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
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be examined with great care

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

Overview of the Revenue Cycle

(Sales made on Account)
1. Receive customer purchase order
2. Check inventory stock status
Generate back order if item not in stock
3. Obtain credit approval
4. Prepare shipping and packing documents
5. Ship and verify shipment of goods
6. Prepare the invoice
7. Send monthly statements to customers
8. Receive payment
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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
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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 yearend
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
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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 6

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
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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

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
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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
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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

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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
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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
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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
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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

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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
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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
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misstatements likely to occur

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
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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
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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
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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
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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
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credit was recorded in the correct period

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
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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
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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
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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

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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
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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
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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
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2.c Whats the follow-up

procedures for non-responses?
1. If customer does not respond to positive
confirmation, auditor may send a second,
or even third, request
2. If customer still does not respond, auditor
will use alternative procedures
a) Examine the cash receipts journal for cash
collected after year-end

Care is taken to ensure receipt is year-end

receivable, not subsequent sale

b) 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

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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

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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 relatedparty transactions
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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
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contain approval for these items

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

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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

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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 writeoff activity
Analyze recoveries of written-off accounts

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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
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