NGEE ANN POLYTECHNIC

SCHOOL OF BUSINESS AND ACCOUNTANCY

AUDITING 1

LECTURE 5
AUDIT OF THE COLLECTIONS CYCLE
WEEK COMMENCING 19 MAY 2014

Required Reading
Textbook – Auditing and Assurance – Chapter 14
Supplementary articles
Learning Objectives

 nature of the collections cycle

 key controls of the collections cycle
 audit tests of controls and transactions in this cycle
 audit objectives achieved by the above controls and audit tests
 cash sales contrasted with credit sales

1 NATURE OF THE COLLECTIONS CYCLE

Cash receipts may result from a variety of sources. For example, cash receipts
may result from revenue transactions, short-term and long-term borrowing,
issuance of share capital, and the sales of marketable securities, long-term
investments, and other assets.
The scope of this topic is limited to cash receipts from sales transactions. Such
receipts include cash sales and collections from trade customers on credit sales.

Refer to Sales Cycle lecture notes sections 1.2 and 1.3 for how the Collection
Cycle fits with the Sales Cycle.

2 INTERNAL CONTROLS AND AUDIT TESTS IN THE COLLECTIONS CYCLE

2.1 Nature of Audit Tests
Cash is often referred as to the lifeblood of the entity. The inflow of cash from the
revenue cycle is an important component of the flow of transactions through an
entity.
Although the cash balance may not be one of the larger balances on the balance
sheet, the volume and dollar amount of transactions flowing through the cash
account is often greater than in other accounts. This is because most business
transactions are ultimately settled with cash.
Being the most liquid of all assets, cash is highly susceptible to misappropriation.
This increases the likelihood of errors or irregularities in executing and recording
cash receipt transactions. Most companies therefore implement extensive
internal controls over cash.

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2.1.1 Test of Controls

The auditor would need to determine the effectiveness of the following internal
control activities:

Types of Control Examples of control procedures

Activities
Segregation of duties
Adequate
documentation and
records
Physical control over
assets and records
Independent internal
verification
Staff responsible for handling cash is separate from staff
responsible for record keeping.
 A prelist is promptly prepared to record the details of
cash or cheques received through the mail.
 The cash receipt journal is updated on a daily basis.
 Monthly customer statements are prepared and
mailed out
 Incoming cheques are immediately crossed upon
receipt
 Cash and cheques received are deposited on a daily
basis
The accountant compares the total of cash receipts in the
cash receipts journal to the A/R subsidiary ledger and
reconciles the differences.

2.1.2 Transaction-Related Audit Objectives in the Collections Cycle

The auditor performs audit tests to ensure that the following transaction-related
audit objectives are achieved:

General Specific Transaction Related Audit Objectives for the

Transaction- Collections Cycle
Related Audit
Objectives
Existence Recorded receipts represent funds actually received by the
company. (Records do not represent fictitious receipts)
Completeness All cheques and cash received are recorded in the cash receipts
journal.
Accuracy Recorded cash receipts are correctly recorded, correctly
reflecting the value of funds received.
Classification Cash receipts are properly classified.
Timing Cash receipts are recorded in the correct accounting period.
(see section 5)
Posting & Transactions are posted to Cash, AR Control accounts in the GL
summarising

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2.2 Environmental Controls

As cash is the most liquid of assets and highly susceptible to fraud, the
prevention and detection of fraud over cash is key to any business. Personnel
involved in handling cash should be competent and trustworthy.

Cash budgets and monthly reports that compare actual results against
expectations can be used to increase control over cash.
Other key controls over cash receipts include:
1) Employees handling cash take a vacation at least once annually.
2) There is a periodic rotation of the assigned duties of cash handlers.
Many corporate embezzlement cases were conducted by highly dedicated and
long serving employees. Most of these employees had no changes to their job
responsibilities nor had they taken vacations.

The above controls would deter and detect fraudulent behavior.

3 MAIL ROOM
Although internet banking is now widely used to remit payments, cheques and
cash may still be used to settle payments. Cheques are often mailed by
customers to their suppliers. Less often but rarely, cash is also sent this way.

Staff responsible for collecting mail will hence be the first in line to handle
cheques received. Such staff could be mail room staff (common in large
companies) or the receptionist or any administration staff.

A major concern with cash receipt transactions is the possible diversion of cash
before the receipt is recorded. This type of cash embezzlement is the most
difficult to detect. Control procedures should provide reasonable assurance that
documentation is produced once cash is received. To avoid this altogether,
companies can discourage or even refuse acceptance of cash from customers.
Instead they may instruct that remittances be made by cheques or direct transfer.
Upon receipt in the mailroom, all cheques should be restrictively crossed and
made payable to the company. This is to prevent theft of cheques by
encashment at a bank. Crossing also ensures that the cheque is banked in and
cleared through the banking system (no direct encashment; keeps records of
recipient in banking process)

The details of cheques received are then recorded in a prelist. The prelist is a
register of incoming cheques, date received, cheque numbers, cheque value,
from whom.

A copy of the prelist, together with the cheques, is given to the cashier (who
takes it to the bank). Another copy is sent to the A/R department with any

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remittance advices (see section 5) received with the cheques. A third copy is
retained by the mailroom.
Remittance advices is a note from the payer (eg customer). This note is attached to
the cheque to tell the payee about:
 Payer’s name
 Reference numbers of sales invoices being paid for
 Cheque number
 Cheque value

Refer to Table 3.1

Table 3.1 Mail Room

Internal Control Control Audit Test Transaction
Procedure Activity related audit
objective
a Regular clearing of Physical Inquiry or observation Existence
mail from mailbox Control
(to prevent theft of
cheques)
b A prelist is Adequate Observe that cheques are Completeness
promptly prepared documents immediately recorded in a
for all cheques and records prelist upon receipt.
received.
OR

Conduct a surprise check to

compare the total cheques
received for the day to the
information in the prelist.

c Cheques are Physical Observe that cheques are Existence

immediately Control crossed immediately when
crossed upon received, if not already done so
receipt (to by sender.
prevent direct
encashment
without clearing
through payee’s
bank)
d Person Segregation Observe or inquire about the Existence
responsible for of duties duties of the person opening
collecting and the mail and ensure that it is
opening the mail not the same person depositing
should not be cheques.
one depositing
the cheques

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AUDITING 1

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AUDITING 1

4 CASHIER’S OFFICE

The cashier’s office will receive the prelist and cash/ cheques received from the
mail room.
If there are cash sales, then the department responsible for cash sales will
forward cash to the cashier’s office. (refer to section 6 for more on cash sales)
The cashier would then prepare a daily cash summary to consolidate the above
collections and bank deposit slips (this is a form provided by the bank). The
cashier is responsible to make the deposits at the bank. The bank keeps a copy
of the bank deposit slip and and returns a validated (date stamped) copy to the
cashier.
Cash should be deposited in total on a daily basis to enhance accountability,
safekeeping and cash management. The bank deposit should equal the total
cash shown on the daily cash summary.
The validated deposit slip is then routed to the general accounting department.
See Table 4.1.

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Table 4.1 Cashier’s Office

Internal Control Control Audit Test Transaction

Procedure Activity related audit
objective
a All cash receipts are well- Physical Compare dates on the Existence
safeguarded and promptly Control following documents to ensure
deposited. that prompt deposits were (physical
made: existence ie
(This reduces the risk of
theft, including “borrowing”  Validated deposit slip asset is not
and bank statement lost)
by the cashier, or cheques
being misplaced.)  credit advice
 prelist of receipts
b The person responsible for Segregation Observe or inquire on the Existence
handling cash is different of duties responsibility of the cashier to
from the person ensure that he/she is not (transaction
responsible for updating involved in updating of is valid and
accounting records. accounting records not fictitious)
c Cashiers have to take Independent Review the company’s policies Existence
mandatory vacations and internal to ensure that there is a policy
be rotated on their duties verification requiring cashiers take (transaction
periodically. mandatory vacations or be is valid and
rotated on their reposnsibility. not fictitious)
(The cashier could have
Review the vacation and
been ‘borrowing” funds
rotation schedule.
(i.e. lapping) and another
person stepping in could
help in uncovering such
activities.)
d The daily prelist is Independent Review for evidence that Existence
reconciled with the Internal independent reconciliations
validated bank deposit verification have been performed. (transaction
slip/bank statement/bank is valid and
credit advice by the not fictitious)
accountant.

5 ACCOUNTS RECEIVABLE DEPARTMENT

Once a cheque is received (ie date recorded onto the prelist), it is recognized as a
receipt in settlement of Accounts Receivable. The timing of recognition of receipts is
not based on the date of clearance by the bank but on the date the cheque is
received.
Should a cheque bounce subsequent to recognition, the above receipt entry is
reversed.
Hence, based on the prelist and remittance advice from the mailroom, the clerk will
record the cheque amounts received in the cash journal. The relevant Accounts
Receivable Subledgers are also reduced.

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Without a prelist, there may be inadequate communication about receipts to

Accounting, leading to incomplete recording of receipts.
When discounts have been taken, the clerk compares the date on the remittance
advice to the date of the corresponding sales entry to confirm payment was made
within the discount period. The amount of discount taken is then verified to determine
that the amount deducted by the customer is correct.
Customer statements are prepared and mailed out to customers periodically. They
reflect a summary of all transactions with each customer in a period. The information
on the customer statements is from the subledger. The customer statement is not a
demand for payment from customer, but sharing of information with the customer.
When customers check the statements against their own records, they may discover
discrepancies which lead them to feedback to their supplier (your audit client). Hence
a company may find out about their errors and correct them through customer’s
feedback on customer statements.
Refer to Sales cycle lecture notes for details on customer statements. Note that
customer statements fulfil a different set of audit objectives for sales and collections.
When customers check the statements, they are probably more interested to check if
they have been overcharged than to check if they were undercharged. When there
are errors leading to an overcharge, customers would be more likely to react and
provide feedback, as compared to when they are undercharged.
Based on the above reasoning, customer statements can only address the existence
objective for sales transactions, but not for collections. A fictitious collection reflected
on a statement may not attract the customer’s attention and feedback since it reflects
an understated A/R subldeger balance.
Likewise, customer statements can only address completeness problems for
collections but not for sales transactions. If customer has paid but statement does
not reflect the payment, he is likely to call to request clarification. Whereas, if the
customer has received goods but the sale transaction was not reflected on the
statement, he would be less compelled to provide feedback. In this case, the
omission of sales transaction represents an understated A/R subledger balance.
Situations which lead to overcharging are:
 Fictitious sales transaction included in statement (existence problem)
 Sales transaction value reflected on statement is larger than sales invoice
amount (accuracy problem)
 Sales delivery in period 2 reflected as a sales transaction on statement for
period 1 (timing problem)
 Customer A’s statement reflected Customer B’s transactions (posting
problem)
 Collections received but not reflected on statements (completeness problem)
 Collections received in period 1 but only reflected in period 2 (timing problem)
 Customer A’s statement did not reflect collection from customer A as it was
posted to Customer B’s account. (posting problem)

See table 5.1.

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Table 5.1 Accounts Receivable Department

Internal Control Control Audit Test Transaction

Procedure Activity related audit
objective
a Monthly statements are Adequate Observe the process of Existence
prepared and sent to Documents preparing and sending Completeness
customers. and records monthly statements to Accuracy
customers. Posting &
Feedback from
Summarisation
customers is promptly
Or review copies of Timing
followed-up on.
statements prepared and
Responsibility for the Segregation mailed out to customers. (note:
above tasks should not of duties different
be allocated to those with objectives
responsibilities for met by
handling or recording customer
receipts. statements on
sales cycle )
b The person recording the Segregation Observe segregation of Existence
cash receipt journals is of duties duties between the (transaction is
different from the person recording of cash receipt valid and not
updating the accounts journals and the updating fictitious)
receivable subsidiary of AR subsidiary ledger.
ledger.

6 CASH SALES
Controls over cash sales transactions are slightly different from those over credit
sales, mainly because cash is received upfront.
a) Two or more employees participate in each transaction
A cashier who receives cash from the customer is a different person than the
employee who prepares a receipt for the customer. If receipts are serially numbered
and accounted for, this separation of responsibility is an effective means of
preventing fraud or unrecorded cash transactions.

b) Cash registers
Cash registers are used when one employee is tasked with making over-the-counter
sales, delivering goods, receiving cash, and recording the transaction.

When sales are recorded on a cash register, the amount is recorded on a locked-in
tape. At the end of the day, the salesperson turns in the cash on hand without
knowing the total sales recorded on the tape.

A supervisor reconciles the cash sales recorded on the tape with the cash handed in
by the sales person. This segregates accountability and custodianship of the cash.

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Cash registers should be located where customers can observe amounts being
recorded.

c) Prompt deposits
Cash receipts should be deposited promptly and intact to prevent theft or "borrowing"
of the daily cash receipts. Deposit slips should be reconciled to the client's records
daily.

Key Control Procedures

a) Transactions recorded by the cash register are “locked-in” to prevent
unauthorized alterations.
b) Cash receipts are printed and given to customer as a proof of payment. The
customer counter-checks if the charges and change are correct. Also useful in cases
of return, exchange, refund or price adjustment.
c) A visual display of keyed-in transactions enables customers to counter-check
them.
d) An independent person reconciles cash received by the cashier and
amount recorded on the locked-in tape.
e) Cash receipts should be deposited promptly.

Key Audit Tests

a) Observe the performance of duties at the point of sale to ensure that

transactions are locked-in, cash receipts are given to customers and there is a
visual display of transactions.
b) Check for evidence of internal independent verification i.e. an
independent person reconciles the cash received by the cashier with the amount
recorded on the locked-in tape.

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