Chapter 10

1. CHAPTER 10AUDITING THE REVENUE PROCESS Chapter 10

2. REVENUE RECOGNITION • Accounting standards (SFAS No. 5) requires that before revenue is recognized it must be realized and earned. • The SEC’s SAB No. 101 requires the following criteria for revenue recognition: • 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. • Collectibility is reasonably assured.

3. OVERVIEW OF THE REVENUE PROCESS • The "cradle to grave" process for revenue begins with an order from a customer, proceeds to the exchange of goods or services for a promise to pay, and ends with the payment of cash. • Figure 10-1: Flowchart for a revenue process

4. TYPES OF TRANSACTIONS • The sale of goods or rendering of a service for cash or credit. • The receipt of cash from the customer in payment for the goods or services. • The return of goods by the customer for credit or cash.

5. FINANCIAL STATEMENT ACCOUNTS • Sales Transaction: • Trade accounts receivable • Sales • Allowance for uncollectible accounts • Bad debt expense • Cash Receipts Transactions: • Cash • Trade accounts receivable • Cash discounts • Sales Return and Allowance Transaction: • Sales returns • Sales allowances • Trade accounts receivable

6. Customer sales order Credit approval form Open-order report Shipping document Sales invoice Sales journal Customer statement Accounts receivable subsidiary ledger Aged trial balance of accounts receivable Remittance advice Cash receipts journal Credit memorandum Write-off authorization DOCUMENTS AND RECORDS

7. FUNCTIONS IN THE REVENUE PROCESS • Order entry: Acceptance of customer orders into the system • Credit authorization: Approval of customer orders for creditworthiness • Shipping: Shipment of authorized goods • Billing: Issuance of sales invoices to customers for goods shipped or services rendered

8. FUNCTIONS IN THE REVENUE PROCESS • Cash receipts: Processing cash receipts from customers • Accounts receivable: Recording sales invoices, collections and credit memoranda in customer accounts • General ledger: Proper accumulation, classification and summarization of revenues, collections and receivables in the financial statement accounts

9. SEGREGATION OF DUTIES • Credit function should be segregated from Billing function. • Shipping function should be segregated from Billing function. • Accounts Receivable function should be segregated from General Ledger function. • Cash Receipts function should be segregated from Accounts Receivable function.

10. INHERENT RISK ASSESSMENT • Industry-related factors. • Complexity of revenue recognition issues. • Difficulty of auditing transactions and accounts. • Misstatements detected in prior audits.

11. CONTROL RISK ASSESSMENT Understanding and documenting the revenue process based on the planned level of control risk Planning and performing tests of controls on revenue transactions Assessing and documenting the control risk for the revenue process

12. CONTROL PROCEDURES AND TESTS OF CONTROLS - REVENUE TRANSACTIONS Table 10-5 (page 387 – 388) -- Revenue Transactions ObjectivesMisstatements

13. CONTROL PROCEDURES AND TESTS OF CONTROLS - CASH RECEIPTS TRANSACTIONS Table 10-6 (page 391) -- Cash Receipts Transactions ObjectivesMisstatements

14. CONTROL PROCEDURES AND TESTS OF CONTROLS - SALES RETURNS AND ALLOWANCES TRANSACTIONS • Credit memos can be used to conceal unauthorized shipments or misappropriation of cash. • A credit memorandum should be approved by someone other than the individual who initiated the credit memorandum. (Segregation of Duties) • Credits for returned goods should be supported by a receiving document indicating that the goods have been returned. (Auditor should examine a sample)

15. RELATING THE ASSESSED LEVEL OF CONTROL RISK TO SUBSTANTIVE TESTING • When the results of the tests of controls support the planned assessed level of CR, the auditor can conduct the substantive tests at the planned level. • If the results of the tests of controls do not support the planned assessed level of CR, DR will have to be set lower, and substantive tests increased.

16. AUDIT OBJECTIVES FOR TESTING ACCOUNTS RECEIVABLE • Validity • Completeness • Cutoff • Ownership • Accuracy • Valuation • Classification • Disclosure

17. AUDITING ACCOUNTS RECEIVABLE AND RELATED ACCOUNTS • Substantive tests that are used to detect material misstatements in accounts receivable include: • Substantive tests of transactions • Analytical procedures • Tests of account balances

18. SUBSTANTIVE TESTS OF TRANSACTIONS Substantive tests of transactions are tests conducted on the individual transactions processed through the revenue process to detect monetary misstatements (Table 10-8 – Page 396).

19. ANALYTICAL PROCEDURES Analytical procedures are useful audit tests for examining the fairness of accounts such as revenue, accounts receivable, allowance for uncollectible accounts, bad debt expense, and sales returns and allowances.

20. ANALYTICAL PROCEDURES - REVENUE • Comparison of gross profit percentage by product line with previous years and industry data. • Comparison of reported revenue to budgeted revenue.

21. ANALYTICAL PROCEDURES - ACCOUNTS RECEIVABLE, ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS AND BAD DEBT EXPENSE • Comparison of receivables turnover and days outstanding in accounts receivable to previous years’ and/or industry data. • Comparison of aging categories on aged trial balance of accounts receivable to previous years’. • Comparison of bad-debt expense as a percentage of revenue to previous years’ and/or industry data. • Comparison of the allowance for uncollectible accounts as a percentage of accounts receivable or credit sales to previous years’ and/or industry data. • Examination of large customer accounts individually and comparison to previous year.

22. ANALYTICAL PROCEDURES – SALES RETURNS, ALLOWANCES, AND COMMISSIONS • Comparison of sales returns as a percentage of revenue to previous years’ and/or industry data. • Comparison of sales discounts as a percentage of revenue to previous years’ and/or industry data. • Estimation of sales commission expense by multiplying net revenue by average commission rate and comparison of recorded sales commission expense.

23. TESTS OF ACCOUNT BALANCES - ACCOUNTS RECEIVABLE (Table 10-10) ObjectivesTests of Account Balance

24. TESTS OF ACCOUNT BALANCES - ACCOUNTS RECEIVABLE (Table 10-10) ObjectivesTests of Account Balance

25. THE CONFIRMATION PROCESS Confirmation is the process of obtaining and evaluating a direct communication from a third party in response to a request for information about a particular item affecting financial statement assertions (AU 330).

26. THE CONFIRMATION PROCESS - ACCOUNTS RECEIVABLE • The auditor will normally request confirmation of accounts receivable during an audit. • Confirmations address the following audit objectives: • Validity • Completeness • Cutoff • Valuation

27. OMISSION OF CONFIRMATION OF ACCOUNTS RECEIVABLE • The accounts receivable are immaterial to the financial statements. • The use of confirmations would not be effective as an audit procedure (e.g., past response rates were low or the responses might not be reliable). • The auditor’s assessment of IR and CR is low, and evidence gathered from other substantive tests is sufficient to reduce audit risk to a low level.

28. RELIABILITY OF ACCOUNTS RECEIVABLE CONFIRMATIONS • Factors that affect the reliability of accounts receivable confirmations: • The type of confirmation request. • Prior experience on the client or similar engagements. • The intended respondent.

29. TYPES OF CONFIRMATIONS • Positive Confirmation (Exhibit 10-7 – Page 407) • A response is required • May use a “blank” form • Used when fewer customer accounts with large balances or when errors are anticipated (high level of CR) • Any non-responses require alternate procedures

30. TYPES OF CONFIRMATIONS • Negative Confirmation (Exhibit 10-8 – Page 408) • Response is required only if the customer disagrees • Used when many customer accounts with small balances, when CR is low, and when the auditor believes the customers will devote adequate attention to the confirmations • Non-responses generally assumed to be valid A/R • Can use a combination of Positive (for large balances) and Negative (for small balances)

31. TIMING OF ACCOUNTS RECEIVABLE CONFIRMATIONS • Interim • Year-end

32. CONFIRMATION PROCEDURES • Maintain Control • Minimize interference by client • Auditor mails them directly with CPA’s address as “return address” • Can use fax if there are time pressures • Responses should be addressed to CPA • Maintain record of confirmations mailed and returned • Positive confirmations may require 2nd and 3rd Requests

33. CONFIRMATION PROCEDURES • Confirmation Exceptions (Table 10-12 – Page 409) ExceptionsPotential Cause

34. ALTERNATIVE PROCEDURES • Examination of subsequent cash receipts. • Examination of customer orders, shipping documents, and duplicate sales invoices. • Examination of other client documentation.

35. AUDITING OTHER RECEIVABLES • Receivables from officers and employees. • Receivables from related parties. • Notes receivable. • These receivables are usually confirmed and evaluated for collectibility.

36. EVALUATING THE AUDIT FINDINGS -ACCOUNTS RECEIVABLE AND RELATED ACCOUNTS • Compare total projected misstatement to tolerable misstatement. • Analyze misstatements for causes of errors.