Audit of the Sales and Collection Cycle: Tests of Controls and Substantive Tests of Transactions

1. Audit of the Sales and Collection Cycle: Tests of Controls and Substantive Tests of Transactions Chapter 14

2. Learning Objective 1 • Identify the accounts and the • classes of transactions in the • sales and collection cycle.

3. Accounts in the Sales and Collection Cycle Sales Cash in Bank Cash sales Accounts Receivable Cash Discounts Taken Sales on account Beginning balance Cash receipts Sales on account Sales returns and allowances Sales Returns and Allowances Ending balance Write-off of uncollectible accounts Bad Debt Expense

4. Accounts in the Sales and Collection Cycle Allowance for Uncollectible Accounts Accounts Receivable Beginning balance Cash receipts Write-off of uncollectible accounts Beginning balance Sales on account Sales returns and allowances Estimate of bad debt expense Ending balance Write-off of uncollectible accounts Ending balance Bad Debt Expense

5. Learning Objective 2 • Describe the business functions • and the related documents and • records in the sales and • collection cycle.

6. Sales Transaction Accounts Business Functions Documents and Records Sales Accounts receivable Processing customer orders Granting credit Shipping goods Billing customers and recording sales Customer order Sales order Customer order or sales order Shipping document Sales invoice Sales transaction file Sales journal or listing Accounts receivable master file Accounts receivable trial balance Monthly statements

7. Cash Receipts Transaction Accounts Business Functions Documents and Records Cash in bank (debits from cash receipts) Accounts receivable Processing and recording cash receipts Remittance advice Prelisting of cash receipts Cash receipts transaction file Cash receipts journal or listing

8. Sales Returns and Allowances Transaction Accounts Business Functions Documents and Records Sales returns and allowances Accounts receivable Processing and recording sales returns and allowances Credit memo Sales and returns and allowances journal

9. Write-off of Uncollectible Accounts Transaction Accounts Business Functions Documents and Records Accounts receivable Allowance for uncollectible accounts Writing off uncollectible accounts receivable Uncollectible account authorization form General journal

10. Bad Debt Expense Transaction Accounts Business Functions Documents and Records Bad debt expense Allowance for uncollectible accounts Providing for bad debts General journal

11. Processing Customer Orders • Customer Order: • A request for merchandise by a customer • Sales Order: • A document describing the goods ordered • by a customer

12. Granting Credit • Before goods are shipped, a properly • authorized person must approve credit • to the customer for sales on account

13. Shipping Goods • This is the first point in the cycle • where company assets are given up

14. Billing Customers and Recording Sales • Sales invoice • Sales transaction file • Sales journal or listing • Accounts receivable master file • Accounts receivable trial balance • Monthly statement

15. Processing and Recording Cash Receipts • Remittance advice • Prelisting of cash receipts • Cash receipts transaction file • Cash receipts journal or listing

16. Processing and Recording Sales Returns and Allowances • Credit memo • Sales returns and allowances journal

17. Writing Off UncollectibleAccounts Receivable • Uncollectible account authorization form • This is a document used internally to • indicate authority to write an account • receivable off as uncollectible

18. Providing for Bad Debts • This provision represents a residual, • resulting from management’s • end-of-period adjustment of the • allowance for uncollectible accounts

19. Learning Objective 3 • Understand internal control, and • design and perform tests of • controls and substantive tests • of transactions for sales.

20. Audit procedures Sample size Items to select Timing Methodology for Designing Controls and Substantive Tests Understand internal control – sales Assess planned control risk – sales Determine extent of testing controls Design tests of controls and substantive tests of transactions for sales to meet transaction- related audit objectives

21. Understand Internal Control – Sales Study the client’s flowcharts, prepare an internal control questionnaire, and perform walk-through tests of sales.

22. Assess Planned Control Risk – Sales Four Steps: 1. Framework for assessing control risk 2. Identify key internal controls and deficiencies 3. Associate controls and deficiencies with the objectives 4. Assess control risk for each objective

23. Assess Planned Control Risk – Sales • Adequate separation of duties • Proper authorization • Adequate documents and records • Prenumbered documents • Monthly statements • Internal verification procedures

24. Determine Extent of Testing Controls • Audits of public companies • Audits of nonpublic companies

25. Transaction-related AuditObjectives for Sales Occurrence: Recorded sales are for shipments actually made. Completeness: Existing sales transactions are recorded. Accuracy: Recorded sales are for the amount shipped.

26. Transaction-related AuditObjectives for Sales Posting and summarization: Sales transactions are correctly included in the accounts receivable master file. Classification: Sales transactions are correctly classified. Timing: Sales are recorded on the correct dates.

27. Direction of Tests for Sales Customer order Shipping document Duplicate sales invoice Sales journal General journal = Accounts receivable master file Occurrence start Completeness start

28. Summary of Methodologyfor Sales • Transaction-related audit objectives (Column 1) • Key existing controls (Column 2) • Tests of control (Column 3) • Deficiencies (Column 4) • Substantive tests of transactions (Column 5)

29. Learning Objective 4 • Apply the methodology for controls • over sales transactions to controls • over sales returns and allowances.

30. Sales Returns and Allowances The transaction-related audit objectives and client’s methods of controlling misstatements are essentially the same for processing credit memos as those described for sales.

31. Sales Returns and Allowances There are, however, two important differences. • Materiality • Emphasis on objectives

32. Learning Objective 5 • Understand internal control, and • design and perform tests of • controls and substantive tests • of transactions for cash receipts.

33. Tests of Controls and Substantive Tests of Transactions for Cash Receipts • Determine whether cash received was recorded • Prepare proof of cash receipts* • Test to discover lapping of accounts receivable* * Only performed when fraud is suspected

34. Learning Objective 6 • Apply the methodology for • controls over the sales and • collection cycle to write-offs • of uncollectible accounts • receivable.

35. Audit Tests for the Write-Offof Uncollectible Accounts • Occurrence transaction-related audit objective • Proper authorization of the write-off of • uncollectible accounts • Verification of accounts written off

36. Additional Internal Controls Over Account Balances • Realizable value • Credit approval • Aged accounts receivable trial balance • Writing off uncollectibles • Rights and obligations • Presentation and disclosure

37. Effect of Results of Controls and Substantive Tests of Transactions The parts of the audit most affected by the tests for the sales and collection cycle are: • Accounts receivable • Cash • Bad debt expense • Allowance for doubtful accounts

38. Types of Audit Tests for the Sales and Collection Cycle Sales Accounts Receivable Cash in Bank Sales transactions Cash receipts transactions Audited by TOC, STOT, and AP Audited by TOC, STOT, and AP Ending balance Ending balance Audited by AP and TDB TOC + STOT + AP + TDB = Sufficient appropriate evidence

39. End of Chapter 14

40. Completing the Testsin the Sales and Collection Cycle:Accounts Receivable Chapter 16

41. Learning Objective 1 • Describe the methodology for • designing tests of details of • balances using the audit • risk model.

42. Accounts Receivable Balance-related Audit Objectives 1. Detail tie-in 5. Classification 2. Existence 6. Cutoff 3. Completeness 7. Realizable value 4. Accuracy 8. Rights

43. Methodology for Designing Testsof Details of Balances for A/R Identify client business risks affecting accounts receivable Phase I Set tolerable misstatement and assess inherent risk for accounts receivable Phase I Assess control risk for sales and collection cycle Phase I

44. Methodology for Designing Testsof Details of Balances for A/R Design and perform tests of controls and substantive tests of transactions for the sales and collection cycle Phase II

45. Methodology for Designing Testsof Details of Balances for A/R Design and perform analytical procedures for accounts receivable balance Phase III Phase III Design tests of details of accounts receivable balance to satisfy balance-related audit objectives Audit procedures Sample size Items to select Timing

46. Relationship Between Sales and Accounts Receivable ACCOUNTS RECEIVABLE BALANCE-RELATED AUDIT OBJECTIVES Detail tie-in Completeness Classification Realizable value Rights Existence Accuracy Cutoff Translation-related audit objectives Sales Occurrence × Completeness × Accuracy × Posting and summarization × Classification × Timing ×

47. Relationship Between Sales and Accounts Receivable ACCOUNTS RECEIVABLE BALANCE-RELATED AUDIT OBJECTIVES Detail tie-in Completeness Classification Realizable value Rights Existence Accuracy Cutoff Translation-related audit objectives Cash receipts Occurrence × Completeness × Accuracy × Posting and summarization × Classification × Timing ×

48. Learning Objective 2 • Design and perform analytical • procedures for accounts in the • sales and collection cycle.

49. Analytical Procedures for the Sales and Collection Cycle Compare by product line: • Gross margin percentage with previous years • Sales by month over time • Sales returns and allowances as a percentage of gross sales with previous years

50. Analytical Procedures for the Sales and Collection Cycle Compare with previous years: • Individual customer balances over a stated amount • Bad debt expense as a percentage of gross sales • Days that accounts receivable are outstanding