Ch14web

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CHAPTER 14

AUDITING THE REVENUE CYCLE

Fall 2007

Nature of the Revenue Cycle

Inherent Risk FactorsAudit objectives

Control Activities

Standard Substantive Tests

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For a merchandising company, the classes oftransactions in the revenue cycle include:

1.credit sales (sales made on accounts),2.cash receipts (collections on accounts and

cash sales), and

3.sales adjustments (discounts, salesreturns and allowances, and uncollectableaccounts [provisions and writeoffs]).

Nature of the Revenue Cycle

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Auditing the Revenue Cycle

Consider: How Can Revenue be

Manipulated?

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1. Pressures to overstate revenues to achieve

announced revenue or profitability targets.

2. Pressures to overstate cash and gross receivables or

understate the allowance for doubtful accounts for

debt covenant working capital requirements.

3. Revenue recognition: ambiguous stds, estimates,

complexity of the calculations, rights of return.

4. Receivables are factored with recourse: correct

classification as a sale vs. a borrowing.

5. Cash receipts susceptible to misappropriation.

6. Sales adjustments can conceal theft.

7. Classification of AR as current vs. non-current

Inherent Risk Assessment and Fraud

Considerations

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Understand the Clients Businessand Industry

1. Develop an expectation of total revenues

2. Develop an expectation of gross margin

3. Develop an expectation of net

receivables

4. Understanding industry accounting

practices.

Inherent Risk Assessment

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Consideration of IC: Obtaining an

Understanding and Assessing CR

Control Environment

Risk Assessment

Information and Communication Initiate transactions

Deliver (receive) goods or services

Record Transactions

Consideration

Control Activities

Monitoring

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Credit SalesInfo & Commun.

Common Documents and Records Customer Order

Sales Order

Shipping Documents (Bill of Lading andPacking Slip)

Sales Invoice

Authorized Price List

Sales Journal

Customer Master File

Accounts Receivable Master File

Customer Monthly Statement

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System FlowchartInitiate

Credit Sales

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System FlowchartDelivery

of Credit Sales

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System Flowchart

Recording Credit Sales

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Cash ReceiptsInfo & Commun.

Common Documents and Records

Remittance advice

Prelist Cash count sheets

Daily cash summary

Validated deposit slip

Cash receipts journal

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Control Activities

Sales Adjustment Transactions

Sales adjustment transactions involve the

following:

1. Granting cash discounts2. Granting sales returns and allowances

(credit memo)

3. Determining uncollectable accounts(write-off authorization memo)

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Substantive Tests of

Revenues and Receivable

Important Concept: The sales that are most

likely to represent potential misstatements

are the uncollected sales. To design

substantive tests for these accounts, theauditor must first determine the acceptable

level of tests of details risk for each

significant related objective.

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Standard Substantive Tests for

Revenues & Receivables

1. Initial procedures

2. Analytical procedures

3. Tests of transactions

a) Test details of sales transactionsb) Cut-off testing

Sales

Cash Receipts

Credit Memos4. Tests of balances

a) Confirmations

b) Estimates

5. Presentation and disclosure

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Substantive Tests of

Accounts Receivable

Figure 14-9Substantive Account Balance Audit Objectives

Category Test EO4 C4 RO3 VA# PD#

Initial 1. Obtain an understanding of 5 4,5Procedures the business and industry and

determine:a. The significance of revenues

and accounts receivable tothe entity.

b. Key economic drivers thatinfluence the entitys sales,margins, and collections.

c. Standard trade terms in the

industry, includingseasonal dating, collectionsperiod, etc.

d. The extent of concentrationof activity with customers.

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Substantive Account Balance Audit Objectives


Initial 2. Perform initial procedures on 4,5Procedures accounts receivable balance

and records that will besubjected to further testing.

a. Trace beginning balance foraccounts receivable to prioryears working papers.

b. Review activity in generalledger account for accountsreceivable and investigateentries that appear unusualin amount or source.

c. Obtain accounts receivabletrial balance and determinethat it accuratelyrepresents the underlyingaccounting records by:

Footing the trial balanceand determiningagreement with (1) thetotal of the subsidiary

ledger or accountsreceivable master file,and (2) the general ledgerbalance.

Testing agreement ofcustomer and balanceslisted on the trial balancewith those included inthe subsidiary ledger or

master file.

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Analytical 3. Perform analytical procedures: 4,5Procedures a. Develop an expectation for

accounts receivable using

knowledge of the entitysbusiness acitvity, marketshare, normal trade terms,and its history of accountsreceivable turn days.

b. Calculate ratios:

Compare sales to theentitys capacity.

Compare sales growthand receivalbes growth.

Accounts receivable turndays.

Uncollectable accountsexpense to net creditsales.

Uncollectable accountsexpense to accountsreceivable writeoffs.

c. Analyze ratio results relativeto expectations based onprior years, industry data,budgeted amounts, or otherdata.

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Analytical Procedures Commonly Used to

Audit the Revenue Cycle

Figure 14-4

AuditRatio Formula Significance

Sales to Capacity Net Sales Nonfinancial Helpful in assessing theMeasure of Capacity reasonableness of total revenues.

Market Share Clients Net Sales Net Sales Helpful in assessing the

of Industry reasonableness of both totalrevenues and gross margins.Larger market share is oftenassociated with larger grossmargins.

Sales to Total Sales Average Total Assets This ratio is useful forAssets manufacturing and other

asset-based companies.Describes the relationshipbetween assets and salesrevenues.

Accounts ((Accounts Receivable n Ratios larger than 1.0 indicateReceivable Accounts Receivable n-1) - that receivables are growingGrowth to Sales 1) ((Sales n Sales n-1) 1) faster than sales. Large ratiosGrowth

may indicate possible collectionproblems.

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AuditRatio Formula Significance

Accounts Average Accounts Receivable Useful in comparing with industryReceivable Turn Sales x 365 averages. Longer collectionDays periods may indicate collection

problems. Prior experience andcurrent sales volumes may beuseful in estimating current netreceivables.

Uncollectable Uncollectable Accounts Useful in evaluating theAccounts Expense Expense Net Sales reasonableness of uncollectableto Net Credit accounts expense. Smaller ratios

Sales may indicate an inadequateprovision for uncollectableaccounts.

Uncollectable Uncollectable Accounts Useful in evaluating theAccounts Expense Expense Actual Accounts reasonableness of uncollectableto Accounts Receivable Writeoffs accounts expense. Smaller ratiosReceivable may indicate an inadequate

Writeoffs provision for uncollectableaccounts.

New Product Revenues from New Products Companies with a high proportionRevenues to Total Introduced During the Year of revenues from new productsRevenues Total Revenues may earn a premium gross

margin due to the ability toinnovate.

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Tests of 4. Vouch a sample of recorded 4Details of sales and receivableTransactions transactions to supporting

documentation.a. Vouch receivable debits to

supporting sales invoices,shipping documents, andsales orders.

b. Vouch receivable creditsto remittance advises orsales adjustments,

authorizations for salesreturns and allowancesor uncollectable accountwriteoffs.

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Tests of 5. Perform cutoff tests for sales Details of and sales returns.Transactions a. Select a sample of

recorded salestransactions from severaldays before and afteryear-end and examinesupporting sales invoicesand shipping documentsto determine sales wererecorded in the proper

period.b. Select sample of credit

memos issued afteryear-end, examinesupportingdocumentation such asdated receiving reportsand determine that

returns were recorded inthe proper period. Alsoconsider whether volumeof sales returns afteryear-end suggest thepossibility ofunauthorized shipmentsbefore year-end.

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Substantive Tests Revenue and

Receivables Cycle: Cut-off Tests

Objective: Ensuring recording of transactions in

the correct period

Types:

1. Sales

2. Credit memos

3. Cash receipts

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Tests of 6. Perform cash receipts cutoff Details of tests.Transactions a. Observe that all cash

received through theclose of business on thelast day of the fiscal yearis included in cash onhand or deposits intransit and that noreceipts of thesubsequent period are

included, orb. Review documentation

such as daily cashsummaries, duplicatedeposit slips, and bankstatements coveringseveral days before andafter year-end for proper

cutoff.

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Tests of 7. Confirm accounts receivable. 4Details of a. Determine the form, timing,

Balances and extent of confirmationrequests.b. Select and execute sample

and investigate exceptions.c. For positive confirmation

requests for which no replywas received, performalternative follow-up

procedures: Vouch subsequent cash

receipts identifiable withitems comprisingthe account balance atthe confirmation date tosupportingdocumentation.

Vouch items comprisingthe balance at theconfirmation date todocumentary supportsuch as sales orders andshipping documents.

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Substantive Tests of AR:

Confirmations

Confirm Receivables

Confirmation of accounts receivable

involves direct written communicationbetween individual customers and the

auditor. This substantive test is used

extensively by the auditor.

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Confirmation of receivables is a generally

accepted auditing procedure which should

be performed unless:

1. AR is immaterial to the financial statements.

2. The use of confirmations ineffective.

3. Inherent risk and control risk are low

enoughand analytical procedures expected

to be effective enough to get audit risk to an

acceptably low level.


Confirmations

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Forms of Confirmation

There are 2 forms of confirmationrequest:

1. the positive confirmation, whichrequires the debtor to respond whetheror not the balance shown is correct,

2. the negative confirmation, whichrequires the debtor to respond onlywhen the balance shown is incorrect.


Confirmations

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Tests of 8. Evaluate the adequacy of the 5Details of allowance component for eachBalances: aging category and in theAccounting aggregate.Estimates a. Foot and crossfoot the aged

trial balance of receivablesand agree the total to thegeneral ledger.

b. Test aging by vouchingamounts in aging categoriesfor sample of accounts tosupporting documents.

c. For past due accounts:

Examine evidence ofcollectability such as

correspondence withcustomers and outsidecollection agencies,credit reports, andcustomers financialstatements.

Discuss the collectabilityof accounts with theappropriate managementpersonnel.

d. Evaluate managementsprocess for estimating theallowance for doubtfulaccounts using hindsight.

e. Evaluate the adequacy ofthe allowance giveninformation about:

Industry trends.

Aging trends.

Collection history forspecific customers.

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Required 9. Confirmation of accountsProcedures receivable included in step

7.

Presentation 10. Compare statement 4 4,5and presentation with GAAP.Disclosure a. Determine that

receivables are properlyidentified and classifiedas to type and expectedperiod of realization.

b. Determine whether thereare credit balances thatare significant in theaggregate and thatshould be reclassified asliabilities.

c. Determine theappropriateness of

disclosures andaccounting for relatedparty, pledged, assigned,or factored receivables.

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