1. Audit of the Revenue Cycle Test of Controls

2. Typical Transactions in the Sales and Collection Cycle Five major classes of Transactions: Sales Cash receipts Sales returns and allowances –Technically two distinct transactions The write-off of uncollectible accounts Bad-debt expense 2

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

4. Okra Development Corp. Copy 8924 Bailey Road Purchase Order 6-3378 Salem, OR 92117Date: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 8924 Bailey Road, Salem, OR 92115 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 invoicesOrdered By Margaret Spangler 4

5. Sales Order To: Okra Development Corp.Copy 8924 Bailey Road Salem, OR 92117 Faragut Sales, Inc. Ship to Okra Development 8924 Bailey Road, OR Ship by September 12, 201XCredit Approval C.H. Terms: 2/10, n/30Goods Counted M.K. FOB Shipping PointCustomer Order Number 6-3378 64412 10Model 317Roller Bearing480.00 Date Shipped:8/20/0X Freight Bill #229-237441 QuantityNumber DescriptionAmount 5 Prenumbered Sales Order. Controlled numerically

6. Shipping involves the Shipping Department Approved Sales Order Prepare Multi-Part Bill of Lading SO BL Order Entry Common Carrier Customer N Billing and A/R 6 Approved by Credit Manager. Always useful to have a numerical file. Kept in Shipping. Dept. A legal document that the carrier is required to have.

7. BILL OF LADING Faragut Sales, Inc. 3812 Briar Drive Salem, OR 92115August 20, 201X Shipp to: Okra Development Corp. Destination:8924 Bailey Road,Salem, OR 92117 Carrier:Yellow ExpressCar Initial:Car No. Number of Packages 5 Description of Articles, Special Marks, and Exceptions Roller Bearings, 2 each Weight 28 lbs. Class or Rate 3 229-237441 Copy Faragut Sales Shipper, Per Joe Chen Agent Yellow Express Per Sue Jones 7 Prenumbered Bill of Lading. Controlled numerically

8. Sales order & Bill of Lading goes to Billing/Accounts Receivable Department Prepare Sales Invoice & Sales Summary SO BL INV SO BL Shipping Department N Cost Department for Perpetual Inventory Customer Sales Summary General Accounting 8 A numerical file that shows approval of the sale, proof of shipment, and billing. Good for testing internal controls. Summary by invoice number. Authorized Price List Pricing checked. Account coding checked.

9. Faragut Sales, Inc.D8-9912 Copy 3812 Briar Drive, Salem, OR 92115 Sales Invoice SoldShipped toFreight Bill No. Okra Development Corp.8924 Bailey Road229-237441 8924 Bailey RoadSalem, 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 10Model 31748.00480.00 Quantity We are pleased to serve youPriceAmount Pricing and Math J.D. Account Coding S.A.L. 9 Key controls. Initials are evidence of control being performed. In total or sample. Prenumbered Sales Invoice. Controlled numerically

10. Page 327SALES JOURNAL DateSold to:Invoice No.Amount August 25Opra Development Corp.D8-9912480.00 10

11. Remittance Advice Cash Collection Receptionist/Mail Room Clerk Prepare List of Cash Received (2 copies) Invoice Copy Cheque Customer Invoice Cheque List Control Copy to General Accounting Cashier 11 Deposits prepared by a person separate from the one who opens the mail. Two separate listing going to two different places for later cross checking

12. Opra Development Corp.REMITTANCE ADVICE Salem, Or. Invoice No.DateVoucherGross AmountDiscountNet Amount D8-99128-25-1X9-00018480.009.60470.40 Cheque No.DateVendor No.Vendor NameTotal Amount 8679-04-1X003270003Faragut Sales, Inc.470.40 12 Notice the complete details on the remittance Advice 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.

13. 15642 September 5, 201X Cash Receipts Listing Fountain City Warehousex,400.00 Charlotte Sawyers, Inc.x,295.00 Brown, Inc.1,200.00 Okra Development Corp.x,470.40 Toil Incorporatedx,490.00 Harreleson Hardware1,872.80 Barnaby Sales, Inc.x,982.00 Hartfordsx,x92.00 5,802.20 Preparer J.T.Lockett September 5, 201X Cash Summary Cash Receipts Listing5,802.20 Over-the-counter cash receipts3,130.40 8,932.60 x,120.00 x,x98.32 x,x23.66 x,842.33 x,988.11 3,130.40 Adding Machine Tape 13 All cash receipts should be listed on the pre-listing from the remittance advices. Also called a pre-listing of cash receipts

14. Remittance Advice Cash must be deposited in the Bank Cashier 14 Once again, a separate dept. Distribution going to separate depts. For reconciliation All cash receipts should be deposited daily Prepare Deposit Slip & Cash Receipts Summary List of Receipts Invoice Copies Cheques Mail Clerk List of Receipts CR Summary Cheques Deposit Slip General Accounting A/R to update A/R Sub-Ledger Bank

15. 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 15 Prepared by cashier, separate from the receipt of cash by Receptionist P.L. Initialed by cashier

16. Page 112CASH RECEIPTS JOURNAL DateCustomer NameCash SalesAccount Receivable DiscountCredit August 25Okra Development Corp.470.409.60480.00 16

17. The Accounts Receivable Sub-Ledger must be updated A/R Department 17 Daily remittance list compared to duplicate deposit slip received from bank by person independent of either function. 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

18. The Role of General Accounting Post to the General Ledger Sales Summary A/R Dept. List of Receipts CR Summary Mail Clerk Cashier 18 Post to the general ledger using data obtained from other depts. Subsidiary customer accounts posted from remittance advices. There should be a monthly reconciliation of control account to customers' individual accounts and bank statement reconciled promptly.

19. Typical Documents and Records Sale is initiated with a What documents accompany the sale? Routine reports –include a sales journal –aged accounts receivable trial balance –Anything else? 19

20. 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 Beginning balance Bad debts Ending balance Charge off of uncollectible accounts Cash in bank Cash discounts taken Bad debts Sales returns and allowances 20

21. Methods of Recording Transactions Manual recording Entered in batches Recorded one transaction at a time 21

22. Control Differences Between Batch and Online Systems Batch systems: Transactions readily traced Groups of transactions are totaled Online systems: Transactions recorded one at a time Document sequencing is important 22

23. Batch systems: one erroneous transaction Error follow-up is required Online systems: Focus is on preventing errors Input edit check for valid customer data and reasonableness Control Differences For Error Detection and Correction 23

24. Batch and Online Systems: Segregation of Duties Batch systems: Separate Reconciliation and error follow- up Online systems: In decentralized systems Use passwords to separate 24

25. Risk Assessment and the Sales Cycle Why do risk assessment? Remember that as risk increases Risk TypeImpact 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. 25

26. Effect of General Controls General controls –Are pervasive and affect multiple transaction cycles –Typical examples of general controls 26

27. If general controls are good, –the auditor may be able to rely upon them If general controls are poor 27

28. 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: 28

29. Documentation of Internal Controls Internal controls need to be documented The auditor focuses on What type of controls can these be? 29

30. Key Controls for Sales Segregation of Duties –requires that different individuals be assigned responsibility for different elements of related activities, particularly those involving authorization, custody, or recordkeeping 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. Documents and Records –Adequate documents and records provide evidence that financial statements are accurate. 30

31. 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. Prenumbered documents Monthly statements 31

32. 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. 32

33. Tests of Internal Controls Once the key controls have been identified, the auditor can decide Tests of internal controls will be devised for 33

34. Examples of Internal Control using the Occurrence Assertion Manual Control Key control: credit is approved before shipment takes place. –The manual control? Possible test of control 34

35. Automated Batch Occurrence assertion Key control: Orders causing balances to exceed credit limits are printed on an exception report Possible test of control: 35

36. Automated Online Occurrence assertion Key control: Orders causing balances to exceed credit limits are held in a separate transaction file Possible test of control: 36

37. Interdependent Occurrence Assertion Key control: Orders causing balances to exceed the credit limit are printed on an exception report and must be approved by a credit manager Possible test of control: 37

38. Manual, Automated and Interdependent Controls From the previous examples, it can be seen that: –Manual controls are controls performed entirely by people –Automated controls (batch or online) are performed only by computerized systems –Interdependent controls rely upon computer processes (automation) but a person must also be involved to fully perform the control 38

39. Direction of Testing Tracing Vouching 39

40. Tracing –Goes from the start of the transaction to the posting –Is this a test for overstatement or understatement of sales? Vouching –Goes from the general ledger or sales journal back to the original document 40

41. Typical Concerns for Tests of Sales 1.Recorded sales occurred –Occurrence –Auditor is concerned with following possible misstatements Recorded sale for which there was no shipment Sale recorded more than once Shipment made to non-existent customer 41

42. 2.Existing sales transactions are recorded –Completeness assertion –Want to test for unbilled shipments –Are shipping documents complete? 3.Recorded Sales are accurately recorded –Measurement assertion 42

43. 4.Recorded sales are properly classified Ensure correct entry into the general ledger 5.Sales transactions are properly updated in the master file and correctly summarized Accuracy of the master file is essential 6.Sales are recorded on the correct dates Sales must be billed as soon as shipment takes place Remember all the tests can be dome with the same sample of sales invoices and shipping documents 43

44. Typical Controls and Tests for Cash Receipts Transaction-Related Audit ObjectiveKey Internal ControlGeneral Tests of ControlsQuantitative/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). Regular monthly statements to customers. 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. 44

45. Frequency of Testing of Internal Controls Is an auditor allowed to use the results of prior testing in a current audit? In this case, which type of controls must be tested annually? Which type of controls could potentially be tested every three years? 45

46. Testing of Interdependent Controls The interdependent control has two parts: –A function performed It is only possible to rely upon the automated function if: Both parts of the control must be tested to enable 46

47. What if Control Testing Yielded Many Errors? The first step is to determine whether the errors or exceptions –were due to a particular circumstance –or restricted to a particular time period 47

48. If the errors are systemic If this alternative control achieves the same purpose and is functioning correctly If no compensating control? 48

49. Material Error If there is no compensating control Want to quantify the extent of the error. 49

50. Results of Quantifying the Error If it turns out that the results of the weakness could result in immaterial error If a material error could result 50

51. Performing the Audit Program The initial audit program is organized by audit assertion In performing for maximum efficiency The use of automated working paper software facilitates this process. 51

52. Computer-Assisted Audit Tests Where there are a large number of transactions E.g. In internal controls testing, the auditor could use automated sampling routines 52

53. Suitability of Test Data Batch systems: –Test data may be inappropriate Online systems –Test data is useful 53

54. Suitability of Generalized Audit Software Best suited for analytical review, tests of detail, or dual- purpose tests, for example: 54

55. Problem 11-1, Page 472 Cash Receipts: Control Objectives and Control Examples Required: Prepare a table similar to Exhibit 11-4 on internal control for cash receipts. 55 GeneralSpecific Validity1 Completeness2 Authorization3 Accuracy4. Classification5 Accounting6 Proper period7

56. Problem 2 The following are auditor judgments and audit sampling results for six populations. Assume large population sizes. 123456 EPER (in percentage) 203118 TER (in percentage) 63852015 ARACR (in percentage) 55105 Actual sample size 100 601002060 Actual number of exceptions in the sample 201418 REQUIRED a.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. b.Calculate SER and CUER for each population. c.For which of the six populations should the sample results be considered unacceptable? What options are available to the auditor? d.Why is analysis of the exceptions necessary even when the populations are considered acceptable? 56

57. EXPECTED POPULATION DEVIATION RATE (IN PERCENTAGE) TOLERABLE DEVIATION RATE (IN PERCENTAGE) 23456789101520 5 PERCENT RISK OF OVER RELIANCE (ARACR) 0.0014999745949423632291914 0.252361571179378665851463022 0.50. 1571179378665851463022 0.75. 2081179378665851463022 1.00.. 1569378665851463022 1.25.. 15612478665851463022 1.50.. 192124103665851463022 1.75.. 227153103887751463022 2.00... 181127887768463022 2.25... 208127887768613022 2.50.... 1501097768613022 2.75.... 1731099568613022 3.00.... 1951299584613022 3.25..... 14811284613022 3.50..... 16711284764022 3.75..... 185129100764022 4.00...... 146100894022 5.00....... 1581164030 6.00........ 1795030 7.00......... 6837 57

58. 23456789101520 10 PERCENT RISK OF OVER RELIANCE (ARACR) 0.0011476574538322825221511 0.25194129967764554842382518 0.50194129967764554842382518 0.75265129967764554842382518 1.00. 176967764554842382518 1.25. 2211327764554842382518 1.50.. 13210564554842382518 1.75.. 16610588554842382518 2.00.. 19813288754842382518 2.25... 13288756542382518 2.50... 158110756558382518 2.75... 209132946558522518 3.00.... 132946558522518 3.25.... 1531138258522518 3.50.... 1941138273522518 3.75..... 1319873522518 4.00..... 1499873652518 4.50..... 21813087653418 5.00...... 160115783418 5.50....... 1421033418 6.00....... 1821164525 7.00........ 1995225 7.50......... 5225 8.00......... 6025 8.50......... 6832 EPDR 58

59. SAMPLE SIZE ACTUAL NUMBER OF DEVIATIONS FOUND 012345678910 5 PERCENT RISK OF OVER RELIANCE 2511.317.6......... 309.514.919.5........ 358.212.916.9........ 407.211.314.918.3....... 456.410.113.316.319.2...... 505.89.112.114.817.419.9..... 555.38.311.013.515.918.1..... 604.97.710.112.414.616.718.8.... 654.57.19.411.513.515.517.419.3... 704.26.68.710.712.614.416.218.019.7.. 753.96.28.210.011.813.515.216.918.420.0. 803.75.87.79.411.112.714.315.817.318.8. 903.35.26.88.49.911.312.714.115.516.818.1 1003.04.76.27.68.910.211.512.714.015.216.4 1252.43.74.96.17.28.29.310.311.312.213.2 1502.03.14.15.16.06.97.78.69.410.211.0 2001.52.33.13.84.55.25.86.57.17.78.3 59

60. Sample sizeACTUAL NUMBER OF DEVIATIONS FOUND 012345678910 10 PERCENT RISK OF OVER RELIANCE 2010.918.1......... 258.814.719.9........ 307.412.416.8........ 356.410.714.518.1....... 405.69.412.815.919.0...... 455.08.411.414.217.019.6..... 504.57.610.312.915.417.8..... 554.16.99.411.714.016.218.4.... 603.86.38.610.812.914.916.918.8... 703.25.47.49.311.112.814.616.217.919.5. 802.84.86.58.39.711.312.814.315.717.218.6 902.54.35.87.38.710.111.412.714.015.316.6 1002.33.85.26.67.89.110.311.512.713.815.0 1201.93.24.45.56.67.68.69.610.611.612.5 1601.42.43.34.14.95.76.57.28.08.79.5 2001.11.92.63.34.04.65.25.86.47.07.6 60

61. 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.) 61