ISA 505 “External Confirmations” is an international auditing standard that provides guidance to auditors on the use of external confirmations as audit evidence. External confirmations are responses obtained by auditors from third parties to corroborate information provided by the audited entity. This standard aims to help auditors obtain reliable and relevant audit evidence from independent sources to support their audit opinion on the financial statements.
Definitions:
External Confirmations:
External confirmations are audit evidence obtained by the auditor from a third party, in writing or other forms of communication, in response to a request for information to corroborate information provided by the audited entity. External confirmations can be in the form of confirmations of balances, transactions, or other relevant information.
Confirming Party:
The confirming party is the third party from whom the auditor requests external confirmation. Confirming parties can include customers, vendors, financial institutions, legal advisors, regulators, or other parties with whom the entity has business transactions.
Explanations:
External confirmations are an important audit procedure that provides independent and reliable evidence about the accuracy and completeness of information provided by the audited entity. Confirmations obtained from external parties can provide direct and persuasive evidence as they come from independent sources that are external to the entity being audited. They can help auditors obtain a higher level of assurance on the financial statements and reduce the risk of material misstatement.
ISA 505 provides guidance on the use of external confirmations in various audit situations. The standard requires auditors to consider the appropriateness and relevance of external confirmations based on the assessed risks of material misstatement, the nature of the entity’s business, and the effectiveness of the entity’s internal controls. Auditors should design and perform external confirmation procedures that are appropriate in the circumstances and provide sufficient and appropriate audit evidence to support their audit opinion.
Examples:
Let’s look at some examples of how external confirmations can be used in different audit situations:
Accounts Receivable Confirmation:
In an audit of a manufacturing company, the auditor may send confirmations to the entity’s customers to confirm the outstanding accounts receivable balances. The auditor may request the customers to confirm the balance, the terms of payment, and any disputes or adjustments. This can provide evidence about the existence, completeness, and valuation of accounts receivable.
Bank Confirmation: In an audit of a financial institution, the auditor may send confirmations to the entity’s banks to confirm the cash balances, outstanding loans, and other financial arrangements. The auditor may request the banks to confirm the balances, the terms of the loans, any collateral, and any related party transactions. This can provide evidence about the existence, rights, and obligations related to cash and financial instruments.
Inventory Confirmation:
In an audit of a retail company, the auditor may send confirmations to the entity’s vendors to confirm the inventory on consignment, held on behalf, or in transit. The auditor may request the vendors to confirm the quantity, condition, and ownership of the inventory. This can provide evidence about the completeness, accuracy, and valuation of inventory.
Legal Confirmation:
In an audit of a company involved in legal disputes, the auditor may send confirmations to the entity’s legal advisors to confirm the status of pending lawsuits, claims, or other legal matters. The auditor may request the legal advisors to confirm the nature, amount, and potential impact of the legal matters on the financial statements. This can provide evidence about the completeness, disclosure, and valuation of legal matters.
Case Studies:
Let’s consider some case studies that illustrate the use of external confirmations in real-world audit scenarios:
XYZ Inc. is a manufacturing company that is being audited by ABC & Co., an audit firm. As part of the audit procedures, ABC & Co. decides to use external confirmations to obtain evidence related to XYZ Inc.’s accounts receivable balances. The auditors send confirmation requests to XYZ Inc.’s customers, requesting them to confirm the outstanding balances, terms of payment, and any disputes or adjustments.
Example Response:
One of the customers, Company A, responds to the confirmation request and confirms the outstanding balance of $100,000 as of the audit date, with a payment term of 30 days. Company A also confirms that there are no disputes or adjustments related to the balance. This confirmation provides ABC & Co. with evidence about the existence and completeness of XYZ Inc.’s accounts receivable balances, as well as the accuracy of the payment terms.
Another customer, Company B, responds to the confirmation request and confirms the outstanding balance of $50,000 as of the audit date, with a payment term of 45 days. However, Company B raises a dispute regarding a defective product that it returned to XYZ Inc. and requests a credit note for $5,000. This confirmation raises a potential issue of valuation and completeness of accounts receivable, as the disputed amount of $5,000 may need to be adjusted or disclosed in XYZ Inc.’s financial statements.
Based on the responses received from various customers, ABC & Co. assesses the reliability and relevance of the external confirmations in the context of the assessed risks of material misstatement and the nature of XYZ Inc.’s business. The auditors may follow up with XYZ Inc. and its customers to resolve any discrepancies or issues raised in the external confirmations, and obtain additional evidence if needed, before concluding on the accounts receivable balances.
LMN Bank is being audited by DEF & Associates, an audit firm. As part of the audit procedures, DEF & Associates decides to use external confirmations to obtain evidence related to LMN Bank’s cash balances and outstanding loans.
Example Response:
The auditors send confirmation requests to LMN Bank’s banks, requesting them to confirm the cash balances, outstanding loans, collateral, and related party transactions. One of the banks, Bank X, responds to the confirmation request and confirms the cash balance of $10 million and the outstanding loans of $50 million as of the audit date. Bank X also confirms the collateral provided by LMN Bank for the loans and states that there are no related party transactions.
Another bank, Bank Y, responds to the confirmation request and confirms the cash balance of $5 million and the outstanding loans of $100 million as of the audit date. However, Bank Y raises a concern regarding the valuation of the collateral provided by LMN Bank, as the market value of the collateral has declined significantly. This confirmation raises a potential issue of valuation and impairment of loans and collateral, which may need to be assessed and disclosed in LMN Bank’s financial statements.
Based on the responses received from the banks, DEF & Associates assesses the reliability and relevance of the external confirmations in the context of the assessed risks of material misstatement and the nature of LMN Bank’s business. The auditors may follow up with LMN Bank and the banks to resolve any discrepancies or issues raised in the external confirmations, and obtain additional evidence if needed, before concluding on the cash balances and outstanding loans.
Conclusion:
External confirmations are a valuable audit procedure that can provide independent and reliable evidence to support the auditor’s opinion on the financial statements. ISA 505 provides guidance on the use of external confirmations, including definitions, explanations, examples, and case studies. Auditors should consider the appropriateness and relevance of external confirmations based on the assessed risks of material misstatement, the nature of the entity’s business