Auditing the Revenue Process Chapter 10 Auditing the Revenue Process McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

LO# 1 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. 10-2

Revenue Recognition Criteria SAB 101 LO# 1 Revenue Recognition Criteria SAB 101 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. 10-3

Fraud Risks in Revenue Recognition LO# 1 Fraud Risks in Revenue Recognition Side agreements Channel stuffing Related party transactions Bill and hold sales 10-4

Overview of the Revenue Process LO# 2 Overview of the Revenue Process Cash Sale Credit Sale Cash collection Purchases Purchases Inventory Cash sales Account receivable Inventory Credit sales 10-5

Types of Transactions and Financial Statement Accounts Affected LO# 3 Types of Transactions and Financial Statement Accounts Affected Three types of transactions are typically processed through the revenue process: The sale of goods or rendering of a service for cash or credit. The receipt of cash from the customer in payment for goods or services. The return of goods by the customer for credit or cash. 10-6

Types of Transactions and Financial Statement Accounts Affected LO# 3 Types of Transactions and Financial Statement Accounts Affected The revenue process affects numerous accounts in the financial statements. The most significant accounts are: 10-7

Figure 10-2 Flowchart of the Revenue Process—EarthWear Clothiers, Inc. 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. (continued) 10-10

Types of Documents and Records LO# 4 Types of Documents and Records 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 procedure for investigating the creditworthiness of the customer. 10-11

Types of Documents and Records LO# 4 Types of Documents and Records 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. 10-12

Types of Documents and Records LO# 4 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 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. 10-13

Types of Documents and Records LO# 4 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. Accounts Receivable Subsidiary Ledger This ledger contains an account and the details of transactions for each customer. 10-14

Types of Documents and Records LO# 4 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. Remittance Advice This is usually the part of the customer’s bill that should be returned with the payment. 10-15

Types of Documents and Records LO# 4 Types of Documents and Records 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. 10-16

Types of Documents and Records LO# 4 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. 10-17

LO# 5 The Major Functions 10-18

Key Segregation of Duties LO# 6 Key Segregation of Duties 10-19

Inherent Risk Assessment LO# 7 Inherent Risk Assessment The four inherent risk factors that may affect the revenue process are: Industry-related factors. The complexity and contentiousness of revenue recognition issues. The difficulty of auditing transactions and account balances. Misstatements detected in prior audits. 10-20

Control Risk Assessment LO# 8 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. 10-21

Understanding and Documenting Internal Control LO# 8 Understanding and Documenting Internal Control Control Environment Understanding the control environment is generally completed on an overall entity basis. 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. 10-22

Understanding and Documenting Internal Control LO# 8 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 Internal control questionnaires Flowcharts 10-23

Information Systems and Communication LO# 8 Information Systems and Communication Process by which sales, cash receipts, and sales returns and allowances transactions are initiated. The flow of each transaction from initiation to inclusion in the financial statements. Auditor’s knowledge Accounting records, supporting documents, and accounts that are involved in sales, cash receipts, and sales returns. The process used to prepare estimates for accounts such as bad debts and sales returns. 10-24

Monitoring of Controls LO# 8 Monitoring of Controls 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. 10-25

Plan and Perform Tests of Controls LO# 8 Plan and Perform 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 procedures. 10-26

Set and Document the Control Risk LO# 8 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.” 10-27

Control Activities and Tests of Controls – Revenue Transactions LO# 9 Control Activities and Tests of Controls – Revenue Transactions Assertions about Classes of Transactions and Events for the Period under Audit 10-28

Table 10-6: Example Tests of Controls for Revenue Transactions LO# 9 Table 10-6: Example Tests of Controls for Revenue Transactions 10-29

Table 10-6: Example Tests of Controls for Revenue Transactions LO# 9 Table 10-6: Example Tests of Controls for Revenue Transactions 10-30

Table 10-6: Example Tests of Controls for Revenue Transactions LO# 9 Table 10-6: Example Tests of Controls for Revenue Transactions 10-31

Occurrence of Revenue Transactions LO# 9 Occurrence of Revenue Transactions The auditor is concerned about two major types of material misstatements: Sales to fictitious customers. 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. 10-32

Completeness of Revenue Transactions LO# 9 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, and (4) maintaining and reviewing the open-order file. 10-33

Authorization and Accuracy of Revenue Transactions LO# 9 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. 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. 10-34

Cutoff and Classification of Revenue Transactions LO# 9 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. The use of a chart of accounts and proper codes for recording transactions should provide adequate assurance about the proper classification of revenue transactions. 10-35

Table 10-7: Example Tests of Controls for Cash Receipts Transactions LO# 9 Table 10-7: Example Tests of Controls for Cash Receipts Transactions 10-36

Table 10-7: Example Tests of Controls for Cash Receipts Transactions LO# 9 Table 10-7: Example Tests of Controls for Cash Receipts Transactions 10-37

Occurrence of Cash Receipts Transactions LO# 9 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. 10-38

Completeness of Cash Receipts and Authorization of Discounts LO# 9 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. 2/10, n/30 Terms of trade generally include discounts for payment within a specified period as a way of encouraging customers to pay on time. 10-39

Accuracy of Cash Transactions LO# 9 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. 10-40

Cutoff and Classification of Cash Receipts Transactions LO# 9 Cutoff and Classification of Cash Receipts Transactions If the client 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. The auditor seldom has major concerns about cash receipts being recorded in the wrong financial statement account. 10-41

LO# 9 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. 10-42

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 Sales 10-43

Auditing Revenue Related Accounts LO# 10 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. 10-44

Substantive Analytical Procedures LO# 11 Substantive Analytical Procedures Ratios used for comparative purposes include: Receivables turnover and days outstanding in accounts receivable. Aging categories on aged trial balance of accounts receivable. Bad-debts expense as a percent of revenue. Allowance for uncollectible accounts as a percent of accounts receivable or credit sales. Large customer account balances compared to last period. 10-45

Substantive Tests of Transactions LO# 12 Substantive Tests of Transactions For Accounts Receivable, Allowance for Uncollectible Accounts, and Bad-Debt Expense 10-46

Tests of Details of Account Balances LO# 12 Tests of Details of Account Balances For Accounts Receivable, Allowance for Uncollectible Accounts, and Bad-Debt Expense 10-47

LO# 12 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. 10-48

Are all transactions tested recorded in the proper period? LO# 12 Cutoff The cutoff test attempts to determine whether all revenue transactions and related accounts receivable are recorded in the proper period. 12/31/12 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? 10-49

Existence and Rights and Obligations LO# 12 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. 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. 10-50 50

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. 10-51

LO# 12 Classification The major issues related to presentation, disclosure, and classification are: Identifying and reclassifying any material credits contained in accounts receivable. Segregating short-term and long-term receivables. Ensuring that different types of receivables are properly classified. 10-52

The Confirmation Process – Accounts Receivable LO# 13 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. 10-53

Omitting Confirmations LO# 13 Omitting Confirmations Accounts receivable are immaterial. The use of confirmations would not be effective. IR and CR are assessed “low” and evidence gathered from other substantive tests is sufficient to reduce AR to an acceptably low level. 10-54

Types of Confirmations LO# 13 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. 10-55

LO# 13 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. 10-56

Confirmation Procedures LO# 13 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. 10-57

Alternative Procedures LO# 13 Alternative Procedures When the auditor does not receive responses to positive confirmations, alternative audit procedures are used. These alternative procedures include: Examination of subsequent cash receipts. Examination of customer orders, shipping documents, and duplicate sales invoices. Examination of other client documentation. 10-58

Auditing Other Receivables LO# 14 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. 10-59

Evaluating the Audit Findings LO# 15 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. 10-60