Revenue and Collection Cycle Chapter 7 Revenue and Collection Cycle “It is better to have a permanent income than to be fascinating” Oscar Wilde McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Learning Objectives Discuss inherent risks related to the revenue and collection cycle with a focus on improper revenue recognition Describe the revenue and collection cycle, including typical source documents and controls. Give examples of tests of controls over customer credit approval, delivery, and accounts receivable accounting McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

Learning Objective (continued) Give examples of substantive procedures in the revenue and collection cycle and relate them to assertions about account balances at the end of the period. Describe some common errors and frauds in the revenue and collection cycle, and design some audit and investigation procedures for detecting them. McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

©2005 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Inherent Risks Improper Revenue Recognition Cut-off Bill and Hold Returns and Allowances Collectibility of Receivables "Lapping” McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Revenue Recognition Must be (1) realized or realizable and (2) earned SEC guidance (SAB 101) Persuasive evidence of an arrangement exists, Delivery has occurred or services have been rendered, The seller's price to the buyer is fixed or determinable, and Collectibility is reasonably assured McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

Exhibit 7.1 Revenue Recognition Rogues McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

Exhibit 7.2 Revenue and Collection Cycle: Typical Activities McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

REVENUE AND COLLECTION CYCLE: KEY control procedures SEGREGATION OF DUTIES Separate functions for recording, authorization, custody AUTHORIZATION OF TRANSACTIONS Write-offs EDI transactions Credit checks prior to approval of sale ACCESS TO ASSETS Shipping department Lock box account ADEQUATE DOCUMENTS AND RECORDS Pre-numbered sales orders, shipping documents (bills of lading), sales invoices Remittance advice INDEPENDENT CHECKS ON PERFORMANCE A/R subsidiary ledger to general ledger Monthly statement to customer McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

Audit Evidence in Management Reports and Data Files Pending order master file Credit check files Price list master file Sales detail file (sales journal) Sales analysis report Accounts receivable aged trial balance Cash receipts listing McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

©2005 by the McGraw-Hill Companies, Inc. All rights reserved. Tests of Controls McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

Exhibit 7.5 Dual Direct of Test Audit Samples McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

AUDITING ACCOUNTS RECEIVABLE Obtain Aged Listing of Accounts Receivable Listing of AR by date due Foot and Test aging Used to evaluate reasonableness of ALLOWANCE FOR BAD DEBTS Confirm Perform analytical procedures Test sales cut-off McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

Exhibit 7.7 Accounts Receivable Aged Trial Balance McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

©2005 by the McGraw-Hill Companies, Inc. All rights reserved. USING CONFIRMATIONS Especially useful for verifying EXISTENCE OR OCCURRENCE and RIGHTS AND OBLIGATIONS assertions. Confirmation testing may also be designed to verify COMPLETENESS Factors are likely to affect the reliability of confirmations Previous audit experience Intended recipient of the confirmation Type of information being confirmed The auditor may confirm entire BALANCES or TRANSACTIONS. Type of confirmation being sent McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

USING CONFIRMATIONS (Continued) Positive Confirmations small number of accounts are involved large number of errors are anticipated Negative Confirmations the combined assessed level of inherent and control risk is low 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. Blank Confirmations should be used if the recipient is likely to return a positive confirmation without verifying the accuracy of the information. McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

Exhibit 7.8 Positive Confirmation Letter McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

Exhibit 7.9 Negative Confirmation Letter McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

USING CONFIRMATIONS (Continued) Responses to positive and blank confirmations provide more reliable evidence than negative non-responses. Recipients of accounts receivable confirmations might not report understatements. McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

USING CONFIRMATIONS (Continued) Non-response to Positive/blank confirmation requests Follow up with second and sometimes third requests. A lower than expected response rate could be indicative of fictitious customer accounts. Alternative procedures. Non-response to negative confirmation requests Only limited evidence concerning financial statement assertions. Alternative procedures are not necessary for unreturned negative confirmation requests. Follow-up on all exceptions McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

ALTERNATIVE PROCEDURES Vouch subsequent cash collections usually sufficient evidence of validity, valuation. Examine shipping documents Examine client-generated supporting documentation, such as invoices. Depends on internal controls Inspect correspondence files McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

Exhibit 7.10 Responses to Positive Confirmations (December 31) McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

Other Matters Related to Confirmation There are three sets of circumstances that could justify the omission of the confirmation of a client's accounts receivable. Not material to the financial statements. If the combined level of inherent risk and control risk is low, and the assessed level of evidence from analytical procedures and other tests of details is sufficient to reduce audit risk to an acceptably low level, confirmation of accounts receivable may be inefficient. Confirmation of accounts receivable is expected to be ineffective (based on previous years' audit experience). McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

UNCOLLECTIBLE ACCOUNTS Inspect AR for collectibility Recalculate ALLOWANCE and BAD DEBT EXPENSE Verify reasonableness of ALLOWANCE and BAD DEBT EXPENSE Verify appropriateness of accounts written off Verify attempts to collect receivable Verify authorization is appropriate. McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

ANALYTICAL PROCEDURES Sales Revenue Comparisons with previous periods Comparisons with industry Allowance for Doubtful Accts, Bad Debt Expense Bad Debt Expense as a percentage of Sales Allowance for Doubtful Accounts as a percentage of Gross Receivables Accounts Receivable Days Sales in Accounts Receivable Accounts Receivable Turnover McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.

SALES CUTOFF PROCEDURES Used to verify whether Sales/Revenues recorded in the CORRECT ACCOUNTING PERIOD. Examine SALES INVOICES and SHIPPING DOCUMENTS shortly prior to and after year-end. McGraw-Hill/Irwin ©2005 by the McGraw-Hill Companies, Inc. All rights reserved.