Revenue cycle accounts

1
Revenue cycle accounts The importance
Chapter 10 Auditing Revenue and Related
Accounts

• 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 Contd

• 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 Contd

• 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 Revenuefor 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 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

23
Substantive Tests of RevenueCutoff 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 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

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

1. Obtain and evaluate aging of accounts receivable
2. Confirm receivables with customers
3. Perform cutoff tests
4. 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 Whats 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 Whats 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