Lesson 22: Substantive Testing of Accounts Receivable and Revenue

Why is it important to audit accounts in the revenue transaction cycle?

• because investors care more about revenue that cash

• it is expected to convert into future cash

• most detected financial statement fraud instances involve improper revenue recognition

Audit guidance for revenue transaction cycle:

• approach with a high level of professional skepticism

• auditors assume inherent risk is extremely high

• requires low detection risk

What are the key assertions, accounts, and documents in the revenue cycle?

• occurrence

• cut off

• accuracy

• completeness

• presentation

2 key assertions are:

• occurrence and cut off

key risk is overstatement

Purchase Order:

(Externally generated)

request from customer to purchase a certain amount of goods

Sales Order:

(Internally generated)

confirms the company’s acceptance if the terms of the purchase order

includes agreements and expectations

Shipping Documents:

(Internally and externally generated)

describe the goods, destination, terms of delivery etc.

Sales Invoice:

(Internally generated)

issued by billing department

specifies how much a customer owes in taxes, fees, etc.

Accounts Receivable Master File:

(Internally generated)

usually electronic

used to maintain sales receipts, discounts etc.

Sales Journal:

(Usually electronic)

record of sale or credit

debit to accounts receivables

Cash Receipts Journal:

(Usually electronic)

record sales for cash, debit is to cash

Credit Memo:

(Internally generated)

formal notice to customers notifying them if an adjustment to a sales invoice

e.g. incorrect sales invoice, defective item

Accounts Receivables Aging:

(Internally generated)

schedule of accounts receivables broken down by the # of days outstanding

Confirmation of Account Receivables:

(Externally generated)

primary tool auditors use to obtain evidence if accounts receivable

sent to clients

What are the key revenue recognition principles you must know before graduating?

a company should recognize revenue when the company transfers its goods or services to a customer for the amount of consideration to which the seller “expects to be entitled”

(FASB) Financial Accounting Standards Board defined the following 5 steps a business should go through in deciding when and how much revenue to recognize:

1. Identify the contract

2. Identify the separate performance obligations by the seller in the contract

3. Determine the total transaction price in the contract

4. Allocate the total transaction (identified in step 3) to the separate performance obligations in the contract (identified in step 2)

5. Recognize revenue (identified in step 4) as the entity satisfies a performance obligation

1. Identify the contract

easiest of the 5 steps

All of the following conditions generally need to be met:

• seller and customer have approved the contract (verbal or in writing)

• seller and customer intend to satisfy their respective obligations stipulated in the contract

• the seller and customer’s rights regarding the goods or services in this contract can be identified

• the payment terms are stipulated in this contract

• it is probable that the seller will collect the payment (or other consideration) as stipulated in the contract

2. Identify the separate performance obligations by the seller in the contract

these days many contracts include things like post-contract support, extended warranties, etc. (in addition)

sales arrangements- described as bundled

revenue guidance helps sellers determine whether revenue from their bundled sales contracts needs to be recognized for all the components in the bundle together or separately

3. Determine the total transaction price in the contract

This step could be very complicated, businesses need to consider all variables included in the contract that could affect the total price received by the business

discounts, rights of return, and so on

discounts are probable due to delays or operational failures

discounts wont be known until a certain time

companies usually have their own thresholds, if below they wont bother adjusting

Step 4: Allocate the total transaction price (identified in step 3) to the separate performance obligations in the contract

fairly intuitive (more for contracts with more than 1 distinct performance obligations)

total transaction price is allocated to these obligations in proportion to the stand alone pricing of each obligation

Step 5: Recognize revenue (identified in step 4) as the entity satisfies a performance obligation

you recognize revenue for each performance obligations as you satisfy that performance obligation stipulated in the contract

shipping terms (determines when goods and services are considered delivered)

FOB shipping point- risk of ownership passes from seller to buyer at the shipping point

FOB destination- risk of ownership passes from seller to buyer when it reaches the buyer and the buyer accepts the shipment

What are some key risks of material misstatement related to the revenue transaction cycle?

1. Practice of accepting returns after sale

2. Derivatives embedded into sales contracts

3. Side agreements

4. Percentage of completion projects

5. Fake or invalid sales and accounts receivables

6. Inability to collect accounts receivables

Risk 1: Practice of accepting returns after sale

Costco will create reserves for estimated returns by examining historical percentage of returns and adjust them for any anticipated changes

• the greater risk is usually underestimation of future returns

• sales and COGS- accuracy assertion

• accounts receivables- rights assertion (company is not expected to maintain rights for the portions expected to be returned

• inventory- valuation assertion (since returned inventory may not be worth as much as when it sold)

Risk 2: Derivatives embedded into sales contracts

• derivatives- an agreement based on a performance of a price if an asset, an interest rate, a stock, and so on

• embedded derivative- an agreement embedded within another agreement such as a sales contract

• they can be very difficult to identify but AI could come in handy in identifying all potential derivatives that could affect revenue recognition

• in the end auditor’s judgement is required to make the ultimate decision about whether a potential derivative is in fact a derivative and what its treatment should be

Why are embedded derivatives a risk related to the revenue cycle?

1. auditors need to have a good understanding of long term sales contracts and any embedded derivatives in these contracts to understand the risks and pressures management faces in recognizing revenue

2. derivatives, including embedded derivatives, get fair valued at the end of each year

   • accountants need to estimate how much an embedded derivative is worth at the end of each year

Key accounts and assertions for risk 2:

potential for omission or significant underestimation of losses on valuation of derivatives

• Other comprehensive income (OCI)

• Accumulated other comprehensive income (AOCI)

Other comprehensive income (OCI):

reflects unrealized gains and losses on the income statement for the year for the fluctuations in derivative’s value

• unrealized gains and losses- occurrence; unrealized gains/losses may have not occurred

• completeness- unrealized losses may not be complete

• accuracy- OCI from derivatives may not be accurate

• presentation (including classification)- may not have presented OCI and relevant disclosures in a way that is clearly described and appropriate

Accumulated other comprehensive income (AOCI)

is the BS account where the unrealized gains and losses are accumulated until the transactions actually take place

• existence- accumulated gains may not exist

• completeness- accumulated losses may not have been complete

• valuation- the derivative may not be properly valued

• rights and obligations- the business may not have the rights to these unrealized gains or may not have the obligations to make payments relevant to the unrealized losses

Risk 3: Side agreements

management simply may not give auditors all of the contracts to review or give them incomplete contracts even if they want to provide all information to their auditors

• executives may want to conceal this information or they are not aware of complete contracts themselves

• not common but happens more in some industry sectors such as companies with significant international operations

• how would auditors find out?- inquiring management and even managers responsible for the contracts (primary tool used to identify agreements)

Key assertions and accounts similar to risk 2

Risk 4: Percentage of completion projects:

in some industries such as energy, construction, software defense and so on

completion of project may take more than a year (sometimes several)

How to recognize this revenue?

• percentage of completion method- allows businesses to recognize revenue based on the % of expended costs or some other measure to complete this project

Percentage of completion method:

2 conditions to use this method

1. the business reasonably expects to be able to collect payment and

2. the business can reasonably estimate the cost to complete the performance obligation and the rate of project completion

involves a lot of judgement

cost overruns, what if it ends up costing more than you anticipated

project managers and engineers on projects have the best view on how much it will really take to complete the project but auditors rarely speak to them

Key risk and accounts for Risk 4: Percentage of completion projects:

the greatest risk is usually overstatement of the actual cost during the periods leading up to the completion to justify recognizing more revenue during those periods

sales and COGS:

• occurrence, both have to have been recorded prematurely and not have occurred yet

• accuracy, both may be too high due to over estimation of completed cost and recognized revenue

• cut off, sales may have been recognized too soon and COGS too late

• presentation, not presented sales and COGS, not clearly described or appropriate

un-billed contracts receivables:

as asset account usually used for the percentage of completion method to reflect receivables that need to be billed for the earned revenue that was calculated using this method

• rights, the business may not have the rights to the receivables because they have been sold to a bank

• existence, un-billed contract receivables may not exist

• presentation, same as before

Risk 5: Fake or invalid sales and accounts receivables

risk of fraud, can easily be unintentional

attention to controls surrounding recording revenue

matching documents is very important

primary risk is overestimation of sales and revenue

• occurrence, the sales may have been recorded prematurely or without support

• accuracy, the recorded sales may be too high due to fake or invalid sales having been recorded

Accounts receivables:

• existence and rights, the receivables do not exist or if they do the business may not yet have the rights to the receivables because the receivables have been sold to a bank

Risk 6: Inability to collect accounts receivables

key controls- checking new customer’s credit worthiness prior to the sale

• regularly check existing customers

• one of the most common audit procedures to assess the extent to which accounts receivables are collectible is reviewing its aging schedule

Key risk and assertions for inability to collect accounts receivables

primary risk of overvaluation of accounts receivables

• bad debt expense, accuracy and completion (the expense is not recorded accurately and in insufficient amounts)

• allowance for uncollectible accounts (contra-asset account that off sets account receivable balance)

  • primarily concerned with the valuation assertion

  • valuation, a/r net of allowance for uncollectible accounts are reported at a higher level than warranted

What is the overall process for auditing the revenue transaction cycle and testing relevant controls?

• 1 key control- matching a customer’s PO, the company’s sales order, and the company’s shipping order before issuing an invoice and recording a sale

What are some substantive test auditors might perform for accounts receivables?

• review aging of accounts receivables

  • clients usually prepare these schedules to keep track of their receivables by age

  • compare those with prior years

  • can be viewed as an analytical procedure because it looks at relationships between financial data

  • points auditors to risky areas

• sending confirmations to confirm A/R is a required procedure