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

Inherent Risks of Revenue Improper Recognition Cut-off Bill and Hold Channel Stuffing Returns and Allowances Collectibility of Receivables 2

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 3

Revenue Cycle Receive customer purchase order Check inventory stock status --- Generate back order if item not in stock Obtain credit approval Prepare shipping and packing documents Ship and verify shipment of goods Prepare the invoice Send monthly statements to customers Receive payment

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 5

Sources of Audit Evidence Pending Order Master File Credit check/approval files Price List Master File Sales Journal Sales Analysis Report Accounts Receivable Aged Trial Balance Cash Receipts Listing Customer Statements 6

Controls No Sales Order without Customer Order Credit Approval Process Restricted Access to Inventory Restricted Access to Terminals and Invoices Documentation in order to Record Sales Proper Dating Invoices compared to BOLs and Orders Pending Order File Reviewed

Accounts in Revenue Cycle Sales 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 Revenue 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

Sources of Accounts Receivable Claims against customers from sale of goods Loans to officers or employees Loans to subsidiaries Claims against various other refunds Claims for tax refunds Advances to suppliers Shown on balance sheet at Net Realizable Value

Inherent Risk in Receivables Net receivables will be overstated, because either receivables have been overstated, or the allowance for uncollectible accounts has been understated Sales of receivables recorded as sales rather than financing transactions Receivables pledged as collateral Receivables classified as current but likelihood of collection is low Collection of receivable contingent on uncertain future events Payment not required until purchaser sells the product

Accounts Receivable Balance-Related Audit Objectives Detail Tie-in Existence Completeness Accuracy Classification Cutoff Realizable Value Rights Presentation and Disclosure

Substantive Tests of Accounts Receivable Obtain and evaluate Aging of Accounts Receivable Confirm receivables with customers Perform cutoff tests Review subsequent collections of receivables

Aging of Accounts Receivable Receivables are at Net Realizable Value --- auditors must evaluate management estimates of uncollectible accounts Obtain or prepare Schedule of Aged Accounts Receivable --- If schedule is prepared by client, it is tested for mathematical and aging accuracy Use an Aging Schedule to Agree detail to control account balance Select customer balances for confirmation Identify amounts due from related parties for disclosure Identify past-due balances Evaluate Percentages of Uncollectibility Calculate the Balance in the Allowance Account

Accounts Receivable Aged Trial Balance

Types of Confirmation Positive Confirmation Blank Confirmation Form Invoice Confirmation Negative Confirmation

Positive Confirmation Letter

Negative Confirmation Letter

Selection of the Items for Testing When selecting a sample of accounts receivable for confirmation, the auditor should be careful to avoid being influenced by the client. If a client tries to discourage the auditor from sending confirmations to certain customers, the auditor should consider the possibility that the client is attempting to conceal fictitious or known misstatements of accounts receivable.

Sample Size Tolerable misstatement Inherent risk Control risk Achieved detection risk from other substantive tests Type of confirmation

Timing The most reliable evidence from confirmations is obtained when they are sent as close to the balance sheet date as possible, as opposed to confirming the accounts several months before year-end.

Maintaining Control After the items for confirmation have been selected, the auditor must maintain control of the confirmations until they are returned from the customer.

Follow-up Procedures for Exceptions Noted Because misstatements are projected to the population of receivables, the auditor must determine the reason for the exception

Exhibit 7.10 Responses to Positive Confirmations

Analysis of Difference Payment has already been made Goods have not been received The goods have been returned Clerical errors and disputed accounts

Follow-up on Nonresponses When positive confirmations are used, SAS 67 requires follow-up procedures for confirmations not returned by he customer. Alternative Procedures

ALTERNATIVE PROCEDURES Vouch Subsequent Cash Collections Examine Shipping Documents Examine Client-Generated Supporting Documentation ----Depends on internal controls Inspect Correspondence Files 27

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 28

Related-Party Receivables Amounts due from related parties should be separately disclosed Audit procedures to identify related-party transactions include: Review SEC filings Review the accounts receivable subsidiary ledger and trial balance Management inquiry Communicate names of all known related parties to audit team members

Sold, Discounted, and Pledged Receivables Receivables sold with recourse, discounted, or pledged as collateral should be disclosed Audit procedures to identify these items Management inquiry Scan cash receipts journal for large cash inflows from unusual sources Bank confirmations, which include information on obligations and terms Review board of director minutes, which contain approval of these items

Auditing of Allowance for Doubtful Accounts Obtain an understanding of how management developed the estimate using one or more of these approaches: Review and test the process used by management to develop the estimate Test aging schedule Evaluate estimated percentages of uncollectibility used Develop an independent model to estimate the accounts Review subsequent events such as subsequent collections on account

Sales Transaction Accounts Sales Receivable Business Functions Processing Customer Orders Granting Credit Shipping Goods Billing Customers and Recording ales Documents and Records Customer Order Sales Order Shipping Document Sales Invoice Sales Transaction File Sales Journal or Listing Accounts Receivable Master File Trial Balance Monthly Statements

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.

Monitoring Controls Comparison of sales and cost of good sold with budgeted amounts Exception reports to identify unusual transactions Internal audit of revenue cycle controls Computer reconciliation of transactions entered with transactions processed Monitoring of accounts receivable for quality Independent follow-up on customer complaints Audits of sales tax collections

Substantive Tests of Revenue Cutoff Tests Sales Cutoff Auditor selects sample of sales recorded during cutoff period and vouches back to sales invoice and shipping documents to determine whether sales are recorded in proper period Cutoff tests assertions of existence and completeness Auditor may also examine terms of sales contracts Sales Return Cutoff Client should document return of goods using receiving reports Reports should date, description, condition, quantity of goods Auditor selects sample of receiving reports issued during cutoff period and determines whether credit was recorded in the correct period

Shipping Documents These are important in establishing whether the shipment was actually made and as a test of cutoff.

Sales Returns and Allowances Transaction Accounts Business Functions Processing and recording sales returns and allowances Sales Returns and Allowances Accounts Receivable Documents and Records Credit Memo Sales and Returns and Allowances Journal

Fraud Indicators Excessive credit memo or other adjustments to accounts receivable just after year-end Customer complaints and discrepancies in receivable confirmations Unusual entries to the receivable subsidiary ledger or sales journal Missing or altered source documents Lack of operating cash flow when operating income has been reported Unusual reconciling differences between receivable subsidiary ledger and control account Sales in the last month with unusual terms Pre- or post-dated transactions Unusual adjustments to sales accounts just before or after year-end

Improper Revenue Recognition Schemes Recognize revenue on fictitious shipments Hidden side letters that give customers unlimited right to return product Record consignment sales as final sales Accelerated recognition of sales occurring after year-end Ship unfinished goods Ship goods before date agreed to by customer Create fictitious invoices Ship goods never ordered Ship more goods than ordered Record shipments to company's warehouse as sales Record shipments of replacement goods as new sales

End of Chapter