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

2. 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.
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3. 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

4. Fraud Risks in Revenue Recognition
LO# 1
Fraud Risks in Revenue Recognition
Side agreements
Channel stuffing
Related party transactions
Bill and hold sales
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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.
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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:
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7. Figure 10-2 Flowchart of the Revenue Process—EarthWear Clothiers, Inc.
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8. LO# 3
Figure 10-2 Flowchart of the Revenue Process—EarthWear Clothiers, Inc. (continued)
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9. LO# 3
Figure 10-2 Flowchart of the Revenue Process—EarthWear Clothiers, Inc. (continued)
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10. 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.
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11. 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.
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12. 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.
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13. 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
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14. 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.
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15. 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.
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16. 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.
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17. 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.”
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18. 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
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19. Table 10-6: Example Tests of Controls for Revenue Transactions
LO# 9
Table 10-6: Example Tests of Controls for Revenue Transactions
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20. Table 10-6: Example Tests of Controls for Revenue Transactions
LO# 9
Table 10-6: Example Tests of Controls for Revenue Transactions
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21. Table 10-6: Example Tests of Controls for Revenue Transactions
LO# 9
Table 10-6: Example Tests of Controls for Revenue Transactions
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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
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23. Table 10-7: Example Tests of Controls for Cash Receipts Transactions
LO# 9
Table 10-7: Example Tests of Controls for Cash Receipts Transactions
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24. 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.
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25. 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.
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26. 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.
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27. Substantive Tests of Transactions
LO# 12
Substantive Tests of Transactions
For Accounts Receivable, Allowance for Uncollectible Accounts, and Bad-Debt Expense
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28. 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
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29. 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.
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30. 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.
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31. 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.
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32. 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.
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33. 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.
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34. 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.
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35. 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.
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