Confirmation as audit evidence
| by Graham Cosserat and Katharine Bagshaw
28 Oct 2003
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:
Situations for using confirmations
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.
Form of request
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.A further issue when requesting confirmation from a large third party is the seniority of the respondent to whom the request is made. Some companies have a standard policy in responding to confirmation requests, such as routing them through internal audit. In other cases, a request may be ignored if it is addressed to senior management. However, a request addressed to the party responsible for maintaining the relevant records, such as the accounts payable manager, is more likely to result in a response. A potential danger is that the response might conceal errors in the other partys records for which the respondent is responsible.
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.
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.
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.
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:
Katharine Bagshaw is Examiner for Paper 2.6
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