Chapter 10. Auditing the Revenue Process
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1 Chapter 10 Auditing the Revenue Process Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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 LO# 1 Revenue Recognition Criteria SAB Persuasive evidence of an arrangement exists. 2. Delivery has occurred or services have been rendered. 3. The seller s price to the buyer is fixed or determinable. 4. Collectibility is reasonably assured. 10-3
4 LO# 1 Fraud Risks in Revenue Recognition 1. Side agreements 2. Channel stuffing 3. Related party transactions 4. Bill and hold sales 10-4
5 Overview of the Revenue LO# 2 Process Cash Sale Credit Sale Purchases Cash collection Purchases Cash sales Account receivable Inventory Inventory Credit sales 10-5
6 Types of Transactions and LO# 3 Financial Statement Accounts Affected Three types of transactions are typically processed through 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. 10-6
7 Types of Transactions and Financial Statement Accounts Affected The revenue process affects numerous accounts in the financial statements. The most significant accounts are: LO#
8 Figure 10-2 Flowchart of the Revenue Process EarthWear Clothiers, Inc. (continued) LO#
9 Figure 10-2 Flowchart of the Revenue Process EarthWear Clothiers, Inc. (continued) LO#
10 Figure 10-2 Flowchart of the Revenue Process EarthWear Clothiers, Inc. (concluded) LO#
11 LO# 4 Types of Documents and Records Customer Sales Order Contains the details of the type and quantity of products or services ordered by the customer. Credit Approval Form For credit sales, the entity must have a formal procedure for investigating the creditworthiness of the customer
12 LO# 4 Types of Documents and Records Open-Order Report A report of all customer orders for which processing has not been completed. 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
13 LO# 4 Types of Documents and Records Sales Invoice The document is used to bill the customer. This document contains information on the type of product or service, the quantity, the price, and the terms of trade. 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
14 LO# 4 Types of Documents and Records 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
15 LO# 4 Types of Documents and Records 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 should be returned with the payment
16 LO# 4 Types of Documents and Records Cash Receipts Journal This journal is used to record the cash receipts of the entity. Credit Memorandum This document is used to record credits for the return of goods by a customer
17 LO# 4 Types of Documents and Records Write-Off Authorization This document authorizes the write-off of an uncollectible account receivable. Final approval is generally authorized by the treasurer
18 LO# 5 The Major Functions 10-18
19 LO# 5 Major Functions Order Entry The initial function in the revenue process is the entry of a new sales order into the system
20 LO# 5 Major Functions Credit Authorization The credit authorization process must determine that the customer is able to pay for the goods or services purchased. Failure to properly authorize credit can lead to extensive bad debts for the entity. Billing Shipping Goods should not be shipped, nor should services be provided without proper authorization. The main control is payment or proper credit authorization. The objective of proper billing is to ensure that all goods shipped and all services rendered are billed to the customer
21 LO# 5 Major Functions Cash Receipts All cash collected must be properly identified and promptly deposited intact at the bank. Accounts Receivable All billings, adjustments, and cash collections must be properly recorded in the customers accounts receivable records. General Ledger As related to the revenue process, the general ledger function must ensure that all revenues, collections, and receivables are properly recorded and classified
22 LO# 6 Key Segregation of Duties 10-22
23 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
24 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
25 Understanding and Documenting Internal Control LO# 8 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 the likelihood of occurrence
26 Understanding and Documenting Internal Control LO# 8 Control Activities The auditor identifies what 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 manuals Narrative descriptions Internal control questionnaires Flowcharts 10-26
27 Information Systems and Communication LO# 8 The process by which sales, cash receipts, and sales returns and allowances transactions are initiated. Auditor s knowledge The flow of each transaction from initiation to inclusion in the financial statements. The accounting records, supporting documents, and accounts that are involved in sales, cash receipts, and sales returns. The process used to prepare estimates for accounts such as bad debts and sales returns
28 LO# 8 Monitoring of Controls The auditor must understand how management assesses the design and operation of controls in the revenue process. This understanding should include how supervisory personnel review the personnel who perform the controls and evaluate the performance of the entity s IT function
29 LO# 8 Plan and Perform Tests of Controls The auditor systematically examines the entity s revenue process to identify relevant controls that help to prevent, or detect and correct, material misstatements. In order to properly set control risk, the auditor must test controls over the revenue process. Such tests may include... Inquiry of client personnel. Inspection of documents and records. Observations of the operation of the control. Walkthroughs. Reperformance of the control activities
30 Set and Document the Control Risk LO# 8 If the results of the tests of controls support the planned level of control risk, the auditor conducts the planned level of substantive procedures for 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
31 Control Activities and Tests of Controls Revenue Transactions Assertions about Classes of Transactions and Events for the Period under Audit LO#
32 Table 10-6: Example Tests of Controls for Revenue Transactions (continued) LO#
33 Table 10-6: Example Tests of Controls for Revenue Transactions (continued) LO#
34 Table 10-6: Example Tests of Controls for Revenue Transactions (concluded) LO#
35 Occurrence of Revenue LO# 9 Transactions The auditor is concerned about two major types of material misstatements: 1. Sales to fictitious customers. 2. Recording revenue when goods have not been shipped or services have not been performed. The auditor needs assurance that all recorded revenue transactions are valid
36 Completeness of Revenue Transactions LO# 9 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
37 Authorization and Accuracy of Revenue Transactions LO# 9 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
38 Cutoff and Classification of Revenue Transactions LO# 9 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 adequate assurance about the proper classification of revenue transactions
39 Table 10-7: Example Tests of Controls for Cash Receipts Transactions (continued) LO#
40 Table 10-7: Example Tests of Controls for Cash Receipts Transactions (concluded) LO#
41 Occurrence of Cash Receipts Transactions LO# 9 The possible misstatement that concerns the auditor when considering the occurrence assertion is that cash receipts are recorded but not deposited in the entity s bank account
42 LO# 9 Completeness of Cash Receipts and Authorization of Discounts A major misstatement is that cash or checks 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
43 LO# 9 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. All bank statements should be reconciled monthly
44 Cutoff and Classification of LO# 9 Cash Receipts Transactions If the entity uses 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
45 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
46 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 receivabl e Allowanc e for bad debts Sales Sales returns and allowanc es Bad debts expense Cash 10-46
47 LO# 10 Auditing Revenue Related Accounts Substantive analytical procedures are used to examine plausible relationships among revenue 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
48 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
49 Substantive Tests of Transactions (continued) For Accounts Receivable, Allowance for Uncollectible Accounts, and Bad-Debt Expense LO#
50 Tests of Details of Account Balances (concluded) LO# 12 For Accounts Receivable, Allowance for Uncollectible Accounts, and Bad-Debt Expense 10-50
51 LO# 12 Aged Trial Balance of Accounts Receivable 10-51
52 LO# 12 Completeness 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
53 LO# 12 Cutoff The cutoff test attempts to determine whether all revenue transactions and related accounts receivable are recorded in the proper period. 12/31/13 Test a few shipping documents just prior to year-end. Test a few shipping documents just after year-end. Are all transactions tested recorded in the proper period? 10-53
54 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. LO# 12 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 or without recourse
55 LO# 12 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
56 LO# 12 Classification The major issues related to presentation, disclosure, and classification are: 1. Identifying and reclassifying any material credits contained in accounts receivable. 2. Segregating short-term and long-term receivables. 3. Ensuring that different types of receivables are properly classified
57 The Confirmation Process Accounts Receivable LO# 13 Confirmation is audit evidence that is a direct written response from third parties about the account receivable balance. Confirmation is a good source of evidence about the existence of the accounts receivable. The confirmation process should be controlled by the auditor
58 LO# 13 Omitting Confirmations Accounts receivable balance is immaterial. External confirmations would be ineffective. The auditor s assessed level of risk of material misstatement at the relevant assertion level is low, and the other planned substantive procedures address the assessed risk
59 Factors Affecting the Reliability of A/R Confirmations LO# 13 Type of confirmation request (positive versus negative). Prior experience with the client or similar engagements (e.g., response rate, accuracy of returned confirmations, misstatements identified). The intended respondent (competence, knowledge, ability, and objectivity)
60 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
61 LO# 13 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
62 LO# 13 Confirmation Procedures The auditor should mail the confirmation requests outside the entity 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
63 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 specific subsequent cash receipts. 2. Examination of shipping documentation. 3. Examination of other client documentation
64 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
65 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. Aggregate misstatement less than tolerable misstatement Aggregate misstatement greater than tolerable misstatement Accept the account as fairly presented. Account is not fairly presented
66 End of Chapter
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