10-1
McGraw-Hill/Irwin
Chapter 10
CHAPTER 10
AUDITING THE REVENUE
PROCESS
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10-2
REVENUE RECOGNITION
Accounting standards (SFAS No. 5) requires that before
revenue is recognized it must be realized and earned.
 The SEC’s SAB No. 101 requires the following criteria for
revenue recognition:
 Persuasive evidence of an arrangement exists.
 Delivery has occurred or services have been rendered.
 The seller's price to the buyer is fixed or determinable.
 Collectibility is reasonably assured.

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10-3
OVERVIEW OF THE
REVENUE PROCESS

The "cradle to grave" process for revenue begins with
an order from a customer, proceeds to the exchange of
goods or services for a promise to pay, and ends with
the payment of cash.

Figure 10-1: Flowchart for a revenue process
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10-4
TYPES OF TRANSACTIONS

The sale of goods or rendering of a service for cash
or credit.

The receipt of cash from the customer in payment
for the goods or services.

The return of goods by the customer for credit or
cash.
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10-5
FINANCIAL STATEMENT ACCOUNTS
Sales Transaction:
 Trade accounts receivable
 Sales
 Allowance for uncollectible accounts
 Bad debt expense
 Cash Receipts Transactions:
 Cash
 Trade accounts receivable
 Cash discounts
 Sales Return and Allowance Transaction:
 Sales returns
 Sales allowances
 Trade accounts receivable

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10-6
DOCUMENTS AND RECORDS
Customer sales order
 Credit approval form
 Open-order report
 Shipping document
 Sales invoice
 Sales journal
 Customer statement

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Accounts receivable
subsidiary ledger
 Aged trial balance of
accounts receivable
 Remittance advice
 Cash receipts journal
 Credit memorandum
 Write-off authorization

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10-7
FUNCTIONS IN THE
REVENUE PROCESS

Order entry: Acceptance of customer orders into
the system

Credit authorization: Approval of customer
orders for creditworthiness

Shipping: Shipment of authorized goods

Billing: Issuance of sales invoices to customers
for goods shipped or services rendered
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10-8
FUNCTIONS IN THE
REVENUE PROCESS

Cash receipts: Processing cash receipts from customers

Accounts receivable: Recording sales invoices, collections
and credit memoranda in customer accounts

General ledger: Proper accumulation, classification and
summarization of revenues, collections and receivables in
the financial statement accounts
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10-9
SEGREGATION OF DUTIES

Credit function should be segregated from Billing
function.

Shipping function should be segregated from
Billing function.

Accounts Receivable function should be segregated
from General Ledger function.

Cash Receipts function should be segregated from
Accounts Receivable function.
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10-10
INHERENT RISK ASSESSMENT

Industry-related factors.

Complexity of revenue recognition issues.

Difficulty of auditing transactions and accounts.

Misstatements detected in prior audits.
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10-11
CONTROL RISK ASSESSMENT
Understanding and documenting
the revenue process based
on the planned level of control risk
Planning and performing tests of controls
on revenue transactions
Assessing and documenting the
control risk for the revenue process
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10-12
CONTROL PROCEDURES AND
TESTS OF CONTROLS REVENUE TRANSACTIONS
Table 10-5 (page 387 – 388) -- Revenue Transactions
Objectives
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Misstatements
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10-13
CONTROL PROCEDURES AND
TESTS OF CONTROLS CASH RECEIPTS TRANSACTIONS
Table 10-6 (page 391) -- Cash Receipts Transactions
Objectives
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Misstatements
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10-14
CONTROL PROCEDURES AND TESTS
OF CONTROLS - SALES RETURNS AND
ALLOWANCES TRANSACTIONS

Credit memos can be used to conceal unauthorized
shipments or misappropriation of cash.

A credit memorandum should be approved by
someone other than the individual who initiated the
credit memorandum. (Segregation of Duties)

Credits for returned goods should be supported by a
receiving document indicating that the goods have
been returned. (Auditor should examine a sample)
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10-15
RELATING THE ASSESSED LEVEL
OF CONTROL RISK TO
SUBSTANTIVE TESTING

When the results of the tests of controls support the
planned assessed level of CR, the auditor can conduct
the substantive tests at the planned level.

If the results of the tests of controls do not support the
planned assessed level of CR, DR will have to be set
lower, and substantive tests increased.
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10-16
AUDIT OBJECTIVES FOR TESTING
ACCOUNTS RECEIVABLE








Validity
Completeness
Cutoff
Ownership
Accuracy
Valuation
Classification
Disclosure
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10-17
AUDITING ACCOUNTS RECEIVABLE
AND RELATED ACCOUNTS

Substantive tests that are used to detect material
misstatements in accounts receivable include:

Substantive tests of transactions

Analytical procedures

Tests of account balances
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10-18
SUBSTANTIVE TESTS OF
TRANSACTIONS
Substantive tests of transactions are tests conducted
on the individual transactions processed through the
revenue process to detect monetary misstatements
(Table 10-8 – Page 396).
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10-19
ANALYTICAL PROCEDURES
Analytical procedures are useful audit tests for
examining the fairness of accounts such as revenue,
accounts receivable, allowance for uncollectible
accounts, bad debt expense, and sales returns and
allowances.
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10-20
ANALYTICAL PROCEDURES REVENUE

Comparison of gross profit percentage by product
line with previous years and industry data.

Comparison of reported revenue to budgeted
revenue.
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10-21
ANALYTICAL PROCEDURES - ACCOUNTS
RECEIVABLE, ALLOWANCE FOR
UNCOLLECTIBLE ACCOUNTS
AND BAD DEBT EXPENSE





Comparison of receivables turnover and days outstanding
in accounts receivable to previous years’ and/or industry
data.
Comparison of aging categories on aged trial balance of
accounts receivable to previous years’.
Comparison of bad-debt expense as a percentage of
revenue to previous years’ and/or industry data.
Comparison of the allowance for uncollectible accounts as
a percentage of accounts receivable or credit sales to
previous years’ and/or industry data.
Examination of large customer accounts individually and
comparison to previous year.
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ANALYTICAL PROCEDURES –
SALES RETURNS, ALLOWANCES,
AND COMMISSIONS



McGraw-Hill/Irwin
Comparison of sales returns as a percentage of
revenue to previous years’ and/or industry data.
Comparison of sales discounts as a percentage of
revenue to previous years’ and/or industry data.
Estimation of sales commission expense by
multiplying net revenue by average commission rate
and comparison of recorded sales commission
expense.
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10-23
TESTS OF ACCOUNT BALANCES ACCOUNTS RECEIVABLE (Table 10-10)
Objectives
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Tests of Account Balance
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10-24
TESTS OF ACCOUNT BALANCES ACCOUNTS RECEIVABLE (Table 10-10)
Objectives
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Tests of Account Balance
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10-25
THE CONFIRMATION PROCESS
Confirmation is the process of obtaining and evaluating
a direct communication from a third party in response
to a request for information about a particular item
affecting financial statement assertions (AU 330).
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10-26
THE CONFIRMATION PROCESS ACCOUNTS RECEIVABLE
The
auditor will normally request confirmation of
accounts receivable during an audit.
Confirmations
address the following audit objectives:
Validity
Completeness
Cutoff
Valuation
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10-27
OMISSION OF CONFIRMATION OF
ACCOUNTS RECEIVABLE

The accounts receivable are immaterial to the
financial statements.

The use of confirmations would not be effective as
an audit procedure (e.g., past response rates were
low or the responses might not be reliable).

The auditor’s assessment of IR and CR is low, and
evidence gathered from other substantive tests is
sufficient to reduce audit risk to a low level.
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10-28
RELIABILITY OF ACCOUNTS
RECEIVABLE CONFIRMATIONS

McGraw-Hill/Irwin
Factors that affect the reliability of accounts
receivable confirmations:
 The type of confirmation request.

Prior experience on the client or similar
engagements.

The intended respondent.
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10-29
TYPES OF CONFIRMATIONS

Positive Confirmation (Exhibit 10-7 – Page 407)
 A response is required
 May use a “blank” form
 Used when fewer customer accounts with large
balances or when errors are anticipated (high
level of CR)
 Any non-responses require alternate procedures
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10-30
TYPES OF CONFIRMATIONS

Negative Confirmation (Exhibit 10-8 – Page 408)
 Response is required only if the customer disagrees
 Used when many customer accounts with small
balances, when CR is low, and when the auditor
believes the customers will devote adequate attention
to the confirmations
 Non-responses generally assumed to be valid A/R

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Can use a combination of Positive (for large balances)
and Negative (for small balances)
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10-31
TIMING OF ACCOUNTS
RECEIVABLE CONFIRMATIONS


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Interim
Year-end
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10-32
CONFIRMATION PROCEDURES

McGraw-Hill/Irwin
Maintain Control
 Minimize interference by client
 Auditor mails them directly with CPA’s address
as “return address”
 Can use fax if there are time pressures
 Responses should be addressed to CPA
 Maintain record of confirmations mailed and
returned
 Positive confirmations may require 2nd and 3rd
Requests
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10-33
CONFIRMATION PROCEDURES

Confirmation Exceptions (Table 10-12 – Page 409)
Exceptions
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Potential Cause
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10-34
ALTERNATIVE PROCEDURES

Examination of subsequent cash receipts.

Examination of customer orders, shipping
documents, and duplicate sales invoices.

Examination of other client documentation.
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AUDITING OTHER RECEIVABLES
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
Receivables from officers and employees.

Receivables from related parties.

Notes receivable.

These receivables are usually confirmed and
evaluated for collectibility.
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10-36
EVALUATING THE AUDIT FINDINGS ACCOUNTS RECEIVABLE AND
RELATED ACCOUNTS
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
Compare total projected misstatement to
tolerable misstatement.

Analyze misstatements for causes of errors.
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