Audit Chapter 14

What is the role of the shipping document in invoicing customers? What are the most important management assertions related to customer billing?

A shipping document is prepared at the time of shipment indicating the quantity and description of goods ordered. It is used to generate an invoice to the customer. Assuring that all shipments are recorded and billed is important to addressing the completeness assertion, as well as the accuracy of the quantities billed.

List several audit procedures that the auditor can use to determine whether all cash received was recorded.

Audit procedures that the auditor can use to determine whether all cash receipts were recorded are: Discussion with personnel and observation of the separation of duties between handling cash and record keeping. Account for numerical sequence of remittance advices or examine prelisting of cash receipts. Observe immediate endorsement of incoming checks. Examine indication of internal verification of the recording of cash receipts. Observe whether monthly statements are sent to customers. Trace from remittance advices or prelisting to cash receipts journal.

Describe whether the auditor is more concerned about the occurrence or completeness objective related to cash receipts.

Auditors are generally more concerned with the completeness of cash receipts as cash is a target for theft or defalcation. The occurrence of cash can be readily verified using bank statements and other evidence.

BestSellers.com sells fiction and nonfiction books and e-books to customers through the company's Web site. Customers place orders for books via the Web site by providing their name, address, credit card number, and expiration date. What internal controls could they implement to ensure that shipments of books occur only for customers who have the ability to pay for those books? At what point will they be able to record the sale as revenue?

BestSellers.com could integrate its online ordering system with its inventory system so that a book shipment is made only after the customer's credit card company approves the customer's purchase. Because credit card issuers often transfer funds electronically almost immediately after a sale, BestSellers.com could also set up their system to ship books only after payment has been received by the credit card issuer. Finally, BestSellers.com could arrange with an online credit service bureau to run credit checks on customers purchasing over a preset minimum amount. Although BestSellers.com sells its goods through the Internet, the company should still record sales revenue when the books are shipped to customers.

Explain why auditors usually emphasize the detection of fraud in the audit of cash receipts. Is this consistent or inconsistent with the auditor's responsibility in the audit. Explain.

Cash is the most liquid asset that a company owns and thus it is the most likely target of misappropriation. The emphasis the auditor places on the possibility of misappropriation of cash is not inconsistent with his or her responsibility, which is to determine the fairness of the presentation of the financial statements. If material fraud has occurred, and it is not fully disclosed in the financial statements, those statements are not fairly presented.

CPA performed tests of controls and substantive tests of transactions for sales for the month of March in an audit of the financial statements for the year ended December 31, 2016. Based on the excellent results of both the tests of controls and the substantive tests of transactions, she decided to significantly reduce her substantive tests of details of balances at year-end. Evaluate this decision.

Generally, successful tests of controls and substantive tests of transactions allow for a reduction of tests of details of balance at year-end. However, Diane Smith chose the month of March, which only represents onetwelfth of the year, as her test period. With such a short test period, Diane cannot conclude that she has selected a representative sample from the total population; therefore, without testing additional months (most firms would require at least nine months coverage), Diane should not change the scope of her tests of details of balances at year-end.

Under what circumstances is it acceptable to perform tests of controls and substantive tests of transactions for sales and cash receipts at an interim date?

It is often acceptable to perform tests of controls and substantive tests of transactions at an interim date. The auditor may decide it is necessary to test the untested period at year-end. It is acceptable to perform tests of controls and substantive tests of transactions for sales and cash receipts at an interim date and not perform additional tests of the system at year-end under the following circumstances: The auditor believes that internal controls are effective. The auditor does not anticipate significant changes in the internal controls during the remaining period. The transactions normally occurring between the completion of the tests of controls and substantive tests of transactions and the end of the year are similar to the transactions prior to the test date. The remaining period is not too long.

Explain what is meant by lapping and discuss how the auditor can uncover it. Under what circumstances should the auditor make a special effort to uncover lapping?

Lapping is the postponement of entries for the collection of receivables to conceal an existing cash shortage. The fraud is perpetrated by someone who records cash in the cash receipts journal and then enters them into the computer system. The person defers recording the cash receipts from one customer and covers the shortage with receipts from another customer. These in turn are covered by the receipts from a third customer a few days later. The employee must either continue to cover the shortage through lapping, replace the stolen money, or find another way to conceal the shortage. This fraud can be detected by comparing the name, amount, and dates shown on remittance advices to cash receipts journal entries and related duplicate deposit slips. Since the procedure is relatively time-consuming, auditors ordinarily perform the procedure only where there is a specific concern with fraud because of internal control deficiencies discovered.

Explain what is meant by a proof of cash receipts and state its purpose.

Proof of cash receipts is a procedure to test whether all recorded cash receipts have been deposited in the bank account. In this test, the total cash receipts recorded in the cash receipts journal for a period of time, such as a month, are reconciled to the actual deposits made to the bank during the same time period. The procedure is not useful to discover cash receipts that have not been recorded in the journals or time lags in making deposits, but it is useful to discover recorded cash receipts that have not been deposited, unrecorded deposits, unrecorded loans, bank loans deposited directly into the bank account, and similar misstatements.

Explain the importance of proper credit approval for sales. What affect do adequate controls in the credit function have on the auditor's evidence accumulation?

Proper credit approval for sales helps minimize the amount of bad debts and the collection effort for accounts receivable by requiring that each sale be evaluated for collection potential. Adequate controls in the credit function enable the auditor to place more reliance on the client's estimate of uncollectible accounts. Without these controls, the auditor would have to make his or her own credit checks on the customers in order to be convinced that the allowance for uncollectible accounts is reasonable.

List the transaction-related audit objectives for the verification of cash receipts. For each objective, state on i.c. that the client can use to reduce the likelihood of misstatements.

TRANSACTION-RELATED AUDIT OBJECTIVE KEY INTERNAL CONTROLS 1. Recorded cash receipts are for funds actually received by the company (occurrence). Separation of duties between handling cash and record keeping. Independent reconciliation of bank accounts. 2. 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 checks. Internal verification of the recording of cash receipts. Regular monthly statements to customers. 3. Cash receipts are deposited and recorded at the amounts received (accuracy). Same as 2 above. Approval of cash discounts. Regular reconciliation of bank accounts. Batch totals are compared with computer summary reports. 4. Cash receipts are properly included in the accounts receivable master file and are correctly summarized (posting and summarization). Regular monthly statements to customers. Internal verification of accounts receivable master file contents. Comparison of accounts receivable master file or trial balance totals with general ledger balance. 5. Cash receipts transactions are properly classified (classification). Use of adequate chart of accounts. Internal review and verification. 6. Cash receipts are recorded on the correct dates (timing). Procedure requiring recording of cash receipts on a daily basis. Internal verification.

State 1 test of control and 1 substantive test of transactions that the auditor can use to verify the following sales transaction-related audit objective: recorded sales are stated at the proper amounts

Tests of controls: 1. On a sample of sales invoices, examine proper authorization and indication of internal verification of sales amounts. 2. Examine approved computer file that reflects the master file contents containing unit selling prices. 3. Examine file of batch control totals for initials of data control clerk who reconciled those totals; compare totals to summary reports. Substantive tests of transactions: 1. Recompute information on sales invoices. 2. Trace entries in sales journal to related sales invoices. 3. Trace detail on sales invoices to shipping documents, approved price lists, and customers' orders.

What audit procedures are most likely to be used to verify accounts receivable written off as uncollectable? State the purpose of each of these procedures.

The audit procedures most likely to be used to verify accounts receivable charged off as uncollectible and the purpose of each procedure are as follows: Examine approvals by the appropriate persons of individual accounts charged off. The purpose is to determine that charge-offs are approved. Examine correspondence in client's files that indicates the uncollectibility of the accounts for a selected number of write-offs. The purpose is to determine that the account appears to be uncollectible. Examine credit records as an indication of the uncollectibility of an account. The purpose is the same as the previous procedure. Consider the reason for the charge-off compared to the company policy for writing off uncollectible accounts. The purpose is to determine whether or not company policy is being followed.

What 3 types of authorizations are commonly used as i.c. for sales? Explain the importance of each.

The following are the three main authorizations in the sales cycle: 1. Credit is authorized before a sale takes place. Credit approval is critical to ensure that goods are only shipped to customers who have the ability to pay for the goods. 2. Goods are shipped only after proper authorization. This authorization is to verify that goods are only shipped to valid customers who have the ability to pay. 3. Prices, including payment terms, freight, and discounts, are properly authorized. Prices are authorized to ensure that customers are charged the appropriate price consistent with company policy.

List the transaction-related audit objectives for the audit of sales transactions. For each objective, state on internal control that the client can use to reduce the likelihood of misstatements.

The following are the transaction-related audit objectives for sales and examples of internal controls that can reduce the likelihood of misstatements. TRANSACTION-RELATED AUDIT OBJECTIVE KEY INTERNAL CONTROLS 1. Recorded sales are for shipments actually made to existing customers (occurrence). Recording of sales is supported by authorized shipping documents and approved customer orders. Credit is authorized before shipment takes place. Sales invoices are prenumbered and properly accounted for. Only customer numbers existing in the computer data files are accepted when they are entered. Monthly statements are sent to customers; complaints receive independent follow-up. 2. Existing sales transactions are recorded (completeness). Shipping documents are prenumbered and accounted for. Sales invoices are prenumbered and accounted for. 3. Recorded sales are for the amount of goods shipped and are correctly billed and recorded (accuracy). Determination of prices, terms, freight, and discounts is properly authorized. Internal verification of invoice preparation. Approved unit selling prices are entered into the computer and used for sales. Batch totals are compared with computer summary reports. 4. Sales transactions are properly included in the accounts receivable master file and are correctly summarized (posting and summarization). Regular monthly statements sent to customers. Internal verification of accounts receivable master file contents. Comparison of accounts receivable master file or trial balance with general ledger balance. 5. Sales transactions are properly classified (classification). Use of adequate chart of accounts. Internal review and verification of the account classifications. 6. Sales are recorded on the correct dates (timing). Procedures requiring billing and recording of sales on a daily basis as close to the time of occurrence as possible. Internal verification of timely recording of transactions.

List the most important duties that should be segregated in the sales and collection cycle. Explain why it is desirable that each duty be segregated.

The most important duties that should be segregated in the sales and collection cycle are: 1. Receiving and approving orders for credit sales 2. Shipping goods 3. Billing customers and recording sales 4. Maintaining inventory records 5. Maintaining general accounting records 6. Maintaining detailed accounts receivable records 7. Processing cash receipts 8. Granting credit and pursuing unpaid accounts Segregation of duties should be used extensively in the sales and collection cycle for two reasons. First, cash receipts are subject to easy manipulation. Second, the large number and nature of transactions within the cycle make the procedure of cross-checking, where one employee's duties automatically serve to verify the accuracy of another's, highly desirable. If the asset-handling activities (shipping goods and processing cash receipts) are combined with their respective accountability activities (maintaining inventory, accounts receivable, and general accounting records), a serious deficiency with respect to safeguarding those assets exists. It would be easy for an employee, by either omitting or adding an entry, to use the company's assets for his or her own purpose. If the credit granting function is combined with the sales function, there may be a tendency of sales staff to optimize volume even at the expense of high bad debt write-offs.

State the relationship between the confirmation of accounts receivable and the results of the tests of controls and substantive tests of transactions

The primary objective of the tests of controls and substantive tests of transactions for sales and cash receipts is to determine whether or not the auditor may rely on internal controls to produce accurate information. If it is determined through tests of controls and substantive tests of transactions that the system provides reliable information as to accounts receivable balances, the auditor may reduce the sample size for the confirmation of accounts receivable and adjust the type of confirmation and timing of the tests. If the system is not considered effective because of deficiencies in internal control, the sample size must be increased, positive confirmations will probably be necessary, and the confirmations will most likely be as of the balance sheet date.

Explain the purpose of footing and cross-footing the sales journal and tracing the totals to the general ledger.

The purpose of footing and crossfooting the sales journal and tracing the totals to the general ledger is to determine that sales transactions are properly included in the accounts receivable master file and are correctly summarized. The auditor will make a sample selection from the sales journal to perform tests of controls and substantive tests of transactions, so he or she must determine that the general ledger agrees with the sales journal.

Distinguish between the sales journal and the accounts receivable master file. What type of info is recorded in each and how do these accounting records relate?

The sales journal contains the record of each sales transaction that includes the customer name, date, amount, and the account classification for each transaction. The sales journal generally represents the record of each individual transaction. Typically, the sales journal accumulates transactions for a period of time, which is often monthly. Transactions recorded in the sales journal are then posted to the general ledger, and if the transaction is for sales on account, the accounts receivable master file is updated for each transaction. The accounts receivable master file is used to record individual sales, cash receipts, and sales returns and allowances for each customer and to maintain customer account balances. The master file is updated using data from the sales journal, sales return journal, and cash receipts journal. The total in the accounts receivable master file equals the total in the accounts receivable general ledger account.

How might the write-off of accounts receivable increase the risk of fraud related to cash receipts?

The theft of cash receipts from customer payments on account is easily identified by sending customers monthly statements, unless the theft is covered by some other means. One way to hide the theft of cash receipts is to write-off the customer's receivable.

Explain how prenumbered shipping documents and sales invoices can be useful controls for preventing misstatements in sales.

The use of prenumbered documents is meant to prevent the failure to bill or record sales as well as to prevent duplicate billings and recordings. An example of a useful control to provide reasonable assurance that all shipments are billed is for the billing clerk to file a copy of all shipping documents in sequential order after a shipment has been billed. Periodically, someone can account for all numbers in the sequence and investigate the reason for missing documents. Computer programs can be used to identify gaps and duplicates in the sequence. The same type of useful test in this area is to account for the sequence of duplicate sales invoices in the sales journal, examining for omitted numbers, duplicate numbers, or invoices outside the normal sequence. This test simultaneously provides evidence of both the occurrence and completeness objectives.

What is the dif between the auditor's approach in verifying sales returns and allowances and that for sales? Explain the reasons for the difference.

The verification of sales returns and allowances is quite different from the verification of sales for three primary reasons: 1. Sales returns and allowances are normally an insignificant portion of operations and therefore receive little attention from the auditor. 2. The primary emphasis the auditor places on sales returns and allowances is to determine that returns and allowances are properly authorized and that sales are not overstated at year-end and subsequently reversed by the issuance of returns. 3. The completeness objective cannot be ignored because unrecorded sales returns and allowances can materially overstate net income.

Describe the flowing documents and records and explain their use in the sales and collection cycle: bill of lading, credit memo, remittance advice, and accounts receivable trial balance

a. The bill of lading is a document prepared at the time of shipment of goods to a customer indicating the description of the merchandise, the quantity shipped, and other data. Formally, it is a written contract of the shipment and receipt of goods between the seller and carrier. It is also used as a signal to bill the client. The original is sent to the customer and one or more copies are retained. b. The credit memo is a document indicating a reduction in the amount due from a customer because of returned goods or an allowance granted. It often takes the same general form as a sales invoice, but it reduces the customer's accounts receivable balance rather than increasing it. c. A remittance advice is a document mailed to the customer and typically returned to the seller with the customer's payment. It indicates the customer name, the sales invoice number, and the amount of the invoice. A remittance advice is used as a record of the payment received to permit the immediate deposit of checks received and to improve control over the custody of assets. d. The accounts receivable trial balance is a report from the accounts receivable master file that shows the amount receivable from each customer at a point in time. An aged trial balance includes the total balance outstanding and the number of days the receivable has been outstanding, grouped by category of days (such as less than 30 days, 31 to 60 days, and so on).

Describe the nature of the following documents and records and explain their use in the sales and collection cycle: customer order, sales invoice, prelisting of cash receipts, and monthly statement to customers.

a. The customer order is a request from the customer indicating the quantity and the description of the merchandise ordered. b. A sales invoice is a document indicating the description and quantity of goods sold, the price including freight, insurance, terms, and other relevant data. It is the method of indicating to the customer the amount owed for the sale and the due date of the payments. The original is sent to the customer and one or more copies are retained. The sales invoice is the document for recording sales in the accounting records. c. A prelisting of cash receipts is a list prepared when cash is received by someone who has no responsibility for recording sales, accounts receivable, or cash and who has no access to accounting records. It is used to verify whether cash received was recorded and deposited at the correct amounts and on a timely basis. d. The monthly statement to customers is the document prepared monthly and sent to each customer indicating the beginning balance of that customer's accounts receivable, the amount and date of each sale, cash payments received, credit memos issued, and the ending balance due. It is, in essence, a copy of the customer's portion of the accounts receivable master file.

Proof of cash receipts

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

sales and collection cycle

involves 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

Performance format audit program

the audit procedures for a class of transaction organized in the format in which they will be performed; this audit program is prepared from a design format audit program

Design format audit program

the audit procedures resulting from the auditor's decisions about eh appropriate audit procedures for each audit objective; this audit program is used to prepare a performance format audit program

Classes of transactions in the sales and collection cycle

the categories of transactions for the sales and collection cycle in a typical company: sales, cash receipts, sales returns and allowances, write-off of uncollectible accounts, and bad debt expense

Business functions for 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, write-off of uncollectible accounts, and bad debt expense

Lapping of accounts receivable

the postponement of entries for the collection of receivables to conceal an existing cash shortage

direction of tests

the starting point for testing the occurrence and completeness of transaction-related audit objectives; vouching from journals to source documents tests for occurrence and tracing from source documents to journals tests for completeness