Chapter 11 final Audit

Controlling customer order's

- Important initial steps include registering the customer's purchase order, reviewing items and quantities to determine whether the order can be filled within a reasonable time, and preparing a sales order

Perpetual inventory records of finished goods should be maintained by:

- the accounting department, not by the storekeeper. and the storekeeper issues the goods covered by a sales order to the shipping department only after the sales order has been approved by the credit department.

Satisfactory control over the recording of partial payments requires that:

- the date and amount of the payment and the new unpaid balance should be recorded and maintained by the accounting system -Any credit memoranda or journal vouchers for partial payments, write-offs, or adjustment of disputed notes should be authorized by proper officials and kept under numerical control.

Indicator for shipments of cosigned items being treated as sales:

-Numerous large returns of merchandise -subsidiary records for receivables include some accounts with large debit entries and more numerous small credit entries,

It is important to remember that for any significant risk, the auditors:

-Should evaluate the design of the related controls and determine that they are implemented. -May not rely solely on analytical procedures to address the risk. -May not rely on evidence obtained in prior periods regarding the operating effectiveness of the related controls. Some of the risks identified by the auditors will be considered to be significant risks that require special audit consideration

Assurance of positive/negatives confirmation requests

-The positive form provides more assurance than the negative form -the expense of using negative confirmation requests is less than for the positive form

Shipping documents, such as bills of lading:

-are created at the time of loading the goods into cars or trucks. -The shipping documents are numerically controlled and are entered in a shipping register before being forwarded to the billing department. -When shipments are made by truck, some type of gate control is also needed to ensure that all goods leaving the plant have been recorded as shipments.

The use of negative confirmation requests consists of a

-communication addressed to the debtor company asking it to advise the auditors only if the balance shown is incorrect. -A negative confirmation request may be in the form of a letter or it may be made merely by applying a rubber stamp to the customer's regular monthly statementor by attaching a gummed label bearing a statement to contact auditors in misstatements exist. -When the negative form of confirmation request is used, the lack of a reply from a given customer is interpreted as satisfactory evidence,

In selecting the individual accounts to be confirmed

-it is customary to include all customers with balances above a selected dollar amount and to select a sample of accounts from the remaining receivables.

The use of positive confirmation requests consists of a

-request addressed to the debtor asking for a reply. Most positive forms ask the debtor to confirm directly to the auditors the accuracy of the dollar amount shown on the confirmation request. -blank forms, do not state the amount on the request, but ask the debtor company to fill in the balance.

If the client has established effective IT application controls for sales transactions, the auditors might decide

-to test these controls directly instead of testing a sample of sales transactions. -Tests of application controls might involve inspecting evidence of the operations control group's reconciliation of batch control totals for sales transactions, as well as the follow-up on any transactions that are listed on exception reports. And enter input validation and test data

The most practical and effective audit procedure for detecting lapping is:

Comparing recorded cash receipts in detail against items making up the bank deposit as shown on duplicate deposit slips validated by the bank.

Risks of material misstatement also arise from the possibility of

FRAUD. -Improper revenue recognition has been the most common technique used by management to engage in fraudulent financial reporting. Therefore, the audit of revenue and receivables is often an area of significant risk to auditors -Auditor should assume material mistatement relating to revenue recognition

management should evaluate the effects of internal factors, such as:

changes in accounting principles, the introduction of new products and services, and the use of new types of sales transactions

management should develop a formal process of monitoring external factors, such as:

changes in economic conditions, competition, customer demand, and regulations that may affect the risk of achieving the company's sales objectives

When a client uses accounting principles that require estimates of significant amounts of revenue,

the auditors may examine evidence of review and approval of the estimates.

Selection of the most appropriate procedures for a particular audit will be guided by

the nature of the internal controls that have been implemented and by the results of the auditors' risk assessments.

Auditors responses to fraud risks include:

-A response that has an overall effect on how the audit is conducted. -A response involving the design of audit procedures -A response involving performing procedures to further address the risk of material misstatement due to management's override of internal control

Ongoing monitoring activities by management primarily involve:

-reviewing various types of performance reports, including sales by product line, by major customer, by geographic area, and by salesperson, review the aging of accounts receivable - In addition, management often will carefullyand may solicit feedback from customers about the accuracy of billings. - When unexpected amounts or relationships are discovered, management should follow up to determine the underlying reasons.

To test the existence assertion for recorded receivables, the auditors would select a sample from the:

Accounts receivable subsidiary ledger.

Confirmation in writing from the holder of the note is ordinarily considered as

an acceptable alternative to inspection of the note.

Management's philosophy and operating style,

as indicated by its attitude toward financial reporting, are also important in the control of revenue and receivables. The relevant questions include: Is management aggressive or conservative in selecting methods of revenue recognition?

Increased control is indicated when management effectively identifies:

the skills and training needed to perform key functions and implements effective procedures to ensure that these functions are performed by competent personnel.

When using positive confirmation requests, the auditors should generally follow up with a second and sometimes a third request to produce replies. When replies are still not received, the auditors should apply alternative procedures to the accounts, unless

(1) the amount of the nonresponses is not significant when projected as a 100 percent misstatement to the total balance of receivables, and (2) there are no unusual characteristics related to the nonresponses. -The best alternative auditing procedure ordinarily is examination of subsequent cash receipts in payment of the receivable

Confirming request

A request sent to a confirming party requesting that the confirming party consider the accuracy of information included in that request. A confirmation request may take one of two forms: positive confirmation request and negative confirmation request. -The external confirmation may be in paper form, electronic form, or other medium

Because of the close relationship between revenue and accounts receivable

, the two can best be considered jointly. The determination of the amount of revenue to be recognized for a particular period is integrally related to a number of financial statement accounts, including sales and accounts receivable, adjustments to sales and accounts receivable, service revenue, deferred revenues, and cash. -Area of significant fraud risk

In the audit of clients that make a substantial amount of sales for cash, the auditors may compare

-selected daily totals in the sales journal with cash register readings or tapes -The serial numbers of all sales tickets used during the selected periods should be accounted for and the individual tickets examined for accuracy of calculations and traced to the sales summary or journal.

When notes receivable owned by the client may be held by others at the time of the examination.

-Confirmation in writing from the holder of the note is considered an acceptable alternative to inspection; it does not, however, eliminate the need for securing confirmation from the maker of the note. -The relative ease of creating a forged or fictitious note suggests that physical inspection by the auditors represents a less significant and conclusive audit procedure for verification of notes receivable than for cash or securities.

The extensions and footings on each invoice in the sample should be proved to be arithmetically correct In addition, the date of each invoice should be compared with two other dates, which are:

(1) the date on the related shipping document and (2) the date of entry in the accounts receivable subsidiary ledger.

The use of solely negative requests should be reserved for situations in which at least one of the following circumstances exists:

(a) The assessed level of the risk of material misstatement is low and sufficient appropriate audit evidence has been obtained on operating effectiveness of controls; (b) a large number of small, homogeneous balances are involved; (c) a low exception rate is expected; or (d) the auditors are not aware of circumstances that would cause recipients of the request to disregard them.

there is a presumption that the auditors will confirm accounts receivable, unless

(a) accounts receivable are immaterial, (b) the use of confirmations would be ineffective, or (c) the auditors' assessment of the risk of material misstatement is low and the auditors plan to obtain sufficient appropriate audit evidence by performing other substantive procedures

Most of these risks for inherent risks are derived from business risks that are faced by management, such as the risks of:

-A decline in sales due to economic declines, product obsolescence, increased competition, or shifts in product or service demand. -Inability to collect receivables. -Improper revenue recognition. -Restrictions placed on sales by laws and regulations.

Audit documentation:Besides preparing lead schedules for receivables and net revenue, the auditors obtain or prepare the following working papers:

-Aged trial balance of trade accounts receivable (often a computer printout). -Analyses of other accounts receivable. -Analysis of notes receivable and related interest. -Analysis of allowance for uncollectible accounts and notes. -Comparative analyses of revenue by month, by product, or by territory, or by relating forecasted revenue to actual revenue. -Documentation of internal controls. -Risk analyses and audit programs.

Review the Use and Authorization of Credit Memoranda:

-Allowances to customers for returned or defective merchandise should be supported by serially numbered credit memoranda signed by an officer or responsible employee having no duties relating to handling cash or to the maintenance of customers' ledgers -includes a requirement that the returned goods be received and examined before credit is granted. -The memoranda should then bear the date and serial number of the receiving report on the return shipment. - Prices, extensions, and footings should be verified, and postings traced from the sales return journal or other accounting record to the customers' accounts in the subsidiary receivable ledgers.

Credit approval

-Before sales orders are processed, the credit department must determine whether goods may be shipped to the customer on open account. -This department is supervised by a credit manager who reports to the treasurer or the vice president of finance. -studying the customer's financial statements and by referring to reports of credit agencies, such as Dun & Bradstreet, Inc.

Good internal control over credits for returned merchandise usually includes a requirement that the goods be

-received and examined before credit is given. -The credit memoranda should then bear the serial number of the receiving report on the returned shipment.

When trial balances or analyses of accounts receivable are furnished to the auditors by the client's employees, some independent verification of the listing is essential which include:

-Determination of the proper extent of testing should be made in relation to the adequacy of the controls over receivables -test footings, cross-footings, and agings. In testing agings, -selected accounts should be traced to the subsidiary ledgers -Totals of schedules prepared by client personnel should also be compared with related controlling accounts. -In addition, the balances of the subsidiary ledger records should be verified by footing the debit and credit columns

If management refuses to allow the auditors to perform external confirmation procedures,

-Evaluate their reasons -Evaluate implications of their refusal -Perform alternative procedures -If the auditors consider management's reasons to be unreasonable, or if the auditors are unable to obtain relevant and reliable audit evidence from alternative audit procedures, the auditors should communicate with those charged with governance about the matter.

Examples of tests of controls for sales and recievables

-Examine significant aspects of a sample of sales transactions. -Compare a sample of shipping documents to related sales invoices. -Review the use and authorization of credit memoranda. -Reconcile selected cash register tapes and sales tickets with sales journals. -Test IT application controls. -Examine evidence of review and approval of revenue estimates.

substantive procedures for receivables and revenue.

-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.

Confirmation of recievables and mailing

-Should be mailed in envelopes bearing the CPA firm's return address -Mailed personally by the auditors

For uncollectible recievables

-The credit manager should initiate the process of uncollectible receivable write-off, with subsequent authorization by the treasurer -Receivables that are written off should then be either turned over to a collection agency or retained and transferred to a separate ledger and control account. -Continue to mail statements requesting payments -Otherwise, any subsequent collections may be embezzled by employees without the necessity of falsifying records to conceal the theft.

Subdivision of duties for notes receivable

-The custodian of notes receivable not have access to cash or to the general accounting records. -The acceptance and renewal of notes be authorized in writing by a responsible official who does not have custody of the notes. -The write-off of defaulted notes be approved in writing by responsible officials and effective procedures adopted for subsequent follow-up of such defaulted notes. -the authorization, recording, and custodial functions should be separate, especially for cash and receivables.

Risks in the confirmation process for recievables

-The information may be delivered to an inappropriate address and signed by a nonauthentic source -Improper intervention into the delivery of a properly addressed confirmation request. -The information may be delivered properly to a debtor company, but an inappropriate individual may reply

Regarding undertanding business and industry for revenue and receivables, this understanding includes matters such as:

-The types of products and services sold. -The classes and categories of the client's customers. -Whether the business is affected by seasonal or cyclical demand. -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.

When a portion of the accounting system relies on manual operations, these controls FOR INVOICES before mailing to customers might consist of:

-a second-person review of the accuracy of prices, credit terms, transportation charges, extensions, and footings. When an IT-based billing system is in use, this objective is generally achieved by -implementing input validation (edit) checks and -various batch processing controls.

When using paper confirmations, the auditors should thoroughly investigate any suspicious circumstances, such as an excessive number of individual debtors with addresses that are post office boxes; the boxes may have

-been rented under fictitious debtors' names by employees of the client company who are engaged in accounts receivable fraud

For many companies, the primary source of revenue is from the sale of goods or services to:

-customers on credit. -Ineffective controls over credit sales and receivables can be costly to a business. When control activities over sales on account are inadequate, large credit losses are almost inevitable.

An aged trial balance of trade accounts receivable at the audit date is commonly prepared by

-employees of the client for the auditors, often in the form of a computer printout. -to display the aging of customers' accounts, the estimate of probable credit losses, and the confirmation control information. -Small concerns and limited number of customers

Adequate controls over notes receivable secured by mortgages and trust deeds must include follow-up:

-procedures that assure prompt action on delinquent property taxes and insurance premiums, as well as nonpayment of interest and principal installments.

With regard to the client's human resource policies and practices,

-management should make appropriate background checks of prospective employees and obtain fidelity bonds on employees in positions of trust. -Require employee's who handle cash to take vacations when their assigned duties are rotated periodically.

internal control is strengthened by the preparation of:

-monthly reports summarizing notes receivable transactions during the month and the details of notes owned at the end of the reporting period. -The person responsible for reporting on note transactions should be someone other than the custodian of the notes.

The term billing means:

-notifying the customer of the amount due for goods or services delivered. This notification is accomplished by preparing and mailing a sales invoice. -A department not under the control of sales executives should perform billing

To understand internal control auditors will also review revenue budgets and the follow-up on the variances and

-perform a walk-through of the cycle; inspect various documents, such as bills of lading, sales invoices, and customer statements; and review document files to determine that the client is appropriately accounting for the sequence of prenumbered documents.

All adjustments to sales for allowances, returns, and write-offs of accounts receivable should be supported by

-serially numbered credit memoranda signed by an officer or responsible employee having no duties relating to cash handling or to the maintenance of customers' ledgers

When performing tests of sales transactions, the auditors should be alert for indications of:

-shipments of consigned items treated as sales. -Some companies that dispose of only a small portion of their total output by consignment fail to make any distinction between consignments and regular sales.

To obtain assurance that all shipments have been billed, the auditors may obtain a sample of:

-shipping documents issued during the year and compare these to sales invoices. -In making this test, particular emphasis should be placed upon accounting for all shipping documents by serial number. -Any voided shipping documents should have been mutilated and retained in the files

To determine that the controls portrayed in the flowchart are effectively functioning in everyday operations, the auditors will examine

-significant aspects of a sample of sales transactions. -Can be statistical or nonstatistical For manufacturing: -May begin with a comparison of the customer's purchase order, the client's sales order, and the duplicate copy of the sales invoice. Compare to documents -The CREDIT MANAGER'S SIGNATURE denoting approval of the customer's credit should appear on the sales order.

Sales invoices are often generated by

-the IT system based upon information that has already been entered into the system -Shipping department personnel input information about the quantities of goods shipped, and prices to be charged either have been entered by personnel in the sales department when the sales order was generated or are contained in a master file of sales prices. -IT system also creates electronic files that is used in conjunction with the cash receipts transactions file to update the master file of accounts receivable. -Periodically updated to ledger

To improve the rate of responses to confirmation requests,

-the auditors should carefully design the form to make sure that the person receiving the confirmation is likely to have easy access to the information requested. -The auditors should also try to include on the form the details of the transactions, such as customers' purchase order numbers.

The inspection of notes receivable on hand should be performed concurrently with

-the count of cash and securities to prevent the concealment of a shortage by substitution of cash for misappropriated negotiable instruments, or vice versa. -securities held by the client as collateral for notes receivable should be inspected and listed at the same time. -Auditor should maintain control of items being audited untill audit is over

An aged trial balance of customers' accounts should be prepared at regular intervals for use by

-the credit department in carrying out its collection of cash/revenues from other companies program. -ALSO: the cashier will control and deposit checks. The remittance advices or a listing of the receipts will then be forwarded to the accounts receivable section of the data processing department, then record them in the appropriate accounts in the customers' ledger. The total reduction in accounts receivable will be posted periodically to the general ledger control account from the total of the accounts receivable column

If the acceptance of a note from a customer requires written approval of a responsible official:

-the likelihood of fictitious notes being created to offset a theft of cash is significantly reduced. The same review and approval should be required for renewal of a note; -The protection provided by this procedure of requiring executive approval of notes will be stronger if the internal auditing department periodically confirms notes directly with the makers.

The auditors' consideration of controls over receivables and revenue may begin with:

-the preparation of a written description or flowchart and the completion of an internal control questionnaire

Internal auditors also contribute to the monitoring process.by:

-they may periodically take over the mailing of monthly statements to customers, or send confirmations and investigate discrepancies reported -perform extensive reviews of shipping reports, invoices, cash receipts, credit memoranda, and the aged trial balances of accounts receivable to determine whether prescribed control activities are being carried out consistently

The sales order is a:

0translation of the terms of the customer's order into a set of specific instructions for the guidance of various divisions, including the credit, finished goods stores, shipping, billing, and accounts receivable units. -The action to be taken by the factory upon receipt of a sales order will depend upon whether the goods are standard products carried in stock or are to be produced to specifications set by the customer.

Usually, internal control over credit sales is strengthened by a division of duties so that different departments or individuals are responsible for:

1) preparation of the sales order, (2) credit approval, (3) issuance of merchandise from stock, (4) shipment, (5) billing, (6) invoice verification, (7) maintenance of control accounts, (8) maintenance of customers' ledgers, (9) approval of sales returns and allowances, and (10) authorization of write-offs of uncollectible accounts. -Accidental errors are likely to be detected quickly through the comparison of documents and amounts emerging from independent units of the company, and the opportunity for fraud is reduced to a minimum.

Direct communication with debtors is the most essential and conclusive step in the verification of accounts and notes receivable

By obtaining written acknowledgment of the debt by the debtor, the auditors obtain audit evidence that helps (a) establish the existence and gross valuation of the asset, and (b) provides some assurance that no lapping or other manipulation affecting receivables is being carried on at the balance sheet date -Limited for completeness

Which assertion relating to sales is most directly addressed when the auditors compare a sample of shipping documents to related sales invoices?

Completeness

Because of the risk of intentional misstatement of revenues, the control environment is very important to effective internal control over revenue and receivables.

Of particular importance is an independent audit committee of the board of directors that monitors management's judgments about revenue recognition principles and estimates, as well as an effective internal audit function. -Establish at tone at the top -undue emphasis on meeting unrealistic sales or earnings targets, should be eliminated.

Recording revenues when significant uncertainties exist issues:

[FRAUD]-Ineffective board of directors, audit comiteee or internal audit functions. "Tone at the top" issues. [ERRORS]-Aggresive attitude by management for financial reporting. Incompetent cheif accounting officer.

Recording unearned revenue issues result from:

[FRAUD]-Ineffective board of directors, audit comiteee or internal audit functions. "Tone at the top" issues. [ERROR]-Ineffective billing processes -Ineffective controls for testing invoices, input validation checks and computer reconcilliation issues. -Incompetent accounting personel.

Early/Late recognition of revenues issues "Cut off problems" result from

[FRAUD]-Ineffective board of directors, audit comiteee or internal audit functions. "Tone at the top" issues. [ERROR]-Ineffective cutoff procedures in the shipping department

Recording revenues before significant services must still be performed

[FRAUD]-Ineffective board of directors, audit comiteee or internal audit functions. "Tone at the top" issues. Undue pressure to meet sales, not conductive to ethical conduct. [ERRORS]-Aggresive attitude by management for financial reporting. Incompetent cheif accounting officer.

The function of billing is generally assigned to a separate section within the:

accounting, data processing, or finance department. The billing section has the responsibility of: (1) accounting for the serially numbered shipping documents, (2) comparing shipping documents with sales orders and customers' purchase orders and change notices, (3) entering pertinent data from these documents on the sales invoice, (4) applying prices and discounts from price lists to the invoice, (5) making the necessary extensions and footings, and (6) accumulating the total amounts billed. -Accordingly, the contract is an extremely important source of information for preparation of the sales invoice.

In the audit of a client that operates subsidiaries or branches,

the auditors should investigate the procedures for recording movements of merchandise among the various units of the company. -MAKE SURE NONE OF THAT ISH IS REPORTED AS SALES

When credit is not approved:

the customer is notified and an effort is made to negotiate some other terms, such as cash on delivery.

Consistent pricing and sales discount policies are a necessary element of good internal control over sales transactions. After discussing the policies with management, the auditors can:

verify the prices and discounts on the invoices selected for testing by comparison with authorized price lists, catalogs, or contracts with customers.