Chapter 9 - Auditing the Revenue Cycle

Performance Obligation

(also called a deliverable) is a promise within the contract to transfer a good or service to your customer.

What are the 5 steps that are used to recognize revenue?

1. Identify the contract with the customer 2. Identify the Performance Obligations 3. Determine the transaction price 4. Allocate the transaction price to the deliverables. 5. Recognize revenue when (or as) you satisfy performance obligations

Steps of Revenue Cycle

1. Receive a Customer Purchase Order 2. Check Inventory Stock Status 3. Generate Back Order 4. Obtain Credit Approval 5. Prepare Shipping and Packing Documents 6. Ship and Verify Shipment of Goods 7. Prepare and Send the Invoice 8. Send Monthly Statements to Customers 9. Receive Payments

What 6 things must the auditor understand to audit the revenue Cycle?

1. The organization's principal business, that is, what is the organization in the business of selling? 2. The earnings process and the nature of the obligations that extend beyond the normal shipment of goods. For example, after goods are shipped, does the seller have any ongoing service requirements to the purchaser? 3.The impact of unusual terms, and when title has passed to the customer. 4. The right of the customer to return a product, a well as the returns history. 5. Contracts that are combinations of leases and sales. 6. The proper treatment of sales transactions made with recourse or that have an abnormal or unpredictable amount of returns.

Positive Confirmations

A request to customers asking them to respond directly to the auditor if they agree or disagree with the indicated balance.

Negative Confirmation

A request to customers asking them to respond directly to the auditor only if they disagree with the indicated balance.

Bill of Lading

A shipping document that describes items being shipped, the shipping terms, and delivery address; a formal legal document that conveys responsibility for the safety and shipment of items to the shipper.

False Confirmation

A situation in which the respondent to a confirmation request (in this chapter, an accounts receivable confirmation) responds inaccurately to the audit firm with respect to the information on the confirmation.

Lapping

A technique used to cover up the embezzlement of cash whereby a cash collection from one customer is stolen by an employee who takes another customer's payment and credits the first customer. This process continues, and at any point in time at least one customer's account is overstated.

Side Letters

An agreement containing contract terms that are not part of the formal contract (often involving rights of return). Side letters increase audit risk because they enable key contract terms affecting revenue recognition to be hidden from the auditor as part of a revenue recognition fraud.

Timing Differences

Confirmation exceptions caused by transactions that are in process at the confirmation date, such as in-transit shipments or payments. These are not misstatements.

Revenue attrition

Equals beginning period reoccurring revenue minus end-of-period reoccurring revenue, less any new revenue gained, divided by beginning period revenue. In simpler terms, revenue attrition helps organization determine the relative extent to which they are losing versus gaining customers.

(9-13) T or F It is not possible for internal controls to mitigate risks associated with the valuation of accounts receivable.

False

(9-14) T or F Diageo made improper cash payments to government officials in Mexico, Brazil, and Argentina during the period 2003-2009, which violated provisions of the Foreign Corrupt Practices Act.

False

(9-18) T or F When performing planning analytical procedures, the auditor could perform trend analysis with ratios, but not with account balances.

False

(9-21) T or F Responding to identified risks in the revenue cycle rarely involves developing an audit approach that contains substantive procedures (e.g., tests of details and, when appropriate, substantive analytical procedures).

False

(9-26) T or F Surprisingly, AmTrust's restatement was followed by a stock price increase, likely because investors inferred that by revealing the restatement the company could move forward with confidence.

False

(9-29) T or F Auditors in practice commonly use negative confirmations.

False

(9-5) T or F Channel stuffing is a fraud in the revenue cycle that involves recording revenue after a customer has requested to purchase the inventory.

False

What is a negative earnings surprise or a negative revenue surprise?

It is a negative departure from the consensus analyst earnings forecast or the revenue forecast; for example, lower actual earnings per share amount compared to the consensus or lower revenue compared to the consensus expectation.

What does the term "analyst consensus forecast" mean?

It means the average earnings per share or revenue based on all the analysts that are following the company. If a company is at or near its consensus forecast and the auditor proposes a material, income decreasing audit adjustment, client management may resist because they do not want to report a negative earnings surprise.

Alternative Procedure

Procedures used to obtain evidence about the existence and valuation of accounts receivable when a positive confirmation is not returned, including examining cash collected after the confirmation date and vouching unpaid invoices to customers' orders, sales orders, shipping documents, and sales invoices.

Revenue Cycle

The process of receiving a customer's order, approving credit for a sale, determining whether the goods are available for shipment, shipping the goods, billing the customers, collecting cash, and recognizing the effect of this process on other related accounts.

(9-1) T or F The revenue cycle involves receiving a customer's order, approving credit for a sale, determining whether the goods are available for shipment, shipping the goods, billing the customer, collecting cash, and recognizing the effect of this process on revenue and other related accounts such as accounts receivable, inventory, and sales commission expense.

True

(9-10) T or F When assessing fraud risks, the auditor should consider the client's motivation to increase revenue due to both internal and external pressures.

True

(9-17) T or F The auditor might conclude that a heightened risk of fraud exists if the planning analytical procedures indicate increases in revenue and net income, but negative cash flow from operations.

True

(9-2) T or F In the revenue cycle, the most significant accounts typically include revenue and accounts receivable.

True

(9-22) T or F While audit firms may have a standardized audit program for the revenue cycle, the auditor should customize the audit program based on the assessment of risk of material misstatement.

True

(9-25) T or F In testing controls over whether sales are properly valued, the auditor could take a sample of recorded sales invoices and agree the price on the invoice to an authorized price list.

True

(9-30) T or F A substantive audit procedure that would reveal ownership and related disclosure issues includes scanning the cash receipts journal for relatively large inflows of cash that from unusual sources.

True

(9-6) T or F If the contract stipulates more than one deliverable, the client must allocate a separate price to each deliverable.

True

(9-9) T or F Research indicates that a majority of financial statement frauds involve inappropriate recording of revenue.

True

What are the most relevant financial statement assertions for receivables?

Usually existence and valuation

(9-12) Which of the following explanations best describes the purpose of lapping? a. Lapping is a technique used by client personnel to cover up the embezzlement of cash. b. Lapping is an approach used by client personnel to eliminate differences between a customer's records and the client's records reported on confirmations. c. Lapping is a procedure used by the auditor to obtain evidence the client's customer does return a positive confirmation. d. Lapping is an agreement containing contract terms that are not part of a formal sales contract.

a. Lapping is a technique used by client personnel to cover up the embezzlement of cash.

Which of the following is a proper control for the detection of unusual sales transactions recorded in the general ledger? a. Review of transactions by upper management or the board. b. Random statements to customers. c. Use of sequentially numbered sales documents. d. Electronic authorization prior to posting.

a. Review of transactions by upper management or the board.

(9-32) The auditor is concerned that the client has recorded fictitious sales. Which of the following procedures would be the best audit procedure to identify fictitious sales? a. Select a sample of recorded sales invoices and trace to shipping documents (bills of lading and packing slips) to verify shipment of goods. b. Select a sample of shipping documents (bills of lading) and trace to the sales invoice to determine whether the invoice was properly recorded. c. Select a sample of customer purchase orders and trace through to the generation of a sales invoice. d. Select a sample of customer purchase orders to determine whether a valid customer actually exists.

a. Select a sample of recorded sales invoices and trace to shipping documents (bills of lading and packing slips) to verify shipment of goods.

(9-20) Assume that an auditor expected that the client's activities related to sales and accounts receivable would be similar to industry averages. Which of the following relationships detected as part of planning analytical procedures would not suggest a heightened risk of material misstatement in the revenue cycle? a. The number of days' sales in accounts receivable decreased from 65 days in the prior year to 47 days in the current year. The industry average increased from 45 to 47 days. b. The gross margin increased from 16.7% to 18.3%, while the industry average changed from 16.7% to 16.3%. c. Accounts receivable increased 35% over the prior year, while sales stayed relatively stable. d. All of the above relationships are suggestive of a heightened risk of fraud.

a. The number of days' sales in accounts receivable decreased from 65 days in the prior year to 47 days in the current year. The industry average increased from 45 to 47 days.

(9-23) After identifying the risks of material misstatement, the auditor develops an audit plan in response to those risks. Which of the following plans for testing revenue would be most likely when the auditor believes that control risk is high? a. The only evidence the auditor plans to obtain is from tests of details. b. The auditor plans to obtain 40% of the necessary audit evidence from tests of controls, and the remaining 60% from substantive analytical procedures. c.The auditor plans to obtain the majority of the necessary audit evidence from tests of controls. d. Any of the above would be an appropriate audit plan if the auditor believes that control risk is high.

a. The only evidence the auditor plans to obtain is from tests of details.

Edge and Gregg, LLP would most likely discover a client's first-time use of channel stuffing through the use of trend analysis. a. True b. False

a. True

Monthly statements provide a detailed list of the customer's activity for the previous month and a statement of all open items. a. True b. False

a. True

The audit team typically reviews journal entries in the receivables ledger for unusual entries that may be indicators of fraudulent activity. a. True b. False

a. True

(9-8) Which of the following statements is false regarding the fraud at ArthroCare? a. Two of ArthroCare's sales executives overstated ending inventory that improperly inflated company revenue and earnings. b. PricewaterhouseCoopers' audit was deficient for ArthroCare, thereby enabling the fraud to go undetected for a period of time. c. ArthroCare agreed to pay a $30 million fine to resolve the investigation. d. ArthroCare is a manufacturer of medical devices, based in Austin, Texas, whose shares are traded on NASDAQ.

a. Two of ArthroCare's sales executives overstated ending inventory that improperly inflated company revenue and earnings.

The primary difference between positive and negative confirmations used in the audit of accounts receivable is which of the following? a.The mode of response. b.The amount of information included. c.The method in which accounts are selected for confirmation. d.The control of the confirmation process by the auditor.

a.The mode of response.

A control that may be implemented to ensure all sales that occur are recorded in the general ledger includes which of the following? a.Use of prenumbered shipping, invoice and sales documents. b.Use of prenumbered statements, inventory lists and credit memos. c.Reconciliation of invoices with customer statements. d.Use of pre-authorized price lists.

a.Use of prenumbered shipping, invoice and sales documents.

(9-15) Which of the following procedures can organizations use to address credit risk most effectively? a. An informal credit policy, which may be automated for most transactions, but requires special approval for large and/or unusual transactions. b. A periodic review of the credit policy by key executives to determine whether changes are dictated either by current economic events or by deterioration of the receivables. c. Periodic monitoring of receivables for evidence of increased risk, such as increases in the number of days past due or an unusually high concentration in a few key customers whose financial prospects are declining d. Adequate segregation of duties over fixed assets, with specific authorization to write off fixed assets that have been fully depreciated.

b. A periodic review of the credit policy by key executives to determine whether changes are dictated either by current economic events or by deterioration of the receivables.

Accounts receivable confirmation letters should be prepared on the auditing firm's letterhead. a. True b. False

b. False

The auditor would examine a sample of sales transactions throughout the entire period to determine if sales were recorded in the proper period when performing a sales cutoff test. a. True b. False

b. False

(9-3) Which of the following statements is true regarding assertions in the revenue cycle? a. It is typical that all five assertions for revenue are equally important. b. If a client has an incentive to overstate revenues, the existence assertion would be more relevant than the completeness assertion. c. Audit evidence about the existence of revenues is also the most appropriate evidence about the valuation of receivables. d. The allowance for doubtful accounts has important implications for the ownership assertion of accounts receivable.

b. If a client has an incentive to overstate revenues, the existence assertion would be more relevant than the completeness assertion.

(9-28) An auditor performs tests of controls in the revenue cycle. First, the auditor makes inquiries of company personnel about credit-granting policies. The auditor then selects a sample of sales transactions recorded in the general ledger and examines documentary evidence of credit approval. Which of the financial statement assertion(s) does this test of controls most likely support? Completeness Valuation or Alloc. a. Yes Yes b. No Yes c. Yes No d. No No

b. No Yes

(9-16) Which of the following statements about the Medicis fraud is false? a. In 2012, the PCAOB settled a disciplinary order censuring Ernst & Young (EY), imposing a $2 million penalty against the firm and sanctioning four of its current and former partners. b. The PCAOB found that EY and its partners failed to properly evaluate a material component of the company's financial statements—its allowance for doubtful accounts. c.EY did not properly evaluate Medicis' practice of reserving for most of its estimated product returns at replacement cost, instead of at gross sales price. It appears that EY accepted the company's basis for reserving at replacement cost, when the auditors should have known that this approach would not be supported by the audit evidence. d. The PCAOB investigation revealed that by using replacement cost for the reserve, rather than gross sales price, Medicis' reported sales returns reserve were materially understated and its reported revenue was materially overstated. e. All of the above are true.

b. The PCAOB found that EY and its partners failed to properly evaluate a material component of the company's financial statements—its allowance for doubtful accounts.

(9-24) Responding to identified risks involves developing an audit approach that addresses those risks. Which of the following statements about the planned audit approach is true for the revenue cycle? a. The audit approach needs to include tests of controls, substantive analytical procedures, and tests of details. b. The audit approach will typically require more evidence for higher risk assertions than lower risk areas. c. The audit approach should follow the audit firm's standardized audit program. d. The sufficiency and appropriateness of selected procedures will not vary across assertions.

b. The audit approach will typically require more evidence for higher risk assertions than lower risk areas.

Which one of the following procedures would be considered improper by the auditor in the process of confirming receivables? a. The auditor allows the client to sign the confirmations after they are prepared. b. The auditor allows the client's staff to mail the confirmation letters after he or she has proofed the typing of the letters. c. The auditor allows the client's staff to prepare the confirmation letters after the auditor has chosen the items to be confirmed. d. The auditor asks the addressee to return the confirmation to the audit firm's office.

b. The auditor allows the client's staff to mail the confirmation letters after he or she has proofed the typing of the letters.

(9-7) Under the FASB's guidance on revenue recognition, which of the following is not a criteria that must be met in order for a contract to exist? a. The parties have approved it. b. The auditor has ensured that the contract's valuation is reasonable in all material respects. c. The goods and/or services involved are clearly identified. d. The payment terms are spelled out. e. There is commercial value to the contract.

b. The auditor has ensured that the contract's valuation is reasonable in all material respects.

(9-31) To test the completeness of sales, the auditor would select a sample of transactions from which of the following populations? a. Customer order file b. Open invoice file c. Bill of lading file d. Sales invoice file

c. Bill of lading file

(9-11) Which of the following factors is not a motivation for clients to fraudulently misstate revenue? a. Bankruptcy may be imminent. b. Management bonuses are contingent on a certain revenue goal. c. Controls over revenue process are ineffective. d. Management wants to meet publicly announced earnings expectations.

c. Controls over revenue process are ineffective.

The auditor traces recorded sales to invoices, sales orders, and shipping documents in order to substantiate which assertion? a. Cutoff. b. Legality. c. Occurrence. d. Completeness.

c. Occurrence.

Substantive tests of the revenue cycle typically do not provide evidence of which of the following? a. Fraudulent transactions are not included in the financial statements. b. Accounts receivable exist. c. The balance in the allowance account is correct. d. Sales transactions exist and are properly valued.

c. The balance in the allowance account is correct.

The major risk associated with receivables is related to which of the following? a. They may be recorded as long-term when in fact they will be realized in the current period. b. They are pledged as collateral as disclosed in the footnotes to financial statements. c. They will not be realized for the entire amount due. d. They may be sold to a bank with recourse.

c. They will not be realized for the entire amount due.

An analysis of monthly sales compared with past years and budgets is a form of what type of testing? a.Regression analysis. b.Ratio analysis. c.Trend analysis. d.Common size analysis.

c. Trend analysis.

For which of the following accounts receivable customer populations would the use of negative confirmations be most appropriate? a. A retail truck and trailer sales company with high inherent risk and moderate control risk over the revenue cycle. b. A mortgage banking company with excellent control over the purchasing cycle. c. A utility company with control risk over the revenue cycle assessed high. d. A cable company with control risk over the revenue cycle assessed low.

d. A cable company with control risk over the revenue cycle assessed low.

(9-27) When auditing a nonpublic company, the auditor would generally make a decision not to test the operating effectiveness of controls in which of the following situations? a. The preliminary assessment of control risk is high. b. It is more cost efficient to directly test ending account balances than to test controls. c. The auditor believes that controls are designed effectively but are not operating as described. d. All of the above are situations when the auditor would likely not test the operating effectiveness of controls.

d. All of the above are situations when the auditor would likely not test the operating effectiveness of controls.

(9-19) Which of the following statements is false regarding planning analytical procedures in the revenue cycle? a. As revenue is typically regarded as a high-risk account, planning analytical procedures related to revenue are not required. b. The first step in planning analytical procedures includes developing an expectation of recorded amounts or ratios, and evaluating whether that expectation is precise enough to accomplish the relevant objective. c. Trend analysis would not be appropriate as a planning analytical procedure in the revenue cycle. d. All of the above statements are false.

d. All of the above statements are false.

A key indicator of fraud in the revenue cycle is the auditor's detection of which of the following? a. Customer collections that are over 90 days past due. b. Credit entries in customer accounts receivable for authorized write-offs. c. Recurring entries in the sales journal. d. Altered shipping documents and invoices.

d. Altered shipping documents and invoices.

In an audit of financial statements, risks related to a high rate of return of products sold include which of the following? a. A reduction of net sales for an increase to the sales returns and allowance account. b. An estimate of accrued returns that reduces net income. c. Consignment goods that are returned and forwarded to third parties. d. Sales that are recorded improperly.

d. Sales that are recorded improperly.

(9-4) Which of the following statements is true regarding the processing and recording of revenue transactions? a. The accurate recording of revenue transactions is important for preparing financial statements, but not important for the client's management decisions. b. Invoices should be prepared once the client determines that the goods ordered by a customer are available. c. A bill of lading provides documentation that the customer has received the goods. d. Sales transactions typically begin with the receipt of a purchase order from a customer.

d. Sales transactions typically begin with the receipt of a purchase order from a customer.

Credit approval policies are implemented by organizations primarily to accomplish which of the following objectives? a. To ensure customer satisfaction. b. To prevent lapping by the accounts receivable department. c. To determine revenue recognition policies. d. To minimize credit losses.

d. To minimize credit losses.

Which of the following is not a form of ratio analysis? a. Sales in last month to total sales. b.Turnover of receivables. c.Gross margin analysis. d.Monthly sales analysis compared with past years.

d.Monthly sales analysis compared with past years.

Auditors will examine significant sales returns immediately subsequent to the period under audit in order to do which of the following? a.Test the sufficiency of cash balances to cover refunds. b.Assess the nature of procedures that will be performed for the next period's audit. c.Monitor customer satisfaction for disclosure. d.Substantiate cutoff and the occurrence of net sales transactions.

d.Substantiate cutoff and the occurrence of net sales transactions.

If a valid sales transaction does not _________, a valid receivable does not _________.

exsist, exsist

What is the primary inherent risk associated with receivables?

is that the net amount is not valid because the receivables recorded do not exist or they are not collectible from the customer.