chapter 10 clothiers, inc. (concluded) 10-10. customer sales order contains the details of the type...
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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.
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.
LO# 1
10-2
Revenue Recognition Criteria
SAB 101
1. 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.
LO# 1
10-3
Fraud Risks in Revenue
Recognition
1. Side agreements
2. Channel stuffing
3. Related party transactions
4. Bill and hold sales
LO# 1
10-4
Overview of the Revenue
Process
Purchases
Inventory
Credit sales
Account
receivable
Cash
collectionPurchases
Inventory
Cash
sales
Cash Sale Credit Sale
LO# 2
10-5
Types of Transactions and
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.
LO# 3
10-6
Types of Transactions and
Financial Statement Accounts
AffectedThe revenue process affects numerous accounts in the
financial statements. The most significant accounts are:
LO# 3
10-7
LO# 3
Figure 10-2 Flowchart of the Revenue Process—
EarthWear Clothiers, Inc. (continued)
10-8
LO# 3
Figure 10-2 Flowchart of the Revenue Process—
EarthWear Clothiers, Inc. (continued)
10-9
LO# 3
Figure 10-2 Flowchart of the Revenue Process—
EarthWear Clothiers, Inc. (concluded)
10-10
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.
Types of Documents and Records
LO# 4
10-11
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.
Types of Documents and Records
LO# 4
10-12
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.
Types of Documents and Records
LO# 4
10-13
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.
Types of Documents and Records
LO# 4
10-14
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.
Types of Documents and Records
LO# 4
10-15
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.
Types of Documents and Records
LO# 4
10-16
Write-Off Authorization
This document authorizes the write-off of an
uncollectible account receivable. Final
approval is generally authorized by the
treasurer.
Types of Documents and Records
LO# 4
10-17
The Major Functions
LO# 5
10-18
Major FunctionsLO# 5
Order Entry
The initial function in the
revenue process is the entry
of a new sales order into the
system.
10-19
Major Functions
Shipping
Goods should not be
shipped, nor should
services be provided
without proper
authorization. The main
control is payment or
proper credit
authorization.
Billing
The objective of proper billing is to ensure that all goods shipped
and all services rendered are billed to the customer.
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.
LO# 5
10-20
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.
Major FunctionsLO# 5
10-21
Key Segregation of Duties
LO# 6
10-22
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.
LO# 7
10-23
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.
LO# 8
10-24
Control Environment
Understanding the control environment is generally
completed on an overall entity basis.
Understanding and Documenting
Internal Control
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.
LO# 8
10-25
Understanding and Documenting
Internal Control
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
descriptionsFlowcharts
Internal
control
questionnaires
LO# 8
10-26
Information Systems and
Communication
Auditor’s
knowledge
The process by which
sales, cash receipts, and
sales returns and
allowances transactions
are initiated.
The accounting records,
supporting documents, and
accounts that are involved in
sales, cash receipts, and sales
returns.
The flow of each
transaction from initiation
to inclusion in the financial
statements.
The process used to
prepare estimates for
accounts such as bad debts
and sales returns.
LO# 8
10-27
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.
Monitoring of Controls
LO# 8
10-28
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.
LO# 8
10-29
Set and Document the Control Risk
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.”
LO# 8
10-30
Control Activities and Tests of
Controls – Revenue TransactionsAssertions about Classes of Transactions and Events for
the Period under Audit
LO# 9
10-31
Table 10-6: Example Tests of
Controls for Revenue Transactions
(continued)
LO# 9
10-32
Table 10-6: Example Tests of
Controls for Revenue Transactions
(continued)
LO# 9
10-33
Table 10-6: Example Tests of
Controls for Revenue Transactions
(concluded)
LO# 9
10-34
Occurrence of Revenue
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.
LO# 9
10-35
Completeness of Revenue
Transactions
The major misstatement that concerns both
management and the auditor is that goods are
shipped or services are performed and norevenue 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.
LO# 9
10-36
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.
LO# 9
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.
10-37
Cutoff 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.
LO# 9
The use of a chart of accounts and proper codes
for recording transactions should provide
adequate assurance about the proper
classification of revenue transactions.
10-38
Table 10-7: Example Tests of Controls
for Cash Receipts Transactions
(continued)
LO# 9
10-39
Table 10-7: Example Tests of Controls
for Cash Receipts Transactions
(concluded)
LO# 9
10-40
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 entity’s bank account.
LO# 9
10-41
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.
LO# 9
2/10, n/30Terms of trade generally include discounts for
payment within a specified period as a way of
encouraging customers to pay on time.10-42
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.
LO# 9
10-43
Cutoff and Classification of
Cash Receipts TransactionsIf 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.
LO# 9
The auditor seldom has major concerns about
cash receipts being recorded in the wrong
financial statement account.10-44
Control Activities and Tests of
Controls – Sales Returns and
AllowancesSales 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.
LO# 9
10-45
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.
Cash
Accounts
receivabl
e Allowanc
e
for bad
debts
Bad
debts
expenseSales
returns
and
allowanc
es
LO# 10
Sales
10-46
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.
LO# 10
10-47
Substantive Analytical Procedures
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.
LO# 11
10-48
Substantive Tests of Transactions
(continued)
For Accounts Receivable, Allowance for Uncollectible
Accounts, and Bad-Debt Expense
LO# 12
10-49
Tests of Details of Account
Balances (concluded)
For Accounts Receivable, Allowance for Uncollectible
Accounts, and Bad-Debt Expense
LO# 12
10-50
Aged Trial Balance of Accounts
Receivable
LO# 12
10-51
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.
LO# 12
10-52
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 priorto year-end.
Test a few shipping
documents just after
year-end.
Are all transactions tested
recorded in the proper period?
LO# 12
10-53
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.10-54
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.
LO# 12
10-55
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.
LO# 12
10-56
The Confirmation Process –
Accounts Receivable
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.
LO# 13
10-57
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.
LO# 13
10-58
Factors Affecting the Reliability of A/R
Confirmations
◆ 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).
LO# 13
10-59
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.
LO# 13
10-60
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.
LO# 13
10-61
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.
LO# 13
10-62
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.
LO# 13
10-63
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.
LO# 14
10-64
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.
LO# 15
10-65
End of Chapter 10
10-66