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

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

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

Analysis of the Sales and Collection Cycle Excellent format for analysis: Business Functions Accounts involved Documents and Records Think Accounting Information Systems

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

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

Sales Returns and Allowances Transaction Accounts Business functions Processing and recording sales returns and allowances Documents and records Credit memo Sales and returns and allowances journal Sales returns and allowances Accounts receivable

Charge-off of Uncollectible Accounts Transaction Business functions Charging off uncollectible accounts receivable Documents and records Uncollectible account authorization form General journal Accounts receivable Allowance for uncollectible accounts

Bad Debt Expense Transaction Accounts Business functions Providing for bad debts Documents and records General journal Bad debt expense Allowance for uncollectible accounts

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

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

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

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

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

Processing and Recording Sales Returns and Allowances Credit memo Sales returns and allowances journal

Charging Off Uncollectible Accounts Receivable Uncollectible account authorization form This is a document used internally to indicate authority to write an account receivable off as uncollectible.

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

Effect of E-Commerce on the Sales and Collection Cycle The Internet and other developing technologies allow companies to develop new business models.

Effect of E-Commerce on the Sales and Collection Cycle Business-to-business (B2B) Business-to-consumer (B2C) Management’s assertions for sales and collection activities remain the same.

Effect of E-Commerce on the Sales and Collection Cycle Auditors should obtain an understanding of the design and operation of key internal controls over e-commerce revenues. Evidence for e-commerce activities is likely to be in electronic form.

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

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

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

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

Determine Extent of Testing Controls Audits of public companies Audits of nonpublic companies

Transaction-Related Audit Objectives for Sales Existence: Recorded sales are for shipments actually made. Completeness: Existing sales transactions are recorded. Accuracy: Recorded sales are for the amount shipped.

Transaction-Related Audit Objectives for Sales Classification: Sales transactions are properly classified. Timing: Sales are recorded on the correct dates. Posting and summarization: Sales transactions are properly included in the accounts receivable master file.

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

Summary of Methodology for 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)

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.

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

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.

Audit Tests for Uncollectible Accounts Existence of recorded write-offs is the most important transaction-related audit objective. What is a major concern in testing accounts charged off as uncollectible? – covering up a defalcation by charging off accounts receivable that have been collected

Additional Internal Controls Over Account Balances Realizable value Charging off uncollectibles Credit approval Aged accounts receivable trial balance

Additional Internal Controls Over Account Balances Rights and obligations Presentation and disclosure

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

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