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

Five Steps to Revenue Recognition (Illustration 5-2) LO5-1 Five Steps to Recognizing Revenue Transactions: Single/Multiple POs* Identify the contract Legal rights of seller and customer established Performance obligation Identify the performance obligation(s) Single Multiple Amount seller is entitled to receive from customer Amount seller is entitled to receive from customer Determine the transaction price Allocate the transaction price No allocation required Allocate a portion to each performance obligation Application of the core revenue recognition principle can be summarized in five steps. All revenue recognition starts with a contract between a seller and a customer. Contracts contain one or more performance obligations , which are promises by the seller to transfer goods or services to a customer. The transaction price for the contract is estimated, and if the contract contains multiple performance obligations the transaction price is allocated to those performance obligations. The seller then recognizes revenue when (or as) it satisfies each performance obligation by transferring control of the promised goods or services underlying that performance obligation. Transfer of control could happen either at a single point in time or over a period of time, so revenue is recognized accordingly at a point in time or over a period of time. And, if a contract contains multiple performance obligations, the timing of revenue recognition is determined separately for each performance obligation depending on when that performance obligation is satisfied. Recognize revenue when (or as) each performance obligation is satisfied At a point in time Over a period of time At whatever time is appropriate for each performance obligation POs* - Performance Obligations

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

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. 10-5

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: 10-6

Figure 10-2 Flowchart of the Revenue Process—EarthWear Clothiers, Inc. 10-7

LO# 3 Figure 10-2 Flowchart of the Revenue Process—EarthWear Clothiers, Inc. (continued) 10-8

LO# 3 Figure 10-2 Flowchart of the Revenue Process—EarthWear Clothiers, Inc. (continued) 10-9

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. 10-10

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. 10-11

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. 10-12

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 10-13

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. 10-14

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. 10-15

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. 10-16

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.” 10-17

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 10-18

Table 10-6: Example Tests of Controls for Revenue Transactions LO# 9 Table 10-6: Example Tests of Controls for Revenue Transactions 10-19

Table 10-6: Example Tests of Controls for Revenue Transactions LO# 9 Table 10-6: Example Tests of Controls for Revenue Transactions 10-20

Table 10-6: Example Tests of Controls for Revenue Transactions LO# 9 Table 10-6: Example Tests of Controls for Revenue Transactions 10-21

Table 10-7: Example Tests of Controls for Cash Receipts Transactions LO# 9 Table 10-7: Example Tests of Controls for Cash Receipts Transactions 10-22

Table 10-7: Example Tests of Controls for Cash Receipts Transactions LO# 9 Table 10-7: Example Tests of Controls for Cash Receipts Transactions 10-23

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. 10-24

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. 10-25

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. 10-26

Substantive Tests of Transactions LO# 12 Substantive Tests of Transactions For Accounts Receivable, Allowance for Uncollectible Accounts, and Bad-Debt Expense 10-27

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 10-28

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. 10-29

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. 10-30

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. 10-31

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. 10-32

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. 10-33

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. 10-34

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. 10-35