McGraw-Hill/Irwin. Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 07 Revenue and Collection Cycle What at first was plunder assumed the softer name of revenue. Thomas Paine 7-2

Learning Objectives 1. Discuss inherent risks related to the revenue and collection cycle with a focus on improper revenue recognition 2. Describe the revenue and collection cycle, including typical source documents and control procedures. 3. Give examples of tests of controls over customer credit approval, delivery, and accounts receivable accounting 7-3

Learning Objectives (continued) 4. Give examples of substantive procedures in the revenue and collection cycle and relate them to assertions about account balances at the end of the period. 5. Describe some common errors and frauds in the revenue and collection cycle, and design some audit and investigation procedures for detecting them. 7-4

Overall Audit Approach 7-5

Inherent Risks Improper Revenue Recognition Cut-off Bill and Hold Channel Stuffing Returns and Allowances Collectibility of Receivables 7-6

Revenue Recognition Must be (1) realized or realizable and (2) earned SEC guidance (SAB 104) 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, and Collectibility is reasonably assured 7-7

7-8 Exhibit 7.2 Revenue Recognition Rogues 7-8

Exhibit 7.3 Revenue and Collection Cycle 7-9

REVENUE AND COLLECTION CYCLE: Key Control Procedures SEPARATION OF DUTIES Separate functions for recording, authorization, custody AUTHORIZATION OF TRANSACTIONS Write-offs EDI transactions Credit checks prior to approval of sale Pricing ACCESS TO ASSETS Shipping department Lock box account ADEQUATE DOCUMENTS AND RECORDS Pre-numbered sales orders, shipping documents (bills of lading), sales invoices Remittance advice INDEPENDENT CHECKS ON PERFORMANCE A/R subsidiary ledger to general ledger Monthly statement to customer 7-10

Audit Evidence in Management Reports and Data Files Pending order master file Credit check/approval files Price list master file Sales detail file (sales journal) Sales analysis report Accounts receivable aged trial balance Cash receipts listing Customer Statements 7-11

Other Controls No sales order without customer order. Credit approval. Restricted access to inventory. Restricted access to terminals and invoices. All documentation in order to record sales. Proper dating. Invoices compared to BOLs and orders. Pending order files reviewed. 7-12

Exhibit 7.5 Assertions about Classes of Transactions and Events for the Period 7-13

Exhibit 7.6 Dual Direction of Test Audit Sample 7-14

Exhibit 7.7 Assertions and Substantive Procedures in the Revenue and Collection Cycle 7-15

AUDITING ACCOUNTS RECEIVABLE Test Accounts Receivable Aged Trial Balance (Exhibit 7.8) Confirm balances. Perform analytical procedures Test sales cut-off 7-16

Exhibit 7.8 Accounts Receivable Aged Trial Balance 7-17

USING CONFIRMATIONS Especially useful for verifying EXISTENCE. Factors likely to affect the reliability of confirmations Previous audit experience Intended recipient of the confirmation Type of information being confirmed The auditor may confirm entire BALANCES or individual TRANSACTIONS. Type of confirmation being sent 7-18

TYPES OF CONFIRMATIONS Positive Confirmations small number of accounts are involved large number of errors are anticipated Negative Confirmations the combined assessed level of inherent and control risk is low a large number of small balances is involved the auditor has no reason to believe that the recipients of the requests are unlikely to give them consideration. Blank Confirmations should be used if the recipient is likely to return a positive confirmation without verifying the accuracy of the information. 7-19

Exhibit 7.9 Positive Confirmation Letter 7-20

Exhibit 7.10 Negative Confirmation Letter 7-21

CONFIRMATION CONSIDERATIONS Responses to positive and blank confirmations provide more reliable evidence than negative non-responses. Recipients of accounts receivable confirmations might not report understatements. Auditors must have heightened professional skepticism for electronic responses (fax or e- mail). 7-22

CONFIRMATION CONSIDERATIONS (Continued) Non-response to Positive/blank confirmation requests Follow up with second and sometimes third requests. A lower than expected response rate could be indicative of fictitious customer accounts. Alternative procedures. Non-response to negative confirmation requests Only limited evidence concerning financial statement assertions. Alternative procedures are not necessary for unreturned negative confirmation requests. Follow-up on all exceptions 7-23

Exhibit 7.11 Responses to Positive Confirmations 7-24

ALTERNATIVE PROCEDURES Vouch subsequent cash collections usually sufficient evidence of existence, valuation. Examine shipping documents Examine client-generated supporting documentation, such as invoices. Depends on internal controls Inspect correspondence files 7-25

Other Matters Related to Confirmation There are three sets of circumstances that could justify the omission of the confirmation of a client's accounts receivable. Not material to the financial statements. If the RISK OF MATERIAL MISSTATEMENT is low, and the assessed level of evidence from analytical procedures and other tests of details is sufficient to reduce audit risk to an acceptably low level, confirmation of accounts receivable may be inefficient. Confirmation of accounts receivable is expected to be ineffective (based on previous years' audit experience). 7-26

UNCOLLECTIBLE ACCOUNTS Inspect customer files for collectibility Recalculate ALLOWANCE and BAD DEBT EXPENSE Verify reasonableness of ALLOWANCE and BAD DEBT EXPENSE Verify appropriateness of accounts written off Verify attempts to collect receivable Verify authorization is appropriate. 7-27

ANALYTICAL PROCEDURES Sales Revenue Comparisons with previous periods Comparisons with industry Allowance for Doubtful Accts, Bad Debt Expense Bad Debt Expense as a percentage of Sales Allowance for Doubtful Accounts as a percentage of Gross Receivables Accounts Receivable Days Sales in Accounts Receivable Accounts Receivable Turnover 7-28

SALES CUTOFF PROCEDURES Used to verify whether Sales/Revenues recorded in the CORRECT ACCOUNTING PERIOD. Examine SALES INVOICES and SHIPPING DOCUMENTS shortly prior to and after year-end. Examine returns after year-end. 7-29