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AUDIT OF THE

SALES AND
COLLECTION CYCLE:
TESTS OF CONTROLS
AND SUBSTANTIVE TESTS
OF TRANSACTIONS
CHAPTER 14

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CHAPTER 14 LEARNING OBJECTIVES

14-1 Identify the accounts and the classes of transactions in the sales
and collection cycle.
14-2 Describe the business functions and the related documents and
records in the sales and collection cycle.
14-3 Understand internal control, and design and perform tests of
controls and substantive tests of transactions for sales.
14-4 Apply the methodology for controls over sales transactions to
controls over sales returns and allowances.

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CHAPTER 14 LEARNING OBJECTIVES

14-5 Understand internal control, and design and perform tests of


controls and substantive tests of transactions for cash receipts.
14-6 Apply the methodology for controls over the sales and collection
cycle to controls related to uncollectible accounts receivable.
14-7 Understand the effect of tests of controls and substantive tests
of transactions on substantive tests of details of balances.

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OBJECTIVE 14-1
Identify the accounts and the classes
of transactions in the sales and
collection cycle.

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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.

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OBJECTIVE 14-2
Describe the business functions and
the related documents and records
in the sales and collection cycle.

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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.

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OBJECTIVE 14-3
Understand internal control, and
design and perform tests of controls
and substantive tests of
transactions for sales.

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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.

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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.

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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.

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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.

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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.

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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

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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

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OBJECTIVE 14-4
Apply the methodology for controls
over sales transactions to controls
over sales returns and allowances.

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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.

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OBJECTIVE 14-5
Understand internal control, and
design and perform tests of controls
and substantive tests of transactions
for cash receipts.

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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.

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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.

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OBJECTIVE 14-6
Apply the methodology for controls
over the sales and collection
cycle to controls related to
uncollectible accounts receivable.

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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.

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OBJECTIVE 14-7
Understand the effect of tests of
controls and substantive tests of
transactions on substantive tests
of details of balances.

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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.

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