Lesson 22 - Substantive Testing (A/R + Revenue)

Most important part of the audit

Revenue

Auditors assume the inherent risk of an MM in Revenue is:

EXTREMELY HIGH, requiring a LOW detection risk

Revenue Cycle Key Assertions

all 6 assertions

Revenue Cycle Key Accounts

1. Cash

2. Sales

3. A/R

4. Allowance for Uncollectibles

5. Sales Returns + Allowances

6. Unearned Revenue

Revenue Cycle Key Documents

1. Purchase Order from customer

2. Sales Order

3. Shipping Documents

4. Sales Invoice

5. Sales Journal

6. Cash Receipts Journal

7. A/R master file

8. Aging of A/R

9. Confirmation of A/R

10. Credit memo

overarching principle for revenue recognition

Co should recognize revenue when co TRANSFERS goods/services to a customer for amount seller “expects to be entitled”

5 steps for Revenue Reecognition

1. Identify the Contract (5 conditions)

2. Identify the Separate Performance Obligations by the Seller

3. Determine the Total Transaction Price

4. Allocate the Total Transaction Price to the Separate Performance Obligations

5. Recognize Revenue when co Satisfies a Performance Obligation

5 Conditions for the Existence of a Contract

1. seller + customer approved contract (verbally/ in-writing)

2. seller + customer intend to satisfy respective obligations stipulated

3. Seller + customer’s rights regarding goods/services are stipulated

4. Payment terms are stipulated

5. It is probable seller will collect payment as stipulated

Key Risks of Material Misstatements related to Revenue Cycle

1. Practice of Accepting Returns after Sale

2. Derivatives Embedded into Sales Contracts

3. Side Agreements

4. Percentage of Completion Projects

5. Fake/Invalid Sales + A/R

6. Inability to Collect A/R

Risk of MM #1 - Practice of Accepting Returns after Sale

reserves made for expected returns based on historical trends may not be reality

Risk of MM #2 - Derivatives embedded into Sales Contract

• embedded derivatives (agreements w/in the agreement/contract) may be difficult to identify or overlooked = MM’s may be overlooked

• company destroyed

Derivatives + embedded derivatives

derivatives - agreement based on performance of asset price, interest rate, etc

embedded derivatives - an agreement w/in another agreement

Risk of MM #3 - Side Agreements

• management may not give auditors all contracts bc executives want to conceal side agreements or are unaware of them

Risk of MM #4 - Percentage of Completion Projects

• co may recognize revenue based on the % of expended costs for projects

• Important judgement for estimation of:

  1. labor hours

  2. total costs

  3. other measures

Risk of MM #5 - Fake/Invalid Sales + A/R

• risk of fraud

• unintentional invalid sales

Risk of MM #6 - Inability to Collect A/R

• co may report revenue but customer may never pay

• important to check customer creditworthiness

• use aging of A/R to watch over

Procedures for Auditing Revenue Cycle

1. identify potential key controls

2. evaluate design of key controls

3. evaluate implementation of key controls

4. evaluate operating effectiveness of key controls

Substantive Tests for A/R

1. Review of Aging of A/R

   • schedule of receivables by age

2. Perform Audit Data Analytics (ADA) to identify risky A/R

3. Confirmations of A/R

   • sent to customers to confirm amount owed

Which of the following statements are correct about auditing revenue transaction cycle? 

a. Audit guidance requires auditors to approach auditing revenue with a very high degree of professional skepticism

b. Most auditors essentially assume that there is a very high likelihood of a material misstatement due to fraud in revenue

c. Both a & b

d. None of the above

c. Auditors assume there are MM’s in Revenue due to fraud and so approach it with high level of professional skepticism

Which of the following approach(s) should be used by the auditor in case if auditing revenue cycle requires a high degree of professional skepticism? 

a. Doing more testing

b. Using the more effective testing methods

c. Doing more work at year-end when there is a higher risk of material misstatements

d. All of the above

d. All of the above

For which of the following accounts in the revenue transaction cycle auditors are primarily concerned about valuation assertion? 

a. Sales returns and allowances

b. Allowance for uncollectable accounts

c. Revenue

d. A & B

b. Allowance for Uncollectible Accounts

Which of the following statements correctly describe the document “credit memo”? 

a. A formal notice to customers notifying them of an adjustment to the sales invoice

b. A schedule of accounts receivable (i.e., credit granted to customers) broken down by the number of days outstanding

c. A document issued by the shipping department to the customer at the point of shipment of goods

d. None of the above

a. a formal notice to customers notifying them of an adjustment to the sales invoice

Under which of the following situations an auditor is likely to conclude that the sales contract includes only one performance obligation. Assume that the contract includes both software and software support? 

a. The company sells software support contracts with similar terms separately at specific prices

b. The company sells the software with similar characteristics separately at specific prices

c. When both A & B are true

d. When A is not true and B is not true

d. When A&B are not true

• when software + software support canNOT be unbundled or sold separately, this = one performance obligation

Which of the following risk areas is least likely to be considered a key revenue risk by an auditor of a large company manufacturing and installing complex robotic manufacturing equipment? 

a. Sales returns

b. Percentage-of-completion revenue recognition method

c. Cash sales

d. All of the above risks are equally likely to be considered a key revenue risk by an auditor of a large company manufacturing and installing complex robotic manufacturing equipment

c. Cash Sales

Which of the following is the primary concern of an auditor about sales returns income statement class of transactions? 

a. Underestimation

b. Overestimation

c. Fraud

d. All of the above

a. Underestimation

• More returns than expected = underestimated returns = overstated revenue

Which of the following statements is not correct about embedded derivatives? 

a. An embedded derivative is an agreement that is embedded within another agreement, such as a sales contract

b. Artificial intelligence contract scanning software can assist auditors in identifying potential embedded derivatives that could affect revenue recognition

c. In some cases management may unintentionally not disclose all of the embedded derivatives

d. All of the above statements are correct

d. All are correct

Which of the following audit procedures are likely to be most effective in testing percentage-of-completion revenue? 

a. Sending confirmations to customers

b. Inquiring from the engineers responsible for the contracts

c. Inquiring from the accounting personnel responsible for recognizing the revenue for the contracts

d. A & C

b. Engineers/those most involved with the project will provide better insight on progress/completion

Which of the following audit procedure(s) might be used by the auditor to identify the side agreement with a sale contract? 

a. Send confirmation letters

b. Examination of sales contracts

c. Inquiries from managers responsible for the contracts

d. Examination of sales invoices

c. Inquiries from managers responsible for contracts (as lower management may have made side agreements w/out executive knowledge)