Auditing Revenue and Related Accounts

1
Chapter 11

• Auditing Revenue and Related Accounts

2
Why are revenue cycle accounts important?

• 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

3
What is 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

4
List the Financial Transactions Processing Cycles

• Revenue
• Acquisition and payment of goods and services
• Payroll
• Financing debt and equity
• Cash and short-term investments

5
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

6
Discuss 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

7
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

8
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

9
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

10
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

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Assessment ofEnvironment Risk (continued)

• 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

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Inherent Risk withRegard 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

13
Inherent Risk withRegard to Sales (continued)

• Impact of any unusual sales terms and whether
  title passed to customer
• Example related party transactions
• Goods recorded as sales have 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

14
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

15
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

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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

17
Understanding Internal Controls (continued)

• Internal control procedures should be sufficient
  to ensure the management assertions are achieved
• Existence/Occurrence sales are recorded only
  when shipment has occurred and the primary
  revenue producing activity has been performed
• Completeness all valid sales transactions are
  recorded
• Rights/obligations
• Valuation
• Presentation and disclosure

18
What are the three components of evaluating
control risk?

• 1. Monitoring Controls
• 2. Control Structure for Returns, Allowances,
  and Warranties
• 3. Importance of Credit Policies Authorizing
  Sales

19
Monitoring Controls

• Designed to signal failures in transaction
  processing, and determine if timely, corrective
  action is taken
• Monitoring controls applicable to revenue
  transactions include
• Compare sales and cost of good sold with budgeted
  amounts
• Exception reports generated 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

20
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

21
Documenting, Testing, and Assessing Environment
Risk (continued)

• 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

22
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
• 1. The nature of the accounting system, controls
  used, and documents generated in the client's
  processing
• 2. Existence of fraud risk factors
• 3. Effectiveness of controls and types of
  misstatements likely to occur

23
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

24
What are some substantive tests of revenue?

• 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

25
Substantive Tests of Revenuefor Occurrence,
Accuracy, and Valuation

• 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

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Substantive Tests of RevenueCutoff 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

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Substantive Tests of RevenueCutoff 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

28
Substantive Tests of Revenuefor 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

29
Substantive Tests of Accounts Receivable
Existence Occurrence

• 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

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Substantive Tests ofAccounts Receivable

• Obtain and evaluate aging of accounts receivable
• Confirm receivables with customers
• Perform cutoff tests
• Review subsequent collections of receivables

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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

32
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

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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

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Types of Confirmations (continued)

• 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

35
What is 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

36
What is 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

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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

38
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

39
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
• 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

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Fraud Indicators and Audit Procedures (continued)

• 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

41
Explain 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