Confirmations and their use in accounting and auditing

April 22, 2015

In its regular course of business, a company needs to verify its balances and turnovers with banks, suppliers or other counterparties. The confirmation process is one of the ways to obtain such information. The article below focuses attention on the confirmation process peculiarities and contrasts accounting and audit confirmation procedures.

1. Confirmation process

Confirmation is a form of inquiry. Confirmation process consists in obtaining representations from third parties and can be undertaken as a result of requests from auditors or the companyís financial management procedures.

A typical confirmation process would include such steps as:

  1. Selecting items to be confirmed. For audit purposes the items are selected in response to both audit risk and fraud risk. Depending on the circumstances, the company may elect different approaches to the sample selection and size (up to 100% coverage if applicable).† For example, if a merchandizing company runs a bonus system for its dealers, it may decide to perform a circularization procedure with the top 20 dealers confirming annual sales volume, accounts receivable balances and bonuses due to the dealers at the financial year end. On the other hand, financial auditors usually select some items randomly or on the risk basis. †It is to be noted that confirmation of accounts receivable is a required procedure under auditing standards in the USA (unless certain exception criteria are met).
  2. Designing requests and their proper authorization. †Auditing standards donít provide a specific form of a confirmation letter; therefore, companies tailor confirmation requests to their needs and objectives. At the same time, large audit firms use standardized confirmation letters and would require a company being audited to adhere to them.† Confirmation requests are prepared on the audited company letterhead and are properly authorized (usually by a financial director and/or chief accountant).
  3. Communicating and sending requests. †In order to obtain relevant and timely information, confirmations are firstly sent electronically (e.g., by fax or e-mail) followed by a hard copy that enables counterparties to prepare responses beforehand.† It is important to know that confirmation requests prepared for the purpose of financial statement audits are required to be handled (e.g., mailed out) by auditors themselves.
  4. Obtaining responses. Circularization helps to identify discrepancies in accounting records, identify missed operations or cut-offs, double-check existence, right and obligations. Based on responses obtained and communication with counterparties, a company (as well as auditors) sometimes can assess recoverability of outstanding balances, reconcile missed shipments or payments, etc. For auditors, obtaining responses is the most critical stage in terms of information reliability. Counterparties should send responses directly to the auditors, and not to the accounting department of the company under the audit, otherwise confirmation letters would be considered unreliable and additional work would need to be performed.
  5. Evaluating results. Since the response rate may not always be satisfactory, second confirmation requests may be necessary. Any discrepancies are followed up and correction entries are posted. For instance, if a companyís customer is in bankruptcy and it is unlikely that the amount due will be collected, the account receivable balance is either written off or fully provided for (i.e., reserved for).

2. Applicability in accounting

By means of confirmation requests, a company may decide to verify the following:

  • Accounts receivable and sales volume. There are two types of confirmation requests for accounts receivable: positive and negative. Under the positive request, the counterparty is asked to reply in any case, while under the negative request the response is only required if the customer disagrees. Negative confirmations are rarely used by auditors as they provide lower level of assurance; however, it is effective and efficient method for intercompany reconciliations or in case of a large scale confirmation campaign.
  • Bank balances and loans. Having permanent access to its bank accounts, the company hardly ever needs to send bank confirmations by its own incentive. However, auditors need to verify cash bank balances, bank overdrafts, loans, access to the accounts, existence of pledges, and compliance with covenants. Thus, if a company is under an audit, it is likely to be requested to prepare confirmation requests to all banks the company deals with at the year end, as well as to those banks it dealt with during the financial year but ceased relationships at the financial year end.
  • Inventory held by third parties. If inventory in custody represents a significant balance to a company, the latter would request the counterparty to provide information regarding quantity and quality of the inventory. As it is common for third parties to use different descriptions of units of measurement, differences may arise. Besides, such requests to confirm inventory balances enable the company to make timely write offs of any obsolete or damaged stock.
  • Accounts payables and purchases. Although companies periodically perform reconciliations via confirmation letters with their suppliers to verify outstanding debts, financial auditors rarely elect this area for confirmation procedures.
  • Intercompany balances and transactions.† You can read more about them in this article about intercompany reconciliations.
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