Chapter 12

Confirmation Decisions (Substantive tests of details for accounts receivable: external confirmations)

Type of Confirmation (2 types): - Positive (accounts receivable) confirmation: 1. Positive confirmation, 2. Blank confirmation form - Negative confirmation - Primary factors affecting the confirmation decision: materiality of total AR, number and size of individual accounts, control risk, inherent risk, the effectiveness of confirmations as audit evidence, and the availability of other audit evidence. Timing: - most reliable - closest to balance sheet date; permits auditor to test AR without inferences about transactions between confirmation date and b/s date - but convenient to confirm the accounts at an interim date (prior to year-end, aka b/s date) for timely audit completion; necessary to test transactions occurring between confirmation date and the b/s date (examine internal documents: duplicate sales invoices, shipping documents, evidence of cash receipts; internal control testing; analytical procedures of intervening period); nature of testing depends upon length of time between the dates and quality of internal controls. Sample Size: consider performance materiality, inherent risk, RMM (relative size, number of accounts, prior year results, expected misstatements), assessed control risk, detection risk (substantive tests results), type of confirmation (negative - larger sample size) Sample Selection of the Items for Testing: consider size and length of time outstanding; select all accounts above a certain dollar amount and a statistical sample (MUS) from the remainder Refusal to Permit Confirmation: CAS 505 - corroborate management's statements and conduct alternative analytical procedures; if account under dispute, examine correspondence with client and consider collectibility, whether management reasons are reasonable, and implications to other assessed risks Maintaining Control: of items selected for confirmation until returned from debtor; close supervision if client helps with preparing confirmations; include PA firm's return address to make sure undelivered mail is received there; self-addressed return envelopes must be addressed for PA firm office; mail confirmation outside client's office; all steps necessary to ensure independent communication Follow-Up on Nonresponses: send second or third positive confirmation request; if still no confirmation return: (1) Alternatives procedures (2) treat as error to be projected from sample to population to assess its materiality Subsequent Cash Receipts: remittance advices, entries in the cash receipts records, subsequent credits in the supporting records; highly useful alternative procedure because customer would not make a payment unless receivable exists; but does not establish obligation on confirmation date; care should be taken to match each unpaid sales transaction with them as a test for disputes or disagreements over individual outstanding invoices, and for matching to the correct period. Duplicate-sales Invoices: useful in verifying actual issuance of sales invoice and actual billing date Shipping Documents: test of cutoff (allocation assertion) Correspondence With the Client: can be used to disclose disputed and questionable receivables not uncovered by other means - extent and nature depend upon materiality of nonresponses, types of misstatements discovered in the confirmed responses, subsequent cash receipts from the nonresponses, and auditor's conclusions about internal control - desirable to account for all unconfirmed balances with alternative procedures even if the amounts are small, as a means of properly generalizing from the sample to the population. Analysis of Differences - timing difference Drawing conclusions: - re-evaluate internal control; if significant number of misstatements inconsistent with original assessed level of control risk, revise it and consider effect of revision on audit - generalize from the sample to the entire AR population: conclusion can be reached by using statistical sampling techniques or a nonstatistical basis.

Fraud Schemes (Identify significant risks and assess risk of material misstatement - Identify and Assess Fraud Risk)

- Fictitious revenues or sham sales (occurrence assertion): false sales, inventory records, shipping documents - Premature revenue recognition (occurrence and cutoff assertions): sales involving unresolved contingencies (customer acceptance, right of return, etc.) - Round-tripping or recording loans as sales (occurrence assertion): recording sales by shipping goods to alleged customers and then providing funds to pay back the company - Improper cutoff of sales (cutoff assertion): Subsequent period sales recorded as current period sales. - Improper recording of sales from "bill-and-holds" that do not meet criteria for revenue recognition (occurrence and (possibly) cutoff assertions): without customers' request or a legitimate business reason - Side arrangements that change the original terms of sale (consignment arrangement or generous right of return) or not meeting requirements for recording revenue (occurrence assertion) - Manipulation of adjustments and estimates - Returns and allowances unrecorded or understated (completeness assertion for returns and allowances, valuation and/or existence for AR); or bad debts understated (valuation assertion for AR) Lapping of accounts receivable

Identify and Assess Fraud Risk (Identify significant risks and assess risk of material misstatement)

- management compensation (bonuses or stock options) being tied to certain earnings targets - financial analysts and other market participants place increasing emphasis on revenue growth pressures management to overstate revenue - client has transactions that appear overly complex with no apparent business rationale: emphasis on particular accounting treatment than economics of the transaction; nonconsolidated related party transactions not reviewed or approved; involve previously unidentified related parties that do not have the substance or financial strength to support the transaction Fraud Schemes - Lapping of accounts receivable

Identify Significant Risks (Identify significant risks and assess risk of material misstatement)

- revenue recognition: affects auditors' assessment of inherent risk for existence of accounts receivable; revenue cutoff, and sales returns and allowances cutoff. - valuation of accounts receivable Table 12-2: Major Risks of Error or Fraud in the Revenue Cycle Preliminary Analytical Review

Processing Customer Orders (Business functions in the sales and collection cycle)

A customer's request (offer to buy goods under specified terms) initiates the entire cycle - receipt of it creates a sales order. retail environment: absent because point of sale Customer Order: request for merchandise; telephone, letter, printed form, salespeople, electronic submission Sales order: document for communicating description, quantity, etc. for goods ordered to indicate credit approval and authorization for shipment Granting Credit: before shipping, properly authorized person/computer must approve credit to the customer for sales on account; weak practice - bad debts Shipping Goods: first point in the cycle the company gives up assets; shipping document used for proper billing and updating perpetual inventory records Shipping Document: initiates shipment of goods, indicating description, quantity, etc; company sends original to customer and retains 1+ copies; signal to bill customer - bill of lading: written contract between carrier and sell; number of boxes, weight; transmitted electronically once shipped; bar codes, handheld computers to record removal of inventory an update perpetual inventory records

Determine Extent of Tests of Controls (Identify key controls and assess effectiveness of controls)

After identifying key internal controls and weaknesses and assessing risks, but before designing tests of controls Planned reliance on controls depends on: - cost-benefit of testing controls - whether substantive tests will be reduced sufficiently to justify the cost of performing tests of controls - assertions where substantive testing is not sufficient and tests of controls are required to reduce RMM to a sufficient level (e.g., necessary to test relevant controls if highly automated processing of sales transactions)

Precision of Expectation (Design and perform substantive analytical procedures)

Analytical procedures used for planning (comparisons, ratios, trend analysis): not precise enough to rely on alone as a substantive test. Substantive Analytical Procedures: more precise expectations from disaggregating the data to effectively evaluate the relationships between variables and further investigate potential misstatements Table 12-7: Examples of Substantive Analytical Procedures for Revenue - In comparison to Table 12-3 Analytical Procedures for Planning the Revenue Cycle: further disaggregation based upon customer or product line - other considerations: by region, store, whatever is relevant to client

Assumptions Underlying Confirmations (Substantive tests of details for accounts receivable: external confirmations)

Auditor makes two assumptions when accepting an external confirmation from a third party as evidence: 1. person returning the confirmation is independent of the company being audited and will provide an unbiased response; if invalid, no value 2. person returning the confirmation has knowledge of the account and the intent of the confirmation; has checked records to ensure confirmation in agreement; not always valid if doubts about confirmation quality: apply professional skepticism and perform additional audit procedures.

Determine audit approach (strategy) for revenue cycle

Design and Perform Tests of Controls for the Revenue Cycle Evaluate Results of Tests of Controls Table 12-4: Comparison of Audit Strategies - based upon the description from the key audit issues in Vodafone's 2014 auditor report and the 2012 City of Toronto Audit Plan - revenue recognition is a significant risk for both organizations; however, the reasons are quite different.

The Audit Process for the Revenue Cycle

Figure 12-2: Summary of ___ Specific Considerations Materiality: Revenue and/or accounts receivable are typically the most material accounts in the financial statements. Significant Risks: - Standards require the auditor to assume a high fraud risk for revenue recognition (occurrence and cut-off assertions). - High-risk assertions are typically occurrence/existence for revenue/accounts receivable, cut-off of revenue, sales returns and allowance, and valuation of accounts receivable. - Multi-element contracts, subscription/usage-based billing, and royalty/licensing models typically increase the risk of revenue recognition. Key Controls: Auditors are especially concerned about the following: controls that prevent and detect fraud, controls over occurrence and cut-off of revenue, controls related to cash receipts, and controls related to allowance for doubtful accounts. Cycle Audit planning: Understand the entity and its environment - Identify significant risks for revenue cycle Determine materiality (overall, performance, and specific) Assess Risk of Material Misstatement: at the assertion level - Identify significant risks - identify relevant controls to mitigate those risks assess the design and implementation of identified relevant controls Develop risk response: Determine audit approach (strategy) for revenue cycle Develop response at assertion level - Design tests of controls (if plan to rely upon controls) - Design substantive analytical procedures - Design substantive tests of details (mandatory if material) - Design fraud-related substantive procedures (required unless revenue recognition is not a significant risk) Perform risk responses: Gather audit evidence - Perform tests of controls - Perform substantive analytical procedures - Perform substantive tests of details (transactions and balances) Evaluate results and adjust audit approach (strategy) if necessary

Identify key controls and assess effectiveness of controls

Figure 12-5: Methodology for Designing Tests of Controls for Sales Transactions - same process for each class of transactions, balances, and disclosures - focusing on sales transactions and cash receipts (this chapter) Understand Internal Control Revenue Assess Planned Control Risk Determine Extent of Tests of Controls

Substantive tests of details for revenue

Figure 12-7: Substantive Tests of Detail for Revenue for an automotive dealership - tests primarily involve inspecting client documentation - tests tend to focus on occurrence and valuation, although all assertions are tested - Quantity: Occurrence (test for overstatement, vouch from sample sales journal to supporting documents); Completeness (test for understatement, trace from sample supporting documents to sales journal) - Price: Valuation/Accuracy; verify sale price used to calculate total sales revenue reflected on the financial statements was in fact $ I0 000 and that it was recorded in the sales journal accurately; tracing or vouching does not matter Direction of Tests for Completeness and Occurrence Revenue: Occurrence Assertion Revenue: Completeness Assertion Revenue: Accuracy Assertion Revenue: Cutoff Assertion Revenue: Classification Assertion

Direction of Tests for Completeness and Occurrence (Substantive tests of details for revenue)

Figure 12-8: ___ for Sales Occurrence: - vouching from the journals back to supporting documents (verifying the journal) - purpose is to test for nonexistent transactions Completeness: - tracing from source shipping documents to the journals - purpose of the test is for omitted transactions Not relevant when testing for the other four transaction-related audit objectives: - accuracy of sales transactions can be tested by tracing from a duplicate sales invoice to a shipping document, or vice versa.

Substantive tests for accounts receivable

Figure 12-9: Substantive Tests of Details for Accounts Receivable Existence: key risk associated with assets is overstatement - concern with rights and obligations under certain circumstances: e.g., company might "factor" (sell) its AR; must verify rights Valuation: receivable exists does not guarantee collectibility of full amount; gain comfort regarding the amount company reasonably expects to collect - key source of information: Aged accounts receivable trial balance - risk of incompleteness is low; management unlikely to understate AR; not a concern in most situations

Positive (accounts receivable) confirmation (Substantive tests of details for accounts receivable: external confirmations - Type of Confirmation)

First type of ___ a letter, addressed to the debtor, requesting that the recipient indicate directly on the letter whether the stated account balance is correct or incorrect and, if incorrect, by what amount (recipient owes client) Variation: - Listing of outstanding invoices making up the balance: useful when debtor uses voucher system for AP - Or copy of the client customer statement attached by the auditor to the confirmation request: easier for debtor to respond client has unusual or complex sales agreements: request confirmation of terms of sale (bill-and-hold transactions, extended payment terms) Compare to Second type (Blank confirmation form): less reliable but higher response rates (both types) more reliable than negative confirmation: can perform follow-up procedures if response not received

Design and Perform Tests of Controls for the Revenue Cycle (Determine audit approach (strategy) for revenue cycle)

For each key control that the auditor plans to reduce control risk (aka rely upon), the auditor must design one or more tests of controls to verify its effectiveness. Designing Tests of Controls for Sales Transactions - Table 12-5: P 410 - Tests of controls for separation of duties are usually restricted to the auditor's observations of activities and discussions with personnel - Several of the tests of controls in Table 12-5 can be performed using test data. - continuity of sales invoices (completeness and occurrence): gap test - scanning the entire transaction history file and identifying any gaps (also duplicates) in the numeric sequence Designing Tests of Controls for Cash Receipts - Table 12-6: P413 - most at-risk assertion is completeness - has all cash been recorded in the accounts and not been stolen? - responsibility to identify control weaknesses that increase likelihood of fraud - the first control tests more general and supplemented with the substantive tests of transactions (dual test) Designing Other Tests of Controls for the Revenue Cycle - Figure 12-6: tests of controls related to sales transactions and cash receipts will not provide evidence on the effectiveness of controls related to the two balance-related assertions (rights and obligations, and valuation) or the presentation and disclosure assertions - key controls vary according to the client's processes and business model but methodology for designing tests of controls is the same as for sales transactions and cash receipts. Controls Related to Accuracy/ Valuation and Rights and Obligations

Identify significant risks and assess risk of material misstatement

Identify Significant Risks Identify and Assess Fraud Risk Assess Inherent Risk for Revenue Criteria for Revenue Recognition Assess Inherent Risk for Accounts Receivable

Design and perform fraud-related substantive procedures

If specific fraud risk factors are present Table 12-4: Comparison of Audit Strategies: addresses fraud risk for the relevant control weakness Other fraud-related procedures: - Interview client personnel regarding knowledge of unusual sales transactions. - To test for fictitious customers, use GAS to identify PO box addresses, duplicated addresses, or addresses that are the same as those of employees. - To test for unusual or unexpected revenue relationships or transactions, use substantive analytical procedures (compare credit memo and write-off activity to prior periods; compare the number of weeks of inventory in distribution channels to prior years) and computer-assisted audit techniques - To test for occurrence of revenue, confirm with customers certain relevant contract terms (acceptance criteria, delivery and payment terms, the absence of future or continuing vendor obligations, the right to return the product, guaranteed resale amounts, cancellation or refund provisions) and the absence of side agreements. - If concerned about cutoff, consider being physically present at one or more locations at period-end to observe goods being shipped or being readied for shipment (or returns awaiting processing). - Review accounting estimates (such as allowance for doubtful accounts or returns allowance) for biases and evaluate whether they represent a RMM due to fraud. If high fraud risk for theft of cash: audit procedure - Proof of cash receipts

Design and perform substantive analytical procedures

In contrast to preliminary analytical procedures, ___ likely use disaggregated data (sales by month, product based on data for the full year under audit) Reminder: three types of substantive tests are analytical procedures, test of details of transactions, tests of details of balances For ___ to provide the necessary assurance, the auditor should take into account: 1. Nature of Assertion 2. Plausibility and Predictability (of the relationship) 3. Availability of Reliable Data (to develop expectations) 4. Precision of Expectation 5. Threshold for Investigation

Assess Inherent Risk for Revenue (Identify significant risks and assess risk of material misstatement)

In order to be able to assess whether the client is recognizing revenue appropriately, the auditor must be knowledgeable about the client's business model, the industry, and the client's different types of sales or service contracts high revenue risk companies are often companies that use multi-element contracts, subscription/usage-based billings, and royalty/licensing models - billings and revenue recognition are managed separately. For complex revenue transactions - inquire marketing and sales personnel and/or in-house legal counsel of unusual terms or conditions. - read sales contracts (for terms and responsibilities of the buyer and seller) - staffing: engagement team with more experienced auditors, specialists, other knowledgeable people within the firm not involved in the engagement

Assess Inherent Risk for Accounts Receivable (Identify significant risks and assess risk of material misstatement)

Primary assertions at risk for AR: - Existence: directly related to occurrence of sales and returns - Valuation: high risk because of judgment involved in evaluating NRV (specifically allowance for doubtful accounts) and if collectibility is questionable (e.g., liberal credit policies to increase sales) Another assertion at risk for AR: Rights and obligations - when companies factor (specialized financial intermediary that purchases AR at a discount and charges interest plus commission) their AR to meet CF needs - discounted from face amount to take into account likelihood of uncollectibility - sold without recourse: factor bears credit risk - sold with recourse: credit risk remains with client (company) inherent risk factors affecting AR: - LT receivables classified as current (LT maintenance contracts) - receivables pledged as collateral, assigned to someone else, factored, or sold (must disclose restrictions) - payment not required until purchaser sells to end customers - collection of receivable contingent upon future events (certain royalty arrangements) - sales made to customers with high credit risk

Presentation and Disclosure Assertions: Revenue and Accounts Receivable (Substantive tests of details for accounts receivable: external confirmations)

Procedures to determine that information about the revenue cycle is fairly presented and disclosed in the financial statements: - Evaluate whether the presentation of revenue on a gross basis (as a principal) versus net (as an agent) is in conformity with the applicable financial reporting framework. - Evaluate the adequacy and understandability of the presentation of the revenue recognition policy. - Evaluate the understandability and completeness of the footnotes for AR; required information: pledging, discounting, factoring, assignment of AR, amounts due from related parties. - Determine that trade AR are segregated from related-party AR and that different types of material transactions are clearly listed as separate line items to facilitate the classification and understandability objectives. - Read management's discussion and analysis (MD&A) to determine whether there are any inconsistencies with the financial statements or other information that the auditor has collected in the course of the audit.

Blank confirmation form (Substantive tests of details for accounts receivable: external confirmations - Type of Confirmation)

Second type of Positive (accounts receivable) confirmation a letter, addressed to the debtor, requesting the recipient to fill in the amount of the accounts receivable balance Compared to First type (positive confirmation - includes the account balance): more reliable, but lower response rates (both types) more reliable than negative confirmation: can perform follow-up procedures if response not received

Revenue: Accuracy Assertion (Substantive tests of details for revenue)

Shipping the correct amount of goods ordered, using the correct price when billing for the amount of goods shipped, and ___ly recording the amount billed in the accounting records. Customer master file must include all sales transactions: ___ of records affects the client's ability to collect outstanding receivables Sales transactions must be correctly totalled and posted to the general ledger: for financial statements to be correct. Computer-based systems relied upon to perform mathematical calculations: - use test data to ensure calculations are properly performed - use generalized audit software to reperform the calculations

Criteria for Revenue Recognition (Identify significant risks and assess risk of material misstatement)

Standard (new IFRS standard, IFRS 15, Revenue from Contracts with Customers; effective Jan 2018): revenue is recognized when there is a transfer of control five-step model to determine when to recognize revenue (occurrence), and at what amount (accuracy/valuation): 1. Identify the Contract & 2. Identify the Performance Obligation(s) contract: written, oral, or implied by the entity's normal business practices (if enforceable rights and obligations) A contract must meet the following criteria: - collection of the consideration is probable - has commercial substance - Risks to goods or services and payment terms can be identified - is approved and the parties are committed to their obligations multi-element contracts: identify each distinct promise to deliver a good or service and account for them separately 3. Determine the transfer price & 4. Allocate the Transaction Price to the performance obligation transaction price: the amount of consideration the entity expects to be entitled, factoring in the effect of discounts, credits, price concessions, returns, and performance bonuses/penalties; challenging to determine if uncertainty about future events allocate transaction price to each performance obligation; if no observable price: - estimate the price customers are willing to pay - forecast expected costs, gross margins - increases inherent risk: auditor faces challenges in obtaining evidence and assessing the reasonableness of the estimates. 5. Recognize Revenue When (or as) the Entity Satisfies Performance-Obligation Over time, in a manner that depicts the entity's performance - when: 1. customer simultaneously receives and consumes benefits as entity performs (e.g., routine or recurring services). 2. entity's performance creates or enhances an asset the customer controls (e.g., building an asset on a customer's site) 3. entity's performance does not create an asset with an alternative use and has an enforcement right of payment for performance completed to date (e.g., building a specialized asset only the customer can use). At a point in time, when control of goods and services is transferred to the customer - indicators: (1) a present obligation to pay, (2) physical possession, (3) legal title, (4) risks and rewards of ownership, and/or (5) accepted the asset. Private companies that follow ASPE 3400 may choose IFRS 15: change in accounting policy increases inherent risk; auditor needs to assess controls relating to change and the accounting staff's knowledge ASPE: no clear guidance, many had referred to US GAAP

Controls Related to Accuracy/ Valuation and Rights and Obligations (Determine audit approach (strategy) for revenue cycle - Design and Perform Tests of Controls for the Revenue Cycle)

Straightforward sales transactions: key control for accuracy /valuation authorized price lists, right and obligations or ownership not an issue Complex transactions: Revenue recognition depends on terms of the contract: assess controls that ensure the capture and analysis of the terms and conditions, changes, payment terms that affect timing and amount of revenue to be recognized. Multi-element contracts: review controls that ensure timely identification of all elements of the arrangement Common deficiencies: - related to entity-level and general controls - increase possibility of material misstatements - accounting expertise, supervision, and IT systems Occurrence: uncover theft of cash from the collection of AR that was covered up by a fictitious sales return or allowance. Completeness: financial reporting risk - material returns after year-end and sales allowances (aka volume rebates) if client achieves a particular sales volume Valuation: NRV for AR; high inherent risk because of considerable judgement Controls to reduce likelihood of uncollectible accounts: - Credit approval by an appropriate person - Preparation of a periodic aged AR trial balance for review and follow up by appropriate management personnel - Policy of writing off uncollectible amounts when they are no longer likely to be collected Write offs: - if weak controls, can be used to conceal theft of cash - control: proper authorization by designated level of management after investigation customer's reason - control test: examine approvals - substantive tests of sample: examine correspondence in client's files; obtain credit reports (detailed summary of an individual's credit history)

Processing and Recording Sales Returns and Allowances (Business functions in the sales and collection cycle)

The company prepares a receiving report for returned goods and returns them to storage. recorded in the sales returns and allowances transaction file and the accounts receivable master file Credit Memo: indicates a reduction in the amount due from a customer; same general form as a sales invoice but supports reductions rather than increases Sales Returns and Allowances Journal: same function as and can record in sales journal rather than seperate

Understand Internal Control - Revenue (Identify key controls and assess effectiveness of controls)

Understand entity-level and general controls pervasive and affect multiple transaction cycles, and the control activities for each particular cycle. assessing control for a particular cycle: focus on transaction controls at the account and assertion levels conduct interviews, review internal audit working papers, prepare flowcharts (or use client's), prepare internal control questionnaires and control matrixes, and perform walk-through tests of sales.

Assess Planned Control Risk (Identify key controls and assess effectiveness of controls)

Using information obtained from understanding control 1. Identify the key controls and deficiencies with knowledge of the following key control activities: - separation of duties - proper authorization - Adequate documents and records - Sequentially numbered documents - Mailing of statements - Independent verification processes 2. Assess control risk for the transaction assertions Figure 12-6: Relationship Between Transaction-Related, Balance-Related, and Presentation and Disclosure-Related Audit Objectives for the Revenue Cycle Sales: CR sales, DR AR & discounts Cash receipt: DR cash, CR AR The occurrence transaction-related audit objective affects the completeness balance-related audit objective: - recording of a valid cash receipt help ensure all AR are recorded (complete) - posting a duplicated or fictitious (did not actually occur) cash receipt against a valid AR means a receivable that is still outstanding is no longer included in the records (violates completeness)

Threshold for Investigation (Design and perform substantive analytical procedures)

When substantive analytical procedures uncover unusual fluctuations, make additional inquires of management Critically evaluate whether management explanation of the unusual fluctuation is adequate and supported by corroborating evidence ___: should be based upon performance materiality; may set tolerable misstatement below it depending upon risk Revenue: - a significant risk - substantive analytical procedures alone are not sufficient - substantive tests of details are always required in the revenue cycle.

Revenue: Cutoff Assertion (Substantive tests of details for revenue)

___ tests of sales transactions before and after year-end provides assurance of both the completeness and occurrence computer systems require shipping date to match invoice date or be within a specified time adequet internal controls: to verify shipments were invoiced in the correct accounting period, obtain shipping document number for the last shipment made at the end of the period and compare to current and subsequent period recorded sales For many companies, sales returns and allowances are recorded in the accounting period in which they occur, under the assumption of approximately equal, offsetting errors at the beginning and end of each accounting period. - if amounts are significant: necessary to examine supporting documentation for a sample recorded several weeks subsequent to closing date to determine the original sale date - If amounts recorded in subsequent period are significantly different from the unrecorded at beginning of period under audit: adjustment must be considered - If internal controls evaluated as ineffective: larger sample needed to verify cutoff May need to review contracts for terms indicating postponement of recording of sales (e.g., extended periods of right of return), additional performance obligations, or collections based upon a future event.

Skimming (Business functions in the sales and collection cycle - Processing and Recording Cash Receipts)

a common form of cash misappropriation in which the employees steal incoming funds prior to their being recorded in the accounting records term comes from money is taken off the top, the way cream is ___ from milk risk reduced when cash handling is separated from deposit and recording in the accounts, and when all cash must be deposited in the bank and recorded on a timely basis.

Lapping of accounts receivable (Identify significant risks and assess risk of material misstatement - Identify and Assess Fraud Risk)

a common fraud scheme the postponement of entries for the collection of receivables to conceal an existing cash shortage; a common type of defalcation. most likely to occur if lack of segregation of duties person who handles cash and accounting records takes cash, defers recording cash receipts from one customer, and covers the shortages with receipts of another customer; must continue to cover the shortage

Negative confirmation (Substantive tests of details for accounts receivable: external confirmations - Type of Confirmation)

a letter, addressed to the debtor, requesting a response only if the recipient disagrees with the amount of the stated account balance. gummed label (sticker label) attached to debtor's monthly statement or printed directly onto the customer statements. less reliable than positive confirmation: failure to reply not regarded as a correct response since debtor may have ignored the confirmation request. provide some evidence of existence: if the address does not exist, the envelope will be returned to the auditor's offices. CAS 505: should be used only when risks of material misstatement are low and when the following are true: - items to be confirmed are homogenous and comprise small account balances - no or few exceptions are likely - expectation they will be read and considered when used, auditor places more weight on internal control (as evidence of fairness and AR) than on confirmations: - municipalities, retail stores, banks, and other industries in which the receivables are due from the general public

Aged accounts receivable trial balance (Substantive tests for accounts receivable)

a listing of the balances in the accounts receivable master file at a particular date (such as the balance sheet date), broken down according to the amount of time elapsed between the date of sale and the effective date of the report. used to: - Agree the accuracy of the total and agreement between subledger and general ledger, including allocation to correct accounts - Select samples for confirmation - Identify unusual transactions using the auditor's criteria. (balances exceeding credit limits, outstanding transactions over a certain size, extremely old); can be used to help assess the reasonableness of the allowance for doubtful accounts - Evaluate classification of AR by reviewing for material receivables from affiliates, officers, directors, or other related parties - Identify credit balances, should be reclassified as AP if significant Figure 12-10: Aged Accounts Receivable Trial Balance Summary for Hillsburg Hardware Limited

Proof of cash receipts (Design and perform fraud-related substantive procedures)

an audit procedure to test whether all recorded cash receipts have been deposited in the bank account by reconciling the total cash receipts recorded in the cash receipts journal for a given period with the actual deposits made to the bank cannot detect cash receipts that have not been recorded in the journals or time lags in making deposits, but it can help uncover recorded cash receipts that have not been deposited, unrecorded deposits, unrecorded loans, bank loans deposited directly into the bank account, and similar errors or misstatements.

Revenue: Completeness Assertion (Substantive tests of details for revenue)

auditor may not be as concerned - overstatement of revenue is a higher risk than understatement To conduct the tests described in Figure 12-7, auditor must be confident all shipping documents are included in the sample population - by accounting for the numerical sequence of the documents (block testing/sampling)

Substantive tests of details for accounts receivable: external confirmations

can be in multiple forms (paper or electronic); used to satisfy the existence, accuracy, and allocation (cutoff aspect) assertions. Not required, can gain required assurance by other means (review of subsequent payments, examination of documentation supporting the receivable balance) Auditor will send confirmations unless: - AR is immaterial (retail store with primarily cash or credit sales) - ineffective evidence because inadequate or unreliable response rates (hospitals) - combined level of inherent risk and control risk is low, and other substantive evidence can provide sufficient evidence (if client has effective internal controls and low inherent risk for the revenue cycle, can satisfy evidence requirements by tests of controls, substantive tests of transactions, and analytical procedures) Assumptions Underlying Confirmations Confirmation Decisions Accounts Receivable: Valuation Accounts Receivable: Rights and Obligation Presentation and Disclosure Assertions: Revenue and Accounts Receivable Drawing Conclusions

Plausibility and Predictability (Design and perform substantive analytical procedures)

crucial in developing a properly designed substantive analytical procedure: Relationships are less predictable: - in less stable environments - when amounts are determined from complex processes, subjective judgments, or transactions subject to management discretion Relationships are more predictable if based upon established relationships such as: - cash flow based on contract terms (assuming low nonpayment risk) - verifiable rate-volume determination (hotel with a fixed number of rooms and a certain room rate).

Billing Customers and Recording Sales (Business functions in the sales and collection cycle)

dependent on charging customer for quantity shipped at authorized price - freight charges, insurance, and terms of payments. Sales invoice: indicate description, quantity, price, freight charges, insurance, terms, payment due date; prepared by computer Sales Transaction File: computer-generated file that includes all sales transactions processed by the accounting system for a period; customer name, date, amount, account classification(s), salesperson, commission rate, return for allowances (or separate); used for records, listings, reports, sales journal, AR master file, transactions for account balance or division Sales Journal or Listing: listing or report generated from the sales transaction file; identifies whether cash or AR; usually for a month but can cover any period; includes totals of every account number for time period; same transactions here are posted to the GL or master AR file (if on account); can include return for allowances (or separate) Accounts Receivable Master File: - computer file used to record individual sales, cash receipts, sales returns and allowances for each customer and to maintain their account balances, updated from the respective computer transaction files. - total of individual account balances in master file = total balance of accounts receivable in GL. - printout shows by customer, the beginning balance in AR, each sales transaction, sales returns and allowances, cash receipts, and the ending balance. Accounts Receivable Trial Balance: list or report shows amount receivable from each customer at a point in time, prepared directly from AR master file, usually an aged trial balance that includes total balance and number days outstanding, grouped by category of days (<30. 31-60) Monthly Statement: sent electronically or by mail to each customer, indicating beginning balance of AR, amount and date of each sale, cash payments received, credit memos issued, and the ending balance due; a copy of customer's portion of the AR master file.

Accounts Receivable: Rights and Obligation (Substantive tests of details for accounts receivable: external confirmations)

disclose in notes of financial statements the details of receivables sold with or without recourse or pledged as collateral Substantive procedures to identify these types of transactions: - inquire management and review directors' meeting minutes for receivables pledged as collateral, assigned to someone else, factored, or sold at discount - send confirmations to banks, and examine correspondence files to verify details,

Alternatives procedures (Substantive tests of details for accounts receivable: external confirmations - Follow-Up on Nonresponses)

for confirmations, the follow-up of a positive confirmation not returned by the debtor with the use of documentation evidence to determine whether the recorded receivable exists, is collectible, (and was properly stated at the confirmation date)

Timing difference (Substantive tests of details for accounts receivable: external confirmations - Analysis of Differences)

in an accounts receivable confirmation from a debtor, a reported difference that is determined to be a discrepancy in timing between the client's and debtor's records and therefore not a misstatement.

Availability of Reliable Data (Design and perform substantive analytical procedures)

key concern in assessing reliability: - the source of the data - the conditions upon which it was gathered client data: - test design or operating effectiveness of the related controls - perform other procedures to test completeness and accuracy of the data To assess the reliability of client's spreadsheet, auditor checks the accuracy of the formulas and ensures all the necessary data is included

Preliminary Analytical Review (Identify significant risks and assess risk of material misstatement - Identify Significant Risks)

part of audit planning, help to identify significant risks Table 12-3: Analytical Procedures for Planning the Revenue Cycle potential warning signals or symptoms of revenue fraud: - special discount.: Gross margins decreasing while sales increasing - channel stuffing (permitting reseller returns of unsold goods): unusually high returns - bill-and-hold fraud: Unexplained differences in physical inventory counts - backdating agreements, side agreements, or channel stuffing arrangements: Buildup of aged accounts receivable balances - revenue recognized prematurely or in the incorrect period: unusual spike in sales just before the end of the reporting period compare client data to prior periods, industry performance, non-financial data only useful in identifying potential risks of misstatement.

Processing and Recording Cash Receipts (Business functions in the sales and collection cycle)

receiving, depositing, and recording cash (currency and cheques) potential fraud risk is theft - Skimming Remittance Advice: - document mailed to the customer and typically returned to the seller with the cash payment - used as a record of the cash received to permit immediate deposit and to improve control over the custody of assets. Prelisting of Cash Receipts: - a list prepared when cash is received by someone who has no responsibility for recording sales, AR, or cash and has no access to accounting records - used to verify whether cash received was recorded and deposited at the correct amounts and on a timely basis. - lockbox systems and EFT transactions: the bank provides information to the company to prepare the cash receipt entries in the accounting records. Cash Receipts Transaction File: - computer-generated file that includes all cash receipts transactions processed by the accounting system for a period - same type of information as the sales transaction file Cash Receipts Journal or Listing: - listing or report generated from the cash receipts transaction file and includes all transactions for a time period - the same transactions, all relevant information, are included in the accounts receivable master file and general ledger.

Revenue: Classification Assertion (Substantive tests of details for revenue)

seller with primary obligation to customer vs. seller acting as an agent: recorded as gross amount billed to customer vs. net amount retained (amount billed to customer less paid to a supplier) or fees received from principal for selling - issue often arises with internet sales but can be found in other business models - both approaches end up with the same net income - reporting fees as gross amount can represent a material misstatement (because it is misleading - qualitative evaluation) proper ___ is essential for companies using more than one sales classification (e.g., segmented earnings statements) common as part of testing for accuracy: - examine supporting documents to determine the proper ___ of a given transaction and compare with actual account in which it is recorded

Evaluate Results of Tests of Controls (Determine audit approach (strategy) for revenue cycle)

significant effect on the remainder of the audit, especially tests of details of balances part of substantive procedures. Parts of the audit most affected by tests of controls for the revenue cycle: balances in AR, cash, bad-debt expense, and allowance for doubtful accounts. Significant accounts -AR and cash: perform substantive testing on balances regardless of the effectiveness of internal controls if results unsatisfactory: do additional substantive testing for sales, sales returns and allowances, charge-off of uncollectible accounts, and processing of cash receipts. analyze each exception: determine cause and implication on assessed control risk, which may affect the supported detection risk and the substantive procedures - Table 12-5: P 410

Nature of Assertion (Design and perform substantive analytical procedures)

substantive analytical procedures are not effective for all assertions: - more effective than tests of details for completeness of revenue and the reasonableness of the allowance for doubtful accounts - not as effective for testing occurrence/existence (although depends upon the client's revenue model); when performed, other substantive tests of details will supplement this evidence - not always effective for rights and obligations

Accounts Receivable: Valuation (Substantive tests of details for accounts receivable: external confirmations)

substantive tests will assure accuracy of AR but not useful for whether client will collect the outstanding receivables - NRV Figure 12-9: overview of the approach to valuation, or evaluating the reasonableness of the allowance for doubtful accounts (what will not be collected at year-end) Perform combination of the following procedures: - determine which noncurrent accounts on the aged AR trial balance have not been paid subsequent to the b/s date - Compare size and age of unpaid balances with similar information from previous years to evaluate whether increasing or decreasing over time. - Examine credit files, discuss with credit manager, review customer correspondence files; consider past history to determine % of current accounts that need to be allowed for. - Conduct substantive analytical review over time (trend analysis) of bad debts to evaluate quality of AR - Verify accuracy of bad debt expense as a residual, checking validity of individual charges

Revenue: Occurrence Assertion (Substantive tests of details for revenue)

tests explained in Figure 12-7 also provide evidence of the existence and valuation of AR Potential misstatements for designing tests for occurrence: - sales in journals with no shipment - duplicate sales - shipments to nonexistent customers and recorded as sales (fictitious sales) The tests rely upon documentation Paperless system: requires IT specialist and audit software to perform substantive tests complex contractual arrangements: evaluate whether appropriate revenue recognition - multiple deliverables: test values assigned to separate units, test reasonableness of accounting estimates CAS 540: obtain an understanding of how management developed the estimate using a combination of the following approaches: - Review and test the process used - Develop an independent expectation to corroborate reasonableness - Review subsequent events or transactions to corroborate reasonableness

Valuation (Substantive tests of details for accounts receivable: external confirmations - Accounts Receivable: Valuation)

the amount of the outstanding balances in accounts receivable that will ultimately be collected.

Six classes of transactions in the revenue cycle (Revenue cycle)

the categories of transactions for the sales and collection cycle in a typical company: 1. sales (cash and sales on account net of cash discounts taken): CR sales, DR accounts receivable and cash discounts taken 2. cash receipts: DR cash in bank, CR accounts receivable 3. sales returns and allowances: DR sales returns and allowances, CR accounts receivable. 4. charge-off of uncollectible accounts: CR accounts receivable, DR allowance for uncollectible accounts. 5. bad-debt expense: DR bad-debt expense, CR allowance for uncollectible accounts. 6. master file changes: no effect on general ledger accounts; effect is on master files. Figure 12-1: summary of the way accounting information flows through the various accounts in the sales and collection cycle by the use of T-accounts

Revenue cycle

the decisions and processes necessary for the transfer of the ownership of goods and services to customers after they are made available for sale; it begins with a request by a customer and ends with the conversion of material or service into an account receivable, and ultimately into cash. Six classes of transactions in the revenue cycle

Business functions in the sales and collection cycle

the key activities that an organization must complete to execute and record business transactions for sales, cash receipts, sales returns and allowances, charge-off of uncollectible accounts, and bad debts. Table 12-1 Processing Customer Orders Billing Customers and Recording Sales Processing and Recording Cash Receipts Processing and Recording Sales Returns and Allowances

Writing Off Uncollectible Accounts Receivable (Business functions in the sales and collection cycle)

typically occurs after a customer files for bankruptcy or the account is turned over to a collection agency. Controls in this area are very important since it can be used as a way to hide embezzlement of cash. Uncollectible Account Authorization Form: document used internally to indicate authority to write an AR off as uncollectible. Providing for Bad Debts: accounting principles require recording bad debt expense for amount not expected to collect; transaction recorded at the end of each month or quarter

Analysis of Differences (Substantive tests of details for accounts receivable: external confirmations - Analysis of Differences)

when confirmation requests are returned, determine reason for reported differences in many cases, caused by timing difference between the client's and the customer's records must distinguish timing differences (not misstatements of AR) and the exceptions (are misstatements of AR) Most commonly reported types of differences in confirmations: Payment Has Already Been Made: prior to confirmation date, customer made payment but client has not received for recording - investigate possibility of cash receipts cutoff misstatement, lapping, theft of cash Goods Have Not Been Received: client records sale on shipment date but customer records purchase on arrival date; caused by transit - investigate possibility of customers not receiving goods at all or cutoff misstatement on client's records Goods Have Been Returned: client's failure to record credit memo - investigate whether timing differences or improper recording of sales returns and allowances Clerical Errors and Disputed Amounts: error in price charged, damaged goods, improper quantity received, etc. - investigate whether client is in error and amount of error - ask client to reconcile different and to resolve audit disagreements with customer - verify client's conclusions on each significant difference