AUDITING THE REVENUE
CYCLE AND RELATED
ACCOUNTS
1
REVENUE
RECOGNITION
Before revenue is recognized (recorded), it must be realized
and earned. Revenue is realized when a product or service
is exchanged for cash, a promise to pay cash, or other
assets that can be converted into cash. Revenue is earned
when a product has been delivered or a service has been
provided.
2
OVERVIEW OF THE
REVENUE CYCLE


An overview of the revenue cycle is
presented, beginning with an order from
a customer, proceeding to the
exchange of goods or services for a
promise to pay, and ending with the
receipt of cash.
Figure 10-1 presents a flowchart for a
reasonably sophisticated revenue cycle.
3
TYPES OF
TRANSACTIONS



The sale of goods or rendering a
service for cash or credit.
The receipt of cash from the
customer in payment for the goods or
services.
The return of goods by the customer
for credit or cash.
4
FINANCIAL STATEMENT
ACCOUNTS

Sales transactions:





Cash receipts transactions:




Trade accounts receivable
Sales
Allowance for uncollectible accounts
Bad debt expense
Cash
Trade accounts receivable
Cash discounts
Sales return and allowance
transactions:



Sales returns
Sales allowances
Trade accounts receivable
5
DOCUMENTS AND
RECORDS







Customer sales
order
Credit approval
form
Open-order
report
Shipping
document
Sales invoice
Sales journal
Customer





Accounts
receivable
subsidiary ledger
Aged trial balance
of accounts
receivable
Remittance advice
Cash receipts
journal
Credit
memorandum
6
FUNCTIONS IN THE
REVENUE CYCLE







Order entry
Credit authorization
Shipping
Billing
Cash receipts
Accounts receivable
General ledger
7
KEY SEGREGATION OF
DUTIES




The credit function should be
segregated from the billing function.
The shipping function should be
segregated from the billing function.
The accounts receivable function
should be segregated from the general
ledger function.
The cash receipts function should be
segregated from the accounts
receivable function.
8
STRATEGIC SYSTEMS
APPROACH
Must understand the client’s
 Ability to create value
 Realize and recognize revenue
 Generate future cash flows
9
INHERENT RISK
ASSESSMENT




Industry-related factors.
The complexity and contentiousness
of revenue recognition issues (see
Table 3-4).
The difficulty of auditing transactions
and account balances.
Misstatements detected in prior
audits.
10
CONTROL RISK
ASSESSMENT
Understanding and documenting
the revenue internal control system based
on the planned level of control risk
Planning and performing tests of controls
on revenue cycle transactions
Assessing and documenting the
control risk for the revenue cycle
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UNDERSTANDING AND
DOCUMENTING
INTERNAL CONTROL





Control environment
Risk assessment
Control activities
Information and communication
Monitoring
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CONTROL PROCEDURES
AND
TESTS OF CONTROLS REVENUE TRANSACTIONS
Table 10-5 summarizes the internal control objectives,
possible misstatements, internal control procedures,
and selected tests of controls for revenue transactions.
13
CONTROL PROCEDURES AND
TESTS OF CONTROLS CASH RECEIPTS
TRANSACTIONS
Table 10-6 summarizes the internal control objectives,
possible misstatements, internal control procedures, and
tests of controls for cash receipts transactions.
14
CONTROL PROCEDURES AND
TESTS OF CONTROLS - SALES
RETURNS AND ALLOWANCES
TRANSACTIONS


Each credit memorandum should be
approved by someone other than the
individual who initiated it.
A credit for returned goods should be
supported by a receiving document
indicating that the goods have been
returned.
15
RELATING THE ASSESSED
LEVEL OF CONTROL RISK TO
SUBSTANTIVE TESTING


The results of the auditor’s testing of
internal control for the revenue cycle
directly impacts on detection risk and the
level of substantive testing that will be
required for the accounts affected by the
cycle.
When the results of the testing controls
support the planned assessed level of
CR, the auditor can conduct the
substantive tests at the planned level.
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AUDITING ACCOUNTS
RECEIVABLE AND
RELATED ACCOUNTS

The auditor uses substantive tests
that are used by the auditor to
detect material misstatements in
accounts receivable and related
accounts. There are three
categories :



Substantive tests of transactions
Analytical procedures
Tests of account balances
17
SUBSTANTIVE TESTS OF
TRANSACTIONS
Substantive tests of transactions are tests conducted
to detect monetary misstatements in the individual
transactions processed through all accounting cycles.
18
AUDIT OBJECTIVES FOR
TESTS OF ACCOUNT
BALANCES








Accuracy
Validity
Completeness
Cutoff
Ownership
Valuation
Classification
Disclosure
19
TESTS OF ACCOUNT
BALANCES - ACCOUNTS
RECEIVABLE
Table 10-10 summarizes the tests of accounts
receivable for each audit objective.
20
ANALYTICAL
PROCEDURES
Analytical procedures are useful audit tests for
examining the fairness of accounts such as revenue,
accounts receivable, allowance for uncollectible
accounts, bad debt expense, and sales returns and
allowances.
21
ANALYTICAL
PROCEDURES REVENUE
Examples :
 Comparison of gross profit percentage
by product line with previous years
and industry data.
 Comparison of reported revenue to
budgeted revenue.
22
ANALYTICAL PROCEDURES –
A/R, ALLOWANCE FOR
UNCOLLECTIBLE ACCOUNTS
AND BAD DEBT EXPENSE
Examples :
 Comparison of receivables turnover and days
outstanding in accounts receivable to previous
years’ and/or industry data.
 Comparison of aging categories on aged trial
balance of accounts receivable to previous years’.
 Comparison of bad-debt expense as a percentage
of revenue to previous years’ and/or industry data.
 Comparison of the allowance for uncollectible
accounts as a percentage of accounts receivable
or credit sales to previous years’ and/or industry
data.
23
ANALYTICAL PROCEDURES SALES RETURNS,
ALLOWANCES, AND
COMMISSIONS



Comparison of sales returns as a
percentage of revenue to previous years’
and/or industry data.
Comparison of sales discounts as a
percentage of revenue to previous years’
and/or industry data.
Estimation of sales commission expense
by multiplying net revenue by average
commission rate and comparison of
recorded sales commission expense.
24
THE CONFIRMATION
PROCESS
Confirmation is the process of obtaining and evaluating
a direct communication from a third party in response
to an auditor’s request for information about a
particular item affecting financial statement assertions.
25
CONFIRMATION OF
ACCOUNTS RECEIVABLE
Confirmation of accounts receivable is considered a
generally accepted auditing procedure, and therefore
the auditors will normally request confirmation of
accounts receivable during an audit.
26
OMISSION OF
CONFIRMATION OF
ACCOUNTS RECEIVABLE



The accounts receivable are immaterial to
the financial statements.
The use of confirmations would not be
effective as an audit procedure (e.g., past
response rates were low or the responses
might not be reliable).
The auditor’s assessment of IR and CR is
low, and evidence gathered from other
substantive tests is sufficient to reduce
audit risk to an acceptably low level.
27
RELIABILITY OF
ACCOUNTS RECEIVABLE
CONFIRMATIONS

The auditor should consider each
of the following factors when
using confirmations to test
accounts receivable :



The type of confirmation request.
Prior experience with the client or
similar engagements.
The intended respondent.
28
TYPES OF
CONFIRMATIONS


Positive (see Exhibit
10-7)
Negative (see Exhibit
10-8)
29
TIMING


Interim
Year-end
30
CONFIRMATION
PROCEDURES


Maintain control
Timing differences (Table 1012)
31
ALTERNATIVE
PROCEDURES



Examination of subsequent cash
receipts.
Examination of customer orders,
shipping documents, and duplicate
sales invoices.
Examination of other client
documentation.
32
AUDITING OTHER
RECEIVABLES



Receivables from officers and
employees.
Receivables from related parties.
Notes receivable.
33
EVALUATING THE AUDIT
FINDINGS -ACCOUNTS
RECEIVABLE AND RELATED
ACCOUNTS



Compare total projected
misstatement to tolerable
misstatement.
Analyze misstatements for causes of
errors.
Conclude
34