CHAPTER 14 AUDITING THE REVENUE CYCLE

Learning Check
14-1. a. b. The revenue cycle includes the activities involved in the exchange of goods and services with customers and the realization of the revenue in cash. The classes of transactions in this cycle for a merchandising company are sales, sales adjustments, and cash receipts. The primary accounts affected by these transactions are sales, accounts receivable, cost of sales, inventory, cash, sales discounts, sales returns and allowances, bad debts expense, and allowance for uncollectable accounts Specific audit objectives for the revenue cycle are derived from the five categories of management's financial statement assertions. Specific audit objectives for credit sales transactions include the following:
Specific Audit Objectives Transaction Objectives Occurrence. Recorded sales transactions represent goods shipped or services provided during the period. Recorded cash receipt transactions represent cash received during the period. Recorded sales adjustment transactions during the period represent authorized discounts, returns and allowances, and uncollectable accounts. Completeness. All sales cash receipts and sales adjustments made during the period were recorded. Accuracy. All sales and cash receipts and sales adjustments are accurately valued using GAAP and correctly journalized, summarized and posted. Cutoff. All sales, cash receipts and sales adjustments have been recorded in the correct accounting period. Classification. All sales, cash receipts, and sales adjustments have been recorded in the proper accounts. Balance Objectives Existence. Accounts receivable representing amounts owed by customers exists at the balance sheet date. Completeness. Accounts receivable include all claims on customers at the balance sheet date. Rights and Obligations. Accounts receivable at the balance sheet date represent legal claims of the entity on customers for payment. Valuation and Allocation. Accounts receivable represents gross claims on customers at the balance sheet date and agrees with the sum of the accounts receivable subsidiary ledger. The allowance for uncollectable accounts represents a reasonable estimate of the difference between gross receivables and their net realizable value.

14-2. a. b.

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Disclosure Objectives Occurrence and Rights and Obligations. Disclosed revenue cycle events and transactions have occurred and pertain to the entity. Completeness. All revenue cycle disclosures that should have been included in the financial statements have been included. Understandability. Revenue cycle information is appropriately presented and information in disclosures is understandable to users. Accuracy and Valuation. Revenue cycle information is disclosed accurately and at appropriate amounts.

14-3. Following are a few examples of differences between how the auditor might use the knowledge of the entity and its environment for a computer company v. a hotel. a. Certain balance sheet accounts like accounts receivable and inventories are going to be very significant for the computer manufacturer, but relatively immaterial for the hotel. The computer company is also likely to have a higher ratio of sales to fixed assets, or sale to total assets, than the hotel. The computer company auditor will have significant issues associated with the risk of misstatement with respect to the existence of receivables and inventories that are not present for the hotel. The computer company auditor will also have to address valuation and allocation issues associated with the collectability of receivables and lower of cost or market of inventories that are insignificant for the hotel. The hotel will have a potential risk of material misstatement in terms of how it accounts for revenues from properties that it manages for others, as opposed to properties that it owns.

b.

14-4. Factors that might motivate management to deliberately misstate revenue cycle assertions include: Pressures to overstate revenues in order to report achieving announced revenue or profitability targets or industry norms that were not achieved in reality owing to such factors as global, national, or regional economic conditions, the impact of technological developments on the entity's competitiveness, or poor management. Pressures to overstate cash and gross receivables or understate the allowance for doubtful accounts in order to report a higher level of working capital in the face of liquidity problems or going concern doubts. Factors that might contribute to unintentional misstatements in revenue cycle assertions include: The volume of sales, cash receipts, and sales adjustments transactions is often high, resulting in numerous opportunities for errors to occur. The timing and amount of revenue to be recognized may be contentious owing to factors such as ambiguous accounting standards, the need to make estimates, the complexity of the calculations involved, and purchasers' rights of return.

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14-5. a.

Following are example analytical procedures that the auditor might use to estimate total revenue for a household appliance manufacturer and for an airline. Industry Household Appliance Mfg. Possible Analytical Procedures Use past ratio of net sales to capacity with adjustments for capacity changes. Use a combination of past ratios of market share with adjustments of current changes in market share. Requires knowledge of the total market size in the industry. Estimate net revenues using information on utilization of capacity (airline seat miles) and average revenue per seat.

Airline

b.

Two analytical procedures that the auditor might use to estimate gross margin for company might include. Analytic Procedure Compare historical trends in market share and gross margin with current unaudited data. Evaluate the percentage of revenues coming from new products. Audit Significance Companies with commanding market shares often are able to obtain larger gross margins. Companies with a high proportion of revenues from new products may earn premium gross margins due to the ability to innovate.

c.

Two analytical procedures that the auditor might use to estimate net receivables and the allowance for doubtful accounts for company might include. Analytic Procedure Accounts receivable turn days Audit Significance Understanding a companys history of accounts and sales volume can assist the auditor in evaluating net receivables and the adequacy of the allowance for doubtful accounts. This procedure is primarily related to the adequacy of the allowance for uncollectable accounts. The above history of accounts receivable turn days would be most useful for evaluating estimating gross receivables given sales.

Evaluate the entities history of uncollectable accounts expense to net credit sales, with adjustment for economic conditions

14-6. Several control environment factors and their applicability to revenue cycle assertions are: Integrity and ethical values - reduction of risk of overstatement of revenues

and receivables by eliminating incentives to dishonest reporting. Commitment to competence - by chief financial officers and accounting personnel.
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Management's philosophy and operating style - conservatism in developing such accounting estimates as the allowance for uncollectable accounts and allowance for sales returns. Human resource policies and practices - bonding of employees who handle cash
14.7. The following table summarizes the functions that apply to credit sales transactions, the department that performs the functions, and the principal documents or records produced in performing the function. Department that Principal documents and records Function performs function produced in performing the function. Initiating credit Sales department Documents sales Customer Order Credit department Sales Order Computer Files and Records Customer Master File (with credit information) and Accounts Receivable Master File. Perpetual Inventory Authorized Price List Open Order File Delivering good and services Warehousing and shipping department for goods. Line operating departments for services. Documents Shipping documents Reports of unfilled orders and back orders Computer Files and Records Open Order File Perpetual Inventory Shipping File Documents Sales Invoice Sales Reports and Sales Journal Various Exception Reports Monthly Customer Statements Computer Files and Records Sales Transaction File Accounts Receivable Master File 14-8. In order to assess control risk as low based on programmed control procedures the auditor should test the following. Control Importance to Control Risk Assessment 14-4

Recording sales

Accounting (Billing)

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Programmed control procedures Computer general control procedures Manual follow-up procedures.

If a programmed control procedure in critical to a low control risk assessment then the auditor should directly test the control procedure. In order to obtain assurance that the programmed control procedure functions effectively throughout the period the auditor also needs to these the effectiveness of computer general control procedures. Programmed controls usually report exceptions noted when performing the control. As a result auditors also need to test the effectiveness of manual controls that follow-up on reported exceptions.

14-9. The following tables describes programmed controls for a typical manufacturing company. Potential Programmed Control CAATs (Assuming Test Data) Misstatement a. Sales invoices may The computer compares Submit test data for a transaction not be recorded. entries in the sales journal that has shipping information, with underlying shipping both with and without a information. All shipping supporting sales invoice. documents must be matched with a sales invoice. b. Sales invoice may The computer compares dates Submit test data with dates on be recorded in the on the sales invoice with sales invoices that both do and wrong accounting dates on shipping documents. do not match with dates on period. related shipping files. c. A fictitious sales The computer will not Submit test data with sales invoice, or a sales prepare a sale invoice without invoice information that both is transaction for underlying information on and is not supported by which revenue shipping files. underlying shipping information. should not be recognized, is recorded. d. Sales are made The computer searches a field Submit test data for sales orders without credit for appropriate credit that both are and are not approval. authorization before an order supported by appropriate credit is placed on an open order authorization. file. e. A sales invoice has The computer matches Submit test data for sales incorrect quantities quantities on a sales invoices invoices that both do and do not or prices. with underlying shipping match underlying shipping information and matches information and authorized price prices with an authorized lists. price list. f. Sales invoices may The computer checks run-to- Submit test data for batches that not be posted or run totals of beginning with complete and incomplete may not be accounts receivable balances, data sets in terms of completed

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Potential Misstatement journalized g. Sales invoices may be posted to the wrong customers accounts.

Programmed Control plus sales transactions, with the ending receivable balances. The computer matches customer information on the sales invoice with the master customer file, the sales order, and the shipping documents.

CAATs (Assuming Test Data) transactions. Submit test data with underlying information that both does and does not match with information on previously created sales order and shipping files.

14-10. A common management control involves having managers with responsibility for sales to review daily or weekly sales reports to assess the reasonableness of recorded sales. Further management responsible for warehousing and shipping should review daily or weekly sales and inventory movement reports to assess the reasonableness of recorded sales and inventory removed from the perpetual inventory. 14-11. The sub-functions involved in cash receipts include (1) receiving cash receipts, (2) depositing cash in bank, and (3) recording the cash receipts. 14-12. a. Two important controls pertaining to cash sales and the transaction class audit objectives to which they relate are: The customer's expectation of a printed receipt and supervisory surveillance of over the counter sales transactions helps to ensure that all cash sales are processed through the cash registers or terminals - completeness. Independent check by supervisor on the accuracy of cash count sheets, and verification of agreement of cash on hand with totals printed by a cash register or terminal - existence or occurrence and valuation or allocation. Two important controls pertaining to the initial handling of mail receipts are (1) immediate restrictive endorsement of checks received and (2) preparation of a multicopy listing (prelist) of mail receipts. A lockbox is a post office box that is controlled by the company's bank. The bank picks up the mail daily, credits the company for the cash, and sends the remittance advices to the company for use in updating accounts receivable. This system eliminates the risk of diversion of the receipts by company employees and failure to record the receipts. Depositing receipts intact daily means that all receipts are deposited; that is, cash disbursements should not be made out of undeposited receipts. This control reduces the risk that receipts will not be recorded (completeness), and the resulting bank deposit record establishes the existence or occurrence of the transactions.

b.

14-13. a.

b.

14-14. Four controls that can aid in preventing or detecting errors or irregularities in recording cash receipts are summarized below along with potential tests of controls:

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Control Independent check of agreement of validated deposit slip with daily cash summary. Computer check of information included in the cash receipts journal with information from prelist. Preparation of periodic independent bank reconciliations. Mailing of monthly statements to customers.

Test of Control Inspect a sample of daily cash summaries and examine evidence of agreement with validated deposit slip by responsible employee. Use CAATs to test computer matching of information from cash receipts journal with electronic prelist. Also follow-up on how exceptions are reported and examine evidence or correction of errors reported on exception reports. Examine a sample of periodic bank reconciliations. Make inquiries about bank reconciliation procedures and test accuracy on a sample basis. Observe the mailing of monthly statements to customers. Make inquiries about procedures to follow-up on issues raised by customers, and examine reports or other evidence of follow-up.

14-15. a. b.

The functions pertaining to sales adjustments transactions are: granting cash discounts; granting sales returns and allowances; and determining uncollectable accounts. The following three types of controls pertaining to sales adjustments transactions have as their common focus establishing the validity, or existence of occurrence, of such transactions: Proper authorization of all sales adjustments transactions. The use of appropriate documents and records, particularly the use of an approved credit memo for granting credit for returned or damaged goods, and an approved write-off authorization memo for writing off uncollectable customer accounts. Segregation of duties for authorizing sales adjustment transactions and handling and recording cash receipts. The accounts receivable balance is a function of the transactions that are posted to the account, namely credit sales, cash receipts, and sales adjustments. A sound system of internal controls over these three transaction cycles that ensure the completeness and accuracy of these transactions, should also ensure the completeness and accuracy of account receivable. The primary control over the balance involves sending monthly statements to customers and having an independent function to receive and follow-up on any issues raised by customers. The rights and obligations assertion for accounts receivable involves selling, or factoring, cash receipts. If an entity sells its receivables, it should keep a documentary record of the receivables that have been sold or pledged, and have a process for following up on collection of those receivables and the reduction of the related liability

14-16. a.

b.

c.

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to the factoring agent. These records should be compared with monthly statements received from a bank or factoring agent. d. Public companies normally control establish controls over the presentation and disclosure assertion and related audit objectives through an effective and independent disclosure committee. The disclosure committee should have individuals who are knowledgeable about GAAP and the transactions being processed.

14-17. The following table provides example controls and tests of controls for each assertion (and transaction level audit objective) related to credit sales and cash receipts. Examples emphasize programmed control procedures where appropriate. Student should note that tests of controls should also emphasize testing computer general controls, observing exception reports, and testing manual follow-up of items that appear on exception reports. Credit Sales
Assertion (Audit Objective) Existence and Occurrence (Occurrence) Completeness (Completeness) Existence and Occurrence / Completeness (Cutoff) Valuation and Allocation (Accuracy) Presentation and Disclosure (Classification) Rights and Obligations Control
Computer matches sales invoice information with underlying shipping information. Computer prints a report of all goods shipped but not billed. Comparison of invoice date with the accounting period when goods were shipped. Computer matches sales prices with authorized price list and sales order. Computer matches customer number on sales invoice with customer number on sales order.

Test of Controls Submit test data where invoice data does not match with underlying shipping information. Submit test data with shipments that have not been billed to test accuracy of report of all good shipped but not billed. Submit test data with shipments in one period and billing in the subsequent period. Submit test data with invoice prices that do not match the authorized price list or sales order. Submit test data the customer information on the sales invoice does not match the underlying sales order. Observe and reperform procedures for documenting receivables that have been factored or sold.

If an entity sells its receivables, it should keep a documentary record of the receivables that have been sold and it should compare that record with monthly statements received from a factoring company.

Cash Receipts
Assertion (Audit Objective) Existence and Occurrence (Occurrence) Completeness (Completeness) Existence and Occurrence / Completeness (Cutoff) Valuation and Allocation Control Independent check of agreement of cash and checks with cash count sheets and prelist. Independent check of agreement of cash and checks with cash count sheets and prelist. Preparation of periodic independent bank reconciliations. Independent check of agreement Test of Controls Observe and reperform manual controls to check independent check of the prelist with the cash receipts journal. Observe and reperform manual controls to check independent check of the prelist with the cash receipts journal. Observe and test the accuracy of independent bank reconciliations. Observe and reperform manual controls to

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(Accuracy) Presentation and Disclosure (Classification) Rights and Obligations

of cash and checks with cash count sheets and prelist. Mailing of statements to customers. If an entity sells its receivables, it should keep a documentary record of the receivables that have been sold and it should compare that record with monthly statements received from a factoring company.

check independent check of the prelist with the cash receipts journal. Make inquiries about mailing of monthly statements to customers. Observe notes and procedures used to follow-up upon questions raised by customers. Observe and reperform procedures for documenting receivables that have been factored or sold.

14-18. a. b.

The transaction classes that should be considered in assessing control risk for accounts receivable assertions are: credit sales, cash receipts, and sales adjustments. In assessing control risk for the existence or occurrence account balance assertion for accounts receivable, the following transaction class control risk assessments should be considered: Existence or occurrence for sales transactions that increase accounts receivable. Completeness for cash receipts and sales adjustments transactions that decrease accounts receivable. A revised acceptable level of detection risk for tests of details and a revised level of substantive tests must be determined for an assertion when the relevant final or actual inherent risk assessments, control risk assessments, and analytical procedure risk assessments, differ from the planned assessed levels.

c.

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14-19. The following table explains some example preliminary audit strategies for each financial statement assertion in the context of the audit risk model.
Assertion Existence and Occurrence Completeness Inherent Risk Maximum due to revenue recognition problems. Moderate. Not a significant inherent risk. Moderate to high depending on the entitys ability to generate operating cash flow. High or maximum due to subjective nature of allowance. Inherent risk is usually high or maximum. Control Risk Low if internal controls over the occurrence of sales are strong. Low if internal controls over the occurrence of sales are strong. Moderate to high depending on internal controls. However, control are more nonroutine than routine. Moderate to high depending on internal controls over collection of receivables. Moderate to high depending on internal controls over disclosures. Analytic Procedures Risk Moderate to high depending on reliability of expectation model. Moderate to high depending on reliability of expectation model. Moderate to high depending on reliability of expectation model. Test of Details Risk Moderate which will allow for smaller sample sizes and changing the timing of confirmations of receivables. It will also reduce the extent of cutoff tests. Moderate to high which will allow for smaller sample sizes and changing the timing of confirmations of receivables. It will also reduce the extent of cutoff tests. Low: Consider confirming with factoring agent and search for large unusual cash receipts.

Rights and Obligations

Valuation and Allocation

Moderate to high depending on reliability of expectation model. Maximum: Analytical procedures are not directed at testing disclosures.

Presentation and Disclosure

The auditor can test the accuracy of receivables at gross value with confirmation. The auditor should consider extensive tests of the allowance after year-end. Maximum to High. It is often cost effective to substantively test disclosures which are not complex for receivables.

14-20. In vouching recorded accounts receivable transactions to supporting documentation, a sample of debits to customers' accounts is compared to data on supporting sales invoices and matching shipping documents, sales orders, and customer orders. The evidence obtained pertains primarily to specific audit objectives derived from the existence or occurrence, rights and obligations, and valuation or allocation assertions for accounts receivable. 14-21. Both the sales cutoff test and the cash receipts cutoff test pertain to accounts receivable. The sales cutoff test involves: Examining shipping documents for several days before and after the cutoff date to determine the date and terms of shipment. Tracing shipping documents to sales and inventory records to establish that the entries were made in the correct accounting period. Inspecting invoices for a period of time before and after the cutoff date to ascertain the validity and propriety of the shipments and corresponding entries. Inquiring of management about any direct shipments by outside suppliers to customers and determining the appropriateness of related entries. In performing a cash receipts cutoff test, the auditor may be present at the balance sheet date to personally observe the promptness of the cutoff. In particular, the auditor determines that all

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collections received prior to the close of business are included in cash on hand or in deposits in transit and are credited to accounts receivable. Alternatively, the auditor may review the daily cash summary and validated deposit slip for the last day of the year. Both cutoff tests relate to the occurrence and completeness audit objectives for accounts receivable. 14-22. a. It may not be necessary to confirm accounts receivable when: The balance is immaterial to the financial statements. The use of confirmations would be ineffective as an audit procedure. The auditor's combined assessment of inherent risk and control risk is low, and that assessment, made in conjunction with the evidence expected to be provided by analytical procedures or other substantive tests of details, is sufficient to reduce audit risk to an acceptably low level for the applicable financial statement assertions. Factors to be considered in choosing the form of confirmation request are (1) the acceptable level of detection risk and (2) the composition of the customer balances. The positive form is used when detection risk is low or individual customer balances are relatively large. The negative form should be used only when all three of the following conditions apply: The acceptable level of detection risk for the related assertions is moderate or high. A large number of small balances is involved. The auditor has no reason to believe that the recipients of the requests are unlikely to give them consideration. When no response is received after the second or third positive confirmation request to a customer, the auditor should apply such alternative procedures as (1) examining subsequent collections and (2) vouching open invoices comprising the customer's balance. Alternate procedures may be omitted when both of the following conditions apply: There are no unusual qualitative factors or systematic characteristics related to the nonresponses, such as that all nonresponses pertain to year-end transactions. The nonresponses, projected as 100% misstatements to the population and added to the sum of all other unadjusted differences, would not affect the auditor's decision about whether the financial statements are materially misstated The aged trial balance is used primarily in assessing the adequacy of the allowance for uncollectable accounts. Procedures applied to the aged trial balance include (1) footing and crossfooting the aged trial balance and comparing the total to the general ledger balance for accounts receivable and (2) testing the aging of the amounts shown in the aging categories by examining supporting documentation such as dated sales invoices.

b.

c.

14-23. a. b.

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c.

After testing the accuracy of the aged trial balance the auditor should perform the following procedures to draw a conclusion about the fair presentation of the allowance for doubtful accounts. Examine past due accounts for evidence of collectability such as correspondence with customers and outside collection agencies, credit reports, and customers financial statements. Discuss collectability of accounts with appropriate management personnel. Evaluated managements process for estimated the allowance for doubtful accounts using hindsight. Evaluate the adequacy of the allowance given information about industry trends, aging trends, and collection history for specific customers. Hindsight allows auditors to evaluate the reasonableness of managements process for estimating the allowance for doubtful accounts. The reliability of managements process for developing this accounting estimate can be gauged by evaluating estimates in prior periods and the degree to which those estimates accurately estimated subsequent uncollectable accounts.

d.

14-24. GAAP disclosure for accounts receivable include: Disclosure of receivables from employees, officers, affiliated companies and other related parties. Appropriate classification of material credit balances. Appropriate classification of current and noncurrent receivables. Disclosure of pledging, assigning, or factoring receivables.

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