Considering what we have gone through on the other assets the audit work to verify the figure of trade debtors would be as follows:
1) Obtain a schedule of debtors, preferably aged.
2) Validate the records and controls over sales and debtors through a selected sample of compliance testing and substantive testing.
3) Detailed examination of the control account including review of the reconciliation between the control account and the debtor’s ledger.
4) Circularisation of a sample of debtors strictly to confirm existence.
5) Carrying out cut off test to ensure that sales and stocks have been accounted for in the correct period.
6) Analytical review by comparing sales/debtors ratio with previous years.
7) Looking for evidence to confirm that balances attributed to individual debtors are composed of specific items.
8) Evidence that all included items are bona fide trade debtors.
9) Review of credit notes issued after date to ensure that they do not cancel debtors balances.
10) Examination of debtors for collectability.
11) Ensuring that each account is settled from time to time and also enquiring into credit balances.
12) On the schedule that is obtained, the auditor tests balances on ledger accounts to the schedule and vice versa, he also tests the cast of the schedules and ensures that the totals agree to the balance of the control accounts.
13) The auditor tests the effectiveness of the system of internal control but before he does that he has to determine what the system is, and a good system for debtors should ensure that:
a) Only bona fide sales bring debtors into being;
b) All such sales are to approved customers;
c) All such sales are properly recorded;
d) Once they have been recorded the dates are only eliminated by receipt of cash or on the authority of a responsible official;
e) Debts are collected promptly;
f) Balances are regularly reviewed and aged. A proper system for follow up exists and if necessary adequate provision for bad and doubtful debts are made.
Under debtors the crucial issues for the auditor are the valuation of debtors and the existence of debtors
Valuation of debtors
Debtors are valued just like other assets at the lower of cost and net realisable value. Valuation of debtors is really a consideration of whether the provision for bad and doubtful debts is adequate or not. The auditor must therefore consider the following matters:
i. How adequate is the system of internal control as far as approval of credit and follow up of poor payers is concerned;
ii. The period of credit allowed and taken;
iii. Whether balances have subsequently been settled by the date of the audit
iv. Whether an account is made up of specific items or not;
v. Whether an account is within the maximum credit allowed;
vi. The market values of any securities if any that have been lodged as collateral;
vii. General information about debtors from collectors, trade associations or other publications;
viii. The issue of set off;
ix. Whether there are any legal proceedings, the state of those proceedings and the legal status of any debtor;
x. The effects of the statute of limitations;
xi. Comparing of debtors to sales this year with previous periods, budgets and other companies;
xii. Evidence that any debt is in dispute for non delivery, breakages or poor quality.
It should be noted that any debts which are considered bad should be written off to the profit and loss account.
Provisions for doubtful debts should be set up against debts which are considered doubtful.
Some companies have the habit of making round sums or percentage provisions for doubtful debts. This practice is generally unacceptable to an auditor unless it is based on good statistical evidence which may come from past experience or may come from data about other similar undertakings which is obtainable from trade associations or which is publicly available.
The easiest way to establish the existence of a debtor is to ask the debtor whether he exists. This is done by use of a practice known as debtor’s circularisation which is basically a direct confirmation from the debtors.
Advantages or reasons for circularising debtors are:
1) To obtain confirmatory direct external evidence of the existence and beneficial ownership of the asset debtors.
2) To give evidence that the figure in the accounts for debtors is a true and fair one.
3) To provide confirmatory evidence that the system of recording and documenting sales and debtors and the controls there on can be relied upon to produce an accurate figure for debtors. Normally, tests which are designed to obtain evidence of the reliability of the system are called compliance tests. Circularisation therefore is useful both for substantive and compliance tests.
4) To provide evidence as to the correctness of cut off. Cut off is the technical term used to ensure that in computing profits sales are accurately compared with the costs of the goods sold. Cut off tests can be substantive i.e. examining last numbers of documents or compliance that is, if controls exists their application can be tested.
5) To provide evidence on the existence of disputed items.
The Audit Approach.
1) Must obtain the cooperation of the client, as only the client can authorise third parties to communicate with the auditor.
2) Select the method to use, this can be positive, negative or a combination of both.
3) Select a sample. All customers can be circularised but this is unusual.
4) Draft the circular, but ensure that it is written out on the client letter head and that it requires a reply to be sent direct to the auditor.
5) Fill in the details.
6) Despatch the letter himself.
7) Receive and evaluate replies.
8) Follow up when replies are not received.