Chapter 10 auditing (part 1)

Five step revenue recognition approach

1. Identify the contract with a customer, 2. Identify the performance obligations in the contract, 3. Determine the transaction price, 4. Allocate the transaction price to the performance obligations in the contract, 5. Recognize revenue when the entity satisfies a performance obligation

Fraud Risks in Revenue Recognition

Side agreements
Channel stuffing
Related party transactions
Bill and hold sales

Side agreements

Arrangements used to alter the terms and conditions of recorded sales

to entice customers to accept delivery of goods and services.

Channel stuffing

Marketing practice by suppliers to boost sales by inducing distributors

to buy substantially more inventory than they can promptly resell

Related party transactions

Transactions that are not considered arms-length

Bill and hold sales

Sales where the customer agrees to purchase goods but the seller

retains physical possession until the customer requests shipments

Cash Sale

Inventory purchase → Sold for cash → cash used for more inventory

Credit Sale

Inventory sold on credit → Account receivable created → Cash collected → cash used to buy more inventory

Three types of transactions processed through the revenue process

Sale of goods or services for cash or credit, Receipt of cash from customer in payment for the goods or services, Return of goods by customer for credit or cash

Sales transactions

Trade accounts receivable, Sales, Allowance for uncollectible accounts, Bad debt expense

Cash receipts transactions

Cash, Trade accounts receivable, Cash discounts

Sales return and allowance transactions

Sales returns, Sales allowances, Trade accounts receivable

Customer sales order

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

Write-offs

Allowance for uncollectible accounts.

Trade accounts receivable

Credit approval form (document)

Customer purchases products on credit from the entity for the first time, the entity should have a formal procedure for investigating the creditworthiness of the customer

Customer Sales Order (document)

Contains the details of the type and quantity of products or services

ordered by the customer

Open order report (document)

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

Shipping document (document)

This document serves as a bill of lading and contains information on the type of product shipped, quantity shipped, and other information

Sales invoice (document)

Used to bill the customer. Contains information on the type of product or service, the quantity, the price, and the terms of trade

Sales journal (document)

Used to record necessary information for each sales transaction

Customer statement (document)

Contains the details of all sales, cash receipts, and credit memorandum transactions processed through the customers account for the period

Accounts receivable subsidiary ledger (document)

Contains an account and the details of transactions with each customer

Aged trial balance of accounts receivable (document)

Summarizes all the customer balances in the accounts receivable subsidiary ledger

Remittance advice (document)

contains information regarding which invoices are being paid by the customer

Cash receipts journal (document)

Contains columns for debiting cash, crediting accounts receivable, and crediting other accounts such as scrap sales or interest income

Credit memorandum (document)

Used to record credits for the return of goods in a customers account or to record allowances that will be issued to the customer

Write off authroization

This document authorizes the write off of an uncollectible account

Order entry

Initial function in the revenue process is the entry of new sales orders into the system

Credit authorization

Must determine that the customer is able to pay for the goods or services

Shipping

The main control that authorizes shipment of goods or performance of services is payment or proper credit approval for the transaction

Billing

Ensure that all goods shipped and all services provided are billed at authorized prices and terms

Cash receipts

Must ensure that all cash collections are properly identified and promptly deposited intact at the bank

Accounts receivable

Responsible for ensuring that all billings, adjustments, and cash collections are properly recorded in customers accounts receivable records

General ledger

Ensure that all revenues, collections, and receivables are properly accumulated, classified, and summarized in the accounts

Four specific inherent risk factors that may affect revenue process

Industry related factors, Complexity and contentiousness of revenue recognition issues, Difficulty of auditing transactions and account balances, Misstatements detected in prior audits

Industry related factors (Inherent Risk)

Profitability and health of the industry, level of competition, and industry's rate of technological change affect the potential for misstatements

Control Risk Assessment

• Understand and document the revenue process and

related controls.

• Plan and perform tests of controls on revenue transactions.

• Assess and document the control risk for the revenue

process.

Understand and document internal control

Control environments, Entity's risk assessment process, Control activities, Information systems and communication, and monitoring controls

Control Environment

Understanding the control environment is generally

completed on an overall entity basis.

The Entity’s Risk Assessment Process

The auditor must understand how management considers

risks that are relevant to the revenue process. The auditor

should estimate the significance of the risk and assess the

likelihood of occurrence.

Control Activities

The auditor identifies what controls ensure that the

assertions for transactions and events are being met.

Information Systems and Communication : Auditor needs to obtain the following knowledge:

• The process by which sales, cash receipts, and sales returns and allowances

transactions are initiated.

• The flow of each transaction from initiation to inclusion in the financial

statements.

• The accounting records, supporting documents, and accounts that are

involved in sales, cash receipts, and sales returns.

• The process used to prepare estimates for accounts such as bad debts and

sales returns.

Monitoring of Controls

• The auditor must understand how management assesses the design and

operation of controls in the revenue process; including how supervisory

personnel review the personnel who perform the controls and evaluate the

performance of the entity’s IT function.

To set control risk,

the auditor must test controls over the

revenue process

Plan and Perform Tests of Controls: Such tests may include . . .

• Inquiry of client personnel.

• Inspection of documents and records.

• Observations of the operation of the control.

• Walkthroughs.

• Reperformance of the control activities.

For the control activities to be effective, employees maintaining the accounts receivable subsidiary ledger should not also approve

Write-offs of customer accounts

Which of the following controls is most likely to help ensure that all credit revenue transactions of an entity are recorded

The billing department supervisor matches prenumbered shipping documents with entries in the sales journal

Which of the following internal controls would be most likely to deter the lapping of collections from customers

Segregation of duties between receiving cash and posting the accounts receivable ledger

Smith Corporation has numerous customers. A customer file is maintained and includes a customer record with a name, an address, a credit limit, and an account balance. The auditor wishes to test this file to determine whether credit limits are being exceeded. The best procedure for the auditor to follow would be to:

Develop a routine in IDEA or an audit data analytic to compare credit limits with account balances and identify any account with a balance exceeding its credit limit

Cash receipts from sales on account have been misappropriated. Which of the following acts would conceal this theft and be least likely to be detected by an auditor

Understating the sales journal