Auditing the Revenue Process

Auditing the Revenue Process Notes

Revenue Recognition – 5 Steps

  • Step 1: Identify the contract(s) with a customer.
  • Step 2: Separate the performance obligations in the contract.
  • Step 3: Determine the transaction price.
  • Step 4: Allocate the transaction price to the performance obligations in the contract.
  • Step 5: Recognize revenue when the entity satisfies a performance obligation.
    • Assumption: Assume a High Risk of Material Misstatement (RMM).

Application of Revenue Recognition

  • Thomson Telecom Case:

    • Scenario: Bayone Telephone Company ordered 10 transformers for $5 million but has not signed a contract.
    • Conclusion: No enforceable contract means no revenue recognition this year.

  • Best Products Case:

    • Scenario: Retailer uses layaway sales. Revenue is not recognized until merchandise is delivered.

  • Dave’s Discount Stores Case:

    • Scenario: Membership fees are collected, but 35% of customers usually cancel.
    • Conclusion: Membership fees should not be recognized as revenue until the membership is validated.

Main Fraud Risk Factors in Revenue Process

  • Side Agreements: Modifications to sales terms to entice customers.
  • Channel Stuffing: Inducing distributors to buy excess inventory.
  • Related Party Transactions: Non-arms-length transactions needing special scrutiny.
  • Bill & Hold Sales: Customer buys but delivery is delayed; recognition of revenue must reflect delivery timing.

Main Transactions in Revenue Process

  • Sale of product or service for cash or credit.
  • Receipt of cash.
  • Return of goods.
  • Possibility of bad debt.

Accounting Entries for Revenue Process

  1. Sale of good or service for cash/credit:

    • Debit Cash / Debit A/R (for credit sales)
    • Credit Sales
    • If inventory sold:
      • Debit COGS
      • Credit Inventory

  2. Receipt of Cash:

    • Debit Cash
    • Credit A/R

  3. Return of Goods:

    • Debit Sales Return & Allowances
    • Credit A/R
    • If physical goods returned:
      • Debit Inventory
      • Credit COGS

  4. Possibility of Bad Debt:

    • Debit Bad Debt Expense
    • If specific accounts are identified:
      • Credit A/R
      • Credit All for Bad Debt

Main Documents in Revenue Process

  • Customer Sales Order: Details of ordered products/services.
  • Credit Approval Form: For assessing customer creditworthiness.
  • Open-order Report: Report of unprocessed customer orders.
  • Shipping Document: Bill of lading with shipment details.
  • Sales Invoice: Used to bill customers, includes product/service details, quantity, and terms.
  • Sales Journal: Records sales transactions.
  • Customer Statement: Details of all sales, cash receipts, and credit transactions sent to customers.
  • A/R Subsidiary Ledger: Transaction details for each customer.
  • Aged Trial Balance of A/R: Summary of customer balances categorized by age.
  • Remittance Advice: Part of the bill returned with payment.
  • Cash Receipts Journal: Records cash received.
  • Credit Memorandum: Records customer returned goods.
  • Write-off Authorization: Authorizes write-offs of uncollectible accounts, usually signed by the treasurer.

Segregation of Duties in Revenue Process

  • Credit function should not overlap with billing function.
  • Accounts receivable should be segregated from general ledger.
  • Shipping function must be separate from billing.
  • Cash receipts must be handled separately from accounts receivable.

Lapping Scheme

  • A type of fraud where cash misappropriation is obscured by adjusting accounts receivable balances.

Red Flags for Lapping

  • Excessive billing errors.
  • Slowing accounts receivable turnover.
  • High write-offs of accounts receivable.
  • Delays in posting customer payments.
  • A/R detail mismatched with general ledger.
  • Decreasing account payments trend.
  • Customer complaints.

Main Inherent Risks to Revenue Process

  1. Industry-related risks (profitability, competition, regulation).
  2. Complexity of revenue recognition.
  3. Difficulty auditing transactions and balances.
  4. Misstatements in prior audits.

Assessing Control Risk

  • Adopt a reliance strategy and document the COSO framework components.
  • Plan and perform tests of controls on revenue transactions.
  • Set and document control risk for the revenue process.
    • Conclusion Options:
    • If control tests support planned level, proceed as planned.
    • If not, raise control risk and increase substantive procedures.

Substantive Testing for Revenue

  • Analytical Procedures: Monitor receivables turnover, aging categories, bad debts as a percent of revenue, etc.
  • Tests of Details: Go deeper into individual transactions.