Chapter 10 Auditing Revenue and Related Accounts Copyright © 2010 South-Western/Cengage Learning

Audit Opinion Formulation Process

LO 1 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

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

LO 2 Audit Steps for an Integrated Audit Update information on business risk Analyze potential motivations to misstate sales Perform analytical procedures to look for unexpected relationships Develop understanding of internal controls Determine the important controls that need to be tested Develop a plan for testing internal controls and perform the tests of key controls Analyze the results of the tests of controls Perform planned substantive procedures

Example: An Integrated Audit of Sales and Receivables Consider the Risk of Misstatement in the Revenue Cycle (Steps 1 and 2) 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

Example: An Integrated Audit of Sales and Receivables (continued) 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

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

Perform Preliminary Analytical Procedures (Step 3) The auditor then performs a preliminary review and notes that: There is no unusual year-end sales activity Accounts receivable growth is consistent with revenue growth Revenue growth, receivables growth, and gross margin are consistent There is no unusual concentration of sales made to customers

Develop an Understanding of Internal Controls (Step 4) 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

Identify Important Controls (Step 5) The auditor understands the risks of the revenue cycle The following key controls are identified for testing: Credit authorization and consistency of credit policies Access to the computerized price list for goods sold Accuracy of quantities and prices for items shipped and billed Daily reconciliation of items shipped and items billed

Following procedures are used to design and test internal controls: Design and Perform Tests of Internal Control and Analyze the Results (Step 6 and 7) Following procedures are used to design and test internal controls: Sample of shipment is selected and traced to invoice Access to the price table maintained in the computer is tested through an examination of the computer access logs The invoices are traced into the general ledger Auditor makes inquires and verifies for changes

Perform Substantive Tests (Step 8) Since revenue is always considered high risk, the auditor performs the following substantive test of details as year-end procedures: Examines shipments made during the last 15 days of the year and the first 15 days of the next year to determine that they are (a) appropriate (normal terms, etc.) and (b) are recorded in the correct time period Sends a sample of accounts receivable confirmations to customers selected using MUS sampling Examines the client’s allowance for uncollectible accounts for: consistency with past years, subsequent collections and consistency with industry trends.

LO 3 Risk Related to Revenue Recognition SAS # 99 states that the auditor should ordinarily presume there is a risk of material misstatement due to fraud relating to revenue recognition. Methods Used to Inflate Revenue Recognition of revenue on shipments that never occurred. Hidden “side letters” giving customers an irrevocable right to return the product. Recording consignment sales as final sales. Early recognition of sales that occurred after the end of the fiscal period. Shipment of unfinished product.

Risk Related to Revenue Recognition (cont.) Methods Used to Inflate Revenue (continue) Shipment of product before customers wanted or agreed to delivery. Creation of fictitious invoices. Shipment to customers that did not place an order. Shipment of more product than the customer ordered. Recording shipments to the company’s own warehouse as sales. Shipping goods that have been returned and recording the reshipment as a sale of new goods before issuing credit for the returned sale.

Criteria for Revenue Recognition Revenue should not be recognized until it is realized As per SEC following criteria should be met in applying the concept 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 Collectibility is reasonably assured

Fraud Risk Factors-Revenue Recognition There are a number of ‘red flags’ to which the auditor should be alert when determining the potential for fraud Identifying and adjusting the audit to address these risk factors involves the following: Examining motivation to enhance revenue due to either internal or external pressures. Examining the financial statements through preliminary analytical procedures Recognizing that not all of the fraud will be instigated by management

External and Internal Risk Factors Analyst Expectations Industry Trends Investigations Internal Management compensation schemes Expiration of stock options Accounting is not centralized Weak controls CFO does not have an accounting background Use of stock option to increase stock’s market value

LO 4 Perform Preliminary Analytical Procedures 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

LO 5 Linking Internal Controls and Financial Statement Assertions 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 Internal controls related to Returns, Allowances, and Warranties Documenting Controls

Design and Perform Tests of Internal Control The approaches to testing the reconciliation control could involve one or more of the following: Inquiry: Talk with the personnel who perform the control about the procedures and processes involved in the reconciliation. Observation: Observe the entity personnel performing the reconciliation. Examination: Review the documentation supporting completion of the reconciliation. Reperformance: Perform the reconciliation and agree to the reconciliation completed by the entity personnel.

Other Testing Procedures in Sales Cycle Manual reviewing evidence of control operation—Take a sample of recorded transactions and determine that the prices agree with authorized prices. Computerized testing of computer controls—Test controls used to limit access to the computer files, select a number of prices in the system and reconcile to pre-authorized price changes. Testing of monitoring controls—Management should have controls in place to assist them in monitoring proper prices.

LO 6 Substantive Tests of Revenue for Existence/Occurrence and Valuation 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

Substantive Tests of Revenue Cutoff Issues 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

Substantive Tests of Revenue Cutoff Issues 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

Substantive Tests of Revenue for 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

LO 7 Substantive Tests of Accounts Receivable Existence Valuation 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

Standard Accounts Receivable Audit Procedures Obtain and evaluate aging of accounts receivable Confirm receivables with customers Perform cutoff tests Review subsequent collections of receivables

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

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

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

Types of Confirmations (continued) 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

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

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

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

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

LO 8 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

Fraud Indicators and Audit Procedures (continued) 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 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:

Explain Auditing of Allowance for Doubtful Accounts (continued) 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