SULTHAN HAKIM/ 145020308121003

International Undergraduate Program in Accounting of Brawijaya University

Course: Auditing Laboratory

AUDITING CASES: 5. TOC: THE REVENUE AND CASH RECEIPTS CYCLE

1. SAS 31, "Evidential Matter," states that: "The measure of the validity of [evidential
matter] for audit purposes lies in the judgment of the auditor...." (paragraph 02) Thus,
the quality of oral evidence is an evaluation made by the auditor that would be
influenced by a number of factors: the perception of management's integrity, the rank
of the individual providing the information, the ability to corroborate the evidence
by other sources, and the purpose for which evidence is being gathered. However, in
all cases, statements made by the employees of a client are only circumstantial
evidence. In a comparison with other forms of evidence (such as observing physical
existence and receiving confirmations directly from third parties), it provides less
assurance.
In this case, Mitchell is attempting to gather additional evidence concerning
Lakeside's systems, especially the design and operating efficiency of control
procedures and policies. Oral evidence serves an important role in such testing but
still has to be complemented by other testing: a review of completed internal
documents, flowcharts, organizational charts, job descriptions, systems manuals, etc.
Conversely, oral information provides less evidence in the substantive testing of
account balances. Whereas company employees should be able to furnish relevant
information as to the functioning of control procedures within the various accounting
systems, the auditor must rely almost exclusively on other types of testing to
determine the fair presentation of the client's financial statements.
2. Accounts receivable generate a constant flow of cash into a company, offering a
temptation to any employee who might be inclined to steal. Over the years, ingenious
individuals have devised a multitude of plans for diverting this monetary inflow to
themselves. Some of the more common schemes include the following:
- Money that comes to the company from a customer is stolen by an employee with
the balance then being written off the records as an uncollectible account. This
diversion of funds is especially likely when an old account is collected, one that
can be removed from the books without arousing suspicion.
- Lapping can occur. One or more accounts receivable are collected by the
company but the money is stolen by an employee. However, since the collection
is not recorded, another invoice will eventually be sent to these customers who
would then alert the company to the earlier payment. To prevent the processing
of this second bill, subsequent cash collections from other customers are applied
to the balances of the original customers. This series of events can be repeated

Aging of the receivables is performed only once a year. an auditor must be constantly alert for any indication of potential problems. for example. The company needs to be in a position to take corrective action as soon as this type of problem begins to occur. the increase in the age of the receivables during the current period seems to have gone unnoticed. no reconciliation with the general ledger is made except for the auditor's testing once a year. Increased income would make this type of financing easier (and. Bank loans or new equity investments may be needed for this purpose. For example. since regular interaction with outside customers occurs. The receivable of a friend or relative. the possibility exists that an individual could make an adjustment to a balance without Miller noticing. Errors and evidence of irregularities could exist and not be discovered for months. . perhaps. the difference may simply be recorded as a discount that has been taken. could be reduced. . For example. an invoice is prepared for a fake customer with the amount being recorded as an increase in both accounts receivable and sales. . however.Access to the accounts receivable subsidiary ledger is available to all employees within the company.Complaints about billings are handled by Miller rather than by someone independent of the system. For example.Miller controls the accounts receivable subsidiary ledger with virtually no company oversight or control. cheaper) to negotiate. If the company does not have a specific policy for rebilling a customer for incorrect discounts. Rogers appears to handle this aspect of the company based almost on intuition. In talking with client personnel. if Miller is assigned to look into and resolve the problems. Consequently. the company needs to be aware of changes that occur over time. In the Lakeside audit. Although Miller claims that he can monitor the age of individual accounts. indefinitely. . the company's assets are tied up for a longer period of time and the chance of accounts becoming uncollectible increases. . 4. Thus. "Red flags" are often encountered in these discussions that need to be investigated to ensure that material misstatements do not exist. the client company wants to grow. The handling of complaints is an important method of control especially in an accounts receivable system. Thus. A company's net income can always be inflated by creating fictitious credit sales.No formal system exists for setting credit limits and granting credit. Therefore. potentially excellent customers may have their credit limited while risky . to inflate their own income. An employee removes cash equal to the 2% discount that is allowed when payment is made within ten days. False sales might also be created for a different reason: the regional sales representatives are paid a commission based on sales. During Mitchell's conversation with Miller. This control mechanism is neutralized. a number of comments are made that should concern the auditors: . Money is stolen on a daily or weekly basis to cover each previous theft. 3. they might attempt to falsify sales records.A customer can pay the total amount of an invoice.

Thus. . customers in financial difficulties can run up large debts that will never be paid. . Therefore. if the account has been paid (and stolen or incorrectly recorded). The possibility exists that bad accounts or false accounts are now included within the receivable balance. . . perhaps. . and customers can become aggravated by later adjustments being made. they should always be reviewed and approved by some independent party within the organization. but the effects of that holiday would have also been encountered in the preceding year. A formalized system needs to be developed with some oversight included.Miller indicates that the company might have previously been holding accounts rather than writing them off as bad on a timely basis. A new attempt must be made to derive an estimation that is a reasonable representation of the company's uncollectible accounts. . The auditor must be concerned that this practice is still being followed. Since bad accounts may indicate errors or irregularities. The auditor cannot corroborate a number that appears to have been selected at random. The company needs to establish a periodic review of credit information to ensure that each customer is still worthy of credit. These individuals have a direct interest in getting additional sales since they are paid on commission.7% of net sales as the estimation of bad accounts. Miller blames the change on Christmas. the information comes back to this independent person. 5. This delay is. because of weaknesses found during the preliminary evaluation of the internal control. control risk may be assessed at the maximum level. First. This system is obviously inefficient. Companies will often attempt to manipulate net income by varying the point at which accounts are determined to be bad. one of the reasons that the age of the accounts has increased. Additional independent information should be accumulated to help the company decide on the granting of credit. Payments may be made incorrectly.Prices and extensions of invoices are sometimes checked after the invoice has been mailed to the customers.The company waits until an account is 15 days old before a second invoice is mailed. . Since Miller has a great many responsibilities in this system. Since maximum control . Many customers may be waiting for the pressure of the second bill before making payment.No justification seems to exist for using 0.Miller writes off accounts as uncollectible with no apparent company control. Therefore. the writing off of a balance as a bad debt. The age of the accounts receivable is up significantly from the previous year without any good explanation. Therefore. this last billing should be made by some other individual. they have reason to want each report to sound as if the customer is worthy of credit. the company learns that a customer is no longer a good credit risk only by incurring a loss. customers are given excessive credit.The credit files are never updated.Miller produces and mails the final invoice for overdue accounts.Credit is based solely on reports that are filed by the sales representatives. .

In positive confirmations. the necessity of performing complicated calculations in order to generate reported figures. returns. carrying out procedures closer to the balance sheet date. Inherent risk is the susceptibility of an account balance or class of transactions to a material misstatement. inventory would be an account that would probably have a high inherent risk. debtors are asked to respond in all cases whether or not they are in agreement with the information given. the need for making estimations. therefore. testing cannot be omitted for public companies. Thus. and obsolescence of inventory would all be high and require periodic estimations. in the Lakeside audit. as would be the application of a cost flow assumption. using more experienced staff personnel. This decision would be justified if additional substantive tests appear to be easier and cheaper to perform than the testing of the operating efficiency of specific control policies and procedures. once again. Since positive confirmations require a response in every case. detection risk need not be kept low. the auditor has no reason to test the operating efficiency of the control procedures. and the possibility of obsolescence. the likelihood of theft. In the new Sarbanes-Oxley environment. this risk can be brought down to an acceptable level by such means as performing additional substantive testing. breakage. or related parties are involved. or relying on more effective testing procedures. they provide better evidence than do negative confirmations. problems inherent to a particular industry. 6. if the inherent risk and the control risk are judged to be high. accounts are large or old. debtors are asked to respond only if they disagree with the information. although potential strengths may be identified by the preliminary evaluation of internal control. As discussed above. If the inherent risk and control risk are both determined to be low. the testing of the control procedures becomes unnecessary. the past history of the company in this area. Increased audit evidence is needed in each of these cases. the auditors may still opt to assess control risk at the maximum level. Hence. 7. The company has numerous transactions in both buying and selling inventory. The auditor's assessments of both inherent risk and control risk have a significant impact on detection risk and. When using the negative form of request. Negative confirmations are not as costly and are most often used when less evidence . substantive testing procedures. The possibility of theft. A number of factors affect this assessment: the quantity and size of transactions occurring over time. Computations of discounts and freight charges could be difficult. less substantive testing (both in quantity and quality) is needed. Thus. For example. the auditor must reduce detection risk. Second. positive confirmations are more appropriate when the internal control is weak. Conversely. risk is being assumed. the results of analytical procedures.

8. Although this verification relates to the inventory system rather than to receivables . The debit entries made to Lakeside's Accounts Receivable control account produce an audit trail made up of the following documents or records . c. The activity within the account has been unusual. The balance appears to be with a related party b. . 9.  that the bill is mathematically correct. .serves within the Lakeside system as both an invoice indicating the amount billed to the customer and a sales order. Inventory Sales Journal . A number of situations exist that would suggest the need for confirmation of a specific account: a.records inventory sales as a basis for perpetual inventory. d. .  prices included on the invoice are appropriate. later invoices were paid while earlier charges were ignored. An auditor matches the debits in the general ledger account to these journal entries to ascertain that no posting errors have been made. Accounts Receivable Subsidiary Ledger . indicating a possible bad debt to be written off or that payment has not been properly recorded. For example. An auditor can use this listing to verify correct pricing of the sales invoices. An auditor compares individual entries made to this subsidiary ledger with entries in the control account in the general ledger. The auditor can use the various copies of the sales invoice to verify that:  credit was approved for the sale. The account is quite large in relation to other accounts receivable.records the quantity and description of the items being shipped.indicates the original journal entry recorded for each sales transaction.Sales Invoice . is required. The account is far overdue.  quantities and types of items billed agree with the quantities and types of items shipped to the customer. . Bill of Lading .used to price sales invoices. Indicates proper functioning of system. The auditor compares it with the sales invoice to make certain that the items ordered and billed are in agreement with the items that were shipped. . The selection of a specific account for confirmation is an indication that the auditor desires additional evidence or assurance about that particular balance. Inventory Price List . An auditor verifies that the items recorded as being sold agree with the sales invoice.indicates the receivable balance from each individual customer.Sales Journal .

For example. Collection of the accounts receivable. 10. they are certainly relevant to any testing made in connection with the fair presentation of those debits: Invoice Slips. the student should be aware that testing this trail provides the auditor with only a portion of the necessary evidence. Cash Remittance Lists. Thus. It is not unusual for a company to grow and what worked before can no longer be relied on to handle the increased volume. Accounts Receivable should be confirmed at yearend. Lakeside's audit trail is composed entirely of internally generated documents. The internal control for the revenues and cash receipts cycle appear to be poor and cannot be relied upon to provide reliable financial information for the month of December. 12. for example. Obviously. Miller seems to exhibit a lax attitude in several of his answers and therefore. Consistent with our answer in #11 above. Miller is uncertain how the 0. 11. Because the audit trail is composed solely of Lakeside documents. This evaluation should include a review of the history of uncollectible accounts. and that the company has always used this figure. since he is responsible for the system. Miller has not designed an effective system. Validated Bank Deposit Slips . and the current aging of accounts receivable. even the original customer order is taken by telephone and recorded by Lakeside employees. the current credit policy. The figure should be evaluated by Lakeside's management at least annually for its reasonableness. Thus. Mitchell probably should not recommend that Accounts Receivable be confirmed as of an interim date (November). Although the following documents are not part of the audit trail leading to the recording of the Accounts Receivable debits. we must conclude that he has not made good decisions. If controls are perceived as strong. thus. the reliability of the documents that comprise this trail such as bills of lading or sales invoices would be closely tied to the auditor's evaluation of internal control. .7% figure was determined. this is not a reasonable method for estimating bad debts. and auditor confirmations would also provide evidence as to the fair presentation of the accounts receivable. He says that the previous auditors determined this figure several years ago.some or all of these documents can be used by the auditor to verify the actual amount of cash received. the auditor will compare the debit entries in the receivable account to the subsequent cash collections. the reliability of these documents is much higher than if controls are weak. This question also asks about the reliability of the evidence gathered from this audit trail. The question of collectibility is best answered by actual collection of the receivable.

Comments .The subsidiary ledger is reconciled annually by the independent auditors. The possibility that errors or irregularities will be discovered on a timely basis becomes remote if not impossible. Miller has the opportunity for manipulating the records to cover thefts and other defalcations.During the year virtually no control is maintained over Miller's handling of the subsidiary ledger. Significance . a member of the administrative staff should verify that the subsidiary ledger for accounts receivable agrees with the general ledger control account.On a periodic basis. In addition. Suggestions . Comments .The criteria for writing off accounts are nebulous and seemingly based .Question 1. 2.

if no follow-up is carried out. Comments .The receivable can be turned over to an outside collection agency or.For the auditor. as an alternative. Finally. Suggestion .Once a system has been established for the write-off procedure (see Question 2). Significance . Additionally. 5. 4. Also. attempting to collect an old account receivable is a control mechanism to ascertain that the balance has not actually been paid and the money stolen or the collection recorded incorrectly.Client should schedule recent bad accounts to arrive at a new estimation of the bad debt percentage. Significance .Establish a formal system for writing off bad accounts. Once again. a member of Lakeside's staff can be assigned to look into the bad accounts periodically.Follow-up of bad debts is not addressed in the case. Significance . solely on the judgment of Miller. 3.No independent party authorizes the write-off of bad accounts. a problem exists as to the consistency of removing bad debts from one year to the next. write- offs may be approved without sufficient attempts being made at collecting the receivables. the company reduces the possibility of making any future collection. Company needs to ensure a review of these accounts. Comments . Comments . an independent employee should be required to review every account prior to removal to make certain that all proper steps have been followed. Suggestion . Suggestion . Mitchell does not ask this specific question.If no follow-up is made.The removal of bad accounts can be used to cover cash thefts.No reevaluation of the method for estimating bad accounts has been made by the client company. the opportunity exists for employees to steal the money if it should be received at a later date.No proof exists that the bad debt expense and the allowance for doubtful accounts is fairly presented. This system need be no more than a list of steps to be taken prior to the decision to remove an account. no control appears to exist over Miller's judgment. Significance . Suggestion . .

this situation is not unusual.The first three invoices are mailed by the sales division. This lack of control reduces the possibility that errors will be discovered. but with the addition of the control procedures suggested in several of the other questions. Comments . outside verification of credit ratings on a periodic basis would help reduce the risk of high bad debt losses. Abernethy and Chapman may want to review the new customer accounts opened during the current year for any indication of a change in credit policy. but it should be accompanied by additional control and reconciliation features. any further billing is made by Miller. Suggestions . thus benefiting from an increase in sales. However.6. all of the responsibilities are in the hands of one person with no independent control being applied. the auditor may have trouble distinguishing an actual change. 7. who is in charge of the subsidiary ledger.Lakeside should have complaints sent to an employee who can then discuss the matter with both Miller and the customer to make certain that the issue is properly resolved. and the apparent write-off of additional uncollectible accounts indicate the possibility that some. Suggestion . Comments . Because the credit policy has never been formally established.The responsibility for looking into complaints is vested in Miller. Basically. the increase in the average age of the balances. This issue may be especially significant in the Lakeside audit since credit reports are filed by the sales representatives who are paid on commission. perhaps informal.Control can be established by allowing Miller to continue the billing. 8.Any shift in credit policy requires auditor attention as to the effect on the allowance account and bad debt expense.By having Miller send the last invoices. 9. Significance . Comments . Comments .According to the client. Significance .No indication is given in the case as to whether sales invoices are verified .Lakeside should adopt a policy to guide Rogers in his credit decisions. an opportunity to establish control over Miller's work is being missed. no formal change in the policy of granting credit has been made.Again. the opportunity for manipulation is increased. Significance . Suggestion . In addition. modification has occurred. the increases in the size of the receivables. In a small company such as Lakeside.

Suggestion . Lakeside should determine the desired contents of a credit file including items such as outside credit reports. . Comments . Significance . As a part of the tests of controls. The system is designed so that credit approval is necessary before the sale is made. Comments . Significance . above.As indicated above. Suggestions . and review of the system by the auditor is quite difficult. Miller implies that his checking of prices and extensions is not made on a timely basis. ideally by a different employee. Suggestions .Credit files contain only the sales representative's credit reports and do not appear to be reviewed periodically.Verification of goods and prices is made by Lakeside employees.Cash discounts are verified by the sales division.As a part of the design of a comprehensive credit system. 12.All verifications should be made prior to mailing the invoice. after the shipment to ascertain appropriate credit approval. the credit granting policy is informal and based almost solely on Rogers' judgment.At the point in the accounting system at which the extensions and prices are verified. etc. Periodically. Thus. financial statements. Also. appear to pertain equally as well to this question. Comments . Each customer's file is also reevaluated at regular time intervals to judge whether credit should continue to be offered. the presence of credit approval should also be checked. In addition. 10. this verification is another responsibility pertaining to accounts receivable concentrated in Miller's hands. correspondence.To the auditor. the possibility of a sale being made without credit approval casts further doubts on the reliability of the system of controls.Verifying extensions and prices after the invoice has been sent to the customer is not a logical approach. having Miller perform this task adds nothing to the efficiency of the organization. The answers to Question (11). but no control mechanism is identified to assure that the system is working properly. Significance . 11. the auditor will want to review a sample of sales invoices for proper credit approval. these files need to be reviewed by an independent Lakeside employee to verify that all information is complete and up-to-date. the efficiency of the system is unknown. 13.

the auditor needs to make certain that Lakeside has a policy for periodically verifying the presence of all forms. Comments . the auditor's ability to gain assurance as to completeness assertion may be severely hampered. .Using prenumbered sales invoices and bills of lading along with the periodic verification of all numbers is essential in assuring that all sales are recorded. Significance . In an earlier case. but the auditor should specifically ask about that procedure. Suggestions . the use of prenumbered forms is mentioned. Miller suggests that the presence of all forms is tested periodically. Significance .System appears adequate. Suggestions – None 14. Financial information should be fairly presented.If the possibility exists that the company can make sales without recording them.Since the documents are already prenumbered.