2. 14 - 1 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Audit of the Sales and Collection Cycle: Tests of Controls and Substantive Tests of Transactions Chapter 14

3. 14 - 2 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 1 Identify the accounts and the classes of transactions in the sales and collection cycle.

4. 14 - 3 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Accounts in the Sales and Collection Cycle SalesCashsales Sales on account Accounts Receivable Cash receipts Sales returns and allowances Charge-off of uncollectibleaccounts Beginningbalance Sales on account Endingbalance Cash in Bank Cash Discounts Taken Bad Debt Expense Sales Returns and Allowances

5. 14 - 4 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Accounts in the Sales and Collection Cycle Accounts Receivable Cash receipts Sales returns and allowances Charge-off of uncollectibleaccounts Beginningbalance Sales on account Endingbalance Allowance for Uncollectible Accounts Charge-off of uncollectibleaccountsBeginningbalance Estimate of bad debt expense Endingbalance Bad Debt Expense

6. 14 - 5 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 2 Describe the business functions and the related documents and records in the sales and collection cycle.

7. 14 - 6 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Sales Transaction Accounts  Sales  Accounts receivable receivable Business functions  Processing customer orders orders  Granting credit  Shipping goods  Billing customers and recording sales and recording sales Documents and records  Customer order  Sales order  Customer order or sales order order  Shipping document  Sales invoice  Sales transaction file  Sales journal or listing  Accounts receivable master file master file  Accounts receivable trial balance trial balance  Monthly statements

8. 14 - 7 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Cash Receipts Transaction Accounts  Cash in bank (debits from (debits from cash receipts) cash receipts)  Accounts receivable receivable Business functions  Processing and recording cash recording cash receipts receipts Documents and records  Remittance advice  Prelisting of cash receipts receipts  Cash receipts transaction file transaction file  Cash receipts journal or listing listing

9. 14 - 8 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Sales Returns and Allowances Transaction Accounts  Sales returns and and allowances allowances  Accounts receivable receivable Business functions  Processing and recording sales recording sales returns and returns and allowances allowances Documents and records  Credit memo  Sales and returns and allowances journal allowances journal

10. 14 - 9 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Charge-off of Uncollectible Accounts Transaction Accounts  Accounts receivable receivable  Allowance for uncollectible uncollectible accounts accounts Business functions  Charging off uncollectible uncollectible accounts accounts receivable receivable Documents and records  Uncollectible account authorization form authorization form  General journal

11. 14 - 10 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Bad Debt Expense Transaction Accounts  Bad debt expense expense  Allowance for uncollectible uncollectible accounts accounts Business functions  Providing for bad debts debts Documents and records  General journal

12. 14 - 11 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Processing Customer Orders Customer Order: Customer Order: A request for merchandise by a customer Sales Order: A document describing the goods ordered by a customer

13. 14 - 12 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Granting Credit Before goods are shipped, a properly authorized person must approve credit to the customer for sales on account.

14. 14 - 13 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Shipping Goods This is the first point in the cycle where company assets are given up.

15. 14 - 14 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Billing Customers and Recording Sales Sales invoice Sales transaction file Sales journal or listing Accounts receivable master file Accounts receivable trial balance Monthly statement

16. 14 - 15 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Processing and Recording Cash Receipts Remittance advice Prelisting of cash receipts Cash receipts transaction file Cash receipts journal or listing

17. 14 - 16 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Processing and Recording Sales Returns and Allowances Credit memo Sales returns and allowances journal

18. 14 - 17 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 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.

19. 14 - 18 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Providing for Bad Debts This provision represents a residual, resulting from management’s end-of-period adjustment of the allowance for uncollectible accounts.

20. 14 - 19 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 3 Understand how e-commerce activities affect the sales and collection cycle.

21. 14 - 20 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Effect of E-Commerce on the Sales and Collection Cycle The Internet and other developing technologies allow companies to develop new business models.

22. 14 - 21 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 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.

23. 14 - 22 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 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.

24. 14 - 23 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 4 Understand internal control, and design and perform tests of controls and substantive tests of transactions for sales.

25. 14 - 24 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Methodology for Designing Controls and Substantive Tests of Sales Transactions for Sales Understand internal control – sales. Audit procedures Sample size Items to select Timing Assess planned control risk – sales. Determine extent of testing controls. Design tests of controls and substantive tests of transactions for sales to meet transaction -related audit objectives.

26. 14 - 25 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Understand Internal Control – Sales Study the client’s flowcharts, prepare an internal control questionnaire, and perform walk-through tests of sales. Study the client’s flowcharts, prepare an internal control questionnaire, and perform walk-through tests of sales.

27. 14 - 26 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Assess Planned Control Risk – Sales 1. Framework for assessing control risk 2. Identify key internal controls and deficiencies 3. Associate controls and deficiencies with the objectives objectives 4. Assess control risk for each objective

28. 14 - 27 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Proper authorization Assess Planned Control Risk – Sales Internal verification Internal verification procedures procedures Prenumbereddocuments Monthly statements Monthly statements Adequate documents and records Adequate separation of duties

29. 14 - 28 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Determine Extent of Testing Controls Audits of public companies companies Audits of nonpublic companies

30. 14 - 29 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Transaction-Related Audit Objectives for Sales Existence: Recorded sales are for shipments actually made. Accuracy: Recorded sales are for the amount shipped. Completeness: Existing sales transactions are recorded.

31. 14 - 30 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 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.

32. 14 - 31 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Direction of Tests for Sales CompletenessstartExistencestart CustomerorderShippingdocumentDuplicatesalesinvoiceSalesjournalGeneraljournalAccountsreceivable master file =

33. 14 - 32 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 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)

34. 14 - 33 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 5 Apply the methodology for controls over sales transactions to controls over sales returns and allowances.

35. 14 - 34 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 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.

36. 14 - 35 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Sales Returns and Allowances There are, however, two important differences. Materiality Emphasis on objectives

37. 14 - 36 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 6 Understand internal control, and design and perform tests of controls and substantive tests of transactions for cash receipts.

38. 14 - 37 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 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.

39. 14 - 38 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Learning Objective 7 Apply the methodology for controls over the sales and collection cycle to write-offs of uncollectible accounts receivable.

40. 14 - 39 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 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

41. 14 - 40 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Additional Internal Controls Over Account Balances Realizable value Credit approval Aged accounts receivable trial balance Charging off uncollectibles

42. 14 - 41 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Additional Internal Controls Over Account Balances Rights and obligations Presentation and disclosure

43. 14 - 42 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder 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 Bad debt expense Cash Allowance for doubtful accounts

44. 14 - 43 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder Types of Audit Tests for the Sales and Collection Cycle SalesAccountsReceivable Cash in BankSalestransactions Cash receipts transactions EndingbalanceEndingbalance TOC + STOT + AP + TDB = Sufficient competent evidence per GAAS Audited by TOC, STOT, and AP Audited by AP and TDB Audited by TOC, STOT, and AP

45. 14 - 44 ©2006 Prentice Hall Business Publishing, Auditing 11/e, Arens/Beasley/Elder End of Chapter 14