audit of sales and collection cycle

audit of the sales and collectioncycle: tests of

controls and substantive tests of transactions
auditors perform both tests of controls and tests of
transactions and balances. as a means of securing
assurance from the clients system of control, it is
important for the auditors to know when they
should rely extensively on internal controls and
when they should not. This chapter studies
assessing control risk and designing tests of
controls and substantive tests of transactions for
each of the classes of transactions in the sales and
collection cycle. in the second part of the chapter,
discussions on designing of tests of account
balances are included.
before studying the process of assessing control
risk and designing tests of controls and substantive
tests of transactions for each class of transactions, it
is important to know the sales and collection cycle
classes of transactions and account balances. it is
also important to understand the typical documents
and records used in the cycle.i. accounts and
classes of transactions in the sales and
collection cycle the overall objective in the audit of
the sales and collection cycle is to evaluate whether
the account balances affected by the cycles are
fairly presented in accordance with gaap.
accounts in the sales and collection cycle includes-
sales, a/receivable, cash in bank, cash discounts
taken,allowance for uncollectible accounts, and bad
debtexpense
classes of transactions in the sales and
collection cycle are – sales (cash and sales on
account), cash receipts, sales returns and
allowances,charge-off of uncollectible accounts
and estimate of bad debt expense.
ii. business functions in the cycle and related
documents and records the sales and collection
cycle involves the decisions and processes
necessary for the transfer of the ownership of
goods and services to customers after they are
made available for sale. it begins with a request by
a customer and ends with the conversion of
material or service into an account receivable, and
ultimately into cash.
there are various business functions for sales and
collection cycle. they occur in every business in the
recording of the fiveclasses of transactions.
below you will find summary discussions of the
classes of transactions, accounts, business
functions, and related documents and records for
the sales and collection cycle.
1. sales transaction
accounts
 sales
 accounts receivable
business functions
 processing customer orders, - customer
places an order
using customer order document.
o this is often followed by the issuance of sales
order.
 granting credit- a properly authorized person
must approve
credit to the customer for sales on account.
o minimizes the possibility of bad debts.
o it may be a programmed approval- based on
preapproved
credit limit maintained in a customer master file.
 shipping goods
o a point at which most companies recognize
sale.
o a shipping document is prepared.
o the shipping document may be a multicopy
bill of lading.
o update perpetual inventory record.
 billing customers and recording sales-
billing is a means by
which the customer is informed of the amount due
for the
goods.
o all shipments should be billed and no
shipment should be
billed more than once.
o billing should consider authorized price,
quantity shipped
and other terms.
2

o done with multicopy sales invoice and

simultaneously
updating of the sales transaction file, accounts
receivable
master file, and the general ledger master file for
sales
and accounts receivable.
documents and records
 customer order- a request for merchandise
by a customer.
o it may be received in differing formats.
 sales order- used to communicate the
description, quantity
and related specification of goods ordered.
o often used to indicate credit approval and
authorization
for shipment.
 shipping document- a document prepared to
initiate shipment
of goods.
o prepared in at lease in three copies –
customer, accounts,
retained
 sales invoice-a document indicating the
description and
quantity of goods sold the price, freight charges,
insurance,
terms, and other relevant data.
o prepared in at least three copies.
 sales transaction file- a computer generated
file that includes
all sales transactions processed by the accounting
system for a
period.
o it includes all information entered into the
system and
information for each transaction- customer name,
date,
amount, account classifications, sales person, and
commission rate.
o the file may include returns and allowances if
separate
files are not kept for those transactions.
o the information in this file is used for a variety
of records,
listing, or reports- e.g. sales journal, a/r master file,
and
transactions for certain account balance or division.
 sales journal or listing- a report generated
from the sales
transaction file that typically includes the customer
name, date,
amount, and account classification or
classifications for each
transaction, such as division or product line.
o it also identifies whether the sale was for cash
or credit.
 accounts receivable master file- a file used
to record
individual sales, cash receipts, and sales returns and
allowances
for each customer and to maintain customer
account balances.
o the master file is updated from the sales, sales
returns
and allowances, and cash receipts computer
transaction
files.
o it is also called the a/r subsidiary ledger or
subledger
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 accounts receivable trial balance- a list of

the amounts
owed by each customer at a point in time.
o this is prepared directly from the a/r master
file.
o it is often an aged trial balance.
 monthly statements- a document sent by
mail or electronically
to each customer indicating the beginning balance
of a/r, the
amount and due date of each sale, cash payments
received,
credit memos issued, and the ending balance due.
2. cash receipts transaction
accounts
 cash in bank (debits from cash receipts)
 accounts receivable
business functions
 processing and recording cash receipts-
includes receiving,
depositing and recording cash- currency & checks.
o the possibility of theft is the most important
concern
(both before and after recorded).
o all cash receipts must be deposited intact and
recorded in
the cash receipts transaction file.
o remittance advices are important for this
purpose.
documents and records
 remittance advice- a document that
accompanies the sales
invoice mailed to the customer and can be returned
to the seller
with the cash payment.
o if no remittance advices are received the
person opening
the mail should prepare it.
o used to permit the immediate deposit of cash
& to
improve control over custody of assets.
 prelisting of cash receipts- a list prepared
when cash is
received by someone who has no responsibility for
recording
sales, a/r, or cash and who has no access to
accounting records.
o it is used for verifying whether cash received
was
recorded and deposited.
 cash receipts transaction file- a computer
generated file that
includes all cash receipts transactions processed by
the
accounting system for a period.
o used to prepare the cash receipts journal and
update the
a/r and general ledger master files.
 cash receipts journal or listing- a report
generated from the
cash receipts transaction file that includes all
transactions for
any time period.
4

3. sales returns and allowances

transaction
accounts
 sales returns and allowances
 accounts receivable
business functions
 processing and recording sales returns and
allowances
o when a customer is dissatisfied with the
goods, the seller
often accepts the returned goods or grants a
reduction in
the charges.
o it is necessary to issue a receiving report and
return the
goods to store.
o record the transaction promptly and accurately
on the
sales and returns journal & a/r master file.
o as an aid for control & to facilitate recording
credit
memos are issued.
documents and records
 credit memo- a document indicating a
reduction in the amount
due from a customer because of returned goods and
allowances
granted.
 sales returns and allowances journal- a
journal used to
record sales returns and allowances.
o sales journal can be used instead.
4. charge-off of uncollectible accounts
transaction
accounts
 accounts receivable
 allowance for uncollectible accounts
business functions
 charging off uncollectible accounts
receivable
o when the company concludes that an amount
is no longer
collectible, it must be charged off- e.g. if a
customer
becomes bankrupt.
o necessary adjusting entries are made.
documents and records
5

 uncollectible account authorization form- a

document used
initially to indicate authority to write an account
receivable off
as uncollectible.
 general journal
5. bad debt expense transaction
accounts
 bad debt expense
 allowance for uncollectible accounts
business functions
 providing for bad debts
o the provision should be sufficient to allow for
the current
period sales that the company will be unable to
collect in
the future.
o allowance method is used.
documents and records
 general journal
iii. methodology for designing tests
of controls and substantive tests
transactions for sales
understanding internal controls- sales
 typical approach- auditor prepares an
internal control
questionnaire, and performs walk-through tests of
sales
assess planned control risk- sales
information obtained in understanding internal
control is used to
assess control risk.
there are four essential steps:
1. the auditor needs a framework for assessing
control risk. the
framework for all classes of transactions is the six
transaction-
related audit objectives.
2. identify the key internal controls and weaknesses
for sales.
3. associate the controls and weaknesses identified
with the
objectives.
4. assess the control risk for each objective by
evaluating the
controls and weaknesses for each objective.
step four is critical because it affects the auditor’s
decisions about
both tests of controls and substantive tests. it is a
highly subjective
decision.
6

the following are key control points auditors will

consider in
their evaluation of the internal control system of
the client.
adequate separation of duties
 person responsible for inputting sales and
cash receipts
transaction information into the computer vs.
person having
access to cash.
 credit granting function vs. the sales
function (to minimize the
sales people tendency to optimize volume even at
the expense of
high bad debt write-offs).
 personnel responsible for doing internal
comparisons vs. those
entering the original data. (e.g. comparison of batch
control
totals with summary reports and comparison of a/r
master file
totals with the gl balance should be done by
someone
independent of those who input sales & cash
receipt
transactions).
proper authorization
three key points of authorization
 credit must be properly authorized before
sales takes place,
 goods should be shipped only after proper
authorization, and
 price, including freight and discount, must
be properly
approved- to ensure sales is billed at the price set
by co policy
adequate documents and records
 documents and records used must be
adequate.
 should contain sufficient information.
 most companies automatically prepare a
multi-copy
prenumbered sales invoice at the time the customer
places an
order. –useful for minimizing the chance of failure
to bill the
customer if all invoices are accounted for
periodically.
prenumbered documents
 use of prenumbered documented prevents
both the failure to
bill or record sales and the occurrence of duplicate
billings and
recordings.
 all should be properly accounted for.
e.g. filing, by a billing clerk, of a copy of all
shipping documents
in sequential order after each shipment is billed,
with someone
else periodically accounting for all numbers and
investigating
the reason for any missing documents.
monthly statements
 sent by someone having no responsibility for
handling cash or
preparing the sales and a/r records.
 encourages response from customers if the
balance is
improperly stated.
7

 all disagreements about the balance in the

account should be
directed to the independent designated official.
internal verification procedure
 for fulfilling the each of the six transactions
related audit
objectives, a computer program or an independent
person check
the processing and recording of sales. e.g.
accounting for
numerical sequence of prenumbered documents,
 checking the accuracy of document
preparation.
 reviewing reports for unusual or incorrect
items.
i) design tests of controls for sales
for each control the auditor plans to rely onto
reduce assessed
control risk, one or more tests of controls must be
designed to verify
its effectiveness.
the nature of the tests of controls is determined
from the nature of
the control.
carefully read the illustration attached in the
material (table 13-2).
ii) designing substantive tests of transactions for
sales
in designing substantive tests of transactions, some
procedures are
commonly used on every audit regardless of the
circumstances of
tests, where as others are dependent on the
adequacy of the controls
and the results of the tests of controls
 the audit procedures are affected by the
internal controls and
tests of controls for that objective.
 materiality and results of the prior year
affect the procedures
used.
the typical substantive tests of transactions are
shown in the table
provided above. (table 13-2). below you will find
additional
procedures to be performed in relation to the
transaction related
audit objectives.
recorded sales exist
for this objective, the auditor is concerned with the
possibility of
three types of misstatements.
 sales being included in the journals for
which no shipment was
made,
 sales recorded more than once, and
 shipments being made to nonexistent
customers and recorded
as sales
 many auditors do substantive tests of
transactions for
existence objective depend on where the auditor
believes
8

the misstatements are likely to take place. the test

will be
done only if they believe that a control weakness
exists.
recorded sales for which there was no shipment
 trace selected entries from the sales journal
to make sure that
related copies of the shipping and other supporting
documents
exist.
 if the possibility of fictitious duplicate copy
of a shipping
document, trace amounts to the perpetual inventory
records.
 trace the credit in the a/r master file to its
source- if collected
or goods returned, there must originally have been
a sale. if
credited for bad debt or if the account was still
unpaid, intensive
follow-up by examining shipping docs and
customer order docs.
sales recorded more than once
 duplicate sales can be determined by
reviewing a numerically
sorted list of recorded sales transactions for
duplicate numbers.
 also test proper cancellation of shipping
documents.
shipment made to nonexistent customers
 can occur only when the person recording
sales is also in a
position to authorize shipments.
 if controls are weak, it is difficult to detect.
existing sales transactions are recorded
 normally, substantive test
for completeness is less
emphasized.
 but if controls are
inadequate, which is likely if the client
does no independent internal tracing from shipping
documents to
the sales journal, substantive testes are necessary.
 test for unbilled shipments to
trace selected
shipping documents from a file in the shipping
department
to related duplicate sales invoices and the sales
journal.
direction of testing

tracing from source documents to the
journals- a test for omitted transactions-
completeness objective…
likely starting point could be a shipping doc…a
sample selected
and traced to sales invoices and sales journal.

tracing from the journals back to source
documents- a test for nonexistent transactions-
existence
objective….likely starting point could be the
journal… a sample of
invoice numbers is selected from the journals and
traced to
duplicate sales invoices, shipping docs, and
customer orders.
sales are accurately recorded
accurate recording of sales - shipping the amount
of goods ordered,
accurate billing for the amount of goods shipped,
and accurately
recording the amount billed.
9

typical substantive tests include: re computing

information in the
accounting records
 start with entries in the sales journal to
compare the total of
selected transactions with a/r master file entries &
duplicate
sales invoices.
 compare prices on the duplicate sales
invoices with an
approved price list,
 re compute extensions and footings
 compare details listed on the invoices with
shipping records for
description, quantity, and customer identification
 when sales invoices are
automatically calculated and
posted by a computer, the auditor may be able to
reduce
substantive tests of transactions for the accuracy
objective.
 if the auditor determines
that the computer is
programmed accurately and the price list master
file is authorized
and correct, detailed invoice calculations can be
reduced or
eliminated. in this case, the focus will be on
determining if
effective computer controls exist.
recorded sales are properly classified
 sales of cash vs. credit sales
 exclude sales of operating assets such as
machinery
 use of more than one sales classification…..
regular,
installment…
sales are recorded on the correct dates
 sales should be billed and recorded as soon
after shipment
takes place as possible to prevent the unintentional
omission of
transactions from the records and to make sure that
sales are
recorded in the proper period.
 compare the date on selected bills of lading
or other shipping
documents with the date on the related duplicate
sales invoices,
the sales journal, and the a/r master file.
sales transactions are properly included in the
master file and correctly summarized
 needed b/se the accuracy of these records
affect’s the client’s
ability to collect outstanding receivables.
 the sales journal must be correctly totaled
and posted to the gl
 perform clerical accuracy tests such as
footing the journals and
tracing the totals and details to the gl and the
master file to
check whether there are misstatements.
 the distinction between
posting and summarization and
other transaction related audit objectives is that
posting and
summarization includes footing journals, master
file records, and
ledgers and tracing from one to the other among
these three.
10

 when footing and comparisons are restricted

to these three
records, the process is posting and summarization
 in contrast, accuracy involves determining
the monetary
correctness of transactions and comparing amounts
b/n docs
or with journals and master file records.
sales returns and allowances
the transaction-related audit objectives and the
client’s methods of
controlling misstatements are essentially the same
for processing
credit memos as those described for sales.
but two important differences:
 materiality, and
 emphasis on audit objectives- primary
emphasis is normally on
testing the existence of recorded transactions as a
means of
uncovering any diversion of cash from collection of
a/r that has
been covered up by a fictitious sales return or
allowance.
 completeness objective is important especially
at year-end.
unrecorded sr/a can be material… overstates net
income if
unrecognized.
iv. methodology for designing tests of
controls and substantive tests of
transactions for cash receipts
the same methodology used for designing tests of
controls and
substantive tests of transactions for sales is used for
cash receipts.
 cash receipts tests of controls and
substantive tests of
transactions audit procedures are developed around
the same
framework used for sales.
 key internal controls for each objective
are determined, tests of
controls are developed for each control, and
substantive tests of
transactions for the monetary misstatements related
to each
objective are developed.
 the tests of controls depend on the
controls the auditor has
identified and the extent they will be relied on to
reduce assessed
control risk.
in the table 13-3 (attached) you will find examples
of key controls,
common tests of controls, and common substantive
tests of
transactions to satisfy each of the transaction-
related audit objectives
for cash receipts.
11

 an essential part of the auditor’s

responsibility in auditing cash
receipts is identification of weaknesses in internal
control that
increase the likelihood of fraud.
determine whether cash received was recorded
it is difficult to detect a cash fraud occurred before
the cash is
recorded in the cash receipt journal or other cash
listing.
 internal controls designed to satisfy
completeness objective are
important.
 trace from prenumbered remittance advices
or prelists of cash
receipts to the cash receipt journal and subsidiary
a/r records
as a substantive tests of the recording of the actual
cash
received… effective only if a cash register tape or
some other
prelisting was prepared at the time cash was
received
prepare proof of cash
 a useful audit procedure to test whether all
recorded cash
receipts have been deposited in the bank account.
 total cash receipts recorded in the journal vs.
actual deposits
made during the month…
 helps to detect recorded cash receipts that
haven’t been
deposited, unrecorded deposits, unrecorded loans,
bank loan
deposited directly into the bank account etc.
 can not help to detect cash receipts that have
not been
recorded in the journals or time lags in making
deposits.
 performed only when controls are weak.
test to discover lapping of a/r
lapping of a/r is the postponement of entries for the
collection of
receivables to conceal an existing cash shortage.
 the defalcation is perpetrated by a person
who handles cash
receipts and then enters them into the computer
system.
 involves differing recording the cash
receipts from one
customer and covers the shortage with receipts of
another. this
in turn is covered from the receipts of a third
customer few days
later.
 prevention…. separate duties and mandatory
vacation policy
for employees who both handle cash and enter cash
receipts
into the system.
 detection… compare the name, amount, and
dates shown on
remittance advices with cash receipts journal
entries and
related duplicate deposit slips.

v. methodology for designing tests of
details of balances
12
the methodology that auditors follow in designing
the appropriate
tests of details of balances for accounts receivable
involves some
major steps summarized in figure 2.1 below. these
steps and related
audit work and decision involves various audit
activities performed
and decisions made in the evidence planning phase
of the audit,
materiality and risk considerations and tests of
controls and
substantive tests of transactions discussed in this
chapter of the
material.
deciding the appropriate tests of details of balances
evidence is
complicated because it must be decided on an
objective-by-objective
basis, and there are several interactions that affect
the evidence
decision.
for example, the auditor must consider inherent
risk, which may
differ by objective, and results of substantive tests
of sales and cash
receipts, which also may vary by objective. the
auditor must also
consider the results of tests of controls and the
related control risk
assessment.
in designing tests of details of balances for
accounts receivable, it is
essential to satisfy each of the nine balance-related
audit objectives.
 existence
 completeness
 accuracy
 classification
 cutoff
 realizable value
 rights and obligations
 presentation and disclosure
figure 2.1: designing tests of details of balances
identify client business risks
affecting accounts receivable.
set tolerable misstatement
and assess inherent risk
for accounts receivable.
assess control risk for sales
and collection cycle.
13

design and perform tests of

controls and substantive tests
of transactions for sales and
collection cycle.
design and perform analytical
procedures for accounts
receivable balance.
design tests of details of
audit
proced
ures
accounts receivable balance
sample
size
to satisfy balance-related
items
to
select
audit objectives. timing
important points on the designing tests of details of
balances (figure
2.1) are discussed below.
identify client business risks affecting accounts
receivable
tests of a/r are based on auditors understanding of
the client’s
business and industry.
 as
part of this understanding,
o the auditor studies the client’s industry and
external
environment and evaluates management objectives
and
business processes to identify significant business
risks
that could affect the fss including a/rs
o perform preliminary analytical procedures
that may
indicate increased risk of misstatement in a/r.
 cli
ent’s business risk affecting a/r is
considered in the auditor’s evaluation of inherent
risk and
planned evidence for a/r
set tolerable misstatement and assess inherent risk
for accounts receivable
14

 set preliminary judgment about materiality

set for the entire fs
and then allocated to each significant balance sheet
accounts,
including a/r… tolerable misstatement
 a/r is one of the most material accounts in
the fs for companies
that sell on credit.
 inherent risk is assessed for each objective
for an account such
as a/r considering the client’s business risk and the
nature of the
client and industry.
 for most audits, inherent risk for a/r is
moderate or low except
for two objectives:
 a/r is stated at net realizable
value- due to
judgment involved & intentional misstatement and
 sales and sales return &
allowance cutoff is correct-
due to possibility of misstatement.
assess control risk for sales and collection cycle
 as a means to good relations with
customers, mgt is concerned
with keeping accurate records….hence may have
good internal
control over sales & cash receipts & a/r
areas of concern:
 controls that prevent or detect defalcations
 controls over cutoff, and
 controls related to allowance for
uncollectible accounts
(e.g. approval of credit before shipment)
 the auditor must
relate control risk for transaction-
related audit objective to balance-related audit
objectives in
deciding planned detection risk and planned
evidence for tests of
details of balances.
example: assume that the auditor concluded that
control risk for
both sales and cash receipts transactions is low for
the accuracy
transaction-related audit objective. the auditor can
therefore
conclude that controls for the accuracy balance-
related audit
objectives for a/r are effective b/se the only
transactions
affecting a/r are sales and cash receipts.
if sales return and allowances & charge-off of
uncollectible a/r
are significant, assessed cr must also be considered
for these
classes of transactions.
important point on the relationships:
 for sales, the existence transaction-related
audit objective
affects the existence balance-related audit
objective, but for
cash receipts the existence transaction-related audit
objective
affects the completeness balance-related audit
objective.
15

 three a/r balance-related audit objectives are

not affected by
assessed control risk for classes of transaction---
realizable
value, rights & presentation and disclosure.
to reduce assessed control risk below maximum for
these three
objectives, separate controls are identified and
tested.
design and perform tests of controls and
substantive
tests of transactions
 the results of the tests of
controls determine whether
assessed control risk for sales and cash receipts
needs to be
revised.
 the results of the
substantive tests of transactions are
used to determine the extent to which planned
detection risk is
satisfied for each accounts receivable balance-
related audit
objective.
design and perform analytical procedures
 most analytical procedures (ap)
performed during the detailed
testing phase are done after the balance sheet date
but before
tests of details of balances --- since all the
transactions are to be in
the record.
 aps are done for the entire sales and
collection cycle, not only
for a/r.---due to close r/n ship among accounts.
 when aps in the sales and collection
cycle uncover unusual
fluctuations, the auditor should make additional
inquiries of
management.
 mgt’s response should be critically
evaluated for adequacy of
the explanation and whether they are supported by
other
corroborative evidence.
in addition to aps,
 review a/r for large and unusual amounts
 individual receivables that deserve special
attention are
large balances, accounts that have been outstanding
for a
long time, receivables from affiliated companies,
officers,
directors, and other related parties, and creditors.
common examples of ap
compare:
 gross margin percentage with previous years
 sales by month over time
 sales returns and allowances as a percentage
of gross sales
with previous years (by product line)
16

 individual customer balances over a stated

amount with
previous years
 bad debt expense as a percentage of gross
sales with
previous years
 days that accounts receivable are
outstanding with previous
years
 aging category as a percentage of
receivables with previous
years
 allowance for uncollectible accounts as a
percentage of
accounts receivable with previous years
 charge-off of uncollectible accounts as a
percentage of total
accounts receivable with previous years
design and perform tests of details of accounts
receivable balance
 tests of details of balances for all cycles are
directed to balance
sheet accounts, but income statement accounts are
not ignored
because they are verified as a by-product of the
balance sheet
accounts.
 for designing tests of details of balances, the
auditor needs to
decide on planned detection risk.
 basically, this decision is a result of
combined consideration of
various factors such as the acceptable audit risk,
inherent risk,
control risk, substantive tests of transactions and
analytical
procedures decision made until this phase of the
audit.
 planned detection risk for each objective is,
finally, an auditor
decision, decided by subjectively combining the
conclusions
reached about each of the factors.
 audit procedures selected and their sample
size depends heavily
on whether planned evidence for a given objective
is low,
medium, or high.
 confirmation of a/r is the most important test
of details of a/r.
designing specific audit procedures and timing of
decisions for accounts receivable (refer the attached
table15-4 and table 15-5)
i) accounts receivable are correctly added and agree
with the master file and the general ledger
 an aged trial balance is a listing
of the balances in the a/r
master file at balance sheet date.
 test information on the aged
trial balance for a detail tie-
in.
17

 test information on the aged

trial balance must done
before any other tests to assure the auditor that the
population
being tested agrees with the gl and a/r master file.
 must be test footed, and total
on the trial balance be
compared with the gl.
 trace individual balances to
supporting documents such
as sales invoices to verify customer’s name,
balance, and proper
aging.
 sample size depends on no. of
a/cs, degree of tests done
in previous phases of the audit, degree of
independent
verification.
 audit software can be helpful-
footing, cross-footing, &
recalculating the aging.
ii) recorded accounts receivable exist
 confirmation is the most important
test of details of
balances.
 if no customer response, examine
supporting documents to
verify the shipment of goods and evidence of
subsequent cash
collection--- alternative evidence for nonresponse.
iii) existing accounts receivable are included
 difficult to test account balance
omitted from the aged trial
balance unless comparison with the controlling
account (gl)
reveals it.
 if all sales to a customer are omitted
from the sales journal,
the understatement of a/r is almost impossible to
uncover by
tests of details of balances.
 the understatement of sales and a/r is
best uncovered by
substantive tests of transactions for shipments
made but not
recorded and by analytical procedures.
iv) accounts receivable are accurate
 confirm selected accounts.
 for nonresponses perform alternative
procedures.
 test debits and credits to individual
customer’s balances by
examining supporting documents for shipment and
cash
receipts.
v) accounts receivable are properly classified
 review the aged trial balance for
material receivables from
affiliates, officers, directors, and other related
parties.
 review for any nontrade receivables.
 ensure that notes receivables or
accounts that should not be
classified as current asset are segregated from the
regular
accounts.
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 if credit balances in a/r are

significant, reclassify it as
accounts payable.
vi) cutoff for accounts receivable is correct
 cutoff misstatements exist when
current period transactions
are recorded in the subsequent period or subsequent
period
transactions are recorded in the current period.
 objective of the test is to verify
whether transactions near
the end of the accounting period are recorded in the
proper
period.
 cutoff errors affect current period
income.
 in determining appropriate cutoff
a) decide on the appropriate criteria for cutoff
b) evaluate whether the client has established
adequate
procedures to ensure a reasonable cutoff, and
c) test whether a reasonable cutoff was obtained.
 sales cutoff
 sales return and allowance cutoff
 cash receipts cutoff
vii) accounts receivable is stated at realizable value
 gaap requires that a/r be stated at the amount
that ultimately
be collected-gross receivable less allowance for
uncollectible
accounts.
 the auditor should evaluate whether the
allowance is
reasonable.
 for evaluation, they prepare an audit
schedule that analyses the
allowance for uncollectible accounts.
 start with review of the results of the tests of
controls that are
concerned with the client’s credit policy.
 if the policy is unchanged and results of the
tests of the credit
policy and credit approval are consistent with the
preceding
year, the change in the balance must reflect only
changes in
economic conditions and sales volume.
 carefully examine the noncurrent accounts
on the aged trial
balance to determine which ones haven’t been paid
subsequent
to balance sheet date.
 then, compare the size and age of unpaid
balances with similar
information from previous years to evaluate
whether the amount
of noncurrent receivable is increasing or decreasing
over time.
 examination of credit files.
 discussion with the credit manager.
 review of the client’s correspondence files.
viii) the client has rights to accounts receivable
to uncover instances in which the client has limited
rights to
receivables (as a result of pledging, assignment,
factoring,
discounting…), auditors,
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 review minutes.
 discuss with the client.
 confirm with the bank.
 examine debt contracts for evidence of a/r
pledged as
collateral, and
 examine correspondence files.
ix) accounts receivable presentation and disclosures
are
proper
 the auditor must decide whether the client
has properly
combined the amounts and disclosed related party
information
in the statements.
 to evaluate adequacy of presentation and
disclosure, auditors
need thorough understanding of gaap.
 decide whether material amounts requiring
separate disclosure
have actually been separated.
e.g. receivable from officers and affiliated
companies
 evaluate adequacy of the footnotes.
e.g. information about pledging, discounting,
factoring,
assignment of a/r, and amount due from related
parties.
confirmation of accounts receivable
balance
 primary audit procedure for testing
existence, accuracy and
cutoff.
 addresses 5 of the 8 balance-related audit
objectives (not
classification, realizable value, and presentation &
disclosure).
 expensive audit procedure – auditor and
client time – but highly
reliable evidence.
 required procedure in normal circumstances.
exceptions to sending a/r confirmations
1. accounts receivable are immaterial.
2. the auditor considers confirmations ineffective
evidence
because response rates will likely be inadequate or
unreliable.
3. the combined level of inherent risk and control
risk is low
and other substantive evidence can be accumulated
to provide
sufficient evidence.
type of confirmation
 positive
confirmation – confirm the printed
balance on the confirmation.
 blank
confirmation form – requests customer to
fill in balance amount on the confirmation.
 invoice
confirmation – confirm one or more
invoices instead of the total balance.
20
audit of the sales and collection
cycle: tests of controls and
substantive tests of transactions
auditors perform both tests of controls and tests of
transactions and
balances. as a means of securing assurance from
the clients system of
control, it is important for the auditors to know
when they should rely
extensively on internal controls and when they
should not. this
chapter studies assessing control risk and designing
tests of controls
and substantive tests of transactions for each of the
classes of
transactions in the sales and collection cycle. in the
second part of the
chapter, discussions on designing of tests of
account balances are
included.
before studying the process of assessing control
risk and designing
tests of controls and substantive tests of
transactions for each class of
transactions, it is important to know the sales and
collection cycle
classes of transactions and account balances. it is
also important to
understand the typical documents and records used
in the cycle.
 i. accounts and classes of
transactions in the sales and
collection cycle
the overall objective in the audit of the sales and
collection cycle is to
evaluate whether the account balances affected by
the cycles are
fairly presented in accordance with gaap.
 accounts in the sales and collection cycle
includes-
sales, a/receivable, cash in bank, cash discounts
taken,
allowance for uncollectible accounts, and bad debt
expense
 classes of transactions in the sales and
collection cycle are – sales (cash and sales on
account), cash receipts, sales returns and
allowances,
charge-off of uncollectible accounts and estimate
of bad
debt expense.
1