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CHAPTER AUDIT OF THE REVENUE AND COLLECTION

CYCLE: TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS

3-1. Directly. Higher levels of control risk induce auditors to audit larger samples of

receivables, with confirmation date closer to the fiscal year end date. As for nature of the procedures: higher levels of control risk induce auditors to use positive confirmations instead of negative confirmations, and to consider vouching subsequent payments by the customers.

3-2. The features of a cash receipts internal control system which would be expected to

prevent an employee from absconding with company funds and covering with funds from the employee pension fund is the prohibition against one employee having custody of company funds and noncompany funds. The auditor can detect such transfers by controlling and counting both funds simultaneously.

To prevent the cash receipts journal and recorded cash sales from reflecting more

than the amount shown on the daily deposit slip, the internal control system should provide that receipts be recorded daily and intact. A careful bank reconciliation by an independent person could detect such errors.

3-3. A strength is defined as a control procedure that can detect, prevent or correct

errors in a timely matter from entering into the accounting records that form the basis of financial statements. A weakness is the lack of a control procedure where the auditor thinks one should exist.

Weaknesses are not subject to test of controls auditing because no reliance is

placed on a weakness. Strengths must be audited because the review phase only describes apparent strengths that may not actually exist.

3-4. The evaluation after the review phase was to determine which controls appeared

adequate as a basis for justifying a low control risk assessment. The final assessment after test of controls auditing is to determine if the controls are actually operating as well as they appeared to be.

3-5. a. An order entry department generally receives customers’ requests to purchase

merchandise either by telephone or in the form of a written purchase order from the customer. A purchase order is a legal offer to purchase goods under the terms specified. In some entities, on receipt of an order, the order entry department generally prepares a sales order. The sales order is the first document prepared by the merchandiser in the sales and collections cycle,

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and it should be prenumbered to facilitate control over processing transactions. A copy of the sales order, acknowledging that the order has been received and is being processed, may be mailed to the customer. Four copies of the sales order are sent to the credit department, which either approves or denies credit and returns a copy of the sales order to the order entry department. The credit department then sends a copy bearing credit approval (assuming it is granted) to the warehouse, the shipping department, and the billing department. The sales order bearing credit approval serves as authorization to warehouse personnel to release goods to shipping. Shipping personnel verify that the quantity and description of goods received from the warehouse match the copy of the sales order received directly from order entry. Billing matches the customer order, the sales order, and the shipping document before recording the sale.

In some entities, when an order is received, the purchase order is sent to the

credit department for approval. The credit department’s decision is returned to the order entry department. When the credit department has approved the sale, a multipart sales invoice is prepared. One copy serves as a shipping order, another as the bill of lading, and another is sent to billing. The sale, however, is not recorded (entered in the sales journal) until the bill of lading is received by billing.

b. Before goods are shipped, the customer’s credit must be approved. The credit

department maintains a list of unauthorized customers and their credit limits, which an employee must review to determine whether to accept an order. A credit department employee signs a copy of the sales order authorizing the credit sale. When an order is received from a prospective customer not on the list or when a customer has exceeded the authorized credit limit, the credit department generally conducts a credit investigation and makes a decision to accept or reject the order. When the order is accepted, a copy of the sales order is sent to the warehouse and a copy is retained in the credit department.

c. On the basis of the sales order approved by the credit department, warehouse

personnel issue goods to the shipping department. The accounting department, rather than warehouse personnel, maintains perpetual records for the inventory.

d. The shipping department verifies that the goods received from the warehouse

to be shipped agree with the quantity and description of goods on the sales order. The shipping department then packs the merchandise, arranges transportation with a common carrier, and prepares a shipping document. The shipping document is a multicopy document that lists the items, gives instructions to the common carrier as to whom and to what the address to ship the merchandise, and may serve as a packing slip for the merchandise. Copies of the shipping document are given to the carrier, and copies are sent to the billing department. Sometimes entities use a bill of lading as a

Audit of the Revenue and Collection Cycle: Tests of Controls and Substantive Tests of Transactions 3-3

shipping document; it may include a general description of the goods and a quantity or number of pounds.

e. Billing involves notifying the customer (by means of an invoice) of the

amount due for the goods or services delivered. The billing function is typically performed by a section of the accounting department and should be independent of sales executives. Billing personnel should (1) account for the sequence of shipping documents to determine that all shipments are billed, (2) compare the details included on the sales order with the shipping documents to serve as an independent check on shipping, (3) prepare the sales invoice from data on the shipping document and sales order, (4) price the invoice by reference to an authorized price list obtained from the sales department, (5) extend and foot the invoices, and (6) account for the sequence of sales orders and shipping documents to ensure that all sales are recorded.

Some entities prepare a turnaround document simultaneously with the sales

invoice. A turnaround document is a form the customer mails back to the merchandiser, along with payment of the invoice that facilitates handling and processing of cash receipts. It contains information, such as the customer’s name and account number, and a place to indicate the amount of the payment.

Prior to mailing, each invoice should be reviewed by a person not involved in

its preparation. The review should cover the propriety and accuracy of prices, extensions, footings, credit terms, and freight charges. The billing department should develop a total of sales invoices and submit it directly to the clerk responsible for maintaining the accounts receivable control account. The accounts receivable subsidiary ledger clerk or data processing department prepares the sales journal and posts debits to individual accounts in the accounts receivable subsidiary ledger. Subsequent reconciliation of the accounts receivable subsidiary ledger to the accounts receivable control account is an important aspect of internal control. Shipping documents are used by accounting to update perpetual inventory records when they are maintained.

f. One of the best controls over cash receipts is a lockbox system in which

customers mail their remittances to a post office box controlled by a bank. The bank’s bonded employees obtain the mail from the post office box, make a listing of the amount by customer, mail the remittance advices and a copy of the list to the business, and deposit the cash. When mail containing remittances comes directly to the entity, the first step in the control process is to obtain a listing of the cash and checks. This listing is generally prepared by a receptionist or a mailroom employee designated to open mail. However, the person should have a high level of integrity and not be otherwise involved in handling cash or maintaining accounts receivable records. The listing of cash receipts, referred to as a prelisting, serves to establish control over cash receipts. Remittance advices are prepared if necessary, and when the listing

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has been prepared, the cash and remittance advices are separated. The cash is given to the cashier to prepare the bank deposit, and the remittance advices are given to the accounts receivable clerk for preparing the cash receipts journal and updating the accounts receivable subsidiary records. The employee preparing the prelisting also develops a total of cash receipts to send directly to the accounting department supervisor, who maintains control over the general ledger accounts.

g. A business issues a credit memo when a customer returns merchandise or

when a price adjustment is allowed. Credit memo authorizations should bear the signature of an employee with authority to issue a credit memo and should be based on a receiving report when merchandise has been returned, or on correspondence between the sales department and the customer when a price adjustment has been authorized.

h. The allowance for uncollectible accounts expense is the result of an adjusting

entry, which should be approved by the controller or chief accountant. Any entries recording uncollectible accounts expense should bear the written authorization of the controller.

i. After exhausting all reasonable efforts to collect accounts, businesses should

write off accounts judged to be uncollectible. Frequently, accounts are written off after the customer declares bankruptcy. Accounts written off should be transferred to a separate control account, and statements should continue to be sent to those debtors in an effort to collect the account.

3-6. a. A merchandiser prepares a shipping document that includes the name and

address of the customer and a description of the goods. The document is a contract between the seller and the carrier and is signed by the carrier when it accepts the goods. Businesses often use a bill of lading as a shipping document. The document may be a copy of the invoice or a delivery ticket.

The signature of the carrier on the shipping document provides externally

created evidence that a sale has occurred. Accounting for the numerical sequence determines that all shipments are recorded as sales.

b. A customer attaches a remittance advice to a check in payment of an invoice.

The document may be a turnaround document, a part of a check, or a statement identifying the invoices being paid. Remittance advices facilitate recording cash receipts. If a customer does not return a remittance advice, the employee opening the mail usually prepares one. A remittance advice indicates the date and amount of payment and the invoices paid. Remittance advices are separated from cash and given to the accounts receivable clerk for posting to accounts receivable.

Audit of the Revenue and Collection Cycle: Tests of Controls and Substantive Tests of Transactions 3-5

c. Uncollectible account forms authorize an accounting clerk to write off an account receivable as an uncollectible account. The form provides permanent written evidence that authorization was made for writing off an account.

3-7. Managers may experience pressure to show high profits and may inflate sales

because of the pressure to meet target profits established by senior managers, to obtain bonuses, to retain the respect of senior managers, or even to retain their jobs.

3-8. Until a record of cash received has been made, removing cash is one of the easiest

forms of fraud to commit and among the hardest to detect because records do not reflect what has occurred.

3-9. Answers will vary. Three possible examples are the following:

A cashier in a retail establishment who does not ring up a transaction on the cash register can generally take the cash without detection. Ringing up the transaction adds the receipt to the total cash receipts, which can be compared to the cash on hand.

An employee who has access to cash receipts and maintains accounts receivable records can record a sale at an amount lower than the invoice amount. When the customer pays, the employee takes the difference between the invoice and the amount recorded as a receivable.

An employee who makes the cash deposit and also prepares the bank reconciliation can withhold cash and hide the shortage by overstating deposits in transit on the bank statement, underfooting the list of outstanding checks, or omitting outstanding checks from the outstanding check list. Routinely testing bank reconciliations should uncover this form of fraud.

3-10. Auditors are not required to perform tests of controls. However, when a client has

effective internal control, performing tests of controls is cost effective because it may provide a basis for the auditor to assess control risk at less than maximum. Assigning a reduced level of risk to control risk reduces the amount of substantive testing the auditor must perform. Substantive tests are more expensive to perform than tests of controls. Hence, auditors perform tests of controls when they believe it will enable them to reduce the amount of substantive testing. Also, auditors may perform much of the testing of controls before year end, thus spreading the audit work.

3-11. Adjustments to sales include cash discounts, sales allowances or reductions in

price, returns of merchandise, volume rebates, corrections of billing errors, and write-offs of uncollectible accounts. The greatest concern from a control point of view is that one of these types of transactions will be recorded to cover a misappropriation of cash receipts.

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3-12. The following potential misstatements could arise: Fictitious cash receipts may be recorded, or cash receipts may be

misappropriated. Cash may be misappropriated and lapping may occur. Bank reconciliations may cover shortages. Credits posted to customers’ accounts may be overstated or understated. Entries may be made to the wrong accounts.

3-13. Auditors’ primary concern with regard to uncollectible accounts is that accounts

written off have actually become uncollectible, rather than being written off to cover a misappropriation. To prevent accounts from being written off to cover misappropriations, any account written off must be authorized by a responsible official not involved in the granting of credit. The auditor usually tests the effectiveness of this control by examining the approvals of accounts written off. For a sample of accounts written off, the auditor generally examines correspondence indicating that efforts were made to collect the account and that the account is uncollectible. Sometimes the auditor examines credit reports on the accounts. The auditor should trace a sample of the entries to the accounts receivable accounts.

3-14. 1. (c) Mailing monthly statements to customers with outstanding accounts will

detect invoices posted to the wrong accounts. Customers whose accounts were misposted for goods not ordered will contest the statements.

2. (g) Each shipping document should have a corresponding invoice when the

goods are shipped. The appropriate direction of testing is from the shipping documents to the sales invoices.

3. (f) Daily sales summaries are from the book of original entry – the sales

journal. Comparing the summaries with the total of invoices will detect failure to record all invoices.

4. (k) Comparing control total amounts posted to the accounts receivable

(subsidiary) ledger with the control total of all invoices for the same period should detect invoices not posted.

5. (i) Credit approval should be received before sales are made. Thus, shipping

to customers on an approved list should reduce the risk of sales to customers with unsatisfactory credit.

6. (b) An approved sales order should be presented to the storekeeper before

release of goods from the warehouse to prevent goods from being removed for unauthorized orders.

Audit of the Revenue and Collection Cycle: Tests of Controls and Substantive Tests of Transactions 3-7

7. (d) Requiring shipping clerks to compare the amounts and types of goods received from the warehouse with approved sales orders ensures that goods shipped agree with those ordered by customers.

8. (l) Comparing sales invoices with shipping documents will ensure that each

invoice is supported by a shipment. Fictitious sales – i.e., those for which no shipment was made – should be detected.

9. (p) The total receipts credited to customer accounts in the subsidiary ledger

should equal the total receipts deposited, given that daily receipts are deposited intact.

10. (c) Checks misappropriated (stolen) prior to forwarding to the cashier will

not be posted to customer accounts (assuming that the remittance advices were stolen as well). Thus, customers will complain when their payments fail to be reflected in the balances on the monthly statements.

11. (c) Mailing monthly statements to customers with outstanding accounts will

detect receipts posted to the wrong accounts. Customers whose accounts were misposted will contest the statements.

12. (p) If more than one customer account is credited for the same cash receipt,

the error will be detected when the total of the amounts posted to the accounts receivable ledger is compared with the total cash receipts.

13. (s) The bank reconciliation will detect errors in recording cash receipts (and

disbursements). The balance in the ledger will not reconcile with the amount in the bank statement.

14. (p) If the checks are misappropriated (stolen) prior to deposit, the total of the

amounts posted to the accounts receivable ledger will be greater than the validated bank deposit slip.

15. (n) Invalid sales returns are prevented by requiring approval of returns by the

sales department supervisor. 3-15. 1) e 2) a 3) c 4) f 3-16. 1) d 2) a 3) c 4) b 3-17. 1) a 2) a 3) d 4) d 3-18. 1) b 2) b 3) c 4) b 3-19. 1) b 2) a 3) c

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3-21. 1. a. Accounting for shipping documents to determine that all shipments are billed.

b. Observe procedure and, for a sample of shipping documents, examine sales invoices.

c. Completeness 2. a. Prelisting of cash receipts and cash register procedures are monitored. b. Compare deposit to cash register total and prelisting. c. Completeness 3. a. A monthly statement should be mailed to customers by someone not

involved in handling accounts receivable or cash. b. Observe procedure and examine follow-up files. c. Existence or occurrence. 4. a. For goods shipped, goods should be counted and descriptions and

quantities should be compared to quantities and descriptions on sales orders and shipping documents prior to shipping.

b. Observe procedure. For a sample, examine signature on documents evidencing performance.

c. Rights and obligations. 5. a. Accounting for all sales invoice numbers to ensure that all are recorded. b. Observe procedure. For a sequence of invoices, account for the

numerical sequence. c. Completeness 6. a. Shipping documents should be accounted for to determine that all items

shipped are billed. b. Observe procedures. Examine invoices for a sample of shipping

documents. c. Completeness 7. a. For goods shipped, goods should be counted and descriptions and

quantities should be compared to quantities and descriptions on sales orders and shipping documents prior to shipping.

b. Observe procedure. For a sample, examine signature on documents evidencing performance.

c. Rights and obligations 8. a. Prenumbered sales invoices should be used and accounted for to

determine that all sales are recorded (in the proper period). b. Observe procedure. Examine entries for a sequence of sales invoices in

sales journal. c. Completeness

Audit of the Revenue and Collection Cycle: Tests of Controls and Substantive Tests of Transactions 3-9

3-22. 1. a. Existence, completeness b. Cash may be misappropriated or lapping may occur. c. Observe separation of duties and inquire of personnel about their

responsibilities. 2. a. Existence, completeness b. Fictitious cash receipts may be recorded or cash receipts may be

misappropriated. c. Observe whether a prelisting is prepared and inquire of preparer about

the procedures followed. 3. a. Existence, completeness b. Cash may be unrecorded or misappropriated. c. Observe the procedure and inquire of personnel who perform the

procedure. 4. a. Existence b. Bank reconciliations may hide shortages. c. Examine bank reconciliations and determine that preparer does not have

conflicting interests. 5. a. Valuation b. A customer may take a larger discount than appropriate. c. For a sample of entries in the cash receipts journal, examine remittance

advices for approval of discounts taken. 6. a. Existence b. A validated deposit ticket is obtained for daily deposits and compared to

the cash receipts summary. c. For a sample of entries in the cash receipts journal, reconcile the total to

validated deposit tickets. 3-23.

Weakness Recommended Improvement

1. There is no segregation of duties between persons responsible for collecting admission fees and persons responsible for authorizing admission.

One clerk (hereafter referred to as the collection clerk) should collect admission fees and issue prenumbered tickets. The other clerk (hereafter referred to as the admission clerk) should authorize admission on receipt of the ticket or proof of membership.

2. An independent count of paying patrons is not made.

The admission clerk should retain a portion of the prenumbered admission ticket (admission ticket stub).

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3. There is no proof of accuracy of amounts collected by the clerks.

The treasurer should reconcile the admission ticket stubs with cash collected by the collection clerk each day.

4. Cash receipts records are not promptly prepared.

Cash collections should be recorded daily by the collection clerk on a permanent record that will serve as the first record of accountability.

5. Cash receipts are not promptly deposited.

Cash should not be left undeposited for a week. Cash should be deposited at least once each day.

6. There is no proof of accuracy of amounts deposited.

Authenticated deposit slips should be compared with daily cash collection records. Discrepancies should be promptly investigated and resolved. In addition, the treasurer should establish a policy that includes performing analytical procedures to cash collections.

7. There is no record of the internal accountability for cash.

The treasurer should issue a signed receipt for all proceeds received from the collection clerk. These receipts should be maintained and should be periodically checked against cash collection and deposit records.

3-24. The Code of Professional Conduct does not prohibit a member of the audit team

from taking advantage of discounts when purchasing goods from clients. However, auditors may follow standards that are more restrictive than the Code of Ethics. The purpose of this exercise is for students to consider the possibility of such a discount’s affecting the auditor’s independence. Some auditors would decide that independence is lost if the discount was equivalent to the discount given employees. Students should also appreciate that auditors do not necessarily agree on acceptable behavior in this situation. Some CPA firms impose restrictions on employees regarding this matter.

3-25. a. Based on the information given, Honey can use the computer to

text extensions and footings of computerized sales records that serve as a basis for the preparation of the invoices and sales journal.

verify the mathematical accuracy of posting from the sales journal to appropriate ledger accounts.

Audit of the Revenue and Collection Cycle: Tests of Controls and Substantive Tests of Transactions 3-11

determine that all sales invoices and other related documents have been accounted for (for example, by accounting for the integrity of the numerical sequence).

select sales transactions for review (based on predetermined criteria) through a review of the sales journal or the accounts receivable subsidiary ledger.

print a working paper that lists each item selected, with relevant data inserted in applicable columns.

select all debits posted to the sales account and all postings to the sales account from a source other than the sales journal.

perform analytical procedures on recorded sales by use of predetermined criteria (percentage relationship, gross margin, trends, and so forth) on a periodic or annual basis.

compare duplicate data maintained in separate files for corrections. For example, the computer may be used to compare the client’s records of quantities sold with the client’s records of quantities shipped.

examine records for quality (completeness, consistency, and so forth). The quality of visible records is readily apparent to the auditor. Sloppy recordkeeping and lack of completeness are observed by the auditor in the normal course of the audit. If machine-readable records are evaluated manually, a complete printout is needed to examine their quality. Honey may choose to use the computer to examine these records for quality.

b. In addition to the procedures outlined above, Honey should

trace postings from the sales journal to invoice copies. trace data from sales invoices to the sales journal. compare dates of recorded sales transactions with dates on shipping

records. determine that all shipping documents have been accounted for (for

example, by accounting for the integrity of the numerical sequence). examine documents for appropriate approval (for example, granting of

credit, shipment of goods, and determination of price and billing). determine the extent and nature of business transacted with major

customers (for indications of previously undisclosed relationships – related parties – and for determination of applicability of disclosure requirements required by generally accepted accounting principles).

verify the sales cutoff at the beginning and end of the period to determine whether recorded sales represent revenues of the period.

test pricing of comparing invoice to daily price list.

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3-26. a. b. c. & d.

TYPE OF EVIDENCE TYPE OF TEST OBJECTIVE

1. Documentation (1) Test of control Existing sales transactions

are recorded (completeness) 2. Inquiry (4) Test of details of

balances Sales transactions are recorded in the proper period

3. Mechanical accuracy (4) Test of details of

balances Accounts receivable are mechanically accurate

4. Observation (4) Test of control Accounts receivable are

mechanically accurate 3-27. Alpha Drug Store, Inc., Processing Cash Collections: Internal Control

Questionnaire – The following questions should be listed:

Are customers who pay by check identified via store identification card or other means?

Does company policy prohibit accepting checks for anything except merchandise sales plus a nominal cash amount?

Is a receipt produced by the cash register given to each customer? Is the reading of each cash register taken periodically by an employee who is

independent of the handling of cash receipts? Are cash counts made on a surprise basis by an individual who is independent

of the handling of cash receipts? Is the reading of each cash register regularly compared to the cash received? Is a summary listing of cash register readings prepared by an employee who

is independent of the physical handling of cash receipts? Are receipts forwarded to an independent employee who makes the bank

deposits? Are each day’s receipts deposited intact daily? Is the summary listing of cash register receipts reconciled to the duplicate

deposit slips authenticated by the bank? Are entries to the cash receipts journal prepared from duplicate deposit slips

or the summary listing of cash register readings? Are entries to the cash receipts journal compared to the deposits per bank

statement? Are areas involving the physical handling of cash reasonably safeguarded? Are employees who handle receipts bonded?

Audit of the Revenue and Collection Cycle: Tests of Controls and Substantive Tests of Transactions 3-13

3-28. 1. a. Existence b. Cash may be misappropriated or lapping may occur. c. Observe separation of duties and inquire of personnel about their

responsibilities. d. For selected days, trace entries in the cash receipts journal to validated

deposit ticket, prelisting of cash receipts, and posting to accounts receivable.

2. a. Existence b. Fictitious cash receipts may be recorded or cash receipts may be

misappropriated. c. Observe whether a prelisting is prepared and inquire of preparer about

the procedures followed. d. For a sample of entries in the cash receipts journal, trace to the prelisting

of cash receipts. 3. a. Completeness b. Cash may be unrecorded or misappropriated. c. Observe the procedure and inquire of personnel who perform the

procedure. d. For a sample of entries in the cash receipts journal, compare prelisting to

the deposit ticket. 4. a. Existence b. Bank reconciliations may hide shortages. c. Examine bank reconciliations and determine that the preparer does not

have conflicting interests. d. Test bank reconciliations. 5. a. Valuation b. A customer may take a larger discount than appropriate. c. For a sample of entries in the cash receipts journal, examine remittance

advices for approval of discounts taken. d. For a sample of entries in the cash receipts journal, examine remittance

advices and verify that discount taken was appropriate. 6. a. Existence b. The cashier may misappropriate a portion of the cash receipts. c. For a sample of entries in the cash receipts journal, reconcile the total to

validated deposit tickets. d. For a sample of entries in the cash receipts journal, examine remittance

advices.