Confirmation as audit evidence

One of the principal methods of obtaining corroborative evidence available to auditors is by inquiry. Inquiry involves seeking information from knowledgeable persons inside or outside the entity. Confirmation is the name given to a specific form of inquiry that is particularly widely used. It involves obtaining written confirmation from a third party, typically, although not exclusively, in relation to an account balance in which the third party has an interest.

Because confirmations are an important source of audit evidence, it is essential that auditors fully understand their use. For this reason, examination questions frequently test candidates’ knowledge and understanding of the use of confirmations. This article considers general issues relating to the use of confirmations in obtaining audit evidence, and then applies these considerations to the use of confirmations in the verification of specific account balances.

General issues relating to confirmations are:

• In what situations are the use of confirmations appropriate?
• What assertions are addressed by confirmations?
• How should a request for confirmation be made?
• How should the evidence provided be interpreted?

Situations for using confirmations
Confirmations are best used where there is a knowledgeable party, independent of the entity and where alternative reliable evidence is not readily available. The most knowledgeable parties are those in a commercial relationship with the entity holding reciprocal information as to entity balances. These include debtors, creditors, banks, lenders, borrowers and custodians of entity assets such as stocks and securities. It is in their own interest for such parties to maintain reliable records of their relationship with the entity. It is also in their interest to respond to an auditor’s request for confirmation to ensure that any differences are identified and resolved.

As a general rule, larger organisations are more likely to have reliable internal control. This ensures that their own accounting information is accurate. Therefore, larger organisations are more likely to have a positive policy for responding to audit confirmations. Smaller organisations may have less reliable accounting records and may be more likely to regard a request for confirmation as an imposition on their time.

Generally speaking, parties from whom confirmation is sought are likely to be independent, ensuring the evidence is reliable. However, there are two situations where the auditor may need to exercise caution. The first is where the other party is ‘related’, e.g. a fellow subsidiary of the same parent or having majority shareholders in common. The second is where the other party might be economically dependent on the entity and may be motivated to provide an inaccurate response for fear of losing business with the entity. Examination candidates tend to overstate this risk in answering questions on confirmations. Such situations are probably extremely rare. The auditor should be aware of the possible risk from their general understanding of the business of the entity. Again, the larger the third party, the less likely it is to be economically dependent and thus the more reliable the evidence from confirmation.

Assertions
Where confirmations relate to reciprocal balances (such as debtors, creditors, banks, borrowers and lenders), they provide persuasive evidence as to rights and obligations. Confirmations also provide strong evidence of ownership where the other party is acting as custodian. However, because of human nature, confirmations may not provide such persuasive evidence of accuracy where the entity’s balance is in error in the other party’s favour, e.g. an understatement of debtors or an overstatement of creditors. Neither do confirmations provide reliable evidence of the valuation of assets. Where the other party is a debtor or borrower, further evidence is required of their ability to pay. Where the other party is custodian, confirmation of the existence of the asset does not provide evidence of its value.

Form of request
As a general rule, the request must be presented in such a form that facilitates a response by the other party. This can be achieved by using a standard form with space for the response and enclosing a return addressed envelope. However, there is sometimes a conflict between facilitating a response and the reliability of that response. For example, it is possible that the other party might confirm the information without checking it. Hopefully, such instances are rare.

More likely is a general reluctance to confirm through misunderstanding the purpose of the request. Debtors may misinterpret the confirmation as a demand for payment. Other parties may fear that confirmation might be binding if they should subsequently discover an error in their own records. It is usually customary to draft the wording of the confirmation to allay such fears when dealing with parties not accustomed to receiving such requests. Nevertheless, some respondents disclaim responsibility should their response be in error. This is usually the case with bank confirmations. However, this does not necessarily compromise the reliability of the confirmation.

Another possible conflict is between the use of confirmations that specify the information to be confirmed, or that request the other party to supply information. The latter approach eliminates the risk that the other party may not undertake a careful check of their records before responding, but increases the risk that the other party fails to respond.

The use of positive or negative confirmations is another possible conflict scenario. Both specify the information to be confirmed but a negative request only requires a response where the information is incorrect. The debate as to their respective benefits is indeterminate. Generally speaking, negative confirmations are used where there are a large number of small balances and the risk of material misstatement is assessed as low. However, the confirmation must be seen more as a test of control than as a substantive procedure. It assists in confirming the presumed low incidence of errors and provides qualitative information on the type of errors that exist. Where detection risk is high, or the materiality of the account balance is high, positive confirmation will be needed to provide substantive evidence.

It is nearly always the case that management of the audited entity must authorise each confirmation request. This exposes the risk that the process could be interfered with by the entity because the confirmation is usually in the form of a request – from the entity – for information to be supplied to their auditor. It is important that auditors control the process by ensuring that confirmations sent are in agreement with those selected for confirmation. It is also important that the envelopes bear the auditors’ return address in the event of non-delivery.

Interpretation of evidence
The factors discussed above must be considered when determining the reliability of confirmation evidence. Confirmation responses are at their most reliable when the auditor has reason to believe that the information has been checked by responsible officials against the other party’s records that are subject to satisfactory internal control. Reliability must be questioned where the auditor has reason to suspect that the request might not have been given appropriate consideration or that the other party’s records might not be wholly reliable.

Where no response is received to a positive request for confirmation (after suitable follow- up requests), alternative evidence must be obtained if the information to be confirmed is material to the financial statements or to maintain the integrity of sample evidence. Although a need to make follow-up requests in seeking confirmation responses is important, examination candidates often give undue prominence to this particular aspect and inadequate attention to suitable alternative sources of evidence.

Debtors’ confirmations
The use of confirmation evidence is usually very important in the audit of trade debtors because there are few other sources of external corroborative evidence. It is usually suitable when the majority of the credit customers are reasonable-sized businesses. Because existence is an important assertion being verified, it is important that the source from which the sample is selected is tested for completeness. This usually requires selecting the sample from a list of balances that has been tested against the sales ledger and totalled and agreed with the general ledger balance.

The list of debtors is usually subdivided into current due balances and overdue balances. Each present separate audit risks. Overdue balances are more likely to contain errors and thus require a proportionately larger sample.

It is necessary to verify non-responses with alternative reliable evidence of the outstanding balance in order to maintain the integrity of the sample where positive confirmations are used. Such evidence includes delivery notes signed for by the customer, written customer sales orders and, if subsequently paid, a remittance advice accompanying the payment identifying the specific invoices being paid.

Creditors’ confirmations
Creditors are much less frequently confirmed than debtors. The auditor already has external evidence in the form of supplier invoices and statements. Although held by the entity and thus potentially at risk from being manipulated, they are likely to provide sufficient appropriate evidence in the absence of any suspicious circumstances. In addition, the principal assertion verified by confirmation evidence would be that of completeness. The available population (creditor balances recorded by the entity), is not a suitable starting point for selecting a sample for confirmation when verifying completeness. If time is available, auditors tend to prefer to use the complementary/reciprocal population of purchases (or payment transactions recorded after the period end) when verifying the completeness of recorded creditors.

Bank confirmations
In many countries, the auditing profession has come to a mutual agreement with the banking industry on the method to be employed in seeking confirmations. A standardised form is commonly used with open questions for the bank to complete. The evidence should be reliable because banks usually maintain a high level of internal control over records of customer balances. However, because the task of completing the confirmation is often entrusted to relatively junior personnel and is not subject to independent checks, auditors must be alert for the possibility of clerical errors when making use of the evidence obtained by confirmation.

Another consideration when confirming bank balances is that they involve both debit and credit balances and contingencies. Therefore, evidence of both completeness and existence is sought. Although balances with each bank are usually individually material (in that all banks are confirmed – not just a sample), the auditors must take reasonable care that all banks which the entity has had dealings with during the year are identified. Auditors should request confirmations from each bank, not just those with recorded balances outstanding at the period end.

Further authoritative sources to be consulted on confirmation evidence are:

• Statement of Auditing Standards 400, Audit Evidence
• International Standard on Auditing 505, External Confirmations

Katharine Bagshaw is Examiner for Paper 2.6
Graham Cosserat is a former ACCA Examiner