Audit Chapter 7
The basic activities in the revenue and collection cycle for a company like this are
(1) receiving and processing customer orders, including credit approval; (2) delivering goods and services to customers; (3) billing customers and accounting for accounts receivable; and (4) collecting and depositing cash Page 281received from customers.
TESTS OF OPERATING EFFECTIVENESS OF INTERNAL CONTROL
Auditors can perform tests of controls to determine whether company personnel are properly performing controls that are said to be in place - In general, the procedures used in tests of controls are client inquiry, observation, inspection of documents and records, reperformance, and walkthroughs.
The negative form is used mostly when the risk of material misstatement is considered low, when a large number of small balances is involved, and when the client's customers can be expected to consider the confirmations properly.
Auditors must use these confirmations with great care. Occasionally, they use both forms by sending positive confirmations on some (large) customers' accounts and negative confirmations on others (usually smaller account balances).
Getting confirmations delivered to the intended recipient requires auditors' careful attention
Auditors need to control the mailing of the confirmations, including the addresses to which they are sent, and the confirmations should be returned directly to the auditors. The confirmations should normally be addressed to the customer's accounts payable department. There have been cases in which confirmations were mailed to company accomplices, who provided false responses.
The auditors should carefully consider features of the reply, such as postmarks, fax and telephone responses, letterhead, e-mail, or other characteristics that may indicate a false response.
Auditors should follow up on electronic and telephone responses to determine their origin (e.g., returning the telephone call to a known number, looking up telephone numbers to determine addresses, or using a directory to determine the location of a respondent)
In addition, a discussion of the bankruptcy of a large customer may appear in the minutes of the board of directors meetings, the audit committee meetings, or a meeting of an executive committee. Credit files should contain the customer's financial statements, credit reports, and correspondence between the client and the customer.
Based on this evidence, the audit team estimates the likely amount of nonpayment for the customer, which is included in the estimate of the allowance for doubtful accounts. In addition, an allowance should be estimated for all other customers, perhaps as a percentage of the current accounts with a higher percentage of past due accounts. The auditors then compare their estimate to the recorded balance in the allowance account and propose an adjusting entry for the difference if needed.
The valuation assertion of accounts receivable is also a relevant assertion in the revenue cycle.
Because collectability problems can be addressed prior to making a sale, companies should have controls in place to ensure that all credit sales are authorized based on a credit limit in the customer master file. Further, collectability of delinquent receivables should be considered on a regular basis, and management should regularly evaluate the adequacy of allowances for sales returns and discounts.
Dual-Purpose Nature of Accounts Receivable Confirmations Accounts receivable confirmation is a substantive procedure designed to obtain evidence of the existence and, secondarily, valuation of customers' balances directly from the customer. However, if such confirmations show numerous exceptions, auditors are concerned with the controls over the details of sales and cash receipts transactions even if previous control evaluations seemed to show little control risk.
The goal in performing substantive procedures is to detect evidence of any material misstatement due to errors or fraud. If there is a risk of material misstatement involving revenue recognition, auditors should consider confirming contract terms and investigate the presence of side agreements with customers. Items to be considered would be acceptance criteria, delivery and payment terms, future or continuing vendor obligations, rights of return, guaranteed resale, and cancellation or refund provisions.
Confirmation of receivables may be performed at a date other than the year-end.
When confirmation is done at an interim date, the audit firm is able to spread work throughout the year and avoid the pressures of overtime that typically occur during "busy season." In addition, the audit can be completed sooner after the year-end date if confirmations have been done earlier.
A substantive analytical procedure is one in which the auditor substantiates an account or disclosure by developing an independent estimate of the amount and then comparing the recorded balance to the estimate.
the evaluation of the accounting estimate for the allowance for doubtful accounts generally involves an analytical review of the adequacy of the provision for bad debt expense.
Sales Detail (Journal) File
- The detailed sales entries, which should correspond with the issuance of invoices to customers and should include the shipping references and dates, should be in the sales detail file. - The company should always compare daily credit sales totals in the sales journal to the total debits posted to accounts receivable.
If an exception cannot be resolved or it appears to indicate a misstatement, auditors should
1) determine the cause of the misstatement, (2) extrapolate the misstatements over the population, and (3) consider whether fraud may have occurred. If similar misstatements could exist, additional procedures are generally necessary to determine the extent of misstatements. In the case of fraud, an extensive investigation may be necessary
bill of lading
A contract between the shipper and the carrier; includes shipping information such as ship dates and origination, purchase order number, and signatures for receipt of merchandise.
packing slip
A document included with a shipment that shows the description and quantity of the goods being shipped.
A primary control in the revenue cycle is ensuring that revenue is only recorded when a complete set of matched sales documents is present.
A three-way match of a customer sales order, evidence of shipment, and a customer invoice provides strong evidence that a sale has been completed and a revenue has been earned
A positive confirmation asks the customer to respond whether the balance is correct or incorrect.
A variation of the positive confirmation is the blank form. A blank confirmation does not contain the balance; customers are asked to fill it in themselves. The blank positive confirmation may produce better evidence because the recipients need to get the information directly from their own records instead of just signing the form and returning it with no exceptions noted. (However, the effort involved on the part of the recipient may cause a lower response rate.)
The following control activities should generally be in place to prevent and detect errors or fraud:
Access to inventory and the shipping area should be restricted to authorized persons. Access to billing terminals and blank invoice forms should be restricted to authorized personnel. Care should be taken to record sales and receivables as of the date the goods were shipped and the cash receipts on the date the payments were received. Customer invoices should be compared with bills of lading and customer orders to determine that the customer is sent the goods ordered at the proper location for the proper prices and that the quantity being billed is the same as the quantity shipped. Pending order files should be reviewed frequently to avoid failure to bill and record shipments
The accounts to be confirmed are often documented with an aged trial balance.
Accounts for confirmation can be selected at random or in accordance with another sampling method consistent with the audit objectives. Statistical methods may be useful for determining the sample size. Audit software can be used to access computerized receivables files, select, and even print the confirmations.
Procedures include tracing shipping documents before and after year-end to the sales journal to ensure the sale was recorded in the proper period. Credit memos for returns after year-end are vouched to receiving reports. Any goods returned after year-end that were sold during the year being audited should be deducted from net sales.
Adjusting entries for cutoff errors (i.e., sales recorded in the current period for next month's shipments) must be considered carefully because not only are accounts receivable and sales overstated, but also inventory is understated and cost of goods sold (COGS) is overstated.
a dual-purpose procedure
An audit procedure that simultaneously serves the substantive purpose (obtain direct evidence about the dollar amounts in account balances) and the test of controls purpose (obtain evidence about the company's performance of its own control activities). -When the auditor tests the controls surrounding three-way matches of customer orders, shipping documents, and invoice
Finally, procedures must be in place to ensure that errors noted by these steps are properly corrected.
An error control log monitored by the information systems supervisor ensures that this is done. Such a log may aid in the identification of patterns that indicate either control weaknesses or possible fraudulent activities. This documentation and subsequent action is part of the information and communications aspect of internal controls.
The accounts receivable aging information is used in connection with assessing the allowance for doubtful accounts
Auditors must ensure that the calculation of the aging is accurate to verify that customer accounts are not listed as current when they are in fact past due. An example of this listing is the aged trial balance: A schedule that lists each receivable and indicates whether it is current or past due and if past due, for how long; the total should equal the accounts receivable general ledger balance.
Confirmation of Accounts and Notes Receivable In general, the use of confirmations for accounts receivable is considered a required audit procedure by audit standards. If auditors decide not to use them, the burden of proof is on the auditors to justify their position.
Auditors should document justifications for the decision not to use confirmations for accounts receivable in a particular audit. Justifications might include (1) receivables are not material; (2) confirmations would be ineffective, based on prior-years' experience or knowledge that responses could be unreliable; and (3) analytical procedures and other substantive procedures provide sufficient, competent evidence.
in general, the most significant risks relate to the occurrence of revenues and the existence and valuation of accounts receivable
Because of the risk of unrecorded revenue, the completeness of revenue and accounts receivable is also considered a significant risk in the revenue and collection cycle.
However, auditing standards also indicate that there is a presumptive risk of fraud in the revenue cycle.
Because revenue is a presumptive high-fraud risk and an overall significant risk, the auditor always performs substantive procedures in the revenue cycle. These procedures are classified as substantive analytical procedures and substantive tests of details.
Inquiring of management and examining support for large cash receipts is the best way to detect these transactions.
Classification of accounts receivable—Scan receivables ledger for negative balances for reclassification to accounts payable. Presentation and disclosure of accounts receivable and revenues—Complete a disclosure checklist and ensure completeness and accuracy of required disclosures.
Analytical Procedures During an audit, a variety of analytical procedures might be employed, depending on the circumstances and the nature of the business.
Comparisons of asset and revenue balances with recent history might help detect overstatements. Such relationships as receivables turnover, days' sales in receivables, amount of past due receivables, gross margin ratio, and sales/asset ratios can be compared to historical data and industry statistics for evidence of overall reasonableness. Account interrelationships also can be used in analytical procedures. Accounts receivable write-offs may also be compared with estimates of doubtful accounts.
other tests of controls related to assertions in the revenue cycle,
Completeness of revenue and accounts receivable—Examine evidence of client review and follow-up of sales data related to specific classes of products or locations. Accuracy of revenue and accounts receivable—Vouch prices to approved price listing. Accuracy of revenue—Observe client comparing shipping quantities to quantities recorded as sold. Examine evidence of client making the comparison. Cutoff of revenue—Trace shipping date on shipping documents to sales invoice date. Check FOB terms. Classification of accounts receivable—Trace posting of intercompany sales, sales returns, etc., to sales.
the auditor often performs other substantive tests related to assertions in the revenue cycle:
Completeness of revenue and accounts receivable—Include a sample of zero-balance accounts in the confirmation process. Rights and obligations of accounts receivable—Inquire whether any receivables have been sold or factored. Rights and obligations of accounts receivable—Inspect the bank confirmations, loan agreements, and minutes of the board for indications of pledged, discounted, or assigned receivables.
Additional Notes about Confirmations Because of the importance of confirmations for verifying the validity of accounts receivable, the auditor should take special care to consider the sufficiency of evidence obtained. Some other considerations that auditors should make when sending confirmations follow.
Confirmations returned by the postal service as "undeliverable" are always a red flag. The address should be double checked and evidence that the company actually exists obtained. Confirmations of accounts, loans, and notes receivable may not produce sufficient evidence of ownership by the client (rights assertion). Debtors may not be aware that the client sold the accounts, notes, or loans receivable to financial institutions or to the public (collateralized securities). Auditors should also consider whether their clients ever factor, or sell, receivables to third parties. Auditors need to perform additional inquiry and detailed procedures to get evidence of the ownership of the receivables and the appropriateness of disclosures related to financing transactions secured by receivables.
Receiving and Processing Customer Orders, Including Credit Granting ①
Customer orders, shipping documents, and invoices should be in prenumbered sequence so the system can check the sequence and determine whether any transactions have not been recorded (completeness assertion) or have been duplicated (occurrence assertion). Prenumbered documents are an example of an internal control (i.e., control activity).
Proper authorization is important:
Employees performing each of these steps should sign transfer documents so they are held accountable. This control procedure prevents employees from misappropriating the goods or shipping product to friends without billing them.
A substantive test of details is one in which the auditor substantiates an account or disclosure by directly testing the transactions that make up the account or the items that comprise the balance of the account.
For example, auditors will generally send confirmations to customers to substantiate the existence and rights and obligations assertions of accounts receivable.
SIGNIFICANT ACCOUNTS AND RELEVANT ASSERTIONS The components of the audit risk model are assessed for each significant account and relevant assertion. This assessment recognizes that certain accounts and assertions assume an increased level of importance and are of more interest to auditors than others.
For example, because of the tendency to use fictitious sales to overstate assets and revenues, the existence assertion is extremely important in the audit of accounts receivable, and occurrence is important for sales. In addition, because material errors happen, auditors need to examine revenue and accounts receivable for completeness.
Collectability of Accounts Receivable In most companies, a portion of accounts receivable will not be collected.
GAAP requires the client to provide an estimate of the amount that will likely be uncollectable and provide an allowance for this amount.
Customer Returns and Allowances In most industries, customers have a right to return unused or unsold merchandise When these agreements are in the purchase contract and disclosed to the auditor, an appropriate evaluation of revenue can be performed.
However, clients may enter into informal right of return agreements with customers unknown to the auditors. Liabilities for known rights of return, warranties, and other potential obligations are often very difficult to estimate. Companies with new products or technologies have an even higher inherent risk in these areas.
Review for Collectability Even if the customer confirms that the account exists, this does not necessarily mean that the customer can or will pay it! Therefore, the primary evidence gained from confirmations relates to existence
However, the audit team must review accounts for collectability and determine the adequacy of the allowance for doubtful accounts in support of the valuation assertion. To do this, auditors review subsequent cash receipts from the customer, discuss unpaid accounts with the credit manager, and examine the credit files.
Confirmations provide evidence of existence as well as rights and obligations of accounts and notes receivable.
However, they do not provide strong evidence on the valuation of accounts receivable. Remember that just because a customer owes an amount does not mean it will pay that amount. Customers in bankruptcy routinely confirm amounts owed, although the receivable's value may be only a small fraction of that amount.
Entity-Level Controls in the Revenue and Collections Cycle As part of the evaluation of internal control, the auditor typically begins in all cycles by considering the entity-level controls in place
In the revenue process, overall performance review by management can serve as strong entity-level control. Management should have a process for continually reviewing revenue and comparing it to budgets and forecasts. Management should also constantly scrutinize total write-offs of accounts receivable, merchandise returns, and the timeliness of collections.
The cash receipts journal contains all the detail entries for cash deposits and credits to various accounts.
It contains the population of entries that should be reflected in the credits to accounts receivable for customer payments. It also contains adjusting and correcting entries that can result from the bank account reconciliation
Although confirmations are most often used for account balances, experienced auditors recognize that confirming a specific transaction, especially a large one, may be more effective. This is especially true if the balance consists primarily of a few large transactions. In your own life, you probably do not know what your current balance is on your credit cards, but you likely remember a recent large purchase (e.g., for textbooks)
It is also possible for an auditor to receive an oral response to a confirmation. Such a response does not meet the definition of an external confirmation because there is no direct written response to the auditor. The auditor should request a written response, and, if one is not forthcoming, the auditor should determine whether alternative audit procedures are warranted.
Companies may sell or factor their accounts receivable to a financial institution to obtain cash immediately.
It is difficult to determine whether receivables have been sold because the customers usually do not know that someone else actually owns their account. The cash goes to the original seller, who passes it on to the financial institution.
Cutoff and Sales Returns The cutoff assertion is particularly relevant in the revenue cycle because of the significance of revenue as a benchmark for users of the financial statements. This high significance of revenues makes it highly appealing to managers for earnings management and fraud.
Many questionable adjustments to revenues occur very close to year-end. As a result, auditors must make sure that sales are recorded in the proper period. To do this, they employ sales cutoff tests
Limited access, frequent backup, and disaster recovery plans are important controls to ensure the availability of information.
Moreover, customer and employee information must be protected.
The primary consideration when planning confirmation of receivables before the balance sheet date is the client's internal control over transactions affecting receivables. When confirmation is performed at an interim date, the following additional procedures should be considered:
Obtain a summary of receivables transactions from the interim date to the year-end date, and review them for unusual items. Vouch a selected sample of transactions for the period. Obtain a year-end trial balance of receivables, compare it to the interim trial balance, and obtain evidence and explanations for large variations. Consider the necessity for additional confirmations as of the balance sheet date if balances have significantly increased
Access to accounts receivable records implies the power to alter them directly or enter transactions (e.g., returns and allowance credits, write-offs) to alter them.
Personnel with this power have a combination of authorization and recording responsibility. Another important facet of control is physical protection of the files. If the files are lost or destroyed, it is unlikely the accounts will be collected, so the records are truly assets.
the SEC believes that revenue generally is realized or realizable and earned when all of the following criteria are met:
Persuasive evidence of an arrangement exists. Delivery has occurred or services have been rendered. The seller's price to the buyer is fixed or determinable. Collectability is reasonably ensured.
Delivering Goods and Services to Customers ②
Physical custody of inventory goods starts in the storeroom or warehouse where inventory is kept. Custody is transferred to the shipping department upon the authorization of the shipping order that permits the inventory clerk to release goods to the shipping department.
A variety of sales analysis reports can be produced.
Sales that are classified by product lines provide required information for the business segment disclosures. Sales classified by sales employee or region can show unusually high or low volume that might bear further investigation if an error or fraud is suspected. Analytical procedures, such as trend analysis or comparison among sales units, can be a great help to the auditor
Management Reports and Data Files in the Revenue and Collection Cycle Pending Order and Back Order Master File
Sales transactions that were initiated but are not yet completed, and thus not yet recorded as sales, are kept in the pending order master file.
By requiring all three documents to be present before recording a revenue, a company reduces the risk of overstating revenues and accounts receivable, providing assurance related to the existence of accounts receivable, and the occurrence of revenue.
Similarly, by ensuring that all three of these primary sales documents are prenumbered, and the numerical sequence is checked, the company can ensure the completeness of recorded revenue and accounts receivable. Verifying the dates on the documents helps reduce risk of misstatement related to the cutoff assertion of revenue.
Substantive procedures differ from tests of controls in their basic purpose.
Substantive procedures are designed to obtain direct evidence about the dollar amounts in account balances, while tests of controls are designed to obtain evidence about the company's performance of its own control activities.
substantive procedures.
The audit processes to gather evidence on the assertions in account balances
The negative form asks for a response only if something is wrong with the balance; thus, lack of response to negative confirmations is considered evidence that the account is fairly stated.
The positive form is by far the more common and is used when individual balances are relatively large or when accounts are in dispute. Positive confirmations generally ask for information about the entire account balance as of a specific date. However, when customers are less likely to be able to respond to entire account balances, auditors may confirm specific invoices.
Recall from the audit risk model that the auditor assesses inherent risk to determine where in the financial statements it is reasonably possible that a material misstatement could enter the process before the consideration of any internal controls. However, recall that risk of material misstatement is the combination of both inherent risk and control risk.
The question an auditor should ask is, "Has the audit client designed and implemented a control that, if operating effectively, would mitigate the identified risk of material misstatement? Would it prevent or detect the material misstatement?
revenue recognition
The recording of revenues in the general ledger, often done fraudulently by schemes such as bill and hold. The recording of revenues in the general ledger, often done fraudulently by schemes such as bill and hold.
sales cutoff tests
The tests that ensure that sales are recorded in the proper period—generally, when they are shipped—and that the cost of sales is recorded and removed from inventory.
Probably the best control over whether cash is received and recorded is the customer.
Therefore, sending customer statements of what has been billed, what has been paid, and ending balances on a monthly basis enables customers to spot discrepancies and notify the company. Statements should be sent if there is any activity in the account, even if the ending balances are zero.
When auditors are satisfied that controls have been examined and transactions and balances have been appropriately tested, the job is not over. The accounts in the revenue cycle require certain disclosures. Revenue recognition policies and the amount of the allowance for doubtful accounts are some of the items requiring specific presentation and disclosures.
These disclosures must ensure that the presentation and disclosure assertions of occurrence, rights and obligations, completeness, classification, accuracy and valuation, and classification and understandability have been met. To ensure this, the auditor will often complete the audit of the revenue cycle with a disclosure checklist.
Alternative Procedures Often, the client's customers are not willing or able to return the confirmation. They may not be able if, for example, they are on a voucher system that lists payables by invoice instead of by vendor account. In these cases, auditors must perform alternative procedures to ensure existence
These include examining (1) subsequent cash receipts; (2) sales orders, invoices, and shipping documents; and (3) correspondence files for past-due accounts. Examining subsequent cash receipts is a particularly effective test because if the customer paid the account, it provides strong evidence that the receivable existed. This examination is often performed even when the customer has confirmed the account. The cash receipt should be traced to the remittance advice and the deposit into the client's cash account.
When considering relevant assertions and obtaining evidence about accounts receivable and other assets, auditors must emphasize the existence assertion
This emphasis on existence is appropriate because a large number of restatements of reports on financial statements involve overstated assets and revenues. When credit sales are recorded too early or fictitious sales are posted, this results in overstated accounts receivable and overstated sales revenue.
Estimation of the allowance for doubtful accounts can be subjective and difficult for the client and the auditor.
This is particularly true when the client has changed products, credit policies, or its customer base, causing it to have little experience on which to make estimates. Changing economic conditions also make it difficult to estimate collectability. Therefore, valuation is a high risk assertion and the auditor evaluates the reasonableness of the allowance.
The most frequent reconciliation is the comparison of the sum of customers' unpaid balances (customer database or subsidiary ledger kept in the accounts receivable department) with the accounts receivable control account total (maintained in corporate accounting).
This reconciliation is accomplished by preparing a trial balance of the accounts receivable subsidiary ledger, adding it, and comparing its total with the control account balance in the general ledger. Internal auditors can perform periodic reviews of the customers' balances by sending confirmations to the customers.
However, the auditor generally presumes that management has an incentive to overstate revenues.
Thus, auditors may assess inherent risk for the existence assertion to be higher than for the completeness assertion for these accounts, all other things being equal.
Auditors typically achieve an understanding of controls by completing a walkthrough of the processes in the revenue and collection cycle
To do so, the auditor identifies the points in the process where a misstatement might occur and then identifies the control activities that have been placed in operation to mitigate these risks.
lapping
When a business receives many cash or check payments from customers on an account, a detailed audit should include a comparison of the checks listed on a sample of deposit slips to the customer credits listed on the day's posting to customer accounts receivable (daily remittance list or other record of detail postings). This procedure is a test for accounts receivable fraud
Billing Customers and Accounting for Accounts Receivable ③
When a delivery or shipment is complete, the transaction is completed by filing a shipment record and preparing a final invoice for the customer (which is recorded as sales revenue and accounts receivable).
SUBSTANTIVE ANALYTICAL PROCEDURES AND TESTS OF DETAILS
because the revenue cycle consists of routine transactions, the majority of audit clients have strong controls in the revenue cycle, and thus tests of controls often support a reduction in control risk. This reduction in control risk reduces the auditor's assessment of the risk of material misstatement in the revenue cycle
Perhaps the most important controls in the revenue and collection cycle for many companies involve
ensuring that revenues are only recorded once the revenue generation process is complete, and ensuring that all revenues that are earned are recorded once and only once. These controls primarily involve the significant accounts of revenue and accounts receivable, and the relevant assertions of occurrence (existence), completeness, and cutoff.
A sales invoice
is the bill sent to the customer that indicates the amount due and the payment terms. Any person who has the power to alter these transactions or to change the invoice before it is mailed to the customer should not have any custody or recording responsibilities.
The accounts receivable listing
of customers' balances contains the actual amounts specifically identified with individual customers. If the control account total is higher than the sum of the customers' balances (trial balance), it will have to be adjusted after the difference is thoroughly investigated.
There are two primary methods of confirming accounts receivable
positive confirmations and negative confirmations.
Control Considerations at the Account and Assertion Level An initial overall control consideration auditors evaluate is the level of separation of duties in the revenue cycle
proper separation involves different people and different departments performing the sales and credit authorization; custody of goods and cash; and record keeping for sales, receivables, inventory, and cash receipts. Combinations of two or more of these responsibilities in one person, one office, or one computerized system might open the door for undetected errors or fraud.
To test the client's controls related to the valuation assertion,
the auditor will discuss procedures with the credit manager and examine credit file documentation for evidence of regular evaluation of credit limits and follow-up on delinquent accounts. The auditor will also examine evidence of credit approval prior to shipment for a sample of sales.
To ensure that the client's required three-way match is in effect and operating appropriately to ensure the occurrence assertion,
the auditor will select a sample of recorded sales from the sales journal and vouch the sales to supporting customer invoices, shipping documents, and customer purchase orders. The availability of electronic client data and audit software sometimes enables auditors to perform exception testing on the entire population of sales and identify any instances where the three-way match did not occur.
RISK OF MATERIAL MISSTATEMENT One way to assess the risk of material misstatement is to use the "what can go wrong?" (WCGW) approach when thinking of each financial statement assertion
three primary concerns: (1) Is revenue recognized when appropriate? (2) Is there a possibility of customers returning the goods? (3) Are the accounts receivable collectible?
