Module 8: Revenue and Collection Cycle, and Acquisition and Expenditure Cycle

file:///F|/Courses/2010-11/CGA/AU1/06course/m08intro.
htm
Module 8: Revenue and collection cycle, and acquisition and expenditure cycle
Overview
In this module, you draw on the concepts learned in the previous modules and apply them to two important transaction cycles: revenue and collection, and acquisition and expenditure. When you have completed this module, you should have a good understanding of each cycles characteristics, evidence sources, control objectives, control risk assessment, tests of controls, and substantive procedures for selected accounts within the cycle. You also apply what you have learned by responding to questions involving audit procedures. Assignment reminder: Assignment 3 in Module 9 is due at the end of Week 9 (see Course Schedule). You may wish to take a look at the assignment before working on Module 8 to familiarize yourself with the requirements and to prepare for any work that may be required in advance.
Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study required.
Learning objectives
8.1 The balance sheet approach 8.2 Revenue and collection cycle The basics Explain how net income is indirectly audited through the balance sheet approach to auditing. (Level 1) Identify the main activities, accounts, sources of evidence, and functional responsibilities in the revenue and collection cycle, and explain how the responsibilities should be segregated. (Level 1)
8.3 Revenue and collection cycle Tests of controls Explain the control objectives and test of controls procedures for the revenue and collection cycle. (Level 1) 8.4 Cash balances Identify the knowledge of the entitys business and significant assertions relevant to the audit of cash balances, and describe the analytical and substantive procedures to support these assertions. (Level 1) Explain the knowledge of the entitys business that is relevant to the audit of accounts receivable, and describe the analytical procedures used to audit accounts receivable. (Level 1) Identify the most significant assertions with respect to accounts receivable, and describe the substantive procedures used to support these assertions. (Level 1) Explain the nature and types of confirmations in the context of accounts receivable and their reliability as evidence. (Level 1)
8.5 Accounts receivable
8.6 Accounts receivable Substantive procedures
8.7 Accounts receivable Confirmations
file:///F|/Courses/2010-11/CGA/AU1/06course/m08intro.htm (1 of 2) [04/10/2010 3:24:43 PM]
file:///F|/Courses/2010-11/CGA/AU1/06course/m08intro.htm
8.8 Acquisition and expenditure cycle The basics
Identify the main activities and accounts, the sources of evidence, and the functional responsibilities in the acquisition and expenditure cycle, and explain how these responsibilities should be segregated. (Level 1) Explain the control objectives and test of controls procedures for the acquisition and expenditure cycle. (Level 1) Explain the knowledge of the entitys business that is relevant to the audit of accounts payable and accrued liabilities. (Level 1) Identify the most significant assertions with respect to accounts payable and accrued liabilities, and describe the substantive procedures used to support these assertions. (Level 1)
8.9 Acquisition and expenditure cycle Tests of controls 8.10 Accounts payable and accrued liabilities Knowledge of the business 8.11 Accounts payable and accrued liabilities Substantive procedures Module summary
Print this module
file:///F|/Courses/2010-11/CGA/AU1/06course/m08intro.htm (2 of 2) [04/10/2010 3:24:43 PM]
file:///F|/Courses/2010-11/CGA/AU1/06course/m08t01.htm
8.1 The balance sheet approach

Learning objective
Explain how net income is indirectly audited through the balance sheet approach to auditing. (Level 1)
No required reading LEVEL 1
The majority of audits are performed using the balance sheet approach, where primary audit evidence is obtained by performing substantive procedures on the year-end balance sheet accounts. This approach relies on properties of the basic accounting equation (A = L + OE), which you learned in your introductory accounting course. A change in net assets (that is, a change in assets less a change in liabilities) must equal the change in owners or shareholders equity. The details of the basic accounting equation are shown in the following exhibit.
Exhibit 8.1-1: The basic accounting equation
Under the balance sheet approach, the majority of work for substantive procedures consists of those performed to support the asset and liabilities account balances.
Activity 8.1-1
Auditors focus mainly on the balance sheet when designing audit procedures. Explain why auditors use of the balance sheet approach provides strong evidence of the net income figure. Solution
file:///F|/Courses/2010-11/CGA/AU1/06course/m08t01.htm [04/10/2010 3:24:45 PM]
8.2 Revenue and collection cycle The basics

Learning objective
Identify the main activities, accounts, sources of evidence, and functional responsibilities in the revenue and collection cycle, and explain how the responsibilities should be segregated. (Level 1)
Required reading
Chapter 11, pages 422428 (up to Control Risk Assessment)
LEVEL 1
The revenue and collection cycle includes activities and transactions related to the sale of goods and services and the receipts of payments for those goods and services. The accounts included in this cycle (such as receivables, sales, and cash) have a close relationship. If the auditor finds an error in receivables, chances are that there is an error in sales as well. The nature of the revenue and collection cycle varies from organization to organization. For instance, the transaction process for revenue will be significantly different between a not-for-profit organization and a profit-oriented corporation. However, this cycle is always present in one form or another.
Functional responsibilities
Authorization is more prominent for sales (particularly credit sales) and accounts receivable than it is for cash receipts. For each sale, prices must come from an approved price list and, for credit sales, credit granting must be authorized by the credit department or through enquiry of a credit bureau. Authorization in the context of cash receipts is limited to the appropriate discount for payments made within a prescribed period. However, authorization is usually implicit because the discount period would be explicitly stated on the customers invoice. Discount calculations are usually automatic when invoices and customer accounts are maintained in a computerized environment.
Activity 8.2-1
As mentioned throughout this course, functional responsibilities should be appropriately segregated. As you read about authorization, custody, recording, and reconciliations for sales, accounts receivable, and cash, think about what these responsibilities entail for the auditor and what key points of segregation the auditor should determine by enquiry and observation. How should the functional responsibilities be appropriately segregated? Hint: Use these base functions as your starting point:

sales function authorizing credit authorizing of non-cash credit custody of cash recording function for accounts receivable recording function for sales recording function for cash reconciling function
Solution
Sources of evidence
file:///F|/Courses/2010-11/CGA/AU1/06course/m08t02.htm (1 of 2) [04/10/2010 3:24:46 PM]
The text describes the sources of evidence available to the auditor in a computerized environment. In reality, these sources are virtually the same in a non-computerized environment. The auditor would also normally have access to a number of other sources for evidence, including these documents:

bank statements and reconciliations invoices shipping documents packing slips customer orders
Such documents are also used in tests of controls and in substantive procedures for cash and accounts receivable.
8.3 Revenue and collection cycle Tests of controls

Learning objective
Explain the control objectives and test of controls procedures for the revenue and collection cycle. (Level 1)
Required reading

Chapter 11, pages 428433 Chapter 11, Exhibit 11-4, page 432, and Appendix 11A, pages 460462 (Note on the textbook reading: On page 462, Exhibit 11A-2, the third line of the second bullet should read: read only , not ready only)
LEVEL 1
In a profit-oriented company, the auditor often places at least some reliance on the clients internal controls for revenue and collection. After gaining an understanding of the control structure and determining that proper segregation of functional responsibilities exists, the auditor can then assess the control risk below maximum so that less substantive work is required. The text gives some specific examples of detailed control checking procedures and provides internal control questionnaires (see Appendix 11A). These questionnaires are conveniently arranged by control objectives and provide concrete examples of what an auditor looks for in the revenue and collection cycle. Note that these questionnaires are used to get information about the control structures that are supposed to exist in the company. In a small business with few employees, functions are often not segregated. Insurance is a good compensating control. A fidelity bond can be used to insure personnel who handle cash. Insurance does not eliminate the risk of employee wrongdoing, but it does eliminate the risk of losses that result from it.
Controls tests
Control tests are covered on pages 430 to 433. If the auditor decides to rely on internal controls, tests must be performed to support the control risk assessment that warrants such reliance. The process is as follows: 1. Identify the general control objectives as they relate to the revenue and collection cycle. The formulation of general control objectives should be similar to those outlined in Exhibit 11-2 on page 431. Although that exhibit describes only the general objectives with respect to sales, the objectives are not much different for cash and accounts receivable.
Activity 8.3-1
The objective of validity for accounts receivable is directly related to that of sales. How? Solution 2. Develop detailed test of controls procedures for sales, cash receipts, and accounts receivable that will satisfy the general control objectives. The test of controls procedures are used to provide evidence that the control structure actually exists and that it is functioning throughout the period under audit. Exhibit 11-4 on page 432 outlines the most common detailed procedures and the related control objectives. The list in this exhibit is by no means exhaustive many other procedures could be used to test the control structure in this cycle, depending on the company being audited and the nature of its control environment.
Activity 8.3-2
In cash receipts, validity can be ascertained by vouching from the cash receipts journal to a remittance list. How is completeness verified? Solution Audit procedures that can simultaneously achieve two purposes (that is, tests of controls and substantive tests of balances) are called dual-purpose procedures. 3. Evaluate the results of the tests and finalize the control risk assessment for each assertion in the revenue and collection cycle. Control objectives and assertions are different, even though a strong relationship exists between them. This relationship allows the auditor to assess control risk for a given assertion.
Example 8.3-1
If a review of a sample of credit memos reveals that all items display proper approval, the control objective of authorization is achieved for receivables. As a result, the control risk assessment for the valuation assertion of accounts receivable may be assessed as low because of the correlation between the authorization control objective and the valuation assertion. The results of the test itself do not directly support the assertion; they only assist the auditor in assessing the risk of misstatement occurring in that assertion for planning substantive procedures.
Importance of the revenue and collection cycle

The revenue and collection cycle is sometimes seen as the most important one for a company because its survival depends on its ability to manage the cash to cash cycle. Moreover, revenue transactions create the assets and the income necessary for the companys survival. For the auditor, assessing revenue is critical especially in light of the pressures placed on enterprises to attain revenue targets set by the stock market analysts. Read The problem of overstating revenue, which explains why companies overstate revenue and how auditors can prevent it.
8.4 Cash balances

Learning objective
Identify the knowledge of the business and significant assertions relevant to the audit of cash balances, and describe the analytical and substantive procedures to support these assertions. (Level 1)
Required reading

Chapter 11, pages 433437 (to Confirmation of Accounts and Notes Receivable) and 442445 Chapter 11, Exhibit 11C-1, page 466 Forms C-210, C-210C, and C-210S: Cash audit program
LEVEL 1
Audit of cash balances

Cash is an account that is used extensively in all transaction processing cycles, and the substantive procedures for cash could have just as easily been presented in the context of the acquisition and expenditure cycle or any other cycle. It is presented at this point because cash balances are first encountered in the revenue and transaction cycle. Cash is probably the only account balance that is always considered to be material, regardless of the size of the year-end balance, because it is the most liquid of all assets owned by an organization, and as such, is more vulnerable to theft and fraud. In addition, even though the year-end balance may not itself be material, the volume of transactions through the cash and bank accounts during the period will certainly be highly material. As a consequence, auditors will always give significant attention to cash attention that may at times seem disproportionate to the year-end account balance.
Knowledge of business
Knowledge of the entitys business as it applies to cash is obtained at both the planning stage and during the field work. To obtain sufficient knowledge, the auditor would normally consider

the amount of currency held on the premises the banks that the company deals with and the nature of the accounts held at those banks the names of directors and managers authorized to sign cheques and/or release funds
If the amount of money held on the premises is significant, or if the aggregate of small amounts (that is, petty cash funds) is significant, the auditor may want to conduct surprise cash counts. However, typically, most of the cash flows through accounts held with various banks. It is not uncommon for an organization to deal with more than one institution and hold several accounts in each of them. The auditor will need to know the details of these institutions and accounts to ensure amounts are properly confirmed and to determine whether there are any valuation issues (for example, foreign currency bank accounts). Finally, the auditor will need to know who can sign the cheques in order to evaluate controls over cash disbursements.
Analysis
The use of analysis in the audit of cash is fairly limited. One analytical procedure is to compare the year-end cash balance to that of the prior year and also to previous months. This analysis is used to determine consistency with accounts receivable and can also be used to evaluate the reasonableness of fluctuations throughout the year. An unusual fluctuation may reveal, for example, situations of cash misappropriation throughout the year. Another analytical
procedure would be to quickly scan bank reconciliations for any unusual items (for example, no outstanding cheques, no reconciling items or large error corrections) or for long-outstanding items on the bank reconciliation.
Substantive procedures
The most important assertions for cash are existence, ownership, and completeness. The first two assertions, existence and ownership (rights and obligations), are important for all asset accounts because of the risk that management might have overstated asset balances.
Existence
As mentioned, the auditor might count the cash held on the premises to determine its existence. However, because the larger portion of cash is held at banks, confirmations will be used to support their existence. Bank confirmations are requested by the client and the bank sends the confirmation directly to the auditors. Any discrepancies between the confirmed amounts and those recorded by the client should be followed up immediately. The existence assertion can also be supported by evidence obtained through a review of cut-off bank statements sent directly to the auditor from the bank. While bank confirmations provide evidence for the year-end balances, cut-off statements provide evidence of significant transactions in the few days after year end. Although cut-off statements are useful in supporting the completeness assertion (that is, by showing that outstanding cheques have cleared), they can also help support existence by providing details of deposits listed as outstanding in the clients year-end bank reconciliation. Studying these statements in conjunction with bank statements for the last month of the year might reveal, for example, large amounts deposited before year end and then withdrawn shortly after year end. Such transactions may be the result of amounts that are deposited for the purpose of inflating year-end balances. If so, then cash is overstated. Finally, the auditor would review the bank reconciliations performed by the client for each bank account. In doing so, the auditor would make sure the amounts shown on the bank reconciliations agree to those found in the bank statements, bank confirmations, and general ledger. Special attention is given to significant reconciling items such as outstanding cheques, deposits in transit, and transfers. Procedures performed on the bank reconciliations, such as reviewing the details of deposits and transfers between bank accounts, can be used to uncover lapping and kiting.
Ownership (rights and obligations)
The ownership assertion can normally be supported by possession. The amounts confirmed on an account in the clients name, as well as those physically counted on the clients premises, usually imply that the client owns the money. However, there might be restrictions on the use of cash that are tantamount to non-ownership. The auditor should review all significant contracts, including bond indentures, loan covenants, and grant agreements to ensure no significant restrictions are placed on cash.
Valuation
The only time that valuation can be a problem for cash is when it is held in foreign currency. This could be the case if a client holds a foreign currency account in the domestic country, or when the client holds an account in a foreign country. To support valuation, the auditor will have to determine the official exchange rate in effect at year end, and to ensure that this official rate was used in the translation calculations. Exchange rates can be easily determined by contacting local financial institutions or through the numerous financial websites on the Internet, such as the Bank of Canada website.
Disclosure
The auditor should ensure that the presentation and disclosure of cash amounts is in accordance with the relevant sections of the CICA Handbook Accounting. In doing so, the auditor must ensure that any restrictions are adequately disclosed in the notes to financial statements. Also, any internally appropriated cash should also be disclosed in the notes. A review of the minutes of the board of directors meetings should provide evidence of any amount of cash appropriated for specific use. Exhibit 11C-1 on page 466 provides an example of a very brief audit program listing substantive procedures for cash. Forms C-210, C-210C, and C-210S contain a more detailed list of procedures. In these documents, the audit assertions are provided
for each procedure in the form of initials, which are annotated at the bottom of each page. For some of the steps listed in the audit program, you may think of other assertions that the procedures provide evidence for. In practice, auditing firms may use different procedures and different terms for the financial statement assertions.
8.5 Accounts receivable

Learning objective
Explain the knowledge of the entitys business that is relevant to the audit of accounts receivable, and describe the analytical procedures used to audit accounts receivable. (Level 1)
Required reading

Chapter 11, pages 445450 Chapter 11, pages 437442 and 456457
LEVEL 1
Accounts receivable is often the most material asset on the balance sheet aside from capital assets. Accounts receivable usually consists of amounts owing from credit sales; that is, trade receivables. A companys receivables can also include amounts receivable from employees, shareholders, and governments (grants). In the case of a not-for-profit organization, receivables will likely be entirely made up of non-trade receivable amounts such as pledges and operating grants. Although all receivable amounts are subject to audit, this topic focuses on trade receivables arising from the revenue and collection cycle of a profit-oriented company.
Knowledge of managements attitudes, such as aggressiveness toward meeting sales projections or over-optimism regarding the companys prospects, can help the auditor identify the risks involved with accounts receivable. For example, if management has overestimated the collectibility of accounts receivable in prior years, the risk of overstating the value of net receivables will be high. In determining which substantive procedures will be most effective in detecting misstatements in accounts receivable, the auditor should have an understanding of the business in the following areas:
Types of products and/or services sold by the company and the likelihood that products will be returned or repaired under warranty Types of customers that deal with the company, including the number of customers and the typical size of their accounts Economic factors that affect both the company and its customers
A good knowledge of the clients types of products and services giving rise to accounts receivable will assist in deciding whether tests for specific assertions should be performed. For example, if the company has excessively liberal return and credit policies, substantive tests for existence/occurrence and valuation may be needed to obtain satisfactory evidence that accounts receivable relate to valid sales and that an adequate allowance has been set up. Another important consideration with respect to the clients operations is the number of customers included in accounts receivable, their relative sizes, types, and locations. It is useful for the auditor to know whether the receivables are made up of numerous small amounts or a few large amounts from regular customers. It is also useful to know if receivables include balances from related parties or foreign customers. Related parties signal presentation and disclosure concerns, and foreign customers may increase the risk of collectibility and/or valuation. Knowledge of general economic conditions will usually provide an indication of a customers ability to pay the company. Economic factors to consider include unemployment levels, concentration of employment (for example, a small town built around a large manufacturing company), and general output levels. An unfavourable economic outlook may signal a declining demand for the companys products. This could put pressure on the company to loosen credit terms for customers with poor credit history, thereby affecting the collectibility of accounts receivable.
Analysis
Analytical procedures for accounts receivable are directed toward the review of

changes in sales volume gross margin aged listing of accounts receivable estimates made for uncollectible amounts
As you would expect, a number of analytical procedures for accounts receivable will be focused on sales and income results. A common analytical procedure for evaluating the collectibility of accounts receivable is to compare the percentage change and volume change (from prior years) for sales relative to that for accounts receivable. If accounts receivable have increased by more than the increase in sales, there may be a collectibility problem. Customers may have started to default on their payment, or the company may have relaxed its credit granting policies in order to increase or maintain sales volumes. Existence problems for receivables may be suggested by comparing the gross profit margin to the prior year. For example, an unexpected increase in gross profit may indicate a possible overstatement of sales, which in turn would point to an overstatement of accounts receivable. The auditor should also perform some analysis on the current years aged listing of accounts receivable. The first thing to do here is to ensure that the listings total agrees to the control account in the general ledger and the amount reported in the financial statements. Then, the auditor can compare the aged listing to that of the prior year to determine if there have been significant changes in major customers, whether the ratio of overdue accounts to total accounts receivable has increased, and whether there are outstanding balances from the previous year end that are still outstanding at the current year end. The auditor should perform an analysis on the estimates for bad debts and allowance for doubtful accounts. One common procedure is to evaluate the change in the ratio of allowance for doubtful accounts to accounts receivable from the prior year. A lower ratio may indicate a significant change in policy, such as the method used to estimate uncollectible accounts (accounting policy) or the rules for granting credit (operating policy).
8.6 Accounts receivable Substantive procedures

Learning objective
Identify the most significant assertions with respect to accounts receivable, and describe the substantive procedures used to support these assertions. (Level 1)
Required reading

Chapter 11, pages 433434 Exhibit 11C-2, page 466 PPM Forms C-230, C-230C, and C-230S: Accounts and notes receivable audit program
LEVEL 1
As is the case for other assets, existence and ownership are important assertions for accounts receivable. However, with accounts receivable, the auditor will also be primarily concerned with valuation as a result of the uncertainty regarding collectibility and the estimates involved in establishing an appropriate allowance for doubtful accounts. For example, management may be overly optimistic regarding the collectibility of accounts receivable in order to improve the liquidity position of the company. The majority of substantive procedures for accounts receivable are aimed at supporting these assertions and ensuring that the financial statement presentation and disclosure are adequate. Although the auditor will perform procedures to support completeness, that assertion is normally not crucial for accounts receivable because of managements preference to overstate assets.
Existence
Existence of accounts receivable is usually established through

a detailed review of sales transactions and related documentation a review of sales and cash receipts journals, and confirmations of balances received directly from customers.
To support the existence of accounts receivable, the auditors perform tests related to the sales transactions that gave rise to the amounts in question. For example, the auditor may select a number of accounts receivable and vouch to the documentation underlying the sales transaction such as invoices, shipping documents, packing slips, and so on. Part of these procedures could be accomplished through dual-purpose tests where a sample of transactions is selected for tests of controls regarding the proper existence of the underlying documentation. In addition, the auditor can determine the existence of a receivable by vouching amounts to subsequent cash receipts, where cash receipts are collected after year-end and before the end of field work. The existence assertion can also be supported by evidence of proper cut-off of sales and cash receipts. This evidence can be gathered by inspecting the documentation relating to sales and cash receipts that have been recorded shortly before and after the year-end date. The company may tend to include sales made shortly after year end in accounts receivable, thereby overstating both sales and accounts receivable for the period. When reviewing the documents, the auditor would ascertain that goods for which accounts receivable exist have been delivered before year end, and that payment for these delivered goods either has not yet been received or was received after year end. In conducting these procedures, the auditor should have knowledge of the last sales invoice number sent in the period as well as the first invoice number sent in the subsequent period, and the number of the last shipping document sent. Finally, confirmations sent to a sample of customers with balances currently owing to the company are the most important substantive procedure for determining the existence of recorded receivables. Generally, the sample will include all significant accounts (that is, those that exceed tolerable misstatements) and a random number of other less significant accounts,
depending on their aggregate value. You will learn more about confirmation of accounts receivable in the next topic the confirmation process for receivables is considerably different than that for cash.
Valuation
Accounts receivable are subject to valuation risk because it is likely that some of the accounts will not be collected. A proper estimate of the uncollectible amount must be made by the company. Collectibility, and hence valuation, can be established by

obtaining confirmations from customers testing the ageing of accounts receivable sub-ledger listing reviewing the details of payments received after year-end determining the adequacy of methods used to estimate allowance for doubtful accounts considering the possible impact of sales returns and warranty provisions
The auditor must obtain an aged listing of accounts receivable and verify its accuracy. Typically, an aged listing would show account balances outstanding for less than 30, 60, 90, and 120 days. Ageing should be tested to supporting documentation; that is, for significant accounts shown as outstanding for less than 60 days, the related invoices and shipping documents should be reviewed to ensure that those amounts have not been receivable for a longer period. The best evidence that an amount is collectible is the actual cash receipt. Before performing any other tests, the auditor should identify the significant accounts for which payments were received after year-end and before the end of the audit. In doing so, the auditor must perform procedures, such as vouching to deposit slips and bank statements, to ensure that the payments received do indeed relate to the accounts receivable listed at year-end. To support the valuation assertion, the auditor must understand the methods used by the company in estimating the allowance for doubtful accounts (ADA). This will be done by discussing the adequacy of ADA with management and the rationale behind the methods used to arrive at the estimate. The adequacy of the methods used by management will be assessed by giving consideration to

credit and collection policies past experience with respect to actual collection the effect of economic factors on the clients operations, and the financial health of customers and the general state of the economy in which they operate.
In considering the credit and collection policies, the auditor would have to ensure that they are consistent with the ADA estimate. For example, a company with loose policies regarding granting credit and follow-up procedures for collection should show a relatively high estimate for ADA. By reviewing the collections made on the previous years receivables, particularly the significant risky ones, the auditor can also determine the adequacy of ADA estimates. The auditor should obtain knowledge of the economic factors that affect both the client and its customers. An unfavourable economic climate will tend to put pressure on the company to grant credit more easily in order to maintain sales volumes. By enquiring about the financial health of major customers, the auditor can ascertain whether management is overly optimistic about the collectibility of overdue accounts. For these accounts, the auditor can review the credit departments files, correspondence with customers, and enquiries of credit bureaus. Once the auditor is satisfied that the methodology used is adequate, the allowance should be recomputed using the clients methods to ensure that the actual ADA amount has been properly calculated. Finally, the auditor should determine whether a provision for warranties and/or sales returns is necessary. By looking at the companys experience with respect to sales returns, the auditor should be in a position to decide whether a provision should be made for the current years receivables, or whether some additional disclosures should be included in the notes to the financial statements.
Ownership
The ownership assertion can only be supported by evidence that the receivables have not been pledged as collateral. The auditor should be aware of the companys various credit arrangements through adequate knowledge of the client. A review of the minutes, enquiry of management, and a review of all bank confirmations, loan documents, bond indentures, and other debt covenants should determine whether accounts receivable have been factored or pledged as collateral.
Disclosure
The auditor should ensure that the presentation and disclosure of receivables are in accordance with the Handbook. The main disclosure issues are that accounts receivable be disclosed at net realizable value (net of uncollectible amounts), and that any liens on them be appropriately reflected in the notes. The details of disclosure will vary depending on the significance and sensitivity of accounts receivable. Material receivables from officers and affiliated companies should be separately disclosed. Exhibit 11C-2 on page 466 provides an example of a brief audit program listing substantive procedures for accounts and notes receivable. Forms C-230, C-230C, and C-230S contain a more detailed list of procedures.
8.7 Accounts receivable Confirmations

Learning objective
Explain the nature and types of confirmations in the context of accounts receivable and their reliability as evidence. (Level 1)
Required reading

Chapter 11, Application Cases 11.1 to 11.3, pages 435442 and 446451 CAS 505 (CICA Handbook , section 5303) CAS 330.1819 and A51
LEVEL 1
As mentioned in Topic 8.6, confirmations of accounts receivable are quite different from those used to evidence cash balances. The differences lie in the design of confirmations and the rate of responses. Bank confirmations are positive and are prepared using a specific form, whereas the design of accounts receivable confirmations is entirely up to the auditor and can be positive or negative. Also, bank confirmations have nearly a 100% response rate, whereas the response rate of accounts receivable confirmations is more variable. recommendation (CAS 330.18) the auditor must consider According to the CICA Handbook whether accounts receivable confirmation procedures are to be used as a means to support existence and valuation. The auditor can choose not to perform confirmations if he or she has assessed that the risk of material misstatement for these assertions is low and/or the confirmation would not be effective in providing reliable evidence. The main issues relating to confirmations are whether the evidence obtained is relevant to the assertions it is meant to support, and whether the evidence is reliable. These issues are explained in detail in CAS 505 (CICA Handbook, section 5303).
Activity 8.7-1
What is relevance? Solution

Activity 8.7-2
What does reliability depend on? Solution In designing the confirmations, the choice between positive and negative confirmation is important. The text describes the circumstances under which each is used and explains the limitations of each. CAS 505.15 sets out the conditions required for the use of negative confirmations as the sole substantive audit procedure. The text and CAS 505.A18.A19 (CICA Handbook paragraphs 5303.20.25) outline the implications of non-responses and the possible audit procedures that can be used as alternatives. If there are no audit procedures available to compensate for a non-response, the entire amount for the related receivable should be deemed to be in error. Recent academic research has called into question the value of accounts receivable confirmations; it has been suggested that auditors may rely too much on the results of the procedure. Auditors make the following assumptions in relying on the evidence provided by confirmation of the accounts:
The person signing the confirmation is independent of the company being audited.

The person signing the confirmation understands what is being requested and can supply the information requested. The person signing the confirmation has the authority and requisite knowledge to do so.
It would be difficult to test whether these assumptions are valid without a lot of additional work on the part of the auditor. The auditor is probably justified in making these assumptions in most cases. Confirmations are generally considered to be strong evidence. The issue is raised as a caution; do not automatically conclude that if a suspicious balance is confirmed, it can be accepted as correct and owing. To reinforce what you have learned so far in Module 8, read through Cases 11.1 to 11.3 on pages 446 to 451.
8.8 Acquisition and expenditure cycle The basics

Learning objective
Identify the main activities and accounts, the sources of evidence, and the functional responsibilities in the acquisition and expenditure cycle, and explain how these responsibilities should be segregated. (Level 1)
Required reading
Chapter 12, pages 468473 (to Control Risk Assessment)
LEVEL 1
The acquisition and expenditure cycle includes the activities and transactions related to the purchase of goods and services and the disbursements made in payment of those goods and services. The main balance sheet accounts in this cycle are cash, inventory, capital assets, accounts payable, and various expenses. As was the case for the accounts in the context of revenue and collection, the auditor must be well aware of the relationships between these accounts. Also, the nature of this transaction processing cycle will differ from one organization to the next, but it will always exist. For example, in a manufacturing or retail company, accounts payable and inventory are the accounts toward which most substantive testing is directed; however, in a services company, there would be little focus on inventory. Exhibit 12-1 on text page 469 shows a typical acquisition and expenditure cycle for any kind of company or organization. The principal activities in the acquisition and expenditure cycle are as follows:

requisitioning a purchase at the department level authorizing a purchase and issuing purchase orders receiving goods and services (includes custody of goods) receiving and approving vendor invoices recording accounts payable approving payment of payables issuing cheques for payment
Additional activities related to this cycle include the verification of proper accounting for cash discounts on early payment, purchase allowances, and purchase returns.
Functional responsibilities
The responsibilities for authorization, custody, recording, and reconciling transactions in the acquisition and expenditure cycle are outlined on pages 469 and 470. There should be a separate purchasing department responsible for obtaining the best prices for goods and services of acceptable quality. It is also important that the goods be received on a timely basis so as not to disrupt production or sales. Increasingly, companies are trying to reduce the costs of storing inventory through a just-intime (JIT) inventory system or other economic ordering quantity scheme.
Custody
The custody function is split between the receiving department, which receives the goods, and the stores department, which stores the goods. The warehouse may be protected by security fences, burglar alarms, and other deterrents to property crime. The receiving department is responsible for accepting shipments, checking their condition and overall acceptability relative to the conditions specified in the purchase order, and filling out a receiving report.
Recording
The recording function involves accounting for purchases and subsequent payments by the accounts payable department when the goods are received and the cheques are issued. Payments should be approved only after checking that the supporting documentation in the form of properly prepared receiving reports, purchase orders, vendors invoices, and cheque payment information are all attached and in agreement.
Activity 8.8-1
Why is it important to make payments promptly? Solution In addition to purchase discounts, the recording function needs to keep proper accounting of any purchase returns or purchase allowances when informed by the receiving department.
Reconciliation
Reconciliation should be done on a periodic basis for cash payments by preparing bank reconciliations, for inventory and capital assets by comparing physical assets on hand to recorded assets, and for accounts payable by comparing vendors statements to recorded account balances. Periodic reconciliation optimally should be done by a party not involved in custody of the asset or recordkeeping for the asset, for instance, internal auditors. In addition, all subsidiary ledgers should be reconciled to the appropriate control account in the general ledger. The general rule is that the functions of authorization, custody, recording, and reconciliation should be segregated to the extent permitted by the size of the organization.
Activity 8.8-2
What are some examples of typical segregation of duties that an auditor should look for? Solution
Sources of evidence
Although the text describes the sources of evidence in the context of a computer environment, they are essentially the same in manual systems.
Activity 8.8-3
Can you name the documents that would typically be included for the acquisition and expenditure cycle? Solution
8.9 Acquisition and expenditure cycle Tests of controls

Learning objective
Explain the control objectives and test of controls procedures for the acquisition and expenditure cycle. (Level 1)
Required reading

Chapter 12, pages 473479 Chapter 12, Appendix 12A, pages 504507
LEVEL 1
General controls
The general control considerations described in the text primarily focus on separation of key duties and use of appropriate forms. They can be summarized as follows:
Processing purchase orders: r Purchasing department should not be responsible for authorizing the acquisition of goods or for the receiving of goods. r All purchase orders should be sequentially pre-numbered. Receiving goods and services: r Storeroom personnel should be independent of the receiving department and accounting. r Pre-numbered receiving reports should be used. Recording the liability (accounts payable): r Accounts payable department should be separate from purchasing, receiving, and reconciling functions. r A pre-numbered voucher system should be used. r Accounts payable personnel should not have access to cash. Processing and recording cash disbursements: r Cheque signer(s) should be separate from accounts payable. r Cheques should be pre-numbered. r Supporting documents should be cancelled on payment. r The person signing the cheques should not authorize or process underlying documentation but should check the documentation. r A cash disbursements journal should be used. Reconciliations: r The person performing the reconciliation should not be recording, have access to, or authorize purchases or payments.
To gain an understanding of the general controls purported to be in place in a company, questionnaires such as those listed in Exhibits 12A-14 on pages 504 to 507 of Appendix 12A can be used.
Test of controls procedures

The process for testing controls for the acquisition and expenditure cycle is the same as for the revenue and collection cycle, except the focus is on control objectives relevant to the accounts and transactions in the acquisition and expenditure cycle. General audit objectives formulated in the context of purchases are shown in Exhibit 12-3 on page 476, as are some examples of corresponding specific objectives. The auditor would also formulate general audit objectives in the context of other transaction streams and accounts within the cycle. Once the auditor has identified all the relevant control objectives, the appropriate test of controls procedures can be developed, such as those outlined in Exhibits 12-4 and 12-6 on pages 477 and 478.
Once again, the dual-nature aspect of the tests is important for the validity and completeness objectives, especially with respect to tests of controls related to perpetual inventory records. Controls over the validity and accuracy of inventory records are very important because those objectives are most closely related to the control risk of overstating assets. Inventory is a material asset for many companies, and inventory valuation is much harder to assess partly because of large quantities (which makes physical inspection difficult) and also because of obsolescence.
8.10 Accounts payable and accrued liabilities Knowledge of the business

Learning objective
Explain the knowledge of the entitys business that is relevant to the audit of accounts payable and accrued liabilities. (Level 1)
Required reading
Chapter 12, page 480 (the last bullet point)
LEVEL 1
Completeness
Accounts payable and accrued liabilities are among the more difficult sections to audit because the auditor needs to apply investigative procedures. The auditor has to look for what may be missing in trying to support the completeness assertion. (This is in part because understating payables could be used by management to overstate net income.) Accounts payable will usually include the regular trade payables, advances payable, and holdbacks on construction projects. The more significant accrued liabilities include wages and related expenses, interest expense (particularly if there are large issues of bonds or if the company has taken significant mortgages), warranty expenses, and income tax accruals.
Deferred or unearned revenue

A special type of accrued liabilities the auditor must look for is deferred or unearned revenue. In profit-oriented companies, these liabilities may arise from progress payments, insurance premiums, or grants (for research and development). In not-for-profit organizations, unless fund accounting is used, any restricted contribution (such as donations, grants, and bequests) has to be deferred and shown as a liability until the funds have been spent toward their intended purpose. In addition to such liabilities, the auditor will also have to consider whether any contingent liabilities need to be accrued. The audit of contingent liabilities will be explained in Module 10.
As was the case for accounts receivable, the auditor should gain an understanding of the clients attitude and biases toward misstatements. For example, management may be motivated by pressure to maintain high profit levels and increase net income by understating expenses and liabilities. Therefore, knowledge of the factors motivating management is essential.
Activity 8.10-1
How can knowledge of business enhance the effectiveness of audit procedures for accounts payable and accrued liabilities? Solution
Vendors
An awareness of the major vendors typically involved in the industry will assist the auditor in assessing the likelihood of unrecorded liabilities. The auditor must know which vendors usually have balances owing from the company before determining who may be missing. A regular vendor with a small balance payable or one not listed as part of accounts payable may give the auditor reasons to suspect that liabilities are understated.
Expansion plans
The auditor needs to gain an understanding of the companys expansion plans because increased activity is normally associated with increased liabilities. For example, a company in the process of building a new factory will usually make progress payments to the contractors, but it is standard practice to hold back about 10% from the progress payments in case of delays or disputes. This holdback gives rise to an accounts payable, which is due at the completion of the project.
Activity 8.10-2
What else is growth and expansion likely to be associated with? Solution
Compensation structure and terms of sales

An appropriate knowledge of the compensation structure will allow the auditor to assess the likelihood of significant wage and salary accruals. The auditor also needs to know the terms of sale and sales returns, and the warranty conditions for the companys products and services, in order to get a sense of any requirements for unearned or deferred revenue, as well as warranty liabilities or a provision for returned goods.
Analysis
Analytical procedures for accounts payable and accrued liabilities can be used as attention directing or corroborative evidence. Analysis typically involves

a comparison of the payables/purchase ratio to the ratios of prior years and to industry standards a comparison of the accounts payable listing to those of prior years
Sales and production

Activity 8.10-3
Liabilities are normally related to the volume of sales and production. Consequently, the ratio of payables/purchases should remain relatively constant from year to year, assuming, of course, a certain level of stability and economies of scale in the company. Why is this so? Solution Finally, a year-to-year comparison of the accounts payable listing should be made with a focus on identifying the major changes in dollar amounts, particularly those accounts payable that have decreased, as well as on identifying any changes in significant vendors.
8.11 Accounts payable and accrued liabilities Substantive procedures

Learning objective
Identify the most significant assertions with respect to accounts payable and accrued liabilities, and describe the substantive procedures used to support these assertions. (Level 1)
Required reading

Chapter 12, pages 479480 Forms C-320, C-320C, and C-320S: Accounts payable and accrued liabilities audit program
LEVEL 1
If management is motivated to understate liabilities, the most important assertion for accounts payable and accrued liabilities is completeness. Almost as important and somewhat related to completeness is the valuation assertion. Accrued liabilities are often subject to significant management estimates, and as a result, although properly identified, these liabilities may be understated because of improper estimation methods. The last significant assertion to consider for accounts payable and accrued liabilities is that of existence. In certain situations, particularly if a company already has a strong liquidity position, there may be an incentive to overstate expenses (or understate income), which could ultimately result in overstating liabilities. An example is when a company attempts to understate net income in order to minimize its income taxes. Some substantive procedures are used to support the other assertions of presentation, rights, and obligations, and so on, but most of the significant procedures will be directed at the assertions stated previously. Form C-320 provides an example of an audit program for accounts payable and accrued liabilities, which outlines relevant substantive procedures in detail.
Completeness
The issue of completeness and the related substantive procedures to support this assertion are explained on pages 479 to 480. Essentially, the procedures focus on searching for unrecorded liabilities. For example, the auditor may review the documentation related to cash disbursements made after year end up to the end of field work, to ensure that any payment relating to a transaction made during the year under audit is properly recorded as a liability. Similarly, the auditor could also review unpaid invoices after the year-end, to ensure that those related to transactions made in the year under audit are recorded as liabilities.
Valuation
Valuation of accounts payable and accrued liabilities can be supported by
determining the adequacy of methods used to estimate significant accruals such as wages and salaries, interest expense, and income taxes, and verifying that the accounts payable and accruals related to transactions in foreign currency are properly translated.
The objective with respect to estimates is similar to what was previously explained in the context of allowance for doubtful accounts. Namely, the auditor needs to understand the methodology used by management in arriving at estimates, and then assess the adequacy of the methods. In the event that the methods are reasonable, the auditor needs to perform recalculations using the methods, to ensure the amounts are indeed correct.
Existence
The auditor must support the existence assertion, particularly when the client may be motivated to inflate liabilities. Some of the general substantive procedures used to support existence include

investigating any unusual or large entries made to accrued liabilities close to year end testing proper cut-off sending confirmations for selected large accounts payable reviewing accounts payable listings for amounts owing to related parties
If management deliberately attempts to understate the results of operations, these attempts are usually made close to year end after the actual yearly results have been reviewed. Investigating unusual accruals close to year end would probably reveal any such action. Confirmations should be sent if amounts payable to specific vendors appear to be unusually large under the circumstances and in comparison to prior years. Also, testing cut-off by looking at cash disbursements made just before year-end, for example, may reveal unrecorded payments. Finally, any significant accounts payable to related parties should be investigated, as such amounts may be artificial and set up for the specific purpose of understating net income.
Presentation and disclosure

The auditor should ensure that the presentation and disclosure of liabilities is in accordance with the relevant CICA Handbook recommendations. In the case of accrued liabilities, the separation between current and noncurrent liabilities should be reviewed to ensure it is adequate (for example, current portion of long-term debt, current versus non-current deferred revenue).
file:///F|/Courses/2010-11/CGA/AU1/06course/m08summary.htm
Module 8 summary
Explain how net income is indirectly audited through the balance sheet approach to auditing.
Because assets minus liabilities equals equity, establishing the validity of the asset and liability amounts establishes the validity of the resulting equity balance. Transactions other than net income that affect equity can be verified relatively easily. Auditing assets and liabilities combined with auditing those transactions (other than net income) that affect equity serves to prove (albeit indirectly) the net income or loss for the period. In addition, audit work on balance sheet accounts provides the auditor with assurance about the related income statement accounts.
Identify the main activities, accounts, sources of evidence, and functional responsibilities in the revenue and collection cycle, and explain how the responsibilities should be segregated.
The main activities include r processing customer orders r granting credit r shipping goods/providing services r billing customers and recording sales r processing and recording cash receipts r processing and recording returns and allowances r writing off uncollectible accounts r providing bad debts r reconciling bank accounts and receivable ledgers The main accounts include r sales r accounts receivable r allowance for doubtful accounts r bad debt expense r sales returns and allowances r cash The sources of evidence are r customer orders r sales orders r shipping documents r sales invoices r sales journal and summary sales reports r credit memos r remittance advices r price lists r cash receipts journals r uncollectible account writeoff authorization r accounts receivable master file r accounts receivable aged trial balance r monthly statements r accounts receivable reconciliations r bank reconciliations r pending order files The key responsibilities that should be segregated in the revenue and collection cycle are as follows: r Authorization of credit should be separate from the sales function. r Custody of cash receipts should be separate from the posting of sales and collections to the receivable records. r Recording of sales should be separate from the recording of cash receipts. r Recording of non-cash credits should be separate from custody of cash. r Custody and recording of cash should be separate from the reconciliation function.
Explain the control objectives and tests of controls procedures for the revenue and collection cycle.
file:///F|/Courses/2010-11/CGA/AU1/06course/m08summary.htm (1 of 4) [04/10/2010 3:24:56 PM]
The main control objectives for the revenue and collection cycle are as follows: r Recorded sales are valid and documented. r All valid sales and all receipts are recorded. r Sales and writeoffs are authorized. r Sales invoices are accurately prepared. r Sales transactions are properly classified. r Accounting for sales is proper. r Sales and receipts are recorded in the proper period. Tests of controls procedures: r The auditor should identify the key control procedures established by management to ensure that the control objectives for the revenue and collection cycle are achieved. r The auditor should assess the extent to which the designed control procedures, if operating effectively, could be relied upon to reduce the risk of material misstatement at the assertion level. r The auditor must design test of controls procedures to evaluate the operating effectiveness of those key controls which the auditor proposes to rely upon in the assessment of the risk of material misstatement at the assertion level.
Identify the knowledge of the entitys business and significant assertions relevant to the audit of cash balances, and describe the analytical and substantive procedures to support these assertions.
The auditor should attempt to ascertain the amount of money held on the premises, the bank accounts used by the company, the names of those authorized to sign cheques, and so on. This information will enable the auditor to assess the relative risk related to the cash balances shown on the balance sheet and to evaluate controls over cash handling and disbursements. The most significant assertions with respect to cash balances are those of existence and disclosure. Analysis is usually limited to comparing cash balances with those of the prior year and scanning the transactions and bank statements/reconciliations for unusual items. The main concern is existence of cash balances, which is usually established by confirmation with the companys bankers. Significant amounts of cash on hand can be counted by the auditor at the balance sheet date. Ownership is usually presumptive with possession. Valuation is only a problem when balances are held in foreign currencies. The auditor should also verify that disclosure is appropriate, particularly if there are restrictions attached to any of the companys cash holdings. The principal substantive audit procedure for the audit of cash balances is the confirmation of bank balances with the companys bankers. The auditor will also verify the reconciling items on the bank reconciliation at year end. Where there is substantial cash on hand (for example, in a bank or casino), the auditor may conduct a cash count at the year end or at an interim date.
Explain the knowledge of the entitys business that is relevant to the audit of accounts receivable, and describe the analytical procedures used to audit accounts receivable.
The auditor should obtain knowledge of sales returns and warranty experience, past collection problems, the economic state of the market into which the company sells, and so on. This knowledge should help the auditor assess valuation of the receivables. Knowledge of the business also helps identify related parties to ensure that disclosure is appropriate. The auditors analytical review should include r reviewing changes in both sales volumes and margin percentages r reviewing the accounts receivable aged trial balance r reviewing the provision for uncollectible accounts This review can include calculation of ratios and comparison with prior periods.
Identify the most significant assertions with respect to accounts receivable, and describe the substantive procedures used to support these assertions.
The existence of accounts receivable is established through confirmation with the customer. Collectibility (valuation) requires r confirmation plus testing the ageing of accounts receivable r reviewing payments received subsequent to the year end r reviewing the adequacy of provisions for returns, allowances, and warranties r reviewing the provision for doubtful accounts Substantive audit procedures include r testing the ageing of the accounts receivable trial balance r confirming receivables with customers r reviewing subsequent cash receipts
Explain the nature and types of confirmations in the context of accounts receivable and their reliability as evidence.
Positive confirmations require that the customer confirm the balance whether the customer is in agreement or not. Such confirmations are considered to be strong evidence of existence and that the amount recorded is in fact owing to the company (although the confirmation does not guarantee that the debt will be paid). Negative confirmations require a reply only where there is a disagreement as to the amount owed. They are generally considered to be less reliable than positive confirmations.
Identify the main activities and accounts, the sources of evidence, and the functional responsibilities in the acquisition and expenditure cycle, and explain how these responsibilities should be segregated.
The main activities in the acquisition and expenditure cycle include r requisitioning purchases r authorizing purchases r issuing purchase orders r receiving goods or services r receiving and approving vendor invoices r recording payables r approving payment r issuing cheques r reconciling bank accounts and accounts payable ledgers The main accounts affected are r the various asset (inventory) and expense accounts r accounts payable r bank accounts The sources of evidence are r open purchase orders r unmatched receiving reports r unmatched vendor invoices r accounts payable trial balance r inventory trial balance r purchases journals r capital asset reports r cash disbursement reports r bank statements r vendor invoices r vendor statements r paid cheques r bank reconciliations The key responsibilities that should be segregated in the acquisition and expenditure cycle are as follows: 1. Authorization of purchases should be separate from requisitioning of materials. 2. Those signing cheques should not authorize payments. 3. Authorization of non-cash debits to accounts payable should be separate from cheque signing. 4. Custody and recording of cash should be separate from the reconciliation function.
Explain the control objectives and test of controls procedures for the acquisition and expenditure cycle.
General control considerations in this cycle include r appropriate segregation of duties r fidelity bonding of employees r adequate physical security over assets such as inventory r checking and reconciliation procedures r appropriate authorizations for transactions r appropriate documents and records The main control objectives for the acquisition and expenditure cycle are as follows: r Recorded purchases are valid and documented. r All valid purchases and all payments are recorded. r Purchases are authorized. r Purchase orders are accurately prepared. r Purchase transactions are properly classified. r Accounting for purchases is proper. r Purchase transactions are recorded in the proper period. The auditor should identify the key control procedures established by management to ensure that the control objectives for the acquisition and expenditure cycle are achieved. The auditor should assess the extent to which the designed control procedures, if operating effectively, could be relied upon to reduce the risk of material misstatement at the assertion level. The auditor must design test of controls procedures to evaluate the operating effectiveness of those key controls which the auditor proposes to rely upon in the assessment of the risk of material misstatement at the assertion level.
Explain the knowledge of the entitys business that is relevant to the audit of accounts payable and accrued liabilities.
Knowing which companies are the clients main suppliers and knowing business plans and trends can help identify unrecorded purchases or purchase commitments. An understanding of managements motivations helps the auditor assess the likelihood of unrecorded liabilities (the greatest risk facing the auditor when auditing purchases and accounts payable). The auditor usually compares the balance owing to significant suppliers with those of prior years and tests the payables/purchases ratio and margins for reasonableness. Stability in ratios provides the auditor with comfort that liabilities have been recorded. Reviewing related expenditure accounts can indicate the reasonableness of accruals for items such as wages and related costs.
Identify the most significant assertions with respect to accounts payable and accrued liabilities, and describe the substantive procedures used to support these assertions.
Completeness is the most significant assertion with respect to current liabilities. To ensure completeness, the auditor will search for unrecorded liabilities. Auditors may also confirm payables with suppliers. Valuation of accruals, such as those for warranties, can be supported by a review of the methods used in their calculation and a comparison with prior periods and industry statistics. Existence of accounts payable and accrued liabilities is usually considered a significant assertion only when the auditor believes that the client may be motivated to overstate liabilities. Substantive procedures may include r confirming payable balances with suppliers r reviewing for unrecorded liabilities by scanning open purchase orders, unmatched receiving reports, and vendor invoices r reviewing payments made shortly after the year end The auditor also reviews accrued liabilities for reasonableness and compares them with prior periods.
file:///F|/Courses/2010-11/CGA/AU1/06course/m08t01sol.htm
Activity 8.1-1 solution
The audit of dividends, capital stock, and contributed surplus would not involve as much detailed work because the number of transactions are limited. Assuming that opening retained earnings are correct given the previous years audit, if assets, liabilities, dividends, capital stock, and contributed surplus are correct based on audit procedures performed, then net income must be correct by default. Therefore, little reliance on the audit of revenues and expenses is necessary to obtain assurance on net income. In fact, provided the auditor already has high assurance through the balance sheet approach that net income is correct, if net income equals revenues minus expenses, the auditor has considerable assurance that the revenues and expenses must also be correct. (The assertions and procedures relevant to the income statement accounts are covered in Module 10.)
file:///F|/Courses/2010-11/CGA/AU1/06course/m08t01sol.htm [04/10/2010 3:24:57 PM]
file:///F|/Courses/2010-11/CGA/AU1/06course/m08t02sol.htm
Segregation of functional responsibilities

The function of authorizing credit should be separate from the sales function. The person with custody of cash receipts should not have access to accounts receivable records. The recording function for the sales/cash receipt journal should be separate from the recording function for accounts receivable. The authorization of non-cash credits to accounts receivable should be separate from the cash custody function. The custody and recording functions for cash should both be separate from the reconciling function.
file:///F|/Courses/2010-11/CGA/AU1/06course/m08t02sol.htm [04/10/2010 3:24:58 PM]
file:///F|/Courses/2010-11/CGA/AU1/06course/m08t03sol1.htm
To establish the validity of an account receivable amount, the auditor needs to ascertain that a valid sale supports it.
file:///F|/Courses/2010-11/CGA/AU1/06course/m08t03sol1.htm [04/10/2010 3:24:59 PM]
Completeness is verified by doing the opposite; that is, tracing an item on the remittance list to the cash receipts journal.
file:///F|/Courses/2010-11/CGA/AU1/06course/m08t03eyk.htm
The problem of overstating revenue

The conceptual framework in place in both Canada and the United States sets up a process for revenue recognition by focusing on four criteria. Under these guidelines, revenue can be realized only when all four of these criteria are met:

Persuasive evidence of an arrangement exists. Delivery has occurred or services have been rendered. The sellers price to the buyer is fixed or determinable. Collectibility is reasonably assured.
A common practice
A March 1999 report sponsored by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), Fraudulent Financial Reporting 1987 1997: An Analysis of U.S. Public Companies , noted that more than half the frauds of that period involved overstating revenue. Other studies from the same period indicated that 50% to 70% of public companies overstated their revenues. In response to these reports, the United States Securities and Exchange Commission (SEC) issued a Staff Accounting Bulletin SAB 101 in December 1999, which emphasized the criteria given above. In times of continued growth, it is possible to overlook such incidents. However, the tech bubble collapse in 2000 and the concomitant recession exacerbated the problem. Even before Enron, companies such as Lucent, Raytheon, Xerox, Sunbeam, and Cendant were being called to account for inappropriate revenue recognition activities. Many cases involved the issue of premature revenue recognition or booking sales before goods were sold in the marketplace.
Computer Associates International
On January 12, 2004, Computer Associates International (CAI), one of the worlds largest software companies, announced that it was under investigation by the SEC. According to CAIs press release, the investigation related to CAIs premature recognition of revenue from software licence contracts in CAIs fiscal year ending March 31, 2000. On January 22, 2004, Lloyd Silverstein, a former senior vice-president of Finance at CAI, admitted that the practice of backdating software contracts to help the company meet quarterly revenue targets was widespread from 1998 to 2000. Why did CAI engage in such activities? The SEC alleged that CAI engaged in these fraudulent practices in order to meet earnings expectations, and that when CAI correctly chose not to recognize revenue prematurely during the second quarter of fiscal year 2001, the company missed its earnings estimate and CAIs stock price dropped over 43% in a single day. A 43% drop in shareholder value in a single day from a missed quarterly target shows the revenue pressures faced by public companies pressures that would make them report earnings inappropriately. A more prominent reason for overstating revenue was illustrated by the Enron case: revenue was overstated because earnings and bonuses (management stock compensation) were directly linked to end profitability.
Key transactions
How do companies record revenue before it is earned? What should the auditor look out for?
Bill and hold transactions: These transactions begin with orders from customers. The order is filled and the customer is billed. Usually the revenue is not recognized until the goods are shipped or delivered to the customer. However, if the customer asks the seller to hold the goods, the seller can still recognize the revenue if the goods are segregated from the sellers inventory. Long-term contract arrangements: Interim accounting for multi-year contracts has generated numerous challenges in the past; it should not be a surprise that unique twists to this already complex area arise regularly. Barter transactions: Companies trade goods and services and each company records the fees it would have charged as revenues and the fees it would have paid as expenses, resulting in an offset between the revenue and expense sections of the income statement. Income can be manipulated if the expense side of the barter transaction can be deferred or capitalized.
file:///F|/Courses/2010-11/CGA/AU1/06course/m08t03eyk.htm (1 of 2) [04/10/2010 3:25:01 PM]
file:///F|/Courses/2010-11/CGA/AU1/06course/m08t03eyk.htm
Agent or facilitator transactions: A company acts as an agent for a buyer and seller. If the agent takes title to the product, then the commission is the difference between the selling price set by the agent and the cost of the product to the agent. Should the revenue be recognized at gross or net?
What auditors must know
To be properly prepared in the area of revenue recognition, auditors should
understand key contract terms determine whether there are side agreements to a contract determine whether there are significant price or other concessions that may be associated with a contract determine whether risk of loss has passed to the buyer determine whether there are multiple elements that have been sold that call for the timing and amounts of revenue to be recognized, and determine whether there are related parties involved.
file:///F|/Courses/2010-11/CGA/AU1/06course/m08t03eyk.htm (2 of 2) [04/10/2010 3:25:01 PM]
Relevance relates to the information received (customer amount exists at one point in time) and the assertions being tested (it supports existence but is not conclusive as to collectibility valuation), as well as the approach used by the auditor in obtaining the confirmations (whether the sample is taken from all possible customers or only from those with recorded balances owing).
Reliability depends on the nature of the evidence obtained in the confirmation process and how it is obtained. It is affected by

the the the the
characteristics of the evidence (written versus oral, third party versus related party) characteristics of the respondents (that is, knowledgeable, competent, and objective) design of confirmation requests (positive versus negative), and auditors control over the confirmation process.
See CAS 330.A51.
It is important to make payments promptly because typical credit terms allow a discount on the purchase price only if the invoice is paid within a very short time period. Such credit terms should usually be exploited by a client because of the potentially large annual savings involved. In addition, suppliers who have not been paid on a timely basis may refuse to supply the company with goods and services essential to its business operations.
These duties are usually separated:

The The The The
authorization of purchases function should be separate from materials requisition. person signing the cheques should not also be authorizing payment. authorization of non-cash debits to accounts payable should be separate from the cheque-signing function. custody and recording functions for cash should be separate from the reconciliation function.
These documents are part of the acquisition and expenditure cycle:

open purchase orders unmatched receiving reports unmatched vendor invoices accounts payable and inventory trial balances purchases journals capital asset reports cash disbursement reports
Other sources of documentary evidence for this cycle:

bank statements and bank reconciliations purchase orders, vendor invoices and statements, vouchers, and cheques
The effectiveness of audit procedures for accounts payable and accrued liabilities will be enhanced if the auditor obtains a good knowledge of the following:

Names of any major vendors with whom the company does business Expansion plans undertaken or contemplated by the company, especially those involving major construction projects Capital structure of the company and the extent of debt financing Size of the organization in terms of the number of employees and their compensation structure Legal climate in which the company operates (that is, the companys exposure to litigation) Types of products and services sold by the company and their terms of sale and cancellation
Growth and expansion are also associated with increased financing, and consequently, the auditor needs to understand the companys capital structure and sources of financing as they will give rise to interest and dividends that may have to be accrued. In a situation of growth and expansion, the company may have difficulty obtaining debt financing, which means that bonds may have been issued with large coupon rates and with correspondingly high interest payments to accrue.
Generally, the larger the sales and production volume, the more purchases and inventory will be accumulated. A change of ratio may direct the auditors attention to potential risk with respect to liabilities, and a stable ratio would provide corroborative evidence that liabilities are properly recorded.
file:///F|/Courses/2010-11/CGA/AU1/06course/m08selftest.htm
Module 8 self-test
Question 1
Review checkpoint 7, page 428 Solution
Question 2
Question 3
Question 4
Question 5
file:///F|/Courses/2010-11/CGA/AU1/06course/m08selftest.htm [04/10/2010 3:30:38 PM]
file:///F|/Courses/2010-11/CGA/AU1/06course/m08selftestsol1.htm
Self-test 8 Solution 1
The support for debit entries for a sample of customers accounts receivable would be found in the sales journal file. The entries could be vouched to a sales invoice, shipping document, and customer order. You would expect to find that the entry was recorded to the correct customer account, that the account name agreed on all the documents, and that the sales invoice date and the recording date were the same as the shipping date. The support for credit entries in accounts receivable would be found in the cash receipts journal file. The entries could be vouched to remittance advices, deposit slips, and to the bank statement. You would expect to find a remittance advice (entry on list) on which the name and amount correspond to the detail on a deposit slip, and that the deposit was made to the bank (per the bank statement) for the same day the deposit was posted in the customers accounts.
file:///F|/Courses/2010-11/CGA/AU1/06course/m08selftestsol1.htm [04/10/2010 3:30:39 PM]
These are the account balances in a revenue and collection cycle:

cash in bank accounts receivable allowance for doubtful accounts bad debt expense sales revenue sales returns, allowances, discounts
Credit entries could also be supported by credit memos for goods returned. The entries could be vouched to a receiving report. You would expect to find that the date, value and quantity of goods returned, and customer name on the receiving report agree with the credit memo, and that the credit was posted to the customers account for the correct amount on the same day the goods were returned.
The following specific control policies and procedures (in addition to separation of duties and responsibilities) should be in place and operating in a control structure governing revenue recognition and cash accounting: 1. No sales order should be entered without a customer order. 2. Access to inventory and the shipping area should be restricted to authorized persons. 3. Access to billing terminals and blank invoice forms should be restricted to authorized personnel. 4. Accountants should be under orders to record sales and accounts receivable when all the supporting documentation of shipment is in order, and care should be taken to record sales and receivables as of the date goods and services were shipped, and cash receipts on the date the payments are received. 5. Customer invoices should be compared with bills of lading and customer orders to determine that the customer is sent the goods ordered at the proper location for the proper prices, and that the quantity being billed is the same as the quantity shipped. 6. Pending order files should be reviewed on a timely basis to avoid failure to bill and record shipments. 7. Bank statements should be reconciled in detail monthly by a person independent of authorization, recording, and custody.
1. The relative risk with accounts receivable is that the account balance may be overstated. Therefore, auditors should be careful to confirm recorded balances. 2. The relative risk with accounts payable is that the account may be understated. Therefore, auditors should be careful to confirm payables where understatement may exist the small and zero balances particularly those of vendors with whom the company does a lot of business. Selection should be made from a complete list of suppliers, not just those showing balances at the confirmation date.
Management may be overly optimistic about their companys future prospects and/or may be motivated to overstate assets and revenues and understate liabilities and expenses to favourably present their companys results and financial position. The financial statement concepts state that information is useful to users if it is reliable and that conservatism should be used in making judgments under conditions of uncertainty. Accordingly, overstated assets and understated liabilities present a higher risk for the auditors than understated assets and overstated liabilities. Therefore, they need to audit for the existence of assets and the completeness of liabilities.

Module 8: Revenue and Collection Cycle, and Acquisition and Expenditure Cycle

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Module 8: Revenue and Collection Cycle, and Acquisition and Expenditure Cycle

Uploaded by

Copyright:

Available Formats

file:///F|/Courses/2010-11/CGA/AU1/06course/m08intro.

Test your knowledge

8.5 Accounts receivable

8.6 Accounts receivable Substantive procedures

8.7 Accounts receivable Confirmations

file:///F|/Courses/2010-11/CGA/AU1/06course/m08intro.htm (1 of 2) [04/10/2010 3:24:43 PM]

8.8 Acquisition and expenditure cycle The basics

Print this module

file:///F|/Courses/2010-11/CGA/AU1/06course/m08intro.htm (2 of 2) [04/10/2010 3:24:43 PM]

8.1 The balance sheet approach

No required reading LEVEL 1

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t01.htm [04/10/2010 3:24:45 PM]

8.2 Revenue and collection cycle The basics

Chapter 11, pages 422428 (up to Control Risk Assessment)

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t02.htm (1 of 2) [04/10/2010 3:24:46 PM]

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t02.htm (2 of 2) [04/10/2010 3:24:46 PM]

8.3 Revenue and collection cycle Tests of controls

Importance of the revenue and collection cycle

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t03.htm (2 of 2) [04/10/2010 3:24:47 PM]

8.4 Cash balances

Audit of cash balances

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t04.htm (1 of 3) [04/10/2010 3:24:48 PM]

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t04.htm (2 of 3) [04/10/2010 3:24:48 PM]

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t04.htm (3 of 3) [04/10/2010 3:24:48 PM]

8.5 Accounts receivable

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t05.htm (2 of 2) [04/10/2010 3:24:49 PM]

8.6 Accounts receivable Substantive procedures

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t06.htm (3 of 3) [04/10/2010 3:24:50 PM]

8.7 Accounts receivable Confirmations

What is relevance? Solution

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t07.htm (1 of 2) [04/10/2010 3:24:51 PM]

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t07.htm (2 of 2) [04/10/2010 3:24:51 PM]

8.8 Acquisition and expenditure cycle The basics

Chapter 12, pages 468473 (to Control Risk Assessment)

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t08.htm (2 of 2) [04/10/2010 3:24:52 PM]

8.9 Acquisition and expenditure cycle Tests of controls

Test of controls procedures

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t09.htm (2 of 2) [04/10/2010 3:24:53 PM]

8.10 Accounts payable and accrued liabilities Knowledge of the business

Chapter 12, page 480 (the last bullet point)

Deferred or unearned revenue

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t10.htm (1 of 2) [04/10/2010 3:24:54 PM]

What else is growth and expansion likely to be associated with? Solution

Compensation structure and terms of sales

Sales and production

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t10.htm (2 of 2) [04/10/2010 3:24:54 PM]

8.11 Accounts payable and accrued liabilities Substantive procedures

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t11.htm (1 of 2) [04/10/2010 3:24:55 PM]

Presentation and disclosure

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t11.htm (2 of 2) [04/10/2010 3:24:55 PM]

file:///F|/Courses/2010-11/CGA/AU1/06course/m08summary.htm (2 of 4) [04/10/2010 3:24:56 PM]

file:///F|/Courses/2010-11/CGA/AU1/06course/m08summary.htm (4 of 4) [04/10/2010 3:24:56 PM]

Activity 8.1-1 solution

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t01sol.htm [04/10/2010 3:24:57 PM]

Activity 8.2-1 solution

Segregation of functional responsibilities

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t02sol.htm [04/10/2010 3:24:58 PM]

Activity 8.3-1 solution

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t03sol1.htm [04/10/2010 3:24:59 PM]

Activity 8.3-2 solution

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t03sol2.htm [04/10/2010 3:25:00 PM]

The problem of overstating revenue

file:///F|/Courses/2010-11/CGA/AU1/06course/m08t03eyk.htm (1 of 2) [04/10/2010 3:25:01 PM]