performing the audit - 2

accounts receivable

The vast majority of a company’s accounts receivable are trade receivables that arise from credit sales of goods or services to customers.

auditors objectives in the audit of receivables and revenues

1) Use the understanding of the client and its environment to consider inherent risks, including fraud risks, related to receivables and revenue.

2) Obtain an understanding of internal control over receivables and revenue.

COSO framework

control environment

risk assessment

control activities

information and communication

monitoring activities

control environment include the following elements

Integrity and ethical values

Management’s philosophy and operating style

Organizational structure

Assignment of authority and responsibility

Human resource policies and practices

Competence of personnel

management should establish a …

tone at the top of the organization that encourages integrity and ethical financial reporting

internal control of COSO

operations, reporting, compliance

What control is indicated when management ensures revenue recognition is performed by trained and competent personnel?

A commitment to competence.
Management increases control by identifying needed skills, providing training, and ensuring key financial functions (like revenue recognition) are performed by qualified staff.

chart of accounts

A classified listing of all accounts in use, accompanied by a detailed description of the purpose and content of each.

manual of accounting policies and procedures

States clearly in writing the methods of treating transactions

What can happen if a company lacks proper control activities over credit sales in the revenue cycle?

Large credit losses are almost inevitable.

control activities

Perform Reviews

Transaction Control Activities

Physical Controls

Segregation of duties

Controls over Accounting Estimates

Fidelity Bonds

fidelity bond

are business insurance policies that cover losses caused by employee dishonesty. When an employee engages in dishonest behavior, such as stealing money or property, the fidelity bond provides financial coverage to the employer for the losses incurred

what might prevent fraud

vacations

assigned duties are rotated periodically

risk assessment

identification, analysis, and management of risks relevant to achieving the organization’s objectives

external factors and internal factors are important

sales invoices

this is what you’re billing the customer

authorization

Activities where approval or decision-making is involved:

• (2) Credit approval

• (9) Approval of sales returns and allowances

• (10) Authorization of write-offs of uncollectible accounts

custody

activities where physical control of assets (inventory, cash, etc.) takes place:

• (3) Issuance of merchandise from stock

• (4) Shipment

reporting

Activities involving documentation, entry, and record maintenance:

• (1) Preparation of the sales order

• (5) Billing

• (6) Invoice verification

• (7) Maintenance of control accounts

• (8) Maintenance of customers’ ledgers

4 important controls

purchase order

sales order

bill of lading

sales invoice

What is a benefit of subdividing duties among independent units in a company?

Accidental errors can be detected quickly by comparing documents and amounts from different units, and the risk of fraud is minimized.

Why are controls and procedures important when processing customer orders?

To avoid costly errors. Controls include registering the purchase order, reviewing items and quantities, and checking order feasibility before preparing a sales order.

What is the purpose of the sales order in the order processing system?

The sales order translates the customer’s purchase order into specific instructions for different divisions like credit, shipping, billing, and A/R, guiding the company's fulfillment process.

Who is responsible for deciding whether goods can be shipped to a customer on open account?

The credit department, supervised by a credit manager who reports to the treasurer or VP of finance.

How does the credit department evaluate prospective and continuing customers?

By applying management’s credit policies, analyzing financial statements, and using credit agency reports (e.g., Dun & Bradstreet).

When can the storekeeper issue goods to the shipping department?

Only after the sales order has been approved by the credit department

Who should maintain perpetual inventory records of finished goods?

The accounting department—not the storekeeper—to ensure proper segregation of duties.

What does the shipping department do once goods are received from the finished goods storeroom?

They arrange transportation (rail, air, or motor freight) and prepare shipping documents such as bills of lading.

What controls are applied to shipping documents?

They are numerically controlled, entered in a shipping register, and sent to the billing department. Gate control may be used to verify all shipments are recorded.

What is the billing function and who should perform it?

Billing notifies the customer of the amount due via a sales invoice. It should be done by a department not under sales control—usually accounting, data processing, or finance.

What are the responsibilities of the billing section when a manual process is used

• Account for serially numbered shipping docs

• Compare shipping docs with sales orders & purchase orders

• Enter data on the sales invoice

• Apply prices/discounts

• Calculate totals

• Accumulate total amounts billed

What must accounting personnel consider when a formal contract exists?

They must review the contract terms and apply the appropriate accounting standards.

revenue should be recognized when…

realizable or earned

How are sales invoices generated and what information do they rely on?

Sales invoices are generated by the IT system using data already entered—like quantities shipped by the shipping department and prices from the sales department or a master price file.

What other functions does the IT system perform when sales invoices are printed?

It creates an electronic sales transactions file, updates A/R master files, posts to the general ledger, prints journals and subsidiary ledgers, and generates monthly customer statements.

What manual control can help ensure invoice accuracy before mailing to customers?

A second-person review of prices, credit terms, transportation charges, extensions, and findings.

How do IT-based billing systems ensure invoice accuracy?

By using input validation (edit) checks and various processing controls.

Who is responsible for handling and depositing customer checks?

The cashier controls and deposits checks received with remittance advices.

What happens after remittance advices are received?

They are forwarded to the A/R section of the data processing department, which records them in the customers’ ledger and updates the general ledger periodically.

What is the purpose of preparing an aged trial balance of customer accounts?

To help the credit department manage collections and to aid in determining the allowance for doubtful accounts.

What controls should be in place when estimating revenue due to complex agreements?

• Control environment policies to support proper estimates

• Risk assessment policies to address misapplication of recognition rules

• Policies ensuring competent personnel who understand standards, contracts, customer traits, and economic factors

• Data policies ensuring relevant, sufficient, and reliable data is used

• Management review of data sources, assumptions, and methods

• Estimation improvement policies comparing past estimates with actual results

What controls should be in place for adjustments to sales and receivables?

• Require serially numbered credit memoranda signed by someone with no cash or ledger duties

• Ensure returned goods are received and examined before issuing credit

• Credit memos should reference the serial number of the receiving report

What are best practices for handling uncollectible receivables?

• Credit manager initiates write-off; treasurer authorizes it

• Written-off receivables should go to a collection agency or a separate ledger

• Maintain memo records and continue sending statements if debtor exists to prevent employee theft through concealed collections

ongoing monitoring

Involves the day-to-day review of control activities through routine processes like data analytics, system reports, and management oversight to identify potential issues as they arise. (Internal)

periodic assessments

Regular, more comprehensive assessments of the internal control system are conducted to evaluate its effectiveness in mitigating key risks, often involving detailed testing and analysis. (External)

What are examples of monitoring controls for revenue and receivables?

• Management review controls: Analyze sales/gross margin by product, customer, area, salesperson

• Review aging schedules of receivables and get customer feedback

• Use data analytics to flag unusual or large transactions, especially near period end, and investigate them

How do internal auditors contribute to monitoring activities?

• They may send customer statements or confirmations and investigate discrepancies

• They review shipping reports, invoices, receipts, credit memos, and aged trial balances to ensure control procedures are followed

How do internal auditors use data analytics in monitoring activities?

• They use analytics to continuously monitor controls

• They investigate unusual transactions to detect misstatements or breakdowns in other controls

• Regulatory reports are also used to guide control improvements

What audit documentation is typically prepared for receivables and revenue?

• Aged trial balance of A/R

• Analysis of other A/R

• Analysis of notes receivable and interest

• Analysis of allowance for uncollectibles

• Comparative revenue analysis (e.g., by month/product)

• Documentation of internal controls

• Risk analysis and audit plan

what are key audit steps for verifying receivables and revenue?

• Understand the client and identify inherent risks (including fraud)

• Understand internal controls over receivables and revenue

• Assess risk of material misstatement and design audit procedures

• Perform tests of controls

What are examples of tests of controls for receivables and revenue?

a. Test sales transaction recording controls
b. Trace shipping docs to sales invoices
c. Review use/authorization of credit memos
d. Reconcile cash register/sales tickets with journals (for OTC sales)
e. Test management review controls
f. Test controls over revenue and receivable estimates

5 financial statement assertions

existence or occurrence

completeness

rights and obligations

valuation and obligation

presentation and disclosure

control assertions

authorization

validity

accuracy

timeliness

confidentiality

integrity

availability

What follows after performing tests of controls in a receivables/revenue audit?

Revise the assessed risks of material misstatement if needed, then perform substantive audit procedures for receivables and revenue.

What are common potential misstatements related to revenue?

• Recognizing revenue that hasn’t been earned

• Early or late revenue recognition (cutoff issues)

• Recording revenue despite significant uncertainties

• Recording revenue before completing performance obligations

• Overstating earned revenue

What is the relationship between testing sales and testing receivables during substantive procedures?

• Assertions about A/R provide evidence for sales assertions and vice versa

• Testing completeness of sales also tests completeness of receivables, since:

  • Sales (credit) ↔ Receivables (debit)

  • Both are recorded together in the sales journal

What are two substantive procedures used to test completeness of sales and receivables?

• Reconcile subsidiary ledger totals to A/R in the general ledger

• Sales cutoff test – ensures sales/receivables are recorded when title passes (e.g., FOB shipping point); helps detect inflated sales around year-end

What are additional substantive procedures are used to test completeness of sales and receivables?

• Analytical procedures – Develop and compare expectations (e.g., A/R turnover) using internal and external benchmarks

• Cash receipts cutoff test – Inspect and trace remittance data before and after year-end to confirm A/R was properly reduced

• Account for the numerical sequence of sales-related documents (sales orders, shipping documents, invoices).

• Trace shipping documents forward to sales invoices and journal entries to ensure sales were recorded at the correct time.

How do auditors test the rights and obligations assertion for receivables?

1. Inquire of management about factoring/selling receivables.

2. Track cash receipts to ensure funds are deposited into entity-controlled accounts.

3. Assess sales with return rights and compare expected vs. actual returns after year-end.

What is the valuation assertion for accounts receivable?

A/R should be valued at net realizable value (gross A/R minus allowance for uncollectibles), in accordance with GAAP.

What does GAAP require for the valuation of accounts receivable?

Accounts receivable must be valued at net realizable value (Gross A/R – Allowance for uncollectible accounts).

What are two audit procedures used to test the valuation of accounts receivable?

• Age the accounts receivable – Classify by age and compare to prior year to assess collectability.

• Trace subsequent cash receipts – Review payments after year-end to evaluate likelihood of collection and adequacy of allowance.

What is the focus of substantive testing for existence or occurrence in sales and receivables?

To determine if accounts receivable are valid assets and whether the related sales actually occurred.

When is the auditor not required to confirm accounts receivable?

• They are immaterial

• Confirmation would be ineffective

• Low audit risk exists and sufficient evidence is available from other procedure

What must an auditor do if accounts receivable are not confirmed?

The auditor must document how they overcame the presumption that confirmations were necessary.

What issues can accounts receivable confirmations help detect?

• Lapping: Theft of one customer’s payment concealed by crediting their account when another customer pays

• Improper cutoff: Sales recorded in the wrong period, inflating year-end receivables

What should an auditor do if a customer fails to respond to a second confirmation request?

Use alternative procedures like reviewing subsequent cash receipts, shipping documents, or other client documentation to verify the validity of the account.

What does it mean to vouch recorded accounts receivable to shipping documents?

It tests for existence by verifying that a receivable is supported by shipment evidence (e.g., bill of lading), confirming the sale actually occurred.

Why do auditors trace recorded sales transactions to customer orders and shipping documents?

To test the occurrence assertion and detect overstatement of sales, especially for large or unusual transactions.

What procedures are used to test the presentation and disclosure assertion for sales and receivables?

• Inspect income statement and balance sheet to confirm proper classification (e.g., revenue net of returns, A/R as a current asset less allowance).

• Read note disclosures for GAAP compliance (e.g., net realizable value, pledges, related-party transactions).

• Obtain management representation letter confirming appropriate disclosures.

how should an auditor test sales returns and allowances?

• Focus on the existence or occurrence assertion.

• Verify proper authorization for the return.

• Check if the goods were actually returned using a receiving report.

• Confirm the credit to the customer’s account matches the return documentation.

How should an auditor test the cutoff assertion for sales and receivables?

• Review transactions near year-end to ensure sales and receivables were recorded in the correct period.

• Trace shipping documents to the sales journal and customer invoices.

• Focus on identifying improper cutoff—e.g., sales recorded in the wrong period.

• The objective is to verify that revenue is recognized in the correct period under the cutoff assertion.