Distinguish between a positive and a negative confirmation and state the circumstances in which each should be used. Why do CPA firms sometimes use a combination of positive and negative confirmations on the same audit?
(Objective 16-4)
CONFIRMATION OF ACCOUNTS RECEIVABLE
Confirmation of accounts receivable was a recurring concept in our discussion about designing tests of details of balances for accounts receivable. The primary purpose of accounts receivable confirmation is to satisfy the existence, accuracy, and cutoff objectives. Confirmations are one of the eight types of audit evidence introduced in Chapter 7. A confirmation is a direct written response from a third party in paper or electronic form, and they are considered to be highly reliable evidence because they are received directly from third parties. Although an oral response provides audit evidence, it is not considered a confirmation. U.S. auditing standards indicate that auditors should use external confirmations for material accounts receivable. Confirmation may not be appropriate in the following circumstances:
- The auditor considers confirmations ineffective evidence because response rates will likely be inadequate or unreliable. In certain industries, such as hospitals, response rates to confirmations are very low.
- The combined level of inherent risk and control risk is low and other substantive evidence can be accumulated to provide sufficient evidence. If a client has effective internal controls and low inherent risk for the sales and collection cycle, the auditor should often be able to satisfy the evidence requirements by tests of controls, substantive tests of transactions, and analytical procedures. If the auditor decides not to confirm accounts receivable, the justification for doing so must be documented in the audit files. While U.S. auditing standards require the use of confirmations for accounts receivable in most circumstances, international auditing standards suggest, but do not require their use. This is one of the few notable difference between requirements of U.S. and international audit standards. In performing confirmation procedures, the auditor must first decide the type of confirmation to use. Positive Confirmation A positive confirmation is a communication addressed to the debtor requesting the recipient to confirm directly whether the balance as stated on the confirmation request is correct or incorrect. Figure 16-5 (p. 534) illustrates a positive confirmation in the audit of Hillsburg Hardware Co. Notice that this con – firmation is for one of the largest accounts on the aged trial balance in Figure 16-3 (p. 527). A blank confirmation form is a type of positive confirmation that does not state the amount on the confirmation but requests the recipient to fill in the balance or furnish other information. Because blank forms require the recipient to determine the information requested, they are considered more reliable than confirmations that include balance information. Blank forms are rarely used in practice because they often result in lower response rates. An invoice confirmation is another type of positive confirmation in which an individual invoice is confirmed, rather than the customer’s entire accounts receivable balance. Many customers use voucher systems that allow them to confirm individual invoices but not balance information. As a result, the use of invoice confirmations may improve confirmation response rates. Invoice confirmations also result in fewer timing differences and other reconciling items than balance confirmations. However, invoice confirmations have the disadvantage of not directly confirming ending balances. Sales to major customers often involve special terms or side-agreements for the return of goods that may affect the amount and timing of revenue to be recognized from the sale. When this has been identified as a significant risk, positive confirmations often request the customer to confirm the existence of any special terms or sideagreements between the client and customer. Negative Confirmation A negative confirmation is also addressed to the debtor but requests a response only when the debtor disagrees with the stated amount. Figure 16-6 (p. 535) illustrates a negative confirmation in the audit of Hillsburg Hardware Co. that has been attached to a customer’s monthly statement. A positive confirmation is more reliable evidence because the auditor can perform follow-up procedures if a response is not received from the debtor. With a negative confirmation, failure to reply must be regarded as a correct response, even though the debtor may have ignored the confirmation request. Offsetting the reliability disadvantage, negative confirmations are less expensive to send than positive confirmations, and thus more can be distributed for the same total cost. Negative confirmations cost less because there are no second requests and no follow-up of nonresponses. The determination of which type of confirmation to use is an auditor’s decision, and it should be based on the facts in the audit. Auditing standards state that it is acceptable to use negative confirmations only when all of the following circum stances are present:
- The auditor has assessed the risk of material misstatement as low and has obtained sufficient appropriate evidence regarding the design and operatingeffectiveness of controls relevant to the assertion being tested by the con – firmation procedure.
- The population of items subject to negative confirmation procedures is made up of a large number of small, homogenous account balances, transactions, or other items.
- The auditor expects a low exception rate.
- The auditor reasonably believes that recipients of negative confirmation requests will give the requests adequate consideration. For example, if the response rate to positive confirmations in prior years was extremely high or if there are high response rates on audits of similar clients, it is likely that recipients will give negative confirmations reasonable consideration as well. Typically, when negative confirmations are used, the auditor puts considerable emphasis on the effectiveness of internal controls, substantive tests of transactions, and analytical procedures as evidence of the fairness of accounts receivable, and assumes that the large majority of the recipients will provide a conscientious reading and response to the confirmation request. Negative confirmations are often used for audits of hospitals, retail stores, banks, and other industries in which the receivables are due from the general public. Auditors may use a combination of negative and positive confirmations by sending the latter to accounts with large balances and the former to those with small balances.
The Correct Answer and Explanation is :
Answer
Positive Confirmation: A communication addressed to the debtor requesting confirmation of the stated balance, with a response required regardless of whether the debtor agrees or disagrees with the balance.
Negative Confirmation: A communication addressed to the debtor requesting a response only if the debtor disagrees with the stated balance.
Circumstances for Use:
- Positive Confirmations: Used when the risk of material misstatement is high, the population includes significant or irregular balances, and reliable responses are expected. Positive confirmations provide strong evidence as nonresponses can be followed up.
- Negative Confirmations: Used when the risk of material misstatement is low, the population consists of many small, homogeneous balances, and recipients are expected to adequately consider the requests. Negative confirmations are less costly and suited for large-volume environments.
Why CPA Firms Use a Combination
CPA firms sometimes use both types of confirmations in the same audit to balance cost-efficiency with reliability:
- Large Balances: Positive confirmations are sent to high-value accounts where material misstatements would significantly impact the financial statements, ensuring stronger evidence.
- Small Balances: Negative confirmations are used for smaller, less material accounts where the risk of error is lower, reducing audit costs without significantly compromising audit quality.
This combination approach optimizes audit resources, tailoring procedures to the materiality and risk profile of account balances while maintaining compliance with auditing standards. It also ensures that the audit gathers sufficient and appropriate evidence in a cost-effective manner.