Rittenberg/Schwieger/Johnstone
Auditing: A Business Risk Approach
Sixth Edition
Chapter 11
Auditing Revenue and
Related Accounts
Copyright © 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo,
and South-Western are trademarks used herein under license.
1
Why are revenue cycle accounts
important?
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
2
What is the cycle approach?
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
3
List the Financial Transactions
Processing Cycles
Revenue
Acquisition and payment of goods
and services
Payroll
Financing: debt and equity
Cash and short-term investments
4
Overview of the Revenue Cycle
(Sales made on Account)
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
5
Discuss 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
6
Some Improper Revenue
Recognition Schemes
 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
7
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
8
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
9
Assessment of
Environment Risk
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
10
Assessment of
Environment Risk (continued)
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
11
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
12
Inherent Risk with
Regard to Sales (continued)
Impact of any unusual sales terms and whether
title passed to customer
Example: related party transactions
Goods recorded as sales have 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
13
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
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
14
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
15
Understanding Internal Controls
Although the auditor must understand all
components of internal controls, particular
attention is paid to significant control procedures
and monitoring controls
The auditor obtains an understanding of the
controls by
Walk-through of the processing of transactions
Inquiry
Observation
Review of client documentation
It is critical this understanding be documented in
the work papers
16
Understanding Internal Controls
(continued)
Internal control procedures should be sufficient to
ensure the management assertions are
achieved:
Existence/Occurrence: sales are recorded only
when shipment has occurred and the primary
revenue producing activity has been performed
Completeness: all valid sales transactions are
recorded
Rights/obligations
Valuation
Presentation and disclosure
17
What are the three components
of evaluating control risk?
1. Monitoring Controls
2. Control Structure for Returns,
Allowances, and Warranties
3. Importance of Credit Policies
Authorizing Sales
18
Monitoring Controls
Designed to signal failures in transaction processing, and
determine if timely, corrective action is taken
Monitoring controls applicable to revenue transactions
include:
 Compare sales and cost of good sold with budgeted
amounts
 Exception reports generated to identify unusual
transactions
 Internal audit of revenue cycle controls
 Computer reconciliation of transactions entered with
transactions processed
 Monitoring of accounts receivable for quality
 Independent follow-up on customer complaints
 Audits of sales tax collections
19
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
20
Documenting, Testing, and
Assessing Environment Risk
(continued)
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
assessment is unchanged
21
Linking Environment Risk
Assessment & Substantive Testing
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:
1. The nature of the accounting system, controls used,
and documents generated in the client's processing
2. Existence of fraud risk factors
3. Effectiveness of controls and types of misstatements
likely to occur
22
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
23
What are some substantive tests
of revenue?
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
24
Substantive Tests of Revenue
for Occurrence, Accuracy, and
Valuation
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
25
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
26
Substantive Tests of Revenue
Cutoff Tests
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
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
27
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
28
Substantive Tests of Accounts
Receivable Existence & Occurrence
Valuation
Are sales and receivables initially recorded at their
correct amount?
Will client collect full amount of recorded receivables?
Rights and Obligations
Contingent liabilities associated with factor or sales
arrangements
Discounted receivables
Presentation and Disclosure
Pledged, discounted, assigned, or related party
receivables
29
Substantive Tests of
Accounts Receivable
Obtain and evaluate aging of
accounts receivable
Confirm receivables with customers
Perform cutoff tests
Review subsequent collections of
receivables
30
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
If schedule is prepared by client, it is tested for mathematical
and aging accuracy
Aging schedule can be used to
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
31
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
32
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
33
Types of Confirmations (continued)
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
34
What is the follow-up procedures
for non-responses?
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
Examine the cash receipts journal for cash collected
after year-end
Care is taken to ensure receipt is year-end receivable, not
subsequent sale
Examine documents supporting receivable (purchase
order, sales invoice, shipping documents) to
determine if sale occurred prior to year-end
Evidence gathered from internal documents is not considered
as reliable
35
What is the follow-up procedures
for exceptions noted?
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
Because misstatements are projected to the
population of receivables, the auditor must
determine the reason for the exception
36
Related-Party Receivables
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
37
Sold, Discounted, and Pledged
Receivables
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
38
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
 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 just before or after year-end
39
Fraud Indicators and
Audit Procedures (continued)
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
40
Explain 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
account
41