Learn about the percentage of receivables method and why it is the most appropriate approach for an internal auditor to estimate uncollectible accounts receivable during an assurance engagement. Understand the benefits of this method compared to alternatives like direct write-off, percentage of sales, and historical estimates.
Table of Contents
Question
During an assurance engagement, an internal auditor must select a basis for estimating the amount of expected uncollectable accounts receivable in order to test the reported net accounts receivable figure in the financial statements for reasonableness. Which of the following methods would be the most appropriate for this assessment?
A. Direct write-off
B. Percentage of sales
C. Historical estimate.
D. Percentage of receivables.
Answer
The most appropriate method for an internal auditor to estimate the amount of expected uncollectible accounts receivable is:
D. Percentage of receivables.
Explanation
The percentage of receivables method applies a percentage to the total accounts receivable balance to estimate the amount that will likely be uncollectible. This percentage is typically based on the company’s historical experience with bad debts.
There are several advantages that make the percentage of receivables method the best choice for an internal auditor:
- It focuses on the current accounts receivable balance, providing the most relevant estimate of uncollectible amounts based on the company’s current receivables situation. This is more useful than methods based on past sales like the percentage of sales approach.
- The percentage can be adjusted each period based on recent trends in collections and defaults. This allows it to be responsive to changes in economic conditions, customer credit quality, etc.
- It is generally seen as a more conservative approach compared to the other options, as it assumes a portion of existing receivables will not be collected. This aligns with the auditor’s responsibility to assess overstatement risks.
- It is a commonly used and well-established method that will be readily understood by financial statement users. Generally accepted accounting principles (GAAP) allow for its use.
In contrast, the other methods have some key disadvantages:
- Direct write-off only records bad debts as they are specifically identified, rather than estimating them in advance. This fails to follow GAAP matching principles.
- Percentage of sales estimates bad debts based on a percentage of credit sales. This relies on past data that may not reflect the collectibility of the current receivables balance.
- A historical average ignores changes or trends that would help refine the estimate for the current circumstances.
So in summary, the percentage of receivables method provides the most targeted, flexible and conservative approach for the auditor to assess the reasonableness of the net accounts receivable figure by estimating uncollectible amounts.
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