Audit Revenue Test

8/12/2019 Audit Revenue Test

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Revenue cycle accounts – The impo rtance

Sales transactions are always material toa company's financial statements

According to the SEC, a majority of

financial statement manipulations andaudit failures involve overstated revenues

Therefore, revenue cycle accounts must

be examined with great care

Cha

pter 10:

Auditing Revenue andRelated Accounts



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The cycle approach Revenue cycle transactions include all the processes

ranging from the sale to shipping a product, billing thecustomer, and collecting cash

A company's revenue cycle transactions reflects itsoperations

A cycle approach is one way to help the auditor focus onthe important account balances surrounding atransaction to ensure that sufficient audit evidence isgathered and evaluated

Other cycles include:

acquisition and payment of goods and services

Payroll

Financing: debt and equity

Cash and short-term investments



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Business Risk and Business

EnvironmentRevenue recognition

SAS 99 - Consideration of Fraud in a

Financial Statement Audit

Auditor should presume risk of material

misstatement due to fraud related to

revenue recognitionResearch shows over half of frauds

involve overstating revenues



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Some Improper Revenue

Recognition Schemes Recognize revenue on fictitious shipments

Hidden side letters that give customers unlimited right toreturn product

Record consignment sales as final sales Accelerated recognition of sales occurring after year-end

Ship unfinished goods

Ship goods before date agreed to by customer

Create fictitious invoices

Ship goods never ordered

Ship more goods than ordered

Record shipments to company's warehouse as sales

Record shipments of replacement goods as new sales



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What are some fraud risk factors

for revenue recognition? There are a number of types of 'red flags' which

signal the potential for fraud in the financialstatements External risk indicators

Internal red flags

Unusual financial results

Auditor deals with red flags by Examining external pressures that could lead to

financial reporting fraud

Examining the financial statements to determine if

account balances seem out of line



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What analytical analysis can be

done for possible misstatements? Compare client revenue trend with

economic conditions and industry trends

Compare cash flow from operations withnet income

Perform analytical procedures

Ratio analysis

Trend analysis

Reasonableness tests



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Assessment of Environment

Risk Risk assessment is ongoing process in everyaudit

Audit steps to assess environment risk for the

revenue cycle:Update information on business risk

Perform analytical procedures to look forunexpected relationships

Develop understanding of internal controls

Analyze business risk for motivations andmethods to misstate sales



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Document operation of accountingapplications and important controls

Develop preliminary assessment of

environment risk If control risk is high, determine likely types of

misstatements

If control risk is lower, develop procedures to

test operation of controlsPerform tests of controls, document results

Based on the results of testing, reassesscontrol risk

Assessment of Environment

Risk –

Cont’d



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Inherent Risk with Regard to

Sales While sales transactions are routine for

most organizations and do not representan abnormally high risk, for otherorganizations, revenue recognition may becomplicated

Difficult audit issues include:

When to recognize revenues Auditor must understand client's operations and

related GAAP issues

Example: point of sale revenue recognition vs.

percentage of completion



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Impact of any unusual sales terms and whethertitle passed to customer Example: related party transactions

Goods recorded as sales have actually beenshipped

Sales made with recourse or that havesignificant returns

Example: irrevocable right to return goods

The presence of these issues increase inherentr isk and the probabi l i ty of mater ial

misstatement

Inherent Risk with Regard to

Sales –

Cont’d



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Inherent Risk in Receivables Primary risk is net receivables will be overstated,because either receivables have been overstated, or

the allowance for uncollectible accounts has beenunderstated

Risks affecting receivables include: Sales of receivables recorded as sales rather than

financing transactions

Receivables pledged as collateral

Receivables classified as current when likelihood ofcollection is low

Collection of receivable contingent on uncertain futureevents

Payment not required until purchaser sells the

product



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The Control Environment and

Sales An organization's control environment

affects revenue and related transactions

more than most accounts The auditor must consider:

Management's integrity

Financial condition of the organizationFinancial pressures on the organization

Management incentives to achieve financial

results



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Understanding Internal Controls Although the auditor must understand all components of

internal controls, particular attention is paid to significantcontrol procedures and monitoring controls

The auditor obtains an understanding of the controls by Walk-through of the processing of transactions

Inquiry

Observation

Review of client documentation

It is critical this understanding be documented in thework papers



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Understanding Internal Controls (2)

Assertions must be addressed during this phase:

Occurrence, Cutoff, Completeness, Accuracy &

Classification Controls Regarding Returns, Allowances and

Warranties are also important. Abnormal returns

or allowances may be the first sign that a

company has problems Credit Policies are also very important



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Documenting, Testing, and

Assessing Environment Risk Develop understanding of the accounting

system and control procedures

Evidence is gathered through inquiry, review of client

accounting manuals, and review of prior year auditworkpapers

Documentation includes questionnaires, flowcharts,

and narratives

Determine whether the application control proceduresare sufficient to achieve the control objectives

Based on control design, make preliminary

assessment of control risk



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The auditor must document those controls thatsupport an assessment of control risk belowmaximum

If the auditor plans to rely on the internalcontrols, the controls are tested to see if they areoperating as designed

If testing indicates the control is not operating

effectively, Auditor will increase assessed control risk,

lower detection risk, and perform morerigorous substantive testing

If the control is working effectively, control riskassessment is unchanged

Documenting, Testing, and

Assessing Environment Risk (2)



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Linking Environment Risk

Assessment & Substantive Testing The rigor of substantive testing is inversely

related to the assessed level of environment risk

The auditor learns three things during theassessment of environment risk that affects thedesign of substantive audit procedures:The nature of the accounting system, controls

used, and documents generated in the client's

processingExistence of fraud risk factors

Effectiveness of controls and types ofmisstatements likely to occur



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Substantive Testing in the

Revenue Cycle Planning for Direct Tests of Transactions and Account Balances Audit objectives and assertions

Account balance relationships Risk of material misstatement

Composition of the account

Persuasiveness of audit procedures

Cost of audit procedures Timing of audit procedures

Determining optimal mix of audit procedures

Exhibit 10.7 Outlines the relationship between Assertions and

Substantive Tests for the Revenue and Accounts Receivables



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Substantive tests of revenue –

object ive s/issues Assertions related to revenue transactions:

Occurrence: Have the transactions occurredand pertain to the entity

Completeness: Have all transactions beenrecorded

Accuracy: Have transactions been accuratelyrecorded

Cutoff: Have transactions been recorded inthe correct accounting period

Classification: Have transactions been

recorded in the proper accounts



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Substantive Tests of Revenue

for Occurrence and Accuracy Vouch recorded sales transaction back to

customer order and shipping document

Compare quantities billed and shippedwith customer order

Special care should be given to sales

recorded at the end of the year

Scan sales journal for duplicate entries



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Cutoff Tests Can be performed for sales, sales

returns, cash receipts

Provides evidence whether transactions

are recorded in the proper period

Cutoff period is usually several daysbefore and after balance sheet date

Extent of cutoff tests depends oneffectiveness of client controls



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Cutoff Tests e.g. Sales cutoff Auditor selects sample of sales recorded during cutoff

period and vouches back to sales invoice andshipping documents to determine whether sales arerecorded in proper period

Cutoff tests assertions of existence and completeness

Auditor may also examine terms of sales contracts

Sales return cutoff Client should document return of goods using

receiving reports Reports should date, description, condition, quantity

of goods

Auditor selects sample of receiving reports issuedduring cutoff period and determines whether credit

was recorded in the correct period



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for Completeness Use of pre-numbered documents is

important

Analytical procedures

Cutoff tests

Auditor selects sample of shipping

documents and traces them into the sales

journal to test completeness of recording

of sales



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Substantive Tests of Accounts

Receivable - issues

Existence & OccurrenceDoes the receivable exist?

Valuation Are sales and receivables initially recorded at their

correct amount?Will client collect full amount of recorded receivables?

Rights and Obligations Contingent liabilities associated with factor or sales

arrangementsDiscounted receivables

Presentation and Disclosure Pledged, discounted, assigned, or related party

receivables



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Standard Substantive Tests of

Accounts Receivable1. Obtain and evaluate aging of

accounts receivable

2. Confirm receivables with customers

3. Perform cutoff tests

4. Review subsequent collections ofreceivables



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1. Aging Accounts Receivable

Because receivables are reported at net realizable value,auditors must evaluate management estimates ofuncollectible accounts

Auditor will obtain or prepare schedule of aged accounts

receivable If schedule is prepared by client, it is tested for mathematical and

aging accuracy

Aging schedule can be used to Agree detail to control account balance

Select customer balances for confirmation Identify amounts due from related parties for disclosure

Identify past-due balances

Auditor evaluates percentages of uncollectibility

Auditor then recalculates balance in the Allowance

account



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2. Confirming Receivables with

CustomersConfirmations provide reliable external evidence about the

Existence of recorded accounts receivable and

Completeness of cash collections, sales discounts, and

sales returns and allowancesConfirmations are required by GAAS unless one of the

following is present:

Receivables are not material

Use of confirmations would be ineffective Environment risk is assessed as low and sufficient

evidence is available from using other substantive tests



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2.a The Types of ConfirmationsPositive confirmations

Customers are asked to agree the amount on

the confirmation with their accounting records

and to respond directly to the auditor whetherthey agree with the amount or not

Positive confirmation requires a response

If customer does not respond, auditor must usealternative procedures



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Negative confirmations

Customers are asked to respond only if they disagreewith the balance (non-response is assumed to meanagreement)

Less expensive since there are no additional proceduresif customer does not respond

May be used when all of the following are present

Confirming a large number of small customer

balances Environment risk for receivables is assessed as low

Auditor believes customers will give proper attentionto confirmations

2.b The Types of Confirmations



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2.c What’s the follow-up

procedures for non-responses?1. If customer does not respond to positive

confirmation, auditor may send a second, oreven third, request

2. If customer still does not respond, auditor willuse alternative proceduresa) Examine the cash receipts journal for cash collected

after year-end Care is taken to ensure receipt is year-end receivable, not

subsequent saleb) Examine documents supporting receivable

(purchase order, sales invoice, shipping documents)to determine if sale occurred prior to year-end Evidence gathered from internal documents is not

considered as reliable



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2.d What’s the follow-up

procedures for exceptions noted? Customers are asked to agree the amount onthe confirmation to their accounting records;differences are called exceptions

Reasons for exceptions: Timing differences

Disputed items

Customer errors

Client misstatement Because misstatements are projected to the

population of receivables, the auditor mustdetermine the reason for the exception



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Related-Party Receivables Amounts due from related parties should be

separately disclosed

Audit procedures to identify related-party

transactions include:Review SEC filings

Review the accounts receivable subsidiary ledger and

trial balance

Management inquiry

Communicate names of related parties so all audit

team members can be alert for related-party

transactions



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Sold, Discounted, and Pledged

Receivables Receivables sold with recourse, discounted, orpledged as collateral should be disclosed

Audit procedures to identify these items include:

Management inquiryScan cash receipts journal for large cash

inflows from unusual sources

Bank confirmations, which include information

on obligations and terms

Review board of director minutes, whichcontain approval for these items



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Fraud Indicators and Audit Procedures

Potential fraud indicators:

Excessive credit memo or other adjustments to accountsreceivable just after year-end

Customer complaints and discrepancies in receivableconfirmations

Unusual entries to the receivable subsidiary ledger or sales journal

Missing or altered source documents



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Fraud Indicators & Audit Procedures - 2

Potential fraud indicators:

Lack of operating cash flow when operating income has beenreported

Unusual reconciling differences between receivable subsidiary

ledger and control account Sales in the last month with unusual terms

Pre- or post-dated transactions

Unusual adjustments to sales accounts before/after year-end



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Fraud Indicators and Audit Procedures - 3

Substantive procedures that may highlight potential fraudindicators:

Review of source documents including invoices, shippingdocuments, customer purchase orders, etc

Review and analyze credit memos and otheradjustments to receivables

Confirm sales terms with customers

Analyze large or unusual sales made near year-end

Scan the general ledger, receivables subsidiary ledger,and sales journal for unusual activity

Perform analytical review of credit memo and write-offactivity

Analyze recoveries of written-off accounts



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Auditing of Allowance for Doubtful

Accounts Accounts receivable should be reported at their net realizable value

The balance of the allowance for doubtful accounts is estimated anddepends on a number of factors

Understating the allowance overstates net accounts receivable and

net incomeWhere accounts receivable are material, the auditor should obtain

an understanding of how management developed the estimate byusing one or more of these approaches:

Review and test the process used by management to develop the

estimate Test aging schedule

Evaluate estimated percentages of uncollectibility used

Develop an independent model to estimate the accounts

R i b t t h b t ll ti

Audit Revenue Test

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