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Sunday, October 18, 2015

Audit of Receivables: Theory

Receivables refer to claims against others for money, goods or services arising from sale of merchandise or money lent or the performance of services.  For accounting purposes however, the term is employed to mean claims expected to be settled by the receipts of cash.

Receivables are recognized when title to the goods passes to the buyer or when transfer of resources take place.  The point at which title passes may vary with the terms of the sales.

    1. At face value
    2. At discounted amount (present value)


1. Receivable are valued at their net realizable value or their expected  cash value.

Determination of NRV requires estimation of uncollectible receivables, as such, an allowance account should be set up for doubtful accounts and for any anticipated adjustments which in the normal course of the business will reduce the amount receivable.

Net realizable value - is the estimated amount of cash that will be collected or realized from receivables.

2. Long term note receivables should be valued at an amount  representing the present value of the expected future cash receipts.

3. Receivable denominated in foreign currency should be translated to local currency at the exchange rate on balance sheet date.

1. Current Assets vs. Non Current

Current -  receivables which are expected to be realized cash within the normal operating cycle or one year, whichever is longer.

Non current - receivables which are expected to be realized beyond one year or those receivables which are not currently collectible.

2. Trade vs. Non-trade

Trade receivable -  refers to claims arising from credit sale of merchandise or services in the ordinary course of the  business.  The usual type of trade receivables are:
a.  Accounts receivable  -  short term, unsecured and informal credit arrangements (open accounts).
b.  Notes receivable -  evidenced by a formal instrument which is the promissory note.

Non trade receivables -  represent claims arising from sources  other than the sale of merchandise or services in the ordinary course of the business.


Receivables whether trade or non trade which are currently collectible should be presented on the balance sheet as one line item called Trade and Other receivables.

1. Existence - to determine whether receivables actually exist.

Audit Procedure: Obtain  a  schedule of aged trade accounts receivable and notes receivable schedules  and reconcile them to the general ledger.

2. Rights and Obligations - to determine whether receivables represent bona fide obligations owed to the company as of balance sheet date.

Audit Procedures:
a. Confirm receivables with debtors
b. Inspect notes on hand
c. Perform analytical  review procedures

3. Completeness - to determine that all transactions relative to receivables have been recorded  in the proper accounting period.

Audit Procedure: Test cutoff of sales and sales returns to determine whether receivables are recorded in the proper accounting period.

4. Valuation - to determine whether receivables are recorded at proper amounts in accordance with GAAP.

Audit Procedure: Review collectibility of receivables and determine the adequacy of allowance for doubtful accounts.

5. Presentation and Disclosure - to determine whether receivables are properly presented and classified in the balance sheet.

Audit Procedure: Evaluate financial statement presentation and disclosure of receivables.

1. Methods of Receivable Confirmation
a. Positive confirmation
- used when individual account balances are relatively large.
- there is a reason to believe that there may be a substantial number of accounts in dispute or with inaccuracies or irregularities.
- internal substantiating evidences are not adequate
- internal control system is weak
b. Negative confirmation
- internal control procedures regarding receivables  are
considered effective.
- a large number of small balances are involved
- the auditor has no reason to believe that persons receiving the requests are unlikely to give them consideration.

2. Trade discounts vs. Cash discounts
Trade discounts-  this also known as volume discount or quantity discount.  It is a means of adjusting the list price for different buyers or varying quantities.  Accounts receivables should be recorded net of trade discounts.

Cash discounts - this is a reduction from the invoice price by reason or prompt payment.

3. Customer’s credit balances -  credit balances in Accounts receivables resulting from overpayments, returns and allowances and advance payments from customer.  This account should be classified as current liabilities and must not be offset against the debit balances in other customers’ account.

4. Terms related to freight charges
a. FOB Destination -  means that ownership to the merchandise is  transferred to the buyer only upon reaching the point of  destination or upon the buyer’s receipt of merchandise.
b. FOB Shipping point -  means that ownership to the merchandise is transferred to the buyer upon shipment thereof.
c. Freight collect -  means that the freight charges on the merchandise shipped is to be paid by  the buyer.
d. Freight prepaid -  means that the freight charges on the merchandise shipped was already paid by the seller.

5. Accounting for bad debts expense
a. Allowance method -  this requires the recognition of bad debt loss if the accounts are doubtful of collection.
b. Direct write off method - this requires the recognition of bad debt loss only when the account proved to be worthless or uncollectible.

6. Methods of estimating bad debts expense
a). Percentage of sales (Income statement approach) -  bad debts expense is calculated by applying a percentage to credit sales for the period.  This process results in an adjusting entry that debits bad debts expense and credits allowance for doubtful accounts without regard to the existing balance in the allowance account.  A proper matching of cost and revenue is achieved because bad debt loss is directly related to sales and reported in the year of sales
b). Percentage of Receivables (Balance sheet approach) -  results in  a more accurate valuation of receivables on the balance sheet since this method attempts to value accounts receivables at their future collectible amounts.
a. Composite percentage - a single rate is applied to Accounts receivable at the end of the period to obtain the desired ending balance of the allowance.  The amount of bad debts expenses recognized is the difference between the existing balance in the allowance account and the desired ending balance.
b. Aging - accounts receivable are classified by age and a different percentage is applied to each age group.  The allowance is then determined by multiplying the total of each classification by the rate or percent of loss depending on the experience of the company for each category.

a. Definition -these are claims supported by formal promises to pay, which are in the form of notes.
b. Recognition
1. Short term notes are generally recorded at face value because the interest implicit in the maturity value is immaterial.
2. Long term notes should be recorded at present value.
a. Interest bearing notes -  the PV of the note is the same as the face amount of the note.
b. Non interest bearing notes
Present Value
note exchanged solely for cash equal to the amount of cash proceeds
note exchanged for property, goods           Present value is according to the
ff. order of priority:
1. FMV of the property, goods or  services
2. FMV of the note received
3. Discounted amount of note using appropriate rate of interest.

The difference between the face amount of the note and its PV is recorded as discount or premium and amortized to Interest income account over the life of the note using the effective interest method.

c. Valuation and reporting
1. Short term notes are reported at their net realizable value.
2. Long term notes are reported at present value.

a. Pledging -  receivables are used as collateral or security for a loan and not reflected in the accounts although a disclosure should be made in the financial statements either in a note or parenthetically.

b. Assignment -  a more formal borrowing arrangement in which the receivables are used as security .  The assignor or borrower transfers its rights in some of its accounts receivables to a lender or assignee in consideration for a loan
1. The loan is at a specified percentage of the face value of the collateral and interest and service fees are charged to the assignor (borrower).
2. The debtors are occasionally notified to make payments to the assignee (lender) but most assignments are not on a notification basis.
3. Assigned accounts are segregated from other accounts.  The Notes payable should be deducted from the balance of A/R assigned to determine the equity in assigned accounts receivable.

c. Factoring -  it is similar to a sale of receivables because it is generally on a  without recourse-notification basis.  The factor or buyer assumes the risk of collectivity and generally handles the billing and collection function.  A gain or loss is recognized for the difference between the proceeds received and the net carrying amount of the receivables factored.

d. Discounting -  this is a sale of the note to a third party, usually a bank.  The sales is usually on a with recourse basis which means that upon the default of the debtor, the seller of the note becomes liable for its maturity value.  Proceeds from discounting is computed as follows:
1. Interest to maturity (P x R x T)
2. Maturity value (P + I)
3. Discount (MV x DR x DP)
4. Net Proceeds (MV - Discount)

If the face value of the note is > proceeds, the difference is interest expense.
If the face value of the note is < proceeds, the difference is interest income.

Copyright 2015 @philcpareview

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