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TOPIC 2
AUDIT OF REVENUE CYCLE

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REVENUE RECOGNITION

Revenues
• the gross inflow of economic benefits during the period of the
ordinary activities which increase equity
•Covers revenues of interest, royalties and dividends
•Fair value (arms-length transactions)
•Certain conditions must be met such as transfer of risk, rewards
or ownership for sale of goods and reliability or outcome.
•Then cash will be exchanged depends on time (short or long)

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OVERVIEW OF THE REVENUE CYCLE

 The "cradle to grave" cycle for revenue begins with an

order from a customer, proceeds to the exchange of
goods or services for a promise to pay, and ends with
the payment of cash.

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TYPES OF TRANSACTIONS

 The sale of goods or rendering a service for cash or

credit.
 The receipt of cash from the customer in payment
for the goods or services.
 The return of goods by the customer for credit or
cash.

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FINANCIAL STATEMENT ACCOUNTS

 Sales Transaction:
 Trade accounts receivable
 Sales
 Allowance for uncollectible accounts
 Bad debt expense
 Cash Receipts Transactions:
 Cash
 Trade accounts receivable
 Cash discounts
 Sales Return and Allowance Transaction:
 Sales returns
 Sales allowances
 Trade accounts receivable

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DOCUMENTS AND RECORDS

 Customer sales order  Accounts receivable
 Credit approval form subsidiary ledger
 Open-order report  Aged trial balance of
 Shipping document accounts receivable
 Sales invoice  Remittance advice
 Sales journal  Cash receipts journal
 Customer statement  Credit memorandum
 Write-off authorization

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FUNCTIONS IN THE REVENUE CYCLE

 Order entry
 Credit authorization
 Shipping
 Billing
 Cash receipts
 Accounts receivable
 General ledger

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SEGREGATION OF DUTIES

 The credit function should be segregated from the

billing function.
 The shipping function should be segregated from the
billing function.
 The accounts receivable function should be
segregated from the general ledger function.
 The cash receipts function should be segregated from
the accounts receivable function.

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INHERENT RISK ASSESSMENT

 Industry-related factors (e.g bank)

 The complexity and contentiousness of revenue
recognition issues (construction)
 The difficulty of auditing transactions and account
balances (doubtful debts)
 Misstatements detected in prior audits

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CONTROL RISK ASSESSMENT

Understanding and documenting

the revenue internal control system based
on the planned level of control risk

Planning and performing tests of controls

on revenue cycle transactions

Assessing and documenting the

control risk for the revenue cycle

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CONTROL PROCEDURES AND TESTS

OF CONTROLS - SALES RETURNS AND
ALLOWANCES TRANSACTIONS
 A credit memorandum should be approved by
someone other than the individual who initiated the
credit memorandum.
 Credits for returned goods should be supported by a
receiving document indicating that the goods have
been returned.

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RELATING THE ASSESSED LEVEL

OF CONTROL RISK TO
SUBSTANTIVE TESTING
 The results of testing of internal control for the revenue
cycle have a direct impact on detection risk and the level
of substantive testing for the accounts.
 When the results of the tests of controls support the
planned assessed level of CR, the auditor can conduct the
substantive tests at the planned level.
 If the results of the tests of controls do not support the
planned assessed level of CR, DR will have to be set
lower.

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AUDITING ACCOUNTS RECEIVABLE

AND REVENUE ACCOUNTS
 Substantive tests that are used by the auditor to
detect material misstatements in accounts
receivable and related accounts include:
 Substantive tests of transactions

 Analytical procedures

 Tests of account balances

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AUDIT OBJECTIVES FOR TESTING

ACCOUNTS RECEIVABLE
 Validity
 Completeness
 Cutoff
 Ownership
 Accuracy
 Valuation
 Classification
 Disclosure

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SUBSTANTIVE TESTS OF
TRANSACTIONS

Substantive tests of transactions are tests conducted

on the individual transactions processed through the
revenue cycle. The intended objective of such tests is
to detect monetary misstatements.

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ANALYTICAL PROCEDURES

Analytical procedures are useful audit tests for

examining the fairness of accounts such as revenue,
accounts receivable, allowance for uncollectible
accounts, bad debt expense, and sales returns and
allowances.

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ANALYTICAL PROCEDURES -
REVENUE
 Comparison of gross profit percentage by product
line with previous years and industry data.
 Comparison of reported revenue to budgeted
revenue.

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ANALYTICAL PROCEDURES -
ACCOUNTS RECEIVABLE, ALLOWANCE
FOR UNCOLLECTIBLE ACCOUNTS AND
BAD DEBT EXPENSE
 Comparison of receivables turnover and days outstanding in
accounts receivable to previous years’ and/or industry data.
 Comparison of aging categories on aged trial balance of
accounts receivable to previous years’.
 Comparison of bad-debt expense as a percentage of revenue
to previous years’ and/or industry data.
 Comparison of the allowance for uncollectible accounts as a
percentage of accounts receivable or credit sales to previous
years’ and/or industry data.
 Examination of large customer accounts individually and
comparison to previous year.

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ANALYTICAL PROCEDURES - SALES

RETURNS, ALLOWANCES, AND
COMMISSIONS
 Comparison of sales returns as a percentage of revenue
to previous years’ and/or industry data.
 Comparison of sales discounts as a percentage of revenue
to previous years’ and/or industry data.
 Estimation of sales commission expense by multiplying
net revenue by average commission rate and comparison
of recorded sales commission expense.

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THE CONFIRMATION PROCESS

Confirmation is the process of obtaining and evaluating

a direct communication from a third party in response
to a request for information about a particular item
affecting financial statement assertions.

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CONFIRMATION OF ACCOUNTS
RECEIVABLE

Confirmation of accounts receivable is considered a

generally accepted auditing procedure and there is a
presumption that the auditor will normally request
confirmation of accounts receivable during an audit.

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OMISSION OF CONFIRMATION OF
ACCOUNTS RECEIVABLE
 The accounts receivable are immaterial to the financial
statements.
 The use of confirmations would not be effective as an
audit procedure (e.g., past response rates were low or the
responses might not be reliable).
 The auditor’s assessment of IR and CR is low, and
evidence gathered from other substantive tests is sufficient
to reduce audit risk to an acceptably low level.

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RELIABILITY OF ACCOUNTS
RECEIVABLE CONFIRMATIONS
 Factors that affect the reliability of accounts
receivable confirmations:
 The type of confirmation request-+or -

 Prior experience on the client or similar

engagements-lower rate
 The intended respondent-large or small

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TYPES OF CONFIRMATIONS

 Positive -agree or not, blank, large errors and

control risk high
 Negative -control risk low, small balance, ask the
customer disagree only

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TIMING OF ACCOUNTS
RECEIVABLE CONFIRMATIONS

 Interim
 Year-end

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CONFIRMATION PROCEDURES

 Maintain control-mailed outside client office,

return undeliverable confirmations shows
fictitious customers
 Timing differences

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ALTERNATIVE PROCEDURES

 Examination of subsequent cash receipts-strong

control of recording cash receipt or not.
 Examination of customer orders, shipping
documents, and duplicate sales invoices.
 Examination of other client documentation.

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AUDITING OTHER RECEIVABLES

 Receivables from officers and employees.

 Receivables from related parties.
 Notes receivable.

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