LECTURE- 2

AUDIT OF THE SALES AND COLLECTION CYCLE TESTS OF

CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS

DR. EBRAHIM ASSAKAF

 LECTURE -05 OUTLINES

1. Identify the accounts and the classes of transactions in the sales and collection
cycle.
2. Describe the business functions and the related documents and records in the
sales and collection cycle.
3. Understand internal control, and design and perform tests of controls and
substantive tests of transactions for sales.
4. Apply the methodology for controls over sales transactions to controls over
sales returns and allowances.
5. Understand internal control, and design and perform tests of controls and
substantive tests of transactions for cash receipts.
6. Apply the methodology for controls over the sales and collection cycle to
controls related to uncollectible accounts receivable.
7. Understand the effect of tests of controls and substantive tests of transactions
on substantive tests of details of balances.
 OBJECTIVE 1
Identify the accounts and the classes
of transactions in the sales and
collection cycle.
 ACCOUNTS AND CLASSES OF TRANSACTIONS IN
THE SALES AND COLLECTION CYCLE
There are five classes of transactions in the sales and
collection cycle:
1. Sales (cash and sales on account)
2. Cash receipts
3. Sales returns and allowances
4. Write-off of uncollectible accounts
5. Estimate of bad debt expense
The way accounting information flows through the various
accounts in the sales and collection cycle is shown in Figure 14-1.
 BUSINESS FUNCTIONS IN THE CYCLE AND RELATED
DOCUMENTS AND RECORDS
There are eight business functions within the sales and collection
cycle:
1. Processing customer orders
2. Granting credit
3. Shipping goods
4. Billing customers and recording sales
5. Processing and recording cash receipts
6. Processing and recording sales returns and allowances
7. Writing off uncollectible accounts receivable
8. Providing for bad debts
The classes of transactions, accounts, business functions, and related documents
and records for the sales and collection cycle are detailed in Table 14-1.
Table 13.1 Classes of Transactions,
Accounts, Business Functions, and
Related Documents and Records for
the Sales and Collection Cycle (1 of 2)
Classes of Accounts Business Functions Documents and Records
Transactions
Sales Sales Processing customer Customer order
Accounts receivable orders Sales order
Granting credit Customer order or sales order
Shipping goods Shipping document
Billing customers and Sales invoice
recording Sales Sales transaction file
Sales journal or listing
Accounts receivable master file
Accounts receivable trial balance
Monthly statement
Cash receipts Cash in bank (debits from Processing and Remittance advice
cash receipts) recording cash Prelisting of cash receipts
Accounts receivable receipts Cash receipts transaction file
Cash receipts journal or listing
Table 13.1 Classes of Transactions,
Accounts, Business Functions, and
Related Documents and Records for
the Sales and Collection Cycle (2 of 2)
Classes of Accounts Business Functions Documents and Records
Transactions
Sales returns and Sales returns and allowances Processing and Credit memo
allowances Accounts receivable recording sales Sales returns and allowances journal
returns and
allowances

Write-off of Accounts receivable Writing off Uncollectible account authorization

uncollectible Allowance for uncollectible uncollectible accounts form
accounts accounts receivable General journal

Bad debt expense Bad debt expense Providing for bad debts General journal
Allowance for uncollectible
accounts
 OBJECTIVE 3
Understand internal control, and
design and perform tests of controls
and substantive tests of
transactions for sales.
 METHODOLOGY FOR DESIGNING TESTS OF CONTROLS
AND SUBSTANTIVE TESTS OF TRANSACTIONS FOR SALES

The methodology for this process is shown in Figure 14-2.

Understand Internal Control—Sales: To gain an understanding, the auditor
can use the client’s flowchart or other documentation and perform walkthrough
tests. A flowchart is shown in Figure 14-3 on page 454.

Assess Planned Control Risk—Sales: There are four steps to this process:
1. Determine a framework for assessing control risk, which is provided by the
transaction-related audit objectives.
2. Identify key internal controls and deficiencies for sales.
3. Associate the key internal controls and deficiencies with the audit objectives.
4. Assess control risk for each objective by evaluating controls and deficiencies.
 METHODOLOGY FOR DESIGNING TESTS
OF CONTROLS AND SUBSTANTIVE TESTS OF
TRANSACTIONS FOR SALES (CONT.)
The key control activities for sales:
• Adequate Separation of Duties—Proper separation of duties helps to
prevent misstatements due to both errors and fraud.
• Proper Authorization—The auditor is concerned about authorization
at three points:
1. Credit must be properly authorized before a sale takes place.
2. Goods should be shipped only after proper authorization.
3. Prices, including basic terms, freight, and discounts, must be authorized.
• Adequate Documents and Records—May be paper or electronic.
 Key Segregation of Duties
Segregation of Duties for the Revenue Process Functions by Department
Revenue and Accounts Receivable Order Accounts Cash
Credit Shipping IT Treasurer
Functions Entry Receivable Receipts

Receiving and preparing customer

order X

Approving credit X
Shipping goods to customer and
completing shipping document X

Preparing customer invoice X X

Updating accounts receivable
records for sales X X

Receiving customer’s remittance X

Updating accounts receivable
records for remittances X X

Preparing account receivable aged

trial balance X X

Authorization accounts receivable

write-off X
 METHODOLOGY FOR DESIGNING TESTS
OF CONTROLS AND SUBSTANTIVE TESTS OF
TRANSACTIONS FOR SALES (CONT.)

The key control activities for sales (cont.):

• Prenumbered Documents—This helps prevent both the failure to bill
and duplicate billings and recordings.
• Monthly Statements—This is a useful control because it encourages
customers to respond if their balance is incorrect.
• Internal Verification Process—Can be manual or computerized.
Determine Extent of Tests of Controls—After key controls and
deficiencies are identified, auditors assess control risk and determine
the extent of tests of controls.
 METHODOLOGY FOR DESIGNING TESTS
OF CONTROLS AND SUBSTANTIVE TESTS OF
TRANSACTIONS FOR SALES (CONT.)
Design Tests of Controls for Sales—Tests of controls for sales are illustrated
in Table 14-2 on page 457.
Design Substantive Tests of Transactions for Sales—Substantive tests are
designed for each transaction-related audit objective, including:
• Recorded Sales Occurred—There are three types of possible misstatements:
1. Sales included in the journals for which no shipment was made
2. Sales recorded more than once
3. Shipments made to nonexistent customers and recorded as sales
• Existing Sales Transactions Are Recorded—This is less likely to be tested
because the risk of overstatement of sales is more likely than
understatement.
 METHODOLOGY FOR DESIGNING TESTS
OF CONTROLS AND SUBSTANTIVE TESTS OF
TRANSACTIONS FOR SALES (CONT.)

Design Substantive Tests of Transactions for Sales (cont.)

• Direction of Tests—The direction of the test fulfills different
objectives:
• Tracing—From source documents to the journals tests for omitted
transactions (completeness objective)
• Vouching—From the journals back to the source documents tests for
nonexistent transactions (occurrence objective)

The direction of tests related to sales is shown in Figure14-4.

 METHODOLOGY FOR DESIGNING TESTS
OF CONTROLS AND SUBSTANTIVE TESTS OF
TRANSACTIONS FOR SALES (CONT.)

Design Substantive Tests of Transactions for Sales (cont.)

• Sales Are Accurately Recorded—Auditor concerns:
• Shipping the amount of goods ordered
• Accurately billing for the amount of goods shipped
• Accurately recording the amount billed in the accounting records
• Sales Transactions Are Correctly Included in the Master File and
Correctly Summarized
• Recorded Sales Are Correctly Classified
• Sales Are Recorded on the Correct Dates
 METHODOLOGY FOR DESIGNING TESTS
OF CONTROLS AND SUBSTANTIVE TESTS OF
TRANSACTIONS FOR SALES (CONT.)
Summary of Methodology for Sales:
• Transaction-related audit objectives
• Key existing controls
• Tests of controls
• Deficiencies
• Substantive tests
Design and Performance Format Audit Procedures—Properly
designed and formatted audit programs do the following:
• Eliminate duplicate procedures
• All procedures on any one document are completed at the same time
• Enables the most effective order in which to perform procedures
 OBJECTIVE 4
Apply the methodology for controls
over sales transactions to controls
over sales returns and allowances.
 SALES RETURNS AND ALLOWANCES

Transaction-related audit objectives are essentially the same for

credit memos as those for processing sales, with two notable
differences:
1. First is materiality. Sales returns and allowances are often so
immaterial that auditors can ignore them.
2. The second is emphasis on the occurrence objective. Auditors usually
emphasize testing recorded transactions to uncover any theft of cash
in the collection of accounts receivable that was covered up by
fictitious sales returns or allowances.
 OBJECTIVE 5
Understand internal control, and
design and perform tests of controls
and substantive tests of transactions
for cash receipts.
 METHODOLOGY FOR DESIGNING TESTS OF
CONTROLS AND SUBSTANTIVE TESTS OF
TRANSACTIONS FOR CASH RECEIPTS

Auditors use the same methodology for tests of controls and

substantive tests of transactions for cash receipts as they use for sales:
• Determine key internal controls for each audit objective.
• Design tests of control for each control used to support reduced control
risk.
• Design substantive tests of transactions to test for monetary
misstatement for each objective.
The control risk matrix for cash receipts is presented in Figure 14-5 on page
466. Key internal controls and common tests of controls are shown in Table
14-3 on page 465. The audit program is shown in Figure 14-6 on page 467.
 METHODOLOGY FOR DESIGNING TESTS
OF CONTROLS AND SUBSTANTIVE TESTS OF
TRANSACTIONS FOR CASH RECEIPTS (CONT.)

Determine Whether Cash Received Was Recorded—It is difficult to detect theft if

cash when it occurs before the cash is recorded. Prenumbered remittance
advices and prelists of cash receipts are usually tested against journals, but this
is effective only if the prelist was prepared when the receipt was received.
Prepare Proof of Cash Receipts—Total cash receipts recorded in the journal for
a specific period is compared with the amount of cash deposited in the bank
during the same period.
Test to Discover Lapping of Accounts Receivable—Lapping is postponing entries
for cash receipts to conceal an existing cash shortage. This can be easily
prevented by adequate separation of duties.
 OBJECTIVE 6
Apply the methodology for controls
over the sales and collection
cycle to controls related to
uncollectible accounts receivable.
 AUDIT TESTS FOR UNCOLLECTIBLE ACCOUNTS

Similar to sales returns and allowances, the auditor’s concern in the

write-off of uncollectible accounts is the possibility that write-offs are
used to cover up embezzlement of cash receipts.
The auditor is also concerned with the balance-related objective of the
realizable value of net accounts receivable. Two controls that address
this issue:
• The preparation of a periodic aged accounts receivable trial balance
for review and follow-up by appropriate management personnel.
• A policy of writing off uncollectible accounts when they are no longer
likely to be collected.
 OBJECTIVE 7
Understand the effect of tests of
controls and substantive tests of
transactions on substantive tests
of details of balances.
 EFFECT OF RESULTS OF TESTS OF CONTROLS AND
SUBSTANTIVE TESTS OF TRANSACTIONS

The results of the tests of controls and substantive tests of

transactions have a significant effect on the remainder of the audit.
If the test results are unsatisfactory, it will be necessary to do additional
substantive testing.
The most significant effect of the results of the tests of controls and
substantive tests of transactions in the sales and collections cycle is on
the confirmation process. The type of confirmation, the size of the
samples, and the timing are all affected.
The major accounts in the sales and collection cycle and the types
of tests are illustrated in Figure 14-7.
Extra-Explanation
 Learning Objective 10-9

Control Activities and Test of

Controls – Revenue Transactions
Assertions about Classes of Transactions and Events for the Period under Audit

All revenue and cash receipt transactions and events that have been recorded or
Occurrence
disclosed have occurred, and such transactions and events pertain to the entity.

All revenue and cash receipt transactions and events that should have been recorded
Completeness have been recorded, and all related disclosures that should have been included in the
financial statements have been included.

Authorization All revenue and cash receipt transactions and events have been properly authorized.

Amounts and other data relating to recorded revenue and cash receipt transactions and
Accuracy events have been recorded appropriately, and related disclosures have been
appropriately measured and described.

All revenue and cash receipt transactions and events have been recorded in the correct
Cutoff
accounting period.

All revenue and cash receipt transactions and events have been recorded in the proper
Classification
accounts.
All revenue and cash receipt transactions and events are appropriately aggregated or
disaggregated and clearly described, and related disclosures are relevant and
Presentation
understandable in the context of the requirements of the applicable financial reporting
framework.

Example Tests of Controls for Revenue Transactions (Table 10-6) (1 of 3)
Assertion Possible Misstatement
Occurrence Fictitious revenue
Revenue recorded, good
not shipped, or services not
performed
Goods shipped or services
Completeness performed, revenue not
recorded
A relevant and required
disclosure is omitted by
management
Example Control Activity
Segregation of duties
Sales recorded only with
approved customer order and
shipping document
Accounting for numerical
sequences of sales invoices
Monthly customer statements;
complaints handled
independently
Accounting for numerical
sequences of shipping
documents and sales invoices
Shipping documents matched
to sales invoices
Sales invoices reconciled to
daily sales report
An open-order file that is
maintained currently and
reviewed periodically
Disclosure Checklist
Learning Objective 10-9
Example Test of Controls
Observation and evaluation of proper segregation
of duties.
Testing of a sample of sales invoices for the
presence of authorized customer order and
shipping document; if IT application, examination
of application control.
Review and testing of client procedures for
accounting for numerical sequence of sales
invoices; if IT application, examination of
application controls.
Review and testing of client procedures for
mailing and handling complaints about monthly
statements.
Review and testing of client’s procedures for
accounting for numerical sequence of shipping
documents and sales invoices; if IT application,
examination of application controls.
Tracing of sample of shipping documents to their
respective sales invoices and to the sales journal.
Testing of a sample of daily reconciliations.
Examination of the open-order file for unfilled
orders.
Review Financial Statement Disclosure Checklist

Example Tests of Controls for Revenue Transactions (Table 10-6) (2 of 3)
Assertion Possible Misstatement
Goods shipped or services
Authorization performed for a customer who
is a bad credit risk
Shipments made or services
performed at unauthorized
prices or on unauthorized
terms
Revenue transaction recorded
Accuracy
at an incorrect dollar amount
Revenue transaction not
posted correctly to the sales
journal, customer’s accounts
in accounts receivable
subsidiary ledger or general
journal
Example Control Activity
Proper procedures for
authorizing credit and
shipment of goods
Authorized price list and
specified terms of trade
Authorized price list and
specified terms of trade
Each sales invoice agreed to
shipping document and
customer order for product
type and quantity;
mathematical accuracy of
sales invoice verified
Sales invoices reconciled to
daily sales report
Daily Posting to sales journal
reconciled with posting to
subsidiary ledger
Subsidiary ledger reconciled
to general ledger control
account
Learning Objective 10-9
Example Test of Controls
Review of client’s procedures for granting credit.
Examination of sales orders for evidence of proper
credit approval; if IT application, examination of
application controls for credit limits.
Comparison of prices and terms on sales invoices
to authorized price list and terms of trade; if IT
application, examination of application controls for
authorized prices and terms.
Same as below.
Examination of sales invoice for evidence that
client personnel verified mathematical accuracy.
Recomputation of the information on a sample of
sales invoices; if IT application, examination of
application controls and consideration of use of
computer-assisted audit techniques.
Examination of reconciliation of sales invoices to
daily sales report.
Examination of reconciliation of entries to sales
journal with entries to subsidiary ledger.
Review of reconciliation of subsidiary ledger to
general ledger control account.
 Learning Objective 10-9

Example Tests of Controls for Revenue Transactions (Table 10-6) (3 of 3)

Assertion Possible Misstatement Example Control Activity Example Test of Controls
Revenue transactions All shipping documents
Comparison of the dates on sales invoices with
Cutoff recorded in the wrong forwarded to the billing
the dates of the relevant shipping documents.
period function daily
Comparison of the dates on sales invoices with
Daily billing of goods shipped the dates they were recorded in the sales
journal.

Revenue transaction not Review of sales journal and general ledger for
Classification Chart of accounts
properly classified proper classification.

Examination of sales invoices for proper

Proper codes for different types
classification; if IT application, testing of
of products or services
application controls for proper codes.
Review Sales Journal and General Ledger for
Revenue transactions not
proper aggregation and disaggregation of
Presentation properly presented and Chart of accounts
revenue transactions, and determine if
disclosed
disclosure is needed.
Examination of sales invoices for proper
aggregation and disaggregation; if IT
application, testing of application controls for
proper codes.

Review disclosure checklist and related

disclosures for relevance and completeness.

Example Tests of Controls for Cash Receipts Transactions (Table 10-7)
(1 of 3)
Assertion Possible Misstatement Example Control Activity
Cash receipts recorded but not
Occurrence Segregation of duties
received or deposited
Use of lockbox system
Monthly bank reconciliations
prepared and independently
reviewed
Cash receipts stolen or lost Same control procedures as
Completeness
before recording above
Checks restrictively
endorsed when received and
daily cash list prepared
Daily cash receipts
reconciled with posting to
accounts receivable
subsidiary ledger
Customer statements
prepared on a regular basis;
complaints handled
independently
Cash discounts not properly Procedures specifying
Authorization
taken policies for cash discounts
Learning Objective 10-9
Example Test of Controls
Observation and evaluation of
proper segregation of duties.
Inquiry of management about
lockbox policy.
Review of monthly bank
reconciliation for indication of
independent review.
Same tests of controls as above.
Observation of the endorsement of
checks.
Testing of the reconciliation of
daily cash receipt with posting to
accounts receivable subsidiary
ledger.
Inquiry of client personnel about
handling of monthly statements
and examination of resolution of
complaint.
Testing of sample of cash receipts
transactions for proper cash
discounts.

Example Tests of Controls for Cash Receipts Transactions (Table 10-7)
(2 of 3)
Assertion Possible Misstatement
Cash receipts recorded at
Accuracy
incorrect amount
Cash receipts properly
posted to cash receipts
journal, account receivable
subsidiary ledger, and
general ledger accounts
Cash receipts recorded in
Cutoff
wrong period
Learning Objective 10-9
Example Control Activity Example Test of Controls
Daily remittance report
Review and testing of
reconciled to control listing of
reconciliation.
remittance advices
Monthly bank statement Examination of monthly bank
reconciled and independently reconciliation for independent
reviewed review.
Review and testing of
Daily remittance report
reconciliation; if IT application,
reconciled daily with postings to
testing of application controls for
cash receipts journal and
posting.
accounts receivable subsidiary
ledger
Review of posting from cash
Monthly cash receipts journal
receipts journal to the general
agreed to general ledger posting
ledger.
Examination of reconciliation of
Account receivable subsidiary
accounts receivable subsidiary
ledger reconciled to general
ledger to general ledger control
ledger control account
account.
Use of a lockbox system or a
Examination of cash receipts for
control procedure to deposit
daily deposit.
cash receipts daily
 Learning Objective 10-9

Example Tests of Controls for Cash Receipts Transactions (Table 10-7)

(3 of 3)

Assertion Possible Misstatement Example Control Activity Example Test of Controls

Tracing of cash receipts from listing
Cash receipts recorded in to cash receipts journal for proper
Classification wrong financial statement Chart of accounts classification.
account Review of cash receipts journal for
unusual items.
Presentation would not
normally be a relevant
Presentation
assertion for cash receipt
transactions