Chapter 11 Auditing the Revenue Process

To which part of the revenue cycle does the assertion of valuation at historical cost and at net realizable value pertain? Account balances Transaction classes Disclosures All of these answer choices are correct

Account balances

For companies that sell goods or services on account, if revenue is recognized prematurely, what would be overstated: sales or accounts receivable? Sales, not accounts receivable Both sales and accounts receivable Neither sales nor accounts receivable Accounts receivable, not sales

Both sales and accounts receivable

Which assertion do auditors test when they trace a sample of sales, cash receipts, and sales adjustment transactions to their recording in the accounting records? Classification Completeness Cutoff Accuracy

Completeness Trace Revenue Transactions To test the completeness assertion, the auditor should trace a sample of sales, cash receipts, and sales adjustment transactions to their recording in the accounting records. For sales, the auditor should start with a sample of shipping documents (see Illustration 11.7) and trace transactions to the sales journal. For cash receipts, the auditor would sample items from the prelist of cash (see Illustration 11.9) and trace them forward to the cash receipts journal. For sales returns, the auditor would normally start with the sale returns authorization and trace forward to the receiving report and the entry in accounting records. The completeness of sales returns may be a particular concern if management has incentives to overstate revenues, and internal controls over sales returns are weak.

Which of the following involves direct written communication between the client's customers and the auditor? Bank confirmations Performing cutoff tests for sales and sales returns Trace revenue transactions Confirmation of accounts receivable

Confirmation of accounts receivable

As a control for cash receipts, which assertion is addressed when the computer starts with the population of daily cash receipts recorded in the daily remittance report (or cash receipts journal) and develops a one for one match with the underlying bank remittance report Completeness Occurrence Classification Accuracy

Occurrence Occurrence of cash receipts. The software application starts with the population of daily cash receipts recorded in the daily remittance report (daily cash receipts journal) and develops a one-for-one match with the bank remittance report (or prelist of cash received). An exception report is generated daily of any recorded cash receipts not supported by the bank remittance report.

When performing an audit, a CPA notes that bad-debt expense is unusually high relative to similar firms in the industry. The CPA should recommend which of the following controls? Use approved price lists for customer billing. Send monthly statements of account to customers with outstanding balances. Reconcile accounts receivable in the general ledger with the subsidiary ledger. Require credit checks on all new customers.

Require credit checks on all new customers.

When rights of return exist, or are likely to be accepted, _______. a company should consult with other firms in the industry with respect to best practices a reasonable estimate of refunds should be made when revenue is recognized the firm should simply expense them as incurred should restrict cash to cover any potential right of return or warranty claim

a reasonable estimate of refunds should be made when revenue is recognized

Many clients build in redundant controls such that if one control does not detect a misstatement, ________. another control will detect the problem no other control will find the same misstatement the control should immediately be eliminated an exception report is generated

another control will detect the problem

Good internal controls over the write-off of uncollectible accounts ________. are typically expensive and cumbersome to implement are less important if accounts receivable are outsourced are important to prevent write-offs from being used to conceal fraud in processing cash receipts are optional if the company is smaller in size

are important to prevent write-offs from being used to conceal fraud in processing cash receipts Strong internal controls over the write-off of uncollectible accounts are important to prevent write-offs from being used to conceal fraud in processing cash receipts. For example, an employee might misappropriate cash received from a customer and cover up the fraud by writing off the customer's account against the allowance for uncollectible accounts. Strong internal controls include: All write-offs of uncollectible accounts should be authorized by an appropriate level of management and supported by documentation, such as correspondence with the customer or collection agencies. Journal entries for write-offs should be reviewed by management to ensure the appropriateness of the transaction.

As an important control for the occurrence assertion related to sales, the computer starts with the population of daily sales invoices and develops a one for one match with underlying shipping documents to ensure that each sales invoice is supported by a ________. sales invoice sales order packing slip bill of lading

bill of lading

It is particularly important in growth companies for auditors to monitor the entity's collection period because any growth in sales is usually accompanied by ________. increase in the market share for the client's product increase in premium gross margins decrease in the client's collection period growth in accounts receivables that consume operating cash

growth in accounts receivables that consume operating cash

Recognizing revenues without shipping would lead to ________ gross margins and _______ accounts receivable turnover in days. decreased; low decreased; high increased; high increased; low

increased; low

An example of a factor that provides the incentive for management to misstate revenue cycle assertions would be ________. strong support from top management of an ethical culture pressures to accurately report revenues to achieve revenue or profitability targets that were achieved realistic sales targets within the firm pressures to overstate revenues to achieve revenue or profitability targets that were not achieved

pressures to overstate revenues to achieve revenue or profitability targets that were not achieved Factors that incentivize management to misstate revenue process assertions and commit fraudulent financial reporting include: Pressures to overstate revenues to achieve revenue or profitability targets that were not achieved in reality owing to such factors as global, national, or regional economic conditions; the impact of technological developments on the entity's competitiveness; or poor management. Pressures to overstate cash and gross receivables or understate the allowance for doubtful accounts in order to report a higher level of working capital in order to meet debt covenants.

If the auditor's expectations regarding effective controls are not confirmed, ________. the auditor will need to evaluate the significance of the weaknesses noted and simply document this the auditor should proceed with testing of controls the auditor will need to evaluate the significance of the weaknesses noted and determine if the client has a compensating control in place that the auditor might rely on the auditor should withdraw from the engagement

the auditor will need to evaluate the significance of the weaknesses noted and determine if the client has a compensating control in place that the auditor might rely on The Risk of Material Misstatement and Audit Strategy Once the auditor has tested internal controls, the auditor will determine whether the auditor's expectations regarding the effectiveness of internal controls are confirmed. Tests of controls are performed when the auditor expects that internal controls are effective. If the auditor's expectations regarding effective controls are not confirmed, the auditor will need to evaluate the significance of the deficiencies noted and determine if the client has a compensating control in place that the auditor might rely on. If no compensating control exists, the auditor will need to revise the audit strategy as control risk is now higher than initially planned, determine if fraud risk is increased as a result of the internal control deficiency, and determine how to revise planned substantive tests for the revenue process. The auditor may need to change the timing of planned substantive tests related to an assertion from interim testing to testing year-end balances. The auditor may also have to consider increasing sample sizes when sampling is involved. If internal controls related to an assertion are ineffective, the auditor will need to communicate significant deficiencies or material weaknesses to management and to those charged with governance of the entity.

An analytical procedure related to substantive testing of revenue would be ________. to check revenue and the related accounts payable accounts on a sample basis ensuring that all efficiency audits conducted by the internal audit function are properly planned to analyze ratio results relative to expectations based on prior years developing an understanding of the client's system of internal control

to analyze ratio results relative to expectations based on prior years