Question

Problem One - Chapter 7: Part. A: You are the lead auditor for the Bella Luna Tree Company, Inc. in Bethel, CT. The company has a June 30" year end, and the audit team is discussing strategies for confirming year end accounts receivable. The composition of the accounts receivable is as follows: Total Accounts Receivable (before any Allowance for Doubtful Accounts): $4,584,600 Aged Composition: $ 3.667.680 Zero - 30 days 687,690 Thirty-60 days 183,390 Sixty - 90 Days 45,840 Over 90 Days $ 4,584,600 of the total accounts receivable, five individual accounts have balances over $ 250,000 each, while 80 of the accounts have balances between $ 25,000 and $ 250,000, while the remaining 200 accounts have balances under $ 25,000. To recap, the composition of Bella Luna Tree Company, Inc's accounts receivable: (1) Over $250,000 -- 5 accounts from different customers. (2) Between $25,000 and $250,000 -80 accounts from different customers. (3) Less than $25,000 - 200 accounts from different customers. Bella Luna has a separate sales group for its largest "preferred" customers, which are the select group of customers that normally make purchases in excess of $250,000 per year. Other customers are handled by Bella Luna's normal sales staff. The audit team is debating whether to send all positive confirmation, or some combination of positive and negative confirmations. After some discussion, the team narrowed choices to four different confirmation approaches: A) Positive confirmations on a sample of all 285 accounts. B) Positive confirmations on all a sample of all accounts over $25,000; negative confirmations on a sample of accounts less than $25,000. C) Positive confirmations on all 5 accounts over $250,000: positive confirmations on a sample of the accounts between $25,000 and $25,000; negative confirmations on a sample of accounts less than $25,000. D) Positive confirmations on all 5 accounts over $250,000; negative confirmations on a sample of the accounts less than $250,000. The audit team has determined that internal control over the sales and accounts receivable cycle is sound for it's preferred customers. For the "non-preferred" customers, while the controls remain sound, the audit team's impression is that the sales staff for these customers appears to be a little "stretched." Required: Describe the advantages and the disadvantages of positive and negative confirmations. Based on the four choices in (A) through (D) above, which approach would you recommend for confirmations and why you would use that approach.

Answer 1

Solution -

Problem 1

Part A

Positive Confirmation request - It is a confirmation request sent by the auditor to confirm the balances with regards to receivables and payable generally. This request asks for responses to the request in all cases that is if the party is agreeing/confirming or not agreeing/not confirming to the balance. In such case the party has to respond to the auditor mandatorily even if they agree or do not agree to the same. These are generally sent for material items where the risk could be high.

Advantages of Positive Confirmation request -

1. Much more reliable as a response is definitely received

2. If any dispute arises, a positive confirmation is physical evidence that the information was confirmed.

3. Effectiveness is more in such responses.

Disadvantages of Positive Confirmation request -

1. It might be costly as follow ups could take place.

2. It can act as a tool which the client might take offensive or might take it personally.

Though these disadvantages are quite simple the advantages of this is much more relevant.

Negative Confirmation request - It is a confirmation request sent by the auditor to confirm the balances with regards to receivables and payable generally. This request asks for responses to the request in cases that is if the party is not agreeing/not confirming to the balance. These are sent when the population is homogenous and the risk is low.

Advantages -

1. They are less expensive than positive confirmations because there are no second requests and no follow-up of no responses.

Disadvantages -

1. less reliable than positive confirmations because a non response must be regarded as a correct response, even though the debtor may have ignored the confirmation request.

2. Effectiveness of such responses is quite low.

3. In case of a dispute there will be no evidence.

As per the given question I would recommend option C, i.e., Positive confirmations for 5 customers whose balances are $250000 or more because this is a material item. Positive Confirmations for a sample of accounts between $25000 to $250000 as in this we could choose the sample which are material. Negative Confirmations for a sample of accounts below $25000 because the materiality is not too high.

Part - B

(a) The response that payment was made on June 30th is important to us because when the payment is made, you cannot continue to include the same and show it as receivable. But in the given case it is still shown as a receivable.

(b) The receipt of shipment on July 2nd isn't a concern because the sale was made before June 30th and recorded in the books and the amount to be paid is still due. Thus not relevant.

(c) Goods returned on credit by June 15th is important observation because you cannot continue to include the same and show it as receivable. But in the given case it is still shown as a receivable.

(d) Balance doesn't show discount for paying by July 5th is not much of relevance because discount will be recorded only when the payment is actually made.

Out of the above four the most important one which could be a concern to the auditor is case (c) because this is affecting the accounts receivable and also the inventory position as on June 30th.

As per guidelines only one question can be asked per time. Thus only answer to Problem no. 1 is answered.

In case of any doubts please feel free to ask and don't forget to give your valuable feedback.