©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Audit of the Sales and Collection Cycle Chapter 14

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 1 Identify the accounts and the classes of transactions in the sales and collection cycle.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Accounts in the Sales and Collection Cycle Sales Cash sales Sales on account Cash in Bank Cash Discounts Taken Sales Returns and Allowances Bad Debt Expense Accounts Receivable BeginningCash receipts balance Sales returns Sales onand allowances account Ending balance

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Accounts in the Sales and Collection Cycle Accounts Receivable BeginningCash receipts balance Sales returns Sales onand allowances account Charge-off of Endinguncollectible balanceaccounts Bad Debt Expense Allowance for Uncollectible Accounts Charge-off ofBeginning uncollectiblebalance accounts Estimate of bad debt expense Ending balance

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 2 Describe the business functions and the related documents and records in the sales and collection cycle.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Processing Customer Orders Customer/Purchase Order: A request for merchandise by a customer Sales Order: A document describing the goods ordered by a customer Credit check and Authorization to ship

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Granting Credit Before goods are shipped, a properly authorized person (system) must approve credit to the customer for sales on account. Access controls

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Sales Transaction Accounts Business Functions Documents and Records Sales (credit) Accounts receivable (debit) esp. B2B/Big Ticket Processing customer orders, Granting credit, Shipping goods, Billing customers and recording sales (j/e) PO,SO, Shipping Document, Sales invoice (bill), Sales journal or listing, Accounts receivable Master file/sub ledger (confirmation), Monthly statements sent to customers

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Cash Receipts Transaction Accounts Business Functions Documents and Records Cash in bank (debit: form = check, EFT, credit card, etc.); Accounts receivable (credit) OR B2C: dr. cash, cr. sales Processing and recording cash receipts Separation of duties key! Remittance advise, Prelisting of cash receipts Separate Cash receipts journal or listing, Bank rec, and A/R records

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Sales Returns and Allowances Transaction Accounts Business Functions Documents and Records Sales returns and allowances (debit–contra sales) Accounts receivable (credit) Processing and recording sales returns and allowances Credit memo – put inv. back and credit customer Separate Sales returns and allowances journal, A/R files

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Bad Debt Expense Transaction Accounts Business Functions Documents and Records Bad debt expense (debit-contra sales) Allowance for uncollectible accounts (cr. contra A/R) – Estimate! Matching Princ. Providing for bad debts – Authorization and review, Separate from handling of cash! General journal - Adjustment

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Charge-off of Uncollectible Accounts Transaction Accounts Business Functions Documents and Records Accounts receivable (credit) Allowance for uncollectible accounts (debit) No I/S effect – for known uncollectibles Charging off uncollectible accounts receivable – Authorization, Doc., Separation from cash handling Uncollectible account authorization form A/R master files and G/L

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 3 Understand internal control, and design and perform tests of controls and substantive tests of transactions for sales.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Methodology for Designing Controls and Substantive Tests: Sales Understand internal control – sales Assess planned control risk – sales Evaluate cost-benefit of testing controls. Design tests of controls and substantive tests of transactions for sales to meet transaction- related audit objectives. Audit procedures/Staffing Sample size/Budget Items to select Timing

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Understanding Internal Control – Sales Study the client’s flowcharts, prepare an internal control questionnaire/matrix, and perform walk-through of sales.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Preliminarily Assess Control Risk – Sales Adequate separation of duties Proper authorization (C1) Adequate documents and records (C2) Prenumbered Documents (C5) Monthly statements (C9) Internal verification procedures (C6) See p. 452 (col 2) for listing of controls!

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Control Risk below MAX? Evaluate cost-benefit of testing controls. Design tests of controls for sales. See p. 452 (col 3)!

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Transaction-Related Audit Objectives for Sales Why are we going over Occurrence and Accuracy? Is there a method to my madness????????? Accuracy (let’s go over I/C and ToT): : Recorded sales are for the amount shipped. Completeness: Existing sales transactions are recorded. Occurrence (let’s go over I/C and ToT): Recorded sales are for shipments actually made.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Direction of Tests for Sales Customer order Shipping document Duplicate sales invoice Sales journal General ledger Accounts receivable master file = Completeness Start Occurrence Start

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Design Substantive Tests of Transactions for Sales Classification: Sales transactions are properly classified. Timing: Sales are recorded on the correct dates. Posting and summarization: Sales transactions are properly included in the accounts receivable master file.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Summary of Methodology for Sales Table 14-2 p. 452: Column 1:Transaction-related audit objectives Column 2:Key internal controls (quest. and matrix) Preliminary CR – test controls or CR at max? Column 3:Test of controls – Final CR assessment Column 4:Weaknesses – Material? Inc. CR? SOX report? Remediate? Compensating control? Column 5:Have DR, Substantive tests of transactions If Prel. CR adjusted upwards for final CR– more ToT!!

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 5 Understand internal control and design and perform tests of controls and substantive tests of transactions for cash receipts.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Tests of Controls and Substantive Tests of Transactions for Cash Receipts  Table 14-3 p. 461– same process as Sales! Most important:  Determine whether cash received was recorded (completeness) Sep. duties, send mthly statements, Test to discover lapping of accounts receivable: Pocket cash and cover A/R with next cash receipt, and so on – separation, vacation, compare name, timing, and amount on remittance to cash receipts and A/R j/e Prepare proof of cash receipts: trace from cash receipts journal to bank deposits, bank rec (occurrence)  Table 14-3 p. 461– same process as Sales! Most important:  Determine whether cash received was recorded (completeness) Sep. duties, send mthly statements, Test to discover lapping of accounts receivable: Pocket cash and cover A/R with next cash receipt, and so on – separation, vacation, compare name, timing, and amount on remittance to cash receipts and A/R j/e Prepare proof of cash receipts: trace from cash receipts journal to bank deposits, bank rec (occurrence)

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Learning Objective 6 Apply the methodology for controls over the sales and collection cycle to write-offs of uncollectible accounts receivable.

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Audit Tests for Uncollectible Accounts-I/C and ToT What is a major concern in testing accounts charged off as uncollectible? Covering up cash pocketed by writing off accounts receivable that have been collected. I/Cs: Separation of duties, proper documentation and authorization. ToTs: compare write-offs to independent credit reports, look at past payment history. Occurrence – writing off A/R accounts that have been “collected.” We will hammer completeness and real. value in A/R testing (analysis of aging).

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Effect of Results of Controls and Substantive Tests of Transactions In summary, the parts of the audit most affected by the tests (I/C and ToT) for the sales and collection cycle are: Accounts Receivable – less confirms? Cash – smaller sample For Dep. In-transit? Bad debt Expense – bigger AP Threshold? Allowance for doubtful accounts – bigger AP threshold? Sales – only AP?

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley Role of all Audit Tests in the Sales and Collection Cycle Sales Accounts Receivable Cash in Bank Sales transactions Cash receipts transactions Ending balance Ending balance TOC + STOT + AP + TDB = Sufficient competent evidence per GAAS Audited by TOC, STOT Audited by AP and TDB Audited by TOC, STOT Audited by AP and TDB Ending balance

©2003 Prentice Hall Business Publishing, Auditing and Assurance Services 9/e, Arens/Elder/Beasley End of Chapter 14