10-1
Chapter Ten
Auditing the Revenue
Process
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10-2
Revenue Recognition (IAS 18)
Revenue is defined as the gross inflow of economic
benefits during the period arising in the course of the
ordinary activities of an entity when those inflows
result in increases in equity, other than increases
relating to contributions from equity participants.
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10-3
Overview of the Revenue Process
Credit Sale
Cash Sale
Purchases
Purchases
Inventory
Account
receivable
Cash
sales
Inventory
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Cash
collection
Credit sales
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10-4
Types of Transactions and Financial
Statement Accounts Affected
Three types of transactions are typically processed by
the revenue process:
1. The sale of goods or rendering of a service for cash
or credit.
2. The receipt of cash from the customer in payment for
goods or services.
3. The return of goods by the customer for credit or
cash.
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10-5
Types of Transactions and Financial
Statement Accounts Affected
The revenue process affects numerous accounts in the
financial statements. The most significant accounts are:
Type of Transaction
Account Affected
Sales transactions
Trade accounts receivable
Sales
Allowance for uncollectible accounts
Bad-debt expense
Cash
Trade accounts receivable
Cash discounts
Sales returns
Sales allowances
Trade accounts receivable
Cash receipts transactions
Sales return and allowance
transactions
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10-6
Revenue Process – EarthWear Clothiers
Order Entry Department
By mail
or fax
Customer
sales order
By phone
or internet
Input
Error
Correction
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A
To the IT Department
A
If a new customer, a credit check
is run by the Credit Department.
Otherwise, credit is checked by IT
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10-7
Revenue Process – EarthWear Clothiers
IT Department
Customer
Price
Inventory
Open
orders
Inventory
From order entry
department
Data validation
program
To order entry
department
Error
Report
Open
orders
Batched
nightly
Shipping
program
To shipping
department
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10-8
Revenue Process – EarthWear Clothiers
Shipping Department
From shipping
department
Approved
shipping ticket
The shipping ticket forwarded to
the customer contains quantity
and price of each item purchased.
Ship goods
Approved
shipping ticket
Input to the billing program
To customer
with goods
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A
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10-9
Revenue Process – EarthWear Clothiers
IT Department
Open
orders
Shipping
transactions
A
Inventory
Billing
program
Sales
Invoice
Customer
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A weekly open order report is prepared
and reviewed by billing department.
Outstanding orders are investigated.
Accounts receivable
update
For receivables
processing
B
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10-10
Revenue Process – EarthWear Clothiers
IT Department
Accounts receivable
Shipping
transactions
Sales
Accounts receivable
update
B
Remittance
transactions
Weekly or
Monthly
Accounts receivable
reporting
D
Daily shipping
listing
Daily sales
report
Daily remittance
report
To cash receipts
department
To sales department
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C
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10-11
Revenue Process – EarthWear Clothiers
IT Department
Accounts receivable
Remittance transactions
Shipping transactions
D
General ledger
Accounts receivable
reporting
Customer statements
Weekly or
Monthly
Reports
•Sales journal
•Cash receipts journal
•Aged trial balance
•Sales summary
•Remittance summary
•Journal entry summary
Customer
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10-12
Revenue Process – EarthWear Clothiers
Cash Receipts Department
IT Department
From bank
Remittance
advice
transactions
Accounts
receivable
Remittance
advice
transactions
Error
correction
C
Cash
remittance
update
From bank
Daily remittance
report
Error
report
Remittance
advice listing
Reconciled by cash
receipts clerks
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B
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10-13
Types of Documents and Records
Customer Sales Order
Contains the details of the type and quantity of
products or services ordered by the customer.
Credit Approval Form
For credit sales, the client must have a formal activity
(procedure) for investigating the creditworthiness of
the customer.
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10-14
Types of Documents and Records
Open-Order Report
A report of all customer orders for which processing
has not been completed.
Shipping Document
This document generally serves as a bill of lading and
contains information on the type of product shipped,
the quantity shipped and other relevant information.
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10-15
Types of Documents and Records
Sales Invoice
The document is used to bill the customer. This
document contains information on the type of product or
service, the quantity, the price and the terms of trade.
Sales Journal
Once a sales invoice has been issued, the sale needs
to be recorded in the accounting records. The sales
journal is used to record information about the sales
transaction.
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10-16
Types of Documents and Records
Customer Statement
This document is mailed to the customer and contains
details of all sales, cash receipts, and credit
memorandum transactions.
Accounts Receivable Subsidiary Ledger
This ledger contains an account and the details of
transactions for each customer.
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10-17
Types of Documents and Records
Aged Trial Balance of Accounts Receivable
This report summarizes all the customer balances in
the accounts receivable subsidiary ledger. Each
account is classified as current or placed into one of
several past due categories.
Remittance Advice
This is usually the part of the customer’s bill that
should be returned with the payment.
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10-18
Types of Documents and Records
Cash Receipts Journal
This journal is used to record the cash receipts of the
entity.
Credit Memorandum
This document is used to record credits for the return
of goods by a customer.
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10-19
Types of Documents and Records
Write-Off Authorization
This document authorizes
the write-off of an
uncollectible account
receivable. Final
authorization is generally
received from the treasurer.
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Order Entry
The initial function in the
revenue process is the entry
of a new sales order into the
system.
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10-20
Types of Documents and Records
Credit Authorization
The credit authorization
process must determine that
the customer is able to pay
for the goods or services
purchased. Failure to
properly authorize credit can
lead to extensive bad debts
for the entity.
Shipping
Goods should not be
shipped, nor should services
be provided without proper
authorization. The main
control is payment or proper
credit authorization.
Billing
The objective of proper billing is to ensure that all goods
shipped and all services rendered are billed to the customer.
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10-21
Types of Documents and Records
Cash Receipts
Accounts Receivable
All cash collected must be
properly identified and
promptly deposited intact at
the bank.
All billings, adjustments and
cash collections must be
properly recorded in the
customers’ accounts
receivable records.
General Ledger
As related to the revenue process, the general ledger
function must ensure that all revenues, collections and
receivables are properly recorded and classified.
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10-22
Key Segregation of Duties
Segregation of Duties for Revenue and Accounts
Receivable Functions by Department
Department
Order
Accounts
Cash
Revenue and Accounts Receivable
Entry Credit Shipping Receivable Receipts
Receiving and preparing customer order
X
Approving credit
X
Shipping goods to customer
X
Preparing customer invoice
X
Updating accounts receivable records for sales
X
Receiving customer's remittance
X
Updating accounts receivable for remittance
X
Preparing accounts receivable aged trial balance
X
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IT
X
X
X
X
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10-23
Inherent Risk Assessment
The four inherent risk factors that may affect the
revenue process are:
1. Industry-related factors.
2. The complexity and contentiousness of revenue
recognition issues.
3. The difficulty of auditing transactions and account
balances.
4. Misstatements detected in prior audits.
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10-24
Control Risk Assessment
Understanding and documenting the revenue
process based on a reliance approach.
Planning and performing tests of controls on
revenue transactions.
Setting and documenting the control risk for the
revenue process.
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10-25
Understanding and Documenting Internal
Control
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.
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10-26
Understanding and Documenting Internal
Control
Control Activities
The auditor identifies what controls ensure that the
assertions for transactions and events are being met.
Documentation of the auditor’s understanding of the
revenue process can be accomplished by using:
Procedures
manuals
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Narrative
descriptions
Internal control
questionnaires
Flowcharts
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10-27
Information Systems and Communication
Process by which sales,
cash receipts and credit
memoranda are initiated.
The flow of each
transaction from initiation
to inclusion in the financial
statements.
Auditor’s
knowledge
Accounting records,
supporting documents and
accounts that are involved in
sales, cash receipts and sales
returns.
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The process used to
prepare estimates for bad
debts and sales returns.
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10-28
Monitoring of Controls
The auditor must understand how management
assesses the design and operation of controls in the
revenue process. This understanding should include
how supervisory personnel review the personnel who
perform the controls and evaluate the performance of
the entity’s IT function.
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10-29
Planning and Performing Tests of
Controls
The auditor systematically examines the client’s revenue
process to identify relevant controls that help to prevent,
or detect and correct material misstatements.
In order to properly
set control risk the
auditor must test
controls over the
revenue process.
Such tests may
include . . .
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Inquiry of client personnel.
Inspection of documents and records.
Observations of the operation of the control.
Walkthroughs.
Reperformance of the control activities.
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10-30
Setting and Documenting the Control Risk
If the results of the tests of controls support the planned
level of control risk, the auditor conducts the planned
level of substantive procedures for the account balances.
The level of control risk for the revenue process can
be set using either quantitative amounts or
qualitative terms such as ‘low,’ ‘medium,’ or ‘high.’
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10-31
Control Activities and Tests of Controls –
Revenue Transactions
Assertions about Classes of Transactions and Events for
the Period under Audit
Occurrence
Completeness
Authorization
Accuracy
Cutoff
Classification
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All revenue and cash receipt transactions and events
that have been recorded have occurred and pertain to
the entity.
All revenue and cash receipt transactions and events
that should have been recorded have been recorded.
All revenue and cash receipts transactions and events
are properly authorized.
Amounts and other data relating to recorded revenue
and cash receipt transactions and events have been
recorded appropriately.
All revenue and cash receipt transactions and events
have been recorded in the correct accounting period.
All revenue and cash receipt transactions and events
have been recorded in the proper accounts.
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10-32
Occurrence of Revenue Transactions
The auditor is concerned about two major types
of material misstatements:
1. Sales to fictitious customers.
2. Recording revenue when goods have not been
shipped or services have not been performed.
The auditor needs assurance that all recorded
revenue transactions are valid.
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10-33
Completeness of Revenue Transactions
The major misstatement that concerns both
management and the auditor is that goods are
shipped or services are performed and no
revenue is recognized.
Controls concerning completeness
include: (1) accounting for numerical
sequence of shipping documents and
sales invoices, (2) matching shipping
documents with sales invoices, (3)
reconciling sales invoices to daily
sales reports.
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10-34
Authorization of Revenue Transactions
Possible misstatements due to improper authorization
include shipping goods to or performing services for
customers who are bad credit risks and making sales at
unauthorized prices or terms.
Test policies and activities
relating to authorization of
revenue transactions.
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10-35
Accuracy of Revenue Transactions
The presence of an authorized price list and
terms of trade reduces the risk of
inaccuracies. The sales invoice should also
be verified for mathematical accuracy before
being sent to the customer.
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10-36
Cutoff of Revenue Transactions
Sales may be recorded in the wrong accounting
period unless proper controls are in place. All
shipping documents should be forwarded to the
billing department daily.
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10-37
Classification of Revenue Transactions
The use of a chart of accounts and proper
codes for recording transactions should
provide adequate assurance about the proper
classification of revenue transactions.
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10-38
Occurrence of Cash Receipts Transactions
The possible misstatement that concerns the
auditor when considering the occurrence
assertion is that cash receipts are recorded but
not deposited in the client’s bank account.
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10-39
Completeness of Cash Receipts
Transactions
A possible misstatement is that cash or
cheques are stolen or lost before being
recorded in the cash receipts records. When
electronic transfer of cash receipts is used, a
strong control exist to ensure that cash
receipts are not stolen or lost before
recording. Otherwise proper segregation of
duties and a lockbox system are controls
relating to completeness.
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10-40
Authorization of Cash Discounts
Terms of trade generally include discounts for
payment within a specified period as a way of
encouraging customers to pay on time.
2/10, n/30
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10-41
Accuracy of Cash Transactions
The wrong amount of cash could be recorded
from the remittance advice, or the receipt could be
incorrectly processed during data entry. To
minimize these types of errors, daily remittance
reports should be reconciled to a control listing of
remittance advices. All bank statements should be
reconciled monthly.
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10-42
Cutoff of Cash Receipts Transactions
If the client uses electronic transfer, a lockbox
system or if cash is deposited daily in the bank,
there is a small possibility of cash being
recorded in the wrong accounting period.
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10-43
Classification of Cash Receipts
The auditor seldom has major concerns about
cash receipts being recorded in the wrong
financial statement account.
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10-44
Control Activities and Tests of Controls –
Sales Returns and Allowances
Sales returns and allowances is usually not a
material amount in the financial statements.
However, credit memoranda that are used to
process sales returns can also be used to cover an
unauthorized shipment of goods or conceal a
misappropriation of cash. As a result, all credit
memoranda should be properly authorized.
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10-45
Relating the Assessed Level of Control
Risk to Substantive Procedures
The auditor’s testing of control for revenue
processing impacts the detection risk and
therefore the level of substantive procedures
impacted by the controls.
Accounts
receivable
Allowance
for bad
debts
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Cash
Bad debts
expense
Sales returns
and
allowances
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10-46
Auditing Accounts Receivable and
Related Accounts
Substantive analytical procedures are used to examine
plausible relationships among accounts receivable and
related accounts.
Tests of details focus on transactions, account balances
or disclosures. Tests of details concentrate on the
ending balance for accounts receivable and related
accounts as well as related disclosures.
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10-47
Substantive Analytical Procedures
Ratios used for comparative purposes include:
1. Receivables turnover and days outstanding in
accounts receivable.
2. Aging categories on aged trial balance of accounts
receivable.
3. Bad-debts expense as a per cent of revenue.
4. Allowance for uncollectible accounts as a per cent
of accounts receivable or credit sales.
5. Large account balances compared to last period.
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10-48
Tests of Details of Transactions, Account
Balances and Disclosure
For Accounts Receivable, Allowance for Uncollectible
Accounts and Bad-Debt Expense
Occurrence
Completeness
Authorization
and Accuracy
A sample of transactions from the sales journal should
be vouched to the sales invoice, customer order and
shipping document.
A sample of shipping documents should be traced to
related sales invoice and customer's account.
Compare prices and terms for sample of sales
invoices with authorized price list.
From a sample, compare date of sales invoice with
date of shipment and date sale was recorded.
For a sample of sales invoices, determine that each is
Classification
properly classified in the revenue accounts.
Cutoff
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10-49
Completeness
The auditor’s primary concern is whether all
accounts receivable have been included in the
accounts receivable subsidiary ledger and the
general ledger accounts receivable account.
Reconciliation of the aged
trial balance to the general
ledger account should
detect an omission of a
receivable from either the
subsidiary or general ledger.
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10-50
Cutoff
The cutoff test attempts to determine whether all
revenue transactions and related accounts
receivable are recorded in the proper period.
31/12/06
Test a few shipping
documents just prior
to year-end.
Test a few shipping
documents just after
year-end.
Are all transactions tested
recorded in the proper period?
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10-51
Rights and Obligations
The auditor must determine that all accounts
receivables are owned by the entity. This is usually
not a problem, however, in some cases, accounts
receivable may be sold or factored with or without
recourse.
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10-52
Valuation and Allocation
Accounts receivable should be shown on the
balance sheet at net realizable value (gross amount
less allowance for uncollectible accounts).
The auditor must verify the adequacy
of the allowance for uncollectible
accounts. The first step is to prepare an
aged trial balance and discuss results
with the credit manager. Next, a
comparison with last year’s results
should be examined.
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10-53
Classification and Understandability
The major issues related to presentation,
disclosure, and classification are:
1. Identifying and reclassifying any material credits
contained in accounts receivable.
2. Segregating short-term and long-term
receivables.
3. Ensuring that different types of receivables are
properly classified.
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10-54
The Confirmation Process – Accounts
Receivables
Confirmation is the process of obtaining
information from third parties about the
account receivable balance.
Confirmation is a good source of evidence
about the validity of the account receivable.
The confirmation process should be controlled
by the auditor.
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10-55
Types of Confirmations
 Positive Confirmation
Requests that customers
indicate whether they
agree with the amount
due to the client.
A response is expected
whether the customer
agrees or disagrees with
the balance indicated.
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 Negative Confirmation
Requests that the
customer respond only
when they disagree with
the amount due to the
client.
Negative confirmations are
used when the client has
many small account
balances and control risk
is assessed as low.
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10-56
Timing
Accounts receivable may be confirmed at an interim
date or at year-end. The confirmation request
should be sent soon after the end of the accounting
period in order to maximize the response rate.
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10-57
Confirmation Procedures
The auditor should mail the confirmation requests
outside the client’s facilities. A record should be
maintained of the confirmations mailed and those
returned. A second request may be necessary in
some cases.
For each exception received, the
auditor should examine the reasons for
the difference between the balance on
the client’s books and the balance
indicated by the customer.
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10-58
Alternative Procedures
When the auditor does not receive responses
to positive confirmations, alternative audit
procedures are used. These alternative
procedures include:
1. Examination of subsequent cash receipts.
2. Examination of customer orders, shipping documents
and duplicate sales invoices.
3. Examination of other client documentation.
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10-59
Evaluating the Audit Findings
When the auditor has completed the planned
substantive procedures, the likely misstatement
(projected misstatement plus an allowance for
sampling risk) for accounts receivable is determined.
Likely misstatement*
less than tolerable
misstatement
Likely misstatement*
greater than tolerable
misstatement
Accept the account
as fairly presented
Account is not fairly
presented.
*Together with any separately identified
known misstatements (cf. ED ISA 320).
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10-60
End of Chapter 10
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