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Revenue cycle accounts The importance

Sales transactions are always material to
a company's financial statements
According to the SEC, a majority of
financial statement manipulations and
audit failures involve overstated revenues
Therefore, revenue cycle accounts must
be examined with great care
Chapter 10:
Auditing Revenue and
Related Accounts
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The cycle approach
Revenue cycle transactions include all the processes
ranging from the sale to shipping a product, billing the
customer, and collecting cash
A company's revenue cycle transactions reflects its
operations
A cycle approach is one way to help the auditor focus on
the important account balances surrounding a
transaction to ensure that sufficient audit evidence is
gathered and evaluated
Other cycles include:
acquisition and payment of goods and services
Payroll
Financing: debt and equity
Cash and short-term investments
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Overview of the Revenue Cycle
(Sales made on Account)
1. Receive customer purchase order
2. Check inventory stock status
Generate back order if item not in stock
3. Obtain credit approval
4. Prepare shipping and packing documents
5. Ship and verify shipment of goods
6. Prepare the invoice
7. Send monthly statements to customers
8. Receive payment
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Business Risk and Business
Environment
Revenue recognition
SAS 99 - Consideration of Fraud in a
Financial Statement Audit
Auditor should presume risk of material
misstatement due to fraud related to
revenue recognition
Research shows over half of frauds
involve overstating revenues
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Some Improper Revenue
Recognition Schemes
Recognize revenue on fictitious shipments
Hidden side letters that give customers unlimited right to
return product
Record consignment sales as final sales
Accelerated recognition of sales occurring after year-end
Ship unfinished goods
Ship goods before date agreed to by customer
Create fictitious invoices
Ship goods never ordered
Ship more goods than ordered
Record shipments to company's warehouse as sales
Record shipments of replacement goods as new sales
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What are some fraud risk factors
for revenue recognition?
There are a number of types of 'red flags' which
signal the potential for fraud in the financial
statements
External risk indicators
Internal red flags
Unusual financial results

Auditor deals with red flags by
Examining external pressures that could lead to
financial reporting fraud
Examining the financial statements to determine if
account balances seem out of line
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What analytical analysis can be
done for possible misstatements?
Compare client revenue trend with
economic conditions and industry trends
Compare cash flow from operations with
net income
Perform analytical procedures
Ratio analysis
Trend analysis
Reasonableness tests
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Assessment of Environment
Risk
Risk assessment is ongoing process in every
audit
Audit steps to assess environment risk for the
revenue cycle:
Update information on business risk
Perform analytical procedures to look for
unexpected relationships
Develop understanding of internal controls
Analyze business risk for motivations and
methods to misstate sales
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Document operation of accounting
applications and important controls
Develop preliminary assessment of
environment risk
If control risk is high, determine likely types of
misstatements
If control risk is lower, develop procedures to
test operation of controls
Perform tests of controls, document results
Based on the results of testing, reassess
control risk
Assessment of Environment
Risk Contd
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Inherent Risk with Regard to
Sales
While sales transactions are routine for
most organizations and do not represent
an abnormally high risk, for other
organizations, revenue recognition may be
complicated
Difficult audit issues include:
When to recognize revenues
Auditor must understand client's operations and
related GAAP issues
Example: point of sale revenue recognition vs.
percentage of completion
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Impact of any unusual sales terms and whether
title passed to customer
Example: related party transactions
Goods recorded as sales have actually been
shipped
Sales made with recourse or that have
significant returns
Example: irrevocable right to return goods

The presence of these issues increase inherent
risk and the probability of material
misstatement
Inherent Risk with Regard to
Sales Contd
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Inherent Risk in Receivables
Primary risk is net receivables will be overstated,
because either receivables have been overstated, or
the allowance for uncollectible accounts has been
understated

Risks affecting receivables include:
Sales of receivables recorded as sales rather than
financing transactions
Receivables pledged as collateral
Receivables classified as current when likelihood of
collection is low
Collection of receivable contingent on uncertain future
events
Payment not required until purchaser sells the
product
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The Control Environment and
Sales
An organization's control environment
affects revenue and related transactions
more than most accounts
The auditor must consider:
Management's integrity
Financial condition of the organization
Financial pressures on the organization
Management incentives to achieve financial
results
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Understanding Internal Controls
Although the auditor must understand all components of
internal controls, particular attention is paid to significant
control procedures and monitoring controls

The auditor obtains an understanding of the controls by
Walk-through of the processing of transactions
Inquiry
Observation
Review of client documentation

It is critical this understanding be documented in the
work papers
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Understanding Internal Controls (2)
Assertions must be addressed during this phase:
Occurrence, Cutoff, Completeness, Accuracy &
Classification
Controls Regarding Returns, Allowances and
Warranties are also important. Abnormal returns
or allowances may be the first sign that a
company has problems
Credit Policies are also very important

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Documenting, Testing, and
Assessing Environment Risk
Develop understanding of the accounting
system and control procedures
Evidence is gathered through inquiry, review of client
accounting manuals, and review of prior year audit
workpapers
Documentation includes questionnaires, flowcharts,
and narratives
Determine whether the application control procedures
are sufficient to achieve the control objectives
Based on control design, make preliminary
assessment of control risk
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The auditor must document those controls that
support an assessment of control risk below
maximum
If the auditor plans to rely on the internal
controls, the controls are tested to see if they are
operating as designed
If testing indicates the control is not operating
effectively,
Auditor will increase assessed control risk,
lower detection risk, and perform more
rigorous substantive testing
If the control is working effectively, control risk
assessment is unchanged

Documenting, Testing, and
Assessing Environment Risk (2)
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Linking Environment Risk
Assessment & Substantive Testing

The rigor of substantive testing is inversely
related to the assessed level of environment risk
The auditor learns three things during the
assessment of environment risk that affects the
design of substantive audit procedures:
The nature of the accounting system, controls
used, and documents generated in the client's
processing
Existence of fraud risk factors
Effectiveness of controls and types of
misstatements likely to occur
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Substantive Testing in the
Revenue Cycle
Planning for Direct Tests of Transactions and
Account Balances
Audit objectives and assertions
Account balance relationships
Risk of material misstatement
Composition of the account
Persuasiveness of audit procedures
Cost of audit procedures
Timing of audit procedures
Determining optimal mix of audit procedures
Exhibit 10.7 Outlines the relationship between Assertions and
Substantive Tests for the Revenue and Accounts Receivables
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Substantive tests of revenue
objectives/issues
Assertions related to revenue transactions:
Occurrence: Have the transactions occurred
and pertain to the entity
Completeness: Have all transactions been
recorded
Accuracy: Have transactions been accurately
recorded
Cutoff: Have transactions been recorded in
the correct accounting period
Classification: Have transactions been
recorded in the proper accounts
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Substantive Tests of Revenue
for Occurrence and Accuracy
Vouch recorded sales transaction back to
customer order and shipping document
Compare quantities billed and shipped
with customer order
Special care should be given to sales
recorded at the end of the year
Scan sales journal for duplicate entries
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Substantive Tests of Revenue
Cutoff Tests
Can be performed for sales, sales
returns, cash receipts
Provides evidence whether transactions
are recorded in the proper period
Cutoff period is usually several days
before and after balance sheet date
Extent of cutoff tests depends on
effectiveness of client controls
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Substantive Tests of Revenue
Cutoff Tests e.g.
Sales cutoff
Auditor selects sample of sales recorded during cutoff
period and vouches back to sales invoice and
shipping documents to determine whether sales are
recorded in proper period
Cutoff tests assertions of existence and completeness
Auditor may also examine terms of sales contracts
Sales return cutoff
Client should document return of goods using
receiving reports
Reports should date, description, condition, quantity
of goods
Auditor selects sample of receiving reports issued
during cutoff period and determines whether credit
was recorded in the correct period
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Substantive Tests of Revenue
for Completeness
Use of pre-numbered documents is
important
Analytical procedures
Cutoff tests
Auditor selects sample of shipping
documents and traces them into the sales
journal to test completeness of recording
of sales
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Substantive Tests of Accounts
Receivable - issues
Existence & Occurrence
Does the receivable exist?
Valuation
Are sales and receivables initially recorded at their
correct amount?
Will client collect full amount of recorded receivables?
Rights and Obligations
Contingent liabilities associated with factor or sales
arrangements
Discounted receivables
Presentation and Disclosure
Pledged, discounted, assigned, or related party
receivables
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Standard Substantive Tests of
Accounts Receivable
1. Obtain and evaluate aging of
accounts receivable
2. Confirm receivables with customers
3. Perform cutoff tests
4. Review subsequent collections of
receivables
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1. Aging Accounts Receivable
Because receivables are reported at net realizable value,
auditors must evaluate management estimates of
uncollectible accounts
Auditor will obtain or prepare schedule of aged accounts
receivable
If schedule is prepared by client, it is tested for mathematical and
aging accuracy
Aging schedule can be used to
Agree detail to control account balance
Select customer balances for confirmation
Identify amounts due from related parties for disclosure
Identify past-due balances
Auditor evaluates percentages of uncollectibility
Auditor then recalculates balance in the Allowance
account
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2. Confirming Receivables with
Customers
Confirmations provide reliable external evidence about the
Existence of recorded accounts receivable and
Completeness of cash collections, sales discounts, and
sales returns and allowances
Confirmations are required by GAAS unless one of the
following is present:
Receivables are not material
Use of confirmations would be ineffective
Environment risk is assessed as low and sufficient
evidence is available from using other substantive tests
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2.a The Types of Confirmations
Positive confirmations
Customers are asked to agree the amount on
the confirmation with their accounting records
and to respond directly to the auditor whether
they agree with the amount or not
Positive confirmation requires a response
If customer does not respond, auditor must use
alternative procedures
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Negative confirmations
Customers are asked to respond only if they disagree
with the balance (non-response is assumed to mean
agreement)
Less expensive since there are no additional procedures
if customer does not respond
May be used when all of the following are present
Confirming a large number of small customer
balances
Environment risk for receivables is assessed as low
Auditor believes customers will give proper attention
to confirmations
2.b The Types of Confirmations
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2.c Whats the follow-up
procedures for non-responses?
1. If customer does not respond to positive
confirmation, auditor may send a second, or
even third, request
2. If customer still does not respond, auditor will
use alternative procedures
a) Examine the cash receipts journal for cash collected
after year-end
Care is taken to ensure receipt is year-end receivable, not
subsequent sale
b) Examine documents supporting receivable
(purchase order, sales invoice, shipping documents)
to determine if sale occurred prior to year-end
Evidence gathered from internal documents is not
considered as reliable
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2.d Whats the follow-up
procedures for exceptions noted?
Customers are asked to agree the amount on
the confirmation to their accounting records;
differences are called exceptions
Reasons for exceptions:
Timing differences
Disputed items
Customer errors
Client misstatement
Because misstatements are projected to the
population of receivables, the auditor must
determine the reason for the exception
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Related-Party Receivables
Amounts due from related parties should be
separately disclosed
Audit procedures to identify related-party
transactions include:
Review SEC filings
Review the accounts receivable subsidiary ledger and
trial balance
Management inquiry
Communicate names of related parties so all audit
team members can be alert for related-party
transactions
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Sold, Discounted, and Pledged
Receivables
Receivables sold with recourse, discounted, or
pledged as collateral should be disclosed
Audit procedures to identify these items include:
Management inquiry
Scan cash receipts journal for large cash
inflows from unusual sources
Bank confirmations, which include information
on obligations and terms
Review board of director minutes, which
contain approval for these items
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Fraud Indicators and Audit Procedures
Potential fraud indicators:
Excessive credit memo or other adjustments to accounts
receivable just after year-end
Customer complaints and discrepancies in receivable
confirmations
Unusual entries to the receivable subsidiary ledger or sales
journal
Missing or altered source documents
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Fraud Indicators & Audit Procedures - 2
Potential fraud indicators:

Lack of operating cash flow when operating income has been
reported
Unusual reconciling differences between receivable subsidiary
ledger and control account
Sales in the last month with unusual terms
Pre- or post-dated transactions
Unusual adjustments to sales accounts before/after year-end
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Fraud Indicators and Audit Procedures - 3
Substantive procedures that may highlight potential fraud
indicators:
Review of source documents including invoices, shipping
documents, customer purchase orders, etc
Review and analyze credit memos and other
adjustments to receivables
Confirm sales terms with customers
Analyze large or unusual sales made near year-end
Scan the general ledger, receivables subsidiary ledger,
and sales journal for unusual activity
Perform analytical review of credit memo and write-off
activity
Analyze recoveries of written-off accounts
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Auditing of Allowance for Doubtful
Accounts
Accounts receivable should be reported at their net realizable value
The balance of the allowance for doubtful accounts is estimated and
depends on a number of factors
Understating the allowance overstates net accounts receivable and
net income
Where accounts receivable are material, the auditor should obtain
an understanding of how management developed the estimate by
using one or more of these approaches:
Review and test the process used by management to develop the
estimate
Test aging schedule
Evaluate estimated percentages of uncollectibility used
Develop an independent model to estimate the accounts
Review subsequent events such as subsequent collections on
account