1. Audit of the sales and collection cycle: Tests of controls and substantive tests of transactions
Chapter 14
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2. Chapter 14 Learning Objectives
14-1 Identify the accounts and the classes of transactions in the sales
and collection cycle.
14-2 Describe the business functions and the related documents and
records in the sales and collection cycle.
14-3 Understand internal control, and design and perform tests of
controls and substantive tests of transactions for sales.
14-4 Apply the methodology for controls over sales transactions to
controls over sales returns and allowances.
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3. Chapter 14 Learning Objectives
14-5 Understand internal control, and design and perform tests of
controls and substantive tests of transactions for cash receipts.
14-6 Apply the methodology for controls over the sales and collection
cycle to controls related to uncollectible accounts receivable.
14-7 Understand the effect of tests of controls and substantive tests
of transactions on substantive tests of details of balances.
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4. OBJECTIVE 14-1
Identify the accounts and the classes of transactions in the sales and collection cycle.
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5. Accounts and classes of transactions in the sales and collection cycle
There are five classes of transactions in the sales and collection cycle:
Sales (cash and sales on account)
Cash receipts
Sales returns and allowances
Write-off of uncollectible accounts
Estimate of bad debt expense
The way accounting information flows through the various accounts in the sales and collection cycle is shown in Figure 14-1.
The sales and collection cycle represents a large part of the transactions that are recorded for most companies.
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6. The accounts that are involved in the sales and collection cycle are illustrated in Figure 14-1.
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7. OBJECTIVE 14-2
Describe the business functions and the related documents and records in the sales and collection cycle.
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8. Business functions in the cycle and related documents and records
There are eight business functions within the sales and collection cycle:
Processing customer orders
Granting credit
Shipping goods
Billing customers and recording sales
Processing and recording cash receipts
Processing and recording sales returns and allowances
Writing off uncollectible accounts receivable
Providing for bad debts
The classes of transactions, accounts, business functions, and related documents and records for the sales and collection cycle are detailed in Table 14-1.
The business functions related to the sales and collection cycle are listed above.
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9. The classes of transactions, accounts, business functions, and documents and records related to the sales and collection cycle are shown above.
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10. transactions for sales.
OBJECTIVE 14-3
Understand internal control, and design and perform tests of controls and substantive tests of
transactions for sales.
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11. METHODOLOGY FOR DESIGNING TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS FOR SALES
The methodology for this process is shown in Figure 14-2.
Understand Internal Control—Sales: To gain an understanding, the auditor can use the client’s flowchart or other documentation and perform walkthrough tests. A flowchart is shown in Figure 14-3 on page 454.
Assess Planned Control Risk—Sales: There are four steps to this process:
Determine a framework for assessing control risk, which is provided by the transaction-related audit objectives.
Identify key internal controls and deficiencies for sales.
Associate the key internal controls and deficiencies with the audit objectives.
Assess control risk for each objective by evaluating controls and deficiencies.
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13. METHODOLOGY FOR DESIGNING TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS FOR SALES (cont.)
The key control activities for sales:
Adequate Separation of Duties—Proper separation of duties helps to prevent misstatements due to both errors and fraud.
Proper Authorization—The auditor is concerned about authorization at three points:
Credit must be properly authorized before a sale takes place.
Goods should be shipped only after proper authorization.
Prices, including basic terms, freight, and discounts, must be authorized.
Adequate Documents and Records—May be paper or electronic.
Key control activities for sales are separation of duties, authorization, and adequate documents and records.
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14. METHODOLOGY FOR DESIGNING TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS FOR SALES (cont.)
The key control activities for sales (cont.):
Prenumbered Documents—This helps prevent both the failure to bill and duplicate billings and recordings.
Monthly Statements—This is a useful control because it encourages customers to respond if their balance is incorrect.
Internal Verification Process—Can be manual or computerized.
Determine Extent of Tests of Controls—After key controls and deficiencies are identified, auditors assess control risk and determine the extent of tests of controls.
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15. METHODOLOGY FOR DESIGNING TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS FOR SALES (cont.)
Design Tests of Controls for Sales—Tests of controls for sales are illustrated in Table 14-2 on page 457.
Design Substantive Tests of Transactions for Sales—Substantive tests are designed for each transaction-related audit objective, including:
Recorded Sales Occurred—There are three types of possible misstatements:
Sales included in the journals for which no shipment was made
Sales recorded more than once
Shipments made to nonexistent customers and recorded as sales
Existing Sales Transactions Are Recorded—This is less likely to be tested because the risk of overstatement of sales is more likely than understatement.
Designing tests of controls and substantive tests of transaction for sales are necessary to address the audit objectives for these processes.
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16. METHODOLOGY FOR DESIGNING TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS FOR SALES (cont.)
Design Substantive Tests of Transactions for Sales (cont.)
Direction of Tests—The direction of the test fulfills different objectives:
Tracing—From source documents to the journals tests for omitted transactions (completeness objective)
Vouching—From the journals back to the source documents tests for nonexistent transactions (occurrence objective)
The direction of tests related to sales is shown in Figure14-4.
The direction of the testing (i.e., tracing vs. vouching) addresses different audit objectives.
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18. METHODOLOGY FOR DESIGNING TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS FOR SALES (cont.)
Design Substantive Tests of Transactions for Sales (cont.)
Sales Are Accurately Recorded—Auditor concerns:
Shipping the amount of goods ordered
Accurately billing for the amount of goods shipped
Accurately recording the amount billed in the accounting records
Sales Transactions Are Correctly Included in the Master File and Correctly Summarized
Recorded Sales Are Correctly Classified
Sales Are Recorded on the Correct Dates
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19. METHODOLOGY FOR DESIGNING TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS FOR SALES (cont.)
Summary of Methodology for Sales:
Transaction-related audit objectives
Key existing controls
Tests of controls
Deficiencies
Substantive tests
Design and Performance Format Audit Procedures—Properly designed and formatted audit programs do the following:
Eliminate duplicate procedures
All procedures on any one document are completed at the same time
Enables the most effective order in which to perform procedures
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20. OBJECTIVE 14-4
Apply the methodology for controls over sales transactions to controls over sales returns and allowances.
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21. SALES returns and allowances
Transaction-related audit objectives are essentially the same for credit memos as those for processing sales, with two notable differences:
First is materiality. Sales returns and allowances are often so immaterial that auditors can ignore them.
The second is emphasis on the occurrence objective. Auditors usually emphasize testing recorded transactions to uncover any theft of cash in the collection of accounts receivable that was covered up by fictitious sales returns or allowances.
The auditor’s main concern with sales returns and allowances is whether the return or allowance actually occurred, or if there is a possibility that it is covering up a theft of cash.
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22. OBJECTIVE 14-5
Understand internal control, and design and perform tests of controls and substantive tests of transactions for cash receipts.
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23. Methodology for designing tests of controls and substantive tests of transactions for cash receipts
Auditors use the same methodology for tests of controls and substantive tests of transactions for cash receipts as they use for sales:
Determine key internal controls for each audit objective.
Design tests of control for each control used to support reduced control risk.
Design substantive tests of transactions to test for monetary misstatement for each objective.
The control risk matrix for cash receipts is presented in Figure 14-5 on page Key internal controls and common tests of controls are shown in Table on page 465. The audit program is shown in Figure 14-6 on page 467.
Methodology for designing tests for cash receipts is basically the same as for sales.
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24. METHODOLOGY FOR DESIGNING TESTS OF CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS FOR cash receipts (cont.)
Determine Whether Cash Received Was Recorded—It is difficult to detect theft if cash when it occurs before the cash is recorded. Prenumbered remittance advices and prelists of cash receipts are usually tested against journals, but this is effective only if the prelist was prepared when the receipt was received. Prepare Proof of Cash Receipts—Total cash receipts recorded in the journal for a specific period is compared with the amount of cash deposited in the bank during the same period. Test to Discover Lapping of Accounts Receivable—Lapping is postponing entries for cash receipts to conceal an existing cash shortage. This can be easily prevented by adequate separation of duties.
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25. OBJECTIVE 14-6
Apply the methodology for controls over the sales and collection cycle to controls related to uncollectible accounts receivable.
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26. Audit tests for uncollectible accounts
Similar to sales returns and allowances, the auditor’s concern in the write-off of uncollectible accounts is the possibility that write-offs are used to cover up embezzlement of cash receipts.
The auditor is also concerned with the balance-related objective of the realizable value of net accounts receivable. Two controls that address this issue:
The preparation of a periodic aged accounts receivable trial balance for review and follow-up by appropriate management personnel.
A policy of writing off uncollectible accounts when they are no longer likely to be collected.
Write-offs of uncollectible accounts are similar to sales returns and allowances for an auditor. The total may be immaterial, but whether the write-off is legitimate or a cover-up of a theft of cash is the main concern.
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27. OBJECTIVE 14-7
Understand the effect of tests of controls and substantive tests of transactions on substantive tests
of details of balances.
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28. Effect of results of tests of controls and substantive tests of transactions
The results of the tests of controls and substantive tests of transactions have a significant effect on the remainder of the audit.
If the test results are unsatisfactory, it will be necessary to do additional substantive testing.
The most significant effect of the results of the tests of controls and substantive tests of transactions in the sales and collections cycle is on the confirmation process. The type of confirmation, the size of the samples, and the timing are all affected.
The major accounts in the sales and collection cycle and the types of tests are illustrated in Figure 14-7.
The results of these tests determine what other testing is necessary for the rest of the audit.
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