How to Audit Accounts Receivable

Owners, banks, shareholders, lenders, even employees rely on the financial information of a business.  Auditing is the method that provides a high level of assurance the numbers are correct and trustworthy!

While you may not be an official auditor, if you deal in any way with accounting records of your business you need to understand how the audit process of accounts receivable works.

Accounts receivable is often the most important asset a company owns; therefore, it rightly receives the bulk of the attention.

Accounts receivable is directly related to the sales of a company, which is often the most visible part of a company, and so auditors will spend much of their time confirming accounts receivables.  As a business owner you should appreciate this attention to detail and understand how to audit accounts receivable even though you may not perform the actual audit.

Accounts receivable fuel your cash flow, so let’s review the steps of an accounts receivable audit.

Accounts receivable audit procedures

To audit accounts receivables the auditors will request several reports that they will use to test the validity and accuracy.  The most common reports used are:

• Balance sheet
• Income statement
• General ledger report
• Accounts receivable ledger
• Accounts receivable aging report

These should be standard reports maintained by the company.  If you use accounting software, the reports will be included in the software reporting section.  If you don’t use accounting software, you will need to manually prepare reports that show all the information.  Excel reports are a great alternative for smaller businesses.

1. Verify the accounts receivable ledger totals correctly.   The accounts receivable ledger details all the customer invoices for the period.  The auditors will add up each invoice on the report to verify that the total listed was added correctly.  Any discrepancies will have to be resolved.  This may seem a simple step, but it builds the foundation for the entire audit.
2. Verify the accounts receivable ledger total matches the accounts receivable total on the general ledger.  Once the detail accounts receivable totals correctly, it is compared to the total on the general ledger.  In essence this demonstrates that the accounts receivable details add up to and support the total balance reported on the general ledger and balance sheet.  If the totals don’t match, it brings doubt and additional work must be performed to identify the difference.  Often the difference is a mis-posted journal entry.
3. Verify the accuracy of journal entries posted to accounts receivable in the general ledger.  Sometimes journal entries need to be posted to adjust an account.  Each journal entry must be justified and explained to the auditors to validate it.  It is important to keep detailed supporting documents for all journal entries posted to the accounts receivable general ledger account.
4. Verify the accuracy of a sampling of individual customer invoices. Once the detailed accounts receivable ledger is totaled and matched to the general ledger the auditors will test invoice accuracy based on a random sample of invoices.  You will have to produce each invoice either an electronic or physical copy.  The invoice date, amount, customer name, and description of purchase will be compared to ensure invoices are properly recorded and recorded in the right sales period.
5. Verify invoices match to shipping logs.  Another assurance that invoices are correct is to match the invoice to a shipping log.  This helps the auditor ensure invoices are recorded in the correct period, and were actually delivered.  This test often includes invoices right at the end of the accounting period and the beginning of a new period.  The risk here is recording sales in the incorrect period.
6. Verify specific customer accounts receivable balances.  This is an important test because it provides third party verification.  Typically, large customer balances and a random sampling of other customer balances will be confirmed directly with the customer.  A letter will be sent to the customer by the auditor detailing the balance and requesting the customer to verify the accuracy and respond.  This is a good test because of the independent verification.
7. Verify cash receipts of accounts receivable.  Not all customers will reply to the requested verification.  In these cases, auditors review cash receipts that may have come in following the end of the period.  A cash receipt shows good support that the receivable was valid.  This step is primarily done only as a backup to customer verification.  Auditors will typically look at bank statements and cash deposit details to see the support for a cash receipt.
8. Verify and review the allowance for doubtful accounts.  Allowance for doubtful accounts is what is called a contra account.  It is an estimate of accounts receivables that will most likely not be paid.  While this is an estimate, a company must have valid justification for writing off an account.  Often this is tested by having a manager or owner describe their process.  Also, an analytical review of prior periods can be completed to ensure there are not large changes.  Consistency is the key along with good explanation and documentation.
9. Verify the percentage of bad debts written off during the period.  Periodically you sell to a customer who fails to pay their invoice for whatever reason.  If you are unable to collect, the invoice amount is written off.  Auditors want to verify that write offs are not excessive which could reveal other problems.  To test this, an auditor will compare the bad debt ratio over several years to see if it appears out of line.  The bad debt ratio is calculated by dividing the bad debt written off divided by the total sales for the period.  Any large discrepancy will need to be justified.
10. Verify the accuracy of credit memos. Much like customer invoices, credit memos also need to be reviewed.  A random selection will be chosen and reviewed to ensure the credit memos were recorded in the correct period, they were authorized, and the credit memos appear reasonable.  A final test would be to review credit memos issued after the end of the period to see that there are no improprieties in terms of recording sales only to credit them following the end of the audit period.
11. Verify the propriety of all bill and hold sales. Bill and hold sales may not be as common, but occasionally a company will bill a customer but hold the inventory until later.  The auditors will test any such sales to verify the legitimacy of the sale.  Also, inventory would need to be clearly marked and set aside to avoid counting it in the inventory for the audit period.
12. Verify receipt of goods log after the end of the audit period.  Again, the purpose of this step is to verify sales are not improperly inflated by invoicing and shipping goods only to have them return after the end of the audit period.  By reviewing the receipt log, any large or significant volume of receipts after the period would need to be explained and validated.
13. Verify the overall accuracy of accounts receivable by analytical ratios. As a general review of accounts receivable, one final test is to compare accounts receivable as a percentage of sales for comparable periods.  This can reveal trends or potential problems that may need additional review.

While this may not be an exhaustive list of audit procedures, these are the most commonly used by external auditors.  You can expect that any discrepancies would require justification and additional procedures.

What happens if there is an audit exception?

One final consideration in regards to auditing accounts receivables is audit exceptions.  It is not uncommon for some audit exceptions to be found.  If an exception is found, the auditor will extrapolate the exception to the entire population of accounts receivable.  Let me explain.  

Because not every single invoice is physically reviewed, auditors make assumptions that if x amount of error is found in the sample, then x amount of error exists in the entire accounts receivable balance.  If the overall error is below a materiality threshold then the error really becomes a moot point as it would not materially affect anybody’s decision making process.

What risks to accounts receivable audits help avoid?

Audit procedures are valuable for all involved.  Sometimes they seem cumbersome, but it is for the good of the company and its invested parties.  Audits help ensure

• Accounts receivable balances are correct and properly recorded
• Sales are not inflated and correctly recorded
• Accounts receivables can reasonably be expected to be collected
• Bad debt expense is not inflated or incorrectly recorded.
• Good account procedures are in place to ensure accuracy of all records.