1. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-1 Chapter Ten Auditing the Revenue Process Chapter Ten Auditing the Revenue Process

2. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-2 Revenue Recognition (IAS 18) Revenue is defined as the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants.

3. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-3 Overview of the Revenue Process Purchases Inventory Credit sales Account receivable Cash collection Purchases Inventory Cash sales Cash Sale Credit Sale

4. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-4 Types of Transactions and Financial Statement Accounts Affected Three types of transactions are typically processed by 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.

5. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-5 Types of Transactions and Financial Statement Accounts Affected The revenue process affects numerous accounts in the financial statements. The most significant accounts are:

6. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-6 Revenue Process – EarthWear Clothiers Order Entry Department By mail or fax Customer sales order Input Error Correction By phone or internet A A If a new customer, a credit check is run by the Credit Department. Otherwise, credit is checked by IT To the IT Department

7. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-7 Revenue Process – EarthWear Clothiers From order entry department Data validation program Customer Price Inventory Open orders Inventory Open orders Shipping program To order entry department Error Report Batched nightly To shipping department IT Department

8. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-8 Revenue Process – EarthWear Clothiers From shipping department Approved shipping ticket Ship goods To customer with goods Shipping Department A The shipping ticket forwarded to the customer contains quantity and price of each item purchased. Approved shipping ticket Input to the billing program

9. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-9 Revenue Process – EarthWear Clothiers IT Department A Open orders Inventory Shipping transactions A weekly open order report is prepared and reviewed by billing department. Outstanding orders are investigated. Billing program Sales Invoice Customer Accounts receivable update For receivables processing B

10. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-10 Revenue Process – EarthWear Clothiers Accounts receivable update IT Department Shipping transactions Sales Remittance transactions Accounts receivable B Daily shipping listing Daily sales report Daily remittance report To sales department C To cash receipts department Accounts receivable reporting Weekly or Monthly D

11. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-11 Revenue Process – EarthWear Clothiers IT Department Remittance transactions Accounts receivable Shipping transactionsGeneral ledger Accounts receivable reporting Customer statements Weekly or Monthly Reports Sales journal Cash receipts journal Aged trial balance Sales summary Remittance summary Journal entry summary D Customer

12. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-12 Revenue Process – EarthWear Clothiers Cash Receipts Department IT Department From bank Remittance advice transactions Accounts receivable Remittance advice transactions Cash remittance update From bank Remittance advice listing Reconciled by cash receipts clerks Daily remittance report C Error correction Error report B

13. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-13 Types of Documents and Records Customer Sales Order Contains the details of the type and quantity of products or services ordered by the customer. 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 client must have a formal activity (procedure) for investigating the creditworthiness of the customer. Credit Approval Form For credit sales, the client must have a formal activity (procedure) for investigating the creditworthiness of the customer.

14. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-14 Types of Documents and Records Open-Order Report A report of all customer orders for which processing has not been completed. 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. 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.

15. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-15 Types of Documents and Records 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 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. 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.

16. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-16 Types of Documents and Records Customer Statement This document is mailed to the customer and contains details of all sales, cash receipts, and credit memorandum transactions. 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. Accounts Receivable Subsidiary Ledger This ledger contains an account and the details of transactions for each customer.

17. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-17 Types of Documents and Records 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. 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. Remittance Advice This is usually the part of the customer’s bill that should be returned with the payment.

18. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-18 Types of Documents and Records Cash Receipts Journal This journal is used to record the cash receipts of the entity. 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. Credit Memorandum This document is used to record credits for the return of goods by a customer.

19. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-19 Types of Documents and Records Write-Off Authorization This document authorizes the write-off of an uncollectible account receivable. Final authorization is generally received from the treasurer. Write-Off Authorization This document authorizes the write-off of an uncollectible account receivable. Final authorization is generally received from the treasurer. Order Entry The initial function in the revenue process is the entry of a new sales order into the system. Order Entry The initial function in the revenue process is the entry of a new sales order into the system.

20. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-20 Types of Documents and Records Shipping Goods should not be shipped, nor should services be provided without proper authorization. The main control is payment or proper credit authorization. Shipping Billing The objective of proper billing is to ensure that all goods shipped and all services rendered are billed to the customer. Billing 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. 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.

21. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-21 Types of Documents and Records Cash Receipts All cash collected must be properly identified and promptly deposited intact at the bank. 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. 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. 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.

22. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-22 Key Segregation of Duties Segregation of Duties for Revenue and Accounts Receivable Functions by Department

23. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-23 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.

24. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-24 Control Risk Assessment Understanding and documenting the revenue process based on a reliance approach. Planning and performing tests of controls on revenue transactions. Setting and documenting the control risk for the revenue process.

25. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-25 Control Environment Understanding the control environment is generally completed on an overall entity basis. 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. 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.

26. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-26 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 descriptions Flowcharts Internal control questionnaires

27. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-27 Information Systems and Communication Auditor’s knowledge Process by which sales, cash receipts and credit memoranda are initiated. 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 bad debts and sales returns.

28. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-28 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

29. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-29 Planning and Performing Tests of Controls The auditor systematically examines the client’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.

30. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-30 Setting and Documenting 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.’

31. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-31 Control Activities and Tests of Controls – Revenue Transactions Assertions about Classes of Transactions and Events for the Period under Audit

32. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-32 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.

33. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-33 Completeness of Revenue Transactions The major misstatement that concerns both management and the auditor is that goods are shipped or services are performed and no revenue 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.

34. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-34 Authorization 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. Test policies and activities relating to authorization of revenue transactions.

35. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-35 Accuracy of Revenue Transactions 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.

36. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-36 Cutoff 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.

37. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-37 Classification of Revenue Transactions The use of a chart of accounts and proper codes for recording transactions should provide adequate assurance about the proper classification of revenue transactions.

38. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-38 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 client’s bank account.

39. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-39 Completeness of Cash Receipts Transactions A possible misstatement is that cash or cheques are stolen or lost before being recorded in the cash receipts records. When electronic transfer of cash receipts is used, a strong control exist to ensure that cash receipts are not stolen or lost before recording. Otherwise proper segregation of duties and a lockbox system are controls relating to completeness.

40. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-40 Authorization of Cash Discounts Terms of trade generally include discounts for payment within a specified period as a way of encouraging customers to pay on time. 2/10, n/30

41. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-41 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.

42. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-42 Cutoff of Cash Receipts Transactions If the client uses electronic transfer, 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.

43. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-43 Classification of Cash Receipts The auditor seldom has major concerns about cash receipts being recorded in the wrong financial statement account.

44. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-44 Control Activities and Tests of Controls – Sales Returns and Allowances Sales 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.

45. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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 receivable Allowance for bad debts Bad debts expense Sales returns and allowances

46. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-46 Auditing Accounts Receivable and Related Accounts Substantive analytical procedures are used to examine plausible relationships among accounts receivable and 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.

47. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 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 per cent of revenue. 4.Allowance for uncollectible accounts as a per cent of accounts receivable or credit sales. 5.Large account balances compared to last period. 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 per cent of revenue. 4.Allowance for uncollectible accounts as a per cent of accounts receivable or credit sales. 5.Large account balances compared to last period.

48. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-48 Tests of Details of Transactions, Account Balances and Disclosure For Accounts Receivable, Allowance for Uncollectible Accounts and Bad-Debt Expense

49. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-49 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.

50. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-50 Cutoff The cutoff test attempts to determine whether all revenue transactions and related accounts receivable are recorded in the proper period. 31/12/06 prior Test a few shipping documents just prior to year-end. Test a few shipping documents just after year-end. Are all transactions tested recorded in the proper period?

51. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-51 Rights and Obligations 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.

52. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-52 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.

53. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-53 Classification and Understandability 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. 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.

54. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-54 The Confirmation Process – Accounts Receivables Confirmation is the process of obtaining information from third parties about the account receivable balance. Confirmation is a good source of evidence about the validity of the account receivable. The confirmation process should be controlled by the auditor.

55. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-55 Types of Confirmations Positive Confirmation Positive Confirmation Requests that customers indicate whether they agree with the amount due to the client. 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. Positive Confirmation Positive Confirmation Requests that customers indicate whether they agree with the amount due to the client. 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 Negative Confirmation Requests that the customer respond only when they disagree with the amount due to the client. 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. Negative Confirmation Negative Confirmation Requests that the customer respond only when they disagree with the amount due to the client. 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.

56. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-56 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.

57. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-57 Confirmation Procedures The auditor should mail the confirmation requests outside the client’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.

58. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-58 Alternative Procedures When the auditor does not receive responses to positive confirmations, alternative audit procedures are used. These alternative procedures include: 1.Examination of subsequent cash receipts. 2.Examination of customer orders, shipping documents and duplicate sales invoices. 3.Examination of other client documentation. 1.Examination of subsequent cash receipts. 2.Examination of customer orders, shipping documents and duplicate sales invoices. 3.Examination of other client documentation.

59. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-59 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. Likely misstatement* less than tolerable misstatement Likely misstatement* greater than tolerable misstatement Accept the account as fairly presented Account is not fairly presented. *Together with any separately identified known misstatements (cf. ED ISA 320).

60. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 10-60 End of Chapter 10