Chapter 12: Audit of the Revenue Cycle

What does the revenue cycle involve?

the decisions and processes necessary for the transfer of the ownership of goods and services to customers after they are made available for sale. 

Business functions included in the revenue cycle

Processing customer orders

Granting credit

Shipping goods

Billing customers and recording sales

Processing and recording cash receipts

Processing and recording sales returns and allowances

Writing off uncollectible accounts receivable

Providing for bed debts

IFRS 5 step model of Revenue Recognition

Identify the contract

Identify the Performance Obligations

Determine the transaction price

Allocate the transaction price to the performance obligation

Recognize revenue when each performance obligation is satisfied.

ASPE Revenue recognition

Collectability

Measurement

Risk and rewards of ownership

IR Risks Revenue

management usually has more incentive to overstate revenues than to understate them, the relevant assertions for revenue are occurrence and cutoff

Examples of IR factors for revenue

Management compensation (bonuses or stock options) being tied to certain earnings targets

Emphasis by financial analysts on revenue growth may pressure management to overstate revenue

Pressure to meet earnings forecasts

Examples of IR factors for AR

Long-term receivables are classified as current (Classification)

Receivables are pledged as collateral, assigned to someone else, factored, or sold (restrictions must be disclosed) (Rights & Obligations)

Payment is not required until the purchaser sells to its end customers (Valuation)

Collection of the receivable is contingent upon future events (for example, certain royalty arrangements) (valuation)

Sales are made to customers with high credit risk (Valuation)

Significant Risks Fraud Schemes Revenue

Fictitious revenues or shame sales (occurrence)

Premature revenue recognition (occurrence and cutoff)

Round-tripping or recording loans as sales (occurrence)

Falsify revenue & working through a whole cycle does not exist

Improper cutoff of sales (cut off)

Improper recording of sales from “bill-and-holds” that do not meet criteria for revenue recognition (occurrence)

Side arrangements that change the original terms of sale (such as a consignment arrangement or generous right of return) or do not meet requirements for recording revenue (occurrence)

Manipulation of adjustments and estimates– Returns and allowances are not recorded or are understated (Completeness)

Determine Audit Approach for Revenue Cycle

Auditors must determine the cost-benefit of testing controls–meaning whether substantive tets will be reduced sufficiently to justify the cost of preforming tests of controls.

Auditors will identify assertions where substantive testing is not sufficient and tests of controls are required to reduce risks of material misstatements to a sufficient level.

Design Tests of Controls

For each key control that the auditor plans to reduce CR, the auditor must design one or more tests of controls to verify its effectiveness.

What assertion is: Recoded Sales for the amount of goods shipped and are correctly billed and recorded

Accuracy

What is the key internal control for: Recoded Sales for the amount of goods shipped and are correctly billed and recorded

Invoices are prepared using authorized prices, terms, freight and discounts established in master files.

How the control could be tested for: Recoded Sales for the amount of goods shipped and are correctly billed and recorded

Test access controls

take a sample of invoices and trace back to authorized list

test for potential override of changes to price list

Implications if control is not working, Recoded Sales for the amount of goods shipped and are correctly billed and recorded

Weak controls over price lists can allow misappropriation of assets and potential over/understatement of revenue due to errors or potential fictitious customers

Use GAS to match invoice prices to authorized prices, terms, and so forth (expand original test). Confirm sales contract details with customers

Expand accounts receivable;e confirmation work.

What assertion is: Sales are recorded on the correct dates

cutoff

What are the key internal controls for: Sales are recorded on the correct dates

• Invoices are prepared using a date equal to the shipping date (or specify the shipping date in the invoice)

• system checks the reasonableness of the date entered

• management reviews sales and cost of sales analytical reports for reasonableness

How the control could be tested for: Sales are recorded on the correct dates

Compare dates of recorded sales transactions with dates on shipping records

Inspect shipping records for unbilled shipments and for unrecorded sales

Verify management walk-through of analytical reports using inquiry or inspect evidence for followup

Implications if control is not working: Sales are recorded on the correct dates

Significant differences in dates indicate a potential cutoff problem (could impact completeness or occurence of revenue).

Perfrom additional substantive cutoff testing at the year-end date.

Substantive Analytical Procedures

designed to provide assurance, in combination with tests of controls and substantive tests of details, about particular assertions for classes of transactions, account balances, and disclosures. 

more effective for completeness of revenue and the reasonableness of the allowance for doubtful accounts.

Examples of SAP for revenue

Substantive Tests of Details (Transactions)

test the details of specific transactions (such as invoices, shipping documents, ect.). 

Substantive Tests of Details (AR)

 test the details of an account balance recorded in the trial balanace. 

Direction of Tests for Completeness

When tracing from source shipping documents to the journals, the purpose of the test is for omitted transactions

Direction of Tests for occurrence

When vouching from the journals back to supporting documents, the purpose is to rest for nonexistent transactions

Direction of tests for Revenue

Revenue: Occurrence Assertion potential misstatements

Sales being included in journals for which no shipment was made

Sales recorded more than once (duplicates)

Shipments made to nonexistent customers and recorded as sales (fictitious sales)

Revenue: completeness Assertion

all revenues are recorded

Revenue: Accuracy Assertion

Shipping the correct amount of goods ordered, using the correct price when billing for the amount of goods shipped, and accurately recording the amount billed in the accounting records

Revenue: cutoff Assertion

performing cutoff tests with sales transactions before and after year-end provides assurance of both the completeness and occurrence of sales transactions 

Revenue: classification Assertion

Not always clear whether the company is the seller with a primary obligation to the customer or the company is a seller acting as an agent.  

Aged accounts receivable trial balance

is a listing of the balances in the accounts receivable customer master files on the balance sheet. 

The aged TB is used to

Agree the accuracy between sub ledger and gl, including allocation to correct accounts

Select samples for confirmation

Identify usually transactions using the auditor’s criteria

Evaluate classification of A/R with related parties

Identify credit balances, which is significant should be classified as accounts payable

Accounts Receivable Confirmations

The use of external confirmations is not required but used frequency in assessing existence of receivables 

Positive (a/r) confirmations

A communication addressed to the debtor requesting them to confirm directly with the auditor whether the balance as stated on the confirmation request is correct or incorrect 

(More expensive)

Negative (a/r) confirmations

Addressed to the debtor and requests a response only when the debtor disagrees with the state amount 

Less reliable than positive since the debtor could have ignored the request 

Less expensive

When should a negative A/R confirmation be used?

Negative confirmations should be used only when risk of MM are low (i.e. controls are effective) and when the following are true: 

• The items to be confirmed are homogeneous (i.e., similar in nature) and comprise small account balances

• no, or few exceptions are likely

• There is an expectation that the negative confirmation will be read and considered.

Positive confirmations are more effective when the following exist:

Individual balances of relatively large amounts 

Few debtors or account balances 

No suspicions or evidence of fraud or serious error

When is the most reliable information obtained using AR confomartions

when confirmations are sent as close to the balance sheet date as possible, as opposed to several months before YE.

Auditors responsibility of confirmations

The auditor must maintain control of the conformations until they are reutned from the debtor.

An auditor can follow up on non-reposne or perform alternate procedures.

Any differences between the confirmation and client must be resolved.

substantive tests of revenue AR valuation

will provide assurance for the accuracy of AR, they are not useful in assuring as to whether the client will collect the outstanding receivables (net realizable value).

AR Assertions R&O: 

For those companies who sell their receivables with or without recourse or have pledged the receivables as collateral, the details need to be disclosed in the notes to the FS.