Audit of the Revenue Cycle

1. Audit of the Revenue Cycle Test of Controls

2. Typical Transactions in the Sales and Collection Cycle Five major classes of Transactions: • Sales • Both cash and on account • Cash receipts • Both receipts for cash sales as well as receipts on account • Sales returns and allowances • Technically two distinct transactions • Sales returns: customer returns defective, damaged, or otherwise undesirable products • Sales allowances: Customer agrees to keep merchandise in return for a reduiction in price • The write-off of uncollectible accounts • An important account for valuation purposes. Remember the management assertion and audit objective of valuation • Bad-debt expense • When an account is deemed uncollectible it is charged off to expense • By auditing uncollectible accounts the auditor is also audit bad debt expense

3. Prepare Sales Order Customer Order Customer Credit Department A An Overview of Functions, Documents, and Accounting Systems = Good control point It is important to notice the separate departments. It shows good segregation of duties. • Order Entry Department • The starting point Signed by the customer, except for telephone or internet orders. By phone, internet or mail Sales order 1 2 3 Credit Manager signs the sales order for credit approval

4. Okra Development Corp.Copy 8924 Bailey Road Purchase Order 6-3378 Salem, OR 92117 Date: August 5, 201X Ship By: September 12, 201X Terms: 2/10, n/30 FOB Shipping Point To: Ship to: Faragut Sales, Inc. Okra Development Corp. 3812 Briar Drive 8924 Bailey Road, Salem, OR 92115 Salem, OR 92117 Quantity 10 Number Model 317 Price 48.00 Amount 480.00 Description Roller Bearing for Model 3118 Ripper Purchase order number must appear on all shipments and invoices Ordered By Margaret Spangler

5. Sales Order To: Okra Development Corp. Copy 8924 Bailey Road Salem, OR 92117Faragut Sales, Inc. Ship to Okra Development 8924 Bailey Road, OR Ship by September 12, 201X Credit Approval C.H. Terms: 2/10, n/30 Goods Counted M.K. FOB Shipping Point Customer Order Number 6-3378 64412 Prenumbered Sales Order. Controlled numerically 10 Model 317 Roller Bearing 480.00 Date Shipped: 8/20/0X Freight Bill #229-237441 Quantity Number Description Amount

6. Order Entry Billing and A/R SO BL BL BL BL Customer Common Carrier N Approved by Credit Manager. • Shipping involves the Shipping Department Approved Sales Order Prepare Multi-Part Bill of Lading A legal document that the carrier is required to have. Always useful to have a numerical file. Kept in Shipping. Dept.

7. BILL OF LADING Faragut Sales, Inc. 3812 Briar Drive Salem, OR 92115 August 20, 201X Shipp to: Okra Development Corp. Destination: 8924 Bailey Road, Salem, OR 92117 Carrier: Yellow Express Car Initial: Car No. Copy 229-237441 Prenumbered Bill of Lading. Controlled numerically Number of Packages 5 Description of Articles, Special Marks, and Exceptions Roller Bearings, 2 each Weight 28 lbs. Class or Rate 3 Faragut SalesShipper, PerJoe ChenAgentYellow ExpressPerSue Jones

8. Shipping Department BL SO SO BL INV Prepare Sales Invoice & Sales Summary INV INV INV Cost Department for Perpetual Inventory Sales Summary General Accounting Customer N Pricing checked. Account coding checked. A numerical file that shows approval of the sale, proof of shipment, and billing. Good for testing internal controls. • Sales order & Bill of Lading goes to • Billing/Accounts Receivable Department Authorized Price List Summary by invoice number.

9. Faragut Sales, Inc.D8-9912Copy 3812 Briar Drive, Salem, OR 92115 Sales Invoice Sold Shipped to Freight Bill No. Okra Development Corp. 8924 Bailey Road 229-237441 8924 Bailey Road Salem, OR 92117 Salem, OR 92117 FOB Shipping Point Prenumbered Sales Invoice. Controlled numerically Invoice Date August 25, 201X Date Shipped August 20, 201X Terms 2/10, n/30 Your Order No. 6-3378 Quantity We are pleased to serve you Price Amount 10 Model 317 48.00 480.00 Key controls. Initials are evidence of control being performed. In total or sample. Pricing and Math J.D. Account Coding S.A.L.

10. Page 327 SALES JOURNAL Date Sold to: Invoice No. Amount August 25 Opra Development Corp. D8-9912 480.00

11. Customer Cheque Remittance Advice Remittance Advice Invoice Copy Invoice Cheque List Prepare List of Cash Received (2 copies) List Cashier Control Copy to General Accounting Deposits prepared by a person separate from the one who opens the mail. • Cash Collection • Receptionist/Mail Room Clerk Two separate listing going to two different places for later cross checking

12. Notice the complete details on the remittance Advice Opra Development Corp. REMITTANCE ADVICE Salem, Or. Invoice No. Date Voucher Gross Amount Discount Net Amount D8-9912 8-25-1X 9-00018 480.00 9.60 470.40 Cheque No. Date Vendor No. Vendor Name Total Amount 867 9-04-1X 003270003 Faragut Sales, Inc. 470.40 If the remittance advice is not returned, the person opening the mail should prepare one so that each cheque received is represented by a remittance advice complete with all pertinent details.

13. Also called a pre-listing of cash receipts 15642 September 5, 201X Cash Receipts Listing Fountain City Warehouse x,400.00 Charlotte Sawyers, Inc. x,295.00 Brown, Inc. 1,200.00 Okra Development Corp. x,470.40 Toil Incorporated x,490.00 Harreleson Hardware 1,872.80 Barnaby Sales, Inc. x,982.00 Hartfords x,x92.00 5,802.20 Preparer Adding Machine Tape x,120.00 x,x98.32 x,x23.66 x,842.33 x,988.11 3,130.40 J.T.Lockett September 5, 201X Cash Summary Cash Receipts Listing 5,802.20 Over-the-counter cash receipts 3,130.40 8,932.60 All cash receipts should be listed on the pre-listing from the remittance advices.

14. Mail Clerk Cheques Invoice Copies List of Receipts Remittance Advice Remittance Advice List of Receipts CR Summary CR Summary Prepare Deposit Slip & Cash Receipts Summary Cheques Deposit Slip General Accounting Bank Once again, a separate dept. • Cash must be deposited in the Bank • Cashier A/R to update A/R Sub-Ledger Distribution going to separate depts. For reconciliation All cash receipts should be deposited daily

15. First National Bank Faragut Sales, Inc. Deposit Slip September 5, 201X Currency 3,130.40 400.00 295.00 1,200.00 470.00 490.00 1,872.80 982.00 92.00 $8,932.60 Cheques Teller 5 Prepared by cashier, separate from the receipt of cash by Receptionist Initialed by cashier P.L.

16. Page 112 CASH RECEIPTS JOURNAL Date Customer Name Cash Sales Account Receivable Discount Credit August 25 Okra Development Corp. 470.40 9.60 480.00

17. Remittance Advice List of Receipts CR Summary Trial Balance Post to the Customer Account & Prepare Trial Balance General Accounting for comparison to the G/L D • The Accounts Receivable Sub-Ledger must be updated • A/R Department Bank Duplicate Deposit Slip Cashier Notice that the posting to the accounts is separate from collection of cash, and deposit in the bank. Subsidiary customer accounts posted from remittance advices. Trial Balance Daily remittance list compared to duplicate deposit slip received from bank by person independent of either function.

18. A/R Dept. Sales Summary List of Receipts CR Summary Post to the General Ledger Mail Clerk Cashier Post to the general ledger using data obtained from other depts. • The Role of General Accounting Subsidiary customer accounts posted from remittance advices. There should be a monthly reconciliation of control account to customers' individual accounts and bank statement reconciled promptly.

19. Typical Documents and Records • Sale is initiated with a • customer order • What documents accompany the sale? • shipping documents and invoice • recorded both in a transaction file (sales) and summarized in a customer master file (or in a database). • Routine reports • include a sales journal • Shows all sales invoices • aged accounts receivable trial balance • Should reconcile to the G/L • What key use does this have? • Anything else? • Monthly statements, sales reports

20. The Accounts of the Sales and Collection Cycle Gross sales Cash in bank Cash Sales Sales on Account Allowance for uncollectible accounts Accounts receivable Charge off of uncollectible accounts Cash receipts Sales returns and allowances Charge-off of uncollectible accounts Beginning balance Sales on account Ending balance Beginning balance Bad debts Ending balance Cash discounts taken Sales returns and allowances Bad debts These are the accounts that have to be audited. Also note the audit efficiency. Only audit one side of the T/A.

21. Methods of Recording Transactions • Manual recording • This, of course is rare today • Entered in batches • Entered into the computer system as groups of transactions • also called batches • Very common with earlier processing system • i.e. non-interactive • Recorded one transaction at a time • online transaction processing • very common today

22. Control Differences Between Batch and Online Systems An audit trail is a necessary requirement for both Batch systems: • Transactions readily traced • Good traditional audit trail • from source transaction to G/L posting • Good example would be payroll • Groups of transactions are totaled • Called batch control totals • These totals can be traced through the system Online systems: • Transactions recorded one at a time • may be initiated and recorded without source documents • e.g. phone orders • Document sequencing is important • Handled by the computer system • Numbers assigned to track documents • Computer edit checks necessary.

23. Control Differences For Error Detection and Correction Online systems: • Focus is on preventing errors • For each transaction as submitted and processed • Input edit check for valid customer data and reasonableness • i.e. all relevant customer data fields • Requires a number of different edit checks Batch systems: • one erroneous transaction • the whole batch is rejected • Error follow-up is required • Error corrected and whole batch re-submitted • Should be done in a timely manner

24. Batch and Online Systems: Segregation of Duties Batch systems: • Separate • Counting and batch totaling from data entry • Reconciliation and error follow-up • should be performed by the batch preparer • independent of data entry Online systems: • In decentralized systems • may result in inadequate segregation of duties • Use passwords to separate • transaction entry from master file entry • example of master file entry would be update of credit limits • This is permanent data, only changed periodically

25. Risk Assessment and the Sales Cycle Why do risk assessment? • Comprises first three phases of audit • Preplanning, client risk profile, and planning the audit Remember that as risk increases • auditor required to do more testing

26. Effect of General Controls • General controls • present in the environment surrounding the information system • Are pervasive and affect multiple transaction cycles • Auditor should document these prior to assessing the individual transaction cycles • Typical examples of general controls • The organizational and administrative structure of the IS function • Policies and procedures for day-to-day operations • The staff and their skills • Job responsibilities • Good data centre • E.g. adequacy of air conditioning, continual power supply, smoke detectors, fire extinguishers, clean air • Physical access and security • All servers in a secure location, protected by locked doors , swipe cards, biometric access

27. If general controls are good, • the auditor may be able to rely upon them • i.e. test interdependent or fully automated controls • Remember that interdependent controls require both programmed and manual components • If general controls are poor • the auditor may be able to rely upon only manual controls • or may need to conduct a substantive-oriented audit

28. Methodology for Designing Tests of Controls for Sales Understand general controls - sales Understand internal control and evaluate design effectiveness - sales By assertion: Assess planned control risk; identify and assess risks of material misstatement - sales Evaluate cost-benefit of testing controls Design tests of controls for sales to meet transaction-related audit objectives Audit procedures Sample size Items to select Timing

29. Documentation of Internal Controls • Internal controls need to be documented • for every audit assertion for every class of transactions. • The auditor focuses on • key controls • or those controls that have the greatest effect for that audit assertion. • What type of controls can these be? • These controls could be manual, automated, or interdependent. • Interdependent controls • Require both programmed and manual components to be effective • E.g. the computer provides a report of missing shipping documents. These documents have to be investigated by a person independent of shipping and accounting

30. Key Controls for Sales • Segregation of Duties • requires that different individuals be assigned responsibility for different elements of related activities, particularly those involving authorization, custody, or recordkeeping. • For example, the same person who is responsible for an asset's recordkeeping should not be responsible for physical control of that asset. • Having different individuals perform these functions creates a system of checks and balances. • Authorization • Proper authorization of transactions and activities helps ensure that all company activities adhere to established guide lines unless responsible managers authorize another course of action. • For example, a fixed price list may serve as an official authorization of price for a large sales staff. In addition, there may be a control to allow a sales manager to authorize reason able deviations from the price list. • Documents and Records • Adequate documents and records provide evidence that financial statements are accurate. • Controls designed to ensure adequate recordkeeping include the creation of invoices and other documents that are easy to use and sufficiently informative; • the use of prenumbered, consecutive documents; and the timely preparation of documents.

31. Internal verification • Independent checks on performance, which are carried out by employees who did not do the work being checked, help ensure the reliability of accounting information and the efficiency of operations. • For example, a supervisor verifies the accuracy of a retail clerk's cash drawer at the end of the day. • Internal auditors may also verity that the supervisor performed the check of the cash drawer. • Prenumbered documents • Using prenumbered documents, means that it is very hard to issue a false document • All documents have to be accounted for • Also prevents duplicate transactions • Monthly statements • Provides a detailed list of each customer’s activity • Customer can question discrepancies

32. Application Controls • These are computer internal controls • Edit checks for key fields can be verified by classifying the transactions on the values for the field. • To illustrate, if an auditor totalled the number of transactions for each value in the “Gender" field, the results might be: M = 2,341; F = 2,295; D = 2; and N = 1. • Such totals indicate that the edit check, which limits possible values to "F" and "M", is not working properly and is allowing the typos "D" and "N" to be keyed instead. • By using audit software to access an application's data directly, • auditors can use simple commands • to verify edit checks, • to test calculations performed by the application, • and to examine the data for reasonableness. • In addition, searching for gaps and duplicates can help to determine the completeness and timeliness of the data.

33. Tests of Internal Controls • Once the key controls have been identified, the auditor can decide • whether the control(s) will be tested • or whether tests of details will be conducted instead. • Tests of internal controls will be devised for • each key control that will be tested.

34. Examples of Internal Control using the Occurrence Assertion • Manual Control • Occurrence shows that the event actually happened • Want evidence of this manual control • Key control: credit is approved before shipment takes place. • The manual control? • The sales manager initials all sales orders over $25 to indicate approval. • Possible test of control • Examine a sample of sales orders to ensure that the sales manager’s initial is present.

35. Automated Batch • Occurrence assertion Remember that this is a batch of sales transaction being processed • Key control: Orders causing balances to exceed credit limits are printed on an exception report • Thus and are not processed for shipment. • N.B. Total passed on for processing plus exception total must equal the batch total • Possible test of control: • Examine a selection of exception reports and ensure that: these orders exceed the credit limit • And that the orders were not processed for shipment.

36. Automated Online • Occurrence assertion • Remember that these transactions are being processed as they occur • i.e. interactively • Key control: Orders causing balances to exceed credit limits are held in a separate transaction file • and as in the previous case, are not processed for shipment. • Possible test of control: • Request the client to print off the day’s on-hold transaction file. • View the file to ensure that all orders in the file exceed the customer’s credit limits.

37. Interdependent • Occurrence Assertion • Remember that interdependent controls require both programmed and manual components • Key control: Orders causing balances to exceed the credit limit are printed on an exception report and must be approved by a credit manager • Thus shows interdependence • Note: must be approved prior to shipment by means of entering a password. • Possible test of control: • Review an exception report and ensure that all sales orders there caused the customers’ credit limit to be exceeded. Discuss with the sales manager processes followed to release such held orders. • Could also examine a computer log that shows evidence of the managers approval

38. Manual, Automated and Interdependent Controls From the previous examples, it can be seen that: • Manual controls are controls performed entirely by people • In the previous case, the manager • Automated controls (batch or online) are performed only by computerized systems • A good control with batches is the use of the batch control total • The total before processing must equal the total after processing • Interdependent controls rely upon computer processes (automation) but a person must also be involved to fully perform the control • Once again the manager

39. Direction of Testing Tracing Vouching

40. Tracing • Goes from the start of the transaction to the posting • i.e. From the customer order to sales invoice to the sales journal and to the G/L • Will look for all relevant documents on the way • Is this a test for overstatement or understatement of sales? • A test for understatement. • If the sales invoice is not in the sales journal, sales are understated or not complete • Vouching • Goes from the general ledger or sales journal back to the original document • A test for overstatement of sales. • If it is in the sales journal and there is no sales invoice, sales are overstated • Thus thew sales did not occur

41. Typical Concerns for Tests of Sales • Recorded sales occurred • Occurrence – both management assertion & audit objective • Did the T/A occur • Key management assertion • Auditor is concerned with following possible misstatements • Recorded sale for which there was no shipment • Auditor can trace form sales journal to the shipping document • Sale recorded more than once • Want to determine duplicate sales • Review a numerically sorted list of sales transactions • Looking for duplicate invoice numbers • Can use audit software • Shipment made to non-existent customer • A fraud situation due to lack of segregation of dusties • Can trace from A/R listing to the cash collection • If cash was collected from a customer, no problem • If written off, could be a problem • Remember that and audit is not intended to detect fraud

42. Existing sales transactions are recorded • Completeness assertion • And audit objective • Want to test for unbilled shipments • Vouch a sample of shipping documents to the corresponding sales invoice and trace to the sales journal • Are shipping documents complete? • Account for numerical sequence of shipping documents. • Recorded Sales are accurately recorded • Measurement assertion • Audit objective of accuracy • Accurate billing • Prices of invoice compared with approved price lists • Extensions and footing recomputed • Accurate recording in the records • Recomputing information in accounting records

43. Recorded sales are properly classified • Ensure correct entry into the general ledger • Most computer systems will do this automatically • Can use audit software to check this • Sales transactions are properly updated in the master file and correctly summarized • Accuracy of the master file is essential • If not in master file, how can they collect money? • Trace from sales invoice to the master file and the G/L • Sales are recorded on the correct dates • Sales must be billed as soon as shipment takes place • FOB shipping point & revenue recognition • Compare date on shipping document with date on invoice • Significant differences show a cut-off problem • Remember all the tests can be dome with the same sample of sales invoices and shipping documents • Do not need to have different samples for each test • Audit efficiency

44. Typical Controls and Tests for Cash Receipts

45. Frequency of Testing of Internal Controls • Is an auditor allowed to use the results of prior testing in a current audit? • Auditing standards board allows this in limited circumstances • Auditor of a nonpublic company • In this case, which type of controls must be tested annually? • For controls that have changed since they were last tested • Which type of controls could potentially be tested every three years? • For controls that have not changed since they were last tested

46. Testing of Interdependent Controls • The interdependent control has two parts: • A function performed by an automated systems • A function performed by an individual • It is only possible to rely upon the automated function if: • general controls have been assessed as good • Both parts of the control must be tested to enable • reliance upon the control

47. What if Control Testing Yielded Many Errors? • The first step is to determine whether the errors or exceptions • were due to a particular circumstance • Could be an unusual circumstance that does not happen very often • or restricted to a particular time period • Could be that regular employee was on vacation • E.g. the credit manager was on holidays • so no one approved credit, • or the person who approved credit in his/her absence made many errors.

48. If the errors are systemic • i.e. throughout the period and cannot be isolated to a particular cause • then the auditor first looks for a compensating or alternative control. • If this alternative control achieves the same purpose and is functioning correctly • then the auditor can still rely upon internal controls. • If no compensating control?

49. Material Error • If there is no compensating control • the auditor needs to investigate to determine whether there is potential for this weakness to result in a material error. • Want to quantify the extent of the error. • Remember the tolerable error • Also sample exception rate (SER) • Extend it to the population • See if the extended error is acceptable

50. Results of Quantifying the Error • If it turns out that the results of the weakness could result in immaterial error • the weakness will be reported in a management letter • extended tests of detail may not be required. • If a material error could result • the matter needs to be reported both to management and the audit committee • the tests of details will have to expanded • Needed to detect the possible material error