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Guidance Note on Audit of Debtors, Loans and Advances

The following is the text of the Guidance Note on Audit of Debtors, Loans and Advances, issued by the Auditing Practices Committee of the Council of the Institute of Chartered Accountants of India. This Guidance Note should be read in conjunction with the Statements on Standard Auditing Practices issued by the Institute.1

1. Paragraph 2.1 of the Preface to the Statements on Standard Auditing Practices issued by the Institute of Chartered Accountants of India states that the "main function of the APC is to review the existing auditing practices in India and to develop Statements en Standard Auditing Practices (SAPS) so that these may be issued by the Council of the Institute." Paragraph 2.4 of the Pref­ace states that the WC will issue Guidance Notes on the issues arising from the SAPS wherever necessary."

2. The Auditing Practices Committee has also taken up the task of reviewing the Statements on auditing matters issued prior to the formation of the Committee. It is intended to issue, in due course of time, SAPS or Guidance Notes, as appropriate, on the matters covered by such Statements which would then stand withdrawn. Accordingly, with the issuance of this Guidance Note on Audit of Debtors, Loans and Advances, Chapter 7 of the Statement on Auditing Practices, titled 'Debtors, Loans and Advances', shall stand withdrawn. In due course of time, the entire Statement on Auditing Practices shall be withdrawn.

INTRODUCTION

3. Debtors, loans and advances may constitute a significant proportion of the total assets of an entity. Debtors represent the amounts due to an entity for goods sold or services rendered or in respect of other similar contractual obligations, but do not include the amounts which are in the nature of loans or advances. Loans represent the claims of an entity in respect of such contractual obligations as moneys lent. Advances represent payments made on account of, but before completion of, a contract or before acquisition of goods or receipt of services. For purposes of this Guidance Note, debtors, loans and advances include instruments such as bills of exchange, promissory notes and similar other instruments, evidencing debtors, loans and advances.

4. An important feature of debtors, loans and advances which has a significant effect on the related audit procedures is that these assets are represented only by documentary evidence; they have no physical existence. Moreover, the documentary evidence is generally in the form of invoices, loan tents, etc., prepared by the entity itself. The auditor should take these factors into account in designing his audit procedures.

INTERNAL CONTROL EVALUATION

5. The auditor should study and evaluate the system of internal control relating to debtors, loans and advances, to determine the nature, timing and extent of his other audit procedures. He should particularly review the following aspects of internal control relating to debtors, loans and advances.**

(a) In respect of debtors

(i) The basis on which credit limits for customers are to be determined should be clearly laid down. The credit limits fixed in respect of individual customers should be approved by an official independent of the sales department. These limits should be checked before orders are accepted from the customers. There should also be a system of periodic review of the credit limits.

(ii) The procedure should ensure prompt recording of debts and realisations and of linking receipts with outstandings.

(iii) There should be a procedure for preparation of aging schedule of debtors at regular intervals. The schedules should be reviewed by a responsible official and necessary action initiated in respect of overdue accounts.

(iv) Statements of account should be sent to all debtors at periodic intervals. They should be prepared and despatched by a person independent of the ledger‑keeper. The debtors should be requested to confirm the balances as per the statements with reference to their own records. The confirmations received should be reviewed by a person in­dependent of the ledger‑keeper and the person responsible for preparing the statements of account, and necessary action taken in case of discrepancies.

(v) All material adjustments in debtors. accounts, particularly those relating to rebates, allowances, commissions etc. should require ap­proval of the competent authority. Similarly, any write‑off of bad debts should require approval of the competent authority.

(vi) There should be a system of periodic reconciliation of various debtor balances with related control accounts.

(b) In respect of loans and advances

(i) As far as possible, the system should specify the, following:

  • total amount up to which loans may be made;
  • the purposes for which loans may be made;
  • maximum amount of loans which may be made for each such purpose in individual cases;
  • the terms on which such loans may be made;
  • the persons who are authorized to make loans;
  • procedure for ensuring compliance with relevant legal requirements.

(ii) All variations in the terms of loans and advances should be duly approved in writing by the competent authority.

(iii) Where security is taken against the loans, the form and adequacy of security should be reviewed by a responsible official.

(iv) The loan and security documents should be kept in safe custody of a responsible official. A record of all such documents should be maintained and the documents should be periodically verified with reference to such records.

(v) The system should provide for identification of cases where principal and/or interest have become overdue or where any other terms are not being complied with.

(vi) Confirmation of balances should be obtained at periodic intervals in the same manner as in the case of debtors.

VERIFICATION

6. In any auditing situation, the auditor employs appropriate procedures to obtain reasonable assurance about various assertions (see Statement on Standard Auditing Practices 5, Audit Evidence). In carrying out an audit of debtors, loans and advances, the auditor is particularly concerned with obtaining sufficient appropriate audit evidence to corroborate the managements assertions regarding the following:

  Existence - that all amounts recorded in respect of debtors, loans and advances are outstanding as at the date of the balance sheet.
  Completeness - that there are no unrecorded debtors, loans and advances.
  Valuation - that the stated basis of valuation of debtors, loans and advances is appropriate and properly applied, and that the recoverability of debtors, loam and advances is recognised in their valuation.
  Disclosure - that the debtors, loans and advances are disclosed, classified, and described in accordance with recognised accounting policies and practices and relevant statutory requirements, if any.

Verification of debtors may be carried out by employing the following procedures:

(a) examination of records;

(b) direct confirmation procedure (also known as 'circularisation procedure');

(c) analytical review procedures.

The nature, timing and extent of audit procedures to be performed is, however, a matter of professional judgement of the auditor.

Examination of Records

7. The auditor should carry out an examination of the relevant record s to satisfy himself about the validity, accuracy and recoverability of the debtor balances. The extent of such examination would depend on the auditor's evaluation of the efficacy of internal controls.

8. The auditor should check the agreement of balances as shown in the schedules of debtors with those in the ledger accounts. He should also check the agreement of the total of debtor balances with the related control accounts. Any differences in this regard should be examined.

9. Verification of subsequent realizations is a widely used procedure, even in cases where direct confirmation procedure is followed. In the case of signifi­cant debtors, the auditor should also examine the correspondence or other documentary evidence to satisfy himself about their validity and accuracy.

10. While examining the schedules of debtors with reference to the debtors' ledger accounts, the auditor should pay special attention to the following aspects:

(a) Where the schedules show the age of the debts, the auditor should examine whether the age of the debts has been properly determined.

(b) Whether the amounts outstanding are made up of items which are not overdue, having regard to the credit terms of the entity.

(c) Whether transfers from one account to another are properly evidenced.

(d) Whether provisions for allowances, discounts and doubtful debts are required. In this regard, the auditor should recognise that even though a debtor may have confirmed the balance due by him, he may still not pay the same.

11. The following are some of the indications of doubtful and uncollectible debts, loans and advances:

(a) The terms of credit have been repeatedly ignored.

(b) There is stagnation, or lack of healthy turnover, in the account.

(c) Payments are being received but the balance is continuously increasing.

(d) Payments, though being received regularly, are quite small in relation to the total outstanding balance.

(e) An old bill has been partly paid (or not paid), while later bills have been fully settled.

(f) The cheques received from the debtor have been repeatedly dishonoured.

(g) The debt is under litigation, arbitration, or dispute.

(h) The auditor becomes aware of unwillingness or inability of the debtor to pay the dues e.g., a debtor has either become insolvent has closed down his business, or is not traceable.

(i) Amounts due from employees, which have not been repaid on termination of employment.

(j) Collection is barred by statute of limitation.

12. Bad debts written off or excessive discounts or unusual allowances should be verified with the relevant correspondence. Proper authorization should be inspected.

13. In the case of claims made against insurance companies, shipping companies, railways, etc., the auditor should examine the correspondence or other available evidence to ascertain whether the claims have been acknowledged as debts and there is a reasonable possibility of their being realized. If it appears that they are not collectible, they should be shown as doubtful. Similar considerations apply in respect of claims for export incentives, claims for price escalation in case of construction contracts, claims for interest on delayed payments, etc.

14. The auditor should examine whether the contingent liability, if any, in respect of bills accepted by customers and discounted with the banks is properly disclosed. He should also examine whether adequate provision on this account has been made, where required.*

Special Considerations in Case of Loans and Advances

15. In general, the procedure outlined above in regard to debtors is also applicable in the case of loans and advances. However, in the case of loans and advances, the auditor may find greater documentary evidence (in the form of loan and security documents and related correspondence) on which he can place reliance.

16. In the case of loans and advances, an important aspect to be examined by the auditor is whether the entity is empowered to make loans. In many cases, the statute governing the entity may contain restrictions or conditions about the amount of loans, purposes for which loans may be granted, parties to which loans may be granted etc. Similarly, the internal regulations of the entity may also prescribe the procedure to be followed for making the loans. For instance in the case of companies, sections 292, 295 and 370 place restrictions on the making of loans by companies.$ The competence of the borrower to receive the loan may also affect the legality and, hence, the recoverability of the loan. The auditor should examine the loan documents and other evidence with reference to the above while determining the legality and recoverability of the loans made by the entity.

17. The auditor should ascertain whether the parties to whom loans and advances have been made have complied with the terms and conditions relating to the payment of interest, repayment of loans or adjustment of advances, etc. In the case of defaults, e.g. where the repayment of loans or advances or the payment of interest are overdue, the auditor should consider whether such defaults are indicative of unwillingness or inability of the parties concerned to make the payment.

18. The auditor should pay particular attention to loans and advances. given to parties in whom directors or persons who are substantial owners of the entity are interested. He should ascertain the purpose, of such loans and advances; the terms and conditions on which they have been made as also their recoverability.

19. The auditor should also examine any, other aspects required to be examined or reported upon by the relevant statute. For example, the auditor of a company covered by the Manufacturing and Other Companies (Auditor's Report) Order, 1988, is required to state in his report whether the terms and conditions on which loans and advances have been made are prima facie prejudicial to the interests of the company. Similarly, clause (a) of sub‑section (IA) of section 227 of the Companies Act, 1956, requires the auditor to inquire "whether loans and advances made by the company on the basis of security have been properly secured and whether the terms on which they have been made are not prejudicial to the interests of the company or its members".

Direct Confirmation Procedure

20. The verification of balances by direct communication with debtors is theoretically the best method of ascertaining whether the balances are genuine, accurately stated and undisputed, particularly where the internal control system is weak. It must be recognised, however, that mere confirmation of balance by a debtor does not by itself ensure ultimate recovery. Moreover, the utility of this procedure depends to a large extent on receiving adequate response to con­firmation requests. Therefore, in situations where the auditor has reasons to believe, based on his past experience or other factors, that it is unlikely that adequate response would be received from the debtors, he may limit his reliance on direct confirmation procedure and place greater reliance on the other auditing procedures.

21. The auditor employs direct confirmation procedure with the consent of the entity under audit. There may be situations where the management of the entity requests the auditor not to seek confirmation from certain debtors. In such cases, the auditor should consider whether there are valid grounds for such a request. For example, the management may explain the reason as being the fact that there is a. dispute with the particular debtor and the request for confirmation may aggravate sensitive negotiations between the entity and the debtor. Before accepting a refusal as justified, the auditor should examine any available evidence to support the management's explanations, e.g., correspondence between the entity and the debtor. In such a case, alternative procedures should be applied to debtors not subjected to confirmation. In appropriate cases, the auditor may also need to re‑consider the nature, timing and extent of his audit procedures including the degree of planned reliance on management's representations.

22. The confirmation date, the method of requesting confirmations, and the particular debtors from whom confirmation of balances is to be obtained are to be determined by the auditor. While determining the information to be obtained; the form of confirmation, as well as the extent and timing of application of the confirmation procedure, the auditor should consider all. relevant factors such as the effectiveness of internal control, the apparent possibility of disputes, inaccuracies or irregularities in the accounts, the probability that requests will receive consideration, and the materiality of the amounts involved.

23. The debtors may be requested to confirm the balances either (a) as at of the date of the balance sheet, or (b) as at any other selected date which is reasonable close to the date of the balance sheet. The date should be settled by the auditor in consultation with the entity. Where the auditor decides to confirm the debtors at a date other than the balance sheet date, he should examine the movements in debtor balances which occur between the confirmation date and the balance sheet date and obtain sufficient evidence to satisfy himself that debtor balances stated in the balance sheet are not materially misstated.

24. The form of requesting confirmation from the debtors may be either (a) the 'positive' form of request, wherein the debtor it requested to respond whether or not he is in agreement with the balance shown, or (b) the 'negative' form of request, wherein the debtor is requested to respond only if he disagrees balance shown.

25. The use of the positive form is preferable when individual account balances are relatively large, or where the internal controls are weak, or where the auditor has reason to believe, that there may be a substantial number of accounts in dispute or with inaccuracies or irregularities. An illustrative positive form of request letter is given in Appendix 1 to this Guidance Note.

26. The negative form is useful when internal controls are considered to be effective, or when a large number of small balances are involved, or when the auditor has no reason to believe that the debtors are unlikely to respond. If the negative rather than the positive form of confirmation is used, the number of requests sent and the extent of the other auditing procedures to be performed should normally be greater so as to enable the auditor to obtain the same degree of assurance with respect to the debtor balances. An illustrative negative form pf request letter is given in Appendix II to this Guidance Note.

27. In many situations, it may be appropriate to use the positive form for debtors with large balances and the negative form for debtors with small balances.

28. Where the number of debtors is small, all of them may be circularized, but if the debtors are numerous, this may be done on a sample basis. The sample list of debtors to be circularized, in order to be meaningful, should be based on a complete list of all debtor accounts. While selecting the‑debtors to be circularized, special attention should be paid to accounts with large balances, accounts with old outstanding balances, and customer accounts with credit bal­ances. In addition, the auditor should select accounts in respect of which provisions have been made or balances have been written off during the period under audit or earlier years and request confirmation of the balance without considering the provision or write‑off The auditor may also consider including in his sample some of the accounts with nil balances. The nature of the entity's business (e.g., the type of sales made or services rendered) and the type of third parties with whom the entity deals, should also be considered in selecting the sample, so that the auditor can reach appropriate conclusions about the debtors as a whole.

29. In appropriate cases, the debtor may be sent a copy of his complete ledger account for a specific period as shown in the entity's books. This procedure is more likely to reveal errors and fraud and may be particularly useful in the case of large accounts involving many entries, or where there is evidence that accounts are in dispute or are not being settled in accordance with the entity's usual trade terms.

30. The method of selection of the debtors to be circularized should not be revealed to the entity until the trial balance of the debtors' ledger is handed over to the auditor. A list of debtors selected for confirmation should be given to the entity for preparing requests for confirmation which should be properly addressed and duly stamped. The auditor should maintain strict control to ensure the correctness and proper dispatch of request letters. In the alternative, the ' auditor may request the client to furnish duly authorised confirmation letters and the auditor may fill in the names, addresses and the amounts relating to debtors selected by him and mail the letters directly. It should be ensured that confirmations as well as any undelivered letters are returned to the auditor and not to the client.

31. Where positive form of request is used, the auditor may, in appropriate cases, request the entity to follow up wit h a reminder to those debtors from whom he receives no replies. In exceptional circumstances, the auditor may also correspond directly with those significant debtors from whom he receives no replies despite reminders. In the event of inadequacy of responses received, the auditor will have to increase the extent of examination of records and analytical review procedures beyond that planned originally.

32. Any discrepancies revealed by the confirmations received or by the additional tests carried out by the auditor may have a bearing on other accounts not included in the original sample. The entity should be asked to investigate and reconcile the discrepancies. In addition, the auditor. should also consider what further tests he can carry out in order to satisfy himself as to the correct­ness of the amount of debtors taken as a whole.

Analytical Review Procedures

33. In addition to the audit procedures discussed above, the following analytical review procedures may often be helpful as a means of obtaining audit evidence regarding the various assertions relating to debtors, loans and advances:

(a) comparison of closing balances of debtors, loans and advances with the corresponding figures for the previous year;

(b) comparison of the relationship between current Year debtor balances and the current year sales with the corresponding figures for the previous year;

(c) comparison of actual closing balances of debtors, loans and advances with the corresponding budgeted figures, if available;

(d) comparison of current year's aging schedule with the corresponding figures for the previous year;

(c) comparison of significant ratios relating to debtors, loans and advances with the similar ratios for other firms in the same industry, if available;

(f) comparison of significant ratios relating to debtors, loans and advances with the industry norms, if available.

It may be clarified that the foregoing is only an illustrative list of analytical review procedures which an auditor may employ in carrying out an audit of debtors, loans and advances. The exact nature of analytical review procedures to be applied in a specific situation is a matter of professional judgement of the auditor.

Disclosure

34. The auditor should satisfy himself that the debtors, loans and advances have been disclosed properly in the financial statements. Where the relevant statute lays down any disclosure requirements in this behalf, the audi­tor should examine whether the same have been complied with.

MANAGEMENT REPRESENTATIONS

35. The auditor should obtain from the management of the entity a written statement regarding recoverability of debtors and loans and advances and their classification for balance sheet purposes. While such a representation letter serves as a formal acknowledgment of the management's responsibilities with regard to debtors, loans and advances, it does not relieve the auditor of his responsibility for performing audit procedures to obtain sufficient appropriate audit evidence to form the basis for the expression of his opinion on the financial information. A sample management representation letter regarding debtors, loans and advances is given in Appendix III to this Guidance Note. It may be mentioned that the representations made in the letter can alternatively be included in the composite representation letter usually issued by the management to the auditor.

DOCUMENTATION

36. The auditor should maintain adequate working papers regarding audit of debtors, loans and advances. Among others, he should maintain on his audit file the confirmations received as well as any undelivered letters of request for confirmation. The management representation letter concerning debtors, loans and advances should also be maintained on the audit file.

******

APPENDIX I

ILLUSTRATIVE LETTER OF CONFIRMATION TO BE SENT TO DEBTORS
- POSITIVE FORM
[Ref. Paragraph 25]

[Letterhead of Entity]

[Date]

[Name and address of debtor]

Dear Sir,

          For audit purposes, kindly confirm directly to Our auditors (name and address of the auditors) that the balance of Rs ............ due by you as on ............ , as shown by our books, is correct. The details of the balance are as under:*

Invoice No. Date Order Reference or Acceptance or Tender No. etc. (To be used particularly for Government Customers)

Amount

        ___________
Total   ___________
Less: Advance received   ___________
Net Amount due by you

(Rs.)

  ___________

         A stamped envelope addressed to our auditors is enclosed for your convenience.

         If the amount shown is in agreement with your books, kindly strike‑out the paragraph marked (B) below. If the amount shown is not in agreement with your books, kindly furnish the details in the proforma given in the paragraph marked (B) below and strike‑out paragraph (A). In either case, kindly sign at the place provided below and return this entire letter directly to our auditors in the enclosed envelope. Your prompt compliance with this request will be appreciated.

         Kindly return this form in its entirety.

Yours faithfully,

  

(Signature  of responsible
official of the entity)

...........................................................................................................

(Do not perforate the form at this point)

(Name and address of entity)

          (A) We confirm that the above stated amount is correct as at _______

OR

(B) We state that the above‑stated amount is not correct as per our records. The details of the balance as at _________ as per our records are as below:

Invoice No. Date Order Reference

Amount

     

 __________

    Total

__________

    Less: Advance paid

__________

    Net Amount due from us    (Rs.)

__________

Date

(Signature of debtor/responsible official)

 

 

 

APPENDIX II

ILLUSTRATIVE LETTER OF CONFIRMATION TO BE SENT TO DEBTORS
‑ NEGATIVE FORM
[Ref. Paragraph 26]

[Letterhead of Entity]

[Date]

[Name and address of debtor]

Dear Sir,

          For audit purposes, kindly write directly to our auditors (name and address of the auditors) if the balance of Rs. ________ due by you as on ________, as shown by our books, is not correct, giving details of the differ­ences. The details of the balance are as under:**

Invoice No. Date Order Reference or Acceptance or Tender No. etc. (To be used particularly for Government Customers)

Amount

        ___________
Total   ___________
Less: Advance received   ___________
Net Amount due by you

(Rs.)

  ___________

         If you do not notify our auditors of any difference within ten days of the date of this letter, it will be presumed that the balance stated above is correct.

         A stamped envelope addressed to our auditors is enclosed for your convenience.

Yours faithfully,

 

(Signature of responsible
official of the entity)

 

 

APPENDIX III

REPRESENTATION LETTER FOR DEBTORS, LOANS AND ADVANCES
[Ref. Paragraph 35]

The following is a sample representation letter for debtors, loans, and advances, It might be used to supplement the general letter of representation or included therein. The letter should be modified where appropriate.

[Letterhead of Entity]

[Date]

[Name and Address of the Auditor]

Dear Sir,

          In connection with your audit of the financial statements of X Ltd. as of ....,19.., and for the year then ended, we certify that the following items appearing in the books as at (date of the Balance Sheet) are considered good and fully recoverable with the exception of those specifically shown as "doubtful" in the Balance Sheet.

Sundry Debtors               Rs.

Loans and Advances1       Rs.

Yours faithfully,

(Signature of responsible
official of the entity)

 


1 With the formation of the Auditing Practices Committee in 1982, the Council of the Institute has been issuing a series of Statements on Standard Auditing Practices (SAPs). Statements on Standard Auditing Practices lay down the principles governing an audit. These principles apply whenever an independent audit is carried out They become mandatory on the dates specified m the respective SAPs. Their mandatory status implies that, while discharging their attest function, it will be the duty of the members of the Institute to ensure that the SAPs are followed in the audit of financial information cov­ered by their audit reports. If, for any reason, a member has not been able to perform an audit in accor­dance with the SAPs, his report should draw attention to the material departures therefrom.
The Auditing Practices Committee has also been issuing, from time to time, guidance notes on is­sues arising from SAPs. 11e Guidance Notes provide guidance on procedures to be employed by an auditor in order to comply with the principles laid down in SAPs. It is recognised that in determining the nature, timing and extent of audit procedures to be employed in a specific situation, an auditor will have to exercise his professional judgement. The Guidance Notes, therefore, are recommendatory. A member should ordinarily follow the recommendations in a guidance note relating to an auditing matter except where he is satisfied that, in the circumstances of the case, it may not he necessary to do so.

** The extent of review of internal controls would depend upon the facts and circumstances of each case. Reference may be made in this regard to the "Internal Control Questionnaire" issued by the Chartered Accountants of India in 1976 which contains in illustrative discussion on internal controls in relation to debtors and loan and advances.

* Reference may be made in this regard to Accounting Standard (AS) 4, Contingencies and Events Occurring after the Balance Sheet Date, issued by the Institute of Chartered Accountants of India.

$ For a detailed study of this aspect, reference may be made to the Institute's publication titled A Guide to Company Audit. Similarly, in the case of entities like banks, insurance companies, etc., reference may be made to the relevant publication(s) of the Institute, e.g., Guidance Note on Audit of Banks, Study on Audit of companies Carrying on general Insurance Business, Guide to Audit of Cooperative Societies, etc.

* In case the list of invoices forming the balance is too large, these details may not be given.

** In case the list of invoices forming the balance is too large, these details may not be given.

1 It may be pointed out that a similar certificate regarding deposits made by the entity may also be obtained by the auditor in appropriate cases.

 

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