Professional Documents
Culture Documents
Chapter 14 Auditing The Revenue Cycle
Chapter 14 Auditing The Revenue Cycle
14-1. a. The revenue cycle includes the activities involved in the exchange of goods and
services with customers and the realization of the revenue in cash.
b. The classes of transactions in this cycle for a merchandising company are sales, sales
adjustments, and cash receipts. The primary accounts affected by these transactions
are sales, accounts receivable, cost of sales, inventory, cash, sales discounts, sales
returns and allowances, bad debts expense, and allowance for uncollectible accounts
14-2. a. Specific audit objectives for the revenue cycle are derived from the five categories of
management's financial statement assertions.
b. Specific audit objectives for credit sales transactions include the following:
Recorded sales transactions represent goods shipped during the period (existence
or occurrence).
All sales transactions that occurred during the period have been recorded
(completeness).
The entity has the rights to receivables resulting from recorded credit sales
transactions (rights and obligations).
All sales transactions are correctly journalized, summarized, and posted
(valuation or allocation).
The details of sales transactions support their presentation in the financial
statements including their classification and related disclosures (presentation and
disclosure).
14-4. Factors that might motivate management to deliberately misstate revenue cycle assertions
include:
Solutions Manual to Modern Auditing: Copyright 2000, John Wiley and Sons, Inc. 14-1
Pressures to overstate revenues in order to report achieving announced revenue or
profitability targets or industry norms that were not achieved in reality owing to such
factors as global, national, or regional economic conditions, the impact of technological
developments on the entity's competitiveness, or poor management.
Pressures to overstate cash and gross receivables or understate the allowance for
doubtful accounts in order to report a higher level of working capital in the face of
liquidity problems or going concern doubts.
Factors that might contribute to unintentional misstatements in revenue cycle assertions include:
The volume of sales, cash receipts, and sales adjustments transactions is often high,
resulting in numerous opportunities for errors to occur.
The timing and amount of revenue to be recognized may be contentious owing to factors
such as ambiguous accounting standards, the need to make estimates, the complexity of
the calculations involved, and purchasers' rights of return.
14-5. a. Following are example analytical procedures that the auditor might use to estimate
total revenue for a household appliance manufacturer and for an airline.
b. Two analytical procedures that the auditor might use to estimate gross margin for
company might include.
c. Two analytical procedures that the auditor might use to estimate net receivables and
the allowance for doubtful accounts for company might include.
Solutions Manual to Modern Auditing: Copyright 2000, John Wiley and Sons, Inc. 14-2
Accounts receivable turn days Understanding a company’s history of accounts
and sales volume can assist the auditor in
evaluating net receivables and the adequacy of
the allowance for doubtful accounts.
Evaluate the entities history of This procedure is primarily related to the
uncollectible accounts expense adequacy of the allowance for uncollectible
to net credit sales, with accounts. The above history of accounts
adjustment for economic receivable turn days would be most useful for
conditions evaluating estimating gross receivables given
sales.
14-6. Several control environment factors and their applicability to revenue cycle assertions are:
Integrity and ethical values - reduction of risk of overstatement of revenues
and receivables by eliminating incentives to dishonest reporting.
Commitment to competence - by chief financial officers and accounting
personnel.
Management's philosophy and operating style - conservatism in developing
such accounting estimates as the allowance for uncollectible accounts and
allowance for sales returns.
Human resource policies and practices - bonding of employees who handle
cash
14.7. The following table summarizes the functions that apply to credit sales transactions, the
department that performs the functions, and the principal documents or records produced in
performing the function.
Department that Principal documents and records
Function performs function produced in performing the function.
Initiating credit Sales department Documents
sales Customer Order
Credit department Sales Order
Solutions Manual to Modern Auditing: Copyright 2000, John Wiley and Sons, Inc. 14-3
Department that Principal documents and records
Function performs function produced in performing the function.
Delivering good Warehousing and shipping Documents
and services department for goods. Shipping documents
Reports of unfilled orders and back orders
Line operating departments
for services. Computer Files and Records
Open Order File
Perpetual Inventory
Shipping File
Recording sales Accounting (Billing) Documents
Sales Invoice
Sales Reports and Sales Journal
Various Exception Reports
Monthly Customer Statements
14-8. In order to assess control risk as low based on programmed control procedures the auditor
should test the following.
14-9. The following tables describes programmed controls for a typical manufacturing company.
Potential Programmed Control CAATs (Assuming Test Data)
Misstatement
a. Sales invoices may The computer compares Submit test data for a
not be recorded. entries in the sales journal transaction that has shipping
with underlying shipping information, both with and
information. All shipping without a supporting sales
documents must be matched invoice.
with a sales invoice.
Solutions Manual to Modern Auditing: Copyright 2000, John Wiley and Sons, Inc. 14-4
Potential Programmed Control CAATs (Assuming Test Data)
Misstatement
b. Sales invoice may The computer compares Submit test data with dates on
be recorded in the dates on the sales invoice sales invoices that both do and
wrong accounting with dates on shipping do not match with dates on
period. documents. related shipping files.
c. A fictitious sales The computer will not Submit test data with sales
invoice, or a sales prepare a sale invoice invoice information that both is
transaction for without underlying and is not supported by
which revenue information on shipping underlying shipping
should not be files. information.
recognized, is
recorded.
d. Sales are made The computer searches a Submit test data for sales orders
without credit field for appropriate credit that both are and are not
approval. authorization before an order supported by appropriate credit
is placed on an open order authorization.
file.
e. A sales invoice has The computer matches Submit test data for sales
incorrect quantities quantities on a sales invoices invoices that both do and do not
or prices. with underlying shipping match underlying shipping
information and matches information and authorized
prices with an authorized price lists.
price list.
f. Sales invoices may The computer checks run-to- Submit test data for batches that
not be posted or run totals of beginning with complete and incomplete
may not be accounts receivable balances, data sets in terms of completed
journalized plus sales transactions, with transactions.
the ending receivable
balances.
g. Sales invoices may The computer matches Submit test data with underlying
be posted to the customer information on the information that both does and
wrong customer’s sales invoice with the master does not match with information
accounts. customer file, the sales order, on previously created sales
and the shipping documents. order and shipping files.
14-10. A common management control involves having managers with responsibility for sales to
review daily or weekly sales reports to assess the reasonableness of recorded sales. Further
management responsible for warehousing and shipping should review daily or weekly sales
and inventory movement reports to assess the reasonableness of recorded sales and
inventory removed from the perpetual inventory.
14-11. The sub-functions involved in cash receipts include (1) receiving cash receipts, (2)
depositing cash in bank, and (3) recording the cash receipts.
Solutions Manual to Modern Auditing: Copyright 2000, John Wiley and Sons, Inc. 14-5
14-12. a. Two important controls pertaining to cash sales and the transaction class audit
objectives to which they relate are:
The customer's expectation of a printed receipt and supervisory surveillance of
over the counter sales transactions helps to ensure that all cash sales are
processed through the cash registers or terminals - completeness.
Independent check by supervisor on the accuracy of cash count sheets, and
verification of agreement of cash on hand with totals printed by a cash register or
terminal - existence or occurrence and valuation or allocation.
b. Two important controls pertaining to the initial handling of mail receipts are (1)
immediate restrictive endorsement of checks received and (2) preparation of a multi-
copy listing (prelist) of mail receipts.
14-13. a. A lockbox is a post office box that is controlled by the company's bank. The bank
picks up the mail daily, credits the company for the cash, and sends the remittance
advices to the company for use in updating accounts receivable. This system
eliminates the risk of diversion of the receipts by company employees and failure to
record the receipts.
b. Depositing receipts intact daily means that all receipts are deposited; that is, cash
disbursements should not be made out of undeposited receipts. This control reduces
the risk that receipts will not be recorded (completeness), and the resulting bank
deposit record establishes the existence or occurrence of the transactions.
14-14. Four controls that can aid in preventing or detecting errors or irregularities in recording cash
receipts are summarized below along with potential tests of controls:
Solutions Manual to Modern Auditing: Copyright 2000, John Wiley and Sons, Inc. 14-6
14-15. a. The functions pertaining to sales adjustments transactions are: granting cash
discounts; granting sales returns and allowances; and determining uncollectible
accounts.
14-16. a. The transaction classes that should be considered in assessing control risk for
accounts receivable assertions are: credit sales, cash receipts, and sales adjustments.
b. In assessing control risk for the existence or occurrence account balance assertion for
accounts receivable, the following transaction class control risk assessments should
be considered:
Existence or occurrence for sales transactions that increase accounts receivable.
Completeness for cash receipts and sales adjustments transactions that decrease
accounts receivable.
c. A revised acceptable level of detection risk for tests of details and a revised level of
substantive tests must be determined for an assertion when the relevant final or
actual inherent risk assessments, control risk assessments, and analytical procedure
risk assessments, differ from the planned assessed levels.
14-18. Both the sales cutoff test and the cash receipts cutoff test pertain to accounts receivable. The
sales cutoff test involves:
Examining shipping documents for several days before and after the cutoff date to
determine the date and terms of shipment.
Tracing shipping documents to sales and inventory records to establish that the entries
were made in the correct accounting period.
Inspecting invoices for a period of time before and after the cutoff date to ascertain the
validity and propriety of the shipments and corresponding entries.
Inquiring of management about any direct shipments by outside suppliers to customers
and determining the appropriateness of related entries.
Solutions Manual to Modern Auditing: Copyright 2000, John Wiley and Sons, Inc. 14-7
In performing a cash receipts cutoff test, the auditor may be present at the balance sheet date
to personally observe the promptness of the cutoff. In particular, the auditor determines that
all collections received prior to the close of business are included in cash on hand or in
deposits in transit and are credited to accounts receivable. Alternatively, the auditor may
review the daily cash summary and validated deposit slip for the last day of the year.
Both cutoff tests relate to the existence or occurrence and completeness assertions for
accounts receivable.
b. Factors to be considered in choosing the form of confirmation request are (1) the
acceptable level of detection risk and (2) the composition of the customer balances.
The positive form is used when detection risk is low or individual customer balances
are relatively large. The negative form should be used only when all three of the
following conditions apply:
The acceptable level of detection risk for the related assertions is moderate or
high.
A large number of small balances is involved.
The auditor has no reason to believe that the recipients of the requests are
unlikely to give them consideration.
c. When no response is received after the second or third positive confirmation request
to a customer, the auditor should apply such alternative procedures as (1) examining
subsequent collections and (2) vouching open invoices comprising the customer's
balance. Alternate procedures may be omitted when both of the following conditions
apply:
There are no unusual qualitative factors or systematic characteristics related to
the nonresponses, such as that all nonresponses pertain to year-end transactions.
The nonresponses, projected as 100% misstatements to the population and added
to the sum of all other unadjusted differences, would not affect the auditor's
decision about whether the financial statements are materially misstated
14-20. a. The aged trial balance is used primarily in assessing the adequacy of the allowance
for uncollectible accounts.
b. Procedures applied to the aged trial balance include (1) footing and crossfooting the
aged trial balance and comparing the total to the general ledger balance for accounts
Solutions Manual to Modern Auditing: Copyright 2000, John Wiley and Sons, Inc. 14-8
receivable and (2) testing the aging of the amounts shown in the aging categories by
examining supporting documentation such as dated sales invoices.
c. After testing the accuracy of the aged trial balance the auditor should perform the
following procedures to draw a conclusion about the fair presentation of the
allowance for doubtful accounts.
Examine past due accounts for evidence of collectability such as correspondence
with customers and outside collection agencies, credit reports, and customers’
financial statements.
Discuss collectability of accounts with appropriate management personnel.
Evaluated management’s process for estimated the allowance for doubtful
accounts using hindsight.
Evaluate the adequacy of the allowance given information about industry trends,
aging trends, and collection history for specific customers.
Objective Questions
Comprehensive Questions
The auditor should consider separately audit the revenues associated with the 27 owned
properties and the 40 managed properties.
Revenues for the 27 owned properties represent direct revenues of the motel chain. The auditor
might consider evaluating the summer season separate from the balance of the year as the auditor
Solutions Manual to Modern Auditing: Copyright 2000, John Wiley and Sons, Inc. 14-9
will expect occupancy to be high during that time of year and the auditor will also expect that
revenues should reflect higher rates. The auditor would also expect that for the balance of the year
occupancy should be lower and revenues per night will be reduced due to significant price
competition. Knowledge of the industry will be particularly helpful in gauging the reasonableness
of occupancy rates and revenues per unit.
Revenues for the 40 managed hotels will likely be related to management fees based on
revenues earned for absentee owners. The auditor needs to consider the same issues as
above, but also need to determine the appropriateness of the management fee based on the
contract with absentee owners.
14-27. PROBLEM 14-27 WAS INCLUDED IN THE TEXT IN ERROR. THE FLOWCHART ON
PAGE 584 DOES NOT GO WITH THIS PROBLEM. INQDEQUATE INFORMATION IS
AVAILABLE FOR STUDENTS TO SOLVE THE PROBLEM. THE AUTHOR’S AND
JOHN WILEY EXTEND THEIR APPOLOGIES.
Finance committee is not exercising its Finance committee should assume a more
assigned responsibility for collections. active supervisory role.
Solutions Manual to Modern Auditing: Copyright 2000, John Wiley and Sons, Inc. 14-10
Weakness Recommended Improvement
The auditing function has been assigned to An audit committee should be appointed to
the finance committee, which also has perform periodic auditing procedures or
responsibility for the administration of the engage outside auditors to perform the
cash function. Moreover, the finance procedures.
committee has not performed the auditing
function.
The head usher has sole access to cash The number of counters should be increased
during the period of the count. One person to at least two, and cash should remain under
should not be left alone with the cash until joint surveillance until counted and recorded
the amount has been recorded or control so that any discrepancy will be brought to
established in some other way. attention.
The collection is vulnerable to robbery The collection should be deposited in the
while it is being counted and from the bank's night depository immediately after the
church safe prior to its deposit in the bank.count. Physical safeguards, such as locking
and bolting the door during the period of the
count, should be instituted. Vulnerability to
robbery will also be reduced by increasing
the number of counters.
The head usher's count lacks usefulness The financial secretary should receive a copy
from a control standpoint because he of the collection report for posting to the
surrenders custody of both the cash and the financial records. The head usher should
record of the count. maintain a copy of the report for use by the
audit committee.
Contributions are not deposited intact. Contributions should be deposited intact. If it
There is no assurance that amounts is considered necessary for the financial
withheld by the financial secretary for secretary to make cash expenditures, she
expenditures will be properly accounted for. should be provided with a cash working
fund. The fund should be replenished by
check based upon a properly approved
reimbursement request and satisfactory
support.
Members are asked to draw checks to Members should be asked to make checks
"cash", thus making the checks completely payable to the church. At the time of the
negotiable and vulnerable to count, ushers should stamp the church's
misappropriation. restrictive endorsement (For Deposit Only)
on the back of the check.
No mention is made of bonding. Key employees and members involved in
receiving and disbursing cash should be
bonded.
Written instructions for handling cash Because much of the work in cash
collections apparently have not been collections is performed by unpaid,
prepared. untrained church members, often on a short-
term basis, detailed written instructions
should be prepared.
Solutions Manual to Modern Auditing: Copyright 2000, John Wiley and Sons, Inc. 14-11
14-30. (Estimated Time: 30 minutes)
Customer
Payment
Remittance Accounts
Advice CASH RECEIPTS Receivable
PROGRAM: File
Updates AR Master
File and Daily
Data Transaction Tape.
Entry Also Produces rece Cash
at Deposit Slip for
CRT Receipts
Cash Received Transaction
File
Deposit
Slip
b. Yes, the new cash receipts procedures have created some systems and internal
control problems. These problems include the following:
There are some potential control problems in the data entry procedures. The CRT
operator should be restricted to cash receipts processing activities. There should
be safeguards to detect or prevent unauthorized entries to the system.
The old master file records are destroyed in the update process. The company
should keep a backup of the accounts receivable file in case the file is destroyed.
This can be accomplished by periodically dumping the accounts receivable file
on magnetic tape or another disk
There is no assurance that all cash receipts have been entered correctly into the
system. There should be some independent computation of batch and/or hash
totals involving the remittance advices and the number of transactions so that a
comparison at the conclusion of processing would reveal omissions or errors
The remittance advices The remittance advices are destroyed the next day, which
probably is too soon. Any errors or operator alterations not discovered by the end
of the next business day would be difficult to trace and correct.
Solutions Manual to Modern Auditing: Copyright 2000, John Wiley and Sons, Inc. 14-12
a. Substantive Test b. Financial Statement c. Type of Evidence
Assertion
Vouch aged trial balance to Valuation or allocation Documentary
supporting documentation
Apply analytical procedures Existence or occurrence, Analytical
completeness, valuation or
allocation
Vouch recorded receivables to Existence or occurrence, Documentary
supporting documentation rights and obligations,
valuation or allocation
Perform sales cutoff test Existence or occurrence, Documentary
completeness
Confirm accounts receivable All except presentation and Confirmation
disclosure.
Vouch aged trial Valuation or allocation Documentary
balance to supporting
documentation
Vouch recorded receivables to Existence or occurrence, Documentary
supporting documentation rights and obligations,
valuation or allocation
Verify accuracy of accounts Valuation or allocation Mathematical
receivable trial balance and
agreement with general ledger
control
Examine subsequent Existence or occurrence, Documentary
collections or allocation completeness, valuation
Confirm accounts receivable All except presentation and Confirmation
disclosure
Compare statement Presentation and Documentary
presentation with GAAP disclosure
Perform cash receipts cutoff Existence or occurrence, Documentary
test completeness
Solutions Manual to Modern Auditing: Copyright 2000, John Wiley and Sons, Inc. 14-13
14-32. (Estimated Time – 20 minutes)
Schedule of Adjustments
Cost of
Sales
Goods Sold
Transaction Under Over Under Over
A 2,000
D 4,000 5,600
E 10,000
F 6,000
H 8,000 5,500
Total 14,000 14,000 7,500 5,600
Adjusting Entry 1,900
Cost of Goods Sold 1,900
Inventory
c. When no response is received after the second or third positive confirmation request
to a customer, the auditor should apply such alternative procedures as (1) examining
subsequent collections and (2) vouching open invoices comprising the customer's
balance. Alternate procedures may be omitted when both of the following conditions
apply:
Solutions Manual to Modern Auditing: Copyright 2000, John Wiley and Sons, Inc. 14-14
There are no unusual qualitative factors or systematic characteristics related to
the nonresponses, such as that all nonresponses pertain to year-end transactions.
The nonresponses, projected as 100% misstatements to the population and added
to the sum of all other unadjusted differences, would not affect the auditor's
decision about whether the financial statements are materially misstated.
a. There are two forms of accounts receivable confirmation requests; the positive form
and the negative form. A positive form asks the debtor to respond whether or not the
debtor is in agreement with the information on the confirmation request. A negative
form asks the debtor to respond only if the debtor disagrees with the information on
the confirmation request. The negative form generally requires follow-up by the
auditor in the form of practicable alternative procedures that are used to obtain
necessary evidence. The use of the positive form is preferable when individual
account balances are relatively large, when there is reason to believe that there may
be a substantial number of accounts in dispute or with inaccuracies or irregularities.
The negative form is useful when internal control surrounding accounts receivable is
considered to be effective, a large number of small balances is involved, and the auditor
has no reason to believe that persons receiving the requests are unlikely to give them
consideration.
Solutions Manual to Modern Auditing: Copyright 2000, John Wiley and Sons, Inc. 14-15
14-35. (Estimated Time – 30 Minutes)
Solutions Manual to Modern Auditing: Copyright 2000, John Wiley and Sons, Inc. 14-16
Cases
a. Selected Ratios
Sales to average total assets 1.35 1.24 1.30 1.27
Industry Median 1.25 1.23 1.29 1.26
Difference 0.10 0.01 0.01 0.01
AR collection period 55 49 48 48
Industry Median 47 48 47 47
Difference 8 1 1 1
Uncollectable account expense to net credit s ales 1.25% 1.25% 1.25% 1.25%
Industry Median 1.50% 1.30% 1.25% 1.25%
Difference -0.25% -0.05% 0.00% 0.00%
Uncollectable account expense to bad debt writeoffs 1.493 1.046 0.972 1.029
b. The unaudited figures for Aurora Manufacturing, Inc. show the following:
There was a significant increase in sales compared to total assets, particularly when
compared to industry averages. This is an indication of possible existence and
occurrence problems as past history of the ratio of total assets to sales would predict
lower sales levels. The auditor should expand the scope of accounts receivable
confirmations.
The collection period is increasing relative to industry averages and past history.
Further, accounts receivable are growing faster than sales. The Aurora continues to use a
historical rate of 1.25% of credit sales to provide for uncollectable accounts while
industry trends show an increase in the rate of bad debts to credit sales. The is an
indication of possible problems of associated with the net realizable value of receivables.
The auditor needs to expand the scope of tests of collection of current receivables, the
allowance for uncollectable accounts, and the provision for bad debt expense.
Solutions Manual to Modern Auditing: Copyright 2000, John Wiley and Sons, Inc. 14-17
14-37. See separate file with answers to the comprehensive case related to the audit of Mt. Hood
Furniture that is included with this chapter.
14-38. See separate file with answers to the comprehensive case related to the audit of Mt. Hood
Furniture that is included with this chapter.
14-39. See separate file with answers to the comprehensive case related to the audit of Mt. Hood
Furniture that is included with this chapter.
Research Questions
For the reasons specified in the introduction to this manual, solutions are not provided for this
category of questions.
Solutions Manual to Modern Auditing: Copyright 2000, John Wiley and Sons, Inc. 14-18