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

2. Audit Opinion Formulation Process

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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.

14. 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.

15. 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.

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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.

22. 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.

23. 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

24. 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

25. 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

26. 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

27. 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

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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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

39. 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:

40. 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