NATIONAL TEACHERS COLLEGE

Auditing Problem

Instructor Name: Mr. Ernesto Nogoy Jr.

Auditing Revenue Cycle
The overall objective of the sales and collection cycle is to evaluate whether the account balances
affected by the cycle are fairly presented in accordance with GAAP.

Nature of the Sales and Collection Cycle

Numerous documents and records are included in the revenue cycle:

 Customer order
 Sales order–frequently used to show credit approval and authorization for shipment.
 Shipping document–the original is sent to the customer and one or more copies are retained.
Used as a signal to bill the customer. One type of shipping document is a bill of lading (a written
contract between the carrier and the seller).
 Sales invoice–a document indicating the description and quantity of goods sold, price, freight
costs, insurance, terms, etc. Sales invoice information in the computer is the basis for recording
sales transactions and updating the A/R master file.
 Sales journal
 Credit memo–a document indicating a reduction in the amount due from a customer because of
returned goods or an allowance.
 Remittance advice–a document that accompanies the sales invoice mailed to the customer and
can be returned to the seller with payment. It is used to indicate customer name, sales invoice #,
and invoice amount.
 Cash receipts journal–daily entries in this journal are supported by remittance advices.
 Uncollectible account authorization form
 A/R master file–updated from the sales, sales returns and allowances, and cash receipts computer
transactions files.
 A/R trial balance

Monthly statement

An understanding of the functions that occur in a client firm for the sales and collection cycle is
useful for understanding how an audit of the cycle is conducted.

1. Processing customer orders--starting point for the entire cycle

2. Granting credit--before goods are shipped, a properly authorized person must approve credit for the
customer.
3. Shipping goods–first critical point where company assets are given up. A shipping document is
essential to the proper billing of shipments to customers.

4. Billing customers–the most important aspects of billing are making sure that all shipments made have
been billed, no shipment has been billed more than once, and each one is billed for the proper amount.
In most accounting systems, customer billing involves simultaneous updating of the sales transaction file
and A/R master file.

5. Processing and recording cash receipts–the most important concern here is theft. All cash must be
deposited in the bank at the proper amount on a timely basis and recorded in the cash receipts transaction
file.

6. Processing and recording sales returns and allowances

7. Charging off uncollectible A/R

8. Providing for bad debts

Internal Controls and Tests of Transactions for Sales

Tests of transactions are usually performed at an interim date if the IC structure is effective, but
they can also be done after the balance sheet date.

Key Controls

If the internal controls necessary to satisfy any one of the objectives are inadequate the likelihood
of misstatements related to that objective is increased (regardless of controls for the other objectives).

Tests of Controls

For each internal control there exists a related test of control to verify its effectiveness. In most
audits, it is somewhat easy to determine the nature of the test of the control from the nature of the
control (e.g., if the IC is to initial customer orders after they have been approved for credit, the test of
control is to examine the customer order for a proper initial).

The auditor may evaluate the client’s exception reports and use test data to be sure the client’s
programs operate correctly.

Another computer audit test is to perform sequence checks to detect a missing or duplicate sales order.

Substantive Tests of Transactions

Some procedures are used in every audit regardless of circumstances while others depend on the
adequacy of controls and results of tests of controls. The substantive tests of transactions are related to
the objective in the first column of Table 11-1 and are designed to determine whether any monetary
errors of the type relating to that objective exist in the transaction.

The audit procedures used are affected by the ICs and tests of controls for that objective. Materiality and
results of the prior year also affect the procedures used.
For example, there is a higher risk of misstatement in A/R. Certain procedures in auditing A/R are high
cost. Usually a larger share of financial statement materiality is allocated to A/R.

General objectives are the same for any class of transactions but specific objectives vary for sales, cash
receipts, etc.

Any given control must be related to one or more specific objectives. The common tests of controls in

A test of control has no meaning unless it tests a particular control. The common substantive
tests of transactions in the last column are evidence to support a specific audit objective in column 1. The
substantive tests of transactions are not directly related to the key control or test of control columns, but
the extent of substantive tests of transactions depends, in part, on which controls exist and on results of
tests of controls.

Many firms prepare a multicopy prenumbered sales invoice at the time a customer order is
received. There is almost no chance of a failure to bill a customer if all invoices are accounted for
periodically. If the client requires a duplicate sales invoice be attached to every sales order to prevent
failure to bill, a test of control is to account for a sequence of sales orders and check each one for a
duplicate sales invoice being attached.

Prenumbered Documents

Prenumbered documents are meant to prevent both the failure to bill or record sales and the
occurrence of duplicate billings and recordings. Tests of controls means the auditor focuses on omitted
and duplicate numbers outside the normal sequence.

Proper Authorization

The auditor is concerned about authorization at 3 points:

1 Credit must be properly authorized before a sale occurs

2 Goods should be shipped only after proper authorization

3 Prices must be authorized

The first two controls are meant to prevent the loss of company assets by shipping to fictitious
customers or those who will fail to pay. It is easy to test for the effectiveness of ICs for authorization by
examining documents for proper approval at these three points. Some computer systems have credit
limits in the A/R master file.

Adequate segregation of duties

Anyone responsible for inputting sales and cash receipts transaction information into the
computer should be denied access to cash. It is also desirable to separate credit-granting functions from
the sales function. Credit checks offset the tendency of sales personnel to optimize volume at the expense
of debt write-offs.

Personnel responsible for doing internal comparisons should be independent from entering original data
(e.g., comparison of batch control totals to summary reports and A/R master file totals to the general
ledger balance should be done by a person different from the one who inputs sales and cash receipt
transactions).

Internal Verification Procedures

The use of independent persons for checking the processing and recording of sales is critical.

Substantive Tests of Sales Transactions

Recorded sales are valid

For this objective, the auditor is concerned with two types of misstatements: sales being included
in the journals for which no shipment was made and shipments being made to fictitious customers.
Appropriate substantive tests of transactions for invalid transactions depends on where the auditor
believes misstatements are likely to occur.

Sales are properly authorized

It is necessary to test by substantive procedures whether the firm’s general credit, shipping, and
pricing policies are being followed. This is especially true of pricing sales.

Substantive tests may be necessary here if adequate controls do not exist. This will be the case if
the client does no internal tracing from the shipping documents to the sales journal. An effective
procedure to test for unbilled shipments is to trace selected shipping documents to related duplicate sales
invoices and the sales journal. Tracing from source documents to the journals is a test for omitted
transactions. Auditing from the journals back to the supporting documents is a test for invalid
transactions.

Validity objective--starting point is a journal

Completeness objective--starting point is a shipping document

When designing audit procedures for validity and completeness, the starting point for tracing the
document is critical. This is referred to as the direction of tests.

Recorded sales are properly valued

This deals with shipping the amount of goods ordered, correctly billing for the amount of goods
shipped, and correctly recording the amount billed. A typical substantive test is to start with entries in
the sales journal and compare the total of selected transactions with A/R master file entries and duplicate
sales invoices. If a control is effective, the sample size for substantive tests of transactions can be reduced.

Recorded sales are properly classified

Here the auditor examines supporting documents to determine the proper classification of a
transaction and compares this to the actual account to which it is charged.

Sales are recorded on a timely basis

Transactions could be omitted from the accounting records or sales could be recorded in the
wrong period if they are not recorded on a timely basis. Significant differences between the dates on
shipping invoices and duplicate sales invoices could indicate a cutoff problem.

Sales transactions are properly included in the master file and correctly summarized.

It is necessary to perform some clerical accuracy tests by footing the journals and tracing the totals
and details to the general ledger and the master file to check whether there are misstatements in the
computer program. The distinction between the summarization and other objectives is that
summarization includes footing journals, master file records, and ledgers and tracing from one to the
other among the three.

Control Activities--Cash Receipts Transactions

 Common Documents (not already covered)

 Prelist–listing of cash receipts received in the mail
 Cash count sheet–listing of cash and checks in a cash register
 Daily cash summary–report showing total over-the-counter and mail receipts received by the
cashier for deposit

Cash Receipts Functions

1. Receiving cash receipts

2. Depositing cash in the bank - All cash receipts should be deposited daily.

3. Recording the receipts

Controls should ensure that only valid transactions and all actual receipts are entered (e.g.-
restricting access to accounting records) and segregation of counting cash receipts and journalizing.

Control Activities--Sales Adjustment Transactions

This entails such things as granting cash discounts and sales returns and allowances. It also
includes determining uncollectible accounts.

The potential for misstatements resulting from errors and fraud in processing these transactions
is considerable in some firms. A main concern here is the possibility of fictitious sales adjustments
transactions being recorded to hide fraud.

Substantive Tests of Accounts Receivable

The auditor must first determine the acceptable level of detection risk for each important
assertion to select substantive tests for A/R and uncollectible accounts. Factors relevant to assessed levels
of control risk and inherent risk must be considered in selecting an appropriate level of detection risk for
each assertion.
Factors relevant to assessed levels of IR and CR must be considered in selecting an appropriate
level of detection risk for each assertion.

Control risk assessments for A/R assertions are dependent on related control risk assessments for
transaction classes (e.g., credit sales, cash receipts and sales adjustments) that affect the A/R balance.
Assessment for transaction class assertions affect the same account balance assertions for accounts
affected by the transactions except:

CR assessments for the existence or occurrence and completeness assertions for a transaction
class that decreases an account balance affect the assessments for the opposite account balance
assertions (e.g. assessments for existence or occurrence for cash receipts and sales adjustments affect the
combined assessment for the A/R completeness assertion).

Appropriate IR assessments and planned assessed levels of CR for account balance assertions are
used in the audit risk model to arrive at planned DR and the planned level of substantive tests. Revised
levels of DR and substantive tests for an assertion may be necessary if actual CR differs from planned CR
assessments.

Designing Substantive Tests

A listing of possible substantive tests that might be included in an audit program developed by
the auditor appears in Fig. 14-9 of your textbook. This figure does not represent a formal audit program.

Initial Procedures

The starting point for verifying A/R and the related allowance account is tracing the current
period’s beginning balances to the ending audited balances in the prior year’s working papers (when
applicable). Next, the current period’s activity in the general ledger control account and related allowance
account should be reviewed for any significant entries that are unusual in nature or amount. A listing of
all customer balances, called an A/R trial balance, is obtained. This listing should be footed and the total
compared with the total of the subsidiary ledger or master file from which it was prepared and the general
ledger control account balance.

As you know from some of the cases and AAERs we have studied, when the client furnishes the
trial balance, a sample of the customers and balances shown on the trial balance should be compared
with those in the subsidiary ledger or master file and vice versa to determine that the trial balance is an
accurate and complete representation of the underlying accounting records.

Tests of Details of Transactions

Vouch Recorded Receivables to Supporting Transactions

In doing this test, a sample of debits to customers’ accounts can be vouched to supporting sales
invoices and matching documents to provide evidence pertaining to the existence or occurrence, rights
and obligations, and valuation or allocation assertions. Credits can be vouched to remittance advices and
sales adjustment authorizations.
Perform Cutoff Tests for Sales and Sales Returns

The sales cutoff test is designed to obtain reasonable assurance that sales and A/R are recorded
in the accounting period in which the transactions occurred and the corresponding entries for inventories
and cost of goods sold are made in the same period. Sales should be recorded in the period in which legal
title to the goods passes to the buyer.

The sales cutoff test is made as of the balance sheet date. For sales of goods from inventory, the
test involves comparison of a sample of recorded sales from the last few days of the current period and
the first few days of the next period with shipping documents to determine whether the transactions were
recorded in the proper period.

The sales cutoff test provides evidence concerning the existence or occurrence and completeness
assertions for A/R and sales. For a calendar year firm, if January sales are recorded in December, there is
a misstatement of the E or O assertion. Conversely, if December sales are not recorded until January,
there is a misstatement of the completeness assertion.

Perform Cash Receipts Cutoff Test

The cash receipts cutoff test is designed to obtain reasonable assurance that cash receipts are
recorded in the accounting period in which received. A proper cutoff at the balance sheet date is essential
to the correct presentation of both cash and A/R. This test relates to the E or O and completeness
assertions for both cash and A/R.

Evidence concerning the promptness of the cutoff can be obtained by personal observation or a
review of documentation. An alternative to personal observation is to review supporting documentation
such as the daily cash summary and validated deposit slip for the last day of the year. The objective of
the review is to determine that the deposit slip total agrees with the receipts shown on the daily cash
summary.

Tests of Details of Balances

Confirm A/R

The Confirmation Process states that there is a presumption that the auditor will request the
confirmation of A/R during an audit unless A/R are immaterial to the financial statements, the use of
confirmations would be an ineffective audit procedure, or the auditor’s combined assessment of inherent
risk and control risk is low, and that assessment, together with the evidence from analytical procedures
or other substantive tests, is adequate to reduce audit risk to an acceptably low level for the relevant
financial statement assertions.

There are two forms of confirmation request: the positive form, which requires the debtor to
respond whether or not the balance shown is correct and the negative form, which requires the debtor
to respond only when the amount shown is incorrect. The positive form usually produces the better
evidence, because under the negative form, the failure to receive a response can only lead to a
presumption that the balance is correct, whereas the customer may have overlooked the request or
neglected to return an exception.
The form selection rests with the auditor. In making the decision, the auditor considers the
acceptable level of detection risk and the makeup of the customer balances. The positive form is used
when detection risk is low or individual customer balances are relatively large. The negative form,
according to GAAS, should be used only when all three of the following conditions are present: (1) the
acceptable level of detection risk for the related assertions is moderate or high; (2) a large number of
small balances is involved; and (3) the auditor has no reason to believe that the recipients of the requests
are unlikely to give them consideration.

The extent of requests, or sample size, is inversely related to each of the following factors: (1) the
acceptable level of DR for the assertions t which the confirmation evidence will apply; (2) the extent to
which other substantive tests contribute to achieving that detection risk; and (3) tolerable misstatement
for A/R.

Tolerable misstatement is the minimum misstatement that can exist in an account balance for it to be
considered materially misstated.

Negative confirmations require larger sample sizes than positive confirmations.

Given the possibility for fraud, the auditor must control every step in the confirmation process.
This means determining that the amount, name, and address on the confirmation agree with the
corresponding data in the customer’s account, maintaining custody of the confirmations until they are
mailed, using the firm’s own return address envelopes for the confirmations, personally depositing the
requests in the mail, and insisting that the returns be sent directly to the auditor.

When no response has been received after the second or third positive confirmation request to a
customer, the two main alternative procedures that may be used are examining subsequent collections
and vouching open invoices comprising customer balances. The matching of collections back to open or
unpaid invoices comprising the customers’ balances at the confirmation date establishes the collectability
of the accounts.

The confirmation of A/R is the primary source of evidence in meeting the E or O assertion. The
test also provides evidence on the rights and obligations assertion.

Evaluate Adequacy of Allowance of Uncollectible Accounts

This test of balances involves footing and cross footing the aged trial balance of A/R and agreeing
that total to the general ledger balance (if different than others used), testing the aging of the amounts
shown in the aging categories, and assessing the reasonableness of the percentages used to compute the
allowance component used for each aging category.