Audit of the Revenue Cycle CAS 265 – Communicating deficiencies in internal control to those charged with governance and management CAS 300 – Planning an audit of financial statements CAS 315 – Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and its Environment CAS 320 - Materiality in Planning and Performing an Audit CAS 330 - The Auditor’s Response to Assessed Risk CAS 500 – Audit Evidence CAS 530 – Audit Sampling

Risk Assessment Must understand the entities method of generating revenues in order to assess the business risk and risk of misstatement. Thus: Also:

Typical Transactions in the Sales and Collection Cycle Five major classes of Transactions: Sales Cash receipts – collecting and depositing Sales returns and allowances Technically two distinct transactions The write-off of uncollectible accounts Bad-debt expense

Typical Activities See the following slides Receiving and processing customer orders. Delivering goods and services to customers. Billing customers and accounting for receivables. Collecting and depositing cash. Reconciling bank accounts. LO1

Revenue and Collection Process Start Here Customer Orders Collections Revenue Cycle Bill Customers Credit Granting Warehousing, Shipping, and Delivery LO1

An Overview of Functions, Documents, and Accounting Systems Order Entry Department The starting point = Good control point Signed by the customer, except for telephone or internet orders. By phone, internet or mail Customer Purchase, or Contracts Prepare Sales Order Sales Order 1 Customer 2 3 Credit Department Credit Granting Credit Manager signs the sales order for credit approval A

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

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

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

Description of Articles, 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 Sales Shipper, Per Joe Chen Agent Yellow Express Per Sue Jones

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

We are pleased to serve you Faragut Sales, Inc. D8-9912 Copy 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, 20XX Date Shipped August 25, 20XX 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.

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

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

Notice the complete details on the Remittance Advice Okra Development Corp. Salem, OR REMITTANCE ADVICE Invoice No. Date Voucher Gross Amount Discount Net Amount D8-9912 8-25-XX 9-00018 480.00 9.60 470.40 Cheque No. Vendor No. Vendor Name Total Amount 867 9-04-XX 00327003 Faragut Sales, Inc. 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.

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 J.T.Lockett Cash Summary Cash Receipts Listing 5,802.20 Over-the-counter cash receipts 3,130.40 8,932.60 x,120.00 x,x98.32 x,x23.66 x,842.33 x,988.11 3,130.40 Adding Machine Tape Also called a pre-listing of cash receipts All cash receipts should be listed on the pre-listing from the remittance advices.

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

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

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

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. Remittance Advice List of Receipts Cash Receipts Summary Subsidiary customer accounts posted from remittance advices. Trial Balance Trial Balance Post to the Customer Accounts & Prepare Trial Balance D General Accounting for comparison to the G/L Daily remittance list compared to duplicate deposit slip received from bank by person independent of either function.

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

Typical Documents and Records Sale is initiated with a What documents accompany the sale? Routine reports include a sales journal aged accounts receivable trial balance Anything else?

The Accounts of the Sales and Collection Cycle Gross sales Cash Sales Sales on Account Accounts receivable Cash receipts Sales returns and allowances Charge-off of uncollectible accounts Beginning balance Sales on account Ending balance Allowance for uncollectible accounts Bad debts Charge off of uncollectible accounts Cash in bank Cash discounts taken

Methods of Recording Transactions Manual recording Recorded one transaction at a time

Control Differences Between Manual and Online Systems Manual systems: Transactions readily traced Online systems: Transactions recorded one at a time Document sequencing is important

Control Differences For Error Detection and Correction Manual systems: An erroneous transaction Error follow-up should be done in a timely manner Online systems: Focus is on preventing errors Input edit check for valid customer data and reasonableness

Manual and Online Systems: Segregation of Duties Manual systems: Separate Reconciliation and error follow-up Online systems: In decentralized systems Use passwords to separate

Risk Assessment and the Sales Cycle Why do risk assessment? Risk Type Impact upon Sales and Collection Cycle Client business risk Increased client business risk could lead to greater risks of misstatement of sales. Audit risk As audit risk decreases, the level of assurance required increases, and the extent of testing required increases. Inherent risk - overall As inherent risk increases, the extent of testing required increases; inherent risks associated with the handling of cash directly affect certain audit assertions in sales (e.g. completeness). Risk of material misstatement - overall Management biases due to bonus incentives or stated earnings forecasts could increase the extent of testing. Risk of fraud - overall Poor fraud risk management could result in increased risk of fraud, with a need to increase the extent of testing. Identify significant risks Revenue recognition is considered a significant risk unless the auditor has evidence to the contrary; this means that controls over revenue recognition need to be assessed and increased testing is required of assertions that affect revenue recognition. Remember that as risk increases

Effect of General Controls Are pervasive and affect multiple transaction cycles Typical examples of general controls

If general controls are good, the auditor may be able to rely upon them If general controls are poor

Methodology for Designing Tests of Controls for Sales Understand general controls - sales Understand internal control and evaluate design effectiveness - sales 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 By assertion:

Documentation of Internal Controls Internal controls need to be documented The auditor focuses on What type of controls can these be?

Key Controls for Sales Segregation of Duties Authorization requires that different individuals be assigned responsibility for different elements of related activities, particularly those involving authorization, custody, or recordkeeping. 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. Documents and Records Adequate documents and records provide evidence that financial statements are accurate.

Internal verification Prenumbered documents Monthly statements Periodic reconciliation

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.

Tests of Internal Controls Once the key controls have been identified, the auditor can decide Tests of internal controls will be devised for

Examples of Internal Control using the Occurrence Assertion Manual Control Key control: credit is approved before shipment takes place. The manual control? Possible test of control

Automated Online Occurrence assertion Key control: Orders causing balances to exceed credit limits are held in a separate transaction file Possible test of control:

Interdependent Occurrence Assertion Key control: Orders causing balances to exceed the credit limit are printed on an exception report and must be approved by a credit manager Possible test of control:

Manual, Automated and Interdependent Controls From the previous examples, it can be seen that: Manual controls are controls performed entirely by people Automated controls (batch or online) are performed only by computerized systems Interdependent controls rely upon computer processes (automation) but a person must also be involved to fully perform the control

Direction of Testing Tracing Vouching

Tracing Vouching Goes from the start of the transaction to the posting Is this a test for overstatement or understatement of sales? Vouching Goes from the general ledger or sales journal back to the original document

Typical Concerns for Tests of Sales Recorded sales occurred Occurrence – Auditor is concerned with following possible misstatements Recorded sale for which there was no shipment Sale recorded more than once Shipment made to non-existent customer

Existing sales transactions are recorded Completeness assertion Want to test for unbilled shipments Are shipping documents complete? Recorded Sales are accurately recorded Measurement assertion

Recorded sales are properly classified Ensure correct entry into the general ledger Sales transactions are properly updated in the master file and correctly summarized Accuracy of the master file is essential Sales are recorded on the correct dates Sales must be billed as soon as shipment takes place Remember all the tests can be dome with the same sample of sales invoices and shipping documents

Typical Controls and Tests for Cash Receipts Transaction-Related Audit Objective Key Internal Control General Tests of Controls Quantitative/Dual-Purpose Test of Controls Recorded cash receipts are for funds actually received by the company (occurrence) Separation of duties between handling cash and record keeping or data entry Independent reconciliation or review of bank accounts. Observe separation of duties. Observe independent reconciliation of bank account. Review the cash receipt journal, general ledger, and accounts receivable master file or trial balance for large and unusual amounts. Trace from cash receipts listing to duplicate deposit slip and bank statements Cash received is recorded in the cash receipts journal (completeness). Separation of duties between handling cash and record keeping. Use of remittance advices or a prelisting of cash. Immediate endorsement of incoming cheques. Internal verification of the recording of cash receipts. Regular monthly statements to customers. Discussion with personnel and observation. As above. Observe immediate endorsement of incoming cheques. Examine indication of internal verification. Observe whether monthly statements are sent to customers. Trace from remittances or prelisting to duplicate bank deposit slip and cash receipts journal. Review reconciliation reports of credit card or electronic funds transfer receipts. Cash receipts are deposited and recorded at the amount received (accuracy). Approval of cash discounts. Regular reconciliation of bank accounts. Comparison of batch totals with duplicate deposit slips and computer summary reports. Examine remittance advices for proper approval. Review monthly bank reconciliations. Examine file of batch totals for initials of data control clerk; compare totals with summary reports. Examine remittance advices and sales invoices to determine whether discounts allowed are consistent with company policy. Cash receipts are properly classified (classification). Use of adequate chart of accounts or automatic posting to specified accounts. Review chart of accounts and computer-assigned posting accounts. Examine documents supporting cash receipts for proper classification. Cash receipts are properly included in the customer master file and are correctly summarized (posting and summarization). Use of properly approved master file change forms. Comparison of customer master file or aged accounts receivable trial balance totals with general ledger balance. Observe whether statements are mailed. Examine master file change forms for proper authorization. Examine documentation verifying that comparison was complete, Foot journals, and trace postings to general ledger and accounts receivable master file. Cash receipts are recorded on correct dates (timing). Procedure requiring recording of cash receipts on a daily basis. Observe unrecorded cash at any point in time. Compare dates of deposits with dates in the cash receipts journal.

Frequency of Testing of Internal Controls Is an auditor allowed to use the results of prior testing in a current audit? In this case, which type of controls must be tested annually? Which type of controls could potentially be tested every three years?

Testing of Interdependent Controls The interdependent control has two parts: A function performed It is only possible to rely upon the automated function if: Both parts of the control must be tested to enable

What if Control Testing Yielded Many Errors? The first step is to determine whether the errors or exceptions were due to a particular circumstance or restricted to a particular time period

If the errors are systemic If this alternative control achieves the same purpose and is functioning correctly If no compensating control?

Material Error If there is no compensating control Want to quantify the extent of the error.

Results of Quantifying the Error If it turns out that the results of the weakness could result in immaterial error If a material error could result

Communicating Deficiencies in Internal Control (CAS 265) Communicate to those charged with governance and management Those deficiencies in internal control identified by the auditor The auditor shall include a written communication of th significant deficiencies

Performing the Audit Program The initial audit program is organized by audit assertion In performing for maximum efficiency The use of automated working paper software facilitates this process.

Computer-Assisted Audit Tests Where there are a large number of transactions E.g. In internal controls testing, the auditor could use automated sampling routines

Suitability of Test Data Online systems Test data is useful

Suitability of Generalized Audit Software Best suited for analytical review, tests of detail, or dual-purpose tests, for example:

Problem DC 10-2, Page 547 1 2 3 4 5 6 TER (in percentage) 8 20 15 The following are auditor judgments and audit sampling results for six populations. Assume large population sizes. 1 2 3 4 5 6 TER (in percentage) 8 20 15 ARACR (in percentage) 10 Actual sample size 100 60 Actual number of exceptions in the sample REQUIRED For each population, did the auditor select a smaller sample size than is indicated by using attribute sampling tables for determining sample size? (Assume K=0 in sample size planning). Evaluate, selecting either a larger or smaller size than those determined in the tables. Calculate Sample Deviation Rate (SDR) and Upper Error Limit (UEL) for each population. For which of the six populations should the sample results be considered unacceptable? What options are available to the auditor? Why is analysis of the exceptions necessary even when the populations are considered acceptable? For the following terms, identify which is an audit decision, which is a non-statistical estimate made by the auditor, which is a sample result, and which is a statistical conclusion about the population. Estimated population deviation rate. Tolerable deviation rate. Acceptable risk of overreliance on internal control. Actual sample size. Actual number of deviations in the sample. Sample deviation rate. Achieved P or UEL

Confidence Factors for MUS Sample Size Design (ARIA in brackets) Number of Errors (K) Confidence Factors for MUS Sample Size Design (ARIA in brackets) 99% (1%) 97.5% (2.5%) 95% (5%) 90% (10%) 85% (15%) 80% (20%) 75% (25%) 4.51 3.69 3.00 2.31 1.90 1.61 1.39 1 6.64 5.58 4.75 3.89 3.38 2.70 2 8.41 7.23 6.30 5.33 4.73 4.28 3.93 3 10.05 8.77 7.76 6.69 6.02 5.52 5.11 4 11.61 10.25 9.16 8.00 7.27 6.73 6.28 5 13.11 11.67 10.52 9.28 8.50 7.91 7.43 6 14.58 13.06 11.85 10.54 9.71 9.08 8.56 7 16.00 14.43 13.15 11.78 10.90 10.24 9.69 8 17.41 15.77 14.44 13.00 12.08 11.38 10.81 9 18.79 17.09 15.71 14.21 13.25 12.52 11.92 10 20.15 18.40 16.97 15.41 14.42 13.66 13.03

ACTUAL NUMBER OF DEVIATIONS FOUND Sample size ACTUAL NUMBER OF DEVIATIONS FOUND 1 2 3 4 5 6 7 8 9 10 5 PERCENT RISK OF OVER RELIANCE (RIA or Beta Risk) 20 14.0 21.7 28.3 34.4 40.2 45.6 50.8 55.9 60.7 65.4 69.9 25 11.3 17.7 23.2 28.2 33.0 37.6 42.0 46.3 50.4 54.4 58.4 30 9.6 14.9 19.6 23.9 28.0 31.9 35.8 39.4 43.0 46.6 50.0 35 8.3 12.9 17.0 20.7 24.3 27.8 31.1 37.5 40.6 43.7 40 7.3 11.4 15.0 18.3 21.5 24.6 27.5 30.4 33.3 36.0 38.8 45 6.5 10.2 13.4 16.4 19.2 22.0 24.7 27.3 29.8 32.4 34.8 50 5.9 9.2 12.1 14.8 17.4 19.9 22.4 27.1 29.4 31.6 55 5.4 8.4 11.1 13.5 15.9 18.2 20.5 22.6 24.8 26.9 28.9 60 4.9 7.7 12.5 14.7 16.8 18.8 20.8 22.8 26.7 65 4.6 7.1 9.4 11.5 13.6 15.5 17.5 19.3 21.2 23.0 70 4.2 6.6 8.8 10.8 12.7 14.5 16.3 18.0 19.7 21.4 23.1 75 4.0 6.2 8.2 10.1 11.8 15.2 16.9 18.5 20.1 21.6 80 3.7 5.8 9.5 14.3 18.9 20.3 90 3.3 5.2 6.9 9.9 12.8 14.2 100 3.0 4.7 7.6 9.0 10.3 125 2.4 3.8 5.0 6.1 7.2 9.3 12.3 13.2 150 2.0 3.2 5.1 6.0 7.8 8.6 200 1.5 3.9 300 1.0 1.6 2.1 2.6 3.1 3.5 4.4 4.8 5.6 400 0.8 1.2 2.3 2.7 3.6 4.3 500 0.6 1.3 1.9 2.9 3.4

ACTUAL NUMBER OF DEVIATIONS FOUND Sample size ACTUAL NUMBER OF DEVIATIONS FOUND 1 2 3 4 5 6 7 8 9 10 10 % Risk of Incorrect Acceptance (RIA or Beta Risk) 20 10.9 18.1 24.5 30.5 36.1 41.5 46.8 51.9 56.8 61.6 66.2 25 8.8 14.7 20.0 24.9 29.5 34.0 38.4 42.6 50.8 54.8 30 7.4 12.4 16.8 21.0 28.8 32.5 36.2 39.7 43.2 46.7 35 6.4 10.7 14.5 18.2 21.6 28.2 31.4 34.5 37.6 40.6 40 5.6 9.4 12.8 16.0 19.0 22.0 27.7 33.2 35.9 45 5.0 8.4 11.4 14.3 17.0 19.7 22.3 24.8 27.3 29.8 32.2 50 4.6 7.6 10.3 12.9 15.4 17.8 20.2 22.5 24.7 27.0 29.2 55 4.2 6.9 11.8 14.1 16.3 18.4 20.5 22.6 24.6 26.7 60 3.8 8.7 10.8 15.0 16.9 18.9 20.8 22.7 65 3.5 5.9 8.0 10.0 12.0 13.9 15.7 17.5 19.3 22.8 70 3.3 5.5 7.5 9.3 11.1 14.6 18.0 19.6 21.2 75 3.1 5.1 7.0 10.4 12.1 13.7 15.2 18.3 19.8 80 2.9 4.8 6.6 8.2 9.8 11.3 15.8 17.2 18.7 90 2.6 4.3 7.3 10.1 11.5 16.7 100 2.3 3.9 5.3 7.9 9.1 12.7 125 1.9 6.3 8.3 10.2 11.2 150 1.6 3.6 4.4 6.1 7.8 8.6 200 1.2 2.0 2.7 3.4 4.0 6.5 7.1 300 0.8 1.3 1.8 4.7 400 0.6 1.0 1.4 1.7 2.4 3.0 500 0.5 1.1 2.1

Problem DC 11-4, Page 612 Control Weakness: Shipping and Billing: Ajax Inc. recently implemented a new accounting system to process the shipping, billing, and accounts receivable records more efficiently. During the interim work of Ajax’s auditors an assistant completed the review of the accounting system and the internal controls. The assistant determined the following information concerning the computer systems and the processing and control of shipping notices and customer invoices. The computer system documentation consists of the following items: program listings, error listings, logs, and database dictionaries. The system and documentation are maintained by the IT administrator. To increase efficiency, batch totals, and processing controls are not used in the system. Ajax ships its product directly from two warehouses, which forward shipping invoices to general accounting. There, the billing clerk enters the price of the item and accounts for the numerical sequence of the shipping notices. The billing clerk also manually prepares daily adding machines tapes of the units shipped and the sales amounts. The computer processing output consists of the following: A three-copy invoice that is forwarded to the billing clerk A daily sales register showing the aggregate total of units shipped and sales amounts that the billing clerk compares with the adding machine tapes The billing clerk mails two copies of each invoice to the customer and retains the third copy in an open invoice file that serves as detailed accounts receivable record. Required: Prepare a list of weaknesses in internal control (manual and computer), and for ,each weakness make one or more recommendations. Suggest how Ajax’s computer processing over shipping and billing could be improved through the use of remote terminals to enter shipping notices. Describe appropriate controls for such an online data entry system.