For companies that sell on credit, accounts receivable can make up a substantial portion of the balance sheet. An auditor must understand how a company could misstate accounts receivable, either inadvertently or intentionally, in order to express an unqualified opinion on a company's financial statements. Conversely, as an accountant, it is helpful to know what the risks are so you can find any errors before an auditor does.
Existence or Occurence
A major risk for accounts receivable is existence. Because accounts receivable usually consist of an aggregation of many smaller accounts, the auditor sends confirmations to the entity's customers to verify the terms of payment and the validity of the debt. Auditors will send these confirmations under their control and follow up on any suspicious or unreturned confirmations. For unreturned confirmations, alternative procedures will be performed at a commensurate level of risk. Alternative procedures could involve phone or fax correspondence and examination of subsequent cash receipts.
The completeness assertion relates to the risk that the company has not recorded all accounts receivable. Because an auditor cannot test the company's records for what is not there, the CPA will usually test completeness by looking at transactions around period cutoff dates. By assessing the sales process and gaining comfort around the company's ability to process transactions in the proper period, the risk of the completeness assertion is mitigated.
Rights and Obligations
The rights assertion relates to the risk that receivables due to the company are not the property of the company. An auditor will determine the risk level of this assertion by learning and understanding the company's business model and revenue cycle. Once the auditor has the requisite knowledge, he will design specific procedures to test this risk, if it is warranted. If not, understanding the transaction cycle can give the CPA the comfort she needs.
Valuation or Allocation
The valuation of accounts receivable is a major risk for many companies. As receivables, they must be held as net realizable value, and companies must make an estimate of collectibility and reduce their balance by an allowance for doubtful accounts. The auditor must determine whether the company's methodology for the estimate is reasonable as well as audit the underlying information used to make the estimate. In companies where this is a significant management estimate, the allowance can be a point of contention among management and the auditors.
Presentation and Disclosure
Both international and U.S. accounting standards have specific guidelines as to the presentation and disclosure of receivables balances. The risk in presentation is that the balances in the company's financial statements and footnotes may not present the company's balances fairly. Usually both the company and the auditor will go through financial statements checklists to analyze the presentation and disclosure of these balances.