Auditing Revenue Recognition
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.
UNDERSTANDING REVENUE RECOGNITION
All principles of revenue recognition are based on the foundation laid in US accounting
standards. On July 1, 2009, the Financial Accounting Standards Board (FASB) launched
its online Accounting Standards Codification (ASC) which is the one authoritative source
of US GAAP. The FASB combined all accounting standards included in the existing
GAAP Hierarchy from SFAS No. 162 in the ASC, all of which is now considered
authoritative GAAP. The basic standards for accounting for revenues are discussed
below.
To understand principles of revenue recognition, the authoritative standards from the
ASC are presented below.
Revenues and Gains:
605-10-25-1: The recognition of revenue and gains of an entity during a period involves
consideration of the following two factors, with sometimes one and sometimes the other
being more important consideration:
a. Being realized or realizable. Revenue and gains generally are not recognized
until realized or realizable. Paragraph 83(a) of FASB Concepts Statement No. 5,
Recognition and Measurement in Financial Statements of Business Enterprises,
states that revenue and gains are realized when products (goods or services),
merchandise, or other assets are exchanged for cash or claims to cash. That
paragraph states that revenue and gains are realizable when related assets received
or held are readily convertible to know amounts of cash or claims to cash.
b. Being earned. Paragraph 83(b) of FASB Concepts Statement No. 5,
Recognition and Measurement in Financial Statements of Business Enterprises,
states that revenue is not recognized until earned. That paragraph states that an
entity’s revenue-earning activities involve delivering or producing goods,
rendering services, or other activities that constitute its ongoing major or central
operations, and revenues are considered to have been earned when the entity has
1
substantially accomplished what it must do to be entitled to the benefits
represented by the revenues. That paragraph states that gains commonly result
form transactions and other events that involve no earning process, and for
recognizing gains, being earned is generally less significant than being realized or
realizable.
Installment and Cost Recovery Methods of Revenue Recognition
605-10-25-3: Revenue should ordinarily be accounted for at the time a transaction is
completed, with appropriate provisions for uncollectible accounts. Paragraph 605-10-251(a) states that revenue and gains generally are not recognized until being realized or
realizable and until earned. Accordingly, 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: There may be exceptional cases 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. As defined in paragraph 360-20-55-7
through 55-9, the installment method apportions collections received between cost
recovered and profit. The apportionment is in the same ratio as total cost and total profit
bear to the sales value. Under the cost recovery method, equal amounts of revenue and
expense are recognized as collections are made until all costs have been recovered,
postponing any recognition of profit until that time.
Ordinarily, revenue from selling products should be recognized at the date of sale, and
revenue from rendering services should be recognized when the services have been
performed and are billable. An appropriate allowance for uncollectible accounts should
also be provided. These conditions normally occur when the transaction is completed
and installment sales generally aren’t acceptable unless there is doubt as to their
collectibility.
Additional Revenue Recognition Guidelines
SFAC No. 5 provides the following additional guidelines:
 If a sale or cash receipt (or both) precedes production and delivery (e.g., a magazine
subscription), revenue may be recognized as earned by production and delivery.
 If a product is contracted for before production, revenues may be recognized by a
percentage-of-completion method as earned while production takes place, provided
reasonable estimates of results at completion and reliable measures of progress are
available.
 If services are rendered or rights to use assets extend continuously over time (e.g.,
interest or rent) and reliable measures based on contractual prices established in
advance are commonly available, revenue may be earned as time passes.
2
 If products or other assets are readily realizable because they are salable at reliably
determinable prices without significant effort (e.g., certain agricultural products,
precious metals, and marketable securities), revenues and some gains or losses may
be recognized at completion of production or when prices of assets change.
 If product, services or other assets are exchanged for non-monetary assets that are
not readily convertible into cash, revenues or gains or losses may be recognized on
the basis that they have been earned and the transaction completed, assuming that
fair value can be determined within reasonable limits.
 If collectibility of assets received for product, services or other assets is doubtful,
revenues may be recognized on the basis of cash already received.
Improper Recognition of Revenue
In various studies by standard setters and fraud discoveries over the past two decades,
circumstances and transactions were identified that may signal improper revenue
recognition. Some examples include the following:
 Letters of intent are used in lieu of signed contracts.
 Products are shipped before the scheduled shipment date without the customer’s
approval.
 Products can be returned without obligation after a free “tryout” period.
 Customers can unilaterally cancel a sale.
 Obligations to pay for products are contingent on a customer’s resale to a third party
or on financing from a third party.
 Sales are billed for products being held by the seller before delivery.
 Products are shipped after the end of the period.
 Products are shipped to a warehouse (or other intermediate location) without the
customer’s approval.
 Sales are invoiced before products are shipped.
 Part of a product is shipped and the part not shipped is a critical component of the
product.
 Sales are recorded based on purchase orders.
 Obligations to pay for the product depend on the seller fulfilling material unsatisfied
conditions.
 Products still to be assembled are invoiced.
 Products are sent to and held by freight companies pending return to the seller for
required customer modifications.
3
 Products require significant continuing vendor involvement (such as installation or
debugging) after delivery.
Sales of Product when Right of Return Exists
605-15-25-1: If an entity sells its product but gives the buyer the right to return the
product, revenue for the sales transaction shall be recognized at time of sale only if all the
following conditions are met:
a. The seller’s price to the buyer is substantially fixed or determinable at the date of
sale.
b. The buyer has paid the seller, or the buyer is obligated to pay the seller and the
obligation is not contingent on resale of the product.
c. The buyer’s obligation to the seller would not be changed in the event of theft or
physical destruction or damage of the product.
d. The buyer acquiring the product for resale has economic substance apart from that
provided by the seller.
e. The seller does not have significant obligations for future performance to directly
bring about resale of the product by the buyer.
f. The amount of the returns can be reasonably estimated.
Multiple-Element Arrangements
A multiple-element arrangement exists when an entity becomes party to an agreement to
perform multiple activities that generate revenue. All elements in such an arrangement
must be evaluated to determine if separate accounting is required.
605-25-25-5: In an arrangement with multiple deliverables, the delivered item or items
shall be considered a separate unit of accounting if all the following criteria are met:
a. The delivered item or items have value to the customer on a standalone basis.
The item or items have value on a standalone basis if they are sold separately by
any vendor or the customer could resell the delivered item(s) on a standalone
basis.
b. There is objective and reliable evidence of the fair value of the undelivered
item(s).
c. If the arrangement includes a general right of return relative to the delivered item,
delivery or performance of the undelivered item or items is considered probable
and substantially in the control of the vendor.
Extended Warranty and Product Maintenance Contracts
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. That is, revenue from separately priced extended warranty and
4
product maintenance contracts shall be deferred and recognized in income on a straightline basis over the contract period except in the circumstances in which sufficient
historical evidence indicates that the costs of performing services under the contract are
incurred on other that a straight-line basis. In those circumstances, revenue shall be
recognized over the contract period in proportion to the costs expected to be incurred in
performing services under the contract.
Principal vs. Agent
Companies that conduct business as agents rather than as principals sometimes face a
dilemma as to how to record revenues, gross amount of billings or net amounts of
commissions. Judgment based on facts and circumstances should guide resolution.
Indicators of gross revenue reporting include whether the entity:
 Is the primary obligor in the arrangement.
 Has general inventory risk.
 Has latitude in establishing price.
 Changes the product or performs part of the service.
 Has discretion in supplier selection.
 Is involved in the determination of product or service specifications.
 Has physical loss inventory risk.
 Has credit risk.
Indicators of net commission reporting include:
 The supplier, not the entity, is the primary obligor in the arrangement.
 The amount the company earns is fixed.
 The supplier has credit risk.
Some Disclosure Checklist Questions
The following questions are illustrative of common disclosure requirements for revenues.
1. Are major categories of income reported separately in the income statement?
2. Are sales discounts and allowances netted against sales?
3. Are unusual and infrequent transactions presented as separate line items or as
extraordinary transactions?
4. Are items of comprehensive income presented as a component of stockholder’s
equity?
5
5. Has the method of accounting and, specifically, recognizing revenues been disclosed
in Note A?
6. Have special disclosures for revenue recognition of sales of software, construction
contract revenues, bartering revenues and non-monetary exchanges been included in the
footnotes?
7. Has the net income and comprehensive income of non-controlling interests of
consolidated entities been disclosed on the applicable statement or in a footnote?
8. Are gains or losses resulting from fair value accounting adjustments appropriately
disclosed in the financial statements or footnotes?
ACCOUNTING STANDARDS UPDATE
ASU 2014-09 Revenue Recognition (Topic 606) Revenue from Contracts with
Customers
Why Issued
Revenue is a crucial number to users of financial statements in assessing an
entity’s financial performance and position. However, revenue recognition
requirements in U.S. generally accepted accounting principles (GAAP) differ
from those in International Financial Reporting Standards (IFRSs), and both sets
of requirements need improvement. U.S. GAAP comprises broad revenue
recognition concepts and numerous requirements for particular industries or
transactions that can result in different accounting for economically similar
transactions.
Accordingly, the Financial Accounting Standards Board (FASB) and the
International Accounting Standards Board (IASB) initiated a joint project to
clarify the principles for recognizing revenue and to develop a common revenue
standard for U.S. GAAP and IFRSs that would:
 Remove inconsistencies and weaknesses in existing
revenue requirements.
 Provide a more robust framework for addressing revenue
issues.
 Improve comparability of revenue recognition practices
across entities, industries, jurisdictions, and capital markets.
 Provide more useful information to users of financial
statements through improved disclosure requirements.
 Simplify the preparation of financial statements by
reducing the number of requirements to which an entity
must refer.
Who is Affected
6
The guidance in this Update
 Affects any entity that enters into contracts with customers unless
those contracts are in the scope of other standards (for example,
insurance contracts or lease contracts).
 Supersedes most of the revenue recognition requirements in Topic 605
(and related guidance) in U.S. GAAP.
 Supersedes IASs 11 and 18 (and related Interpretations) In IFRSs.
 Amends the existing requirements for the recognition of a gain or loss
on the transfer of some nonfinancial assets that are not an output of an
entity’s ordinary activities (for example, property, plant, and
equipment within the scope of Topic 360, IAS 16, Property, Plant and
Equipment, or IAS 40, Investment Property) to be consistent with the
proposed recognition and measurement guidance in this proposed
Update.
Main Provisions
The core principle of this guidance is that an entity should recognize revenue to
depict the transfer of promised goods or services to customers in an amount that
reflects the consideration to which the entity expects to be entitled in exchange for
those goods or services.
To achieve that core principle, an entity would apply all of the following steps:
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 contract.
Step 5: Recognize revenue when (or as) the entity satisfies a performance
obligation.
Effective Dates
 Public entities—Annual and interim reporting periods beginning after
December 15, 2016.
 Non-Public Entities—Annual reporting periods beginning after
December 15, 2017 and interim periods within annual periods
beginning after December 15, 2018.
SUMMARY
Normally, revenue should be recognized (and an appropriate provision for uncollectible
amounts should be recorded) when a transaction, or an identifiable part of a transaction,
is completed. When the buyer has the right to return the merchandise sold, revenue
7
should be recognized only if certain criteria are met. Revenue and cost of sales
recognized when a right of return exists should be reduced by an allowance for estimated
returns. Expected costs or losses related to sales returns should also be accrued.
Multiple-element sales arrangements should be divided into separate units of accounting.
Revenue should be allocated to the separate units of accounting based on their relative
fair values. Each unit of accounting should be considered separately for revenue
recognition.
Revenue related to separately priced extended warranty and product maintenance
contracts should be deferred and ordinarily recognized over the life of the contracts on a
straight-line basis. Costs directly related to the acquisition of the contracts should be
charged to expense in proportion to the revenue recognized. All other costs, including
costs associated with performing services under the contracts, should be charged to
expense as incurred.
MISREPRESENTATIONS IN FINANCIAL STATEMENTS
Improper Revenue Recognition in Smaller Entities
Many CPA firms have experienced revenue recognition problems with smaller clients.
Here are a few examples:
 A nightclub that continually reports a very low gross margin from beer and liquor
sales (Skimming).
 A construction contractor that purchases all materials for certain contracts to
increase actual costs before its year-end (Dumping materials at sites to inflate the
percentage of completion).
 A trailer leasing company that bills customers for extra, unused trailers each month
(Fraud).
 Products shipped subject to customer approval are recorded before receiving such
approval (Improper cutoff).
 Billing customers for products shipped on consignment, or before products are
shipped and recording revenue prematurely (Inflating revenues).
 Recording multi-year contracts, or revenues benefiting future periods, at the date of
the contract or customer order (Improper matching of costs and revenues).
 Recording grant revenues when received rather than as expended (Improper
matching costs and revenues).
 An entity that won’t provide inventory quantities and pricing information until the
CPA informs management of the taxable income before the inventory adjustment
(Fraud).
8
The opportunities for misrepresentations of revenue recognition are many and varied.
Some may be inadvertent and some may be intentional. In the materials that follow,
approaches to enable auditors to gather sufficient evidence to evaluate financial statement
assertions and respond to risks of material misstatements due to error or fraud will be
discussed.
AUDITING REVENUE RECOGNITION
This section discusses a general approach to audits, financial statement assertions, the
types of audit evidence and auditing procedures and ways to increase efficiency when
auditing revenues.
Slicing the Audit Evidence Pie
Clarified Auditing Standards include redrafts of the risk assessment standards of 2006.
These standards have expanded auditors’ understanding of the composition of audit
evidence. Following is a list of the evidence sources that are available to satisfy the
requirements of the risk assessment auditing standards:
 Risk assessment procedures
 Internal control questionnaires, flowcharts, systems walk-through
procedures, memorandums, forms, checklists and other planning
documentation.
 Evidence of owner-manager key controls.
 Documentation of substantive evidence from reading the general ledger.
 Tests of controls, including owner-manager key controls.
 Preliminary analytical procedures.
 Substantive evidence from prior year’s risk assessment and other substantive
procedures.
 Analytical procedures (performed to the maximum extent practical)
 Substantive tests of details of balances (modified to reflect assessed levels of
risk)
The risk assessment standards clearly indicate that everything an auditor does in the risk
assessment process becomes substantive evidence that can support an opinion on the
financial statements. By taking credit for the reliable substantive evidence obtained from
risk assessment procedures, an auditor ordinarily will need less other substantive
evidence from more costly tests of balances. Time consuming detailed tests of balances
may be reduced, even on audits of small nonpublic or nonprofit organizations.
Management’s Financial Statement Assertions
9
AU-C 315 discusses management’s financial statement assertions for account balances,
transactions and presentation and disclosures in financial statements. Following is an
acronym synthesizing those assertions:
C ompleteness
To determine that all transactions and accounts that should be presented
have been included in the financial statements.
O ccurrence and cutoff
To determine that all transactions occurring during the period have been
recorded in the financial statements in the proper period.
V aluation and accuracy
To determine that all asset, liability, revenue and expense components
have been included in the financial statements at accurate amounts,
classified properly.
E xistence
To determine that all recorded assets and liabilities exist at a given
date.
R ights
To determine that the entity has rights to all assets recorded at a given
date.
Ob ligations
To determine that all liabilities are obligations of the entity at a given date.
D isclosure and Presentation
To determine that all components of the financial statements and other
transactions and events are accurately classified, clearly described and
disclosed.
Common Sense Questions about Assertions for Revenues
For revenues to be recognized properly in financial statements, all of these assertions will
be considered by management and auditors. Here are some common sense questions that
auditors should ask about the assertions for revenues:
 Were sales of products or services made to valid customers, do they meet the
criteria for valid sales, and did they actually occur in the reporting period?
 Do other revenues represent legitimate income of the entity received or earned in
the reporting period?
 Have all revenues of the entity been reflected in the financial statements?
10
 Are the sales or other revenues valued properly, i.e., do they reflect arms-length
valuation for products, services or transactions recorded during the reporting
period?
 Are the revenues presented in the proper account classifications and are all
necessary disclosures included?
 Are revenues consistently recorded to reflect generally accepted accounting
principles or another comprehensive basis of accounting?
 Are only revenues applicable to the reporting period presented in the financial
statements?
AU-C 500 and AU-C 315 make clear that auditors must gather sufficient evidence to
evaluate relevant assertions for all material financial statement classifications. The
auditing standards also make it clear that some assertions, particularly the completeness
assertion for revenues, may require procedures other than detailed tests of balances to
reduce detection risk to an acceptably low level.
Audit Evidence and Auditing Procedures for Revenues
As discussed above, the auditing standards identify financial statement assertions,
management’s representations in financial statements. The standards describe the types
of audit evidence and auditing procedures an auditor may use to gather evidence to
evaluate financial statement assertions. Some of this information is discussed below.
Nature, Extent, and Timing
The nature, extent, and timing of audit procedures designed by the auditor are in direct
response to the assessment of the risk of material misstatement in the financial statement
classification. The auditor must perform risk assessment procedures to provide a
satisfactory basis for the assessment of risks at the financial statement and relevant
assertion levels. Risk assessment procedures by themselves do not provide sufficient
competent audit evidence on which to base the audit opinion, but combined with other
audit procedures (tests of controls and substantive procedures), they provide substantive
evidence that can be sufficient to enable an auditor to express an opinion on financial
statements.
Tests of Controls
Tests of controls are necessary in two circumstances. 1) When the auditor’s risk
assessment includes an expectation of the operating effectiveness of controls, the auditor
should test those controls to support the risk assessment. In addition, 2) when the
substantive procedures alone do not provide sufficient appropriate audit evidence, the
auditor should perform tests of controls to obtain audit evidence about their operating
effectiveness, such as evaluating the completeness assertion for revenues discussed
further below.
11
The risk assessment standards describe inquiries and observations as acceptable
procedures for performing certain tests of controls. For smaller audits, these procedures
may be used for testing and evaluating key controls at the entity level performed by
owners or managers of smaller entities. Acceptable results from such tests of controls,
and considering the results of other risk assessment procedures, may enable an auditor to
evaluate control risk at a level less than high.
Systems Walk-through Procedures
As part of an auditor’s risk assessment procedures, internal control documentation may
include a system’s walk-through procedure for the basic transactions cycles (sales and
collections, payments and acquistions and payroll). Following the flow of a transaction
from its inception to its termination (cradle to grave), an auditor will normally inspect
supporting documents and records. The auditor may even re-perform some or all of the
accounting system and internal control procedures evidenced by the documentation.
Performing such procedures generates substantive evidence that contributes to the
evaluation of financial statement assertions, even if no tests of controls are performed. A
larger number of transactions selected for the walk-through procedure results in more
substantive evidence from the risk assessment procedures. A systems walk-through
procedure for the sales and collection cycle will enable an auditor to understand a client’s
accounting and internal control systems and to identify control deficiencies.
When the systems walk-through procedure is being performed to confirm internal control
documentation, or to determine there has been no change in policies, procedures or
personnel from the prior period, a smaller number of transactions may be selected,
ordinarily five to 10. When more substantive evidence is required from the procedure, a
10 to 15 transactions are common. The transaction selection method, in this case, will
usually be biased to include all the types of transactions in a cycle. Even so, this risk
assessment procedure is producing substantive evidence to support an auditor’s
conclusion on financial statements. The end result is that necessary amounts of other
substantive procedures at the reporting date (analytical procedures and detailed tests of
balances) should be reduced.
Substantive Procedures
Substantive procedures for material classes of transactions, account balances, and
disclosures are always required to obtain sufficient competent audit evidence due the
limitations of internal controls and the subjective nature of the auditor’s judgments when
making risk assessments regarding the entity and its environment. Therefore, regardless
of the assessed risk of material misstatement, the auditor should design and perform
substantive procedures for all relevant assertions related to each material class of
transactions, account balances and disclosures to obtain sufficient, appropriate audit
evidence (as planned in a cost-beneficial audit strategy). More evidence from tests of
balances will be required, in other words, when less evidence is gathered from risk
assessment procedures and analytical procedures. Conversely, less evidence will be
12
required from tests of balances when more evidence is gathered from risk assessment and
analytical procedures.
Analytical Procedures
Analytical procedures consist of absolute comparisons of dollar balances with prior
years’ account balances, or with budgets, ratio comparisons and trend analysis, and
computations based on financial or operational data designed to predict the balance in a
general ledger account. Analytical procedures also extend beyond numerically-based
procedures to become a part of an auditor’s thought process (this is professional
skepticism).
Challenging financial information or the lack of such information that appears unusual,
maintaining a positive, healthy skepticism when considering client responses to inquiries,
and searching for the cause of a problem beyond its symptoms are examples of analytical
thinking. The term “professional skepticism” is used in the literature to describe this kind
of thinking. It is loosely defined as neither blindly trusting every client or, on the other
hand, considering each client dishonest as we gather information.
Most common analytical procedures are corroborative in their nature. Their primary
purpose is to corroborate evidence gathered from other tests designed to evaluate
financial statement assertions.
When the results of analytical procedures contribute evidence to evaluate financial
statement assertions, related tests of balances can be reduced at least to a limited extent.
The extent of the reductions of tests of balances depends on the effectiveness of the
analytical procedures. Determination of the effectiveness of a procedure must be based
on the procedure’s contribution of evidence for verifying the financial statement
assertions. Computations designed to predict the balance in a general ledger account
based on audited financial or operational data, e.g. quantity reconciliations and
reasonableness tests, are normally the most effective analytical procedures.
Corroborating procedures performed at lower levels of detail are more effective than
corroborating procedures based on balances of financial statement classifications. When
expectations of analytical procedures are other than for normal or consistent results,
auditors are required to document calculations of their expectations.
Reading (Scanning) the General Ledger
One of the most pervasive analytical procedures is reading, or scanning, the general
ledger account activity. Whether done manually, or with the assistance of data extraction
software, this analytical procedure is discussed in auditing standards standards
Many auditors customarily perform this procedure but fail to consider its affect on their
audit strategy. After unusual matters are investigated and any errors are corrected by
proposed journal entries, the auditor has obtained significant, substantive evidence that
relevant assertions for many account balances are reasonable. The evidence obtained
13
from this risk assessment procedure should enable the auditor to reduce the assessed level
of risk of material misstatement and, therefore, the extent of evidence desired from
detailed tests of balances.
This procedure is usually performed by looking for unusual amounts or postings,
transactions or general journal entries greater than the lower limit for individually
significant items, checks or disbursements to be used in support tests, and other unusual
matters. Documentation of the procedure should include the parameters of the test, the
exceptions the test revealed and the resolution of the exceptions in a spreadsheet, memo
or other working paper.
A spreadsheet is often the most effective way to document all unusual matters discovered
during an audit engagement. It provides one central location for documentation of such
matters, related follow-up procedures and the auditor’s concluding actions. Such a
spreadsheet can eliminate numerous other working papers and provide documentation to
facilitate the engagement leader’s review of unusual matters.
Tests of Balances
Substantive tests of the details of general ledger account balances include, among other
evidence collection procedures, the following:






Physical examination of assets.
Confirmation of account balances.
Inspection of support for transactions and balances.
Observation of the work of client personnel.
Inquiries of client personnel.
Tests of the mechanical accuracy of balances.
The substantive tests of balances normally make the most substantial contributions for
evaluating the financial statement assertions. They are ordinarily, however, the most
expensive types of tests.
Evaluating the Completeness Assertion
When tests of balances or analytical procedures can be performed to efficiently evaluate
the completeness assertion, tests of controls are not necessary for this purpose.
Evaluating the completeness of revenues through tests of balances, however, is difficult
at best.
Examples of substantive tests that can be used to evaluate the completeness assertion for
revenues include examining contracts to determine all revenues that should be recorded
are recorded (for the construction industry) or using predictive analytical procedures to
determine the accuracy of recorded revenues or expenses, e.g., using copy machine meter
readings for a copying business to compute copying revenues and copy machine rental
expense. In other instances, limited tests of controls may be necessary to properly
14
evaluate the completeness of revenues. Tracing, say, 10 to 15 or more documents
originating sales transactions, e.g. customer orders or shipping reports, to the sales
journal is an example of a limited test of control procedure for completeness.
THE SPECIFICS OF AUDITING REVENUE RECOGNITION
AU-C Section 240 and Planning
AU-C 240, Consideration of Fraud in a Financial Statement Audit, requires an auditor to
consider improper revenue recognition as a potential fraud risk on all audits. If improper
revenue recognition is not identified as a fraud risk, the auditor is required to document
the reasons why.
AU-C 240 indicates that an audit should be planned and executed with appropriate
professional skepticism. Following are some conditions that may increase the risk of
misstatement:

















A change in the company’s revenue recognition policy
New product or service introductions or new sales arrangements
Sales terms that do not comply with the company’s normal policies
Existence of longer that expected payment terms or installment receivables
Significant sales or volume of sales that are recorded at or near the end of the
reporting period
Individually significant sales
Unusual or complex revenue transactions
Unusual volume of sales to distributors/resellers
Sales billed to customers prior to the delivery of goods and held by the seller
The use of non-standard contracts or contract clauses
The use of letters of authorization in lieu of signed contracts or agreements
Transactions with related parties
Transactions involving barters, swaps, “round trip” or “back to back”
The existence of “side-agreements”
Multiple-element arrangements
Revenue recognition when right of return exists
Control environment considerations, such as:
o Aggressive accounting policies or practices.
o Pressure from senior management to increase revenues and earnings.
o Lack of involvement by the accounting/finance department in sales
transactions or in the monitoring of arrangements with distributors.
AU-C 240 requires auditors to conduct a “brainstorming meeting” during engagement
planning. Considering common revenue recognition frauds will make such meetings
more effective. Here are some examples of revenue recognition frauds:
15
 Sales in which evidence indicates the customer’s obligation to pay for the
merchandise depends on:
o Receipt of financials from a third party.
o Resale to a third party.
o Fulfillment by the seller of material unsatisfied conditions.
 Sales of merchandise that are shipped in advance of the scheduled shipment date
without evidence of the customer’s agreement or consent.
 Pre-invoicing of goods that are in the process of being assembled or invoicing
prior to, or in the absence of, actual shipments.
 Shipments are made after the end of the period.
 Sales are not based on actual orders to buy.
 Shipments are made on cancelled or duplicate orders.
 Shipments are made to a warehouse or other intermediary location without the
instruction of the customer.
 Shipments that are sent to and held by freight forwarders pending return to the
company for required customer modifications.
 Altered dates on contracts or shipping documents.
Auditor’s responses to potential fraud risks can be numerous and varied. Here are some
illustrations:
 Comparing revenue reported by month and by product line or business segment
(disaggregated data) from the current period with the prior period.
 Confirming with customers certain relevant contract terms and the absence of side
agreements.
 Inquiring about any sales near the end of the period and any related unusual terms
or conditions.
 Performing appropriate sales cutoff procedures.
 Testing controls for electronic systems.
 Performing a detailed review and investigation of any client adjusting journal
entries that appear unusual.
 Scanning (reading) the general ledger, accounts receivable sub-ledger and sales
journal for unusual activity during the year and a period subsequent to the balance
sheet date.
 Analyzing and reviewing deferred revenue accounts for propriety of deferral.
 Analyzing and reviewing credit memos and accounts receivable adjustments for a
period subsequent to the balance sheet date.
 Reviewing significant year-end contracts and periods subsequent to the balance
sheet date for related revisions, cancellations, returns, credits, etc.
 Confirming sales agreements and the absence of right of return and other terms
that might affect the period of recognition.
Any improperly recorded revenues should be considered for an adjustment proposal,
discussed with management and included in the communication to persons charged with
governance.
16
Relevant Assertions
Earlier in these materials, we discussed the financial statement assertions included in AUC 315. For revenues, all assertions are relevant. While most assertions will be evaluated
through a combination of risk assessment procedures, analytical procedures and other
substantive tests mentioned above, the completeness assertion will be the most difficult to
evaluate. Because substantive tests of balances usually can’t generate sufficient evidence
to evaluate the completeness assertion, either a highly-effective, predictive type of
analytical procedure or a test of the controls over the documents, data and procedures
initiating revenue transactions will be necessary.
Sales and Collection Cycle Flowchart
Drawing a flowchart is often the most effective and efficient method of documenting an
entity’s internal control. A flowchart also facilitates performing a complete systems
walk-through procedure of a transaction cycle. Flowcharts may be prepared using
manual templates or flowcharting software. The hardcopies, or the electronic copies,
may be carried forward with changes reflected in different color pencils or typing fonts.
All accounting systems software applications, procedures, documents and data, and all
internal controls, should be reflected on the flowcharts. Here are some suggestions from
our Flowcharting Guide that will facilitate preparation of a flowchart for sales.
The flowchart should contain documentation of:



Different types of shipping terms such as F.O.B. shipping point or destination,
different shipping locations, different types of carriers, drop ships from suppliers,
customer pick up, etc.
Different types of customers such wholesale, retail, distributor, consumer, and
related parties.
All accounting records, documents, data and procedures.
Consider the entity’s key controls and activity-level controls when preparing flowchart
documentation. These questions can facilitate the identification of accounting and
internal control procedures:




Can goods be shipped without invoices being prepared?
Can sales be invoiced but not recorded?
Can sales be made and recorded without inventory being relieved?
Can customer invoice errors be made and go undetected?
17
Illustrative Flowchart for the Sales and Collections Cycle
18
Key Controls
Professional standards recommend a “top-down” approach to obtaining and testing
internal controls. Control activities consist of entity-level and activity-level controls.
Certain controls, i.e., key controls, are highly effective in detecting and preventing
misstatements due to error or fraud. For larger entities, key controls may be from either
category of controls. For smaller entities, key controls are normally performed at the
entity level by an owner, manager or other authoritative person.
Properly designed and operating key controls can detect and prevent most misstatements
from affecting the financial statements of an entity. On the other hand, improperly
designed key controls, or properly designed key controls that are not operating properly,
will normally result in significant deficiencies or material weaknesses in internal control.
Here are illustrative key controls at the entity-level, and activity-level controls, for a
typical small entity:
SALES/REVENUES—KEY CONTROLS
(O/M = Owner or manager or other authoritative position)
1. O/M approves all credit sales.
2. O/M reviews copies of all sales invoices and shipping reports.
3. O/M reviews customers’ statements before mailing.
4. O/M reviews monthly aged trial balance, calls past due customers and resolves
customer complaints.
SALES/REVENUES—ACTIVITY-LEVEL CONTROLS
1. Sales are recorded in the period made or shipped (considering shipping terms).
2. Pre-numbered sales invoices and shipping reports are prepared.
3. Copies of sales invoices or customer statements are mailed at least monthly.
4. All returns, allowances, discounts and account adjustments are approved by a
supervisor.
Basic Test of Controls vs. Performing a Systems Walk-through Procedure
A formal test of controls, i.e., a test of all the attributes of a transaction, is required under
GAO’s “Yellow Book” standards for governmental audits, by the PCAOB for audits of
19
publically-held companies and by other standard-setters for certain entities in regulated
industries. Tests of controls are not required by the professional standards for non-public
companies and non-profit organizations, although they may be used as risk assessment
procedures. Even for some small audits, limited tests of key controls and other risk
assessment procedures may enable auditors to assess control risk at a level less than high
for some financial statement classifications. Unless performed for these purposes, tests
of controls should only be performed if other substantive tests can be reduced or
eliminated.
A system’s walk-through procedure, when combined with other risk assessment
procedures such as reading the general ledger, can also provide substantive evidence that
may enable an auditor to evaluate control risk at a level less than high. The greater the
number of transaction units selected for the walk-through, the greater the substantive
evidence provided by the procedure.
Carrying Out the Audit Strategy
The following illustrative documentation demonstrates the planned audit strategies for
major financial statement classifications:



Internal Control Deficiency Worksheet
Risk of Material Misstatements Form
Linking Working Paper
Caveat: These forms are presented for the purpose of illustrating the concepts in these
materials. They have not been peer reviewed.
Internal Control Deficiency Worksheet
This form summarizes the risk assessment procedures and reflects findings transferred
from the internal control flowcharting, systems walk-through procedure, analytical
procedures, fraud risk assessments, and/or other planning procedures that are documented
to summarize the combined risks and to make a control risk assessment by financial
statement classification (considering relevant assertions).
Risk of Material Misstatements Form
The assessed level of control risk by financial statement classification documented on the
illustrative Internal Control Deficiency Worksheet can be transferred to this illustrative
Form to combine with inherent risk and make a final assessment of risk of material
misstatement. The risk of material misstatement by financial statement classification
should be transferred to the illustrative Linking Working Paper. For small audits, there
usually is little benefit in determining the risk of material misstatement individually for
relevant assertions in each financial statement classification. Therefore, the assessed risk
of material misstatement is normally determined for each financial statement
20
classification by considering all relevant assertions combined. Planned audit responses
for smaller entities will normally provide evidence for all relevant assertions.
Linking Working Paper
For small audits, the illustrative Linking Working Paper documents the assessed level of
risk of material misstatement from the illustrative Risk of Material Misstatements Form
by financial statement classification which is determined by considering all relevant
assertions combined. This Paper documents the audit strategy by financial statement
classification and guides the design of the nature, extent and timing of analytical and tests
of balances procedures.
MATCHING PROCEDURES WITH ASSERTIONS
Recognizing that risk assessment procedures and analytical procedures are being
performed for revenues, and that cash and accounts receivable tests of balances
contribute evidence for evaluating financial statement assertions for revenues, the
question at this point is “What additional tests of balances are necessary for revenues?”
The following table presents an analysis of evidence collected in carrying out the audit
strategy.
In the hypothetical example presented in the accompanying illustrative Linking Working
Paper, the planned audit strategy based on moderate risk of material misstatement is 1)
high reliance on risk assessment procedures, 2) high reliance on analytical procedures,
and 3) low reliance on tests of balances. Here’s how the evidence collected under this
strategy will impact the financial statement assertions (x=a small contribution; X=a large
contribution):
AUDIT STRATEGY AND
PROCEDURES
Risk Assessment Procedures
1. Completing Client Acceptance and
Continuance Form
2. Reading the general ledger.
3. Internal control flowchart for sales and
collections cycle.
4. Systems walk-through procedure with 10
sales transactions selected from shipping
reports without bias.
Analytical Procedures
1. Number of days sales in accounts
receivable.
2. Gross margin by product line.
3. Inventory turnover by product line.
4. Dollar balances of sales by product line
trend comparison for three years.
ASSERTIONS AFFECTED BY
EVIDENCE FROM PROCEDURES
Complete/Occur/Value/Exist
x
X
21
X
X
X
X
X
X
X
X
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
x
After assessing the contributions of substantive evidence from the risk assessment and
analytical procedures, our question at this point is “What other substantive tests of sales
revenues are necessary?” Assuming no significant misstatements were found as a result
of the procedures above, at the moderate risk level the answer to the question is likely
“none” other than customary tests of balances for related receivables accounts, such as
confirmation procedures, sales cut-off tests and tests of the allowance for uncollectible
accounts at the beginning and end of the year.
If the auditor can perform a predictive analytical procedure for sales (such as the number
of units sold times sale price) for comparison to recorded sales and results are as
expected, and the results of procedures for related sales accounts are acceptable, the
substantive evidence will likely be more than sufficient, even for high risk! In other
words, no other tests of balances for the sales account would ordinarily be necessary.
When significant misstatements are found in the risk assessment and/or analytical
procedures, other tests of balances will be necessary. For the completeness assertion as
an example, the auditor may need to select a sample of 25-40 shipping reports and trace
them to their entry in the sales journal. It also may be necessary to compare sales by
month with preceding years to identify any material variations. If material variations are
identified, performing detailed support tests for a sample of recorded sales invoices may
be necessary to further evaluate the existence assertion.
22
ILLUSTRATIVE AUDIT PROGRAMS
SMALL AUDITS TESTS OF BALANCES PROGRAM
SALES
OBJECTIVES
C ompleteness
To determine that all transactions and accounts that should be presented
have been included in the financial statements.
O ccurrence and cutoff
To determine that all transactions occurring during the period have been
recorded in the financial statements in the proper period.
V aluation and accuracy
To determine that all asset, liability, revenue and expense components
have been included in the financial statements at accurate amounts,
classified properly.
E xistence
To determine that all recorded assets and liabilities exist at a given date.
R ights
To determine that the entity has rights to all assets recorded at a given
date.
O bligations
To determine that all liabilities are obligations of the entity at a given date.
D isclosure and Presentation
To determine that all components of the financial statements and other
transactions and events are accurately classified, clearly described and
disclosed.
W/P
PROCEDURES
Done by Date
Ref.
A.
B.
Review the results of the risk assessment procedures
and Small Audits Analytical Procedures Program
and assess the impact on tests of balances.
(C, V, O, E)
______
______
______
Review the source journal for any large or unusual
sales transactions, especially near year end. Examine
invoices and shipping documents. (E, O, and V)
______
______
______
23
C.
Randomly select ____ shipping orders prepared at
various times during the year. Obtain related sales
invoice, and trace to the sales journal. (C)
______
______
______
The extent of this procedure, and whether or not it is performed at all, depends on
the results of the risk assessment and analytical procedures.
D.
Determine proper income recognition when the right
of return exist. (E, O, and V)
______
______
______
When the right of return exists for material amounts of sales, an allowance for
sales returns must be provided. This allowance should reflect historical trends and
be supported by documentation prepared by client personnel.
E.
F.
Determine that any product financing arrangements
are accounted for properly. (E, O, V, and D)
______
______
______
Determine that sales of extended warranty and product maintenance contracts are accounted for properly.
(E, O, and V)
______
______
______
Allowances for warranty expenses and maintenance costs must be provided based
on historical documentation and trends.
G.
Determine that bill and hold sales are accounted for
properly. (E, O, and V)
______
______
______
Title must transfer and the customer must have significant equity in the
transaction for a sale to be recorded.
H.
Additional procedures:
________________________________________
________________________________________
________________________________________
________________________________________
______
______
______
Prepared by: ___________________________________ Date: ____________________
Reviewed by: __________________________________ Date: ___________________
24
SMALL AUDITS TESTS OF BALANCES PROGRAM
COST OF GOODS SOLD
OBJECTIVES
C ompleteness
To determine that all transactions and accounts that should be presented
have been included in the financial statements.
O ccurrence and cutoff
To determine that all transactions occurring during the period have been
recorded in the financial statements in the proper period.
V aluation and accuracy
To determine that all asset, liability, revenue and expense components
have been included in the financial statements at accurate amounts,
classified properly.
E xistence
To determine that all recorded assets and liabilities exist at a given date.
R ights
To determine that the entity has rights to all assets recorded at a given
date.
O bligations
To determine that all liabilities are obligations of the entity at a given date.
D isclosure and Presentation
To determine that all components of the financial statements and other
transactions and events are accurately classified, clearly described and
disclosed.
Date
W/P
Ref.
Review the results of the risk assessment procedures
and the Small Audits Analytical Procedures Program
and assess the impact on tests of balances.
(C,O,V,E)
______
______
______
If major, unexplained variances exist, scan entries in
source journals and investigate timing, size and method
of recording unusual items. Discuss findings with
management. (E, C, V, and D)
______
______
______
PROCEDURES
A.
B.
Done by
25
C.
D.
Calculate gross profit percentage and inventory
turnover by product line, if possible. If not, use
trial balance amounts. Compare them to prior year
amounts and investigate any unusual fluctuations.
(E, C, O, and V)
______
______
______
______
______
Additional procedures:
_________________________________________
_________________________________________
_________________________________________
_________________________________________ ______
Prepared by: ____________________________________ Date: ___________________
Reviewed by: ___________________________________ Date: ___________________
26
SMALL AUDITS TESTS OF BALANCES PROGRAM
OTHER REVENUES AND EXPENSES
OBJECTIVES
C ompleteness
To determine that all transactions and accounts that should be presented
have been included in the financial statements.
O ccurrence and cutoff
To determine that all transactions occurring during the period have been
recorded in the financial statements in the proper period.
V aluation and accuracy
To determine that all asset, liability, revenue and expense components
have been included in the financial statements at accurate amounts,
classified properly.
E xistence
To determine that all recorded assets and liabilities exist at a given date.
R ights
To determine that the entity has rights to all assets recorded at a given
date.
O bligations
To determine that all liabilities are obligations of the entity at a given date.
D isclosure and Presentation
To determine that all components of the financial statements and other
transactions and events are accurately classified, clearly described and
disclosed.
PROCEDURES
A.
Done by
Review the results of the risk assessment procedures
and Small Audits Analytical Procedures Program and
assess the impact on tests of balances . (C,O,V,E) ______
27
Date
W/P
Ref.
______
______
SMALL AUDITS TESTS OF BALANCES PROGRAM
OTHER REVENUES AND EXPENSES (Continued)
Date
W/P
Ref.
Obtain or prepare schedules of other revenues and
expenses, foot, tie to general ledger, and investigate
large or unusual items. (E, V, and D)
______
______
______
C.
Vouch as considered necessary. (E, C, and V)
______
______
______
D.
Additional procedures:
_________________________________________
_________________________________________
_________________________________________
_________________________________________ ______
______
______
PROCEDURES
B.
Done by
Prepared by: ____________________________________ Date: ___________________
Reviewed by: ___________________________________ Date: ___________________
CONCLUSION
Auditing revenue recognition is one of the most important parts of an audit engagement.
As outlined in SAS No. 99, the risk of management override of controls and the potential
risk of misstatement of revenues are among the most significant fraud risk factors. An
auditor begins consideration of these fraud risks, and other risks of misstatement due to
error, during engagement planning and utilizes an increased level of professional
skepticism throughout the audit to detect further misstatements.
Understanding generally accepted accounting principles, how misstatements of revenue
can occur, and how to design audit responses for risks of misstatement are key
ingredients for effective and efficient audits of revenue recognition.
28