Auditing Revenue Recognition

Auditing Revenue Recognition
Presented by:
Larry L. Perry, CPA
CPA Firm Support Services, LLC
Learning Objectives
 Explain the basic principles of revenue recognition.
 Describe the basic procedures for auditing revenues.
 Explain the impact of audit strategies on revenues
auditing procedures.
 Outline the mix of evidence and the design of tests of
balances auditing procedures for revenues.
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Understanding Revenue Recognition
Starting with FASB’s Accounting Standards
The recognition of revenue and gains involves
considering two factors—605-10-25-1:
Being realized or realizable—when products,
merchandise, or other assets are exchanged for
cash or claims to cash.
Being earned—when the entity has substantially
accomplished what it must do to be entitled to
the benefits represented by the revenues.
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Installment and Cost Recovery Methods of
Revenue Recognition
 605-10-25-3: …unless the circumstances are such that
the collection of the sale price is not reasonably
assured, the installment method of recognizing
revenue is not acceptable.
 605-10-25-4: …where receivables are collectible over
an extended period of time and, because of the terms
of the transactions or other conditions, there is no
reasonable basis for estimating the degree of
collectability. When such circumstances exist, and as
long as they exist, either the installment method or cost
recovery method of accounting may be used.
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SFAC No. 5—Additional Revenue
Recognition Guidelines
 If a sale precedes production and delivery, revenue is
recognized with production and delivery.
If sale is by contract before production, percentage of
completion method may be used.
Revenue may be earned as time passes if services or right to
use assets extend continuously.
If there is a ready market, revenues and some gains and losses
may be recognized when production is completed or the price
of assets change.
If product, services or other assets are exchanged for nonmonetary assets, revenues, or gains or losses may be
recognized assuming fair value can be determined.
If collectability of assets received is doubtful, revenues may be
recognized on the basis of cash already received.
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Sale of Product When Right of Return Exists
605-15-25-1: When right of return exists revenue can be
recognized at the time of sale if all conditions are met:
• Seller’s price is fixed or determinable
• The buyer has paid the seller or is obligated to do so
• The buyer’s obligation would not change if product
damaged or stolen
• A reseller has economic substance
• The seller doesn’t have to perform to bring about resale
• Returns can be reasonably estimated
Slide 10
Polling Question No. 1
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Multiple-Element Arrangements
 All elements in such an arrangement must be evaluated
to determine if separate accounting is required.
 605-25-25-5: All these criteria must be met for separate
Delivered items have value on a standalone basis
There is evidence of fair value
If a general right of return exists, delivery or performance
is considered in the control of vendor
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Extended Warranty and Product Maintenance
 604-20-25-3: Sellers of extended warranty or
product maintenance contracts have an
obligation to the buyer to perform services
throughout the period of the contract and,
therefore, revenue shall be recognized in
income over the period in which the seller is
obligated to perform.
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Principal vs. Agent
 Revenues can be recorded gross or net based on
 Indicators of gross reporting
 The entity is the primary obligor, has general and physical
loss inventory risk, has pricing latitude, can change the
product or perform part of the service, can choose
supplier, sets product or service specifications, has credit
 Indicators of net commission reporting
 The supplier is the primary obligor, the amount earned is
fixed, the supplier has credit risk
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ASU 2014-09 Revenue Recognition (Topic
606) Revenue from Contracts with Customers
 Main provisions:
 Step 1: Identify the contract with a customer.
 Step 2: Identify the separate performance
obligations in the contract.
 Step 3: Determine the transaction price.
 Step 4: Allocate the transaction price to the
separate performance obligations in the
 Step 5: Recognize revenue when (or as) the
entity satisfies a performance obligation.
Polling Question No. 2
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Auditing Revenue Recognition
 Occurs within the framework of the risk assessment
standards—see evidence sources in text
 Begins with questions about relevant assertions
 Completeness
 Occurrence and cutoff
 Valuation
 Existence
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Audit Evidence and Auditing Procedures for
 Nature, extent and timing of detailed tests of balances is
in response to the assessed risks at the financial
statement (assertion) level.
 Tests of controls should be performed when
 Controls are being relied upon to reduce control risk
 Substantive procedures alone are not sufficient to verify
relevant assertions
 Systems walk-through procedures are risk assessment
procedures that provide substantive evidence
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More Evidence
 Performing highly-effective analytical procedures
reduce tests of balances procedures.
 Reading the General Ledger provides HUGE amounts
of substantive evidence and can reduce tests of
balances procedures.
 Evaluating the completeness assertion may require
more than substantive tests.
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AU-C 240 and Planning
AU-C 240
Improper revenue recognition is always a potential fraud
If not identified as a fraud risk, the auditor is required to
document why not.
Requires planning and performing audits with
appropriate professional skepticism.
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Conditions Increasing the Risk of
Key conditions that may increase the risk of
Significant sales recorded at or near year-end
Individually significant sales
Unusual or complex revenue transactions
Unusual volume of sales to distributors or resellers
Sales billed prior to delivery
Use of letters of authorization or intent instead of
Transactions with related parties
Slide 24
Auditor’s Responses to Potential Revenue
Fraud Risks
 Comparing revenue
with prior period at
lowest level of detail
Confirming contracts
Inquiring about sales
near year-end
Appropriate sales cutoff
Testing controls for IT
Detailed review of
unusual client adjusting
 Scanning the general ledger,
accounts receivable subledger and sales journal
during year and for
subsequent events period
Analyzing deferred revenue
Reviewing credit memos and
other accounts receivable
Reviewing large contracts at
year-end for later changes
Confirming sales agreements
terms that might affect the
period of recognition
Slide 27
Polling Question No. 3
Slide 26
Sales and Collection Cycle Flowchart
 May be most efficient annual IC documentation
 Facilitates systems walk-through procedures
 Can be easily replicated and carried forward
 In addition to all records, documents, data,
procedures and personnel, flowchart should include:
 Shipping terms, locations, carriers, drop ships, pick
 Different types of customers
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Focusing on Key Controls
 Key controls exist
At both the entity and activity level for larger entities
Primarily at the entity level for smaller entities
 Properly designed and operating key controls
Can detect and prevent most misstatements
Can be informal
Can be performed by one or a few persons
Are a primary defense against error or fraud occurring
and going undetected
Slide 29
Tests of Controls vs. Systems Walk-through
 TOC are required by GAO, PCAOB; are not required for non-
public entities and NPOs
 For larger entities, TOCs would normally be required to
reduce control risk to moderate or low
 For smaller entities, some tests of key controls and other risk
assessment procedures may enable an auditor to assess
control risk at less than high to moderate
 SWT with larger number of transactions and other risk
assessment procedures may also enable auditor to assess
control risk less than high to moderate
Slide 30
Carrying Out the Audit Strategy
 Check the illustrative risk assessment documentation
 Internal Control Deficiency Worksheet
 Risk of Material Misstatement Form
 Linking Working Paper
 Modify the Tests of Balances Audit Program
 Consider the impact of evidence from risk assessment
and analytical procedures on financial statement
 Modify program before beginning fieldwork
 See illustrative programs in text
Slide 32
Polling Question No. 4
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The End
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