Topic 2: Auditing the Revenue

Process
 Introduction cont.
• What is revenue
• The revenue and collection cycle of;
– Banks and financial institutions
– Restaurants
• The effect of modern mode of payment-
electronic
• Then the discussion follow is based on the
manufacturing industry and other business that
sale goods/services on credit
 Basic activities in the cycle
• There mainly four activities
– Receiving and processing customer orders,
including credit approval;
– Delivering goods and services to customers;
– Billing customers and accounting for accounts
receivable; and
– Collecting and depositing cash
 Revenue Recognition

• Name the accounts affected by sales

transaction (direct and indirect)
• What are criteria for revenue recognition?
• an account or disclosure is significant if there
is a reasonable chance that it could contain a
material misstatement.
• How
– apply the audit risk model
 Recall
• Audit risk is defined as the risk that auditors will
issue an unqualified opinion on financial
statements that contain a material misstatement.
• Three types of Audit risk
– Inherent risk - a material misstatement relating to the
financial reporting process
– Control risk - the client’s internal controls do not
prevent or detect (control risk) and
– Detection risk - that the auditors’ substantive
procedures do not detect.
 Recall cont.
• It is relevant to address the relevant assertions
• See ISA 315- for definition
• For example match the following assertions and
accounts; sales and accounts receivable v/s
existence, completeness and occurrence
• Note;
– financial statement assertion is relevant if it has a
“reasonable possibility of containing a misstatement or
misstatements that would cause the financial
statements to be materially misstated”.
 Significant Accounts and Relevant Assertions in the
Revenue and Collection Cycle
account assertion
Revenue Occurrence

completeness
cutoff
Accounts Receivable Existence
completeness
valuation
 Quiz
• What makes an account significant?
• What makes assertion relevant?
• Read and write a 1 page on “what can go
wrong?” approach
 summary
account assertion Risk
Revenue occurrence Mgt overstate sales
Mgt fails to approximate
return
completeness Not all sales are recorded
cutoff Sales been recorded in
incorrect period
Accounts receivable existence A/R be overstated from
actual sales
completeness Not all A/R recorded
valuation Not included in
appropriate amount and
Valuation adjustment not
recorded propely
 Risk of Material Misstatement
• We have said revenue is recognized when; it is
realizable and when it is earned.
• Revenue generally is realized or realizable and
earned when all of the following criteria are met:
– Persuasive evidence of an arrangement exists.
– Delivery has occurred or services have been rendered.
– The seller’s price to the buyer is fixed or determinable.
– Collectability is reasonably ensured.
 Risk of Material Misstatement cont.
• Most challenging area
– Collectability of Accounts Receivable
– Customer Returns and Allowances
• The assessment of the risk of material misstatement is
completed to help form the basis for determining;
– the nature,
– timing, and
– extent of substantive testing.
• Risk of material misstatement at the assertion level is
comprised of both
– inherent risk and
– control risk for each relevant assertion.
 Inherent Risk
• We just said the reason to assess inherent risk
– to determine where in the financial statements it
is reasonably possible that a material
misstatement could enter the process before the
consideration of any internal controls.
• Then most important is to gain an
understanding of internal control
 Review- Internal control
• Auditors typically achieve an understanding of
controls by completing a walkthrough of the
processes in the revenue and collection cycle.
• To do so, the auditor identifies the points in
the process where a misstatement might
occur and
• then identifies the control activities that have
been placed in operation to mitigate these
risks.
 Review- Internal control cont.
• Example; One control that the auditor would
expect management to implement involves
periodic reconciliation of debits to accounts
receivable to sales invoices, customer
purchase orders, and shipping documents.
• If management regularly evaluates the validity
of recorded accounts receivable, fewer errors
can proceed through the accounting system
undetected.
Controls at accounts and assertion level
• An initial overall control - is the level of
separation of duties in the revenue cycle.
– Is it economic reasonable to have complete
separation of duties in small business?
– Most important is to obtain reasonable assurance
that financial controls are intact when duties are
not appropriately separated
 Controls at accounts and assertion level
cont.
• Revenue is only recorded when a complete set
of matched sales documents is present.
• customer sales order,
• evidence of shipment, and a
• customer invoice
– These documents provides strong evidence that a
sale has been completed and a revenue has been
earned.
– What assertions will be assured by these
documents?
 Controls at accounts and assertion level
cont.
• Ensuring that all three of these primary documents
are pre-numbered, and the numerical sequence is
checked
– What assertion does this assist?
• Verifying the dates on the documents
– What assertion does this assist?
• collectability of receivables – be considered regular
basis and evaluate the adequacy of allowances for
sales returns and discounts.
– What assertion does this assist?
 Task
• Find other control activities that should
generally be in place to prevent and detect
errors or fraud in revenue and collection cycle,
remember to consider the assertion that it will
assist.
• Why should always auditor perform
subsatantive procedure in revenue cycle?
 Note
• Auditors should also perform a walkthrough
to verify that they understand each of the
process activities.
 Test of Controls
• Auditors can perform tests of controls to determine
whether company personnel are properly
performing controls that are said to be in place.
• In general, the procedures used in tests of controls
are;
– client inquiry,
– observation,
– inspection of documents and records,
– Re-performance, and
– walkthroughs.
 Recall - audit evidence
• The audit processes to gather evidence on the
assertions in account balances are called
substantive procedures.
• Substantive procedures differ from tests of controls
in their basic purpose.
• Substantive procedures are designed to obtain
direct evidence about the amounts in account
balances, while tests of controls are designed to
obtain evidence about the company’s performance
of its own control activities.
 Tests of controls related to assertions
• Completeness of revenue and accounts
receivable—Examine evidence of client review
and follow-up of sales data related to specific
classes of products or locations.
• Accuracy of revenue and accounts receivable
—Vouch prices to approved price listing.
Tests of controls related to assertions cont.

• Accuracy of revenue— Observe client comparing

shipping quantities to quantities recorded as sold.
Examine evidence of client making the comparison.
• Cutoff of revenue— Trace shipping date on shipping
documents to sales invoice date. Check FOB terms.
• Classification of accounts receivable— Trace
posting of intercompany sales, sales returns, etc.,
to sales.
Summary – control risk assesment
• Two phases;
– obtaining an understanding of the company’s
controls and
– The process of obtaining evidence from actual
tests of controls
• are two of the phases of control risk
assessment
 Analytical procedure
• Substantive procedure can be classified as
– substantive analytical procedures and
– substantive tests of details
• Analytical procedure-the auditor substantiates
an account or disclosure by developing an
independent estimate of the amount and then
compare the recorded balance to the
estimate.
 Analytical procedure cont.
• Analytical procedure to be performed
depends on the circumstances and nature of
business
• Analyze items overtime and make comparison,
consider industry comparison too
• Most relation to consider, receivables
turnover, amount of past due receivables,
gross margin ratio, sales/asset ratios etc
 Conformation
• It is mandatory
• However not all the time; reason not to
– receivables are not material;
– confirmations would be ineffective, based on
prior-years’ experience or knowledge that
responses could be unreliable; and
– analytical procedures and other substantive
procedures provide sufficient, competent
evidence.
 Conformation cont.
• Confirmations provide evidence of existence
as well as rights and obligations of accounts
and notes receivable.
• However, they do not provide strong evidence
on the valuation of accounts receivable.
• How do we get accounts for conformation?
 Conformation cont.
• There are two primary methods of confirming
accounts receivable:
– positive confirmations
– negative confirmations.
• A positive confirmation asks the customer to
respond whether the balance is correct or incorrect.
• The negative confirmation asks for a response only if
something is wrong with the balance; thus, lack of
response to negative confirmations is considered
evidence that the account is fairly stated.
AUDITING THE PURCHASING
AND EXPENSE PROCESSES
 Introduction
• Mention the auditing process stages
• Where are we at those stages?
• Activities involved at the acquisition and
expenditure includes;
– Purchasing goods and services,
– Receiving the good or service,
– Recording the asset or expense and related
liability, and
– Payment.
 Source Document
• Mention the possible source documents at
each acquisition and expenditure activity (5
minutes)
 Source Document cont.
– purchase requisition
– purchase order
– receiving report
– Purchase invoice
• From our assumption, transactions are on
credit, when a voucher will be written?
• In total these documents are referred to as
‘voucher package’
 Accounts affected
• This cycle affects more general ledger accounts than any
other cycle
• Accounts to be affected are such as;
– Inventory/Raw Materials
– Prepaid Expenses
– Property, Plant, and Equipment
– Intangible Assets
– Accrued Liabilities
– Various Expenses
– Cash
– Accounts Payable
– Payroll
 Recognition
• What are recognition criteria for expenses?
Mention them (3 minutes)
• Let us begin the audit process now!
• What makes an auditor identify an account as
significant? (1 minute)
• Significant accounts to be dealt with
– Accounts payable
– Expenses
 Relevant Assertions
• All the time remember the risk model at this
stage three of auditing process.
• Summary of the assertions are shown here
below
Significant accounts assertion Risk level
Account payable Completeness High
Cutoff High
Existence Moderate
Rights and Obligations Moderate
Valuation Moderate
Expenses accounts Completeness High
Cutoff High
Accuracy High
Classification High
 Accounts Payable
• Management may desire to improve the
books by not recording an obligation in the
correct period. An incomplete listing of
accounts payable at the end of the period
lowers current liabilities and corresponding
expenses.
• THUS Completeness and cutoff are necessary
assertions to be undertaken
 expenses accounts
• Read the case of worldcom.inc
• Major problem in expenses accounts is wrong
classification
• For example, capitalizing expenses increases
net income in the year in which they should
have been completely expensed
 Task
• Why do auditors focus on completeness of
expenditures as a significant account and
relevant assertion in the expenditure cycle?
• Why is inherent risk for the existence of
inventory an issue in the expenditure cycle
audit?
• Why is a service expense a good account for
recording a fictitious expense?
 Test of Risk of Misstatement
• Should we use a ‘what can go wrong’
approach
Account Assertion WCGW
Account Payable Completeness Liabilities are not recorded
Cutoff Liabilities have been recorded in incorrect
periods
Existence Liabilities may not represent actual
obligations of the company
Rights and Obligations Liabilities may not represent actual
obligations of the company
Valuation Payables are recorded at an incorrect
amount
Expenses Completeness Not all expenses are recorded
accounts
Cutoff Expenses have not been recorded in
incorrect periods
Accuracy Expenses are recorded at an incorrect
amount
Classification Expenses have been improperly recorded
as capitalized expenses
 Internal Control Activities
• Control risk assessment is important because
it governs the
– nature,
– timing, and
– extent of substantive procedures.
 Internal Control Activities cont.
• It is important that auditors consider entity-level
controls in all processes and procedures.
– In the expenditure process, management should have a
process for continually reviewing expenses and comparing
them to budgets and forecasts.
– Proper authorization for all expenditures should be
established and included in company policy and procedures.
– Corporate values and ethics that have been established
should be communicated to suppliers and other partners of
the entity along with a place where inappropriate behavior
(such as the solicitation of a bribe or kickback) may be
reported.
 Internal Control Activities cont.
• Specifically, major controls are;
– separation of responsibilities
– Custody both in by place and by accesses of
documents
– Periodic reconciliation
 Tests of Control
• Tests of controls are done to determine whether company
controls actually are in place and operating effectively.
• Yesterday we said, it is management responsibilities to
ensure controls are in place and operating to prevent,
detect, and correct accounting errors.
• In the four activities, purchasing is the most risk activity
• Tests of controls consist of identification of;
– the control that will be relied on to reduce assessed control
risk and
– the data population from which a sample of items will be
selected for audit.
 Tests of Control cont.
• In general, the actions in tests of controls
involve;
– inspecting,
– inquiry,
– observing,
– scanning,
– matching, and
– recalculating.
 Tests of Control cont.
• An auditor might select a sample of voucher
packages and inspect the documents for
indications that reconciliations and approvals
for payment are evident.
• Procedures such as matching, recalculating,
and scanning for unusual items often can be
performed electronically using computer-
assisted audit techniques (CAATs).
 Tests of Control cont.
• Tests of controls over occurrence involve tests of the additions
to the expense accounts.
• Selecting a sample of closed purchase orders, receiving
reports, or vendor invoices and tracing them to the accounts
payable journal provides evidence of
– Completeness
– proper authorization
• Taking a sample of payments to vendors and vouching those
payments to the receiving report and purchase order provides
evidence that
– the delivery occurred and the purchase existed
– may find fictitious vendors
 Task

• How should an auditor test for proper

authorization in the expenditure cycle?
• Where would an auditor find the proper
authorization that indicates it is okay to pay a
vendor?
Substantive analytic procedure and Tests of
Details
• The audit of account balances consists of
making procedural efforts to detect errors and
frauds that could exist in the balances, thus
making them misleading in financial
statements.
• First as an auditor we should learn where to
obtain evidence
• Purchase orders - no liability exists until the
transactions have been completed
Substantive analytic procedure and Tests of
Details cont.
• Receiving reports - Liabilities should be
recorded on the date the goods and services
are received and accepted by the receiving
department or by another responsible person
• Invoice- Sometimes purchase invoices arrive in
the accounts payable department before the
receiving activity is complete.
Substantive analytic procedure and Tests of
Details cont.
• Accounts payable trial balance amount - The total
should agree with the accounts payable control
account.
• Purchase journal –it provides information for;
– the analysis of purchasing patterns that can exhibit
characteristics of errors and frauds and
– the sample selection of transactions for tests of controls
• Fixed assets reports - Auditors should trace large
purchases to the fixed asset reports and ensure that the
details of fixed assets in control accounts are consistent
with purchase orders.
Substantive analytic procedure and Tests of
Details cont.
• There is emphasis on completeness in this
cycle because financial statement users are
typically more concerned if a company
understates expenses and liabilities than if
management overstates those accounts.
• Procedure to search for unrecorded liabilities
 Note
• Many accounts, particularly expense
accounts, can be tested using analytical
procedures, such as horizontal and vertical
analyses
• vouching payments is the main way of
accumulating evidence for prepaid, deferred,
and accrued expenses.
Accrued income tax and other expenses
• It is by law companies to estimate deferred
income tax assets and liabilities – income tax
expenses
• most expense accounts can be tested in
conjunction with tests of related assets and
liabilities (e.g., depreciation) or through
analytical procedures.
• Auditors vouch payments, test the expense,
and recalculate the liability.
 Presentation and Disclosure
• Once auditors are satisfied that controls have been examined and
significant transactions and balances have been appropriately tested,
then it follows the disclosure issue.
• Depreciation methods, asset impairments, leases, and details about
income taxes are only a few of the essential items with specific
presentation and disclosure requirements.
• These disclosures must ensure that the presentation and disclosure
assertions of;
– occurrence
– rights and obligations,
– completeness,
– classification and understandability, and
– accuracy and valuation are all met.
 issues
• Auditing the acquisition and expenditure cycle
is not straightforward.
• Because it is ripe for fraud, an auditor must be
aware that inappropriate policies and
procedures or poor execution of processes can
lead to problems for the client