Audit- Chapter 9 Notes

The ______ and ______ assertions are most relevant to accounts receivable

Existence and Valuation

Management Assertions and Substantive Procedures in the Revenue Cycle:

Existence/Occurrence -Recorded sales and AR are valid Completeness -All sales are recorded Rights and Obligations -The AR are owned by the organization Valuation and Allocation -Sales and AR are properly valued and recorded in the correct period -Revenue has been recognized in accordance with GAAP Presentation and Disclosure -Credit balance and related-party accounts receivable are properly disclosed -Revenue recognition policies have been properly disclosed

Documenting controls

Must document understand of controls for both integrated audit and financial statement only audit First part of questionnaire documents the auditors understanding Second part of the questionnaire each negative "no" indicates a possible internal control efficiency. If another internal control does not compensate for this deficiency, the auditor will likely have a control risk assessment of moderate or high in this area

Accounts Receivable: Rights and Obligations

Should reveal ownership and related disclosure issues involving client's who have sold their receivables but retain the responsibility of collecting receivables and may be liable if collection percentage drops. -Obtain confirmations from client's bank about contingent liabilities -Inquire of management about activities relating to receivables -Sanning of cash receipts journal for relatively large cash inflows from unusual sources -Obtaining bank confirmations which include information on obligations to the bank and loan collateral -Reviewing the BOD minutes

Alternative Procedures

Subsequent collection of the balance after year end: -attention paid to amount reflecting invoices at confirmation date -provides strong evidence about both the existence and valuation of related receivables Examination of supporting documents: -include customer orders, sales orders, bills of lading or internal shipping documents, and sales invoices -Bills of lading are usually external and provide independent verification of shipments

Follow-Up Procedures for Negative Confirmations

Underlying assumption, if no response is received, the auditor assumes that the customer agrees with the balance Not always accurate: 1. Letter could have been lost, improperly addressed, or misplaced 2. The customer did not understand the request 3. The request was simply ignored or thrown away Follow-up work to determine whether the confirmed amount represents a misstatement: -look at subsequent cash receipts or vouch back to a customer's order and evidence of shipment to help make the assessment

Controls Related to Valuation

Valuation issues most often arise in situations with unusual or uncertain sales terms such as: -customer has recourse with the selling company, franchise sales, bundled sales, cost-plus contracts, or other contracts covering long periods with provisions for partial payments Abnormal returns or allowances may be the first sign that a company has inappropriate recording of revenue

Sub. Analytical Procedures Step 3: Develop expectations

Will be more precise than those used during planning analytical procedures Use more disaggregated data for better precision Level of disaggregation based on the size, complexity, and nature of the organization

Accounts Receivable: Substantive Procedures for the Allowance Account

are relevant to the valuation of accounts receivable Difference between gross value of receivables and net realizable value determining the reasonableness of the clients ADA AR should be recorded at NRV

In the revenue cycle the most important accounts are _____ and _____

revenue and accounts receivable

The Confirmation Process

-Return address should list the auditor's address -Undeliverable confirmations should raise a red flag

Responding to an identified risk typically involves:

-Substantive procedures (tests of details, substantive analytical procedures) -test of controls (when applicable) The auditor should customize the audit program based on the assessment of risk of material misstatement

Controls that the client should implement for identifying and promptly recording returned goods include formal policies and procedures for:

1. clearly articulating contractual return provisions in the sales contract 2. approving acceptance of returns 3. recording goods returns on prenumbered documents that are accounted for, to be sure they are all recorded promptly 4. identifying whether credit should be given 5. determining the potential obsolescence or defects in the goods 6. assuring proper classification of the goods and determining that the goods are not reshipped as if they were new goods 7. developing and implementing a sales returns reserve methodology, requiring reasonable and supportable assumptions

If errors are detected on a negative confirmation, the auditor should us expanded procedures to

1. find the underlying cause of the errors 2. estimate the amount of misstatement on the account balance

3. Generate Back Order

A confirmation of the back order is prepared and sent to the customer. If the order is not filled in a specific amount of time, the customer is generally given the option of canceling the order A list should be maintained to current customer demands and future inventory needs. Appending a separate field to the individual inventory records should accomplish this.

Sampling Unit

Can be a customer's entire account balance or one or more of the unpaid invoices

Sample Selection

Can confirm large balances randomly or haphazardly, select some of the smaller balances using either non statistical or monetary unit sampling credit balances or past due or have unusual customer names

Sufficiency of Evidence for Completeness of Revenue

Client with Low Risk: 20% Test of Details 40% Analytical Procedures 40% Tests of Controls Client with High Risk 60% Test of Details 20% Analytical Procedures 20% Test of Controls

The _____ assertion is most relevant revenue.

Existence

Step 2: Evaluate the Reliability of Data Used to Develop Expectations

Factors that influence reliability of data: -Independence: better from a source outside the company (industry benchmarks) -Comparability: consider if the client's data may differ in an expected way from the industry

Revenue Cycle

Involves the process of receiving a customer's order, approving credit for a sale, determining whether the goods are available for shipment, shipping the goods, pilling 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.

2. Check Inventory Stock Status

Most company's computer's are capable of informing a customer of current inventory status and likely delivery date.

Accounts Receivable: Substantive Procedures Based on the Aged Trial Balance

Starting point- aged AR from client, manually preparing, or using GAS to develop aging info If client prepared, auditor should recalculate mathematical accuracy and agree to GL Credit balances should be identified and, if significant, reclassified as liabilities

Undeliverable Confirmations

The auditor should make every effort to determine the customer's existence (telephone directory, credit rating, internet) If a valid address cannot be found, the auditor should assume the account is fictitious

9. Receive Payments

The proper recording of all revenue receipts is crucial to the ultimate valuation of both cash and accounts receivable Usually a part of the cash cycle

Formal credit policies are designed to provide reasonable assurance of the realization of....

accounts receivable into cash

Side Letter:

an agreement containing contract terms that are not part of the formal contract (often involving rights of return), thereby increasing audit risk because it enables key contract terms affecting revenue recognition to be hidden from the auditor as part of a revenue recognition fraud often associated with material revenue misstatements

Bill of Lading

describes the packages to be conveyed by the common carrier to the customer, the shipping terms, and the delivery address. is a formal legal document that conveys responsibility to the shipper

Exceptions

differences between customer's records and the amounts shown on the confirmation Auditor investigates exceptions to determine if the difference is a customer error, an item in dispute, a client misstatement, or a timing difference

If no control deficiencies are identified...

likely determine the preliminary assessment of control risk as low is still appropriate determine the extent to which controls can provide evidence on the correctness of account balances and determine planned substantive audit procedures (level of sub. procedures will be lower)

Auditors should ______ assume there is a risk of _______ _______ caused by ______ relating to revenue recognition

ordinarily material misstatement fraud

Collectability

refers to the risk that the seller will be unable to collect the entitled contractual consideration from the customer

The primary inherent risk associated with receivables is...

that the net amount is not collectible because either the receivables recorded do not represent genuine claims or an insufficient allowance exists for uncollectible accounts other risks such as ownership exist if receivables are being sold or pledged -if a valid sales transaction doesn't exist, a valid receivable doesn't exist -company shipping poor-quality goods has a high return risk -company trying to generate sales sells to new customers with poor credit

An importan inherent risk related to revenue transactions is:

the timing of revenue recognition revenue should only be recognized when it is realizable or is realizable and earned

Sales transactions should only be recorded when...

title has passed and the company has received cash or a collectible receivable

Documenting Substantive Procedures

- Confirmation procedures should detail the extent of dollars and items confirmed, confirmation response rate, the number and dollar amount of exceptions that were and were not misstatements (with cross-reference to the work paper including and explanation and conclusion), and a projection of the sample misstatements to the population - Tests of adequacy of the allowance for doubtful accounts - Details on inquiries made regarding whether receivables are sold, pledged, or assigned - Cutoff Tests - Evidence on roll-forward procedures if confirmations were sent at an interim date

To audit the revenue cycle, the auditor must understand the following:

- what is the organization in the business of selling - the earnings process and the nature of the obligations that extend beyond the normal shipment of goods (ongoing service requirements) - impact of unusual terms and when title has passed to the customer - the right of the customer to return a product, as well as returns history - contracts that are combinations of leases and sales - the proper treatment of sales transactions made with recourse or that have an abnormal or unpredictable amount of returns

Companies should use the following procedures to address credit risk:

1. formal credit policy (can be automated for most transactions but should require approval for large and/or unusual transactions) 2. 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 3. continuous monitoring of receivables for evidence of increased risk, such as increases in the number of days past due or an unusually concentration of a few key customers whose financial prospects are declining 4. adequate segregation of duties in the credit department, with specific authorization to write off receivables segregated from individuals who handle cash transactions with the customer management should have a well-controlled process in place to develop a reasonable and supportable estimate for this allowance account

Sub. Analytical Procedures Step 2: Evaluate reliability of data used to develop expectations

Consider operating effectiveness of controls over the preparation of information used in those analytics

Cutoff Test of Sales Returns

Examine receiving reports and related credits to customer accounts

Cutoff Test of Sales

Examine shipping documents and related recorded sales

7. Prepare and Send the Invoice

Invoices are usually prepared when notice is received that goods were shipped. should include: - terms of sale - payment terms - prices for merchandise shipped AN IMPORTANT DOCUMENT FOR AUDIT EVIDENCE

Follow-Up to Nonresponses for Positive Confirmations

Send two or three more confirmations, possibly call customer if large balance

Steps 6 & 7: Investigate Significant Unexpected Differences and Ensure Proper Documentation

Significant unexpected differences suggest that audit effort for the account/assertion will need to be increased Documentation accumulated in the work papers

Step 1: Identify Suitable Analytical Procedures

Some basic ratios used in planning analytical procedures: -gross margin analysis -turnover of receivables or number of days -average receivables balance per customer -AGING of receivables -sales in last month (or quarter) to total sales -percentages to totals Trend Analyses: -monthly comparisons to past years and budgets -identification of spikes in sales and end of quarters or end of year -treds in discounts allowed to customers that exceed both past and industry average

Determining the reasonableness of a client's estimate for the ADA is one of the more difficult audit judgements because, at the time of the audit, as single answer is not available.

The allowance should reflect management's best estimate of accounts receivable that will not be collected at year-end Reflecting: -the current economic status of the client's customers -current economic conditions -an informed expectation about potential default on payment

Planning analytical procedures helps the auditors identify...

areas of potential material misstatements

The cycle approach recognizes the

interrelationship of accounts. Audit evidence addressing the existence and valuation of accounts receivable also provides evidence on the existence and valuation of recorded revenue, and vice versa

In a situation where a sale is being made from an authorized price list (scanner at wal mart check out) control procedures

should provide reasonable assurance of the correct input of authorized price changes into the computer files and limit access to those files including 1. limiting accès to the files 2. printing a list of changed prices for review by the department that authorized the changes 3. reconciling input with printed output reports to assure that all changes were made and no unauthorized ones were added 4. limiting authorization privileges to those individuals with the responsibility for pricing

In performing substantive procedures, the auditor wants reasonable assurance that...

the client's revenue recognition policies are appropriate and that revenue transactions are in accordance with GAAP. Substantive Procedures: (substantive analytical procedures, test of details, or both) should be performed for all relevant assertions related to significant revenue cycle accounts and disclosures. Even if the test of controls indicate controls are operating effectively, it is not enough evidence to provide reliability.

Revenue: Completeness Assertion

-Auditor expects client uses renumbered shipping and billing documents -Auditor selects a sample of of shipping documents and trace them into the sales journal to obtain evidence on whether all shipments have been recorded as sales transactions -audit software can be used to look for gaps in the recorded sales invoice numbers and verify missing numbers are appropriate and do not represent unrecorded sales -voided documents or different numbers at different locations -these procedures all provide evidence on the completeness of AR

1. Receiving a Customer Purchase Order

-begins processing (could be preparation of a sales order by a salesperson) -might be taken by a clerk at checkout, salesperson making a call on a client, customer service agent of a catalogue, computer receiving purchase order info electronically from the customer's computer, or the sales department directly receiving the purchase order -The computer file (log of transactions) contains all the information for sales orders taken over a period of time and can be used for control and reconciliation purposes.

Sub. Analytical Procedures Step 1: Identifying suitable analytical procedures

-more precise level using organization-relevant categories -ratios and trend analysis on product lines, geographic regions, or business units -ratio and trend analysis are compared to industry and prior periods -use reasonableness test or regression analysis -cross-sectional analysis: comparing sales per square foot of retail space among stores

The following unexpected relationships might suggest a heightened risk of fraud:

-revenue increasing when there is strong competition and a competitor has introduced a new product -revenue increases are not consistent with the industry or the economy -gross margins are higher than average, or there is an unexpected change in gross margins -large increases in revenue occur at the end of the quarter or end of the year -revenue has grown and net income has increased but there is negative cash flow from operations

Accuracy of recording transactions in the revenue cycle is important for management decisions and financial statements because:

-sales transactions serve as a basis for computing commissions for sales staff -sales info is used for strategic, long-term decision making and marketing analysis

Tests of controls include:

-selecting samples of transactions and obtaining supporting documents -reviewing monitoring controls -testing computer access controls -using generalized audit software to match or look for gaps or duplicate document numbers -reviewing customer complaints -reviewing documents such as reconciliations and management reports noting timely action taken, and reviewing sales contracts

Auditing Standards generally require the use of confirmations unless one of the following conditions exists:

1. AR are not material 2. The use of confirmations would be ineffective 3. The auditor's assessment of the risk of material misstatement is low and that assessment, in conjunction with the evidence provided by other substantive tests, is sufficient US standards generally require the use of confirmations, international do not

Steps in Using Analytical Procedures to Identify Possible Material Misstatements

1. Identify suitable analytical procedures 2. Evaluate reliability of data used to develop expectations 3. Develop expectations 4 & 5. Define and identify significant unexpected differences 6 & 7. Investigate significant unexpected differences and ensure proper documentation

After reviewing and testing the process used by management, including the controls over the process, auditors generally use one or a combination of the following approaches to obtain evidence about the reasonableness of the client's estimate:

1. Inquire of management about the collectibility of customer balances 2. Develop an independent model to estimate those accounts 3. Review credit reports from outside credit bureaus 4. Review customer correspondence files to gain additional insight on the collectibility of specific accounts 5. For account unusually large or past due, review customer's latest financials to perform independent assessment of collectibility 6. Inquire about the client's procedures for deciding when to write off an account

Examples of Exceptions in Timing Differences

1. Payment has already been made 2. Merchandise has not been received 3.The goods have been returned 4.Clerical erros and disputed amounts exist

Criteria for Revenue Recognition

1. Persuasive evidence of an arrangement exists 2. Delivery has occurred, or services have been rendered 3. The seller's price to the buyer is fixed or determinable 4. Collectability is reasonably assured

Some of the inherent risks associated with receivables include:

1. Receivables are pledged as collateral against specific loans with restricted use (disclosures are required) 2. Receivables are incorrectly classified as current when the likelihood of collection during the next year is low 3. Collection of a receivable is contingent on specific events that cannot currently be estimated 4. Payment is not required until after the purchaser sells the product to its end customers 5. Accounts receivable are aged incorrectly, and potentially uncollectible amounts are not recognized 6. Orders are accepted from customers with poor credit, but the allowance for doubtful accounts is not increased accordingly

Substantive tests in the Revenue Cycle are typically performed to provide evidence that:

1. Sales transactions do exist and are properly valued 2. Accounts receivable exist 3. The balance in the allowance account is reasonable 4. Fraudulent transactions are not included in the financial statements

Step 4 & 5: Define and Identify Significant Unexpected Differences

Define what will be considered significant, then compare When the risk of material misstatement is higher, the amount of acceptable difference is lower When revenue fraud is taking place, the financial statements usually will contain departures from industry norms but may not differ from expectations set by management

4. Obtain Credit Approval

Formal policies minimize credit losses. -require payment through a credit card -require a check accompany the order -withhold shipment of goods until check clears Industrial organizations who issue credit to customers accept some risk that they will ultimately not receive payment from a customer due to: -dissatisfaction with, ore return of goods received -inability to make payments because of financial constraints Organizations need to have a credit approval process that: - evaluates the creditworthiness of new customers - updates the creditworthiness of existing customers Credit approval process might include: - a review of sales orders and customer credit information by a computer program that contains current account balance information and credit scoring information to determine whether credit should be extended to the customers Most organizations set customer credit limits and develop controls to assure a pending sale will not push the customer over the credit limit

Step 3: Develop Expectations

Important to identifying accounts with a heightened risk of material misstatement Possible expected relationships in the revenue cycle include: -no unusual year end sales activity -AR growth is consistent with revenue growth -revenue growth, AR growth, and gross margin growth are consistent with the industry -there is no unusual concentration of sales to customers (in comparison to prior years) -the AR turnover is not significantly different than prior years -the ratio for the allowance for doubtful accounts to total receivables or to credit sales is similar to the prior year

Sub. Analytical Procedures Steps 6 & 7: Investigate significant unexpected differences and ensure proper documentation

Materiality and the desired level of assurance will aid the auditor in determining how to proceed with investigating significant differences. Auditor will investigate significant differences with through substantive tests of details Substantive analytical procedures alone are not sufficient evidence, if they result in no unresolved issues, direct testing of account balances can be reduced but not eliminated

6. Ship and Verify the Shipment of Goods

Most goods are shipped though common carriers such as trucking lines, railroads, and airfreight companies Shipper prepares a bill of lading which is signed by the common carrier, acknowledging receipt of the goods The shipping department confirms the shipment by 1) completing the packing slip and returning it to the billing department 2) electronically recording everything shipped and transmitting the shipping information to the billing department or 3) preparing independent shipping documents, a copy of which is sent to the billing department

5. Prepare Shipping and Packing Documents

Pick tickets: documents that tell the warehouse personnel the most efficient sequence in which to pick items for shipment and the location of all items to be shipped. Pick tickets are generated from sales orders or customer's purchase orders Separate packing slips are prepared and inserted with the shipment to verify all items have been shipped Sometimes a barcode is put on the shipping container to identify the contents and is scanned by the customer to record the receipt of the order

Revenue: Substantive Tests of Details

Primarily involve inspection of client documentation Focus on existence and valuation although some tests might relate to completeness

8. Send Monthly Statements to Customers

Provides a detailed list of the customer's activity for the previous month and a statement of all open items

Revenue: Cutoff Issues

The auditor is concerned with whether transactions recorded during the subsequent year actually relate to the year being audited. -Performing cutoff tests with sales transactions recorded several days before and after year-end is important to assuring both the existence and completeness of revenue transactions

Accounts Receivable: Presentation and Disclosure

Trade accounts receivable (officers, directors, stockholders, employees, and related parties) should be recorded separately form other receivables with appropriate disclosures provided -Reviewing SEC filings -Reviewing the AR trial balance -Inquiring of management and the audit committee about receivables from related parties Material debit balances in AP from vendors should be reclassed as AR Material credit balances in AR for customers should be reclassed as AP Receivables not due within one year or operating cycle should be concurrent

Lapping

a fraud scheme in the revenue cycle used to cover up the embezzlement of cash causes individual customer account balances to be misstated employee first steals a payment from a customer, then covers up the fraud by posting a second customer's payment to the first customer's account and so on. There will always be one customer whose account is overstated, unless the employee pays the cash back

Timing Differences

are due to transactions that are in process at the confirmation date, such as in-transit shipments or payments If the auditor can determine that the timing difference did not result in recording the receivable in the wrong period, the differences do not represent a misstatement in the account balance Because the auditor only sends confirmations to a sample of AR balances, exceptions should be investigated and determined the cause of any exceptions rather than rationalizing as an isolated instance

Controls Related to Completeness

are intended to provide reasonable assurance that all valid sales transactions are recorded -use of renumbered shipping documents -immediate online entry into the computer system and immediate assignment of unique identification number by the computer application -reconciliation of shipping records with billing records -supervisory review, such as review of transactions at a fast-food franchise -reconciliation of inventory with sales, such as reconciliation of liquor at a bar at the end of every night with recorded sales

Negative Confirmation

askes the customer to review the balance owed to the client, but requests the customer to respond directly to the auditor only if the customer disagrees with the indicated balance Used if the following conditions exist: 1. large number of relatively small customer balances 2. the assessed level of risk of material misstatement for receivables and related revenue transactions is low 3. the auditor has reason to believe the customers are likely to give proper attention to the requests

If control deficiencies are identified...

auditor should assess the severity of deficiencies. modify the preliminary assessment of control risk up and document the implications of control deficiencies appropriate modifications to planned substantive audit procedures will be determined by the types of misstatements that are most likely to occur because of the control deficiency

Controls Related to Existence/Occurrence

should provide reasonable assurance that a sale and accounts receivable are recorded only when shipment has occurred or the primary revenue-producing activity has been performed -distribute monthly statements to customers -prepared and sent by independent department -also customer inquiries should be channeled to a department different from the original recording department -unusual transactions, because of their size, complexity, or special terms should require a high level of management review as a control -authorization should be part of an audit trail for typical transactions and should not be performed by the same person who records the transactions

Once the auditor has obtained an understanding of the inherent and fraud risks of material misstatement in the revenue and accounts receivable accounts, the auditor needs to understand...

the controls that the client has designed and implemented to address those risks. gained by means of a walkthrough of the process, inquiry, observation, and review of the client's documentation

The SEC generally does not consider delivery to have occurred until...

the customer takes title and assumes the risks and rewards of ownership

Accounts Recievable: Substantive Tests of Details- Confirmations

-Existence is necessary for correct valuation, however, existence does not necessarily assure correct valuation -Confirmations are generally considered to provide quality evidence about the existence of receivables and the completeness of collections, sales discounts, and sales returns and allowances.

Positive Confirmations of Unusual or Complex Agreements or Transactions

-May be in conjunction or separately from confirmation of account balances -sent to knowledgeable personnel -specifically inquire about possibility of bill and hold, extended payment terms or nonstandard installment receivables, or an unusual volume of sales to distributors or retailers -Also confirm the potential existence of a side letter

Selecting controls to test and performing test of controls

-Select controls that are important to the auditor's conclusion about whether the organization's controls adequately address the assessed risk of material misstatement. Both entity-wide and transaction controls

Documentation related to the revenue substantive procedures would typically include:

-Substantive analytical procedures performed -Unusual sales transactions -Information indicating an understanding of the client's recognition policies -Identification of specific items tested -Relevant informado on tests of details

Revenue: Existence and Valuation Assertions

-Vouching a sample of recorded sales transactions back to customer orders and shipping documents provides support for the existence assertion -Auditor should compare the quantities billed and shipped with customer orders and verify the clerical accuracy of the sales invoices to provide assurance on valuation These procedures also provide evidence on the existence and valuation of accounts receivable -GAS can be used to accomplish these things also

Tests of transaction controls

-inquiry of personnel performing the control -observation of the control being performed -inspection of documentation confirming that the control has been performed -reperformance of the control by the individual auditor testing the control

The aged trial balance is used by the auditor to:

1. Agree the detail to the balance in the control account 2. Select customer balances for confirmation 3. Identify amounts due from officers, employees, or other related parties or any non trade receivables that need to be separately disclosed in the financial statements 4. Help determine the reasonableness of the allowance for doubtful accounts by identifying past-due balances

Steps in Processing Revenue Transactions

1. Receive a customer purchase order 2. Check inventory stock status 3. Generate back order (if necessary) 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

Positive Confirmations

Are correspondence (paper or electronic) sent to a sample of customers, asking them to review the current balance or unpaid invoice(s) due to the client and return the letters directly to the auditor indicating whether they agree with the balance. If the customer does not return a signed confirmation, the auditor needs to us follow-up audit procedures verify the existence of the customer's balance. -Printed on the client's letterhead -Addressed to the customer -Is signed by the client -Indicates the balance or unpaid invoice amount as of a particular date (confirmation date) -Tells the customer to respond directly to the auditor in an enclosed self-addressed, postage-paid envelope

Sub. Analytical Procedures Steps 4 & 5: Define and identify significant unexpected differences

The amount of difference that is considered significant is influenced by materiality, desired level of assurance, and assed risk of material misstatement As the auditor's assessed risk of material misstatement increases, the amount of unexpected difference that would be considered significant declines Then auditor compares numbers

Example on revenue recognition: seller delivers a product to a customer but the buyer has the right to return the product and does not have the obligation to pay until the buyer resells the product when is revenue recognized?

when the buyer has obligation to pay, that is, when the buyer resells it