Audit of the Revenue Cycle

Audit of the Revenue Cycle
Test of Controls

Typical Transactions in the Sales and Collection Cycle
Five major classes of Transactions: Sales Both cash and on account Cash receipts Both receipts for cash sales as well as receipts on account Sales returns and allowances Technically two distinct transactions Sales returns: customer returns defective, damaged, or otherwise undesirable products Sales allowances: Customer agrees to keep merchandise in return for a reduiction in price The write-off of uncollectible accounts An important account for valuation purposes. Remember the management assertion and audit objective of valuation Bad-debt expense When an account is deemed uncollectible it is charged off to expense By auditing uncollectible accounts the auditor is also audit bad debt expense

An Overview of Functions, Documents, and Accounting Systems
It is important to notice the separate departments. It shows good segregation of duties. Order Entry Department The starting point = Good control point Signed by the customer, except for telephone or internet orders. Customer Order Prepare Sales Order 2 3 Customer Credit Department A Sales order 1 By phone, internet or mail Credit Manager signs the sales order for credit approval

Okra Development Corp. Copy
8924 Bailey Road Purchase Order Salem, OR 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 Bailey Road, Salem, OR 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
To: Okra Development Corp Copy 8924 Bailey Road Salem, OR Faragut Sales, Inc. Ship to Okra Development 8924 Bailey Road, OR Ship by September 12, 201X Credit Approval C.H. Terms: 2/10, n/ Goods Counted M.K. FOB Shipping Point Customer Order Number 64412 10 Model Roller Bearing Date Shipped: 8/20/0X Freight Bill # Quantity Number Description Amount Prenumbered Sales Order. Controlled numerically

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

Description of Articles,
BILL OF LADING Faragut Sales, Inc. 3812 Briar Drive Salem, OR August 20, 201X Shipp to: Okra Development Corp. Destination: 8924 Bailey Road, Salem, OR 92117 Carrier: Yellow Express Car Initial: Car No. Number of Packages 5 Description of Articles, Special Marks, and Exceptions Roller Bearings, 2 each Weight 28 lbs. Class or Rate 3 Copy Faragut Sales Shipper, Per Joe Chen Agent Yellow Express Per Sue Jones Prenumbered Bill of Lading. Controlled numerically

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. Prepare Sales Invoice & Sales Summary SO BL INV Shipping Department N Cost Department for Perpetual Inventory Customer Sales Summary General Accounting Authorized Price List Summary by invoice number.

We are pleased to serve you
Faragut Sales, Inc D Copy 3812 Briar Drive, Salem, OR 92115 Sales Invoice Sold Shipped to Freight Bill No. Okra Development Corp Bailey Road 8924 Bailey Road Salem, OR 92117 Salem, OR 92117 FOB Shipping Point Invoice Date August 25, 201X Date Shipped August 20, 201X Terms 2/10, n/30 Your Order No. 6-3378 10 Model Quantity We are pleased to serve you Price Amount Pricing and Math J.D. Account Coding S.A.L. Prenumbered Sales Invoice. Controlled numerically Key controls. Initials are evidence of control being performed. In total or sample.

Page SALES JOURNAL Date Sold to: Invoice No. Amount August 25 Opra Development Corp. D

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
Opra Development Corp. REMITTANCE ADVICE Salem, Or. Invoice No. Date Voucher Gross Amount Discount Net Amount D X Cheque No. Date Vendor No. Vendor Name Total Amount X 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
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 First National Bank Faragut Sales, Inc. Deposit Slip September 5, 201X Cheques Teller 5 Prepared by cashier, separate from the receipt of cash by Receptionist Initialed by cashier P.L.

Page 112 CASH RECEIPTS JOURNAL
Date Customer Name Cash Sales Account Receivable Discount Credit August 25 Okra Development Corp

The Accounts Receivable Sub-Ledger must be updated A/R Department
Duplicate Deposit Slip Remittance Advice Post to the Customer Account & Prepare Trial Balance List of Receipts CR Summary Trial Balance General Accounting for comparison to the G/L D Notice that the posting to the accounts is separate from collection of cash, and deposit in the bank. Bank Subsidiary customer accounts posted from remittance advices. Cashier 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 customer order What documents accompany the sale? shipping documents and invoice recorded both in a transaction file (sales) and summarized in a customer master file (or in a database). Routine reports include a sales journal Shows all sales invoices aged accounts receivable trial balance Should reconcile to the G/L What key use does this have? Anything else? Monthly statements, sales reports

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 These are the accounts that have to be audited. Also note the audit efficiency. Only audit one side of the T/A.

Methods of Recording Transactions
Manual recording This, of course is rare today Entered in batches Entered into the computer system as groups of transactions also called batches Very common with earlier processing system i.e. non-interactive Recorded one transaction at a time online transaction processing very common today

Control Differences Between Batch and Online Systems
An audit trail is a necessary requirement for both Batch systems: Transactions readily traced Good traditional audit trail from source transaction to G/L posting Good example would be payroll Groups of transactions are totaled Called batch control totals These totals can be traced through the system Online systems: Transactions recorded one at a time may be initiated and recorded without source documents e.g. phone orders Document sequencing is important Handled by the computer system Numbers assigned to track documents Computer edit checks necessary.

Control Differences For Error Detection and Correction
Batch systems: one erroneous transaction the whole batch is rejected Error follow-up is required Error corrected and whole batch re-submitted Should be done in a timely manner Online systems: Focus is on preventing errors For each transaction as submitted and processed Input edit check for valid customer data and reasonableness i.e. all relevant customer data fields Requires a number of different edit checks

Batch and Online Systems: Segregation of Duties
Batch systems: Separate Counting and batch totaling from data entry Reconciliation and error follow-up should be performed by the batch preparer independent of data entry Online systems: In decentralized systems may result in inadequate segregation of duties Use passwords to separate transaction entry from master file entry example of master file entry would be update of credit limits This is permanent data, only changed periodically

Risk Assessment and the Sales Cycle
Why do risk assessment? Comprises first three phases of audit Preplanning, client risk profile, and planning the audit 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 auditor required to do more testing

Effect of General Controls
present in the environment surrounding the information system Are pervasive and affect multiple transaction cycles Auditor should document these prior to assessing the individual transaction cycles Typical examples of general controls The organizational and administrative structure of the IS function Policies and procedures for day-to-day operations The staff and their skills Job responsibilities Good data centre E.g. adequacy of air conditioning, continual power supply, smoke detectors, fire extinguishers, clean air Physical access and security All servers in a secure location, protected by locked doors , swipe cards, biometric access

If general controls are good,
the auditor may be able to rely upon them i.e. test interdependent or fully automated controls Remember that interdependent controls require both programmed and manual components If general controls are poor the auditor may be able to rely upon only manual controls or may need to conduct a substantive-oriented audit

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 for every audit assertion for every class of transactions. The auditor focuses on key controls or those controls that have the greatest effect for that audit assertion. What type of controls can these be? These controls could be manual, automated, or interdependent. Interdependent controls Require both programmed and manual components to be effective E.g. the computer provides a report of missing shipping documents. These documents have to be investigated by a person independent of shipping and accounting

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. For example, the same person who is responsible for an asset's recordkeeping should not be responsible for physical control of that asset. Having different individuals perform these functions creates a system of checks and balances. 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. For example, a fixed price list may serve as an official authorization of price for a large sales staff. In addition, there may be a control to allow a sales manager to authorize reason able deviations from the price list. Documents and Records Adequate documents and records provide evidence that financial statements are accurate. Controls designed to ensure adequate recordkeeping include the creation of invoices and other documents that are easy to use and sufficiently informative; the use of prenumbered, consecutive documents; and the timely preparation of documents.

Internal verification
Independent checks on performance, which are carried out by employees who did not do the work being checked, help ensure the reliability of accounting information and the efficiency of operations. For example, a supervisor verifies the accuracy of a retail clerk's cash drawer at the end of the day. Internal auditors may also verity that the supervisor performed the check of the cash drawer. Prenumbered documents Using prenumbered documents, means that it is very hard to issue a false document All documents have to be accounted for Also prevents duplicate transactions Monthly statements Provides a detailed list of each customer’s activity Customer can question discrepancies

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. To illustrate, if an auditor totalled the number of transactions for each value in the “Gender" field, the results might be: M = 2,341; F = 2,295; D = 2; and N = 1. Such totals indicate that the edit check, which limits possible values to "F" and "M", is not working properly and is allowing the typos "D" and "N" to be keyed instead. By using audit software to access an application's data directly, auditors can use simple commands to verify edit checks, to test calculations performed by the application, and to examine the data for reasonableness. In addition, searching for gaps and duplicates can help to determine the completeness and timeliness of the data.

Tests of Internal Controls
Once the key controls have been identified, the auditor can decide whether the control(s) will be tested or whether tests of details will be conducted instead. Tests of internal controls will be devised for each key control that will be tested.

Examples of Internal Control using the Occurrence Assertion
Manual Control Occurrence shows that the event actually happened Want evidence of this manual control Key control: credit is approved before shipment takes place. The manual control? The sales manager initials all sales orders over $25 to indicate approval. Possible test of control Examine a sample of sales orders to ensure that the sales manager’s initial is present.

Remember that this is a batch of sales transaction being processed
Automated Batch Occurrence assertion Remember that this is a batch of sales transaction being processed Key control: Orders causing balances to exceed credit limits are printed on an exception report Thus and are not processed for shipment. N.B. Total passed on for processing plus exception total must equal the batch total Possible test of control: Examine a selection of exception reports and ensure that: these orders exceed the credit limit And that the orders were not processed for shipment.

Possible test of control:
Automated Online Occurrence assertion Remember that these transactions are being processed as they occur i.e. interactively Key control: Orders causing balances to exceed credit limits are held in a separate transaction file and as in the previous case, are not processed for shipment. Possible test of control: Request the client to print off the day’s on-hold transaction file. View the file to ensure that all orders in the file exceed the customer’s credit limits.

Possible test of control:
Interdependent Occurrence Assertion Remember that interdependent controls require both programmed and manual components Key control: Orders causing balances to exceed the credit limit are printed on an exception report and must be approved by a credit manager Thus shows interdependence Note: must be approved prior to shipment by means of entering a password. Possible test of control: Review an exception report and ensure that all sales orders there caused the customers’ credit limit to be exceeded. Discuss with the sales manager processes followed to release such held orders. Could also examine a computer log that shows evidence of the managers approval

Manual, Automated and Interdependent Controls
From the previous examples, it can be seen that: Manual controls are controls performed entirely by people In the previous case, the manager Automated controls (batch or online) are performed only by computerized systems A good control with batches is the use of the batch control total The total before processing must equal the total after processing Interdependent controls rely upon computer processes (automation) but a person must also be involved to fully perform the control Once again the manager

Direction of Testing Tracing Vouching

Tracing Vouching Goes from the start of the transaction to the posting
i.e. From the customer order to sales invoice to the sales journal and to the G/L Will look for all relevant documents on the way Is this a test for overstatement or understatement of sales? A test for understatement. If the sales invoice is not in the sales journal, sales are understated or not complete Vouching Goes from the general ledger or sales journal back to the original document A test for overstatement of sales. If it is in the sales journal and there is no sales invoice, sales are overstated Thus thew sales did not occur

Typical Concerns for Tests of Sales
Recorded sales occurred Occurrence – both management assertion & audit objective Did the T/A occur Key management assertion Auditor is concerned with following possible misstatements Recorded sale for which there was no shipment Auditor can trace form sales journal to the shipping document Sale recorded more than once Want to determine duplicate sales Review a numerically sorted list of sales transactions Looking for duplicate invoice numbers Can use audit software Shipment made to non-existent customer A fraud situation due to lack of segregation of dusties Can trace from A/R listing to the cash collection If cash was collected from a customer, no problem If written off, could be a problem Remember that and audit is not intended to detect fraud

Existing sales transactions are recorded
Completeness assertion And audit objective Want to test for unbilled shipments Vouch a sample of shipping documents to the corresponding sales invoice and trace to the sales journal Are shipping documents complete? Account for numerical sequence of shipping documents. Recorded Sales are accurately recorded Measurement assertion Audit objective of accuracy Accurate billing Prices of invoice compared with approved price lists Extensions and footing recomputed Accurate recording in the records Recomputing information in accounting records

Recorded sales are properly classified
Ensure correct entry into the general ledger Most computer systems will do this automatically Can use audit software to check this Sales transactions are properly updated in the master file and correctly summarized Accuracy of the master file is essential If not in master file, how can they collect money? Trace from sales invoice to the master file and the G/L Sales are recorded on the correct dates Sales must be billed as soon as shipment takes place FOB shipping point & revenue recognition Compare date on shipping document with date on invoice Significant differences show a cut-off problem Remember all the tests can be dome with the same sample of sales invoices and shipping documents Do not need to have different samples for each test Audit efficiency

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? Auditing standards board allows this in limited circumstances Auditor of a nonpublic company In this case, which type of controls must be tested annually? For controls that have changed since they were last tested Which type of controls could potentially be tested every three years? For controls that have not changed since they were last tested

Testing of Interdependent Controls
The interdependent control has two parts: A function performed by an automated systems A function performed by an individual It is only possible to rely upon the automated function if: general controls have been assessed as good Both parts of the control must be tested to enable reliance upon the control

What if Control Testing Yielded Many Errors?
The first step is to determine whether the errors or exceptions were due to a particular circumstance Could be an unusual circumstance that does not happen very often or restricted to a particular time period Could be that regular employee was on vacation E.g. the credit manager was on holidays so no one approved credit, or the person who approved credit in his/her absence made many errors.

If the errors are systemic
i.e. throughout the period and cannot be isolated to a particular cause then the auditor first looks for a compensating or alternative control. If this alternative control achieves the same purpose and is functioning correctly then the auditor can still rely upon internal controls. If no compensating control?

Material Error If there is no compensating control
the auditor needs to investigate to determine whether there is potential for this weakness to result in a material error. Want to quantify the extent of the error. Remember the tolerable error Also sample exception rate (SER) Extend it to the population See if the extended error is acceptable

Results of Quantifying the Error
If it turns out that the results of the weakness could result in immaterial error the weakness will be reported in a management letter extended tests of detail may not be required. If a material error could result the matter needs to be reported both to management and the audit committee the tests of details will have to expanded Needed to detect the possible material error

Performing the Audit Program
The initial audit program is organized by audit assertion existence, occurrence, completeness, etc. this ensures that controls as assessed are properly tested, if applicable, for each assertion. In performing for maximum efficiency E.g. all tests for the shipping document would be grouped together. Examination of sales invoices could cover a number of tests The use of automated working paper software facilitates this process.

Computer-Assisted Audit Tests
Where there are a large number of transactions it is effective for auditors to use computer-assisted audit tests. Sales, Purchases, Payroll. i.e. many T/A’s E.g. In internal controls testing, the auditor could use automated sampling routines to access the client sales transaction file and select an attribute sample of sales transactions, printing details of the transactions. Need details to do the test.

Suitability of Test Data
Batch systems: Test data may be inappropriate the transactions would be processed by the accounting system. Do not want them to affect the books and records Could test rejected transactions, i.e. T/A’s rejected by the system for re-entry (put O/P to SCARF) Online systems Test data is useful Can verify the accurate functioning of online input edit controls e.g. rejection of invalid customer numbers Put O/P to SCARF

Suitability of Generalized Audit Software
Best suited for analytical review, tests of detail, or dual-purpose tests, for example: Adding up the sales transactions to sum to the sales for the day, month or year Reperformance of tax calculations Examination of customer master file to determine if any balances exceed their credit limit

Problem 11-1, Page 472 General Specific Validity 1 Completeness 2
Cash Receipts: Control Objectives and Control Examples Required: Prepare a table similar to Exhibit 11-4 on internal control for cash receipts. General Specific Validity 1 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. Completeness 2 All cash receipts should be listed from remittance advices. Deposits prepared by a person separate from the one who opens the mail. Subsidiary customer accounts posted from remittance advices. General ledger control account posted from cash receipts journal. Bank statement reconciled independent of other functions. Control account reconciled to subsidiary ledger monthly. Authorization 3 (Authorization is usually not a problem for cash receipts on accounts receivable.) Cash receipts from other than merchandise sales authorized on unique remittance advice forms. Accuracy 4 Daily remittance list compared to duplicate deposit slip received from bank by person independent of either function. Classification 5 Cash receipts entered properly in cash receipts journal as to the origin of the receipts. Separate deposits made for non-merchandise sales cash receipts. Accounting 6 Monthly reconciliation of control account to customers' individual accounts and bank statement reconciled promptly. Proper period 7 Daily deposit of all cash receipts. Cash receipts recorded as period of date of receipt. Accounts posted as of date cash received.

Problem 2 The following are auditor judgments and audit sampling results for six populations. Assume large population sizes. 1 2 3 4 5 6 EPER (in percentage) 8 TER (in percentage) 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? Evaluate, selecting either a larger or smaller size than those determined in the tables. Calculate SER and CUER 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?

12-27 The sample sizes and CUERs are shown in the following table:
The auditor selected a sample size smaller than that determined from the tables in population 1 and 3. The effect of selecting a smaller sample size than the initial sample size required from the table is the increased likelihood of having the computed upper exception rate exceed the tolerable exception rate. If a larger sample size is selected, the result may be a sample size larger than needed to satisfy tolerable exception rate. That results in excess audit cost. Ultimately, however, the comparison of CUER to tolerable exception rate determines whether the sample size was too large or too small. Actual Sample Size Initial Sample Size from Table 13-7 Tolerable Exception Rate Sample Exception Rate (SER) CUER from Table 13-8 1. 100 127 6.0% 2.0% 6.2% 2. 99 3.0 0.0 3. 60 65 8.0 1.7 6.3 4. 93 5.0 4.0 8.9 5. 20 18 20.0 18.1 6. 15.0 13.3 >20.0 The sample exception rate and computed upper exception rate are shown in columns 5 and 6 in the above table. The population results are unacceptable for populations 4 and 6. In each of those cases, the CUER exceeds tolerable exception rate. In population 1, the CUER is marginally more than the TER. The auditor’s options are to change tolerable exception rate or ARACR, increase the sample size, or perform other substantive tests to determine whether there are actually material errors in the population. Increasing sample size would not likely result in improved results for either population 4 or 6 because the CUER exceeds tolerable exception rate by a large amount. Analysis of exceptions is necessary even when the population is acceptable because the auditor wants to determine the nature and cause of all exceptions. If, for example, the auditor determines that an error was intentional, additional action would be required even if the CUER was less than tolerable exception rate.

TOLERABLE DEVIATION RATE (IN PERCENTAGE) 2 3 4 5 6 7 8 9 10 15 20
EXPECTED POPULATION DEVIATION RATE (IN PERCENTAGE) TOLERABLE DEVIATION RATE (IN PERCENTAGE) 2 3 4 5 6 7 8 9 10 15 20 5 PERCENT RISK OF OVER RELIANCE (ARACR) 0.00 149 99 74 59 49 42 36 32 29 19 14 0.25 236 157 117 93 78 66 58 51 46 30 22 0.50 . 0.75 208 1.00 156 1.25 124 1.50 192 103 1.75 227 153 88 77 2.00 181 127 68 2.25 61 2.50 150 109 2.75 173 95 3.00 195 129 84 3.25 148 112 3.50 167 76 40 3.75 185 100 4.00 146 89 5.00 158 116 6.00 179 50 7.00 37

10 PERCENT RISK OF OVER RELIANCE (ARACR)
2 3 4 5 6 7 8 9 10 15 20 10 PERCENT RISK OF OVER RELIANCE (ARACR) 0.00 114 76 57 45 38 32 28 25 22 11 0.25 194 129 96 77 64 55 48 42 18 0.50 0.75 265 1.00 . 176 1.25 221 132 1.50 105 1.75 166 88 2.00 198 75 2.25 65 2.50 158 110 58 2.75 209 94 52 3.00 3.25 153 113 82 3.50 73 3.75 131 98 4.00 149 4.50 218 130 87 34 5.00 160 115 78 5.50 142 103 6.00 182 116 7.00 199 7.50 8.00 60 8.50 68 EPDR

ACTUAL NUMBER OF DEVIATIONS FOUND 1 2 3 4 5 6 7 8 9 10
Table 12-10 SAMPLE SIZE ACTUAL NUMBER OF DEVIATIONS FOUND 1 2 3 4 5 6 7 8 9 10 5 PERCENT RISK OF OVER RELIANCE 25 11.3 17.6 . 30 9.5 14.9 19.5 35 8.2 12.9 16.9 40 7.2 18.3 45 6.4 10.1 13.3 16.3 19.2 50 5.8 9.1 12.1 14.8 17.4 19.9 55 5.3 8.3 11.0 13.5 15.9 18.1 60 4.9 7.7 12.4 14.6 16.7 18.8 65 4.5 7.1 9.4 11.5 15.5 19.3 70 4.2 6.6 8.7 10.7 12.6 14.4 16.2 18.0 19.7 75 3.9 6.2 10.0 11.8 15.2 18.4 20.0 80 3.7 11.1 12.7 14.3 15.8 17.3 90 3.3 5.2 6.8 8.4 9.9 14.1 16.8 100 3.0 4.7 7.6 8.9 10.2 14.0 16.4 125 2.4 6.1 9.3 10.3 12.2 13.2 150 2.0 3.1 4.1 5.1 6.0 6.9 8.6 200 1.5 2.3 3.8 6.5

1 2 3 4 5 6 7 8 9 10 Sample size ACTUAL NUMBER OF DEVIATIONS FOUND .
1 2 3 4 5 6 7 8 9 10 10 PERCENT RISK OF OVER RELIANCE 20 10.9 18.1 . 25 8.8 14.7 19.9 30 7.4 12.4 16.8 35 6.4 10.7 14.5 40 5.6 9.4 12.8 15.9 19.0 45 5.0 8.4 11.4 14.2 17.0 19.6 50 4.5 7.6 10.3 12.9 15.4 17.8 55 4.1 6.9 11.7 14.0 16.2 18.4 60 3.8 6.3 8.6 10.8 14.9 16.9 18.8 70 3.2 5.4 9.3 11.1 14.6 17.9 19.5 80 2.8 4.8 6.5 8.3 9.7 11.3 14.3 15.7 17.2 18.6 90 2.5 4.3 5.8 7.3 8.7 10.1 12.7 15.3 16.6 100 2.3 5.2 6.6 7.8 9.1 11.5 13.8 15.0 120 1.9 4.4 5.5 9.6 10.6 11.6 12.5 160 1.4 2.4 3.3 4.9 5.7 7.2 8.0 9.5 200 1.1 2.6 4.0 4.6 7.0

Problem 11-3, Page 474 Cash Receipts: Weaknesses and Recommendations. The Pottstown Art League operates a museum for the benefit and enjoyment of the community. During hours when the museum is open to the public, two volunteer clerks positioned at the entrance collect a $5 admission fee from each nonmember patron. Members of the Art League are permitted to enter free of charge on presentation of their membership cards. At the end of each day, one of the clerks delivers the proceeds to the treasurer. The treasurer counts the cash in the presence of the clerk and places it in a safe. Each Friday afternoon, the treasurer and one of the clerks deliver all the cash held in the safe to the bank, and they receive an authenticated deposit slip that provides the basis for the weekly entry in the cash receipts journal. The board of directors of the Pottstown Art League has identified a need to improve the system of internal control over cash admissions fees. The board has determined that the cost of installing turnstiles or sales booths or otherwise altering the physical layout of the museum will greatly exceed any benefits that may have derived. However, the board has agreed that the sale of admission tickets must be an integral part of its improvement efforts. Required: The board of directors has requested your assistance. Prepare a report for presentation and discussion at their next board meeting that identifies the weaknesses in the existing system of cash admission fees and suggest recommendations. (AICPA adapted.)

Weakness: There is no segregation of duties between persons responsible for collecting admission fees and persons responsible for authorizing admission. Recommendation: One clerk (hereafter referred to as the collection clerk) should collect admission fees and issue prenumbered tickets. The other clerk (hereafter referred to as the admission clerk) should authorize admission upon receipt of the ticket or proof of membership. Weakness: An independent count of paying patrons is not made. Recommendation: The admission clerk should retain a portion of the prenumbered admission ticket (admission ticket stub). Weakness: There is no proof of accuracy of amounts collected by the clerks. Recommendation: Admission ticket stubs should be reconciled with cash collected by the treasurer daily. Weakness: Cash receipts records are not promptly prepared. Recommendation: The cash collections should be recorded by the collection clerk daily on a permanent record that will serve as the first record of accountability. Weakness: Cash receipts are not promptly deposited. Cash should not be left undeposited for a week. Recommendation: Cash should be deposited at least once each day. Weakness: There is no proof of accuracy of amounts deposited. Recommendation: Authenticated deposit slips should be compared with daily cash collection records. Discrepancies should be promptly investigated and resolved. In addition, the treasurer should establish a policy that includes an analytical review of cash collections. Weakness: There is no record of the internal accountability of cash. Recommendation: The treasurer should issue a signed receipt of all proceeds received from the collection clerk. These receipts should be maintained and should be periodically checked against cash collection and deposit records.

Audit of the Revenue Cycle

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