Chapter 10
Auditing Revenue and Related
Accounts
Why are revenue cycle accounts
important?
Sales transactions are always material
to a company's financial statements
According to the SEC, a majority of
financial statement manipulations and
audit failures involve overstated
revenues
Therefore, revenue cycle accounts
must be examined with great care
What is the cycle approach?
Revenue cycle transactions include all the
processes ranging from the sale to shipping
a product, billing the customer, and
collecting cash
A company's revenue cycle transactions
reflects its operations
A cycle approach is one way to help the
auditor focus on the important account
balances surrounding a transaction to
ensure that sufficient audit evidence is
gathered and evaluated
List the Financial Transactions
Processing Cycles
Revenue
Acquisition and payment of goods
and services
Payroll
Financing: debt and equity
Cash and short-term investments
Overview of the Revenue Cycle
(Sales made on Account)
Receive customer purchase order
Check inventory stock status
Generate back order if item not in stock
Obtain credit approval
Prepare shipping and packing documents
Ship and verify shipment of goods
Prepare the invoice
Send monthly statements to customers
Receive payment
Discuss Business Risk and
Business Environment
Revenue recognition
SAS 99 - Consideration of Fraud in a
Financial Statement Audit
Auditor should presume risk of
material misstatement due to fraud
related to revenue recognition
Research shows over half of frauds
involve overstating revenues
Name Some Improper Revenue
Recognition Schemes
 Recognize revenue on fictitious shipments
 Hidden side letters that give customers unlimited
right to return product
 Record consignment sales as final sales
 Accelerated recognition of sales occurring after
year-end
 Ship unfinished goods
 Ship goods before date agreed to by customer
 Create fictitious invoices
 Ship goods never ordered
 Ship more goods than ordered
 Record shipments to company's warehouse as sales
 Record shipments of replacement goods as new
sales
What are some fraud risk factors
for revenue recognition?
There are a number of types of 'red flags'
which signal the potential for fraud in the
financial statements
External risk indicators
Internal red flags
Unusual financial results
Auditor deals with red flags by
Examining external pressures that could lead
to financial reporting fraud
Examining the financial statements to
determine if account balances seem out of
line
What analytical analysis can be
done for possible misstatements?
Compare client revenue trend with
economic conditions and industry
trends
Compare cash flow from operations with
net income
Perform analytical procedures
Ratio analysis
Trend analysis
Reasonableness tests
Review Assessment of
Environment Risk
Risk assessment is ongoing process in every
audit
Audit steps to assess environment risk for the
revenue cycle:
Update information on business risk
Perform analytical procedures to look for
unexpected relationships
Develop understanding of internal controls
Analyze business risk for motivations and
methods to misstate sales
Review Assessment of
Environment Risk
Document operation of accounting
applications and important controls
Develop preliminary assessment of
environment risk
If control risk is high, determine likely types
of misstatements
If control risk is lower, develop procedures to
test operation of controls
Perform tests of controls, document results
Based on the results of testing, reassess
control risk
Discuss Inherent Risk with
Regard to Sales
While sales transactions are routine for most
organizations and do not represent an
abnormally high risk, for other organizations,
revenue recognition may be complicated
Difficult audit issues include:
When to recognize revenues
Auditor must understand client's operations and
related GAAP issues
Example: point of sale revenue recognition vs.
percentage of completion
Discuss Inherent Risk with
Regard to Sales
Impact of any unusual sales terms and
whether title passed to customer
Example: related party transactions
Goods recorded as sales have been shipped
Sales made with recourse or that have
significant returns
Example: irrevocable right to return goods
The presence of these issues increase inherent
risk and the probability of material
misstatement
Comment on Inherent Risk in
Receivables
Primary risk is net receivables will be overstated,
because either receivables have been overstated, or
the allowance for uncollectible accounts has been
understated
Risks affecting receivables include:
 Sales of receivables recorded as sales rather than
financing transactions
 Receivables pledged as collateral
 Receivables classified as current when likelihood of
collection is low
 Collection of receivable contingent on uncertain
future events
 Payment not required until purchaser sells the
product
Reflect upon the Control
Environment and Sales
An organization's control environment
affects revenue and related
transactions more than most accounts
The auditor must consider:
Management's integrity
Financial condition of the organization
Financial pressures on the organization
Management incentives to achieve
financial results
Understanding Internal Controls
Although the auditor must understand all components
of internal controls, particular attention is paid to
significant control procedures and monitoring
controls
The auditor obtains an understanding of the controls
by
 Walk-through of the processing of transactions
 Inquiry
 Observation
 Review of client documentation
It is critical this understanding be documented in the
work papers
Understanding Internal Controls
(Continued)
Internal control procedures should be
sufficient to ensure the management
assertions are achieved:
Existence/Occurrence: sales are recorded
only when shipment has occurred and the
primary revenue producing activity has been
performed
Completeness: all valid sales transactions
are recorded
Rights/obligations
Valuation
Presentation and disclosure
What are the three components
of evaluating control risk?
Monitoring Controls
Control Structure for Returns,
Allowances, and Warranties
Importance of Credit Policies
Authorizing Sales
Explain Monitoring Controls
Designed to signal failures in transaction processing,
and determine if timely, corrective action is taken
Monitoring controls applicable to revenue transactions
include:
 Compare sales and cost of good sold with budgeted
amounts
 Exception reports generated to identify unusual
transactions
 Internal audit of revenue cycle controls
 Computer reconciliation of transactions entered with
transactions processed
 Monitoring of accounts receivable for quality
 Independent follow-up on customer complaints
 Audits of sales tax collections
Define Documenting, Testing,
and Assessing Environment Risk
Develop understanding of the accounting
system and control procedures
Evidence is gathered through inquiry, review
of client accounting manuals, and review of
prior year audit workpapers
Documentation includes questionnaires,
flowcharts, and narratives
Determine whether the application control
procedures are sufficient to achieve the
control objectives
Based on control design, make preliminary
assessment of control risk
Define Documenting, Testing,
and Assessing Environment Risk
The auditor must document those controls
that support an assessment of control risk
below maximum
If the auditor plans to rely on the internal
controls, the controls are tested to see if they
are operating as designed
If testing indicates the control is not
operating effectively,
Auditor will increase assessed control
risk, lower detection risk, and perform
more rigorous substantive testing
If the control is working effectively, control
risk assessment is unchanged
Discuss Linking Environment Risk
Assessment & Substantive Testing
The rigor of substantive testing is inversely
related to the assessed level of environment
risk
The auditor learns three things during the
assessment of environment risk that affects
the design of substantive audit procedures:
The nature of the accounting system,
controls used, and documents generated in
the client's processing
Existence of fraud risk factors
Effectiveness of controls and types of
misstatements likely to occur
Comment on Substantive Testing
in the Revenue Cycle
Planning for Direct Tests of Transactions and
Account Balances
Audit objectives and assertions
Account balance relationships
Risk of material misstatement
Composition of the account
Persuasiveness of audit procedures
Cost of audit procedures
Timing of audit procedures
Determining optimal mix of audit procedures
What are some substantive tests
of revenue?
Assertions related to revenue transactions:
Occurrence: Have the transactions occurred
and pertain to the entity
Completeness: Have all transactions been
recorded
Accuracy: Have transactions been accurately
recorded
Cutoff: Have transactions been recorded in
the correct accounting period
Classification: Have transactions been
recorded in the proper accounts
List Substantive Tests of Revenue
for Occurrence and Accuracy
Vouch recorded sales transaction back to
customer order and shipping document
Compare quantities billed and shipped
with customer order
Special care should be given to sales
recorded at the end of the year
Scan sales journal for duplicate entries
List Substantive Tests of Revenue
Cutoff Tests
Can be performed for sales, sales
returns, cash receipts
Provides evidence whether
transactions are recorded in the
proper period
Cutoff period is usually several days
before and after balance sheet date
Extent of cutoff tests depends on
effectiveness of client controls
List Substantive Tests of Revenue
Cutoff Tests
 Sales cutoff
 Auditor selects sample of sales recorded during cutoff
period and vouches back to sales invoice and shipping
documents to determine whether sales are recorded in
proper period
 Cutoff tests assertions of existence and completeness
 Auditor may also examine terms of sales contracts
 Sales return cutoff
 Client should document return of goods using receiving
reports
 Reports should date, description, condition, quantity of
goods
 Auditor selects sample of receiving reports issued during
cutoff period and determines whether credit was recorded
in the correct period
List Substantive Tests of Revenue
for Completeness
Use of pre-numbered documents is
important
Analytical procedures
Cutoff tests
Auditor selects sample of shipping
documents and traces them into the
sales journal to test completeness of
recording of sales
Substantive Tests of Accounts
Receivable Existence & Occurrence
Valuation
Are sales and receivables initially recorded
at their correct amount?
Will client collect full amount of recorded
receivables?
Rights and Obligations
Contingent liabilities associated with factor
or sales arrangements
Discounted receivables
Presentation and Disclosure
Pledged, discounted, assigned, or related
party receivables
Discuss Substantive Tests of
Accounts Receivable
Obtain and evaluate aging of
accounts receivable
Confirm receivables with
customers
Perform cutoff tests
Review subsequent collections of
receivables
Comment on Aging Accounts
Receivable
Because receivables are reported at net realizable
value, auditors must evaluate management
estimates of uncollectible accounts
 Auditor will obtain or prepare schedule of aged
accounts receivable
 If schedule is prepared by client, it is tested for
mathematical and aging accuracy
 Aging schedule can be used to
 Agree detail to control account balance
 Select customer balances for confirmation
 Identify amounts due from related parties for disclosure
 Identify past-due balances
 Auditor evaluates percentages of uncollectibility
 Auditor then recalculates balance in the Allowance
account
Review Confirming Receivables
with Customers
Confirmations provide reliable external evidence about
the
 Existence of recorded accounts receivable and
 Completeness of cash collections, sales discounts,
and sales returns and allowances
Confirmations are required by GAAS unless one of the
following is present:
 Receivables are not material
 Use of confirmations would be ineffective
 Environment risk is assessed as low and sufficient
evidence is available from using other substantive
tests
Define the Types of
Confirmations
Positive confirmations
Customers are asked to agree the amount on
the confirmation with their accounting
records and to respond directly to the
auditor whether they agree with the amount
or not
Positive confirmation requires a response
If customer does not respond, auditor must
use alternative procedures
Define the Types of
Confirmations
Negative confirmations
 Customers are asked to respond only if they
disagree with the balance (non-response is assumed
to mean agreement)
 Less expensive since there are no additional
procedures if customer does not respond
 May be used when all of the following are present
Confirming a large number of small customer
balances
Environment risk for receivables is assessed as
low
Auditor believes customers will give proper
attention to confirmations
What’s the follow-up procedures
for non-responses?
If customer does not respond to positive confirmation,
auditor may send a second, or even third, request
If customer still does not respond, auditor will use
alternative procedures
 Examine the cash receipts journal for cash collected
after year-end
 Care is taken to ensure receipt is year-end receivable, not
subsequent sale
 Examine documents supporting receivable
(purchase order, sales invoice, shipping documents)
to determine if sale occurred prior to year-end
 Evidence gathered from internal documents is not
considered as reliable
What’s the follow-up procedures
for exceptions noted?
Customers are asked to agree the amount on
the confirmation to their accounting records;
differences are called exceptions
Reasons for exceptions:
Timing differences
Disputed items
Customer errors
Client misstatement
Because misstatements are projected to the
population of receivables, the auditor must
determine the reason for the exception
Discuss Related-Party
Receivables
Amounts due from related parties should be
separately disclosed
Audit procedures to identify related-party
transactions include:
Review SEC filings
Review the accounts receivable subsidiary
ledger and trial balance
Management inquiry
Communicate names of related parties so all
audit team members can be alert for relatedparty transactions
Comment on Sold, Discounted,
and Pledged Receivables
Receivables sold with recourse, discounted, or
pledged as collateral should be disclosed
Audit procedures to identify these items
include:
Management inquiry
Scan cash receipts journal for large cash
inflows from unusual sources
Bank confirmations, which include
information on obligations and terms
Review board of director minutes, which
contain approval for these items
Review Fraud Indicators and
Audit Procedures
Potential fraud indicators:
 Excessive credit memo or other adjustments to accounts
receivable just after year-end
 Customer complaints and discrepancies in receivable
confirmations
 Unusual entries to the receivable subsidiary ledger or sales
journal
 Missing or altered source documents
 Lack of operating cash flow when operating income has been
reported
 Unusual reconciling differences between receivable subsidiary
ledger and control account
 Sales in the last month with unusual terms
 Pre- or post-dated transactions
 Unusual adjustments to sales accounts just before or after
year-end
Review Fraud Indicators and
Audit Procedures
Substantive procedures that may highlight potential
fraud indicators:
 Review of source documents including invoices,
shipping documents, customer purchase orders, etc
 Review and analyze credit memos and other
adjustments to receivables
 Confirm sales terms with customers
 Analyze large or unusual sales made near year-end
 Scan the general ledger, receivables subsidiary
ledger, and sales journal for unusual activity
 Perform analytical review of credit memo and writeoff activity
 Analyze recoveries of written-off accounts
Explain Auditing of Allowance
for Doubtful Accounts
Accounts receivable should be reported at their net realizable
value
The balance of the allowance for doubtful accounts is estimated
and depends on a number of factors
Understating the allowance overstates net accounts receivable
and net income
Where accounts receivable are material, the auditor should obtain
an understanding of how management developed the estimate
by using one or more of these approaches:
 Review and test the process used by management to develop
the estimate
 Test aging schedule
 Evaluate estimated percentages of uncollectibility used
 Develop an independent model to estimate the accounts
 Review subsequent events such as subsequent collections on
account