Revenue Recognition (IAS 18)

Revenue is defined as the gross inflow of economic benefits during

the period arising in the course of the ordinary activities of an entity
when those inflows result in increases in equity, other than
increases relating to contributions from equity participants.

Overview of the Revenue Process

Cash Sale Credit Sale
Cash
Purchases collection Purchases

Inventory
Cash Account
sales receivable

Inventory
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 Types of Transactions and Financial
Statement Accounts Affected
Three types of transactions are typically processed by the revenue process:
1. The sale of goods or rendering of a service for cash or credit.
2. The receipt of cash from the customer in payment for goods or services.
3. The return of goods by the customer for credit or cash.

The revenue process affects numerous accounts in the financial

statements. The most significant accounts are:
Type of Transaction Account Affected
Sales transactions Trade accounts receivable
Sales
Allowance for uncollectible accounts
Bad-debt expense
Cash receipts transactions Cash
Trade accounts receivable
Cash discounts
Sales return and allowance Sales returns
transactions Sales allowances
Trade accounts
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 Flowchart of the Revenue Process: EarthWear Clothiers

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 Types of Documents and Records
Customer Sales Order
Contains the details of the type and quantity
of products or services ordered by the
customer and customer information.
Credit Approval Form
For credit sales, the client must have a
formal procedure for investigating the
creditworthiness of the customer.
Shipping Document
This document generally serves as a bill of
lading and contains information on the type
of product shipped, the quantity shipped and
other relevant information.
Open-Order Report
A report of all customer orders for which
processing has not been completed.
Sales Invoice
The document is used to bill the customer.
This document contains information on the
type of product or service,
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the quantity,
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Sales Journal
Once a sales invoice has been issued, the sale
needs to be recorded in the accounting records. The
sales journal is used to record information about the
sales transaction.
Customer Statement
This document is mailed to the customer and
contains details of all sales, cash receipts, and
credit memorandum transactions.
Accounts Receivable Subsidiary Ledger
This ledger contains an account and the details of
transactions for each customer.
Aged Trial Balance of Accounts Receivable
This report summarizes all the customer balances in
the accounts receivable subsidiary ledger. Each
account is classified as current or placed into one of
several past due categories.
Remittance Advice
This is usually the part of the customer’s bill that
 Types of Documents and Records
Cash Receipts Journal
Order Entry
This journal is used to record the cash
receipts of the entity. The initial function
Credit Memorandum in the revenue
process is the entry
This document is used to record of a new sales order
credits for the return of goods by a into the system.
customer.
Write-Off Authorization
This document authorizes the write-off of an
uncollectible account receivable. Final
authorization is generally received from the
treasurer.
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 Major Functions
Credit Authorization Shipping Accounts Receivable

The credit authorization All billings, adjustments,

Goods should not be and cash collections must
process must determine
that the customer is able
shipped, nor should be properly recorded in the
customers’ accounts
to pay for the goods or services be provided receivable records.
services purchased. without proper General Ledger
Failure to properly authorization. The As related to the revenue
authorize credit can lead main control is process, the general ledger
function must ensure that
to extensive bad debts for payment or proper all revenues, collections,
the entity. credit authorization. and receivables are
properly recorded and
classified.
Billing Cash Receipts
The objective of proper billing is to ensure that all goods All cash collected must be
shipped and all services rendered are billed to the customer. properly identified and
promptly deposited intact
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 Major Functions
Functions of the Purchasing Process

Order entry Acceptance of customer orders for goods and services into
the system in accordance with management criteria.
Appropriate approval of customer orders for
Credit authorization
creditworthiness.
Shipping Shipping of goods that has been authorized.
Issuance of sales invoices to customers for goods shipped
Billing or services provided; also, processing of billing
adjustments for allowances, discounts, and returns.
Cash receipts Processing of the receipt of cash from customers.
Recording of all sales invoices, collections, and credit
Accounts receivable
memoranda in individual customer accounts.
Proper accumulation, classification, and summarization of
General ledger revenues, collections, and receivables in the financial
statement accounts.

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Inherent Risk Assessment Control Risk Assessment
Understand and document the revenue
process based on a reliance approach.

Plan and perform tests of controls on

revenue transactions.

Set and document the control risk for the

revenue process.

Understanding and Documenting Internal

Control
Control Environment
Understanding the control environment is generally completed on an overall entity basis.
The Entity’s Risk Assessment Process
The auditor must understand how management considers risks that are relevant to the
revenue process. The auditor should estimate the significance of the risk and assess
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 Understanding and Documenting
Internal Control
Control Activities
The auditor identifies which controls ensure that the
assertions for transactions and events are being met.
Documentation of the auditor’s understanding of the
revenue process can be accomplished by using:

Procedures Narrative Internal control

Flowcharts
manuals descriptions questionnaires

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 Information Systems and Monitoring
Communication of Controls
Process by which The flow of each The auditor must
sales, cash receipts transaction from
and credit initiation to understand how
memoranda are inclusion in the management
initiated. financial assesses the design
statements.
and operation of
controls in the
Auditor’s
revenue process. This
knowledge
understanding should
include how
Accounting records, supervisory personnel
supporting documents review the personnel
and accounts that are The process used to
prepare estimates
who perform the
involved in sales, cash
receipts and sales for bad debts and controls and evaluate
returns. sales returns. the performance of
the entity’s IT
function.
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 Planning and Performing
Tests of Controls
The auditor systematically examines the client’s
revenue process to identify relevant controls that
help to prevent, or detect and correct material
misstatements.
Inquiry of client personnel.
In order to properly
set control risk the Inspection of documents and records.
auditor must test
controls over the Observations of the operation of the
control.
revenue process.
Walkthroughs.
Such tests may
include . . . Reperformance of the control activities.

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 If the results of the tests of controls support the
Setting and Documenting planned level of control risk, the auditor conducts
the planned level of substantive procedures for
the Control Risk the account balances.
The level of control risk for the revenue process can be set using either quantitative amounts or
qualitative terms such as ‘low,’ ‘medium,’ or ‘high.’

Control Activities and Tests of Controls –

Revenue Transactions
Assertions about Classes of Transactions
and Events for the Period under Audit
All revenue and cash receipt transactions and events
Occurrence of Revenue
Occurrence that have been recorded have occurred and pertain to Transactions
the entity.

Completeness
All revenue and cash receipt transactions and events The auditor is concerned about two
that should have been recorded have been recorded. major types of material misstatements:
All revenue and cash receipts transactions and events
Authorization
are properly authorized. 1. Sales to fictitious customers.
Amounts and other data relating to recorded revenue 2. Recording revenue when goods
Accuracy and cash receipt transactions and events have been have not been shipped or services
recorded appropriately.
have not been performed.
Cut-off All revenue and cash receipt transactions and events
have been recorded in the correct accounting period. The auditor needs assurance that
All revenue and cash receipt transactions and events all recorded revenue transactions
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have been recorded in the proper accounts.
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 Completeness of Revenue Transactions
The major misstatement that concerns both management and the auditor is
that goods are shipped or services are performed and no revenue is
recognized.
Controls concerning completeness include: (1) accounting for numerical sequence of
shipping documents and sales invoices; (2) matching shipping documents with sales
invoices; (3) reconciling sales invoices to daily sales reports; and (4) maintaining and
reviewing the open-order file.

Authorization and Accuracy of Revenue Transactions

Possible misstatements due to improper authorization include shipping goods to, or performing
services for, customers who are bad credit risks and making sales at unauthorized prices or terms.
The presence of an authorized price list and terms of trade reduces the risk of inaccuracies. The
sales invoice should also be verified for mathematical accuracy before being sent to the customer.

Cut-off and Classification

of Revenue Transactions
Sales may be recorded in the wrong accounting period unless proper controls are in place. All
shipping documents should be forwarded to the billing department daily.
The use of a chart of accounts and proper codes for recording transactions should provide
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 Occurrence of
Cash Receipts Transactions
The possible misstatement that concerns the auditor when considering the occurrence
assertion is that cash receipts are recorded but not deposited in the client’s bank
account.

Completeness of Cash Receipts

and Authorization of Discounts
A major misstatement is that cash or cheques are stolen or lost before being recorded in
the cash receipts records. Proper segregation of duties and a lockbox system are strong
controls relating to completeness. 2/10, n/30
Terms of trade generally include discounts for payment within a specified period as a way
of encouraging customers to pay on time.

Accuracy of Cash Transactions

The wrong amount of cash could be recorded from the remittance advice, or the receipt could
be incorrectly processed during data entry: To minimize these types of errors, daily remittance
reports should be reconciled to a control listing of remittance advices.
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 Cut-off and Classification of
Cash Receipts Transactions
If the client uses electronic fund transfer, a lockbox system or if cash is
deposited daily in the bank, there is a small possibility of cash being recorded
in the wrong accounting period.
The auditor seldom has major concerns about cash receipts
being recorded in the wrong financial statement account.

Control Activities and Tests of Controls – Sales Returns and

Allowances
Sales returns and allowances is usually not a material amount in the financial
statements. However, credit memoranda that are used to process sales returns can also
be used to cover an unauthorized shipment of goods or conceal a misappropriation of
cash. As a result, all credit memoranda should be properly authorized.
Relating the Assessed Level of Control Risk to Substantive
Procedures
The auditor’s testing of control for revenue processing impacts the detection risk and
therefore the level of substantive procedures impacted by the controls.
Sales returns
AR Bad debts
AFDA and Cash
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 Auditing Accounts Receivable and
Related Accounts
Substantive analytical procedures are used to
examine plausible relationships among accounts
receivable and related accounts.
Tests of details focus on transactions, account
balances or disclosures. Tests of details
concentrate on the ending balance for accounts
receivable and related accounts as well as related
disclosures.

Ratios used for comparative purposes include :

1. Receivables turnover and days outstanding in accounts receivable.

2. Aging categories on aged trial balance of accounts receivable.
3. Bad-debts expense as a per cent of revenue.
4. Allowance for uncollectible accounts as a per cent of accounts receivable or
credit sales.
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Large account balances
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to last period.
 Tests of Details of Transactions,
Account Balances and Disclosure
For Accounts Receivable, Allowance for
Uncollectible Accounts and Bad-Debt Expense
A sample of transactions from the sales journal should
Occurrence be vouched to the sales invoice, customer order and
shipping document.
A sample of shipping documents should be traced to
Completeness
related sales invoice and customer's account.
Authorization Compare prices and terms for sample of sales
and Accuracy invoices with authorized price list.

Cut-off From a sample, compare date of sales invoice with

date of shipment and date sale was recorded.
For a sample of sales invoices, determine that each is
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properly classified in the revenue accounts.

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 Completeness and Accuracy

The auditor’s primary concern is whether all

accounts receivable have been included in
the accounts receivable subsidiary ledger
and the general ledger accounts receivable
account.
Reconciliation of the aged trial balance
to the general ledger account should
detect an omission of a receivable
from either the subsidiary or general
ledger.

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 Cut-off
The cut-off test attempts to determine whether
all revenue transactions and related accounts
receivable are recorded in the proper period.
31/12/10

Test a few shipping Test a few shipping

documents just prior documents just after
to year end. year end.

Are all transactions tested

recorded in the proper period?
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 Existence and Rights and Obligations
Existence is one of the more important assertions for
accounts receivable because the auditor wants assurance
that this account balance is not overstated through the
inclusion of fictitious customer accounts or amounts.
Confirmation is the major audit procedure used for testing
this assertion.

The auditor must determine that all accounts receivables are

owned by the entity. This is usually not a problem, however, in
some cases, accounts receivable may be sold or factored with
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 Valuation and Allocation
Accounts receivable should be shown on the
balance sheet at net realizable value (gross
amount less allowance for uncollectible
accounts).
The auditor must verify the adequacy
of the allowance for uncollectible
accounts. The first step is to prepare an
aged trial balance and discuss results
with the credit manager. Next, a
comparison with last year’s results
should be examined.

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 Classification and Understandability

The Confirmation Process –

Accounts Receivables
Confirmation is the process of obtaining information from third parties about the
account receivable balance. Confirmation is a good source of evidence about
the existence of the account receivable. The confirmation process should be
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 Types of Confirmations
Positive Negative
Confirmation Confirmation
Requests that Requests that the
customers indicate customer respond only
whether they agree when they disagree with
with the amount due the amount due to the
to the client. client.
A response is Negative confirmations
expected whether the are used when the client
customer agrees or has many small account
disagrees with the balances and control risk
balance indicated. is assessed as low.

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 Timing
Accounts receivable may be confirmed at an
interim date or at year end. The confirmation
request should be sent soon after the end of
the accounting period in order to maximize the
response rate.

Confirmation Procedures
For each exception received, the auditor
should examine the reasons for the
difference between the balance on the
client’s books and the balance indicated
by the customer.
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The auditor should mail the
confirmation requests outside the
client’s facilities. A record should be
maintained of the confirmations
mailed and those returned. A second
request may be necessary in some
cases.
 Alternative Procedures
When the auditor does not receive responses to positive confirmations, alternative audit
procedures are used. These alternative procedures include:
1. Examination of subsequent cash receipts.
2. Examination of customer orders, shipping documents and duplicate sales invoices.
3. Examination of other client documentation.

Auditing Other Receivables

Other types of receivables that are reported on the balance sheet may include: (1)
receivables from officers and employees; (2) receivables from related parties; and
(3) notes receivable. The auditor’s concern with satisfying the assertions for these
receivables is similar to that for trade accounts receivable. Each of these types of
receivables is confirmed and evaluated for collectibility. The transactions that result
in receivables from related parties are examined to determine if they were at ‘arm’s
length.’ Notes receivable would also be confirmed and examined for repayment
terms and whether©interest
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 Evaluating the Audit Findings

The auditor compares the aggregated identified

misstatement to materiality to determine if the identified
misstatement would affect the audit.
The auditor requests the client to correct the identified
misstatements and then compares the uncorrected
misstatements with materiality to conclude whether the
financial statements are fairly stated.
If uncorrected misstatements in accounts receivable and,
when considered together with other uncorrected
misstatements, are less than materiality, the auditor may
accept that the financial statements are fairly presented.
Conversely, if the uncorrected misstatement exceeds the
materiality, the auditor should conclude that the financial
statements are not fairly presented.

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