customer, the amount, the date sent, the date a reply came, the outcome (agreed, differences, no reply), the follow-up steps and the conclusion. The log shows that the auditor controlled the process, helps to compute the error rate and supports the conclusion. Any request returned undelivered is followed up, since it may show a fictitious customer.

Receivables and the going concern view

A rise in overdue balances, a growing share of sales to a few customers, or customers asking for longer terms can show both a valuation risk for receivables and a cash flow problem for the client. The auditor links the receivables work to the going concern assessment, reviewing cash flow forecasts that assume collections and checking whether those collection assumptions agree with the ageing the auditor has found.

Worked examples

1. The auditor checks whether the customer paid after the year end.
2. If not, the auditor examines the signed purchase order, signed delivery note and invoice for each outstanding invoice.

1. The client reconciles the difference: a payment of ₦300,000 made on 30 December was banked on 3 January.
2. This is a timing difference, so it is not an error, but the auditor checks the cut-off of the cash receipt.

1. All four ISA 505 conditions may be met.
2. Negative confirmation can be used for these accounts, with positive confirmation for large ones.

1. The error rate is 3%.
2. The projected error is ₦60,000, which is compared with performance materiality.

How to score full marks

• Name the assertions tested: existence, rights, valuation, cut-off.
• Explain why the auditor, and not the client, sends the letters.
• Give alternative procedures for non-replies.
• Add irrecoverable debts and cut-off as extra work.

Common mistakes in the exam

• Treating silence to a positive request as agreement.
• Letting the client post the letters.
• Ignoring unreconciled differences.
• Forgetting credit notes after the year end.

Quick revision

• Confirmation: external, written and direct to the auditor.
• Positive versus negative; negative only if all four conditions are met.
• Non-replies: later cash or documents.
• Extrapolate errors; carry them to the schedule of errors.

Practice questions

Questions 1 to 10 are multiple choice. Questions 11 to 13 are written. Try each before opening the answer.

Model answers

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