Auditing & Assurance Services, 6e

1. Auditing & Assurance Services, 6e

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

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

4. Learning Objectives (continued) • 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. • Describe some common errors and frauds in the revenue and collection cycle, and design some audit and investigation procedures for detecting them. 7-4

5. Overall Audit Approach 7-5

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

7. 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

8. Exhibit 7.2 Revenue Recognition Rogues 7-8 7-8

9. Exhibit 7.3 Revenue and Collection Cycle 7-9

10. 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

11. 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

12. 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

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

14. Exhibit 7.6 Dual Direction of Test Audit Sample 7-14

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

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

17. Exhibit 7.8 Accounts Receivable Aged Trial Balance 7-17

18. USING CONFIRMATIONS • Primarily 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

19. 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

20. Exhibit 7.9 Positive Confirmation Letter 7-20

21. Exhibit 7.10 Negative Confirmation Letter 7-21

22. CONFIRMATION CONSIDERATIONS • All confirmations returned by the post office as non-deliverable must be investigated • 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). • Verify that the response came from an appropriate person at the employer 7-22

23. 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

24. Exhibit 7.11 Responses to Positive Confirmations 7-24

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

26. 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 • 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

27. UNCOLLECTIBLE ACCOUNTS • Inspect customer files for collectibility • Recalculate ALLOWANCE and BAD DEBT EXPENSE • Verify reasonableness of ALLOWANCE and BAD DEBT EXPENSE • Inspect documentation for appropriateness of accounts written off • Inspect documentation for additional collection procedures • Inspect documentation for appropriate authorization. 7-27

28. 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

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