AUDIT OF SALES, DEBTORS AND PREPAYMENTS
PRESENTED BY
AUDIT AND ASSURANCE DEPARTMENT:
PEAK PROFESSIONAL SERVICES
IN HOUSE SEMINAR SERIES NO 6
PEAK PROFESSIONAL SERVICES
(CHARTERED ACCOUNTANTS)
NIGERIA
A member of Kreston International | A global network of independent accounting firms
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INTRODUCTION
As part of the year-end audit of a company's financial statements, external
auditors test sales transactions and the internal controls over those
transactions to ensure that the company is not materially misstating its
revenues or accounts receivable.
The sales and collections cycle in a business refers to the set of processes
that begin when a customer makes a request for the purchase of goods or
services and ends when the company receives complete payment for the
purchase.
The overall objective in the audit of sales and collection cycle is to evaluate
whether the account balances affected by the cycle are fairly presented in
accordance with relevant accounting standards.
It should be noted that there are various accounts that are involved in the
sales and collection cycle of a business. The name given to the various types
of accounts in the sale and collection cycle vary from business to business.
For example, the name given to sales in a retail business will be SALES while
in an Insurance business it would be PREMIUM. Though the names differ, it
is important to note that the key concepts and principles are the same.
Debtors and Prepayments form significant part of the assets of most
companies. While sales figure is key to determining the overall result and
performance of a business. It is therefore important that the auditor carries
out appropriate audit procedures to verify the accounts in the financial
statements of a company being audited.
This paper covers the audit of Sales, Debtors and Prepayments. It is hoped
that at the end of the presentation members of staff will be able to identify
the processes involved in any sales cycle and carry out audit procedures to
verify the associated balances in the financial statements of our clients.
The topics covered in this paper are as follows:
 Definition of terms
 Understanding the client’s Revenue System
 Internal Controls over the Sales System
 Audit of the Revenue/Sales System
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 Audit of Cash Sales/ Receipts
 Audit of Accounts Receivable/Debtors
 Audit of prepayments
Definition of Terms
Revenue
Revenue is defined by the International Accounting Standard (IAS) 18 as
income that arises from the course of ordinary activities of an entity. This
could be referred to by a variety of different names such as Sales, Fees,
Interest, Dividends and Royalties.
It is important to note that sales are generated from the ordinary course of
the business. Incomes generated from the activities that are not part of the
core business of an entity are regarded as gains and not sales. For instance,
sale revenue of a business whose main aim is to sell biscuits is income
generated from selling biscuits. If the business sells one of its factory
machines, income from the transaction would be classified as a gain rather
than sale revenue.
Debtors
Trade debtors also known as account receivables are the value of revenue
invoiced for which money is still owed to the business after the sale is made
or service rendered. In practice, this usually happens when goods are
dispatched or service rendered and invoice issued to the customer.
Debtors are recorded in the balance sheet of the accounts as a current asset
at the time that sales are recorded, but before cash has been received from
the customer. The debtors control account in the balance sheet will be the
net of all invoices to customers (debits) less the receipts from all customers
(credits), and should always be a debit balance.
Prepayments
Prepayments are amounts paid for one period which relates to the next
period. They are sometimes referred to as deferred charges and could be
related to different expense heads such as Prepaid Rent, Prepaid Insurance,
and Prepaid Trade Marks etc.
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Understanding the Entity’s Revenue System
We stated at the beginning of this paper that the sales and collections cycle
in a business refers to the set of processes that begin when a customer
makes a request for the purchase of goods or services and ends when the
company receives complete payment for the purchase.
The process begins with a request by a customer and ends with the
conversion of material or service into accounts receivable and ultimately
cash.
Kindly note that the process is common to all types of business no matter
what they are engaged in. What would be different is the names and degree
of details.
In order to have a good understanding of a company’s sale system, we must
understand that every company has specific functions that are associated
with the sales cycle. It is important that we understand the functions and
the documents that are used for each function whenever we set forth to
perform audit on any company.
In order to facilitate our understanding of the sales system, we present a
summary of the functions in the table below:
BUSINESS
FUNCTION
DOCUMENT
USED
ACCOUNTS
AFFECTED
CLASSES
OF
TRANSACTIONS
1
Processing
of Customer
Sales
and Sales
customer orders
Order/
Sales Accounts
Order
Receivable
2
Granting Credit
Customer
Order/Sales
order
3
Shipping
Goods/Rendering
Service
Shipping
Sales
and Sales
Documents/
Accounts
Waybills,
Receivable
Certificate
of
completion etc
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Sales
and Sales
Accounts
Receivable
4
Billing Customers Sales
invoice, Sales
and Sales
and
recording Bills, Sales list
Accounts
sales
Receivable
5
Processing
recording
receipts
and Remittance
Cash in Bank Cash Receipts
cash Advice,
and
Accounts
Prelisting
of Receivable
Cash Receipts
6
Processing
recording
returns
allowances
and Credit
Memos,
sales Sales
Returns
and Journals
and
allowances
Journals
Sales
Returns Sales
Returns
and Allowances and Allowances
and
Accounts
Receivable
Accounts
7
Writing
uncollectable
accounts
receivable
off Uncollectible
Accounts
authorization
Journal, General
Journal Form
Accounts
Write
Off
of
Receivable and Uncollectible
Provision
for Accounts
Bad
Debt
Account
8
Providing for Bad General Journal
Debts
Bad
Expense
Provision
Bad
expense
account
Debt Bad
and expense
for accounts
Debt
Debt
The table is now explained as follows:
When carrying out the audit of a client’s sales cycle, we must understand
and document the activities in the table above. Such understanding will help
us to design the nature of audit test to be performed. It would also help us
to fulfill the requirements in ISA 315 Understanding the entity and its
Environment.
CUSTOMER ORDER
A customer order is a request for goods or service by a customer. This could
take the form of telephone, letter or a printed form. The form can be sent by
post, hand delivered or by internet.
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Sales Order
This is a document that is used for communicating the description, quantity
or related information for goods or and services ordered by a customer.
Sometimes the sales order also includes details relating to credit.
It is important to note that before services are rendered or goods are
shipped to customer, a properly authorized person must approve credit to
the customer for credit sales.
Shipping of Goods/ Rendering of Service
This is the most important function in the sales cycle. It is the point at which
risks and rewards of an asset are transferred to the customer. At this point,
most companies recognize income.
The document for this important stage is known as the shipping document.
It indicates the description of goods, the quantity shipped and other relevant
data. The name given to a shipping document could be waybill, bill of laden
or any other name depending on the nature of business.
Billing Customers
Billing customers is the means by which customer is informed of the amount
of goods shipped or services rendered. The most important aspects of billing
are:



All shipments or services have been billed (Completeness)
No shipment or service has been billed more than once (Occurrence)
Each one is billed for the proper amount (Accuracy)
Billing is normally done by means of a sales invoice. A sales invoice is a
document indicating the description and quantity of goods sold, the price
and other relevant terms.
In a computerized accounting system, it is usually possible to obtain what is
often referred to as a Sales Transaction File. This file includes all information
entered into the system and information for each transaction such as the
customer name, date, amount, account classification etc.
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This file can also be varied to obtain what is known as the Sales Journal. The
Sales Journal is a listing or report which also includes the product line or
division.
NOTE
The transaction functions explained above are necessary for getting the
goods and services into the hands of the customers, correctly billing them
and reflecting the information in the accounting records.
The other four functions are concerned with collection and recording of cash,
sales returns and allowances, write off of uncollectible
accounts and
providing for bad debt expense.
PROCESSING AND RECORDING CASH RECEIPTS
Processing and recording cash receipt involve receiving, depositing and
recording cash. Kindly note that cash includes currency, cheques and
electronic funds transfer. The auditor’s concern here is the possibility of theft
and misappropriation of the asset.
Sometimes customers will include a remittance advice when making
payments, such advice helps the seller to keep track of what has been paid
for in order to pass the accounting entries. In the case of electronic funds
transfer or purchase of goods by credit cards, the bank provides information
to the company to prepare the accounting entries.
Most computer system can also generate a cash receipt transaction file that
will indicate the name of the customer and invoice details.
PROCESSING AND RECORDING OF SALES RETURNS AND ALLOWANCES
When a customer is dissatisfied with the goods or services, the seller often
accepts the return of goods and grants a reduction in the charges. The
company prepares a receiving report for returned goods and returns them
for storage. These are recorded in the sales returns transaction file.
Credit memos or credit notes are raised to indicate a reduction in the
amount due from a customer.
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A sales return journal is used to record sales returns and allowances, though
some companies might use the sales journal to also record sales returns.
WRITING OFF UNCOLLECTIBLE RECEIVABLES
When the company has assessed that certain amount is not collectible, it
must be provided for. The process is done by making use of an internal
document known as the uncollectible Account Authorization Form.
PROVIDING FOR BAD DEBTS
When it becomes clear that an amount cannot be collected for example the
customer has become bankrupt, the amount must be written off as bad debt
expenses
EXERCISE
1. Each member of staff is required to take a particular business and
explain their sales process using the 8 sales cycle function above. The
explanation should clearly indicate the document that are used for
each function
2. Explain the difference between bad debt and allowance for bad debt
and tell us how this is treated in the accounts
INTERNAL CONTROL SYSTEM OVER SALES
Internal Control is defined as the process designed and effected by
management to provide reasonable assurance about the entities objectives
with regard to the reliability of financial reporting, effectiveness and
efficiency of operations and compliance with applicable laws and regulations.
From the above, it would be observed that internal controls are designed to
enable the business achieve specific business objectives.
In this section, we shall be looking at what the control objectives of the sales
systems and the control procedures which are put in place to achieve the
objectives.
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REVENUE OR SALES SYSTEM OBJECTIVES
The objectives of any revenue system can be broadly classified into three
categories.
 Ordering and granting of credit
 Dispatch and invoicing
 Accounting
The details of each component are as follows:
ORDERING AND GRANTING OF CREDIT
1. Goods and services are supplied to customers with good credit
standing
2. All Orders are recorded correctly
3. All Orders are met
4. Goods and Services returned by customers are recorded
DISPATCH AND INVOICING
1.
2.
3.
4.
All invoices raised relate to goods and services supplied by a business
All dispatches and Services are accurately recorded
Any Credit notes are only given for valid reason
Cut off procedures are correctly applied to recording dispatch of goods
ACCOUNTING
1. All invoices and credit notes are properly recorded in the books of
accounts
2. All receipts from customers are properly recorded
3. All payments are for goods and services which have been supplied
4. All credit notes given have been properly recorded in the books and
records of the business
5. All entries to the receivable ledger are in the correct customer
accounts
6. Potential or actual bad debts are identified
7. Cut off procedures are applied
Based on the objectives mentioned above, an entity’s sales control system
will be designed to achieve the set objectives.
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In addition to the set objectives, the sales control system would be designed
to minimize the possibility of fraud.
ELEMENTS OF CONTROL PROCEDURES
When reviewing the Internal Control Procedures put in place by management
to achieve the sales system objectives, the relevant aspects to examine are:





Organizational Controls
Segregation of duties
Physical Controls
Authorization
Arithmetic and Accounting Controls
The application of the elements to the three objectives is summarized in the
following table.
ORDERING AND GRANTING OF CREDIT
1
Organizational controls
There should be written procedures for
receiving orders and granting of credits
Authority for approving new credit customers
must be well defined
There should be procedures for checking the
suitability of customers for credit
2
Segregation of duties
Different members of staff should be involved
in different aspect of the sales process. For
example, the same staff should not be
involved in dispatching of goods and raising
invoices
3
Physical Controls
There should be physical control over access
to sales order documents
Sales order forms should be pre- numbered
4
Authorization
Changes in customer database can only be
made with proper authority
Changes to credit limit must be properly
authorized
5
Arithmetic and accounting
Prices are correctly quoted
Discounts are calculated correctly
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Matching of customers orders to dispatch
notes
Accurate computation of VAT
SHIPPING AND INVOICING
1
Organizational controls
There should be written procedures for
dispatching of goods and invoicing
Authority level for selling prices and
discounts
There should be authority for issuing credit
notes to customers
2
Segregation of duties
Different members of staff should be involved
in different aspect of the sales process. For
example, the same staff should not be
involved in dispatching of goods and raising
invoices
3
Physical Controls
There should be monitoring of quantity and
condition of goods supplied.
Delivery notes should be pre- numbered
Sales invoices should be pre numbered
Goods returned notes should be pre
numbered
Goods delivery notes/service performance
notes should be signed by customers
There should be pre numbered goods
returned notes
4
Authorization
Authorization of selling prices
Authorization of discounts
Matching of sales invoices with dispatch
notes
Matching of credit notes with goods returned
notes
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ACCOUNTING
1
Organizational controls
There
should
be
written
procedures
accounting for sales and receivables
There should be written procedures for write
off of bad debts
2
Segregation of duties
Different members of staff should be involved
in posting invoices and maintaining customer
accounts receivable. They should also be
different from those responsible for receiving
cash from customers
3
Physical Controls
Sales
invoices
should
be
numbered
consecutively
There should be control over unused invoices
There should be control over the computer
system used for creating invoices
Restriction of access to unauthorized persons
4
Authorization
Authorization to implement credit control
procedures
5
Arithmetic and accounting
Checking invoices for prices and calculations
Invoices and credit notes are entered into
accounting records promptly
Sending Statements to customers
Production of aged receivable reports and
credit control procedure
Reconciliation of receivable ledger control
accounts with receivable ledger subsidiary
account
Cut off checks to ensure that goods
dispatched but not invoiced are dealt with in
the correct period
Analytical review procedures
PRACTICAL APPLICATION
Most of the issues raised in the above tables can be ascertained and
documented by administering a standard Internal Control Questionnaire on
the Sales process to a client.
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An example of a typical ICQ on sales is as follows:
PEAK PROFESSIONAL SERVICES
INTERNAL CONTROL QUESTIONNAIRE- SALES
CLIENT:
1
2
COMPLETED BY:
DATE----------------------
REVIEWED BY
DATE----------------------
QUESTIONS
ANSWERS
N/
Y N A
GENERAL INFORMATION TECHNOLOGY
What software is used to record and manage customer
information
Is it the same thing as the General Ledger Software
SALES ORDERS/SERVICE REQUEST
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
What record is kept of service request/ Sales Orders
Who receives the order
Upon receipt of the order is there a verification of the approved
buyer
If yes, how is this function performed
Who is responsible for inputing the order into the system
Are customer orders approved before execution
If yes, how is performance evidenced?
Is there Automatic matching of price by the computer system
For non standard billing terms when and how is the billing terms
set up
Are customers credit limit checked before orders are performed
Does the Company have a Credit Policy
is it documented? obtain a copy
If yes, how often is the policy subject to review
Are new Customers required to submit credit application
If yes, is it standardized
If so who performs the task
How is the performance evidenced
Who are those that have access to the order entry system
What controls are in place to check unathorised access to the
order entry system
What record is kept of orders received but not yet performed
How often is the record reviewed
Who is responsible for the review
PERFORMANCE OF SERVICE/DISPATCH OF GOODS
1
List the major centres at which Goods/ Services are sold
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REMARKS
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3
4
5
6
7
8
9
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2
3
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5
6
7
8
9
10
1
2
3
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What records are kept of Goods Sold/ Services rendered to
customers
Are these records under numerical control
Are these records kept by a person independent of the Sales/
Invoice
Processing
Are acknowledgement of the receipts of goods or service
performance obtained from customers
How is it evidenced
How does the system ensure that all services performed or
Goods
sold are covered by the issue of sales Invoice?
What records are kept of short deliveries or inadequate performance
of service
Are these records under numerical control
CONTROLS OVER CREDIT MEMOS
How does the system ensure that Credit Notes are issued for all
returns from customers or claims by customers
List other conditions that warrant the issue of Credit Notes
Who is authorized to issue credit notes
Is this person Independent of the collection function
Is this person independent of operations/ Dispatch of Goods
What level of approval is required for various Credit Notes
Are Credit Memos Pre numbered
Is there an Independent Review of the Schedule of Credit
Memos
If yes by whom
How often is this done
CONTROLS OVER BILLING AND INVOICING
Does the Company have a billing policy
Does the policy specify the period in which a bill must be issued
after task is performed?
Who or which department is responsible for raising Invoice
Is the person/ department separate from the collection function
From what sources of Information are Invoices prepared
How many copies of sales Invoices are Prepared
How are they distributed
Are Invoices/Bills prenumbered
Does the Bill/Invoice have contact information
How are cancelled, altered and no charge invoices authorized
Are Provisional or proforma invoices rendered?
If yes, how are they treated for accounting purposes?
Is there a procedure for reconciling service request and
performance
of service to invoices issued
Is there a software for raising Invoices
If yes, what is the software
Is it Integrated with the General Ledger
Is it Integrated with the operational/service delivery and Goods
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19
20
21
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23
1
2
3
4
5
6
7
8
9
10
11
issued?
Does the billng process involve automatic validation check on
price
(per standard tarif or contract terms and quantity (as per stores
records and service request/operational records)
Is there an authorized price list/ tariff
if yes who is authorized to change it
Is there a restriction of access to invoicing software to only
authorized personnel
If yes how is it done
GENERAL
Do sales to related parties have the same process as third party
sales
If no kindly describe the system for processing Intercompany
sales
Are Customers given Month end statements
If yes who is responsible for this function
Does the computer automatically post transactions to account
receivable master file and General Ledger
Is the account receivable master file reconcile with the General
Ledger on a Monthly basis?
Is there a memorandum Invoice Account?
If yes is there a reconcilition of the Invoice listing to the Chart of
accounts
Who performs this function
How often are Journal entries into the Sales Ledger reviewed?
Describe the procedure for authorizing, controlling and recording
sales to Employees, sale of scrap and cash on delivery/cash
sales
AUDIT OF THE SALES SYSTEM
The nature and timing of audit procedures will depend on the assessment of
the client’s system which is obtained from an understanding and assessment
of the system.
Typical and practical steps that will be taken would be a combination of the
following:
1. Obtain the client’s sales journal and review for unusual transactions
and amounts
2. Check new accounts and credit limits are properly authorized and
credit procedures are operating
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3. Check that sales invoices are supported by customer orders, and
signed delivery notes or evidence of work performance
4. Check for prices, arithmetic and calculations of invoices
5. Check that invoices are correctly coded with customer codes
6. Test numerical sequences of invoices and enquire into missing
invoices, sales orders, delivery notes and goods returned notes
7. Check goods returned are supported by goods returned notes,
evidence of correspondence with customers and credit note
authorized.
8. Observe whether monthly statements are sent to customers
9. Observe whether accountant compares subsidiary ledger total with
control totals
10.
Account for the sequence of dispatch/shipping documents
11.
Trace selected dispatch documents to sales journal to be sure
that each one has been included
12.
Account for the sequence of sales invoices to the sales journal
13.
Trace selected sales invoice numbers from the sales journals to
the accounts receivable ledger
14.
Sample selected sales invoices and check supporting documents
for internal verification
15.
Test selected invoices with customer order checking for customer
name, product description, quantity, date, contracts and credit
approval
16.
Obtain prelisting of cash receipts and trace amounts to the cash
receipt journal testing for names, amounts, dates and internal
verification
17.
Trace cash receipt entries to bank statement
18.
Trace selected entries from the cash receipt journal to entries in
the customer subsidiary ledger
As stated above, how the above procedures are combined in the audit of
sales will depend on our assessment of the clients system of internal
controls over sales
ANALYTICAL REVIEW
As with most audit exercise, we should carry out relevant analytical
procedures when carrying out the audit of sales.
Prepare summary for present year and previous
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two years to compare –
Sales
Cost of Sales
Gross Profit
G.P.
%
Stock at Balance Sheet date
Trade Debtors
2.Explain material fluctuations in above.
3. Explain any significant changes in type of business carried on, method
of operating source of earning, etc.
AUDIT OF CASH REVENUE
In certain types of businesses, a significant proportion of sales is carried
out in cash. For example, shops, supermarkets, bars and restaurants.
In these instances, the auditor must be aware that the activities are
highly susceptible to fraud.
Therefore audit procedures must be designed to verify sales revenue and
to detect fraud.
Some of the steps to be undertaken by the auditor are as follows:
Review the procedures for recording cash revenues e.g cash sheets, tills
etc
Review and test the reconciliation of cash taking to the records above
Review and test bank transactions by ensuring that:
Cash takings are banked intact
Reconciliation and banking of cash receipts are carried out by persons
independent of revenues
Ensure cash takings are banked the same day or the next date by
checking pay in slips
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TESTING FOR LAPPING OF ACCOUNTS RECEIVABLE AND PROOF OF CASH
RECEIPTS
Lapping of account receivable is the postponement of entries for the
collection of receivables to conceal an existing cash shortage. The fraud is
perpetrated by a person who handles cash receipts and then enters them
into the computer system. This fraud can be prevented by separation of
duties and mandatory vacation policy for employees who handle both
cash and entry into the system.
A useful audit procedures for testing whether all recorded cash has been
deposited in the bank is the proof of cash receipts. In this test, the total
cash receipts recorded in the cash receipts journal is compared with the
actual cash deposited in the bank for a given period say one month.
Differences observed should be reconciled and explained.
AUDIT OF SALES RETURNS AND WRITE OFF OF UNCOLLECTIBLE
ACCOUNTS
The audit procedures for sales returns are similar to the procedures
adopted for sales. We should however test recorded transactions to
ensure that theft of cash is not concealed with sales returns. The point
also applies to write off of uncollectible accounts.
The major control for these transactions is proper authorization by a
designated official.
AUDIT OF ACCOUNTS RECEIVABLES (DEBTORS)
Receivables also known as debtors form part of the sales receivable cycle.
It is therefore important to carry out the compliance procedures in the
sales audit as part of the debtors audit procedure. In summary, check to
ensure that the system for receivables has the following features:
Only bona fide sales bring receivables
All such sales are to approved customers
All such sales are recorded
Once recorded, the debts can only be eliminated by receipt of cash
or on the authority of a responsible official
 Debts are collected promptly




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 Balances are regularly reviewed and aged, a proper system of
follow up exists and if necessary adequate provision for bad debt
exists.
We are required to carry out further audit procedures to verify debtors’
balances at year end on the completion of our compliance review.
See section 13 of our file divider
1.
Obtain and check or prepare schedules of all debtors in detail and
summary per Balance Sheet showing
1.
Trade Debtors
2.
Hire Purchase Debtors
3.
Sundry Debtors
4.
Staff Accounts
5.
Deposits
6.
Prepayments
7.
Others
2.
Circularize major accounts as at or prior to year end and tabulate
results in normal form i.e.
(i)
(a)
number and value of all debtors
(b)
number and value of all confirmations requested
(c)
number and value of replies received and agreeing
(d)
number and value of replies received and disagreeing
(e)
percentage results achieved
(f)
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(1)
Replies Received
(2)
Replies Agreeing
(3)
Replies Disagreeing
Remittances to date from those not replying
(ii)
Investigated disagreed replies and record reasons.
(iii)
Pass requests from customers for information to client.
3.
Agree all control accounts with Ledger Balances.
4.
Obtain Age analysis of debtors
5.
Identify balances to specific invoices.
6.
Explain nature of all Sundry Debtors and Deposits.
7.
Vouch authority for Staff Loans and ensure being
repaid regularly. Trace sample repayments to payroll
8.
Review all accounts to determine if provision necessary
and indicate on schedules all information given to us in
arriving at decision
9.
Prepare schedule of movements on Bad Debts –
Provision Accounts and Debts written off.
10.
Check and file calculations of major prepayments.
11.
Review cut-off procedure for sales with stock audit
by appropriate schedules showing:(a)
That all sales made within the last two weeks
of the accounting period had been entered in
the stock records before the end of the period.
(b)
Goods relating to purchase invoices taken up
in the books and actually been received.
(c)
That sales invoices after the year end do not
relate to the preceding year – also purchases.
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CUT OFF PROCEDURES
Cut off is a very important term that has implications for sales, purchases
and inventory. We should read it up and discuss in our next seminar.
AUDIT OF PREPAYMENTS
In the audit of prepayments, the auditor reviews the clients system for
ensuring that all prepayments are recorded
The auditor obtains a schedule from the client or prepares one that includes
the opening figures of the previous year, the current year additions and
write offs and the ending balance of prepayments.
Re-performing the calculations for arithmetic accuracy
Reviewing previous year working papers for evidence that the same
prepayments existed previously
We could also carryout certain analytical procedures such as:
Comparing the ratio of prepaid expense to the total of related expense for
the current and previous year
Compare the actual expense with prior year figure
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