1. Revenue cycle accounts – The importance
Chapter 10:
Auditing Revenue and
Related Accounts
Revenue cycle accounts – The importance
Sales transactions are always material to a company's financial statements
According to the SEC, a majority of financial statement manipulations and audit failures involve overstated revenues
Therefore, revenue cycle accounts must be examined with great care

2. The cycle approach
Revenue cycle transactions include all the processes ranging from the sale to shipping a product, billing the customer, and collecting cash
A company's revenue cycle transactions reflects its operations
A cycle approach is one way to help the auditor focus on the important account balances surrounding a transaction to ensure that sufficient audit evidence is gathered and evaluated
Other cycles include:
acquisition and payment of goods and services
Payroll
Financing: debt and equity
Cash and short-term investments

3. Overview of the Revenue Cycle (Sales made on Account)
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

4. Business Risk and Business Environment
Revenue recognition
SAS 99 - Consideration of Fraud in a Financial Statement Audit
Auditor should presume risk of material misstatement due to fraud related to revenue recognition
Research shows over half of frauds involve overstating revenues

5. Some 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

6. What are some fraud risk factors for revenue recognition?
There are a number of types of 'red flags' which signal the potential for fraud in the financial statements
External risk indicators
Internal red flags
Unusual financial results
Auditor deals with red flags by
Examining external pressures that could lead to financial reporting fraud
Examining the financial statements to determine if account balances seem out of line

7. What analytical analysis can be done for possible misstatements?
Compare client revenue trend with economic conditions and industry trends
Compare cash flow from operations with net income
Perform analytical procedures
Ratio analysis
Trend analysis
Reasonableness tests

8. Assessment of Environment Risk
Risk assessment is ongoing process in every audit
Audit steps to assess environment risk for the revenue cycle:
Update information on business risk
Perform analytical procedures to look for unexpected relationships
Develop understanding of internal controls
Analyze business risk for motivations and methods to misstate sales

9. Assessment of Environment Risk – Cont’d
Document operation of accounting applications and important controls
Develop preliminary assessment of environment risk
If control risk is high, determine likely types of misstatements
If control risk is lower, develop procedures to test operation of controls
Perform tests of controls, document results
Based on the results of testing, reassess control risk

10. Inherent Risk with Regard to Sales
While sales transactions are routine for most organizations and do not represent an abnormally high risk, for other organizations, revenue recognition may be complicated
Difficult audit issues include:
When to recognize revenues
Auditor must understand client's operations and related GAAP issues
Example: point of sale revenue recognition vs. percentage of completion

11. Inherent Risk with Regard to Sales – Cont’d
Impact of any unusual sales terms and whether title passed to customer
Example: related party transactions
Goods recorded as sales have actually been shipped
Sales made with recourse or that have significant returns
Example: irrevocable right to return goods
The presence of these issues increase inherent risk and the probability of material misstatement

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

13. The Control Environment and Sales
An organization's control environment affects revenue and related transactions more than most accounts
The auditor must consider:
Management's integrity
Financial condition of the organization
Financial pressures on the organization
Management incentives to achieve financial results

14. Understanding Internal Controls
Although the auditor must understand all components of internal controls, particular attention is paid to significant control procedures and monitoring controls
The auditor obtains an understanding of the controls by
Walk-through of the processing of transactions
Inquiry
Observation
Review of client documentation
It is critical this understanding be documented in the work papers

15. Understanding Internal Controls (2)
Assertions must be addressed during this phase:
Occurrence, Cutoff, Completeness, Accuracy & Classification
Controls Regarding Returns, Allowances and Warranties are also important. Abnormal returns or allowances may be the first sign that a company has problems
Credit Policies are also very important

16. Documenting, Testing, and Assessing Environment Risk
Develop understanding of the accounting system and control procedures
Evidence is gathered through inquiry, review of client accounting manuals, and review of prior year audit workpapers
Documentation includes questionnaires, flowcharts, and narratives
Determine whether the application control procedures are sufficient to achieve the control objectives
Based on control design, make preliminary assessment of control risk

17. Documenting, Testing, and Assessing Environment Risk (2)
The auditor must document those controls that support an assessment of control risk below maximum
If the auditor plans to rely on the internal controls, the controls are tested to see if they are operating as designed
If testing indicates the control is not operating effectively,
Auditor will increase assessed control risk, lower detection risk, and perform more rigorous substantive testing
If the control is working effectively, control risk assessment is unchanged

18. Linking Environment Risk Assessment & Substantive Testing
The rigor of substantive testing is inversely related to the assessed level of environment risk
The auditor learns three things during the assessment of environment risk that affects the design of substantive audit procedures:
The nature of the accounting system, controls used, and documents generated in the client's processing
Existence of fraud risk factors
Effectiveness of controls and types of misstatements likely to occur

19. Substantive Testing in the Revenue Cycle
Planning for Direct Tests of Transactions and Account Balances
Audit objectives and assertions
Account balance relationships
Risk of material misstatement
Composition of the account
Persuasiveness of audit procedures
Cost of audit procedures
Timing of audit procedures
Determining optimal mix of audit procedures
Exhibit 10.7 Outlines the relationship between Assertions and Substantive Tests for the Revenue and Accounts Receivables

20. Substantive tests of revenue – objectives/issues
Assertions related to revenue transactions:
Occurrence: Have the transactions occurred and pertain to the entity
Completeness: Have all transactions been recorded
Accuracy: Have transactions been accurately recorded
Cutoff: Have transactions been recorded in the correct accounting period
Classification: Have transactions been recorded in the proper accounts

21. Substantive Tests of Revenue for Occurrence and Accuracy
Vouch recorded sales transaction back to customer order and shipping document
Compare quantities billed and shipped with customer order
Special care should be given to sales recorded at the end of the year
Scan sales journal for duplicate entries

22. Substantive Tests of Revenue Cutoff Tests
Can be performed for sales, sales returns, cash receipts
Provides evidence whether transactions are recorded in the proper period
Cutoff period is usually several days before and after balance sheet date
Extent of cutoff tests depends on effectiveness of client controls

23. Substantive Tests of Revenue Cutoff Tests e.g.
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

24. Substantive Tests of Revenue for Completeness
Use of pre-numbered documents is important
Analytical procedures
Cutoff tests
Auditor selects sample of shipping documents and traces them into the sales journal to test completeness of recording of sales

25. Substantive Tests of Accounts Receivable - issues
Existence & Occurrence
Does the receivable exist?
Valuation
Are sales and receivables initially recorded at their correct amount?
Will client collect full amount of recorded receivables?
Rights and Obligations
Contingent liabilities associated with factor or sales arrangements
Discounted receivables
Presentation and Disclosure
Pledged, discounted, assigned, or related party receivables

26. Standard Substantive Tests of Accounts Receivable
Obtain and evaluate aging of accounts receivable
Confirm receivables with customers
Perform cutoff tests
Review subsequent collections of receivables

27. 1. Aging Accounts Receivable
Because receivables are reported at net realizable value, auditors must evaluate management estimates of uncollectible accounts
Auditor will obtain or prepare schedule of aged accounts receivable
If schedule is prepared by client, it is tested for mathematical and aging accuracy
Aging schedule can be used to
Agree detail to control account balance
Select customer balances for confirmation
Identify amounts due from related parties for disclosure
Identify past-due balances
Auditor evaluates percentages of uncollectibility
Auditor then recalculates balance in the Allowance account

28. 2. Confirming Receivables with Customers
Confirmations provide reliable external evidence about the
Existence of recorded accounts receivable and
Completeness of cash collections, sales discounts, and sales returns and allowances
Confirmations are required by GAAS unless one of the following is present:
Receivables are not material
Use of confirmations would be ineffective
Environment risk is assessed as low and sufficient evidence is available from using other substantive tests

29. 2.a The Types of Confirmations
Positive confirmations
Customers are asked to agree the amount on the confirmation with their accounting records and to respond directly to the auditor whether they agree with the amount or not
Positive confirmation requires a response
If customer does not respond, auditor must use alternative procedures

30. 2.b The Types of Confirmations
Negative confirmations
Customers are asked to respond only if they disagree with the balance (non-response is assumed to mean agreement)
Less expensive since there are no additional procedures if customer does not respond
May be used when all of the following are present
Confirming a large number of small customer balances
Environment risk for receivables is assessed as low
Auditor believes customers will give proper attention to confirmations

31. 2.c What’s the follow-up procedures for non-responses?
If customer does not respond to positive confirmation, auditor may send a second, or even third, request
If customer still does not respond, auditor will use alternative procedures
Examine the cash receipts journal for cash collected after year-end
Care is taken to ensure receipt is year-end receivable, not subsequent sale
Examine documents supporting receivable (purchase order, sales invoice, shipping documents) to determine if sale occurred prior to year-end
Evidence gathered from internal documents is not considered as reliable

32. 2.d What’s the follow-up procedures for exceptions noted?
Customers are asked to agree the amount on the confirmation to their accounting records; differences are called exceptions
Reasons for exceptions:
Timing differences
Disputed items
Customer errors
Client misstatement
Because misstatements are projected to the population of receivables, the auditor must determine the reason for the exception

33. 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 related parties so all audit team members can be alert for related-party transactions

34. Sold, Discounted, and Pledged Receivables
Receivables sold with recourse, discounted, or pledged as collateral should be disclosed
Audit procedures to identify these items include:
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 for these items

35. Fraud Indicators and Audit Procedures
Potential 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

36. Fraud Indicators & Audit Procedures - 2
Potential fraud indicators:
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 before/after year-end

37. Fraud Indicators and Audit Procedures - 3
Substantive procedures that may highlight potential fraud indicators:
Review of source documents including invoices, shipping documents, customer purchase orders, etc
Review and analyze credit memos and other adjustments to receivables
Confirm sales terms with customers
Analyze large or unusual sales made near year-end
Scan the general ledger, receivables subsidiary ledger, and sales journal for unusual activity
Perform analytical review of credit memo and write-off activity
Analyze recoveries of written-off accounts

38. Auditing of Allowance for Doubtful Accounts
Accounts receivable should be reported at their net realizable value
The balance of the allowance for doubtful accounts is estimated and depends on a number of factors
Understating the allowance overstates net accounts receivable and net income
Where accounts receivable are material, the auditor should obtain an understanding of how management developed the estimate by 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