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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

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chapter 10

Chapter 10

Auditing Revenue and Related Accounts

why are revenue cycle accounts important
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
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
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
Overview of the Revenue Cycle (Sales made on Account)
  • Receive customer purchase order
  • Check inventory stock status
    • Generate back order if item not in stock
  • Obtain credit approval
  • Prepare shipping and packing documents
  • Ship and verify shipment of goods
  • Prepare the invoice
  • Send monthly statements to customers
  • Receive payment
discuss business risk and business environment
Discuss Business Risk and Business Environment

Revenue recognition

  • SAS 99 - Consideration of Fraud in a Financial Statement Audit
    • Auditor 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
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
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 indicators
  • Internal red flags
  • Unusual financial results

Auditor deals with red flags by

  • Examining external pressures that could lead to financial reporting fraud
  • Examining the financial statements to determine if account balances seem out of line
what analytical analysis can be done for possible misstatements
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 procedures

  • Ratio analysis
  • Trend analysis
  • Reasonableness tests
review assessment of environment risk
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 risk
  • Perform analytical procedures to look for unexpected relationships
  • Develop understanding of internal controls
  • Analyze business risk for motivations and methods to misstate sales
review assessment of environment risk11
Review Assessment of Environment Risk
  • 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 results
  • Based on the results of testing, reassess control risk
discuss inherent risk with regard to sales
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
discuss inherent risk with regard to sales13
Discuss Inherent Risk with Regard to Sales
  • Impact of any unusual sales terms and whether title passed to customer
    • Example: related party transactions
  • Goods recorded as sales have been shipped
  • Sales made with recourse or that have significant returns
    • Example: irrevocable right to return goods

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

comment on inherent risk in receivables
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
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 integrity
  • Financial condition of the organization
  • Financial pressures on the organization
  • Management incentives to achieve financial results
understanding internal controls
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 documentation

It is critical this understanding be documented in the work papers

understanding internal controls continued
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/obligations
  • Valuation
  • Presentation and disclosure
what are the three components of evaluating control risk
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
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 risk
Define Documenting, Testing, and Assessing Environment Risk

Develop understanding of the accounting system and control procedures

  • Evidence 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
define documenting testing and assessing environment risk21
Define Documenting, Testing, and Assessing Environment 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
discuss linking environment risk assessment substantive testing
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 factors
  • Effectiveness of controls and types of misstatements likely to occur
comment on substantive testing in the revenue cycle
Comment on Substantive Testing in the Revenue Cycle

Planning for Direct Tests of Transactions and Account Balances

  • Audit objectives and assertions
  • Account balance relationships
  • Risk of material misstatement
  • Composition of the account
  • Persuasiveness of audit procedures
  • Cost of audit procedures
  • Timing of audit procedures
  • Determining optimal mix of audit procedures
what are some substantive tests of revenue
What are some substantive tests of revenue?

Assertions related to revenue transactions:

  • Occurrence: Have the transactions occurred and pertain to the entity
  • Completeness: Have all transactions been recorded
  • Accuracy: Have transactions been accurately recorded
  • Cutoff: Have transactions been recorded in the correct accounting period
  • Classification: Have transactions been recorded in the proper accounts
list substantive tests of revenue for occurrence and accuracy
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 revenue cutoff tests
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 revenue cutoff tests27
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 revenue for completeness
List Substantive Tests of Revenuefor Completeness
  • Use of pre-numbered documents is important
  • Analytical procedures
  • Cutoff tests
  • Auditor 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
Substantive Tests of Accounts Receivable Existence & Occurrence


  • Are sales and receivables initially recorded at their correct amount?
  • Will client collect full amount of recorded receivables?

Rights and Obligations

  • Contingent liabilities associated with factor or sales arrangements
  • Discounted receivables

Presentation and Disclosure

  • Pledged, discounted, assigned, or related party receivables
discuss substantive tests of accounts receivable
Discuss Substantive Tests of Accounts Receivable
  • Obtain and evaluate aging of accounts receivable
  • Confirm receivables with customers
  • Perform cutoff tests
  • Review subsequent collections of receivables
comment on aging accounts receivable
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
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 allowances

Confirmations 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
Define the Types of Confirmations

Positive confirmations

  • Customers 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 response
  • If customer does not respond, auditor must use alternative procedures
define the types of confirmations34
Define the Types of Confirmations

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 present
    • Confirming a large number of small customer balances
    • Environment risk for receivables is assessed as low
    • Auditor believes customers will give proper attention to confirmations
what s the follow up procedures for non responses
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
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 differences
  • Disputed items
  • Customer errors
  • Client misstatement

Because misstatements are projected to the population of receivables, the auditor must determine the reason for the exception

discuss related party receivables
Discuss Related-Party Receivables

Amounts due from related parties should be separately disclosed

Audit procedures to identify related-party transactions include:

  • Review SEC filings
  • Review the accounts receivable subsidiary ledger and trial balance
  • Management inquiry
  • Communicate names of related parties so all audit team members can be alert for related-party transactions
comment on sold discounted and pledged receivables
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 inquiry
  • Scan cash receipts journal for large cash inflows from unusual sources
  • Bank confirmations, which include information on obligations and terms
  • Review board of director minutes, which contain approval for these items
review fraud indicators and audit procedures
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 procedures40
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
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