Auditors obtain several different confirmations from various sources during the course of their audit.
Describe the audit evidence provided each of the confirmations listed below, the practical difficulties in obtaining them and the alternative audit evidence available when they are not provided:
(a) Management representations. (7 marks)
(b) Direct confirmation of receivables. (7 marks)
(c) Confirmation of inventory held third parties. (6 marks)
(a) Management representations Evidence
(i) Auditors obtain written representations from management on material matters where other sufficient appropriate audit evidence cannot reasonably be expected to exist. ISA 580 ‗Management Representations‘ deals with this subject.
(ii) Such matters might include confirmation that all related party transactions have been disclosed in the financial statements and confirmation of all matters that rely principally on the exercise of judgement directors – such as ‗soft‘ provisions. The letter also usually includes confirmation that all matters occurring since the balance sheet date that should be brought to the attention of auditors have been brought to their attention, and that all of the accounting records have been made available to the auditors.
(iii) Management representations should not conflict with other audit evidence. If they do, the matter should be investigated and resolved.
(iv) In practice, it is not always easy to obtain a signed management representation letter. The letter should be addressed from the client to the auditor, but it can take the form of a letter from the auditor to management that is acknowledged management, or signed minutes of a board or similar meeting.
(v) If management refuses to provide representations, this may be grounds for a qualification of the audit report on the basis of a limitation in the scope of the audit. However, this is an extreme step and auditors will always discuss with directors alternative wordings that will be acceptable to them before considering qualification of the audit report. There may be genuine uncertainty on the part of management as to the reasonableness of the representations that auditors request them to make.
(vi) Unfortunately, because of the content of these letters, there is very little alternative evidence; that is why the letter is requested in the first place.
(vii) Auditors need to think carefully about the content of the letter if management refuses to sign altogether, and consider whether there is alternative evidence, whether the matters are truly material and whether an audit qualification is needed. Auditors can exert some pressure on management to sign making this threat, in practice.
(b) Direct confirmation of receivables
(i) Auditors often seek direct confirmation of receivables to ensure that the amounts stated in the entity‘s accounts receivable ledger are not overstated. Confirmation also provides evidence in relation to certain frauds and the quality of internal controls.
(ii) Confirmation that an amount is owed is not confirmation that the amount will be paid and auditors need additional evidence on the recoverability of receivables.
(iii) There are two types of confirmation, positive and negative. In the former case, the customer is requested to reply in any case, and the auditor can either insert the balance to be confirmed or the customer can be requested to do so. In the latter case, a reply is only requested if the customer disagrees. This method is only suitable where receivables are well controlled.
(iv) The response rate to requests for confirmations is not always satisfactory and repeated requests may be necessary. It is not uncommon for replies to be inaccurate, especially where the amount stated is too low.
(v) Where the customer is requested to insert the balance, the reconciliation can sometimes be very difficult, even with the help of the client, and the customer‘s assistance may be needed.
(vi) Where no reply is received it is important that alternative evidence is obtained on the same balance (and not to test another balance). Where there is a discrepancy between the client‘s records and the customer‘s records, the matter should be investigated and resolved.
(vii) Sometimes, the customer can provide a reconciliation, particularly if the matter only relates to timing differences. On other occasions there may be a dispute and a provision may be necessary.
(viii) Alternative evidence for receivables includes payment of the amount after the period- end, a review of contracts and signed delivery notes, and analytical procedures on the ageing of receivables.
(c) Confirmation of inventory held third parties
(i) It is often not possible for auditors to confirm inventory held third parties attendance at an inventory count and therefore the only evidence available is confirmation from the third party.
(ii) It is particularly important to ensure that the confirmation is genuine because of the possibility of fraudulent collusion between the third party and the client to inflate inventory and profit figures.
(iii) The reliability of service from the third party and the quality of documentation and correspondence are all taken account of as part of the auditor‘s risk assessment in this area.
(iv) Both the quality and quantity of inventory held should be confirmed. It is common for third parties to use different descriptions or units of measurement in their records to those used the client and it is necessary to reconcile these items.
(v) It may be possible for the auditor of the third party to provide some evidence in relation to the amounts held.
(vi) If the inventory held the third party is likely to be material, the auditor must consider the possibility of visiting the third party and attending the inventory count.
(vii) The auditor may review and test the controls over the movement of inventory to and from the third party and the related records, in order to reduce the level of substantive evidence needed at the period-end.
(viii) Records that show ‗negative‘ inventory (more ‗outs‘ than ‗ins‘) at either the client or the third party may be indicative of misclassifications, for example.