CHAPTER 14 AUDITING THE REVENUE CYCLE Fall 2007 Nature of the Revenue Cycle Inherent Risk Factors Audit

objectives Control Activities Standard Substantive Tests

Nature of the Revenue Cycle

For a merchandising company, the classes of transactions in the revenue cycle include: 1. credit sales (sales made on accounts), 2. cash receipts (collections on accounts and cash sales), and 3. sales adjustments (discounts, sales returns and allowances, and uncollectable accounts [provisions and writeoffs]).

Auditing the Revenue Cycle

Consider: How Can Revenue be Manipulated?

Inherent Risk Assessment and Fraud Considerations

1. 2. Pressures to overstate revenues to achieve announced revenue or profitability targets. Pressures to overstate cash and gross receivables or understate the allowance for doubtful accounts for debt covenant working capital requirements. Revenue recognition: ambiguous stds, estimates, complexity of the calculations, rights of return. Receivables are factored with recourse: correct classification as a sale vs. a borrowing. Cash receipts susceptible to misappropriation. Sales adjustments can conceal theft. Classification of AR as current vs. non-current

3. 4. 5. 6. 7.

Inherent Risk Assessment

Understand the Clients Business and Industry
1. Develop an expectation of total revenues 2. Develop an expectation of gross margin 3. Develop an expectation of net receivables 4. Understanding industry accounting practices.

Consideration of IC: Obtaining an Understanding and Assessing CR

Control Environment Risk Assessment Information and Communication
Initiate transactions Deliver (receive) goods or services Record Transactions Consideration

Control Activities Monitoring

Credit Sales Info & Commun.

Common Documents and Records
Customer Order Sales Order Shipping Documents (Bill of Lading and Packing Slip) Sales Invoice Authorized Price List Sales Journal Customer Master File Accounts Receivable Master File Customer Monthly Statement

System Flowchart Initiate Credit Sales

System Flowchart Delivery of Credit Sales

System Flowchart Recording Credit Sales

Cash Receipts Info & Commun.

Common Documents and Records
Remittance advice Prelist Cash count sheets Daily cash summary Validated deposit slip Cash receipts journal

Control Activities Sales Adjustment Transactions

Sales adjustment transactions involve the following: 1. Granting cash discounts 2. Granting sales returns and allowances (credit memo) 3. Determining uncollectable accounts (write-off authorization memo)

Substantive Tests of Revenues and Receivable

Important Concept: The sales that are most likely to represent potential misstatements are the uncollected sales. To design substantive tests for these accounts, the auditor must first determine the acceptable level of tests of details risk for each significant related objective.

Standard Substantive Tests for Revenues & Receivables

1. Initial procedures 2. Analytical procedures 3. Tests of transactions
a) Test details of sales transactions b) Cut-off testing
Sales Cash Receipts Credit Memos

4. Tests of balances
a) Confirmations b) Estimates

5. Presentation and disclosure

Substantive Tests of Accounts Receivable

Figure 14-9
Category Initial Procedures Substantive Test 1. Obtain an understanding of the business and industry and determine: a. The significance of revenues and accounts receivable to the entity. b. Key economic drivers that influence the entitys sales, margins, and collections. c. Standard trade terms in the industry, including seasonal dating, collections period, etc. d. The extent of concentration of activity with customers. Account Balance Audit Objectives EO4 C4 RO3 VA# PD#

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Category Initial Procedures

Substantive Test 2. Perform initial procedures on accounts receivable balance and records that will be subjected to further testing. a. Trace beginning balance for accounts receivable to prior years working papers. b. Review activity in general ledger account for accounts receivable and investigate entries that appear unusual in amount or source. c. Obtain accounts receivable trial balance and determine that it accurately represents the underlying accounting records by: Footing the trial balance and determining agreement with (1) the total of the subsidiary ledger or accounts receivable master file, and (2) the general ledger balance. Testing agreement of customer and balances listed on the trial balance with those included in the subsidiary ledger or master file.

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Category Analytical Procedures

Substantive Test 3. Perform analytical procedures: a. Develop an expectation for accounts receivable using knowledge of the entitys business acitvity, market share, normal trade terms, and its history of accounts receivable turn days. b. Calculate ratios: Compare sales to the entitys capacity. Compare sales growth and receivalbes growth. Accounts receivable turn days. Uncollectable accounts expense to net credit sales. Uncollectable accounts expense to accounts receivable writeoffs. c. Analyze ratio results relative to expectations based on prior years, industry data, budgeted amounts, or other data.

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Analytical Procedures Commonly Used to Audit the Revenue Cycle Figure 14-4
Ratio Sales to Capacity Market Share Formula Net Sales Nonfinancial Measure of Capacity Clients Net Sales Net Sales of Industry Audit Significance Helpful in assessing the reasonableness of total revenues. Helpful in assessing the reasonableness of both total revenues and gross margins. Larger market share is often associated with larger gross margins. This ratio is useful for manufacturing and other asset-based companies. Describes the relationship between assets and sales revenues. Ratios larger than 1.0 indicate that receivables are growing faster than sales. Large ratios may indicate possible collection problems.

Sales to Total Assets

Sales Average Total Assets

Accounts Receivable Growth to Sales Growth

((Accounts Receivable n Accounts Receivable n-1) 1) ((Sales n Sales n-1) 1)

Ratio Accounts Receivable Turn Days

Formula Average Accounts Receivable Sales x 365

Audit Significance Useful in comparing with industry averages. Longer collection periods may indicate collection problems. Prior experience and current sales volumes may be useful in estimating current net receivables. Useful in evaluating the reasonableness of uncollectable accounts expense. Smaller ratios may indicate an inadequate provision for uncollectable accounts. Useful in evaluating the reasonableness of uncollectable accounts expense. Smaller ratios may indicate an inadequate provision for uncollectable accounts. Companies with a high proportion of revenues from new products may earn a premium gross margin due to the ability to innovate.

Uncollectable Accounts Expense to Net Credit Sales

Uncollectable Accounts Expense Net Sales

Uncollectable Accounts Expense to Accounts Receivable Writeoffs New Product Revenues to Total Revenues

Uncollectable Accounts Expense Actual Accounts Receivable Writeoffs

Revenues from New Products Introduced During the Year Total Revenues

Category Tests of Details of Transactions

Substantive Test 4. Vouch a sample of recorded sales and receivable transactions to supporting documentation. a. Vouch receivable debits to supporting sales invoices, shipping documents, and sales orders. b. Vouch receivable credits to remittance advises or sales adjustments, authorizations for sales returns and allowances or uncollectable account writeoffs.

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Category Tests of Details of Transactions

Substantive Test 5. Perform cutoff tests for sales and sales returns. a. Select a sample of recorded sales transactions from several days before and after year-end and examine supporting sales invoices and shipping documents to determine sales were recorded in the proper period. b. Select sample of credit memos issued after year-end, examine supporting documentation such as dated receiving reports and determine that returns were recorded in the proper period. Also consider whether volume of sales returns after year-end suggest the possibility of unauthorized shipments before year-end.

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Substantive Tests Revenue and Receivables Cycle: Cut-off Tests

Objective: Ensuring recording of transactions in the correct period
Types: 1. Sales 2. Credit memos 3. Cash receipts

Category Tests of Details of Transactions

Substantive Test 6. Perform cash receipts cutoff tests. a. Observe that all cash received through the close of business on the last day of the fiscal year is included in cash on hand or deposits in transit and that no receipts of the subsequent period are included, or b. Review documentation such as daily cash summaries, duplicate deposit slips, and bank statements covering several days before and after year-end for proper cutoff.

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Category Tests of Details of Balances

Substantive Test 7. Confirm accounts receivable. a. Determine the form, timing, and extent of confirmation requests. b. Select and execute sample and investigate exceptions. c. For positive confirmation requests for which no reply was received, perform alternative follow-up procedures: Vouch subsequent cash receipts identifiable with items comprising the account balance at the confirmation date to supporting documentation. Vouch items comprising the balance at the confirmation date to documentary support such as sales orders and shipping documents.

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Substantive Tests of AR: Confirmations

Confirm Receivables
Confirmation of accounts receivable involves direct written communication between individual customers and the auditor. This substantive test is used extensively by the auditor.

Substantive Tests of AR: Confirmations

Confirmation of receivables is a generally accepted auditing procedure which should be performed unless:
1. AR is immaterial to the financial statements. 2. The use of confirmations ineffective. 3. Inherent risk and control risk are low enough and analytical procedures expected to be effective enough to get audit risk to an acceptably low level.

Substantive Tests of AR: Confirmations

Forms of Confirmation
There are 2 forms of confirmation request: 1. the positive confirmation, which requires the debtor to respond whether or not the balance shown is correct, 2. the negative confirmation, which requires the debtor to respond only when the balance shown is incorrect.

Category Tests of Details of Balances: Accounting Estimates

Substantive Test 8. Evaluate the adequacy of the allowance component for each aging category and in the aggregate. a. Foot and crossfoot the aged trial balance of receivables and agree the total to the general ledger. b. Test aging by vouching amounts in aging categories for sample of accounts to supporting documents. c. For past due accounts: Examine evidence of collectability such as correspondence with customers and outside collection agencies, credit reports, and customers financial statements. Discuss the collectability of accounts with the appropriate management personnel. d. Evaluate managements process for estimating the allowance for doubtful accounts using hindsight. e. Evaluate the adequacy of the allowance given information about: Industry trends. Aging trends. Collection history for specific customers.

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Category Required Procedures Presentation and Disclosure

Substantive Test 9. Confirmation of accounts receivable included in step 7. 10. Compare statement presentation with GAAP. a. Determine that receivables are properly identified and classified as to type and expected period of realization. b. Determine whether there are credit balances that are significant in the aggregate and that should be reclassified as liabilities. c. Determine the appropriateness of disclosures and accounting for related party, pledged, assigned, or factored receivables.

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