C11 Accounts Receivable, Notes Receivable, and Revenue

Audit Documentation

Lead schedules for receivables and net revenue and Working papers. • Aged trial balance of A/R. • Analyses of other accounts receivable. • Analysis of notes receivable and related interest. • Analysis of allowance for doubtful accounts and notes. • Comparative analyses of revenue. • Documentation of internal control. • Risk analyses and audit plan (program).

Figure 11.4 (2)

Figure 11.4 provides examples of potential misstatements of revenue and weaknesses in internal control that make them more likely to occur.

LO 11-6 Assess the risks of material misstatement of receivables and revenue and design further audit procedures, including tests of controls and substantive procedures, to address the risks. (7)

11. Determine the adequacy of the client's allowance for uncollectible accounts. Primary Audit Objectives: Valuation ---> Audit of Allowance for Doubtful Accounts • Review collections in subsequent period. • Develop estimate and evaluate reasonableness of management estimate. • Compare the details of the aging of accounts receivable to prior years' aging. • Investigate the credit ratings for delinquent and unusually large accounts. • Review confirmation exceptions for an indication of amounts in dispute or other clues as to possible uncollectible accounts. • Summarize in a working paper those accounts whose collectability is doubtful based on the preceding procedures. List customer names, doubtful amounts, and reasons for considering these accounts doubtful. • Review with the credit manager the current status of significant doubtful accounts. • Compute relationships, such as the number-of-days'-sales in accounts receivable and the relationship of the valuation allowance to (1) accounts receivable and (2) net credit sales. 12. Ascertain whether any receivables have been pledged. Primary Audit Objectives: Presentation ---> The auditors should inquire directly as to whether any notes or accounts receivable have been pledged or assigned. Evidence of the pledging of receivables also may be disclosed through the medium of financial institution confirmation requests, which specifically call for a description of the collateral securing bank loans. Analysis of the interest expense accounts may reflect charges from the pledging of receivables to finance companies. ---> Accounts receivable that have been pledged should be plainly identified through coding in the accounts receivable records. Accounts labeled in this manner would be identified by the auditors in their initial review of receivables and confirmed by direct correspondence with the bank to which they were pledged. The auditors cannot, however, proceed on the assumption that all pledged receivables have been labeled to that effect, and they should be alert to detect any indications of an unrecorded pledging of accounts receivable.

LO 11-6 Assess the risks of material misstatement of receivables and revenue and design further audit procedures, including tests of controls and substantive procedures, to address the risks. (8)

13. Investigate any transactions with or receivables from related parties. Primary Audit Objectives: Presentation ---> Transactions between the corporation and its officers, directors, stockholders, or affiliates require particular attention from the auditors because these related party transactions are not the result of arm's-length bargaining by parties of opposing interests. ---> Furthermore, such transactions may be prohibited by federal or state law or by the corporation's bylaws. The independent auditors have an obligation to stockholders, creditors, and others who rely upon audited statements to require adequate disclosure of any significant related party transactions. ---> To identify related party transactions, auditors should review. (a) proxy and other filings with the SEC or other regulatory agencies, (b) conflict-of-interest statements obtained by the company from its management, (c) transactions with customers or suppliers that have unusual terms, and (d) accounting records for unusual balances or transactions, particularly those occurring near year-end. ---> If related party transactions are identified, the auditors should obtain an understanding of the transactions, determine whether the transactions have been approved by the board of directors or other appropriate officials, confirm the terms of the transactions with the related parties, evaluate the collectibility of any receivables outstanding, and evaluate the adequacy of disclosure of the details of the transactions in the notes to the financial statements. 14. Evaluate the business purpose of significant and unusual sales transactions. Primary Audit Objectives: Presentation, Accuracy, Valuation ---> As the auditors perform the audit of revenue and receivables, they will be alert for significant and unusual transactions. In fact, certain procedures are specifically directed at discovering such transactions, for example, the analytical and data analytic procedures described previously. Auditors are required to evaluate the business purpose of any transaction that comes to their attention that is significant and unusual. Such transactions may be indicative of fraudulent financial reporting. 15. Evaluate financial statement presentation and disclosure of receivables and revenue. Primary Audit Objectives: Presentation ---> The auditors should determine that the financial presentation of accounts and notes receivable and the related disclosures are in accordance with generally accepted accounting principles. Related party receivables should be shown separately with disclosure of the nature of the relationships and the amounts of the transactions. ---> Any unusual terms of notes receivable should be disclosed in the notes. Also, the amounts of allowances for uncollectible receivables should be shown as deductions from the related receivables. Finally, significant concentrations of credit risk arising from trade accounts receivable should be disclosed in accordance with FASB ASC 310-10-50.

LO 11-6 Assess the risks of material misstatement of receivables and revenue and design further audit procedures, including tests of controls and substantive procedures, to address the risks. (4)

5. Perform analytical procedures for accounts receivable, notes receivable, and revenue. Primary Audit Objectives: Existence, Occurrence, Rights, Cutoff, Valuation, Accuracy ---> During the risk assessment stage of the audit, professional standards require the auditors to perform analytical procedures with the objective of identifying potential misstatements of revenue. Several ratios and relationships can be computed to indicate the overall reasonableness of the amounts shown for accounts receivable, revenue, and notes receivable. ---> In performing analytical procedures related to revenue and receivables, the auditors also will review ledgers and journals for unusual entries or amounts that may be indicative of errors, fraud, or other material issues. While this review may be performed manually, it may be more efficiently and thoroughly performed with the use of data analytics. Data analytics software may examine 100 percent of the transactions or entries in journals and ledgers using the criteria specified by the auditors 6. Review significant year-end sales contracts for unusual terms. Primary Audit Objectives: Existence, Occurrence, Rights, Cutoff, Valuation, Accuracy ---> To boost the level of sales for a period, management may be inclined to modify the terms of sales contracts near year-end. These modifications may affect the collectibility of the related accounts receivable, the customers' return rights, and even whether the sales meet the criteria to be recognized in the current period. Therefore, the auditors should carefully review any significant year-end sales contracts for unusual pricing, billing, delivery, return, exchange, or acceptance clauses.

LO 11-6 Assess the risks of material misstatement of receivables and revenue and design further audit procedures, including tests of controls and substantive procedures, to address the risks. (5)

7. Review the year-end cutoff of sales transactions. Primary Audit Objectives: Existence, Occurrence, Rights, Cutoff, ---> One of the more common methods of falsifying accounting records is to inflate the sales for the year by holding open the sales journal beyond the balance sheet date. Shipments made in the first part of January may be covered by sales invoices bearing a December date and included in December sales. The purpose of such misleading entries is to present a more favorable financial picture than actually exists, or to meet analysts' sales expectations. Because sales are frequently used as the base for computation of bonuses and commissions, an additional incentive for padding the sales account is often present. ---> Misstatements due to inaccurate cutoff of sales records also may be detected by comparing the sales recorded for several days before and after the balance sheet date with the duplicate sales invoices and shipping documents. The effectiveness of this step is largely dependent upon the degree of segregation of duties between the shipping, receiving, and billing functions. If warehousing, shipping, billing, and receiving are independently controlled, it is most unlikely that records in all these departments will be manipulated to disguise shipments of one period as sales of the preceding period. On the other hand, one individual with control over both shipping records and billing documents could manipulate both sets of records to overstate the year's sales. ---> Fictitious sales are occasionally recorded at year-end as a means of overstating financial results. Therefore, auditors should be aware of and investigate a. Unusually large increases in year-end sales to a single customer or a few. This might be indicative of bill and hold transactions, in which sales are billed, but goods are not shipped. Such transactions may not meet the requirements for revenue recognition. b. Large increases in revenue and receivables along with increases in gross profit margins that are inconsistent with the client's experience or industry averages. c. Inappropriate changes in accounting principles that result in an increase in recorded revenue. d. Substantial sales returns following the balance sheet date that might indicate merchandise shipped to customers without a customer order for those goods or channel stuffing, in which sales are boosted by inducing customers to buy substantially more inventory than they can promptly resell. e. Substantial revisions in the amounts to be received under sales contracts possibly indicating the application of inappropriate accounting methods or misestimates of the amount of revenue to be realized. 8. Test the valuation of notes receivable, computation of interest income, interest receivable, and amortization of discount or premium. Primary Audit Objectives: Existence, Occurrence, Rights, Completeness ---> Unless a company elects the fair value option, notes receivable are valued at their outstanding face value plus or minus any unamortized premium or discount. When a company has not adopted the fair value option, the auditors may effectively audit valuation, interest income, interest receivable, and the amortization by performing an independent computation of the interest earned during the year on notes receivable. The working paper used to analyze notes receivable should show the interest rate and date of issuance of each note. The interest section of this working paper consists of four columns, which show for each note receivable owned during the year the following information: a. Accrued interest receivable at the beginning of the year (taken from the preceding year's audit working papers). b. Interest earned during the year (computed from the terms of the notes). c. Interest collected during the year (traced to cash receipts records). d. Accrued interest receivable at the end of the year (computed by the auditors).

LO 11-6 Assess the risks of material misstatement of receivables and revenue and design further audit procedures, including tests of controls and substantive procedures, to address the risks. (6)

9. Evaluate the propriety of the client's accounting methods for receivables and revenue. Primary Audit Objectives: Valuation, Accuracy ---> As indicated earlier in this chapter, many instances of misstatements in financial statements have involved the inappropriate recognition of revenue and related receivables— often through the premature recording of revenues or the recording of fictitious revenues. ---> Previous steps in this audit plan have addressed this risk through consideration of a proper year-end cutoff of sales transactions (step 5); performance of analytical procedures for accounts receivable, notes receivable, and revenue (step 6); and the review of significant year-end sales contracts for unusual terms (step 7). In step 9, we directly address the propriety of the accounting methods relating to receivables and revenue. ---> FASB Revenue Recognition Standard • Step 1: Identify the Contract. Step 2: Identify the Performance Obligations. • Step 3: Determine the Transaction Price. • Step 4: Allocate the Transaction Price to the Performance Obligations. • Step 5: Recognize Revenue When the Performance Obligations Are Satisfied. Auditing Revenue Recognition ---> In an overall sense, audit procedures for revenue recognition involve obtaining reasonable assurance that management has followed generally the appropriate accounting framework. If the framework is accounting standards generally accepted in the U.S., management should recognize revenue applying the five steps previously described. ---> Because revenue recognition may involve difficult judgments by management, especially when the sales contract terms are complex, the audit of revenue transactions may involve a high degree of risk. ------> In these situations, the auditors should expect management to have established effective controls, including engaging competent personnel in developing the estimates, and establishing effective management review controls to identify errors or fraud should they occur. The auditors should assess effectiveness of these controls in preventing and detecting material misstatements, and perform appropriate tests of controls to determine whether the controls are operating effectively. Potential Revenue Recognition Problems ---> For complex contracts, the auditors also should determine whether management is appropriately accounting for complexities such as multiple performance obligations, variable or noncash consideration, or significant financing components. Problems that the auditors might encounter in auditing revenue recognition include: a. Estimates of revenue recognized might not give consideration to sales return rights that have been granted to customers. b. Management or client personnel may have established, formally or informally, side agreements that significantly alter the terms of sale. c. Cash receipts from franchise fees may be inappropriately recognized when services have not been rendered to the franchisees. d. Bill and hold transactions may be recorded when they do not meet the requirements for revenue recognition. e. Notes receivable may not bear reasonable interest rates at the time they are accepted, resulting in a need to discount the notes to present values. f. Management of a construction contractor might overestimate the amount of revenue earned. g. Management of a software company might sell goods and services under a contract with multiple performance obligations and inappropriately overload revenue recognized on the performance obligations completed initially. 10. Evaluate accounting estimates related to revenue and receivables. Primary Audit Objectives: Valuation, Accuracy ---> Revenue recognition may involve significant accounting estimates. Auditors can evaluate these estimates by: • Reviewing and testing management's method of developing the estimates, • Developing their own estimates, or, • Reviewing subsequent transactions and other events that provide evidence about the accuracy of the estimates. ---> The auditors are required to perform a retrospective review of the prior year's significant accounting estimates to determine whether they indicate bias on the part of management. ---> Construction industry -compare prior year estimates of costs to complete projects with the actual costs incurred -may show bias on the part of management -use this information for current year audit of estimates

LO 11-6 Assess the risks of material misstatement of receivables and revenue and design further audit procedures, including tests of controls and substantive procedures, to address the risks. (2)

D. Perform further audit procedures—tests of controls (Additional Tests of Controls). ------> Tests directed toward the effectiveness of controls help to evaluate the client's internal control and determine whether the auditors' planned assessed levels of control risk can be supported. Certain tests of controls are performed as the auditors obtain an understanding of the client's internal control; these were described in our earlier discussion of that process. ------> 1. Examples of tests of controls: a. Test the controls over sales transactions by examining the process of recording the transactions. ---> To determine that the controls portrayed in the documentation are effectively functioning in everyday operations, the auditors may decide to examine significant aspects of a sample of sales transactions. The size of the sample and the transactions included therein may be determined by either statistical or nonstatistical sampling techniques. The auditors often use generalized computer audit software to select the transactions to be tested b. Trace details of shipping documents to related sales invoices. ---> The preceding step in the audit plan called for an examination of selected sales transactions and a comparison of the invoices with sales records and shipping documents. That procedure would not, however, disclose orders that had been shipped but not billed. To obtain assurance that all shipments have been billed, the auditors may obtain a sample of shipping documents issued during the year and compare these to sales invoices. In designing and performing this test, particular emphasis should be placed upon accounting for all shipping documents by serial number. c. Review the use and authorization of credit memoranda. ---> All allowances to customers for returned or defective merchandise should be supported by serially numbered credit memoranda signed by an officer or responsible employee having no duties relating to handling cash or to the maintenance of customers' ledgers. Good internal control over credits for returned merchandise usually includes a requirement that the returned goods be received and examined before credit is granted. The memoranda should then bear the date and serial number of the receiving report on the return shipment. ---> In addition to establishing that credit memoranda were properly authorized, the auditors should perform tests of these documents similar to those suggested for sales invoices. Prices, extensions, and footings should be verified, and postings traced from the sales return journal or other accounting record to the customers' accounts in the subsidiary receivable ledgers. d. Test controls for over-the-counter sales by reconciling cash register records or sales tickets with sales journals. ---> In the audit of clients that make a substantial amount of over-the-counter sales, the auditors may compare selected daily totals in the sales journal with cash register readings or tapes. The serial numbers of all sales tickets used during the selected periods should be accounted for and the individual tickets examined for accuracy of calculations and traced to the sales summary or journal. If the client uses electronic point-of-sale terminals with effective controls the auditors may be able to this evidence by testing the computer application controls. e. Test management review controls. ---> If management review controls are suitably designed the auditors may decide to test their operating effectiveness. The auditors will evaluate management review controls by considering the relevance and precision of the controls. Relevance is based on whether the the controls address appropriate financial statement assertions, the precision of the controls depends on the level of aggregation of the data, the consistency of performance, the predicability of management expectations, and the criteria used to determine when items are investigated. The auditors can test the operating effectiveness of the controls by inspecting documentation of performance of the controls, including the manner in which unusual items or relationships were identified, investigated, and resolved. f. Test controls over estimates related to revenues and receivables. ---> When a client uses accounting principles that require estimates of significant amounts of revenue, the auditors may decide to evaluate and test the controls over the estimates. The auditors will evaluate the competence of personnel involved in developing the estimates. They will also test the controls over the accumulation of relevant, reliable data to base the estimates. Finally, the auditors will examine evidence of management review and approval of the assumptions and related estimates. ---> The auditors may also decide to evaluate and test the controls over the development of the estimates of uncollectible amounts. The auditors will evaluate the competence of the personnel involved in developing the estimates. Generally, input from accounting, sales, and credit department personnel should be involved. The auditors may evaluate and test the completeness and reliability of the data used by the client to develop the estimates. ------> 2. If necessary, revise the risks of material misstatement based on the results of tests of controls. ---> When the auditors have completed the procedures described in the preceding sections, they should reassess the extent of the risk of material misstatement for each financial statement assertion regarding receivables and sales transactions. These assessments will determine whether the auditors should modify their planned substantive procedures for the financial statement assertions about receivables and sales. Figure 11.5 summarizes the relationships among these assertions, the controls, and typical tests of controls. This figure illustrates which controls affect the auditors' assessment of the risks of material misstatement for the various assertions.

LO 11-4 Use the understanding of the client and its environment to consider inherent risks (including fraud risks) related to receivables and revenue

A. Use the Understanding of the Client and Its Environment to Consider Inherent Risks, Including Fraud Risks, Related to Receivables and Revenue (Risk Assessment for the Audit of Receivables). ------> The auditors use their understanding of the client's environment to assess the inherent risks for the assertions about receivables and revenue. The auditors face a number of potential inherent risks related to receivables and revenue. Most of these risks are derived from business risks that are faced by management, such as the risks of: ∙ A decline in sales due to economic declines, product obsolescence, increased competition, or shifts in product or service demand. ∙ Inability to collect receivables. ∙ Improper revenue recognition (either intentionally or unintentionally). ∙ Restrictions placed on sales by laws and regulations. ------> Risks of material misstatement also arise from the possibility of fraud. Improper revenue recognition has been the most common technique used by management to engage in fraudulent financial reporting. Therefore, the audit of revenue and receivables is often an area of significant risk to auditors. This is so much so that the professional standards indicate that the auditors should ordinarily presume that there is a risk of material misstatement due to fraud relating to revenue recognition. ------> Because material misstatement related to revenue recognition is normally a fraud risk, the auditors will make sure that they understand the controls established by management to control this risk. They also will determine whether the controls have been implemented. Finally, the auditors will design their responses to the risks. As discussed in Chapter 6, the auditors' responses may take one or more of the following forms: 1. A response that has an overall effect on how the audit is conducted. For example, the auditors might assign personnel with significant experience in the client's industry to evaluate the accounting principles used to recognize revenue. 2. A response involving the design of audit procedures. For example, the auditors might require the confirmation of accounts receivable to be performed at year-end as opposed to an interim date. 3. A response involving performing procedures to further address the risk of material misstatement due to management's override of internal control. For example, the auditors will evaluate particularly carefully the business purpose of any unusual and significant sales transactions that they encounter, and they will evaluate the allowance for uncollectible accounts for evidence of management bias.

LO 11-3 Describe the documents, records, and accounts that compose the revenue (sales) transactions cycle and the fundamental controls over receivables and revenue. (3)

Audit of Receivables and Revenue The following steps indicate the general pattern of work performed by the auditors in the verification of receivables and revenue. Selection of the most appropriate procedures for a particular audit will be guided by the nature of the internal controls that have been implemented and by the results of the auditors' risk assessments. A. Use the understanding of the client and its environment to consider inherent risks, including fraud risks, related to receivables and revenue (Risk Assessment for the Audit of Receivables). B. Obtain an understanding of internal control over receivables and revenue (Risk Assessment for the Audit of Receivables). C. Assess the risks of material misstatement and design further audit procedures (Risk Assessment for the Audit of Receivables). D. Perform further audit procedures—tests of controls (Additional Tests of Controls). ------> 1. Examples of tests of controls: a. Test the controls over sales transactions by examining the process of recording the transactions. b. Trace details of shipping documents to related sales invoices. c. Review the use and authorization of credit memoranda. d. Test controls for over-the-counter sales by reconciling cash register records or sales tickets with sales journals. e. Test management review controls. f. Test controls over estimates related to revenues and receivables. ------> 2. If necessary, revise the risks of material misstatement based on the results of tests of controls. E. Perform further audit procedures—substantive procedures for receivables and revenue (Sustantive Tests). 1. Obtain an aged trial balance of trade accounts receivable and analyses of other accounts receivable and reconcile to ledgers. 2. Obtain analyses of notes receivable and related interest and reconcile to the general ledger. 3. Inspect notes on hand and confirm those with holders. 4. Confirm receivables with debtors. 5. Perform analytical procedures for accounts receivable, notes receivable, and revenue. 6. Review significant year-end sales contracts for unusual terms. 7. Review the year-end cutoff of sales transactions. 8. Test the valuation of notes receivable, computation of interest income, interest receivable, and amortization of discount or premium. 9. Evaluate the propriety of the client's accounting methods for receivables and revenue. 10. Evaluate accounting estimates related to revenue and receivables. 11. Determine the adequacy of the client's allowance for uncollectible accounts. 12. Ascertain whether any receivables have been pledged. 13. Investigate any transactions with or receivables from related parties. 14. Evaluate the business purpose of significant and unusual sales transactions. 15. Evaluate financial statement presentation and disclosure of receivables and revenue. Figure 11.2 relates these major substantive procedures for receivables and revenue to their primary audit objectives. As discussed in Chapter 6, it is essential for the auditors to have a thorough understanding of the client's business and the industry in which it operates. Regarding revenue and receivables, this understanding includes matters such as ∙ The types of products and services sold. ∙ The classes and categories of the client's customers. ∙ Whether the business is affected by seasonal or cyclical demand. ∙ Level of competition in the industry. ∙ Typical marketing policies for the client and its industry. ∙ Contract terms, including pricing, sales returns, discounts, extension of credit, and normal delivery and payment terms. ∙ Compensation arrangements that are based on recorded revenue. ∙ Typical revenue recognition principles used in the industry and their methods of application. An understanding of these matters helps ensure that the auditors effectively execute the audit plan for receivables and revenue.

Audit Risk of Receivables

Audit risk significant because: • Many incidences of fraud have involved overstatement of receivables and revenue. • Revenue recognition may be based on complex accounting rules. ------> Examples—long term contract accounting multiple element arrangements • Receivables and revenues are usually subject to valuation using significant accounting estimates.

LO 11-5 Obtain an understanding of internal control over receivables and revenue.

B. Obtain an Understanding of Internal Control over Receivables and Revenue (Risk Assessment for the Audit of Receivables). ------> The auditors' consideration of controls over receivables and revenue may begin with the preparation of a written narrative description or flowchart and the completion of an internal control questionnaire. Typical of the questions comprising an internal control questionnaire for revenue and receivables are the following: - Are orders from customers initiated and reviewed by the sales department? - Are sales invoices prenumbered and all numbers accounted for? - Are all sales approved by the credit department before shipment? - Are estimates of revenue performed by competent personnel using appropriate methods? After the auditors have prepared a description of the controls, they will determine whether the client is actually using the policies and procedures—that is, whether they have been implemented. As the auditors confirm their understanding of the revenue cycle, they will observe whether there is an appropriate segregation of duties and inquire as to who performed various functions throughout the year. They also will review revenue budgets and the follow-up on the variances; perform a walk-through of the cycle; inspect various documents, such as bills of lading, sales invoices, and customer statements; and review document files to determine that the client is appropriately accounting for the sequence of prenumbered documents.

LO 11-6 Assess the risks of material misstatement of receivables and revenue and design further audit procedures, including tests of controls and substantive procedures, to address the risks.

C. Assess the Risks of Material Misstatement and Design Further Audit Procedures (Risk Assessment for the Audit of Receivables). ------> After considering the information about the client and its environment, including internal control, the auditors assess the risks of material misstatement related to the assertions about receivables and revenue. To make these assessments, the auditors should consider the relationships between specific misstatements and internal controls. Figure 11.4 provides examples of potential misstatements of revenue and weaknesses in internal control that make them more likely to occur. ------> The auditors' assessments of the risks of material misstatement (inherent and control risks) are used to design further audit procedures, including tests of controls and substantive procedures. The further audit procedures should include tests of controls when the auditors' assessments of control risk assume that controls are operating effectively but, in regard to their understanding of the client's internal control, the auditors have not obtained sufficient evidence that controls are operating effectively. ------> Some of the risks identified by the auditors will be considered to be significant risks that require special audit consideration. As an example, if the client executes complex sales contracts, there may be a significant risk of misstatement of sales revenue that requires specific audit tests. In this case, the auditors may decide to confirm the terms of contracts with the client's customers. It is important to remember that for any significant risk, the auditors 1. Should evaluate the design of the related controls and determine that they are implemented. 2. May not rely solely on analytical procedures to address the risk. 3. May not rely on evidence obtained in prior periods regarding the operating effectiveness of the related controls.

LO 11-6 Assess the risks of material misstatement of receivables and revenue and design further audit procedures, including tests of controls and substantive procedures, to address the risks. (3)

E. Perform further audit procedures—substantive procedures for receivables and revenue (Sustantive Tests). 1. Obtain an aged trial balance of trade accounts receivable and analyses of other accounts receivable and reconcile to ledgers. Primary Audit Objectives: Valuation ---> An aged trial balance of trade accounts receivable at the audit date is commonly prepared by employees of the client for the auditors, often in the form of a computer printout. It's the summary of so many phases of the examination of receivables in a single working paper is practicable only for small concerns with a limited number of customers. If the client has any accounts receivable other than trade accounts, the auditors also should obtain similar analyses of those accounts. ---> When trial balances or analyses of accounts receivable are furnished to the auditors by the client's employees, some independent verification of the listing is essential. Determination of the proper extent of testing should be made in relation to the adequacy of the controls over receivables. 2. Obtain analyses of notes receivable and related interest and reconcile to the general ledger. Primary Audit Objectives: Valuation, Accuracy ---> An analysis of notes receivable supporting the general ledger control account may be prepared for the auditors by the client's staff. The information to be included in the analysis normally will include the name of the maker, date, maturity, amount, and interest rate. In addition to verifying the accuracy of the analysis prepared by the client, the auditors should trace selected items to the accounting records and to the notes themselves. 3. Inspect notes on hand and confirm those with holders. Primary Audit Objectives: Existence, Occurrence, Rights ---> The inspection of notes receivable on hand should be performed concurrently with the count of cash and securities to prevent the concealment of a shortage by substitution of cash for misappropriated negotiable instruments, or vice versa. Any securities held by the client as collateral for notes receivable should be inspected and listed at the same time. The auditors should maintain complete control over all negotiable instruments until the count and inspection are completed. ---> Notes receivable owned by the client may be held by others at the time of the examination. Confirmation in writing from the holder of the note is considered an acceptable alternative to inspection; it does not, however, eliminate the need for securing confirmation from the maker of the note. The confirmation letter sent to a bank, collection agency, secured creditor, or other holder should contain a request for verification of the name of the maker, the balance of the note, the interest rate, and the due date 4. Confirm receivables with debtors. Primary Audit Objectives: Valuation, Accuracy, Rights, Occurrence, Existence ------> An external confirmation is audit evidence obtained by the auditors as a direct written response to the auditors' confirmation request sent to a third party (the confirming party). The external confirmation may be in paper form, electronic form, or other medium (e.g., the auditors' direct access to information held by a third party). Direct communication with debtors is the most essential and conclusive step in the verification of accounts and notes receivable. By obtaining written acknowledgment of the debt by the debtor, the auditors obtain audit evidence that helps(a) establish the existence and gross valuation of the asset and (b) provides some assurance that no lapping or other manipulation affecting receivables is being carried on at the balance sheet date. ---> However, the confirmation of a receivable provides only limited evidence about the completeness and valuation assertions because only recorded amounts are confirmed, and debtors may acknowledge debts even though they are not able to pay them. ---> Receivables should be confirmed, unless: • Accounts receivable are immaterial, • The use of confirmations would be ineffective, or, • The auditors' combined assessment of inherent and control risk is low, and audit risk can be reduced to an acceptably low level with substantive tests, !!!!! Note - if client refuses to allow auditors to send confirmations to Customers ---could lead to qualified opinion or disclaimer of opinion. The same result could occur if auditors cannot get written responses. Types of Confirmations Two methods of confirmation of receivables: (1) Positive confirmation requests - Most positive forms ask the debtor to confirm directly to the auditors the accuracy of the dollar amount shown on the confirmation request. In this request, the entire balance due as of month end is being confirmed, as contrasted to individual unpaid transactions. • In this request, the entire balance due as of month end is being confirmed, as contrasted to individual unpaid transactions. • Other positive forms, referred to as blank forms, do not state the amount on the request, but ask the debtor company to fill in the balance due (either for the account as of monthend or for one or more individual unpaid transactions). Blank forms are generally not used for accounts receivable because the additional time involved in completing the form generally results in a lower response rate. ------> The positive form provides more assurance than the negative form because the auditors are alerted to the need for further investigation if a reply is not received. However, when positive confirmations ask recipients to confirm the accuracy of information provided on the request, there is a risk that the recipient may simply sign and return it without verifying the information. Blank forms control this risk by requiring the recipient to provide the information. But blank confirmations generally result in lower response rates and, therefore, require more follow-up procedures. (2) Negative confirmation requests - consists of a communication addressed to the debtor company asking it to advise the auditors only if the balance shown is incorrect. A negative confirmation request may be in the form of a letter or it may be made merely by applying a rubber stamp to the customer's regular monthly statement, or by attaching a gummed label. ------> Although positive confirmation requests may be used in any circumstance, the use of solely negative requests should be reserved for situations in which the following circumstances exist: (a) The assessed level of the risk of material misstatement is low and sufficient appropriate audit evidence has been obtained on operating effectiveness of controls; (b) a large number of small, homogeneous balances are involved; (c) a low exception rate is expected; and (d) the auditors are not aware of circumstances that would cause recipients of the request to disregard them. ------> When the auditors use negative requests, they should consider supplementing the confirmation process with other substantive procedures. In many situations, a combination of positive and negative confirmation requests is used, with the positive form used for large balances and the negative form for small balances.

LO 11-3 Describe the documents, records, and accounts that compose the revenue (sales) transactions cycle and the fundamental controls over receivables and revenue. (2)

Monitoring over Controls for Revenue and Receivables ------> A major type of monitoring controls for revenue and receivables is management review controls. Appropriate controls here involve reviewing various types of performance reports, such as sales and gross margin by product line, by major customer, by geographic area, and by salesperson. ------> In addition, management often will carefully review the aging of accounts receivable and may solicit feedback from customers about the accuracy of billings. ------> Internal auditors also contribute to the monitoring process. As a part of their audit activities, they may periodically take over the mailing of monthly statements to customers, or send confirmations and investigate discrepancies reported. They also may perform extensive reviews of shipping reports, invoices, cash receipts, credit memoranda, and the aged trial balances of accounts receivable to determine whether prescribed control activities are being carried out consistently. In addition, reports of regulatory agencies should be considered in making improvements in internal control Internal Control over Notes Receivable As previously stated, a basic characteristic of effective control consists of the subdivision of duties. As applied to notes receivable, this principle requires that: ∙ The custodian of notes receivable not have access to cash or to the general accounting records. ∙ The acceptance and renewal of notes be authorized in writing by a responsible official who does not have custody of the notes. ∙ The write-off of defaulted notes be approved in writing by responsible officials and effective procedures adopted for subsequent follow-up of such defaulted notes. ------> These rules are obviously corollaries of the general proposition that the authorization, recording, and custodial functions should be separate, especially for cash and receivables Audit Documentation for Receivables and Revenue Besides preparing lead schedules for receivables and net revenue, the auditors obtain or prepare the following working papers: 1. Aged trial balance of trade accounts receivable (often a computer printout). 2. Analyses of other accounts receivable. 3. Analysis of notes receivable and related interest. 4. Analysis of allowance for uncollectible accounts and notes. 5. Comparative analyses of revenue by month, by product, or by territory, or by relating forecasted revenue to actual revenue. 6. Documentation of internal controls. 7. Risk analyses and audit plan (program).

LO 11-3 Describe the documents, records, and accounts that compose the revenue (sales) transactions cycle and the fundamental controls over receivables and revenue.

Revenue Cycle— Accounting System and Control Activities ------> For many companies, the primary source of revenue is from the sale of goods or services to customers on credit. Ineffective controls over credit sales and receivables can be costly to a business. When control activities over sales on account are inadequate, large credit losses are almost inevitable EX: Merchandise may be shipped to customers whose credit standing has not been approved. Shipments may be made to customers without notice being given to the billing department; consequently, no sales invoice is prepared. Sales invoices may contain errors in prices and quantities; and if sales invoices are not controlled, some may be lost and never recorded as accounts receivable. ------> To avoid such difficulties, strong controls over credit sales are necessary. Usually, internal control over credit sales is strengthened by a division of duties so that different departments or individuals are responsible for: (1) preparation of the sales order, (2) credit approval, (3) issuance of merchandise from stock, (4) shipment, (5) billing, (6) invoice verification, (7) maintenance of control accounts, (8) maintenance of customers' ledgers, (9) approval of sales returns and allowances, and (10) authorization of write-offs of uncollectible accounts Monitoring over Controls for Revenue and Receivables (we talk about these later on): • Management review controls. • Internal audits. When this degree of subdivision of duties is feasible, accidental errors are likely to be detected quickly through the comparison of documents and amounts emerging from independent units of the company, and the opportunity for fraud is reduced to a minimum. While our discussion of the accounting system and control activities will be developed primarily in terms of the sales processes of manufacturing companies, most of the principles also apply to service organizations. (Revenue Cycle) Controlling Customers' Orders (Purchase/Sale Orders) ------> The controlling and processing of orders received from customers require carefully designed operating procedures and numerous controls if costly errors are to be avoided. ------> Important initial steps include registering the customer's purchase order, reviewing items and quantities to determine whether the order can be filled within a reasonable time, and preparing a sales order. Credit Approval ------> Before sales orders for new or unapproved customers are processed, the credit department must determine whether goods may be shipped to the customer on open account. This department is supervised by a credit manager who reports to the treasurer or the vice president of finance. ------> Once a new customer has been granted a line of credit, approval of a particular sales transaction involves a simple determination of whether the customer has sufficient unused credit. This process is often performed by the IT system. If the sales transaction will cause the customer's credit limit to be exceeded, the computer will alert the credit department, which will initiate the process of determining whether to increase the customer's line of credit. When credit is not approved, the customer is notified and an effort is made to negotiate other terms, such as cash on delivery. Issuing Merchandise ------> Companies that carry standard products in stock maintain a finished goods storeroom supervised by a storekeeper. The storekeeper issues the goods covered by a sales order to the shipping department only after the sales order has been approved by the credit department. Perpetual inventory records of finished goods should be maintained by the accounting department, not by the storekeeper. The Shipping Function (Bills of Landing) ------> When the goods are transmitted by the finished goods storeroom to the shipping department, this group must arrange for space in railroad cars, aircraft, or motor freight carriers. Shipping documents, such as bills of lading, are created at the time of loading the goods into cars or trucks. ----------> The shipping documents are numerically controlled and are entered in a shipping register before being forwarded manually or electronically to the billing department. The Billing Function (Invoice) ------> The term billing means notifying the customer of the amount due for goods or services delivered. This notification is accomplished by preparing and mailing a sales invoice in either electronic or paper form. A department not under the control of sales executives should perform billing. Collection of Receivables (Control Listing) ------> Receivables held by companies are collected by receipt of customers' checks and remittance advices through the mail or electronically. The cashier will control and deposit checks. The remittance advices or a listing of the receipts will then be forwarded to the accounts receivable section of the data processing department, which will record them in the appropriate accounts in the customers' ledger. The total reduction in accounts receivable will be posted periodically to the general ledger control account from the total of the accounts receivable column in the cash receipts journal Controls over Revenue Estimates ------> When amounts of revenue must be estimated because of the complexity of the agreements or difficulties in determining the portion of the revenue earned, the client should establish effective controls over the development of the estimates, including: 1. Control environment policies and procedures that encourage proper estimates. 2. Risk assessment policies that consider the risks of inappropriate selection or application of revenue recognition principles. 3. Policies that ensure that competent personnel are involved in developing the revenue estimates, including those that have an understanding of revenue recognition accounting standards, contract terms, characteristics of customers, and economic conditions. 4. Policies and procedures that ensure that relevant, sufficient, and reliable data are considered in the development of the revenue estimates. 5. Management review and approval of sources of data, processes used to development the assumptions, changes in the methods used, and the reasonableness of assumptions and revenue estimates. 6. Policies to improve estimation processes by comparison of prior revenue estimates with actual revenue realized. Adjustments to Sales and Receivables (Credit Memos AKA Credit Memorandum) ------> All adjustments to sales for allowances, returns, and write-offs of accounts receivable should be supported by serially numbered credit memoranda signed by an officer or responsible employee having no duties relating to cash handling or to the maintenance of customers' ledgers. Good internal control over credits for returned merchandise usually includes a requirement that the goods be received and examined before credit is given. The credit memoranda should then bear the serial number of the receiving report on the returned shipment. ------> The credit manager should initiate the process of uncollectible receivable write-off, with subsequent authorization by the treasurer. Receivables that are written off should then be either turned over to a collection agency or retained and transferred to a separate ledger and control account. The records may be of a memorandum nature rather than part of the regular accounting system. Also, when possible—generally when the debtor is still in existence—statements requesting payment should continue to be mailed. Otherwise, any subsequent collections may be embezzled by employees without the necessity of falsifying records to conceal the theft. Revenue Cycle Controls • Segregation of duties--sales and collections • Matching of sales invoices and shipping documents • Clerical accuracy checks on invoices • Credit approval for sales transactions • Mailing of monthly statements • Reconciliation of bank accounts • Use of control listing of cash receipts • Use of budgets and analysis of variances • Control over shipping and billing documents • Use of authorized credit memoranda • Use of chart of accounts and review of account codings

LO 11-1 Describe the nature of receivables.

Sources and Nature of Accounts Receivable (A/R) ------> The vast majority of a company's accounts receivable are trade receivables that: ---> arise from credit sales of goods or services to customers. Trade notes and accounts receivable usually are relatively large in amount and should appear as separate items in the current assets section of the balance sheet at their net realizable value. ---> Accounts receivable also include a variety of miscellaneous claims such as loans to officers, loans to subsidiaries, claims against other firms, claims for tax refunds, and advances to suppliers. ------>Auditors are especially concerned with the presentation and disclosure of loans to officers, directors, and affiliated companies. ----------> These related party transactions are commonly made for the convenience of the borrower rather than to benefit the lending company. Consequently, such loans are often collected only at the convenience of the borrower. It is a basic tenet of financial statement presentation that transactions not characterized by arm's-length bargaining should be fully disclosed. _____________________________________________________________________________ Sources and Nature of Notes Receivable (N/R ------> Notes receivable are written promises to pay certain amounts at future dates. Typically, notes receivable are used for handling transactions of substantial amount; these negotiable documents are widely used (Substantial loans to individuals or companies). ------> In banks and other financial institutions, notes receivable usually constitute the single most important asset. ------> An installment note or contract may be used in an exchange that grants possession of goods to a purchaser but permits the seller to retain a lien on the goods until the final installment under the note has been received. Installment notes are widely used in the sale of industrial machinery, farm equipment, and automobiles. Other transactions that may lead to the acquisition of notes receivable include: (a) the disposal of items of plant and equipment; (b) the sale of divisions of a company; (c) the issuance of capital stock; (d) and the making of loans to officers, employees, and affiliated companies.

LO 11-2 Describe the auditors' objectives in the audit of receivables and revenue.

The Auditors' Objectives in Auditing Receivables and Revenue The auditors' objectives in the audit of receivables and revenue are to: 1. Use the understanding of the client and its environment to consider inherent risks, including fraud risks, related to receivables and revenue. 2. Obtain an understanding of internal control over receivables and revenue. 3. Assess the risks of material misstatement and design tests of controls and substantive procedures that ---> a. Substantiate the existence of receivables and the occurrence of revenue transactions. ---> b. Establish the completeness of receivables and revenue transactions. ---> c. Verify the cutoff of revenue transactions. ---> d. Determine that the client has rights to recorded receivables. ---> e. Establish the proper valuation of receivables and the accuracy of revenue transactions. ---> f. Determine that the presentation and disclosure of information about receivables and revenue are appropriate, including the classification of receivables into appropriate categories, adequate reporting of any receivables pledged as collateral, and disclosure of related party sales and receivables. Because of the close relationship between revenue and accounts receivable, the two can best be considered jointly. The determination of the amount of revenue to be recognized for a particular period is integrally related to a number of financial statement accounts, including sales and accounts receivable, adjustments to sales and accounts receivable, service revenue, deferred revenues, and cash. In addition, it is a major determinant of the amount of net income that the company reports for a particular period. Therefore, the audit of revenue and receivables is an area of significant risk to auditors. ____________________________________________________________________________ Internal Control of Accounts Receivable and Revenue\ ------> To understand internal control over accounts receivable and revenue, the auditors should consider the various components, including the control environment, risk assessment, monitoring, the (accounting) information and communication system, and control activities. ____________________________________________________________________________ Control Environment ------> Because of the risk of intentional misstatement of revenues, the control environment is very important to effective internal control over revenue and receivables. ----------> Of particular importance is an effective board of directors (and audit committee) that provides effective oversight of management's judgments about revenue recognition principles and estimates, as well as an effective internal audit function. Management should establish a tone at the top of the organization that encourages integrity and ethical financial reporting. These ethical standards should be communicated and observed throughout the organization. Also, incentives for dishonest reporting, such as undue emphasis on meeting unrealistic sales or earnings targets, should be eliminated. ----------> Appropriate revenue recognition may involve complex accounting principles, estimates, and computations. As a result, management should make a commitment to competence, especially as it relates to key financial and accounting personnel. Increased control is indicated when management effectively identifies the skills and training needed to perform key functions and implements effective procedures to ensure that these functions are performed by competent personnel. Management's commitment to integrity and ethical values, as indicated by its attitude toward financial reporting, is also important in the control of revenue and receivables. The relevant questions include: Is management aggressive or conservative in selecting methods of revenue recognition? Are estimates of uncollectible accounts developed in a conscientious manner? ----------> With regard to its commitment to attract, develop, and retain competent employees, management should make appropriate background checks of prospective employees and obtain fidelity bonds on employees in positions of trust. Individuals with significant control responsibilities must be competent to perform their assigned duties. Internal control is also improved when individuals who maintain accounting records or cash are required to take vacations and when their assigned duties are rotated periodically. Fidelity Bonds: A form of insurance protection that covers policyholders for losses that they incur as a result of fraudulent acts by specified individuals. Fidelity bonds usually insure a business for losses caused by the dishonest acts of its employees. ____________________________________________________________________________ Risk Assessment ------> As discussed in Chapter 7, risk assessment involves identification, analysis, and management of risks relevant to achieving the organization's objectives. In relation to the revenue cycle, management should develop a formal process of monitoring external factors, such as changes in economic conditions, competition, customer demand, and regulations that may affect the risk of achieving the company's sales objectives. In addition, management should evaluate the effects of internal factors, such as changes in accounting principles, the introduction of new products and services, and the use of new types of sales contracts. These internal and external factors may create new risks for the company, indicating a need to implement new types of controls to prevent the misstatement of revenue. E.I. Risk of misstatement of revenue may be high based on its nature and complex rules regarding revenue recognition.

What this chapter is about:

This chapter describes the audit of receivables and revenue, both products of the revenue cycle. In broad terms, this cycle includes receiving orders from customers, providing and billing merchandise or services to customers, and recording and collecting accounts receivable. Receivables from customers include both accounts receivable and various types of notes receivable.