B4555 - Chapter 10

Auditing the Revenue Process

revenue

the inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both)

what is the underling principal about revenue recognition?

an entity recognizes revenue to depict the transfer of promised goods/services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods/services

what are the 5 steps to revenue recognition?

1. identify the contract(s) with a customer

2. identify the performance obligations in the contract

3. determine the transaction price

4. allocate the transaction price to the performance obligation in the contract

5. recognize revenue when the entity satisfies a performance obligation

what are the 4 fraud risks in revenue recognition?

1. side agreements

2. channel stuffing

3. related party transactions

4. bill and hold sales

side agreements

arrangements that are use to alter the terms and conditions of recorded sales to entice customers to accept delivery of goods/services

channel stuffing

marketing practice that suppliers use to boost sales by inducing distributors to buy substantially more inventory than they can promptly resell (aka., trade loading)

related party transactions

transactions that are not considered arms-length and they require special consideration because related parties can be difficult to identify and may pose significant “substance over form” issues

bill and hold sales

sales where the customer agrees to purchase the goods, but the seller retains physical possession until the customer requests shipments, unless certain conditions are met (aka., parked inventory schemes)

what is the pathway for a cash sale?

purchases → inventory → cash sales

what is the pathway for a credit sale?

purchases → inventory → credit sales →AR → cash collection

what are the 3 types of transactions processed through the revenue process?

1. the sale of goods or rendering of a service for cash or credit

2. the receipt of cash from the customer in payment for goods/services

3. the return of goods by the customer for credit or cash

what are the 3 most significant accounts that the revenue process affects in the FS?

1. sales transactions

2. cash receipts transactions

3. sales return and allowance transactions

what type of accounts are in the sales transactions account?

• trade AR

• sales

• allowance for uncollectible accounts

• bad debt expense

what type of accounts are in the cash receipts transactions account?

• cash

• trade AR

• cash discounts

what type of accounts are in the sales return and allowance transactions account?

• sales returns

• sales allowances

• trade AR

credit approval form

used for credit sales, the entity must have a formal procedure for investigating the creditworthiness of the customer

customer sales order

contains the details of the type and quantity of products or services ordered by the customer

open order report

a report of all customer orders for which processing has not been completed

shipping document

this document serves as a bill of lading and contains info on the type of product shipped, the quantity shipped, and other relevant info

sales invoice

this document is used to bill the customer and it contains info on the type of product or service, the quantity, the price, and the terms of the trade

sales journal

used to record info about the sales transaction

customer statement

this document is mailed to the customer and contains details of all sales, cash receipts, and credit memorandum transactions

AR subsidiary ledger

this contains an account and the details of transactions for each customer

aged trial balance of AR

this report summarizes all the customer balances in the AR subsidiary ledger and each account is classified as current or placed into one of several past due categories

remittance advice

this is part of the customer’s bill that should be returned with the payment

cash receipts journal

used to record the cash receipts of the entity

credit memorandum

used to record credits for the return of goods by a customer

write off authorization

this document authorizes write-offs of an uncollectible AR and the final approval is authorized by the treasurer

what are the 7 functions of the revenue process?

1. order entry

2. credit authorization

3. shipping

4. billing

5. cash receipts

6. AR

7. GL

order entry

this is the acceptance of customer orders of goods/services into the system in accordance with management criteria

credit authorization

this is the appropriate approval of customer orders for creditworthiness and it must determine that the customer can pay for the goods/services purchased

shipping

the shipping of the goods has been authorized

billing

issuance of sales invoices to customers or goods shipped or services provided as well as the processing of billing adjustments for allowances, discounts, and returns

cash receipts

processing of the receipt of cash from customers

AR

recording of all sales invoices, collections, and credit memoranda in individual customer accounts

GL

the proper accumulation, classification, and summarization of revenues, collections, and receivables in the FS accounts

what are the 4 inherent risk factors that may affect the revenue process?

1. industry related factors

2. complexity and contentiousness of revenue recognition issues

3. difficulty of auditing transactions and account balances

4. misstatements detected in prior audits

what are the 3 control risk assessments?

1. understand and document the revenue process based on a reliance strategy

2. plan and perform tests of controls on revenue transactions

3. set and document the control risk for the revenue process

what are the 5 factors in understanding and documenting internal control?

1. control environment

2. the entity’s risk assessment process

3. control activities

4. info systems and communication

5. monitoring of controls

what are the 4 approaches an auditor can use to document their understanding of the revenue process?

1. procedures manual

2. narrative descriptions

3. internal control questionnaire

4. flowcharts

what are the 5 tests that auditors can use to test controls over the revenue process?

1. inquiry of client personnel

2. inspection of documents and records

3. observations of the operation of the control

4. walkthroughs

5. reperformance of the control activities

what are the 2 types of material misstatements that auditors are concerned with?

1. sales to fictitious customers

2. recording revenue when goods have not been shipped or services have not been performed

what is the major misstatement that concerns both management and the auditor about the completeness assertion?

goods are shipped or services are performed but no revenue is recognized

what are the 4 controls concerning completeness?

1. accounting for numerical sequence of shipping documents and sales invoices

2. matching shipping documents with sales invoices

3. reconciling sales invoices to daily sales reports

4. maintaining and reviewing the open-order file

what is the possible misstatement that concerns the auditor when considering the occurrence assertion?

cash receipts are recorded but not deposited in the entity’s bank account

substantive analytical procedures

used to examine plausible relationships among revenue related accounts - this gives us an idea as to where we will spend most of our audit testing

tests of details

focuses on transactions, account balances or disclosures

what are the 5 ratios used for comparative purposes under substantive analytical procedures?

1. receivables turnover and days outstanding in AR

2. aging categories on aged trial balance of AR

3. bad debt expense as a percent of revenue

4. allowance for uncollectible accounts as a percent of AR or credit sales

5. large customer account balances compared to last period

what does the cutoff test attempt to do?

this test determines whether all revenue transactions and related AR are recorded in the proper period

why is existence an important assertion for auditors?

auditor wants assurance that the AR account balance is not overstated through the inclusion of fictitious customer accounts or amounts

what is the major audit procedure used for testing existence?

the test of confirmation

what are the 2 steps when verifying the adequacy of the allowance for uncollectible accounts?

1. Prepare an aged trial balance and discuss the results with the credit manager

2. Compare with last year’s results

what are the 3 major issues related to presentation disclosure and classification?

1. identifying and reclassifying any material credits contained in AR

2. segregating ST and LT receivables

3. ensuring that different types of receivables are properly classified

confirmation

this is when audit evidence has a direct written response from 3rd parties about the AR balance

when would an auditor omit confirmations?

• AR balance is immaterial

• external confirmations would be ineffective

• auditor’s assessed level of RMM at the relevant assertion level is low, and the other planned substantive procedures address the assessed risk

what are the 3 factors affecting the reliability of AR confirmations?

1. type of confirmation request

2. prior experience with the client or similar engagements

3. the intended respondent

what are the 2 types of confirmations?

1. positive

2. negative

positive confirmation

these are requests that customers indicate whether they agree with the amount due to the client

negative confirmations

these are requests that the customer responds only when they disagree with the amount due to the client

when may AR be confirmed?

interim date or at year end

what are the 3 alternative procedures that an auditor may use when they do not receive responses to positive confirmations?

1. examination of specific subsequent cash receipts

2. examination of shipping documentation

3. examination of other client documentation

when would an auditor accept the account as fairly stated?

aggregate misstatement < tolerable misstatement

when would an auditor not accept the account as fairly stated?

aggregate misstatement > tolerable misstatement