Chapter 10:
Auditing Revenue and
Related Accounts
Revenue cycle accounts – The importance
Sales transactions are always material to
a company's financial statements
 According to the SEC, a majority of
financial statement manipulations and
audit failures involve overstated revenues
 Therefore, revenue cycle accounts must
be examined with great care
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1
The cycle approach
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Revenue cycle transactions include all the processes
ranging from the sale to shipping a product, billing the
customer, and collecting cash
A company's revenue cycle transactions reflects its
operations
A cycle approach is one way to help the auditor focus on
the important account balances surrounding a
transaction to ensure that sufficient audit evidence is
gathered and evaluated
Other cycles include:
 acquisition
and payment of goods and services
 Payroll
 Financing:
 Cash
debt and equity
and short-term investments
2
Overview of the Revenue Cycle
(Sales made on Account)
1.
2.
3.
4.
5.
6.
7.
8.
Receive customer purchase order
Check inventory stock status
 Generate back order if item not in stock
Obtain credit approval
Prepare shipping and packing documents
Ship and verify shipment of goods
Prepare the invoice
Send monthly statements to customers
Receive payment
3
Business Risk and Business
Environment
Revenue recognition
 SAS 99 - Consideration of Fraud in a
Financial Statement Audit
Auditor should presume risk of material
misstatement due to fraud related to
revenue recognition
Research shows over half of frauds
involve overstating revenues
4
Some Improper Revenue
Recognition Schemes
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Recognize revenue on fictitious shipments
Hidden side letters that give customers unlimited right to
return product
Record consignment sales as final sales
Accelerated recognition of sales occurring after year-end
Ship unfinished goods
Ship goods before date agreed to by customer
Create fictitious invoices
Ship goods never ordered
Ship more goods than ordered
Record shipments to company's warehouse as sales
Record shipments of replacement goods as new sales
5
What are some fraud risk factors
for revenue recognition?

There are a number of types of 'red flags' which
signal the potential for fraud in the financial
statements
 External risk indicators
 Internal red flags
 Unusual

financial results
Auditor deals with red flags by
 Examining
external pressures that could lead to
financial reporting fraud
 Examining the financial statements to determine if
account balances seem out of line
6
What analytical analysis can be
done for possible misstatements?
Compare client revenue trend with
economic conditions and industry trends
 Compare cash flow from operations with
net income
 Perform analytical procedures

 Ratio
analysis
 Trend analysis
 Reasonableness tests
7
Assessment of Environment
Risk

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Risk assessment is ongoing process in every
audit
Audit steps to assess environment risk for the
revenue cycle:
 Update
information on business risk
 Perform analytical procedures to look for
unexpected relationships
 Develop understanding of internal controls
 Analyze business risk for motivations and
methods to misstate sales
8
Assessment of Environment
Risk – Cont’d
 Document
operation of accounting
applications and important controls
 Develop preliminary assessment of
environment risk
 If control risk is high, determine likely types of
misstatements
 If control risk is lower, develop procedures to
test operation of controls
 Perform tests of controls, document results
 Based on the results of testing, reassess
control risk
9
Inherent Risk with Regard to
Sales
While sales transactions are routine for
most organizations and do not represent
an abnormally high risk, for other
organizations, revenue recognition may be
complicated
 Difficult audit issues include:

 When
to recognize revenues
Auditor must understand client's operations and
related GAAP issues
 Example: point of sale revenue recognition vs.
percentage of completion
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10
Inherent Risk with Regard to
Sales – Cont’d

Impact of any unusual sales terms and whether
title passed to customer
 Example:
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related party transactions
Goods recorded as sales have actually been
shipped
Sales made with recourse or that have
significant returns
 Example:
irrevocable right to return goods
The presence of these issues increase inherent
risk and the probability of material
misstatement
11
Inherent Risk in Receivables

Primary risk is net receivables will be overstated,
because either receivables have been overstated, or
the allowance for uncollectible accounts has been
understated
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Risks affecting receivables include:
 Sales
of receivables recorded as sales rather than
financing transactions
 Receivables pledged as collateral
 Receivables classified as current when likelihood of
collection is low
 Collection of receivable contingent on uncertain future
events
 Payment not required until purchaser sells the
product
12
The Control Environment and
Sales
An organization's control environment
affects revenue and related transactions
more than most accounts
 The auditor must consider:

 Management's
integrity
 Financial condition of the organization
 Financial pressures on the organization
 Management incentives to achieve financial
results
13
Understanding Internal Controls

Although the auditor must understand all components of
internal controls, particular attention is paid to significant
control procedures and monitoring controls
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The auditor obtains an understanding of the controls by
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Walk-through of the processing of transactions
Inquiry
Observation
Review of client documentation
It is critical this understanding be documented in the
work papers
14
Understanding Internal Controls (2)
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Assertions must be addressed during this phase:
 Occurrence,
Cutoff, Completeness, Accuracy &
Classification
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Controls Regarding Returns, Allowances and
Warranties are also important. Abnormal returns
or allowances may be the first sign that a
company has problems
Credit Policies are also very important
15
Documenting, Testing, and
Assessing Environment Risk

Develop understanding of the accounting
system and control procedures
 Evidence
is gathered through inquiry, review of client
accounting manuals, and review of prior year audit
workpapers
 Documentation includes questionnaires, flowcharts,
and narratives
 Determine whether the application control procedures
are sufficient to achieve the control objectives
 Based on control design, make preliminary
assessment of control risk
16
Documenting, Testing, and
Assessing Environment Risk (2)
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The auditor must document those controls that
support an assessment of control risk below
maximum
If the auditor plans to rely on the internal
controls, the controls are tested to see if they are
operating as designed
If testing indicates the control is not operating
effectively,
 Auditor will increase assessed control risk,
lower detection risk, and perform more
rigorous substantive testing
 If the control is working effectively, control risk
17
assessment is unchanged
Linking Environment Risk
Assessment & Substantive Testing
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The rigor of substantive testing is inversely
related to the assessed level of environment risk
The auditor learns three things during the
assessment of environment risk that affects the
design of substantive audit procedures:
 The
nature of the accounting system, controls
used, and documents generated in the client's
processing
 Existence of fraud risk factors
 Effectiveness of controls and types of
misstatements likely to occur
18
Substantive Testing in the
Revenue Cycle

Planning for Direct Tests of Transactions and
Account Balances
 Audit
objectives and assertions
 Account balance relationships
 Risk of material misstatement
 Composition of the account
 Persuasiveness of audit procedures
 Cost of audit procedures
 Timing of audit procedures
 Determining optimal mix of audit procedures
Exhibit 10.7 Outlines the relationship between Assertions and
Substantive Tests for the Revenue and Accounts Receivables
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Substantive tests of revenue –
objectives/issues
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Assertions related to revenue transactions:
 Occurrence:
Have the transactions occurred
and pertain to the entity
 Completeness: Have all transactions been
recorded
 Accuracy: Have transactions been accurately
recorded
 Cutoff: Have transactions been recorded in
the correct accounting period
 Classification: Have transactions been
recorded in the proper accounts
20
Substantive Tests of Revenue
for Occurrence and Accuracy
Vouch recorded sales transaction back to
customer order and shipping document
 Compare quantities billed and shipped
with customer order
 Special care should be given to sales
recorded at the end of the year
 Scan sales journal for duplicate entries
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21
Substantive Tests of Revenue
Cutoff Tests
Can be performed for sales, sales
returns, cash receipts
 Provides evidence whether transactions
are recorded in the proper period
 Cutoff period is usually several days
before and after balance sheet date
 Extent of cutoff tests depends on
effectiveness of client controls
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Substantive Tests of Revenue
Cutoff Tests e.g.
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Sales cutoff
 Auditor
selects sample of sales recorded during cutoff
period and vouches back to sales invoice and
shipping documents to determine whether sales are
recorded in proper period
 Cutoff tests assertions of existence and completeness
 Auditor may also examine terms of sales contracts
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Sales return cutoff
 Client
should document return of goods using
receiving reports
 Reports should date, description, condition, quantity
of goods
 Auditor selects sample of receiving reports issued
during cutoff period and determines whether credit
was recorded in the correct period
23
Substantive Tests of Revenue
for Completeness
Use of pre-numbered documents is
important
 Analytical procedures
 Cutoff tests
 Auditor selects sample of shipping
documents and traces them into the sales
journal to test completeness of recording
of sales
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24
Substantive Tests of Accounts
Receivable - issues

Existence & Occurrence
 Does
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the receivable exist?
Valuation
 Are
sales and receivables initially recorded at their
correct amount?
 Will client collect full amount of recorded receivables?
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Rights and Obligations
 Contingent
liabilities associated with factor or sales
arrangements
 Discounted receivables
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Presentation and Disclosure
 Pledged,
discounted, assigned, or related party
receivables
25
Standard Substantive Tests of
Accounts Receivable
1.
2.
3.
4.
Obtain and evaluate aging of
accounts receivable
Confirm receivables with customers
Perform cutoff tests
Review subsequent collections of
receivables
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1. Aging Accounts Receivable
Because receivables are reported at net realizable value,
auditors must evaluate management estimates of
uncollectible accounts
 Auditor will obtain or prepare schedule of aged accounts
receivable
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Aging schedule can be used to
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If schedule is prepared by client, it is tested for mathematical and
aging accuracy
Agree detail to control account balance
Select customer balances for confirmation
Identify amounts due from related parties for disclosure
Identify past-due balances
Auditor evaluates percentages of uncollectibility
Auditor then recalculates balance in the Allowance
account
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2. Confirming Receivables with
Customers
Confirmations provide reliable external evidence about the
 Existence of recorded accounts receivable and
 Completeness of cash collections, sales discounts, and
sales returns and allowances
Confirmations are required by GAAS unless one of the
following is present:
 Receivables are not material
 Use of confirmations would be ineffective
 Environment risk is assessed as low and sufficient
evidence is available from using other substantive tests
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2.a The Types of Confirmations
Positive confirmations
 Customers are asked to agree the amount on
the confirmation with their accounting records
and to respond directly to the auditor whether
they agree with the amount or not
 Positive confirmation requires a response
 If customer does not respond, auditor must use
alternative procedures
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2.b The Types of Confirmations
Negative confirmations
 Customers are asked to respond only if they disagree
with the balance (non-response is assumed to mean
agreement)
 Less expensive since there are no additional procedures
if customer does not respond
 May be used when all of the following are present
 Confirming a large number of small customer
balances
 Environment risk for receivables is assessed as low
 Auditor believes customers will give proper attention
to confirmations
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2.c What’s the follow-up
procedures for non-responses?
1.
2.
If customer does not respond to positive
confirmation, auditor may send a second, or
even third, request
If customer still does not respond, auditor will
use alternative procedures
a) Examine the cash receipts journal for cash collected
after year-end
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Care is taken to ensure receipt is year-end receivable, not
subsequent sale
b) Examine documents supporting receivable
(purchase order, sales invoice, shipping documents)
to determine if sale occurred prior to year-end
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Evidence gathered from internal documents is not
considered as reliable
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2.d What’s the follow-up
procedures for exceptions noted?
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Customers are asked to agree the amount on
the confirmation to their accounting records;
differences are called exceptions
Reasons for exceptions:
 Timing
differences
 Disputed items
 Customer errors
 Client misstatement
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Because misstatements are projected to the
population of receivables, the auditor must
determine the reason for the exception
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Related-Party Receivables
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Amounts due from related parties should be
separately disclosed
Audit procedures to identify related-party
transactions include:
 Review
SEC filings
 Review the accounts receivable subsidiary ledger and
trial balance
 Management inquiry
 Communicate names of related parties so all audit
team members can be alert for related-party
transactions
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Sold, Discounted, and Pledged
Receivables
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Receivables sold with recourse, discounted, or
pledged as collateral should be disclosed
Audit procedures to identify these items include:
 Management inquiry
 Scan cash receipts journal for large cash
inflows from unusual sources
 Bank confirmations, which include information
on obligations and terms
 Review board of director minutes, which
contain approval for these items
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Fraud Indicators and Audit Procedures
Potential fraud indicators:
 Excessive credit memo or other adjustments to accounts
receivable just after year-end
 Customer complaints and discrepancies in receivable
confirmations
 Unusual entries to the receivable subsidiary ledger or sales
journal
 Missing or altered source documents
35
Fraud Indicators & Audit Procedures - 2
Potential fraud indicators:
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Lack of operating cash flow when operating income has been
reported
Unusual reconciling differences between receivable subsidiary
ledger and control account
Sales in the last month with unusual terms
Pre- or post-dated transactions
Unusual adjustments to sales accounts before/after year-end
36
Fraud Indicators and Audit Procedures - 3
Substantive procedures that may highlight potential fraud
indicators:
 Review of source documents including invoices, shipping
documents, customer purchase orders, etc
 Review and analyze credit memos and other
adjustments to receivables
 Confirm sales terms with customers
 Analyze large or unusual sales made near year-end
 Scan the general ledger, receivables subsidiary ledger,
and sales journal for unusual activity
 Perform analytical review of credit memo and write-off
activity
 Analyze recoveries of written-off accounts
37
Auditing of Allowance for Doubtful
Accounts
Accounts receivable should be reported at their net realizable value
The balance of the allowance for doubtful accounts is estimated and
depends on a number of factors
Understating the allowance overstates net accounts receivable and
net income
Where accounts receivable are material, the auditor should obtain
an understanding of how management developed the estimate by
using one or more of these approaches:
 Review and test the process used by management to develop the
estimate
 Test aging schedule
 Evaluate estimated percentages of uncollectibility used
 Develop an independent model to estimate the accounts
 Review subsequent events such as subsequent collections on 38
account