Audit procedures and confirmations - External confirmations ...

Learning Outcomes

After reading this article, you will be able to explain the nature and purpose of external confirmations as an audit procedure under ISA 505. You will understand when and why auditors use confirmations, describe the process for obtaining and controlling them, and evaluate their reliability as audit evidence. You will be able to apply these principles to accounts receivable and other balances, identify typical problems, and suggest suitable alternative procedures if confirmations are not obtained.

ACCA Audit and Assurance (AA) Syllabus

For ACCA Audit and Assurance (AA), you are required to understand the role, procedures, and practical considerations of external confirmations. In particular, you should be familiar with:

• The definition and purpose of external confirmations as a source of audit evidence (ISA 505).
• How to design and perform confirmation procedures for account balances (especially receivables and payables).
• The auditor’s responsibilities in maintaining control over the confirmation process and evaluating responses.
• The relevance and reliability of external confirmations, including the difference between positive and negative requests.
• Appropriate auditor actions when confirmations are not received, or when alternative procedures are required.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the main difference between positive and negative external confirmation requests?
2. In what situations might an auditor choose not to use external confirmations for accounts receivable?
3. What should an auditor do if no reply is received from a receivable selected for confirmation?
4. Which of the following most increases the reliability of confirmation evidence:
   a) Client prints and sends the confirmation, auditor receives the reply
   b) Auditor prepares and controls the confirmation request directly

Introduction

External confirmations are a key audit procedure for verifying certain balances and transactions. They provide direct written responses from independent third parties and can be particularly persuasive evidence regarding existence and accuracy of items such as receivables, bank balances, and payables. ISA 505 'External Confirmations' sets out how these procedures should be used and controlled within the audit process.

Key Term: external confirmation
Audit evidence obtained as a direct written response from a third party to the auditor, in paper or electronic form, confirming specific information requested.

When Are External Confirmations Used?

External confirmations are typically used to gather evidence over items where a third party holds relevant information. Most commonly, confirmations are requested for:

• Accounts receivable (debtors) balances.
• Bank balances, loans, and facilities.
• Accounts payable, where statements are not available or completeness is at risk.
• Inventories or assets held by third parties.
• Details of legal claims or contingent liabilities from legal advisers.

For accounts where existence or accuracy is especially important and cannot be easily confirmed by internal client records, external confirmations are often the most reliable form of evidence.

Purpose and Advantages

• They provide evidence directly from independent sources (not influenced by management).
• They can detect misstatements, errors, fraud, overridden or omitted transactions.
• May reveal undisclosed liabilities or arrangements.

Key Term: positive confirmation request
A request sent to a third party asking for a reply to confirm whether specific information is correct or to provide the requested information, regardless of whether it agrees or disagrees.

Key Term: negative confirmation request
A request sent to a third party asking for a reply only if the information provided by the auditor is incorrect.

The External Confirmation Process

An effective confirmation involves several steps:

1. Design the Request:
   Identify the specific information to be confirmed (e.g., outstanding balance as of a given date).

2. Maintain Control:
   To ensure reliability, the auditor must control the entire process:

   • Prepare the confirmation request.
   • Send it directly to the third party (never via the client).
   • Ensure replies are returned directly to the auditor’s office.

3. Select the Recipient:
   Choose an appropriate responsible party (e.g., accounts manager for customer confirmations, branch for bank balances).

4. Choose Method and Type:
   Use positive requests where possible (more reliable). Negative confirmations are only suitable when the risk of material misstatement is low and large numbers of small balances exist.

5. Follow Up:
   For non-replies to positive requests, the auditor should send reminders and, if still not received, perform alternative audit procedures.

6. Evaluate Responses:
   Investigate any disputed amounts or conditions noted, analyse discrepancies, and consider the reliability of the entire confirmation process.

Worked Example 1.1

Scenario:
You are auditing TradeCo and select several receivable balances for confirmation. Despite reminders, one customer does not reply to the positive confirmation request.

Answer:
Perform alternative procedures to obtain sufficient appropriate evidence. This may include reviewing subsequent cash receipts, examining supporting sales invoices, and matching goods despatch notes to amounts outstanding.

Evaluating Reliability

External confirmations are generally highly reliable, but their value depends on:

• The auditor’s direct control over sending and receiving replies.
• The independence and knowledge of the respondent.
• Evidence that responses are authentic and complete.
• The risk of collusion between management and third parties.

Written evidence from a well-controlled process is more reliable than oral confirmations or documentation routed through the client.

Exam Warning

Always ensure the auditor controls the sending and receipt of confirmation requests. If the client is involved, the reliability of the evidence is greatly reduced—a frequent source of errors in exams and practice.

Types of External Confirmations

• Positive confirmation request: Requires the recipient to respond whether they agree or disagree with the stated information.
• Negative confirmation request: Asks the recipient to respond only if they disagree.
• Blank form (non-stated balance): The third party is asked to fill in the amount themselves, increasing detection of any errors.

Positive requests are more persuasive, while negative requests are less reliable. Blank forms can uncover unrecorded transactions but may result in lower response rates.

Worked Example 1.2

Scenario:
During the audit of Frost Ltd, the client suggests using negative confirmations for all 1000 customers as most pay on time and balances are small. You assess that inherent and control risks over receivables are high due to recent IT implementation problems.

Answer:
Negative confirmations are inappropriate. When risk is high, positive confirmations should be used, even if it means a more targeted sample or accepting a lower response rate.

Dealing with Non-Replies and Exceptions

If a confirmation is not received, the auditor cannot assume the balance is correct. Alternative procedures must be performed, such as:

• Inspecting post year-end bankings or receipts.
• Tracing invoices and delivery notes.
• Investigating correspondence with the customer.

All discrepancies between confirmed and recorded amounts must be reconciled and evaluated for possible misstatements.

Worked Example 1.3

Scenario:
A receivable replies to the confirmation stating the balance agrees, but points out a disputed invoice included in the total.

Answer:
Investigate the disputed item. If the discrepancy is valid, consider whether a provision or write-off is necessary, and adjust the receivables balance accordingly.

Limitations and When Not to Use Confirmations

External confirmations are not required for all audit areas. Limitations include:

• Low response rates, especially for negative requests.
• Deliberate fraud or collusion between client and third party.
• Irrelevant or unreliable respondent.
• Not useful where internal evidence is more relevant (e.g., supporting documentation exists, or balances are immaterial).

In such cases, substantive tests such as subsequent cash receipts, invoice verification, or ledger reconciliations may give better or supplementary evidence.

Revision Tip

Use external confirmations when existence, rights, or accuracy are high-risk assertions and suitable third parties can be contacted. Always document any decision not to seek confirmations for material balances.

Summary

External confirmations are a valuable audit procedure for obtaining direct, independent evidence from third parties. Under ISA 505, confirmations must be controlled by the auditor and responses carefully analysed. They are particularly relevant for testing existence and accuracy of receivables, bank balances, and payables when reliability is essential. The type (positive, negative, blank) and extent of confirmations depend on assessed audit risk. Non-replies require alternative procedures to ensure sufficient appropriate evidence is obtained.

Key Point Checklist

This article has covered the following key knowledge points:

• The definition and audit purpose of external confirmations under ISA 505.
• The process for designing, sending, and controlling confirmation requests.
• Distinctions between positive and negative confirmation requests and when each is appropriate.
• Evaluating the reliability and limitations of confirmation evidence.
• Actions to take if confirmations are not received or responses indicate discrepancies.
• When and how to perform alternative substantive procedures.

Key Terms and Concepts

• external confirmation
• positive confirmation request
• negative confirmation request