Chapter 10

Auditing Revenue and Related Accounts

Why are revenue cycle accounts important?

Sales transactions are always material to a company's financial statements

According to the SEC, a majority of financial statement manipulations and audit failures involve overstated revenues

Therefore, revenue cycle accounts must be examined with great care

What is the cycle approach?

Revenue cycle transactions include all the processes ranging from the sale to shipping a product, billing the customer, and collecting cash

A company's revenue cycle transactions reflects its operations

A cycle approach is one way to help the auditor focus on the important account balances surrounding a transaction to ensure that sufficient audit evidence is gathered and evaluated

List the Financial Transactions Processing Cycles

Revenue

Acquisition and payment of goods and services

Payroll

Financing: debt and equity

Cash and short-term investments

Overview of the Revenue Cycle (Sales made on Account)

Receive customer purchase orderCheck inventory stock status

Generate back order if item not in stockObtain credit approvalPrepare shipping and packing documentsShip and verify shipment of goodsPrepare the invoiceSend monthly statements to customersReceive payment

Discuss Business Risk and Business Environment

Revenue recognitionSAS 99 - Consideration of Fraud in a

Financial Statement AuditAuditor should presume risk of

material misstatement due to fraud related to revenue recognition

Research shows over half of frauds involve overstating revenues

Name Some Improper Revenue Recognition Schemes

Recognize revenue on fictitious shipments Hidden side letters that give customers unlimited

right to return 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

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 financial statements

External risk indicatorsInternal red flagsUnusual financial resultsAuditor deals with red flags byExamining external pressures that could lead

to financial reporting fraudExamining the financial statements to

determine if account balances seem out of line

What analytical analysis can be done for possible misstatements?Compare client revenue trend with

economic conditions and industry trends

Compare cash flow from operations with net income

Perform analytical proceduresRatio analysisTrend analysisReasonableness tests

Review Assessment of Environment Risk

Risk assessment is ongoing process in every audit

Audit steps to assess environment risk for the revenue cycle:

Update information on business riskPerform analytical procedures to look for

unexpected relationshipsDevelop understanding of internal controlsAnalyze business risk for motivations and

methods to misstate sales

Document operation of accounting applications 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 controls

Perform tests of controls, document resultsBased on the results of testing, reassess

control risk

Review Assessment of Environment Risk

Discuss Inherent Risk with Regard to Sales

While sales transactions are routine for most organizations and do not represent an abnormally high risk, for other organizations, revenue recognition may be complicated

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

Impact of any unusual sales terms and whether title passed to customerExample: related party transactions

Goods recorded as sales have been shipped Sales made with recourse or that have

significant returnsExample: irrevocable right to return goods

The presence of these issues increase inherent risk and the probability of material misstatement

Discuss Inherent Risk with Regard to Sales

Comment on 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 been understated

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

financing transactions Receivables pledged as collateral Receivables classified as current when likelihood of

collection is low Collection of receivable contingent on uncertain

future events Payment not required until purchaser sells the

product

Reflect upon 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 integrityFinancial condition of the organizationFinancial pressures on the organizationManagement incentives to achieve

financial results

Understanding Internal Controls

Although the auditor must understand all components of internal controls, particular attention is paid to significant control 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 documentationIt is critical this understanding be documented in the

work papers

Understanding Internal Controls (Continued)

Internal control procedures should be sufficient to ensure the management assertions are achieved:

Existence/Occurrence: sales are recorded only when shipment has occurred and the primary revenue producing activity has been performed

Completeness: all valid sales transactions are recorded

Rights/obligationsValuationPresentation and disclosure

What are the three components of evaluating control risk?

Monitoring Controls

Control Structure for Returns, Allowances, and Warranties

Importance of Credit Policies Authorizing Sales

Explain Monitoring Controls

Designed to signal failures in transaction processing, and determine if timely, corrective action is taken

Monitoring controls applicable to revenue transactions include:

Compare sales and cost of good sold with budgeted amounts

Exception reports generated to identify unusual transactions

Internal audit of revenue cycle controls Computer reconciliation of transactions entered with

transactions processed Monitoring of accounts receivable for quality Independent follow-up on customer complaints Audits of sales tax collections

Define Documenting, Testing, and Assessing Environment RiskDevelop understanding of the accounting

system and control proceduresEvidence is gathered through inquiry, review

of client accounting manuals, and review of prior year audit workpapers

Documentation includes questionnaires, flowcharts, and narratives

Determine whether the application control procedures are sufficient to achieve the control objectives

Based on control design, make preliminary assessment of control risk

The auditor must document those controls that support an assessment of control risk below maximum

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

If testing indicates the control is not operating effectively,Auditor will increase assessed control risk,

lower detection risk, and perform more rigorous substantive testing

If the control is working effectively, control risk assessment is unchanged

Define Documenting, Testing, and Assessing Environment Risk

Discuss 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 the assessment of environment risk that affects the design of substantive audit procedures:

The nature of the accounting system, controls used, and documents generated in the client's processing

Existence of fraud risk factorsEffectiveness of controls and types of

misstatements likely to occur

Comment on Substantive Testing in the Revenue Cycle

Planning for Direct Tests of Transactions and Account Balances

Audit objectives and assertionsAccount balance relationshipsRisk of material misstatementComposition of the accountPersuasiveness of audit proceduresCost of audit proceduresTiming of audit proceduresDetermining optimal mix of audit procedures

What are some substantive tests of revenue?

Assertions related to revenue transactions:Occurrence: Have the transactions occurred

and pertain to the entityCompleteness: Have all transactions been

recordedAccuracy: Have transactions been accurately

recordedCutoff: Have transactions been recorded in

the correct accounting periodClassification: Have transactions been

recorded in the proper accounts

List Substantive Tests of Revenuefor Occurrence and Accuracy

Vouch recorded sales transaction back to customer order and shipping document

Compare quantities billed and shipped with customer order

Special care should be given to sales recorded at the end of the year

Scan sales journal for duplicate entries

List Substantive Tests of RevenueCutoff 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 days before and after balance sheet date

Extent of cutoff tests depends on effectiveness of client controls

List Substantive Tests of RevenueCutoff Tests

Sales cutoff Auditor selects sample of sales recorded during cutoff

period and vouches back to sales invoice and shipping documents to determine whether sales are recorded 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 issued during

cutoff period and determines whether credit was recorded in the correct period

List Substantive Tests of Revenuefor Completeness

Use of pre-numbered documents is important

Analytical procedures Cutoff testsAuditor selects sample of shipping

documents and traces them into the sales journal to test completeness of recording of sales

Substantive Tests of Accounts Receivable Existence & Occurrence

ValuationAre sales and receivables initially recorded

at their correct amount?Will client collect full amount of recorded

receivables?Rights and ObligationsContingent liabilities associated with factor

or sales arrangementsDiscounted receivablesPresentation and DisclosurePledged, discounted, assigned, or related

party receivables

Discuss Substantive Tests of Accounts Receivable

Obtain and evaluate aging of accounts receivable

Confirm receivables with customers

Perform cutoff testsReview subsequent collections of

receivables

Comment on Aging Accounts Receivable

Because receivables are reported at net realizable value, auditors must evaluate management estimates of uncollectible 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

Review Confirming Receivables with Customers

Confirmations 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

Define the Types of Confirmations

Positive confirmationsCustomers are asked to agree the amount on

the confirmation with their accounting records and to respond directly to the auditor whether they agree with the amount or not

Positive confirmation requires a responseIf customer does not respond, auditor must

use alternative procedures

Negative confirmations Customers are asked to respond only if they

disagree with the balance (non-response is assumed to mean agreement)

Less expensive since there are no additional procedures if customer does not respond

May be used when all of the following are presentConfirming a large number of small customer

balancesEnvironment risk for receivables is assessed as

lowAuditor believes customers will give proper

attention to confirmations

Define the Types of Confirmations

What’s the follow-up procedures for non-responses?

If customer does not respond to positive confirmation, auditor may send a second, or even third, request

If customer still does not respond, auditor will use alternative procedures

Examine the cash receipts journal for cash collected after year-end Care is taken to ensure receipt is year-end receivable, not

subsequent sale 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

What’s the follow-up procedures for exceptions noted?

Customers are asked to agree the amount on the confirmation to their accounting records; differences are called exceptions

Reasons for exceptions:Timing differencesDisputed itemsCustomer errorsClient misstatementBecause misstatements are projected to the

population of receivables, the auditor must determine the reason for the exception

Discuss Related-Party Receivables

Amounts due from related parties should be separately disclosed

Audit procedures to identify related-party transactions include:

Review SEC filingsReview the accounts receivable subsidiary

ledger and trial balanceManagement inquiryCommunicate names of related parties so all

audit team members can be alert for related-party transactions

Comment on Sold, Discounted, and Pledged Receivables

Receivables sold with recourse, discounted, or pledged as collateral should be disclosed

Audit procedures to identify these items include:

Management inquiryScan cash receipts journal for large cash

inflows from unusual sourcesBank confirmations, which include

information on obligations and termsReview board of director minutes, which

contain approval for these items

Review Fraud Indicators and Audit Procedures

Potential fraud indicators: Excessive credit memo or other adjustments to accounts

receivable just after year-end Customer complaints and discrepancies in receivable

confirmations Unusual entries to the receivable subsidiary ledger or sales

journal Missing or altered source documents Lack of operating cash flow when operating income has been

reported 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 just before or after

year-end

Review Fraud Indicators and Audit Procedures

Substantive procedures that may highlight potential fraud indicators:

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

Review and analyze credit memos and other adjustments 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-

off activity Analyze recoveries of written-off accounts

Explain 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 and depends on a number of factors

Understating the allowance overstates net accounts receivable and net income

Where accounts receivable are material, the auditor should obtain an understanding of how management developed the estimate by using 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 Review subsequent events such as subsequent collections on

account