Chapter 10. Auditing the Revenue Process. Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

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1 Chapter 10 Auditing the Revenue Process McGraw-Hill/Irwin Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2 LO# 1 Revenue Recognition Revenue is defined as inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivery or producing goods, rendering services, or other activities that constitute the entity s major or central operations. 10-2

3 Overview of the Revenue LO# 2 Process Cash Sale Credit Sale Purchases Cash collection Purchases Cash sales Account receivable Inventory Inventory Credit sales 10-3

4 Types of Transactions and Financial Statement Accounts Affected The revenue process affects numerous accounts in the financial statements. The most significant accounts are: LO#

5 LO# 4 Types of Documents and Records 10-5

6 LO# 5 The Major Functions Functions of the Revenue Process Order entry Credit authorization Shipping Billing Cash receipts Accounts receivable General ledger Acceptance of customer orders for goods and services into the system in accordance with management criteria. Appropriate approval of customer orders for creditworthiness. Shipping of goods that has been authorized. Issuanace of sales invoices to customers for goods shipped or services provided; also, processing of billing adjustments for allowances, discounts, and returns. Processing of the receipt of cash from customers. Recording of all sales invoices, collections, and credit memoranda in individual customer accounts. Proper accumulation, classification, and summarization of revenues, collections, and recivables in the financial statement accounts. 10-6

7 LO# 6 Key Segregation of Duties 10-7

8 LO# 7 Inherent Risk Assessment The four inherent risk factors that may affect the revenue process are: 1. Industry-related factors. 2. The complexity and contentiousness of revenue recognition issues. 3. The difficulty of auditing transactions and account balances. 4. Misstatements detected in prior audits. 10-8

9 LO# 8 Control Risk Assessment Understand and document the revenue process based on a reliance strategy. Plan and perform tests of controls on revenue transactions. Set and document the control risk for the revenue process. 10-9

10 Control Activities and Tests of Controls Revenue Transactions Assertions about Classes of Transactions and Events for the Period under Audit Occurrence Completeness Authorization Accuracy Cutoff Classification All revenue and cash receipt transactions and events that have been recorded have occurred and pertain to the entity. All revenue and cash receipt transactions and events that should have been recorded have been recorded. All revenue and cash receipts transactions and events are properly authorized. Amounts and other data relating to recorded revenue and cash receipt transactions and events have been recorded appropriately. All revenue and cash receipt transactions and events have been recorded in the correct accounting period. All revenue and cash receipt transactions and events have been recorded in the proper accounts LO# 9

11 Revenue Transactions LO#

12 Cash Receipts Transactions LO#

13 LO# 9 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

14 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. LO# 10 Accounts receivable Allowance for bad debts Sales Sales returns and allowances Bad debts expense Cash 10-14

15 Substantive Analytical Procedures LO# 11 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 percent of revenue. 4. Allowance for uncollectible accounts as a percent of accounts receivable or credit sales. 5. Large customer account balances compared to last period

16 Substantive Tests of Transactions For Accounts Receivable, Allowance for Uncollectible Accounts, and Bad-Debt Expense LO#

17 Tests of Details of Account Balances For Accounts Receivable, Allowance for Uncollectible Accounts, and Bad-Debt Expense LO#

18 LO# 13 Types of Confirmations Positive Confirmation Requests that customers indicate whether they agree with the amount due to the client. A response is expected whether the customer agrees or disagrees with the balance indicated. Negative Confirmation Requests that the customer respond only when they disagree with the amount due to the client. Negative confirmations are used when the client has many small account balances and control risk is assessed as low

19 LO# 13 Confirmation Procedures 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. 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

20 LO# 13 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

21 LO# 14 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 income has been properly recognized

22 LO# 15 Evaluating the Audit Findings When the auditor has completed the planned substantive procedures, the likely misstatement (projected misstatement plus an allowance for sampling risk) for accounts receivable is determined. Likely misstatement less than tolerable misstatement Likely misstatement greater than tolerable misstatement Accept the account as fairly presented. Account is not fairly presented

23 End of Chapter