Audit Procedures for Revenue Cycles

by Christine Aldridge

As part of a financial audit, the auditor must assess the inherent risk associated with
the revenue cycle and perform tests to determine it is relatively free of error or
fraud. The inherent risk for this cycle is related to the cutoff dates for particular
types of sales and the pressures from management to misstate revenues. By
conducting so-called substantive tests and tests of controls, the auditor can provide
some assurance that the revenues of the company are recorded accurately.

Issues
Revenue recognition issues usually stem from consignment sales, round-trip sales,
refund and return rights, gross sales and bill and hold transactions. Sometimes
management feels pressure to misstate revenues to encourage investors or impress
upper-level management or the board of directors. Other times it is simply a case of
human error and recording the revenue at the wrong time. Before performing the
audit, the auditor should develop an understanding of both the entity and industry in
which the organization operates so he can better assess the outcome of the auditing
procedures.
Analytical Procedures
Analytical procedures often include running various financial ratios and comparing
them to industry benchmarks. For the revenue cycle, the auditor examines the gross
profit margin and the amount of growth that the company has experienced in one
year. As part of the analytical procedures, he should analyze the organization's
maximum capacity for sales if its facility and employees were fully utilized. He must
also examine the accounts receivable account to ensure it is not outgrowing sales. If
it is, this could indicate that the company is a credit risk and may have cash flow
problems in the future.
Tests of Controls
The main component for the internal controls of an organization, no matter which
cycle they are pertinent to, is management's adoption and adherence to high ethical
standards and strong controls. Tests of controls for the revenue cycle include who
accepts and approves credit sales; the separation of duties for filling out, shipping,
and recording sales orders; appropriate documentation for collecting and depositing
cash and recording the receipts; the appropriate authority and documentation to
grant discounts for early or cash payments and sales returns; and management
authorization to determine that an account is uncollectible and should be written off
to bad debts.
Sustantive Tests
Performance of substantive tests will help to find any errors or misstatements within
the accounts or documentation associated with the revenue cycle. These tests
include checking the trial balance that the accountant creates at the end of the cycle,
confirming receivable amounts with the company or person who owes money and
evaluating the accuracy of the allowance for uncollectible accounts by reviewing the
history of the entity. They also include vouching, tracing and performing cutoff tests
for all sales, sales returns and cash receipts. To do this, the auditor examines all
documentation related to a customer and also examines a journal entry; she then
either works forward from the initial sales order to the journal entry or backward
from journal entry to initial sales order to determine accuracy.