Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

CHAPTER 11 Accounts Receivable, Notes Receivable, and Revenue

Review Questions 11-1 The term "customer's order" refers to the purchase order received from a customer. The term "sales order" refers to the document created upon receipt of a customer's order. The sales order is a translation of the terms of the customer's order into a set of specific instructions for the guidance of various departments, including the credit department, finished goods, stores, shipping, billing, and accounts receivable. The audit of revenue and receivables is of significant audit ris! because "1# overstatement of revenue has been a factor in man$ instances of fraudulent financial reporting, " # the overstatement of revenue results in a corresponding overstatement of net income, "%# the determination of the amount of revenue recogni&ed ma$ be determined b$ the application of comple' accounting principles, and "(# significant accounting estimates ma$ be involve in the determination of the financial statement presentation of receivables and revenue. )ood internal control in the billing process re*uires that someone other than the emplo$ee preparing the invoice shall revie+ the accurac$ of prices, credit terms, and other data on the invoice before this document is released. The ob,ective of the billing process is to notif$ the customer of the amount due for goods or services delivered. A most important document created b$ the billing department is the sales invoice. The original is sent to the customer, and copies are used to record accounts receivable and sales. The statement is incorrect. Credit memoranda are used to credit "reduce# accounts receivable +hen goods sold on credit are being returned, or +hen a defect in the goods ,ustifies a price reduction. Credit memoranda are not issued to remove uncollectible accounts receivable from the records. .uch +rite-off of +orthless receivables is handled b$ a general ,ournal entr$ debiting the Allo+ance for /oubtful Accounts and crediting Accounts Receivable.

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Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

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The sales invoices "and the shipping documents as +ell# should be seriall$ numbered. 1hen each da$'s invoices are transmitted from the billing department to the accounts receivable department, the$ should be accompanied b$ a transmittal list sho+ing the serial numbers of all sales invoices. 2ver$ number in the series should be accounted for. 3f a computer is used to record sales invoices item counts and control totals should be used to ensure that all sales are recorded. The statement is correct in suggesting that voided shipping documents should be cancelled. 5o+ever, the$ should be retained, and not discarded so as to assure that the numerical se*uence ma$ be accounted for. All sales invoices should be seriall$ numbered. 2ach da$ the billing department should send copies of the invoices prepared that da$ to the accounts receivable department accompanied b$ a transmittal letter specif$ing the invoice numbers used and the total dollar amount billed. 7$ comparing the individual invoices +ith the list of serial numbers and comparing the total debits to accounts receivable +ith the total figure for billings, the accounts receivable department can be sure that it has received and recorded all sales invoices. 9ther specific procedures +hich contribute to good internal control over the business processes related to accounts receivable include "onl$ three re*uired#: "1# " # "%# "(# "-# "0# The separation of the duties of the accounts receivable accountant from all cash handling functions. Regular balancing of the subsidiar$ ledger of receivables +ith the general ledger control account b$ an emplo$ee other than the accounts receivable accountant. Regular aging of accounts receivable and revie+ b$ management. ;eriodic revie+ of delin*uent accounts b$ an appropriate e'ecutive. ;eriodic confirmation of accounts receivable b$ internal auditors. .erial numbering of shipping documents, sales invoices, and credit memoranda, and regular accounting for all numbers in the series.

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11-1< The auditors should confirm +ith the ban! the loss contingenc$ for notes receivable discounted. The auditors also should send separate confirmation re*uests to the ma!ers of the notes receivable +hich +ere discounted to determine the genuineness and validit$ of the notes. 11-11 The +rite-off of small notes receivable from officers, directors, stoc!holders, or affiliated companies is obviousl$ irregular and unacceptable practice. .uch notes are almost al+a$s collectible b$ virtue of the positions held b$ the ma!ers. The auditors should investigate these related part$ transactions full$= the$ +ill probabl$ find that the charges to the allo+ance for uncollectible notes +ere made in error and +ere not authori&ed b$ management. 3f the amounts +ere large, there +ould be more reason to suspect an intention of self-serving activities or fraud on the part of the management.

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Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

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Among the audit procedures commonl$ applied to notes receivable but not to accounts receivable are the follo+ing: "1# " # >erification of interest earned and accrued interest receivable. 2'amination of the note.

11-1% The client compan$ should re*uest "on its letterhead# the customer to confirm the account receivable. The auditors have no authorit$ to ma!e such a re*uest directl$ on their stationer$. The return envelope should be addressed to the auditors' office to assure that the auditors have control over confirmation returns. 11-1( The audit ob,ective of determining the e'istence of receivables is most directl$ addressed b$ the audit procedure of confirming accounts receivable and notes receivable b$ direct communication +ith debtors. 3n addition, +ritten confirmation also addresses the completeness and valuation assertions, but less effectivel$ because it deals onl$ +ith recorded accounts and provides limited information on +hether the receivable is collectible. The procedure also provides evidence of occurrence and accurac$ of revenue transactions. 11-1- 3f the auditors find post office bo' addresses for man$ individual customers +hose accounts +ere selected for confirmation, the auditors should consider the possibilit$ that the customers ma$ be fictitious, and that dishonest emplo$ees of the client compan$ plan to "ans+er" the confirmation re*uests. 11-10 Alternative auditing procedures to verif$ accounts receivable +hen confirmation is not practicable or possible include e'amination of customers' purchase orders or contracts= e'amination of client's duplicate shipping documents and invoices= and revie+ of pa$ments received from customers subse*uent to the balance sheet date. 11-14 Alternate auditing procedures that ma$ be used +hen customers have not replied to confirmation re*uests include: "1# " # "%# "(# .end additional re*uests b$ registered or certified mail, +ith return receipt re*uested. The auditors might telephone to ascertain the balance or the reason for failure to respond to the +ritten re*uest. ?nder some circumstances, re*uests ma$ be made b$ fa' machine. The auditors ma$ e'amine an$ pa$ments to the account made subse*uent to the balance sheet date. The auditors ma$ also e'amine the duplicate invoices, shipping records, purchase orders, etc., for transactions ma!ing up the unpaid balance.

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Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

11-16 To test the client's sales cutoff at @une %<, the auditors should compare shipping records +ith entries in the sales ,ournal, and receiving records +ith entries recording sales returns, for several da$s prior to and subse*uent to @une %<. The auditors +ill be alert for sales and sales returns recorded in the +rong accounting period. 11-18 An unusuall$ large number of sales transactions ,ust prior to the balance sheet date should be full$ investigated b$ the auditors. This situation ma$ result from a strenuous effort made during the closing da$s of the period to get out shipments and meet a sales *uota. 9n the other hand, it ma$ reflect an improper cutoff of sales transactions at $ear-end, or even the recording of fictitious sales. 3n an$ event, the auditors' investigation should include matching of sales invoices +ith shipping documents and customers' orders, and discussions +ith e'ecutives. Careful anal$sis of sales returns during the succeeding period ma$ also shed light on the situation. 11- < 2'cessive sales returns or allo+ances ma$ indicate shipments made +ithout customers' orders, shipments of defective merchandise, a misstatement of inventor$ or of sales and receivables, or +ea!nesses in internal control. 9ne purpose of a revie+ of sales returns and allo+ances subse*uent to the balance sheet date is to uncover an$ facts +hich necessitate ad,ustment of inventories, receivables, or sales in the statements being audited. Another purpose is to test internal control effectiveness. 11- 1 The credit memoranda should bear the date and serial number of the receiving report on the return shipment. The credit memoranda selected b$ the auditors for testing can be compared +ith records of the receiving department to determine that goods +ere actuall$ returned. 113n testing the ade*uac$ of the client compan$'s allo+ance for doubtful accounts receivable, the auditors revie+ the follo+ing: "1# " # "%# "(# "-# "0# Aarge past-due accounts not paid subse*uent to the audit date. An aged trial balance of accounts receivable and comparison +ith those of prior $ears. Accounts in dispute as evidenced b$ confirmation e'ceptions or b$ correspondence in the client's files. ?nfavorable reports of collection prospects on accounts assigned to collection agencies or attorne$s. 9pinions of the client's credit manager as to the collectible portion of each large past-due account. Relationship of the valuation allo+ance to "a# accounts receivable, "b# net credit sales, and "c# accounts +ritten off during the $ear. These ratios should be compared +ith those prevailing in past $ears and industr$ averages. 3nformation from a retrospective revie+ of prior $earBs allo+ance that indicates +hether management might bias its estimates.

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Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

11- % 2'amples of t$pes of receivables originating +ithout arm's-length bargaining include loans to insiders "directors, officers, !e$ emplo$ees# and loans to affiliated companies. These t$pes of receivables should be sho+n separatel$ +ith disclosure of the nature of the relationships and the amounts of the transactions. 11- ( A retrospective revie+ is an anal$sis of the ,udgments and assumptions underl$ing a prior $ear accounting estimate. 1ith hindsight the auditors can evaluate +hether there appears to be an$ management bias in the prior $ear estimate. The purpose +ith respect to revenue is to provide information about possible management bias to assist in the audit of the current $ear revenue estimates. Questions Requiring Analysis 11- "a# According the .2C Staff Accounting Bulletin No. 104 the follo+ing criteria must be met for revenue to be recogni&ed: ;ersuasive evidence of an arrangement "contract# e'ists, /eliver$ has occurred or services have been rendered, The sellerBs price to the bu$er is fi'ed or determinable, and Collectibilit$ is reasonabl$ assured.

"b# To overstate revenue the follo+ing techni*ues might be used b$ ;rocessing .olutionsB management "onl$ t+o re*uired#: 1. Recording of fictitious contracts +ith customers. . Recording revenue before a contract is e'ecuted. %. Recording revenue +hen the compan$ has entered into side agreements +ith the customers that affect the reali&ation of revenue "e.g., allo+ing liberal return privileges#. (. Allocating e'cessive amounts of revenue to the deliver$ and set-up of the s$stem to recogni&ed revenue earl$.

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Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

"c# Overstate ent Tec!nique 1. Recording of fictitious contracts +ith customers. Audit Procedure Confirmation of contracts +ith customers. 3n*uiries of salespeople about contracts. Confirmation of contract terms +ith customers. 3n*uiries of salespeople about contract e'ecution dates. Confirmation of contract terms +ith customers, including the e'istence of an$ side agreements. 3n*uiries of salespeople about oral modification of contract terms and side agreements. Revie+ of allocation of contract revenue to the multiple elements of the contract, e.g., soft+are, setup, maintenance, etc. Revenue should be recogni&ed on the elements based on their relative fair mar!et values.

. Recording revenue before a contract is e'ecuted. %. Recording revenue +hen the compan$ has entered into side agreements +ith the customers that affect the recognition of revenue "e.g., allo+ing liberal return privileges#.

(. Allocating e'cessive amounts of revenue to the deliver$ and set-up of the s$stem to recogni&e revenue earl$.

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"a# 1hen a compan$ engages in bill and hold transactions there is a possibilit$ that the compan$ is inappropriatel$ recogni&ing revenue. The auditors must ascertain that an$ transactions recogni&ed as sales meet the criteria for revenue recognition as set forth in .2C Accounting and Auditing 2nforcement Release No. 1<6. 3n these circumstances, the auditors +ill revie+ the provisions of sales contracts and consider confirming the terms +ith customers. "b# 1hen a compan$ sells using a multiple element arrangement, the revenue must be allocated to the elements in relation to their fair values. Therefore, there is a possibilit$ that management ma$ attempted to misstate revenue b$ inappropriate allocation. 3n these situations, the auditors +ill revie+ the sales contracts and evaluate the reasonableness of managementBs allocation of the revenue to the various elements.

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Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

"c#

1hen a compan$ uses the percentage-of-completion method, there is a ris! that management ma$ misestimate the amount of revenue earned on uncompleted contracts. The auditors must carefull$ evaluate the costs allocated to the contracts and the estimates of the percentage-of-completion. 3n some cases, the auditors ma$ decide to engage a specialist, such as an engineer. 1hen a compan$Bs sales agreements allo+ for returns, there is a ris! that management misstate the estimate of sales returns and, therefore, misstate revenue and receivables. 3n these situations, the auditors should carefull$ revie+ the contracts to determine that revenue should be recogni&ed at the time of sale. 3f revenue recognition is appropriate, the$ should ne't evaluate the ade*uac$ of managementBs estimate of sales returns.

"d# ma$

"e#

1hen salespeople modif$ the terms of sales through various side agreements and issue ma$ arise as to +hether an$ particular sale meets accounting criteria to be recorded as such, and +hether the allo+ance for returns needs to be ad,usted.

11- 4 "a# .ales invoice= "b# approved sales order= "c# customerBs purchase order= "d# approved sales order= "e# sales invoice. 11- 6 "a# An audit confirmation re*uest is a +ritten communication received b$ the auditors directl$ from a part$ outside the client organi&ation. The +ritten communication usuall$ affirms the e'istence of, and rights to, an amount recorded in the clientBs accounting records. "b# "c# To be valid evidence, an audit confirmation response must be received directl$ b$ the C;A firm from the outside part$ +ho has replied to the confirmation re*uest. A positive confirmation re*uest re*uires a repl$ from the clientBs customer in ever$ case. A negative confirmation re*uest re*uires a repl$ onl$ if the balance for +hich confirmation has been re*uested is incorrect. Negative confirmation re*uests ma$ be used for situations in +hich "1# the combined assessed level of inherent and control ris! is lo+= "b# a large number of small balances is involved= and "c# the auditors have no reason to believe that the recipients of the re*uests are not li!el$ to give them consideration.

"d#

11- 8 The confirmation re*uests should go to the ma!ers of the notes regardless of +hether the notes have been discounted. The act of discounting a note receivable does not reduce the importance of the note being genuine and collectible. A compan$ +hich discounts its notes receivable remains in a position of sustaining a loss if the ma!ers of the notes fail to ma!e pa$ment at the maturit$ dates. 11-%< Confirmation of accounts receivable b$ direct communication +ith debtors is usuall$ essential to the issuance of an un*ualified audit report. Confirmation of receivables is a presumed procedure, and failure to perform such a procedure +hen issuing an un*ualified report re*uires ,ustification in the +or!ing papers. The auditors must generall$ disclaim an opinion on the clientBs financial statements +hen the$ have been forbidden b$ the client to confirm receivables.

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"a# 1hen confirmation re*uests are mailed to debtors +hose accounts +ere +ritten off as uncollectible, the auditorsB purposes are to determine that the receivables +ere genuine +hen the$ +ere first recorded in the accounts and to determine that the accounts +ere not collected and the proceeds stolen. 3n some fraud cases, fictitious accounts receivable have been created to cover up a shortage. 2ventuall$ these fictitious receivables must be disposed of= one method is to +rite off the fictitious accounts as uncollectible. 3n other cases, valid accounts receivable have been collected, but +ritten off as uncollectible b$ the emplo$ee +ho has procured the funds. "b# The .olar e'ecutive appears to believe the auditors are solel$ concerned +ith the valuation or collectibilit$ of accounts and notes receivable. 3n fact, the confirmation process is primaril$ intended to establish that the receivables are valid and that the customers "or ma!ers of notes# e'ist. 9ther audit procedures are follo+ed to determine proper valuation.

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Conn should consider appl$ing the follo+ing additional substantive audit procedures: "1# " # "%# "(# "-# "0# "4# "6# "8# "1<# "11# Test the accurac$ of the aged accounts receivable schedule. .end second re*uests for all unans+ered positive confirmation re*uests. ;erform alternative auditing procedures for unans+ered second confirmation re*uests. Reconcile and investigate e'ceptions reported on the confirmations. ;ro,ect the results of the sample confirmation procedures to the population and evaluate the confirmation results. /etermine +hether an$ accounts receivable are o+ed b$ emplo$ees or related parties. Test the cutoff of sales, cash receipts, and sales returns and allo+ances. 2valuate the reasonableness of the allo+ance for doubtful accounts. ;erform anal$tical procedures for accounts receivable "e.g., accounts receivable to credit sales, allo+ance for doubtful accounts to accounts receivable, sales to sales returns and allo+ances, doubtful accounts e'pense to net credit sales.# Revie+ activit$ after the balance sheet date for unusual transactions. /etermine that the presentation and disclosure of accounts receivable is in conformit$ +ith generall$ accepted accounting principles, consistentl$ applied.

11-%% 3n testing the aging of accounts indicated as past due, the assistant indeed verified the aging of those accounts. 5o+ever, the assistant completel$ neglected the accounts indicated as current on the client-prepared trial balance. An$ number of "current" accounts might in realit$ be past due. 7$ ignoring a significant number of individual accounts, the assistant +as deficient in the test and he had no basis +hatsoever for reporting to the senior auditor that the client's aging +or! +as satisfactor$. 11-%( The ans+er to this *uestion +ill var$ +ith the nature of the compan$ that the students select. 5o+ever, almost universall$ these companies use the percentage-of-completion method for at least a portion of their revenues. This obviousl$ presents the auditors +ith the ris! that managementBs estimates of cost to complete a pro,ect +ill not be reasonable, and revenue +ill be prematurel$ recogni&ed.

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Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

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1hen the auditors identif$ a ris! as being significant and re*uiring special audit consideration, the$ must: "1# " # "%# 2valuate the design of the related controls and determine that the$ have been implemented= Not rel$ solel$ on anal$tical procedures to address the ris!= and Not rel$ on evidence obtained from prior audits regarding the operating of the related internal controls.

effectiveness "b# 2'amples of +a$s that Nelson ma$ react to this particular ris! include "onl$ one: "1# " # "%# Ob"ective Questions 11-%0 Cultiple Choice Duestions "a# "(# 9ver-recorded sales due to a lac! of control over the sales entr$ function relates to control ris! not inherent ris!. The other three replies all relate to inherent ris!. "b# "(# Ans+er "(# is correct because receivables are valued at net reali&able value, and assessing the allo+ance for uncollectible accounts for reasonableness +ill help the auditor determine the proper amount. Ans+er "1# is incorrect because the limited information in the accounts receivable ledger +ill not ma!e possible tracing details to the shipping documentsEalso, the shipping documents ma$ not even capture the total sales price that is included in the accounts receivable ledger. Ans+er " # is incorrect because +hile comparing turnover ratios ma$ provide some information on the collectibilit$ of receivables, it is ver$ imprecise. Ans+er "%# is incorrect because it relates to presentation and disclosure more directl$ than valuation. "c# "(# A sale either shouldnBt be recorded, or a proper allo+ance for returns should be established +hen a customer is li!el$ to return the goods. Thus, simpl$ recording the sale is an e'ample of fraudulent financial reporting +hen the customer is li!el$ to record the goods. Ans+ers "1# and "%# are e'amples of errors, +hile ans+er " # is an e'ample of misappropriation of assets. "(# Theft of cash register sales is an e'ample of misappropriation of assets. Ans+er "1# is an e'ample of an error +hile ans+ers " # and "%# are e'amples of fraudulent financial reporting. "1# A presumption that receivables +ill be confirmed re*uires a combined assessment of inherent ris! and controls ris! at the lo+ level, immaterial receivables, or circumstances in +hich the use of confirmations +ould be ineffective. Confirm the terms of sales contracts +ith selected customers. 2'amine a larger sample of sales contracts. Ca!e e'panded in*uiries of sales personnel regarding the terms of contracts.

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Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

"f#

" # Ans+er " # is not among the criteria because of the portion of the ans+er that states Fscheduled to occur in the near future.G 9rdinaril$ deliver$ must have occurred. Ans+ers " #, "%# and "(# all describe circumstances re*uired to recogni&e revenue. "g# "1# The goal is to determine the population to be sampled from to determine that all sales have been recorded= therefore, the sample should be ta!en from a population of source documents, here the shipping documents file. None of the other three ans+ers represent source documents that ma$ be sampled from to determine that all sales have been recorded.

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"(# /etecting overstated sales is a primar$ reason the auditors' revie+ of a client's sales cutoff. Hor e'ample, shipments made in the first part of @anuar$ ma$ be improperl$ included in the /ecember sales total. "%# The ob,ective is to determine the population the auditors +ould sample from to test the e'istence assertion for recorded receivables. The direction of testing should be from the accounts receivable subsidiar$ ledger to the available support, such as sales invoices, bills of lading, sales orders, and customers' orders. " # Comparing shipping documents to related sales invoices addresses the completeness assertion relating to sales. Core specificall$, it addresses +hether all items that have been shipped have been recorded as sales. "1# The auditor +ould send positive confirmations rather than negative confirmations because the fact that the balances are delin*uent ma$ indicate that amounts are in dispute. 2'amining subse*uent cash receipts, ans+er "%#, is unli!el$ to be effective since man$ of the accounts +ill not have been collected. 3nspection of internal records, ans+er "(#, is li!el$ to result in less credibilit$ evidential matter than confirming the accounts. "1# 1rite-offs of receivables should be approved b$ a responsible officer after a revie+ of the account b$ the credit department. Ans+er " # is incorrect because accounts receivable, a record!eeping function, should not authori&e such entries. Ans+er "%# is incorrect because other procedures "e.g., a revie+ of shipping documents# ma$ be used to determine that the goods +ere received and because the shipping department +ould have no other information on +hether the receivable is li!el$ to be collectible. Ans+er "(# is incorrect because the account need not be overdue b$ several months as a "current" receivable ma$ become +orthless due to, for e'ample, a ban!ruptc$.

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Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

11-%4 .imulation "a# "b# "c# "d# "e# "f# "g# "h# "i# ",# "!# "l# "m# "n# Neither .trength .trength /eficienc$ Neither /eficienc$ /eficienc$ /eficienc$ /eficienc$ .trength .trength .trength .trength .trength

11-%6 .imulation "a# "C# 3nvoices posted to incorrect customer accounts +ill be detected b$ anal$&ing customer responses to monthl$ statements that include errors, particularl$ statements +ith errors not in favor of the customer. "b# "## The comparison of shipping documents +ith sales invoices +ill detect goods that have been shipped but not billed +hen no sales invoice is located for a particular shipping document. "c# "$# To provide assurance that all invoiced goods that have been shipped are recorded as sales, dail$ sales summaries should be compared +ith invoices. Hor e'ample, a sale that has not been recorded +ill result in a sales summar$ that does not include certain sales invoices. "d# "%# A comparison of the amounts posted to the accounts receivable ledger +ith the control total for invoices +ill provide assurance that all invoices have been posted to a customer account. "e# "&# Comparing customer orders +ith an approved customer list +ill provide assurance that credit sales are made onl$ to customers that have been granted credit. "f# "'# Re*uiring an approved sales order before goods are released from the +arehouse +ill provide assurance that goods are not removed for unauthori&ed orders. "g# "(# A comparison b$ shipping cler!s of goods received from the +arehouse +ith the approved sales orders +ill provide assurance that goods shipped to customers agree +ith goods ordered b$ customers. "h# ")# A comparison of sales invoices +ith shipping documents and approved sales orders +ill detect invoices that do not have the proper support. Accordingl$, it +ill help prevent the recording of fictitious transactions. "i# "P# Comparing amounts posted to the accounts receivable ledger +ith the validated ban! deposit +ill detect improper postings to accounts receivable since an$ differences in amounts +ill be investigated.

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Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

",# "C# Cisappropriations of customersB chec!s +ill be detected +hen customers indicate that the$ have made pa$ments for items sho+n as pa$able on their monthl$ statement. Note that replies 9 and ; +ill onl$ detect this misappropriation in the unli!el$ event that the perpetrator does not dispose of the remittance advice. "!# "C# Cispostings of pa$ments made +ill be detected +hen customers indicate that the$ have made pa$ments for items sho+n as pa$able on their monthl$ statement. "l# "P# Crediting more than one account for a cash receipt +ill be detected +hen the total of amounts posted to the accounts receivable ledger is compared +ith the validated ban! deposit slip. "m# "*# An independent reconciliation of the ban! account +ill reveal improper total recording of receipts in the cash receipts ,ournal because unlocated differences bet+een ban! and boo! balances +ill occur and be investigated. "n# "P# Comparing total amounts posted to the accounts receivable ledger +ith the validated ban! deposit slip +ill detect a difference bet+een total cash receipts and the amount credited to the accounts receivable ledger. "o# "N# Re*uiring the approval of the supervisor of the sales department for goods received +ill provide assurance that invalid transactions granting credit for sales returns are not recorded. Note that using prenumbered credit memos "repl$ C# +ill onl$ be effective if the se*uence is accounted for and if credit memos ma$ be compared in some form to actual returns. 11-%8 .imulation "a# Correct. "b# 3ncorrect. "c# Correct. "d# Correct. "e# 3ncorrect. "f# Correct. "g# 3ncorrect. "h# Correct. "i# 3ncorrect. ",# 3ncorrect. 11-(< "a# " # Ans+er " # is correct because vouching sales recorded in @anuar$ <I8 +ill provide evidence on +hether sales made prior to $ear-end are properl$ included in <I6. Ans+er "(# is correct because a revie+ of the aged trial balance for significant past due accounts +ill provide evidence on ho+ much is e'pected to be reali&ed on receivables. Ans+er " # is correct because vouching sales recorded in @anuar$ +ill reveal +hether /ecember sales +ere improperl$ recorded in @anuar$. Ans+er "%# is correct because vouching sales recorded in November +ill reveal +hether those sales are properl$ recorded.

"b#

"(#

"c# "d#

" # "%#

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Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

"e# "f#

"4# "%#

Ans+er "4# is correct because a revie+ of drafts of financial statements +ill help assure that presentation and disclosure of receivables is ade*uate. Ans+er "%# is correct because vouching a sample of sales supporting receivables from the $ear +ill best address the accurac$ of receivables. 9f the options listed, vouching November sales is best.

Proble s 11-(1 .9A?T39N: 5alston To$ Canufacturing Co. "2stimated time: 1- minutes# "a# /ue to the fact that 5alston has a number of ne+ products and a liberal return polic$, it ma$ be ver$ difficult to estimate the allo+ance for sales returns. 1ith ne+ products it ma$ be difficult to use prior return histor$ to estimate the amount of returns. "b# The auditors might consider performing the follo+ing procedures: "1# Revie+ an$ trade ,ournals and industr$ data that might have information relevant to sales of the ne+ products. Revie+ trends in sales returns in prior periods, especiall$ +hen ne+ products +ere introduced. Ca!e in*uiries of sales personnel about customer feedbac! on sales of the ne+ to$s. Revie+ sales returns given in the subse*uent period and compare the amounts to prior periods.

" # "%# "(# 11-(

.9A?T39N: 3nternal Control, Tests of Controls, .ubstantive ;rocedures "2stimated time: < minutes# "a# " # "%# "1# Chec!ing the clerical accurac$ of invoices is a procedure that is designed to improve the accurac$ of customer billings and, therefore, the accurac$ of sales and accounts receivable. Accounting for prenumbered shipping documents is a procedure that is designed to reduce the ris! of unbilled shipments to customers. Thus, the procedure serves to insure that all sales and accounts receivable are recorded. Approval of credit prior to shipment reduces the ris! of sales to customers in amounts in e'cess of their credit limits. The procedure helps to prevent e'cessive credit losses. "1# Clerical chec!ing of invoices could be tested b$ e'amining a sample of sales invoices processed throughout the $ear for indication "e.g., the chec!er's initials# of performance of the procedure. 9f course, the auditors should verif$ the clerical accurac$ of the sample invoices themselves to obtain evidence that the chec!er effectivel$ performed the procedure. Accounting for prenumbered shipping documents might be tested b$ revie+ing the numerical file of shipping documents "t$picall$ maintained in the billing department# for missing items.

"b#

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Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

"%#

Adherence to credit approval procedures could be tested b$ e'amining the documentation of a sample of transactions processed throughout the $ear, noting that the credit approval date is before the date of shipment. "1# Hailing to chec! the clerical accurac$ of sales invoices results in an increased probabilit$ of errors in sales and accounts receivable. The auditors might compensate b$ increasing the number of accounts receivable selected for confirmation, or b$ shifting the confirmation date from an interim date to $earend. Also, anal$tical procedures applied to the client's sales or gross margin might provide evidence that sales are not materiall$ misstated. Hor e'ample, monthl$ sales for the $ear under audit could be compared to forecasted amounts, or similar amounts from prior $ears. Aac! of control over shipping documents ma$ result in an understatement of sales and accounts receivable. To test for this understatement the auditors could select a sample of shipping documents processed during the $ear and trace the details to a recorded sales transaction. Again, anal$tical procedures for sales or gross margin percentages might provide an indication of +hether sales are understated b$ a material amount. 1hen credit approval is not obtained prior to shipment of goods, the amount of uncollectible account e'pense as a percentage of sales is not li!el$ to be as stable. Thus, loss percentages of prior $ears are less useful in testing the ade*uac$ of the current $ear's allo+ance for doubtful accounts. To compensate, the auditors might e'amine more credit information for specific accounts, especiall$ for those that are larger in amount or past due.

"c#

" #

"%#

11-(% .9A?T39N: Cartin Cfg. Co. "2stimated time: %< minutes# The ,ournal entr$ recording Cartin's sale of land to Ardmore is not acceptable, for it fails to recogni&e the discount implicit in the transaction. The fair value of the note receivable from Ardmore is not J--<,<<<= because Ardmore refused to pa$ more than J44<,<<< principal and interest. 7$ ac*uiescing to an 6 percent interest rate, Cartin's management tacitl$ ac!no+ledged that the fair value of the land +as less than the J--<,<<< face amount of the note. The auditors should propose the follo+ing ad,usting entr$ as of Carch %1, <<I: )ain on .ale of Aand -<,<<< Aoss on .ale of Aand "J-<<,<<< - J(%0,-8<# 0%,(1< /iscount on Note Receivable "J--<,<<<-J(%0,-8<#

11%,(1<

To correct entr$ recording sale of land to Ardmore Corp. Note receivable from Ardmore "J--<,<<<# has a present value of J(%0,-8< +hen its J44<,<<< maturit$ value is discounted at 1 K= as a result a loss of J0%,(1< "J-<<,<<< cost less J(%0,-8< fair value of note# +as reali&ed on the sale.

11-1(

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

11-(( .9A?T39N: Aa+rence Compan$ "2stimated time: (< minutes# "1# "b# "a# 2'amine supporting documents, including the sales invoices and applicable sales and shipping orders, for propriet$ of the account receivable. Revie+ the cash receipts ,ournal for the period after .eptember %<, <<I, and note an$ collections from Coss Compan$. The degree of internal control over cash receipts should be an important consideration in determining the reliance that can be placed on the cash receipts entries. 3n addition, as there is no assurance that collections after .eptember %< represent the pa$ment of invoices supporting the .eptember %< account balance, consideration should be given to re*uesting a confirmation from Coss Compan$ of the invoices paid b$ its chec!s. "a# The e'ception should be investigated thoroughl$. 3f the credit +as posted to the +rong account, it ma$ indicate merel$ a clerical error. 9n the other had, posting to the +rong account ma$ indicate lapping. To assure that both accounts have been properl$ stated, the account originall$ credited should be reconfirmed unless the customer has alread$ *uestioned the propriet$ of the credit. .uch a comment ma$ also indicate a dela$ in recording and depositing of receipts. 3f, upon investigation, such is the case, the compan$ should be informed so that the$ can ta!e corrective steps.

" #

"b#

"%#

This is a confirmation of the balance +ith an additional comment. As the customer has given the data, it is preferable to see that the information agrees +ith the compan$'s records. .uch a procedure ma$ disclose lapping, misposting, or dela$ in recording of receipts. This incomplete comment should raise an immediate *uestion: /oes the customer mean paid before or paid after .eptember %<L As it is unsafe to assume +hat the customer intended, this account should be reconfirmed and the customer as!ed to state the e'act date. ?pon receipt of the second confirmation, the information thereon should be traced to the cash receipts ,ournal. A comment of this t$pe indicates that the compan$ ma$ be recording sales before a sale has legall$ ta!en place. The auditors should e'amine the invoice and revie+ +ith the appropriate officials the compan$'s polic$ on shipment terms and determine if sales, cost of goods sold, inventories, and accounts receivable have to be ad,usted. Hollo+-up for comparable cutoff problems should be made as of 9ctober %1, the balance sheet date. "a# /etermine if such advance pa$ment has been received and that it has been properl$ recorded. A revie+ should be made of other advance pa$ments to ascertain that charges against such advances have been properl$ handled. 3f the advance pa$ment +as to cover these invoices, the auditors should propose a reclassification of the J1,%-<, debiting the advance pa$ment account and crediting Accounts ReceivableETrade.

"(#

"-#

"0# "b#

11-1-

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

"4# "b#

"c#

"a# 2'amine the shipping order for indications that the goods +ere shipped and, if available, carrier's invoice andMor bill of lading for receipt of the goods. 3f it appears that goods +ere shipped, send all available information to the customer compan$ and as! it to reconfirm. 3f the customer still insists that goods +ere never received, all data should be presented to an appropriate compan$ official for a complete e'planation. This ma$ indicate that accounting for shipments is inade*uate and consideration should be given to revie+ing the procedures to determine if improvements can be made. 3f the goods +ere not shipped, the auditors should recommend an ad,ustment reducing sales, cost of goods sold, and accounts receivable, and increasing inventories.

"6#

This should be discussed +ith the appropriate officials and correspondence +ith the customer revie+ed and determination made if an ad,ustment should be made in the amount receivable, or if the allo+ance for doubtful accounts should be increased as of 9ctober %1. As title on an$ goods shipped on consignment does not pass until those goods are sold, the sales entr$ should be reversed, inventor$ charged, and Cost of )oods .old credited. 9ther so-called sales should be revie+ed and compan$ officials *ueried to determine if other sales actuall$ represent consignment shipments. This is a noncurrent asset and should be reclassified to either deposits or prepaid rent. A revie+ of other accounts, especiall$ those +ith round figures, ma$ disclose other accounts that should be so reclassified. This ma$ indicate a misposting of the credit or a dela$ in posting the credit. Comments under " # above +ould also appl$ to credits.

"8#

"1<#

"11#

11-(- .9A?T39N: Carlborough Corporation "2stimated time: %< minutes# "a# Classif$ing the advance to 9lds as a current asset is inappropriate. The date of repa$ment is not set, and it is doubtful that the funds +ill be available to meet obligations during the ne't operating c$cle. ;resentation as a current asset +ill mislead users of the financial statements= the$ ma$ conclude that the compan$'s current position is stronger than it is. Hinancial presentation is not ade*uate unless all material matters are disclosed. 9lds's contention that this +ould ",ust give the raiders ammunition" implies that additional disclosure is needed to ma!e the financial statements complete. /escription of the advance as "miscellaneous accounts receivable" is inade*uate. ;roperl$ it should be sho+n as an advance "or loan# to a compan$ officer. 3n vie+ of the materialit$ of the advance, the note description should identif$ 9lds and the nature of the collateral. ?nder some circumstances 9lds's ac*uisition of the stoc! might be considered as disguising the compan$'s ac*uisition of treasur$ stoc!. Hactors involved in this determination are the parties' intentions, 9lds's fiscal capacit$ to ac*uire the stoc!, and the legal implications of the transactions.

11-10

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

"b#

The first three actions proposed b$ 9lds are desirable, but the$ have limited usefulness and are not valid alternatives to further disclosure. .pecific comments on each follo+: "1# " # "%# The 7oard of /irectors appears to be dominated b$ 9lds, and its post-factum approval +ill be perfunctor$ and lac! independence. 2'ecution of a demand note formali&es 9lds's obligation, but it probabl$ +ill not improve collectibilit$. The date of repa$ment remains uncertain and the demand designation does not ,ustif$ classification as a current asset. 2ndorsement of the stoc! +ill help the compan$ establish o+nership, if that should become a problem, but it appears that the collateral ma$ be inade*uate because: "a# The mar!et price of the stoc! ma$ have been artificiall$ stimulated b$ the purchases of 9lds and the raiders. "b# The prevailing mar!et price often cannot be reali&ed +hen large bloc!s of stoc! are sold. A +ritten opinion from the compan$'s attorne$, +ill not eliminate the need for further disclosure, but it is vital and should be obtained under an$ circumstances. 3n particular, the attorne$ could be as!ed to consider +hether the stoc! transactions might be considered an ac*uisition of treasur$ stoc!, if this +ould be a valid use of funds, and +hat 9lds's voting rights +ould be in this circumstance.

"(#

"c#

3f the C;A concludes that additional disclosure is essential to fair presentation of the financial statements and Carlborough refuses to disclose the additional information, the C;A should provide the necessar$ supplemental information in his report and e'press an adverse opinion, as the client's statements do not present fairl$ its financial position, results of operations, and cash flo+s in conformit$ +ith generall$ accepted accounting principles. 3f the client is un+illing to accept his report, the C;A's onl$ alternative is to +ithdra+ from the engagement. The effect of 9lds's +arning, if an$, should be the opposite of his intention. The C;A must be especiall$ careful and avoid an$ appearance of collusion +ith the client. 3f the raiders are successful, he probabl$ +ill lose the audit engagement. 5e also can e'pect that the compan$'s accounting and his past +or! +ill be carefull$ revie+ed. Accordingl$, he should evaluate his present actions in the light of ho+ the$ must subse*uentl$ appear in a court of la+. 5e probabl$ should consult his o+n attorne$ concerning his ris! and responsibilities.

"d#

11-(0 .9A?T39N: )ranite Corporation "2stimated time: 1- minutes# "1# " # A contingent liabilit$ of J-<,<<< e'ists +ith respect to the discounted 0<-da$ note from the customer of un*uestioned financial standing and this contingenc$ should be disclosed b$ a note to the balance sheet. The contingent liabilit$ to the ban! for the J0<,<<< note receivable discounted should be disclosed b$ a note to the financial statements. This disclosure should include a statement of the intention to ma!e an advance of J6<,<<< to the affiliate from +hich the affiliate +ill ma!e pa$ment of the present note to the ban!. The disclosure should also describe the relationship bet+een the t+o companies.

11-14

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

"%#

The J <,<<< note from the former e'ecutive appears to be +orthless and the loss should be recogni&ed and reflected in the financial statements. 3n this case, the liabilit$ to the ban! is not reall$ of a contingent nature since all available information indicates that )ranite Corporation +ill have to ma!e the pa$ment. Conse*uentl$, a current liabilit$ should be included in the balance sheet to sho+ the anticipated pa$ment to the ban!.

11-(4 .9A?T39N: Aerospace Contractors, 3nc. "2stimated time: < minutes# "a# A2R9.;AC2 C9NTRACT9R., 3NC. ;artial 7alance .heet @ul$ %1, <<I Current Assets: Accounts receivable: Commercial, less allo+ance for uncollectible accounts J4-,<<< ?... government, including J% <,<<< claims under terminated contracts 9ther Assets: /ue from 5ar+ood Co., investee "b#

J -( ,<<< %,-< ,<<< (6<,<<<

The claims receivable from public carriers and the trade notes receivable are immaterial, and ma$ be included +ith commercial accounts receivable. The allo+ance for doubtful accounts and notes relates to the commercial accounts and trade notes, since receivables from the ?... government are collectible. Receivables from the ?... government are of sufficient materialit$ to +arrant presentation. .ince the termination claims are different from the regular receivables and are themselves material, the$ should be disclosed. The amount due from the investee should be sho+n separatel$ because it is a related part$ receivable. 3t also ma$ need to be classified as a noncurrent asset, since it ma$ be collected at the convenience of the borro+er. Case

&n+Class Tea

11-(6 .9A?T39N: 1ellington .ales, 3nc. "2stimated Time %< Cinutes# N Oimber should determine that the chec! +as deposited on /ecember 6 b$ e'amining the supporting documentation "e.g., entr$ in cash receipts ,ournal, deposit tic!et, ban! statement#. 5e should also determine "1# that the error has been corrected, " # +h$ the account +as recorded improperl$, and "%# +hether it is indicative of broader problem. This account should have had a balance of &ero as of $ear-end. N Oimber should determine +hether these goods +ere ever shipped, and if so, +hether the$ have been returned. The e'istence "or none'istence# of a shipping document +ill in this case provide a starting point for the anal$sis. 3t seems li!el$ that the balance of the account should be &ero, but, prior to performing the above procedures, this is uncertain.

11-16

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

N(4 Oimber should send a second re*uest to The 7ig 2dge. This second re*uest should include individual invoice numbers and amounts. 3t might also be helpful to send copies of the invoices themselves. Another option here is to e'amine shipping documents and subse*uent cash receipts. At this point, no evidence on the proper balance has been collected. N-1 Oimber should determine +hether "and +hen# the chec! +as received and recorded in the cash receipts ,ournal. 3f it +as received after $ear-end, the account is a valid receivable as of /ecember %1. N0 Oimber should determine ;ibson )on!er Corporation's address. This ma$ be available, for e'ample, from the purchase order ;ibson sent initiating the order. Oimber might +ish to further e'amine the propriet$ of this address through various databases on the 3nternet. 1hile the return of a confirmation re*uest such as this might simpl$ be due to misprocessing the address, it might also have resulted from the compan$ going out of e'istence or never having e'isted in the first place. The proper balance is ver$ much in *uestion, although it ma$ +ell be found to be proper. N06 Oimber should simpl$ determine that the chec! +as received earl$ in @anuar$. The balance of J00,<<< has been confirmed +ithout e'ception. N4 1hile this receivable +ould seem to be confirmed +ithout e'ception, the note might lead the auditors to an investigation of +hether the right of return on these and other goods is t$pical for the industr$ and +hether an$ sort of allo+ance for returns is necessar$. N 44 Oimber should e'amine the terms of the documents supporting the transaction to determine +hether this is a sale or a consignment. 3f it is a sale, it represents a receivable, although the customer's misunderstanding ma$ cause the auditor to *uestion +hether an allo+ance for returns is necessar$. 3f it is a consignment, the transaction should be recorded at cost +ith a debit to Consigned 3nventor$ and a credit to 3nventor$--in such case the receivable is misstated. Oimber should consider the terms of shipment to determine +hether a valid sale has occurred. Hor e'ample, if goods +ere shipped "H97 shipping point" on /ecember %1, or before, the receivable is properl$ recorded as of $ear end. 3f shipped "H97 destination" no sale should be recorded until the goods are received b$ the customer. .tudents +ill probabl$ have learned about shipping terms in prior classes= the information is subse*uentl$ presented in this te't in Chapter 1%. The onl$ real !no+ledge necessar$ is that for transactions such as this title ordinaril$ passes as follo+s: H97 shipping points--title ordinaril$ passes +hen the goods are shipped. H97 destination--title ordinaril$ passes +hen the goods are received b$ customer.

N 48

11-18

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

Et!ics Case 11-(8 .9A?T39N: ?niversal Air "2stimated time: < minutes# "a# 3ssues related to each of the ,ustifications include: This e'planation ma$ be acceptable if the auditor has reasonable assurance that no material misstatement is li!el$ to e'ist. An$ unrecorded liabilit$ relating to these flights at $ear-end must be immaterial in order to ,ustif$ the treatment. 1hile boo!ing the sale ma$ be critical, the service provided b$ this compan$ is transportation. Conceptuall$, the revenue should not be recogni&ed before the flight. The difficult$ of obtaining the information does not ,ustif$ a departure from )AA; that materiall$ distorts results.

"b#

1hile under circumstances of relativel$ small changes in sales one might e'pect an Faveraging outG to occur, there seems to be no reason to e'pect this to be so +hen sales are up %<K as compared to the previous $ear. 5o+ significant the %<K change is depends upon the dollar amount of advance sales. To determine +hether this averages out, one approach is to randoml$ select a sample of sales late in each $ear "depending upon ho+ far in advance passengers t$picall$ boo! tic!ets# and attempt to determine +hether the$ appro'imate one another. Also, an estimate might be based on number of reservations boo!ed in the ne+ $ear if it is possible to efficientl$ capture that information from the preceding $ear "+hich seems doubtful#. ?sing that approach one still needs to ma!e an estimate of revenues related to the boo!ings. Another approach that might or might not be possible, is to obtain assistance from the sales department "reservation department#. Hor e'ample, the sales department could have helpful reports that could help the accountant to ma!e an estimate of sales for ne't $earBs flight.

"c#

11- <

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

11--< .9A?T39N: ?niversal Air 33 "a#

"2stimated time: < minutes#

A significant deficienc$ is a deficienc$ that adversel$ affects the compan$Bs abilit$ to initiate, authori&e, record, process, or report e'ternal data reliabl$ in accordance +ith generall$ accepted accounting principles, such that there is more than a remote li!elihood that a misstatement of the compan$Bs financial statements +hich is more than inconse*uential +ill not be prevented or detected. This does not appear to be a significant deficienc$. 3f the auditor considers it a significant accounting polic$ it should be communicated to the audit committee. There is no re*uirement to report it else+here. 3t is doubtful that this polic$ is illegal. 3f material refunds are e'pected an allo+ance for sales returns t$pe entr$ might be necessar$. The polic$ might cause one to *uestion the integrit$ of the firmBs management. 3t also seems shortsighted as the airlineBs success must in part be due to repeat customers. Huture customer or press a+areness of this polic$ is not li!el$ to have a positive impact on sales. 9ther issues that might be addressed include:

"b# "c#

"1# " #

/iscuss the some+hat incomplete nature of auditor responsibilities in a case such as this. The clientBs polic$ does not seem ethical, and one might *uestion +hat other similar policies e'ist. 1hat response is appropriate if the accountantBs assistant, @ane CcClain, believes that someone should be informed or, at a minimum, the financial statements should include a note regarding the polic$. Arguments for such a note +ould be that it is a significant accounting polic$ or that a possible contingent liabilit$ e'ists. 7oth of these seem doubtful. 3n recent $ears, auditors have increasingl$ attempted to provide value-added services to clients in addition to the audit itself. The problem described in this case is a fla+ in the clientBs business process and should be brought to the attention of management.

"%#

11- 1

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue .C!a,ter 11 A,,endices

Audit Case E-ercises 11A-1 PCN Revenue C$cle Controls "2stimated time: < minutes# "a# .ales controls: Control 1. Application controls are applied +hen customer orders are entered b$ the sales order cler!. The computer assigns numbers to sales invoices +hen the$ are prepared. Conthl$ statements are mailed to customers. Cash receipts controls &nternal Control Procedure 1. . Cash receipts are prelisted b$ the receptionist. The accounting manager reconciles control totals generated b$ the accounts receivable computer program. The computer summaries of cash collections and cash sales are reconciled to prelistings of cash receipts and cash deposits b$ the accounting manager. Error or $raud Controlled Controls errors in the recording of cash and controls the abstraction of cash. Controls the embe&&lement of cash receipts and errors in and incomplete postings to accounts receivables records. Controls the abstraction of cash and the incorrect recording of cash receipts and cash sales. Error or $raud Controlled Controls errors in the deliver$ and billing of sales transactions. Controls the recording of sales to ensure completeness. Controls the recording of fictitious sales and inaccurate sales to customer accounts.

. %.

"b#

%.

11A-

PCN 3nternal Control 1ea!nesses "2stimated time: 1- minutes# The first +ea!ness is that sales invoices are prepared and mailed prior to deliver$ of goods. 2rrors ma$ occur in that different *uantities of goods ma$ ultimatel$ be delivered than have been ordered, or goods ma$ not be delivered at all. A related problem, at $ear-end, is that sales ma$ be recorded for goods not delivered until subse*uent to $ear-end, thus overstating sales and accounts receivable for the $ear.

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Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

The second +ea!ness is that accounts receivable are not +ritten-off on a regular basis. This ma$ result in an inade*uate Allo+ance for /oubtful Accounts, +ith an associated understatement of 7ad /ebt 2'pense. Also, if management is not monitoring receivables collections, the compan$ ma$ currentl$ be selling goods on credit to uncredit+orth$ customers. 11A-% PCN Attributes .ampling "2stimated time: %- minutes# "a# Audit sampling for tests of controls can be used +hen performance of the internal control procedure leaves some evidence of performance, such as a completed document or the initials of the person performing the procedure. This evidence of performance allo+s the auditors to determine +hether the control procedure +as applied to each item included in the sample. 3n addition, sampling +ill onl$ be used in circumstances in +hich "1# the auditors +ish to assess control ris! for an assertion belo+ the ma'imum, and " # the li!el$ rate of deviation from the control is less than the tolerable deviation rate. The appropriate table for determining the re*uired sample si&e is illustrated in Higure 8-(. ?sing the ro+ for a 1 percent e'pected deviation rate, and the column for a tolerable deviation rate of 1- percent, +e find a re*uired sample si&e of %< items, +ith 1 allo+able deviation. Pe$stone Computers Q Net+or!s, 3nc. Attributes .ampling .ummar$ERevenue C$cle /ecember %1, <I-

"b#

"c#

11- %

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

Ob"ectives o. test/

To test the operating effectiveness of the procedures for matching sales invoices +ith deliver receipts.

Test "1# Po,ulation *i0e .ales invoices '''

*a ,ling unit/ 3ndividual reports Rando selection ,rocedure/ Random number table

Ris1 o. assessing control ris1 too low/ -K

Planning Para eters/ Tolerable (eviation Rate E-,ected (eviation Rate *a ,le *i0e

*a ,le Results/ Nu ber o. (eviations Ac!ieved 2a-i u Rate

1. 1. Catching of . sales invoices %. +ith deliver$ (. receipts

1-K

1K

%<

Conclusion/

11- (

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

117-1 .9A?T39N: PCN .ubstantive ;rocedures Audit ;rogram "2stimated time: < minutes# "a# FPCN has engaged in a strateg$ to sell to customers +ith higher credit ris!.G The implication of this ris! is that the compan$ ma$ e'perience significant additional amounts of bad debt e'pense. The audit team addressed this ris! primaril$ +ith the follo+ing steps: 1<. Revie+ the ade*uac$ of the allo+ance for uncollectible accounts b$ performing the follo+ing procedures: "a# Revie+ the aged trial balance of accounts receivable +ith the president. "b# Revie+ confirmation e'ceptions for indications of disputed amounts. "c# Anal$&e and revie+ trends in the follo+ing relationships: "1# Accounts receivable to net sales. " # Allo+ance for bad debts to accounts receivable. "%# 7ad debt e'pense to net sales. 1%. Revie+ credit memoranda for sales returns and allo+ances through the last da$ of field+or! to determine if an ad,ustment is needed to record the items as of $ear-end. 1(. "c# Compute the accounts receivable turnover. "b# FThe officers of the compan$ receive significant bonuses based on *uarterl$ results.G The implication of this ris! is that management ma$ be inclined to misstate *uarterl$ results to ma'imi&e bonuses. The audit team addressed this ris! primaril$ +ith the follo+ing steps: 117The confirmation procedures for accounts receivable, +hich include steps ., (., -., 0., and 4. Revie+ credit files and investigate an$ indications of fictitious accounts, step 6. The cut-off procedures for sales, steps 11., 1 ., and 1%. The anal$tical procedures in step 1(., especiall$ the sales b$ month b$ salesperson.

"a# 2'amining the sales b$ month schedule provides an indication that management ma$ be overstating revenue to meet *uarterl$ and annual sales budgets. Hrom the schedule, +e see a pattern of increases in sales in the months of Carch, @une, .eptember, and /ecember, +ith respect to computer sales. Also, note that the amount of sales tends to fall off in the month follo+ing the end of the *uarter. This pattern is even more pronounced +ith respect to consulting revenue. The pattern is illustrated more dramaticall$ +ith the follo+ing t+o tables. .chedule 3 presents monthl$ sales amounts as a percentage of total sales for the $ear, and .chedule 33 presents changes in monthl$ sales from the same *uarter in the previous $ear.

11- -

Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

*c!edule & %eystone Co ,uters 3 Networ1s 2ont!ly *ales 4Percentages5 $or t!e 6ear Ended 1789187:;< *ales o. Co ,uters 7:;< 4.4 K 6.(8K 6.8%K 4.-<K 4.8(K 6.6<K 4.6(K 6.(%K 8.16K 4.(0K 6.%0K 8.%0K 1<<.<<K Consulting Revenue 7:;< 0.80K 4. 8K 6. 0K 4.(-K 4.08K 6.88K 4.44K 6. 0K 8.%8K 6.-<K 8.1-K 1<. 6K 1<<.<<K *ervice Revenue 7:;< 4.11K 6.<0K 6.4-K 6.%1K 6.<0K 8.<<K 6.<0K 6.<0K 8.(4K 6.-(K 6.<0K 6.-%K 1<<.<<K

=anuary $ebruary 2arc! A,ril 2ay =une =uly August *e,te ber October Nove ber (ece ber Total

*c!edule && %eystone Co ,uters 3 Networ1s C!anges in *ales .ro t!e *a e 2ont! in t!e Prior 6ear *ales o. Co ,uters 7:;> 7:;< %.8 K -0.<0K 8.4%K - .06K %.1 K -<.< K - .44K -1 .06K -(.46K -4.%8K 1.% K -1.6(K -1<.%<K -(.40K -%.%4K -(.0(K %.%8K - .%8K --.10K -10.04K -6. (K -4.64K -(.1%K -1.0%K Consulting Revenue 7:;> 7:;< - .8<K -8.06K -1-.1<K --.(1K -<. 1K -1.88K <.<4K -1<.-<K --. 4K --. -K %.44K (.1 K -11.40K -(. -K .61K -4.0 K <.4 K 6.61K --.( K -(.8<K 1.0(K - .10K (.16K 6.44K *ervice Revenue 7:;> 7:;< -<.1%K -1<.<6K -.6%K -1<.6%K -<.6(K %.%0K (.8(K -6.<1K - .-(K -(.8%K %.8 K -0. 6K -1.%-K -1<.4(K -<.0-K -(.66K <. 0K (.60K -4. 1K --.0(K 1. 0K -1<.08K - .4<K <.08K

=anuary $ebruary 2arc! A,ril 2ay =une =uly August *e,te ber October Nove ber (ece ber "b#

The procedures that +ould address the ris! of management overstatement of revenue in the e'isting audit program include:

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Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

1. .

Confirm a sample of customerBs accounts at 1 M%1MI-. Revie+ the aged trial balance of accounts receivable +ith the president. %. Hor all sales recorded in the last +ee! of the $ear inspect the related deliver$ receipt to determine the sale occurred before 1 M%1MI-. (. Revie+ credit memoranda for sales returns and allo+ances through the last da$ of field+or! to determine if an ad,ustment is needed to record the items as of $ear-end.

"c#

9ther procedures that might address the ris! of management overstatement of revenue include "onl$ t+o re*uired#: "1# Revie+ contracts for consulting ,obs performed during the period and e'amine time records or other records that serve as a basis for billings. Ascertain that actual billings agree to these records. " # Consider confirming consulting contract terms +ith customers and progress on e'isting contracts. "%# Ca!e in*uiries of salesmen regarding modifications to t$pical sales terms, e.g., right to return goods for an e'tended period of time. "(# Revie+ sales recorded near the end of each *uarter and inspect the related deliver$ receipts.

117-% .9A?T39N: PCN .ampling Results "2stimated time: %- minutes# "a# Anal$sis of e'ceptions 7oo! 1. Audited Cistate>alue >alue ment J1 <,<<< ----2'planation The boo! value is correct because the cash receipt +as not received b$ PCN prior to $ear-end. J 8,04< J%%< The return should have been dated as of /ecember %1. J 1(,<<< ----The balance is correct because the pa$ment +as made and received after $earend. J1 <,<<< J1<,<<< 7ecause a portion of the deliver$ +as subse*uent to $ear-end, it should not be recorded until <I0. J14,(0< J-(< 7ecause onl$ J1,4(0 +ill be received, the ad,ustment should be made in the period the sale is recorded.
11- 4

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Chapter 11 - Accounts Receivable, Notes Receivable, and Revenue

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"1# 7oo! >alue J %<,<<< 1%<,<<< 16,<<< " #

;ro,ected misstatement Audited >alue Cisstatement Tainting K .ampling 3nterval ;ro,ected Cisstatement

1 <,<<< 14,(0<

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J 8,04< J %%< 1.1K %8,(<< J (%%.(< NA NA 1<,<<<.<< %.<K %8,(<< 1,16 .<< J 11,01-.(<

7asic precision R

Reliabilit$ factor ' .ampling interval %.<< J116, << ' J %8,(<< R

"%#

3ncremental allo+ance Reliabilit$ Hactor %.<< (.40.%< 3ncrement 1.41.-;ro,ected "3ncrement-1# Cisstatement .4.-1,16 .<< 3ncremental Allo+ance 660.-< (%%.(< J1,1 (.64

%6.%4

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?pper limit on misstatement R J 11,01-.(< S J116, << S J1,1 (.64 R J1%<,8(<. 4 .ince the upper limit on misstatement is less than the tolerable misstatement "J1-<,<<<#, the results indicate that the auditors +ould accept the population as being materiall$ correct.

11- 6