The Confirmation That Came Back Wrong
You are auditing receivables of a distribution company. You send 40 positive confirmations covering AZN 6.8 million of a AZN 8.1 million receivable balance. Twenty-eight replies are received and agree. Seven are not returned despite a second request. Five replies show differences: three customers say the balance is lower because of credit notes issued after year-end, and two say they have never heard of the company. The finance director explains the two 'unknown' customers as 'small traders who use a different name' and offers to provide alternative evidence himself. One of the 'unknown' customers is a related party of the sales manager. The audit report is due in two weeks.
1. How should you evaluate the confirmation results and what follow-up is required for the non-responses and differences?
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Framework (ISA 505): Positive confirmations are the preferred form for receivables. The auditor must evaluate the results, including non-responses and differences, and perform alternative procedures where necessary.
Non-responses (7): Perform alternative procedures - inspect subsequent cash receipts, sales invoices, shipping documents and contracts - to obtain evidence of existence and valuation. Do not simply accept management's explanation.
Differences (5):
- Three credit-note differences: These indicate cut-off issues. Determine whether the credit notes relate to pre-year-end sales; if so, receivables and revenue are overstated. Test the credit-note dates and the underlying returns.
- Two 'unknown' customers: These are serious. A customer denying the balance suggests the receivable may be fictitious. The finance director's offer to provide his own alternative evidence is not independent evidence and must not be relied upon.
Related party link: The sales manager's relationship to one 'unknown' customer raises a fraud risk and a related-party disclosure issue (ISA 550). Escalate and investigate.
2. What are the implications for the audit opinion if the two 'unknown' balances cannot be substantiated?
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Quantify: Determine the amount of the two balances. If they are, say, AZN 400,000 against a AZN 8.1m receivable balance and a materiality of AZN 250,000, they are material.
Nature of the issue: If the balances are fictitious, this is a misstatement (existence and valuation of receivables, and possibly revenue). If the auditor cannot obtain evidence either way, it is a scope limitation. The distinction matters for the opinion.
Opinion:
- Material misstatement confirmed: Qualified opinion (or adverse if pervasive).
- Scope limitation, material but not pervasive: Qualified opinion.
- Scope limitation, pervasive: Disclaimer.
Fraud consideration (ISA 240): The 'unknown' customers and the related-party link may indicate fraudulent financial reporting. The auditor must communicate to those charged with governance, consider the need for further investigation, and document the matter. The auditor should not sign off until the matter is resolved or the opinion reflects it. The two-week deadline does not justify accepting inadequate evidence.