audit chapter 7: The revenue and collection cycle

Pending order and Back Order Master File

-Sales initiated but not yet completed and not recorded on sales = pending. -Orders for products that are out of stock currently = Back Order Master File

What computer-based files might auditors examine to find evidence of unrecorded sales? of inadequate credit checks? of incorrect product unit prices?

-Unrecorded sales - Pending order master file -Inadequate credit checks: credit data/check files -incorrect product unit prices: price list master file

SEC rule when revenue is generally realized or realizable ad earned. ALLL MUST BE MET

1) Persuasive evidence of an arrangement exists 2) Delivery has occured or services have been rendered 3) The Seller's price tot he buyer is fixed or determinable 4)collect ability is reasonably ensured.

revenue to be recognized

1) realized /realizable and 2) earned. When entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues

Revenue and collection Cycle steps:

1: Receiving and processing customer orders. 2: Delivering goods and services to customers: 3: Billing customers, producing sales invoices 4:collecting and depositing check 5: Reconcile bank statements

Why do auditors focus on revenue as a significant account and the occurrence of revenue as a relevant assertion in the revenue cycle?

7.7 Occurrence of revenue is considered a significant account and relevant assertion for several reasons: • The magnitude of revenue is often substantial indicating that recorded revenues are generally material. • Management has an incentive to overstate revenues, thus the occurrence assertion is relevant. • Stakeholders focus on revenue as a performance measure, therefore the account is significant to users of the financial statements.

The negative request form of accounts receivable confirmation is useful particularly when

A. Negative confirmations are most appropriate when the assessed level of risk is low, dollar balances on accounts are small, and the auditor believes recipients will give consideration to the confirmations. b. Incorrect The auditor assumes customers are likely to respond to errors. c. Incorrect Because negative confirmations offer higher detection risk, risk of material misstatement should be low when they are used. d. Incorrect Because negative confirmations offer higher detection risk, risk of material misstatement should be low when they are used.

what controls should be implemented to safeguard accounts receivable files?

Access to computer terminal should be restricted to only authorized users to change or enter transaction data.

4)Collecting cash and depositing in the bank

Accounting for cash receipts

What special care should be taken with regard to examining the sources of AR confirmation response?

Auditors need to take special care in examining sources of accounts receivable confirmation responses. Auditors need to control the confirmations, including the addresses to which they are sent. History is full of cases in which confirmations were mailed to company accomplices who had provided false responses. The auditors should carefully consider features of the reply such as postmarks, FAX, and email responses, letterhead, electronic mail, telephone number, or other characteristics that may give clues to indicate false responses. Auditors should follow up electronic and telephone responses to determine their origin (for example, returning the telephone call to a known number, looking up telephone numbers to determine addresses, or using a crisscross directory to determine the location of a respondent).

2) Delivering goods and services to customers

Authorizing release from storeroom to shipping to customers. Enter shipping info in system.

Why is access to master files important?

Because changes in them affect automatic computer controls Ex credit checking and accurate inv pricing.

Auditors will review items in the pending order file for evidence of the

COMPLETENESS of recorded sales and account receivables

What information should be obtained when dealing with delinquent accounts?

Confirmations to taxpayers who had actually paid their taxes would have produced exceptions, complaints, and people with their counter receipts. These results would have revealed the embezzlement.

What is dual-direction test of controls sampling in revenue and collection cycle?

Dual direction tests of controls sampling refers to procedures that test file contents in two "directions": the occurrence direction and the completeness direction. The occurrence direction involves a sample from the account balance (e.g., sales revenue) vouched to supporting sales and shipping documents for evidence of occurrence. The completeness direction is a sample from the population that represents all sales (e.g., shipping document files) traced to the sales journal or sales account for evidence that no transactions (shipments, sales) were omitted.

1) receiving and processing customer orders include?

Entering data in an order system and obtaining a credit check

what effect do entity level controls have on control risk assessments of an auditor?

Entity level controls provide an additional level of assurance for the auditor related to control risk. For example, if the client has a strong audit committee, this provides additional assurance that appropriate oversight is being conducted internally. Control risk assessment should always be conducted in a top-down approach, with entity level controls considered initially.

True or False: A negative confirmation is more likely when inherent risk is high

FALSEEEE, negative confirmation should be used when there is low risk involved and small accounts.

Suppose that you selected a sample of customers' account receivable and wanted to find supporting evidence for the entries in the accounts. Where would you go to vouch the credit entries? What would you find?

Find the support for credit entries in the cash receipts journal file. Expect to find a remittance advice (entry on list), which corresponds to detail on a deposit slip, on a deposit actually in a bank statement for the day posted in the customers' accounts.

What types of audit procedures are typically performed in testing operating effectiveness of controls over the revenue and collection cycle?

In general, the types of procedures in tests of controls over the operating effectiveness involve vouching, tracing, observing, scanning, and recalculating.

Suppose that you selected a sample of customers' account receivable and wanted to find supporting evidence for the entries in the accounts. Where would you go to vouch the debit entries? What would you find?

In the Sales journal files. Expect to find sales of invoice, shipping document and customer order. "Shipping dates"

What are some justifications for not using confirmations of accounts receivable on a particular audit?

Justifications for the decision not to use confirmations for trade accounts receivable in a particular audit include (a) receivables are not material, (b) confirmations would be ineffective based on prior years' experience or knowledge that responses could be unreliable, and (c) analytical procedures and other substantive procedures provide sufficient, competent evidence.

What is lapping?

Lapping is the delayed recording of cash receipts to cover a cash shortage.

Why is the audit of revenue recognition riskier for a new company?

New companies often do not show a profit during their first few years. Therefore, creditors and investors often place more emphasis on the revenues, especially looking for revenue growth that might lead to future profitability. Knowing this, management could try to inflate revenues.

Not always but most significant risk relate to the (in AUDIT) Occurrence of _____ and existence/valuation of ______

Occurrence of revenues and existence/valuation of accounts receivable.

2 Methods to confirm A/R Positive and ______ confirmation

Positive (usually "blank form"). Does not contain balance and lets customer fill in. NEGATIVE** confirmation asks for a response only IFIFIFIFIF something is wrong with the balance.

3) Billing customers and account for accounts receivable

Preparing invoice for customer. Prepare account receivables

what is relevant assertions for Revenue and A/R??

Revenue = Occurrence, Completeness and Cutoff A/R = Existence, Completeness, Valuation.

Why do you think companies use revenue recognition as a primary means for inflating profits?

Revenue recognition is used as a primary means for inflating profits for several reasons. First, it is not always straightforward when revenues have been earned. Sales can be structured with return provisions or can have other performance provisions attached. Second, the timing of shipments at year-end may be easy to falsify. Third, markets often value companies based on a multiple of its revenue instead of net income.

Why should customer orders, shipping documents, and invoices be in pre-numbered sequence?

So system (or person) can check the sequence and determine whether any transactions have not been recorded (completeness) or have been duplicated (occurrence)

Auditors is REQUIRED to audit A/R in their procedures True or False

TRUE

Risk of Material Misstatement

The combined probability that a material misstatement (error or fraud) will occur and not be prevented or detected on a timely basis by the entity's internal controls

Why is inherent risk for the existence assertion for accounts receivable often set higher than inherent risk for the completeness assertion?

The inherent risk for the existence assertion for accounts receivable is often higher than inherent risk for the completeness assertion because management has an incentive to overstate accounts receivable. It is important to place emphasis on the existence assertion because auditors have often been sued for malpractice by providing unqualified reports on financial statements that overstated assets and revenues and understated expenses. For example, credit sales recorded too early (e.g., a fictitious sale) result in overstated accounts receivable and overstated sales revenue.

What is a walkthrough of internal control? What is its purpose?

The purpose of the walkthrough is to obtain an understanding of the transaction flow, the control procedures, and the populations of documents that may be utilized in tests of controls. In a walkthrough of a sales transaction, auditors take a small sample (usually 1-3 items) of a sales transaction and trace it from the initial customer order through credit approval, billing, and delivery of goods to the entry in the sales journal and subsidiary accounts receivable records, and then its subsequent collection and cash deposit. Sample documents are collected, and employees in each department are questioned about their specific duties. The information gained from documents and employees can be compared to answers obtained on an internal control questionnaire to ensure proper procedures are taking place.

Audit Risk

The risk that the auditor expresses an inappropriate audit opinion when the financial statements are materially misstated.

What specific control procedures should be placed and operating in internal controls governing revenue recognition?

These specific control procedures (in addition to separation of duties and responsibilities) should be in place and operating in a control system governing revenue recognition and cash accounting: • No sales order should be entered without a customer order. • A credit check code or manual signature should be recorded by an authorized person. • 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. • Accountants should be instructed to record sales and accounts receivable when all the supporting documentation of shipment is in order, and care should be taken to record sales and receivables as of the date goods and services were shipped, and cash receipts on the date the payments are received. • Customer invoices should be compared with bills of lading and customer orders to assure 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 in a timely manner to avoid failure to bill the customer and record shipments • Bank statements should be reconciled in detail monthly.

what are primary control procedures to ensure completeness of recorded revenues?

To ensure completeness of recorded revenue, all invoices, shipping documents, and sales orders should be prenumbered, and the numerical sequence should be checked on a timely basis.

True or False: A positive confirmation is more likely when inherent risk is high

True, positive confirmation is more likely used when inherent risk is high.

Cash receipts from sales on account have been misappropriated. Which of the following acts would conceal this defalcation and be least likely to be detected by an auditor? A. understating the sales journal b. overstating the AR control account c. overstating the AR subsidiary ledger d. understating the cash receipts journal

a. Correct Not recording sales on account in the books of original entry is the most effective way to conceal a subsequent theft of cash receipts. The accounts will be incomplete but balanced, and procedures applied to the accounting records will not detect the defalcation. b. Incorrect The control account wouldn't match the total of customer accounts. c. Incorrect Customers would catch the overstatement when examining their statements. d. Incorrect This is a possibility, but (a) is a better answer. There is less likelihood of getting caught if the sale is never recorded.

When an audit team traces a sample of shipping documents to the related sales invoice copies, they are trying to find relevant evidence that A.Shipments to customers were invoiced B. Shipments to customers were recorded as sales C. Recorded sales were shipped D. Invoiced sales were shipped

a. Correct Shipments are traced to customers' invoices. (This does not imply that the invoices were recorded in the sales journal.) b. Incorrect See (a) above. The invoice copies need to be traced to the sales journal and general ledger to determine whether the shipments were recorded as sales. c. Incorrect Recorded sales were shipped is not established because the sample selection is from shipments, not from recorded sales. d. Incorrect See (c) above.

When a sample of customer accounts receivable is selected for vouching debits, auditors will vouch them to A. Sales invoices with shipping documents and customer sales invoices B. Records of account receivable write offs C. Cash remittance lists and bank deposit slips D. Credit files and reports

a. Correct The accounts receivable debits are supposed to represent sales that have been ordered by customers and actually shipped to them. b. Incorrect This is not evidence about existence. c. Incorrect This provides some evidence about existence, but even if the receivables haven't been paid, they may still be valid. d. Incorrect These file will likely not provide detailed evidence about specific sales.

Write-offs of doubtful accounts should be approved by A. the salesperson B. the credit manager c. the treasurer d. the cashier

a. Incorrect Salespeople could write-off accounts for their friends to keep them from having to pay. b. Incorrect The credit manager may propose write-offs to reduce days outstanding and make her or him look better. c. Correct The treasurer or another high-ranking manager should approve write-offs. d. Incorrect The cashier could fraudulently collect cash and write off the balance.

An audit client sells 15 to 20 units of product annually. A large portion of the annual sales occur in the last month of the fiscal year. Annual sales have not materially changed over the past five years. Which of the following approaches would be most effective concerning the timing of audit procedures for revenue? a. The auditor should perform analytical procedures at an interim date and discuss any changes in the level of sales with senior management. b. The auditor should inspect transactions occurring in the last month of the fiscal year and review the related sale contracts to determine that revenue was posted in the proper period. c. The auditor should perform tests of controls at an interim date to obtain audit evidence about the operational effectiveness of internal controls over sales. d. The auditor should review period-end compensation to determine whether bonuses were paid to meet earnings goals.

a. Incorrect Since a large portion of the sales occur in the last month of the year using analytical procedures at an interim date would not be effective. b. Correct Since a large portion of the sales occur in the last month the auditor needs to test end of year sales, specifically the determination of the timing of sales is important to ensure sales were recorded in the proper period. c. Incorrect Since a large portion of the sales occur in the last month of the year using testing internal controls at an interim date would not be effective in determining that year-end sales were accurate. Additional testing through year end would be required. d. Incorrect Period-end compensation may or may not be based on sales. Even if period-end compensation is tied to sales, a review of the compensation would not provide evidence of the valuation or cut-off of sales.

Audit team uses aged trial balance of AR primarily to A. Evaluate internal control over credit sales B. Test the accuracy of recorded charge sales C. Estimate credit losses D/ Verify the existence of the recorded receivables

a. Incorrect The aged trial balance provides only indirect evidence about controls. b. Incorrect The aged trial balance provides no evidence about accuracy. c. Correct The age of accounts is an indication of credit losses. d. Incorrect The aged trial balance provides no evidence about existence.

An audit team is auditing sales transactions. One step is to vouch a sample of debit entries from the accounts receivable subsidiary ledger back to the supporting sales invoices. The purpose of this audit procedure is to establish that A. Sales invoice represent bona fide sales B. All sales have been recorded C. All sales invoices have been properly posted to customer accounts D. Entries in the account receivable subsidiary ledger were properly invoiced

a. Incorrect This doesn't verify that the sales invoices represent actual shipments. b. Incorrect This would require tracing from shipping documents to invoices. c. Incorrect This would require tracing from invoices to customer accounts. d. Correct Vouching is used to establish support for recorded amounts.

auditors sometimes use comparisons of ratios as audit evidence. An unexplained decrease in the ratio of gross profit to sales may suggest which of the following possibilities? a. unrecorded purchases b.unrecorded sales c.merchandise purchases being charged to selling and general expense d. fictitious sales

a. Incorrect This would increase gross profit. b. Correct Less sales revenue and correct amount of cost of goods sold results in less gross profit, therefore the ratio of gross profit to sales will decrease. (Actually, the gross profit numerator will decrease at a greater rate than the sales denominator in the ratio, causing the ratio to decrease.) c. Incorrect This would increase gross profit. d. Incorrect This would increase sales and cost of sales, and the ratio would not change. If cost of sales is not recorded, gross profit would increase

An auditor noted that client sales increased 10 percent for the year. At the same time, Cost of Goods Sold as a percentage of sales had decreased from 45 percent to 40 percent and year-end accounts receivable had increased by 8 percent. Based on this information, the auditor is most likely concerned about___ A. Unrecorded costs B. Improper credit approvals C. Improper sales cutoff D. Fictitious sales

a. Incorrect Unrecorded costs would not increase sales. b. Incorrect Improper credit approvals would not lower COGS. Goods were shipped for these sales, and COGS as a percentage of sales would be unchanged. c. Incorrect Improper sales cutoff would not decrease COGS as a percent of sales. d. Correct Fictitious sales would increase sales. Because no actual product was shipped, COGS as a percent of sales would decrease. The most likely debit for fictitious sales is accounts receivable, causing accounts receivable to increase.

cash receipts listing

contains all detail entries for cash deposits and credits to various accounts

Which 3 events should generally have occurred prior to the recognition of sales revenue?

customer purchase order, evidence of shipment (perhaps a bill of lading), and a customer invoice (AKA 3 way match). This control will provide assurance about the occurrence of revenues and the existence of accounts receivable. This control will provide assurance about the occurrence of revenues and the existence of accounts receivable.

Sales Detail (Journal) File

detailed sales entries, which should correspond with issuance of invoices to customers (including shipping references and dates)

5) Reconciling bank statement

double check accounts like AR to customers AP.

What makes an account significant or an assertion relevant?

has reasonable possibility of containing a misstatement(s) that would cause the F/S to be materially misstated.

Control Risk

risk that a material misstatement will get through the internal control structure and into the financial statements

Accounts receivable listing and aging

the AR lisitng = amoun they owe AR aging = Allowance for doubtful accounts

Inherent Risk

the probability that in the absence of internal controls, material errors or frauds could enter the accounting system used to develop financial statements