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CHAPTER 14 AUDITING THE REVENUE CYCLE

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14-1. a. b. The revenue cycle includes the activities involved in the exchange of goods and services with customers and the realization of the revenue in cash. The classes of transactions in this cycle for a merchandising company are sales, sales adjustments, and cash receipts. The primary accounts affected by these transactions are sales, accounts receivable, cost of sales, inventory, cash, sales discounts, sales returns and allowances, bad debts expense, and allowance for uncollectable accounts Specific audit objectives for the revenue cycle are derived from the five categories of management's financial statement assertions. Specific audit objectives for credit sales transactions include the following:
Specific Audit Objectives Transaction Objectives Occurrence. Recorded sales transactions represent goods shipped or services provided during the period. Recorded cash receipt transactions represent cash received during the period. Recorded sales adjustment transactions during the period represent authorized discounts, returns and allowances, and uncollectable accounts. Completeness. All sales cash receipts and sales adjustments made during the period were recorded. Accuracy. All sales and cash receipts and sales adjustments are accurately valued using GAAP and correctly journalized, summarized and posted. Cutoff. All sales, cash receipts and sales adjustments have been recorded in the correct accounting period. Classification. All sales, cash receipts, and sales adjustments have been recorded in the proper accounts. Balance Objectives Existence. Accounts receivable representing amounts owed by customers exists at the balance sheet date. Completeness. Accounts receivable include all claims on customers at the balance sheet date. Rights and Obligations. Accounts receivable at the balance sheet date represent legal claims of the entity on customers for payment. Valuation and Allocation. Accounts receivable represents gross claims on customers at the balance sheet date and agrees with the sum of the accounts receivable subsidiary ledger. The allowance for uncollectable accounts represents a reasonable estimate of the difference between gross receivables and their net realizable value.

14-2. a. b.

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Factors that might motivate management to deliberately misstate revenue cycle assertions include: • Pressures to overstate revenues in order to report achieving announced revenue or profitability targets or industry norms that were not achieved in reality owing to such factors as global. Completeness. Solutions Manual to Modern Auditing: Copyright © 2005. but relatively immaterial for the hotel. The computer company auditor will have significant issues associated with the risk of misstatement with respect to the existence of receivables and inventories that are not present for the hotel. cash receipts. Disclosed revenue cycle events and transactions have occurred and pertain to the entity. • Pressures to overstate cash and gross receivables or understate the allowance for doubtful accounts in order to report a higher level of working capital in the face of liquidity problems or going concern doubts. 14-4. than the hotel. 14-2 . a. the need to make estimates. Following are a few examples of differences between how the auditor might use the knowledge of the entity and its environment for a computer company v. the impact of technological developments on the entity's competitiveness. 14-3. • The timing and amount of revenue to be recognized may be contentious owing to factors such as ambiguous accounting standards. b. John Wiley and Sons. Inc. Understandability. national. the complexity of the calculations involved. as opposed to properties that it owns. All revenue cycle disclosures that should have been included in the financial statements have been included. or sale to total assets.Disclosure Objectives Occurrence and Rights and Obligations. a hotel. The computer company is also likely to have a higher ratio of sales to fixed assets. The computer company auditor will also have to address valuation and allocation issues associated with the collectability of receivables and lower of cost or market of inventories that are insignificant for the hotel. Factors that might contribute to unintentional misstatements in revenue cycle assertions include: • The volume of sales. Revenue cycle information is disclosed accurately and at appropriate amounts. Revenue cycle information is appropriately presented and information in disclosures is understandable to users. or poor management. and purchasers' rights of return. Accuracy and Valuation. The hotel will have a potential risk of material misstatement in terms of how it accounts for revenues from properties that it manages for others. Certain balance sheet accounts like accounts receivable and inventories are going to be very significant for the computer manufacturer. and sales adjustments transactions is often high. resulting in numerous opportunities for errors to occur. or regional economic conditions.

Two analytical procedures that the auditor might use to estimate gross margin for company might include. Analytic Procedure Accounts receivable turn days Audit Significance Understanding a company’s history of accounts and sales volume can assist the auditor in evaluating net receivables and the adequacy of the allowance for doubtful accounts. Following are example analytical procedures that the auditor might use to estimate total revenue for a household appliance manufacturer and for an airline. Audit Significance Companies with commanding market shares often are able to obtain larger gross margins.14-5. Inc. • • Possible Analytical Procedures Use past ratio of net sales to capacity with adjustments for capacity changes. Industry Household Appliance Mfg. The above history of accounts receivable turn days would be most useful for evaluating estimating gross receivables given sales. Two analytical procedures that the auditor might use to estimate net receivables and the allowance for doubtful accounts for company might include. Evaluate the entities history of uncollectable accounts expense to net credit sales. John Wiley and Sons. Companies with a high proportion of revenues from new products may earn premium gross margins due to the ability to innovate. a. Estimate net revenues using information on utilization of capacity (airline seat miles) and average revenue per seat. Solutions Manual to Modern Auditing: Copyright © 2005.reduction of risk of overstatement of revenues and receivables by eliminating incentives to dishonest reporting. Evaluate the percentage of revenues coming from new products. with adjustment for economic conditions 14-6. c. • Commitment to competence .by chief financial officers and accounting personnel. Requires knowledge of the total market size in the industry. 14-3 . Analytic Procedure Compare historical trends in market share and gross margin with current unaudited data. Several control environment factors and their applicability to revenue cycle assertions are: • Integrity and ethical values . This procedure is primarily related to the adequacy of the allowance for uncollectable accounts. Use a combination of past ratios of market share with adjustments of current changes in market share. Airline • b.

Documents Shipping documents Reports of unfilled orders and back orders Computer Files and Records Open Order File Perpetual Inventory Shipping File Documents Sales Invoice Sales Reports and Sales Journal Various Exception Reports Monthly Customer Statements Computer Files and Records Sales Transaction File Accounts Receivable Master File 14-8. the department that performs the functions. John Wiley and Sons. . Initiating credit Sales department Documents sales Customer Order Credit department Sales Order Computer Files and Records Customer Master File (with credit information) and Accounts Receivable Master File.bonding of employees who handle cash • 14. Inc. Line operating departments for services. Department that Principal documents and records Function performs function produced in performing the function. and the principal documents or records produced in performing the function. Perpetual Inventory Authorized Price List Open Order File Delivering good and services Warehousing and shipping department for goods.Management's philosophy and operating style .conservatism in developing such accounting estimates as the allowance for uncollectable accounts and allowance for sales returns.7. In order to assess control risk as low based on programmed control procedures the auditor should test the following. • Human resource policies and practices . Control Importance to Control Risk Assessment 14-4 Recording sales Accounting (Billing) Solutions Manual to Modern Auditing: Copyright © 2005. The following table summarizes the functions that apply to credit sales transactions.

John Wiley and Sons. b. should not be recognized. or a sales prepare a sale invoice without invoice information that both is transaction for underlying information on and is not supported by which revenue shipping files. documents must be matched with a sales invoice. Sales invoices may The computer compares Submit test data for a transaction not be recorded. Sales invoices may The computer checks run-to. with underlying shipping match underlying shipping information and matches information and authorized price prices with an authorized lists. Sales are made The computer searches a field Submit test data for sales orders without credit for appropriate credit that both are and are not approval. Sales invoice may The computer compares dates Submit test data with dates on be recorded in the on the sales invoice with sales invoices that both do and wrong accounting dates on shipping documents. entries in the sales journal that has shipping information. Programmed controls usually report exceptions noted when performing the control. is recorded. price list. If a programmed control procedure in critical to a low control risk assessment then the auditor should directly test the control procedure. e.Submit test data for batches that not be posted or run totals of beginning with complete and incomplete may not be accounts receivable balances. f. Inc. file. All shipping supporting sales invoice.Programmed control procedures Computer general control procedures Manual follow-up procedures. 14-5 . with underlying shipping both with and without a information. A sales invoice has The computer matches Submit test data for sales incorrect quantities quantities on a sales invoices invoices that both do and do not or prices. A fictitious sales The computer will not Submit test data with sales invoice. In order to obtain assurance that the programmed control procedure functions effectively throughout the period the auditor also needs to these the effectiveness of computer general control procedures. related shipping files. data sets in terms of completed Solutions Manual to Modern Auditing: Copyright © 2005. underlying shipping information. As a result auditors also need to test the effectiveness of manual controls that follow-up on reported exceptions. d. authorization before an order supported by appropriate credit is placed on an open order authorization. do not match with dates on period. c. The following tables describes programmed controls for a typical manufacturing company. 14-9. Potential Programmed Control CAATs (Assuming Test Data) Misstatement a.

Sales invoices may be posted to the wrong customer’s accounts. and the resulting bank deposit record establishes the existence or occurrence of the transactions. Submit test data with underlying information that both does and does not match with information on previously created sales order and shipping files. 14-6 . credits the company for the cash. and sends the remittance advices to the company for use in updating accounts receivable. that is. and the shipping documents. 14-10. The sub-functions involved in cash receipts include (1) receiving cash receipts.completeness. 14-12. cash disbursements should not be made out of undeposited receipts. and verification of agreement of cash on hand with totals printed by a cash register or terminal . a. • Independent check by supervisor on the accuracy of cash count sheets. Four controls that can aid in preventing or detecting errors or irregularities in recording cash receipts are summarized below along with potential tests of controls: Solutions Manual to Modern Auditing: Copyright © 2005. Depositing receipts intact daily means that all receipts are deposited. b. A common management control involves having managers with responsibility for sales to review daily or weekly sales reports to assess the reasonableness of recorded sales. Further management responsible for warehousing and shipping should review daily or weekly sales and inventory movement reports to assess the reasonableness of recorded sales and inventory removed from the perpetual inventory.Potential Misstatement journalized g. and (3) recording the cash receipts. with the ending receivable balances. The bank picks up the mail daily. A lockbox is a post office box that is controlled by the company's bank. Inc. John Wiley and Sons. The computer matches customer information on the sales invoice with the master customer file. CAATs (Assuming Test Data) transactions. b. Programmed Control plus sales transactions. Two important controls pertaining to the initial handling of mail receipts are (1) immediate restrictive endorsement of checks received and (2) preparation of a multicopy listing (prelist) of mail receipts. This control reduces the risk that receipts will not be recorded (completeness). 14-14. (2) depositing cash in bank. the sales order. This system eliminates the risk of diversion of the receipts by company employees and failure to record the receipts. 14-11. a.existence or occurrence and valuation or allocation. 14-13. Two important controls pertaining to cash sales and the transaction class audit objectives to which they relate are: • The customer's expectation of a printed receipt and supervisory surveillance of over the counter sales transactions helps to ensure that all cash sales are processed through the cash registers or terminals .

c. Make inquiries about procedures to follow-up on issues raised by customers. The rights and obligations assertion for accounts receivable involves selling. and examine reports or other evidence of follow-up. it should keep a documentary record of the receivables that have been sold or pledged. A sound system of internal controls over these three transaction cycles that ensure the completeness and accuracy of these transactions. particularly the use of an approved credit memo for granting credit for returned or damaged goods. cash receipts. Use CAATs to test computer matching of information from cash receipts journal with electronic prelist. and an approved write-off authorization memo for writing off uncollectable customer accounts. Examine a sample of periodic bank reconciliations. and determining uncollectable accounts. 14-15. The functions pertaining to sales adjustments transactions are: granting cash discounts. Computer check of information included in the cash receipts journal with information from prelist. Preparation of periodic independent bank reconciliations. • Segregation of duties for authorizing sales adjustment transactions and handling and recording cash receipts. a. namely credit sales. • The use of appropriate documents and records. If an entity sells its receivables. b. a. Solutions Manual to Modern Auditing: Copyright © 2005. should also ensure the completeness and accuracy of account receivable. Make inquiries about bank reconciliation procedures and test accuracy on a sample basis. Mailing of monthly statements to customers. The following three types of controls pertaining to sales adjustments transactions have as their common focus establishing the validity. or factoring. or existence of occurrence. Also follow-up on how exceptions are reported and examine evidence or correction of errors reported on exception reports. The accounts receivable balance is a function of the transactions that are posted to the account. and have a process for following up on collection of those receivables and the reduction of the related liability 14-16. Inc. John Wiley and Sons. The primary control over the balance involves sending monthly statements to customers and having an independent function to receive and follow-up on any issues raised by customers. cash receipts. 14-7 . b.Control Independent check of agreement of validated deposit slip with daily cash summary. Test of Control Inspect a sample of daily cash summaries and examine evidence of agreement with validated deposit slip by responsible employee. granting sales returns and allowances. and sales adjustments. Observe the mailing of monthly statements to customers. of such transactions: • Proper authorization of all sales adjustments transactions.

Inc. Credit Sales Assertion (Audit Objective) Existence and Occurrence (Occurrence) Completeness (Completeness) Existence and Occurrence / Completeness (Cutoff) Valuation and Allocation (Accuracy) Presentation and Disclosure (Classification) Rights and Obligations Control Computer matches sales invoice information with underlying shipping information. John Wiley and Sons. Observe and reperform procedures for documenting receivables that have been factored or sold. Preparation of periodic independent bank reconciliations. The disclosure committee should have individuals who are knowledgeable about GAAP and the transactions being processed. Submit test data with shipments in one period and billing in the subsequent period.to the factoring agent. 14-17. d. Observe and reperform manual controls to check independent check of the prelist with the cash receipts journal. Computer prints a report of all goods shipped but not billed. Examples emphasize programmed control procedures where appropriate. Submit test data with invoice prices that do not match the authorized price list or sales order. If an entity sells its receivables. Computer matches customer number on sales invoice with customer number on sales order. Independent check of agreement Test of Controls Observe and reperform manual controls to check independent check of the prelist with the cash receipts journal. and testing manual follow-up of items that appear on exception reports. Observe and test the accuracy of independent bank reconciliations. 14-8 . Student should note that tests of controls should also emphasize testing computer general controls. Submit test data the customer information on the sales invoice does not match the underlying sales order. These records should be compared with monthly statements received from a bank or factoring agent. Submit test data with shipments that have not been billed to test accuracy of report of all good shipped but not billed. Computer matches sales prices with authorized price list and sales order. Observe and reperform manual controls to Solutions Manual to Modern Auditing: Copyright © 2005. Comparison of invoice date with the accounting period when goods were shipped. Test of Controls Submit test data where invoice data does not match with underlying shipping information. Public companies normally control establish controls over the presentation and disclosure assertion and related audit objectives through an effective and independent disclosure committee. observing exception reports. Cash Receipts Assertion (Audit Objective) Existence and Occurrence (Occurrence) Completeness (Completeness) Existence and Occurrence / Completeness (Cutoff) Valuation and Allocation Control Independent check of agreement of cash and checks with cash count sheets and prelist. it should keep a documentary record of the receivables that have been sold and it should compare that record with monthly statements received from a factoring company. Independent check of agreement of cash and checks with cash count sheets and prelist. The following table provides example controls and tests of controls for each assertion (and transaction level audit objective) related to credit sales and cash receipts.

cash receipts. differ from the planned assessed levels. • Completeness for cash receipts and sales adjustments transactions that decrease accounts receivable. A revised acceptable level of detection risk for tests of details and a revised level of substantive tests must be determined for an assertion when the relevant final or actual inherent risk assessments. and sales adjustments. check independent check of the prelist with the cash receipts journal. 14-9 . c. 14-18. Observe and reperform procedures for documenting receivables that have been factored or sold. Observe notes and procedures used to follow-up upon questions raised by customers.(Accuracy) Presentation and Disclosure (Classification) Rights and Obligations of cash and checks with cash count sheets and prelist. The transaction classes that should be considered in assessing control risk for accounts receivable assertions are: credit sales. Make inquiries about mailing of monthly statements to customers. a. Inc. control risk assessments. John Wiley and Sons. the following transaction class control risk assessments should be considered: • Existence or occurrence for sales transactions that increase accounts receivable. If an entity sells its receivables. and analytical procedure risk assessments. b. Mailing of statements to customers. it should keep a documentary record of the receivables that have been sold and it should compare that record with monthly statements received from a factoring company. Solutions Manual to Modern Auditing: Copyright © 2005. In assessing control risk for the existence or occurrence account balance assertion for accounts receivable.

14-20. Moderate to high which will allow for smaller sample sizes and changing the timing of confirmations of receivables. Moderate to high depending on internal controls over collection of receivables. Low if internal controls over the occurrence of sales are strong. the auditor determines that all Solutions Manual to Modern Auditing: Copyright © 2005. Moderate to high depending on reliability of expectation model. The sales cutoff test involves: • Examining shipping documents for several days before and after the cutoff date to determine the date and terms of shipment. Rights and Obligations Valuation and Allocation Moderate to high depending on reliability of expectation model. Moderate to high depending on the entity’s ability to generate operating cash flow. Presentation and Disclosure The auditor can test the accuracy of receivables at gross value with confirmation. control are more nonroutine than routine. 14-10 . • Tracing shipping documents to sales and inventory records to establish that the entries were made in the correct accounting period. • Inspecting invoices for a period of time before and after the cutoff date to ascertain the validity and propriety of the shipments and corresponding entries.14-19. Analytic Procedures Risk Moderate to high depending on reliability of expectation model. Low: Consider confirming with factoring agent and search for large unusual cash receipts. rights and obligations. Inherent risk is usually high or maximum. Both the sales cutoff test and the cash receipts cutoff test pertain to accounts receivable. The evidence obtained pertains primarily to specific audit objectives derived from the existence or occurrence. Maximum to High. It will also reduce the extent of cutoff tests. In performing a cash receipts cutoff test. 14-21. Assertion Existence and Occurrence Completeness Inherent Risk Maximum due to revenue recognition problems. Moderate. and valuation or allocation assertions for accounts receivable. John Wiley and Sons. Moderate to high depending on internal controls. Not a significant inherent risk. the auditor may be present at the balance sheet date to personally observe the promptness of the cutoff. Moderate to high depending on reliability of expectation model. and customer orders. Maximum: Analytical procedures are not directed at testing disclosures. Inc. a sample of debits to customers' accounts is compared to data on supporting sales invoices and matching shipping documents. It will also reduce the extent of cutoff tests. sales orders. Moderate to high depending on internal controls over disclosures. However. In vouching recorded accounts receivable transactions to supporting documentation. • Inquiring of management about any direct shipments by outside suppliers to customers and determining the appropriateness of related entries. The following table explains some example preliminary audit strategies for each financial statement assertion in the context of the audit risk model. The auditor should consider extensive tests of the allowance after year-end. It is often cost effective to substantively test disclosures which are not complex for receivables. High or maximum due to subjective nature of allowance. Control Risk Low if internal controls over the occurrence of sales are strong. In particular. Test of Details Risk Moderate which will allow for smaller sample sizes and changing the timing of confirmations of receivables.

• The auditor's combined assessment of inherent risk and control risk is low.collections received prior to the close of business are included in cash on hand or in deposits in transit and are credited to accounts receivable. is sufficient to reduce audit risk to an acceptably low level for the applicable financial statement assertions. 14-11 . such as that all nonresponses pertain to year-end transactions. 14-23. projected as 100% misstatements to the population and added to the sum of all other unadjusted differences. b. a. the auditor may review the daily cash summary and validated deposit slip for the last day of the year. • The use of confirmations would be ineffective as an audit procedure. • The auditor has no reason to believe that the recipients of the requests are unlikely to give them consideration. c. The negative form should be used only when all three of the following conditions apply: • The acceptable level of detection risk for the related assertions is moderate or high. a. Inc. It may not be necessary to confirm accounts receivable when: • The balance is immaterial to the financial statements. When no response is received after the second or third positive confirmation request to a customer. Alternatively. 14-22. b. and that assessment. made in conjunction with the evidence expected to be provided by analytical procedures or other substantive tests of details. John Wiley and Sons. Solutions Manual to Modern Auditing: Copyright © 2005. would not affect the auditor's decision about whether the financial statements are materially misstated The aged trial balance is used primarily in assessing the adequacy of the allowance for uncollectable accounts. Alternate procedures may be omitted when both of the following conditions apply: • There are no unusual qualitative factors or systematic characteristics related to the nonresponses. Factors to be considered in choosing the form of confirmation request are (1) the acceptable level of detection risk and (2) the composition of the customer balances. Procedures applied to the aged trial balance include (1) footing and crossfooting the aged trial balance and comparing the total to the general ledger balance for accounts receivable and (2) testing the aging of the amounts shown in the aging categories by examining supporting documentation such as dated sales invoices. Both cutoff tests relate to the occurrence and completeness audit objectives for accounts receivable. The positive form is used when detection risk is low or individual customer balances are relatively large. the auditor should apply such alternative procedures as (1) examining subsequent collections and (2) vouching open invoices comprising the customer's balance. • The nonresponses. • A large number of small balances is involved.

• Discuss collectability of accounts with appropriate management personnel. assigning. • Examine past due accounts for evidence of collectability such as correspondence with customers and outside collection agencies. GAAP disclosure for accounts receivable include: • Disclosure of receivables from employees. After testing the accuracy of the aged trial balance the auditor should perform the following procedures to draw a conclusion about the fair presentation of the allowance for doubtful accounts. 14-12 . • Appropriate classification of current and noncurrent receivables. officers. John Wiley and Sons. Inc. d. credit reports. Solutions Manual to Modern Auditing: Copyright © 2005. aging trends. affiliated companies and other related parties. The reliability of management’s process for developing this accounting estimate can be gauged by evaluating estimates in prior periods and the degree to which those estimates accurately estimated subsequent uncollectable accounts. Hindsight allows auditors to evaluate the reasonableness of management’s process for estimating the allowance for doubtful accounts. and collection history for specific customers. and customers’ financial statements. 14-24. • Disclosure of pledging.c. • Evaluated management’s process for estimated the allowance for doubtful accounts using hindsight. or factoring receivables. • Appropriate classification of material credit balances. • Evaluate the adequacy of the allowance given information about industry trends.