Chapter 11 Audit

When a company uses the percentage-of-completion method, there is a risk

that management may misestimate the amount of revenue earned on uncompleted contracts.

When a company's sales agreements allow for returns, there is a risk

that management may misstate the estimate of sales returns and, therefore, misstate revenue and receivables. -the auditors should carefully review the contracts to determine that revenue should be recognized at the time of sale

Negative confirmation requests may be used for situations in which

(1) the combined assessed level of inherent and control risk is low; (b) a large number of small balances are involved (c) the auditors have no reason to believe that the recipients of the requests are not likely to give them consideration.

wo methods of confirmation of receivables:

1) Positive confirmation 2) Negative confirmation

Receivables should be confirmed, unless:

-Accounts receivable are immaterial -The use of confirmations would be ineffective -The auditors' combined assessment of inherent and control risk is low, and audit risk can be reduced to acceptably low level with substantive tests

Responses to risk related to Receivables and Revenue

-An overall effect on audit -Alter the design of audit procedures -Performing procedures to address risk of material misstatement due to management override of internal control

Sources of Accounts Receivable

-Claims against customers from sale of goods or services -Loans to officers or employees -Loans to subsidiaries -Claims against various other refunds -Claims for tax refunds -Advances to suppliers

Revenue Cycle - Documents

-Customer purchasing--Purchase order -Sales--Sales order -Shipping--Bill of lading -Billing—Invoice -Receiving cash receipts--Control listing -Authorizing adjustments to accounts receivable--Credit memo

Internal control over A/R and Revenue - Control Environment

-Important because of risk of intentional misstatement of revenue -Commitment to integrity and ethical behavior -Independence of board and audit committee -Appropriate structure and lines of responsibility -Commitment to recruit, develop, and retain competent employees -Holding employees accountable

Internal Control over A/R and Revenue - Monitoring Controls

-Management review controls -Internal audits

Audit risk of receivables is significant because

-Many incidences of fraud have involved overstatement of receivables and revenue -Revenue recognition may be based on complex accounting rules -Receivables and revenues are usually subject to valuation using significant accounting estimates

Perform further audit procedures—substantive procedures for receivables and revenue. Examples:

-Obtain an aged trial balance of trade accounts receivable and analyses of other accounts receivable and reconcile to ledgers. -Obtain analyses of notes receivable and related interest. -Inspect notes on hand and confirm those with holders. -Confirm receivables with debtors. -Review the year-end cutoff of sales transactions. -Perform analytical procedures for accounts receivable, notes receivable, and revenue. -Review significant year-end sales contracts for unusual terms. -Test the valuation of notes receivable, computation of interest income, interest receivable, and amortization of discount or premium -Evaluate the propriety of the client's accounting methods for receivables and revenue. -Evaluate accounting estimates related to revenue recognition -Determine the adequacy of the client's allowance for uncollectible accounts -Ascertain whether any receivables have been pledged. -Investigate any transactions with or receivables from related parties. -Evaluate the business purpose of significant and unusual sales transactions. -Evaluate financial statement presentation and disclosure of receivables and revenue.

Internal Control over A/R and Revenue - Control Activities

-Prepare sales order -Approve credit -Issue merchandise from stock -Shipment -Billing -Invoice verification -Maintenance of control accounts -Maintenance of customers' ledgers -Approval of sales returns and allowances -Authorization of write-offs of uncollectible accounts

o identify related party transactions, auditors should review:

-Proxy and other filings with SEC or other regulatory agencies -conflict-of-interest statements by management -Transactions with unusual terms -Accounting records for unusual balances or transactions particularly near year-end -Determine that related party transactions are appropriately disclosed

Audit of Allowances 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.

Auditors can evaluate revenue estimates by:

-Reviewing and testing management's method of developing the estimates -Developing their own estimates -Reviewing subsequent transactions and other events that provide evidence about the accuracy of the estimates

Potential Revenue Recognition Problems

-Sales with unusual right to return -Side agreements -Franchise fees -Bill and hold transactions -Sales using notes with unusual interest rates -Long-term construction contracts -Multiple element agreements

Sources of Notes Receivable

-Substantial loans to individuals or companies -Installment note or contract can allow seller to hold lien on goods. Examples: Sale of industrial machinery, or farm equipment -Loans to subsidiaries or other types of related companies -Loans to officers, employees

Assess the risks of material misstatement and design tests of controls and substantive procedures that:

-Substantiate the existence of receivables and the occurrence of revenue transactions -Establish the completeness of receivables and revenue transactions -Verify the cutoff of revenue transactions -Determine that the client has rights to recorded receivables -Establish the proper valuation of receivables and the accuracy of revenue transactions -Determine that the presentation and disclosure of receivables and revenue are appropriate

Perform further audit procedures—tests of controls. Examples:

-Test the controls over sales transactions by examining the process of recording the transactions. -Trace details of shipping documents to related sales invoices -Review the use and authorization of credit memoranda. -Test controls over over-the-counter sales by reconciling cash register tapes or sales tickets with sales journals. -Test management review controls. -Test controls over accounting estimates related to revenues and receivables.

Internal Control over Notes Receivable, subdivision of duties

-The custodian of notes receivable should not have access to cash or to the general accounting records -The acceptance and renewal of notes are authorized in writing by a responsible official who does not have custody of notes -The write-off of defaulted notes are approved in writing by responsible officials and effective procedures adopted for subsequent follow-up of such defaulted notes

Details on Understanding the Client Business

-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. -Typical marketing policies for the client and its industry. -Policies regarding 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.

Fraud Risk related to Receivables and Revenue

-Understand controls established by management to control risks -Determine controls have been implemented

Audit Documentation

1) Lead schedules for receivables and net revenue 2) 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)

When the auditors identify a risk as being significant and requiring special audit consideration, they must:

1) Evaluate the design of the related controls and determine that they have been implemented (2) Not rely solely on analytical procedures to address the risk (3) Not rely on evidence obtained from prior audits regarding the operating effectiveness of the related internal controls.

The following tests could be performed:

1) Test for authorization of sales by determining whether all sales transactions are authorized by an authorized salesperson. (2) Test for credit approval for all customers. (3) Identification of sales not supported by shipping documents. (4) Test for accounting for all invoices by number. (5) Test for accounting for all shipping documents by number. (6) Test to identify customers with outstanding balances in excess of credit limits. (7) Test to identify premature billing by comparison of shipping date to invoice date.

Additional substantive audit procedures:

1) Test the accuracy of the aged accounts receivable schedule. (2) Confirm receivables. (3) Review the year-end cutoff of sales transactions. (4) Perform analytical procedures. (5) Review significant year-end sales contracts for unusual terms. (6) Evaluate the propriety of the client's accounting methods for receivables. (7) Determine the adequacy of the client's allowance for uncollectible accounts. (8) Ascertain whether any receivables have been pledged. (9) Investigate any transactions with or receivables from related parties. (10) Evaluate the business purpose of significant and unusual sales transactions .(11) Evaluate financial statement presentation and disclosure.

The audit of revenue and receivables is of significant audit risk because

1) overstatement of revenue has been a factor in many instances of fraudulent financial reporting (2) the overstatement of revenue results in a corresponding overstatement of net income (3) the determination of the amount of revenue recognized may be determined by the application of complex accounting principles (4) significant accounting estimates may be involve in the determination of the financial statement presentation of receivables and revenue.

To overstate revenue the following techniques might be used by Processing Solutions' management:

1. Recording of fictitious contracts with customers. 2. Recording revenue before a contract is executed. 3. Recording revenue when the company has entered into side agreements with the customers that affect the realization of revenue (e.g., allowing liberal return privileges). 4. Allocating excessive amounts of revenue to the performance obligations of delivery and set-up of the system to recognized revenue early.

Risk Assessment for the Audit of Receivables

1. Understand the control environment and inherent risk 2. Understand internal control over receivables and revenue 3. Asses the risk of material misstatement

The auditors should confirm with the bank

1. The loss contingency for notes receivable discounted. 2. Should send separate confirmation requests to the makers of the notes receivable which were discounted to determine the genuineness and validity of the notes.

Objectives for the Audit of Receivables and Revenue

1. Understand control environment and inherent risk 2. Understand internal control 3. Asses the risks of material misstatement

Fictitious receivables must be disposed of

1. write off the fictitious accounts as uncollectible. 2. valid accounts receivable have been collected, but written off as uncollectible by the employee who has procured the funds.

In testing the adequacy of the client company's allowance for doubtful accounts receivable, the auditors review the following:

1.Large past-due accounts not paid subsequent to the audit date. 2.An aged trial balance of accounts receivable and comparison with those of prior years. 3.Accounts in dispute as evidenced by confirmation exceptions or by correspondence in the client's files. 4.Unfavorable reports of collection prospects on accounts assigned to collection agencies or attorneys. 5.Opinions of the client's credit manager as to the collectible portion of each large past-due account. 6.Relationship of the valuation allowance to (a) accounts receivable, (b) net credit sales, and (c) accounts written off during the year. These ratios should be compared with those prevailing in past years and industry averages. 7.Information from a retrospective review of prior year's allowance that indicates whether management might bias its estimates.

Alternate auditing procedures that may be used when customers have not replied to confirmation requests include:

1.Send additional requests by registered or certified mail, with return receipt requested. 2.The auditors might telephone to ascertain the balance or the reason for failure to respond to the written request. 3.Under some circumstances, requests may be made by fax machine. 4.The auditors may examine any payments to the account made subsequent to the balance sheet date. The auditors may also examine the duplicate invoices, shipping records, purchase orders, etc., for transactions making up the unpaid balance.

Other specific procedures which contribute to good internal control over the business processes related to accounts receivable include:

1.The separation of the duties of the accounts receivable accountant from all cash handling functions. 2.Regular balancing of the subsidiary ledger of receivables with the general ledger control account by an employee other than the accounts receivable accountant. 3.Regular aging of accounts receivable and review by management. 4.Periodic review of delinquent accounts by an appropriate executive. 5.Periodic confirmation of accounts receivable by internal auditors. 6.Serial numbering of shipping documents, sales invoices, and credit memoranda, and regular accounting for all numbers in the series.

Example: Recording sales when the customers payment is contingent upon the customer receiving financing or selling the goods to another party (Consignment sales)

Aggressive attitude of management toward financial reporting incompetent chief of accounting officer

Example: Amount of revenue earned on franchises is miscalculated

Aggressive attitude of management toward financial reporting; incompetent chief accounting officer

Overstatement: Recording revenue when the company has entered into side agreements with the customers that affect the recognition of revenue (e.g., allowing liberal return privileges).

Audit Procedure: 1. Confirmation of contract terms with customers, including the existence of any side agreements. 2. Inquiries of salespeople about oral modification of contract terms and side agreements.

Overstatement: Recording of fictitious contracts with customers.

Audit Procedure: 1. Confirmation of contracts with customers. Inquiries of salespeople about contracts. 2. Confirmation of contract terms with customers.

Overstatement: Recording revenue before a contract is executed.

Audit Procedure: Inquiries of salespeople about contract execution dates.

Overstatement: Allocating excessive amounts of revenue to the delivery and set-up of the system to recognize revenue early.

Audit Procedure: Review of allocation of contract revenue to the performance obligations of the contract, e.g., software, setup, maintenance, etc. Revenue should be recognized on the performance obligations based on their standalone prices. The auditors should evaluate the approach used and the related assumptions.

How should the accounts receivable department be sure that it has received and recorded all sales invoices.

Each day the billing department should send copies of the invoices prepared that day to the accounts receivable department accompanied by a transmittal letter specifying the invoice numbers used and the total dollar amount billed. By comparing the individual invoices with the list of serial numbers and comparing the total debits to accounts receivable with the total figure for billings

Example: Recording cash that represents a liability (receipt of a customer deposit) as revenue

Inadequate accounting manual; incompetent accounting personnel

Example: Recording sales based on the receipt of orders from customers rather than the shipment of goods

Ineffective billing process in which billing is not tied to shopping information

Example: Intentional over shipment of goods

Ineffective board of directors, audit committee, or internal audit function; "tone at the top" not conducive to ethical conduct; undue pressure to meet sales target

Example: Recording fictitious sales without receiving a customer order or shipping the goods

Ineffective board of directors, audit committee, or internal audit function; "tone at the top" not conducive to ethical conduct; undue pressure to meet sales target

Example: Recording franchise revenue when the franchises are sold even though an obligation to perform significant services still exist

Ineffective board of directors, audit committee, or internal audit function; "tone at the top" not conducive to ethical conduct; undue pressure to meet sales target

Example: Holding the sales journal open to record next years sales as having occurred in the current year

Ineffective board of directors, audit committee, or internal audit function; "tone at the top" not conducive to ethical conduct; undue pressure to meet the sales targets

Example: Inaccurate billing and recording of sales

Ineffective controls for testing invoices, or ineffective input validation checks and computer reconciliations to ensure the accuracy of databases

Example: Recording sales in the wrong period based on incorrect shipping information

Ineffective cutoff procedures in the shipping department

Positive confirmation

Request addressed to the debtor asking for a reply -Ordinarily sent with balances due on them -Blank forms - leave amount blank (used less frequently)

Internal Control over A/R and Revenue - Risk Assessment

Risk of misstatement of revenue may be high based on its nature and complex rules regarding revenue recognition

FASB ASC 606 establishes a five-step process for recognizing revenue from contracts:

Step 1: Identify the Contract -it can be written, oral, or implied by customary business practice. Step 2: Identify the Performance Obligations. Step 3: Determine the Transaction Price. -amount expected and entitled to receive Step 4: Allocate the Transaction Price to the Performance Obligations Step 5: Recognize Revenue When the Performance Obligations are Satisfied.

Steps for Recognition of Revenue

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.

If a computer is used to record sales invoices item counts and control totals should be

Used to ensure that all sales are recorded.

A positive confirmation request requires

a reply from the client's customer in every case.

A negative confirmation request requires

a reply only if the balance for which confirmation has been requested is incorrect.

An audit confirmation request is

a written communication received by the auditors directly from a party outside the client organization. The written communication usually affirms the existence of, and rights to, an amount recorded in the client's accounting records.

When each day's invoices are transmitted from the billing department to the accounts receivable department, they should be

accompanied by a transmittal list showing the serial numbers of all sales invoices.

A retrospective review is

an analysis of the judgments and assumptions underlying a prior year accounting estimate. -purpose with respect to revenue is to provide information about possible management bias to assist in the audit of the current year revenue estimates.

When salespeople modify the terms of sales through various side agreements

an issue may arise as to whether any particular sale meets accounting criteria to be recorded as such, and whether the allowance for returns needs to be adjusted.

Negative confirmation

ask debtor to advise the auditors only if the balance shown is incorrect -Low level of assessed risk of material misstatement -Large number of small balances -A low error rate is expected -No reason to believe the respondent will ignore the request

The credit memoranda should

bear the date and serial number of the receiving report on the return shipment.

The client company should request (on its letterhead) the customer to

confirm the account receivable. -The auditors have no authority to make such a request directly on their stationery. The return envelope should be addressed to the auditors' office to assure that the auditors have control over confirmation returns.

The sales order is a translation of the terms of the

customer's order into a set of specific instructions for the guidance of various departments, including the credit department, finished goods, stores, shipping, billing, and accounts receivable.

Alternative auditing procedures to verify accounts receivable when confirmation is not practicable or possible include

examination of customers' purchase orders or contracts; examination of client's duplicate shipping documents and invoices; and review of payments received from customers subsequent to the balance sheet date.

When a company engages in bill and hold transactions there

is a possibility that the company is inappropriately recognizing revenue. -The auditors must ascertain that any transactions recognized as sales meet the criteria for revenue recognition

Confirmation of accounts receivable by direct communication with debtors

is usually essential to the issuance of an unqualified audit report.

Examples of types of receivables originating without arm's-length bargaining include

loans to insiders (directors, officers, key employees) and loans to affiliated companies. -these types of receivables should be shown separately with disclosure of the nature of the relationships and the amounts of the transactions.

Accounts Receivable is shown on balance sheet at

net realizable value

The objective of the billing process is to

notify the customer of the amount due for goods or services delivered. A most important document created by the billing department is the sales invoice.

The write-off of small notes receivable from officers, directors, stockholders, or affiliated companies is

obviously irregular and unacceptable practice Such notes are almost always collectible by virtue of the positions held by the makers. The auditors should investigate these related party transactions fully; they will probably find that the charges to the allowance for uncollectible notes were made in error and were not authorized by management. If the amounts were large, there would be more reason to suspect an intention of self-serving activities or fraud on the part of the management.

The confirmation process is

primarily intended to establish that the receivables are valid and that the customers (or makers of notes) exist. Other audit procedures are followed to determine proper valuation.

To be valid evidence, an audit confirmation response must be

received directly by the CPA firm from the outside party who has replied to the confirmation request.

Confirmation of receivables is a presumed procedure, and failure to perform such a procedure when issuing an unqualified report

requires justification in the working papers.

voided shipping documents should be

retained, and not discarded so as to assure that the numerical sequence may be accounted for.

The sales invoices (and the shipping documents as well) should be

serially numbered.

Excessive sales returns or allowances may indicate

shipments made without customers' orders, shipments of defective merchandise, a misstatement of inventory or of sales and receivables, or weaknesses in internal control.

An unusually large number of sales transactions just prior to the balance sheet date

should be fully investigated by the auditors. -This situation may result from a strenuous effort made during the closing days of the period to get out shipments and meet a sales quota. -May reflect an improper cutoff of sales transactions at year-end, or even the recording of fictitious sales.

All sales invoices

should be serially numbered.

Revenue recognition may involve

significant accounting estimates

Good internal control in the billing process requires

that someone other than the employee preparing the invoice shall review the accuracy of prices, credit terms, and other data on the invoice before this document is released.

When confirmation requests are mailed to debtors whose accounts were written off as uncollectible, the auditors' purposes are to determine

that the receivables were genuine when they were first recorded in the accounts and to determine that the accounts were not collected and the proceeds stolen.

The audit objective of determining the existence of receivables is most directly addressed by

the audit procedure of confirming accounts receivable and notes receivable by direct communication with debtors.

To test the client's sales cutoff at June 30

the auditors should compare shipping records with entries in the sales journal, and receiving records with entries recording sales returns, for several days prior to and subsequent to June 30. The auditors will be alert for sales and sales returns recorded in the wrong accounting period.

Written confirmation also addresses

the completeness and valuation assertions, but less effectively because it deals only with recorded accounts and provides limited information on whether the receivable is collectible. The procedure also provides evidence of occurrence and accuracy of revenue transactions.

Personnel in the credit department should grant credit and decide when accounts should be written off.

the credit department is independent and is evaluated on its ability to balance maximizing sales with the collection of accounts.

If the auditors find post office box addresses for many individual customers whose accounts were selected for confirmation, the auditors should consider the possibility that

the customers may be fictitious, and that dishonest employees of the client company plan to "answer" the confirmation requests.

he confirmation requests should go to the makers of the notes regardless of whether

the notes have been discounted -The act of discounting a note receivable does not reduce the importance of the note being genuine and collectible.

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.

When a company sells goods or services using a multiple performance obligation arrangement

the revenue must be allocated to the performance obligations based their standalone selling prices. -When the goods or services are not sold separately, management must estimate the standalone prices using an appropriate method, such as the adjusted market assessment approach or the expected cost plus a margin approach.

If the auditors decide to use artificial intelligence to tests the contracts,

they could use software to read every contract and classify them based on the relevant terms. The auditors would have to use their understanding of the accounting principles to establish the criteria used by the software to classify the contracts.

f sales department personnel knew they could grant credit and write off accounts,

they may be inclined to make sales quotas by selling to customers with questionable ability to pay; or worst they may conspire with customers to receive kick-backs by agreeing to write off their accounts.

If the auditors decide to manually test the contracts

they would select a sample of contracts and review them for contract terms. In selecting the sample, the auditors would want select items form all types of customers.

In IT systems controls are established

to ensure that product prices are accurately in the system, such as reasonableness tests and input controls.

The term "sales order" refers

to the document created upon receipt of a customer's order.

The term "customer's order" refers

to the purchase order received from a customer.

One purpose of a review of sales returns and allowances subsequent to the balance sheet date is to

uncover any facts which necessitate adjustment of inventories, receivables, or sales in the statements being audited. Another purpose is to test internal control effectiveness.

The credit memoranda selected by the auditors for testing can be compared

with records of the receiving department to determine that goods were actually returned.