Chapter 10Auditing the

Revenue Process

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Types of Transactions and Financial Statement Accounts

Affected

Three types of transactions are typically processed through the revenue process:

1. The sale of goods or rendering of a service for cash or credit.

2. The receipt of cash from the customer in payment for goods or services.

3. The return of goods by the customer for credit or cash.

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Types of Transactions and Financial Statement Accounts

AffectedThe revenue process affects numerous accounts in the financial statements. The most significant accounts are:

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Customer Sales Order

Contains the details of the type and quantity of products or services ordered by the customer.

Customer Sales Order

Contains the details of the type and quantity of products or services ordered by the customer.

Credit Approval Form

For credit sales, the client must have a formal procedure for investigating the creditworthiness of the customer.

Credit Approval Form

For credit sales, the client must have a formal procedure for investigating the creditworthiness of the customer.

Types of Documents and RecordsLO# 4

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Open-Order Report

A report of all customer orders for which processing has not been completed.

Open-Order Report

A report of all customer orders for which processing has not been completed.

Shipping Document

This document generally serves as a bill of lading and contains information on the type of product shipped, the quantity shipped, and other relevant information.

Shipping Document

This document generally serves as a bill of lading and contains information on the type of product shipped, the quantity shipped, and other relevant information.

Types of Documents and Records

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Sales Invoice

The document is used to bill the customer. This document contains information on the type of product or service, the quantity, the price, and the terms of trade.

Sales Invoice

The document is used to bill the customer. This document contains information on the type of product or service, the quantity, the price, and the terms of trade.

Sales Journal

Once a sales invoice has been issued, the sale needs to be recorded in the accounting records. The sales journal is used to record information about the sales transaction.

Sales Journal

Once a sales invoice has been issued, the sale needs to be recorded in the accounting records. The sales journal is used to record information about the sales transaction.

Types of Documents and RecordsLO# 4

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Customer Statement

This document is mailed to the customer and contains details of all sales, cash receipts, and credit memorandum transactions.

Customer Statement

This document is mailed to the customer and contains details of all sales, cash receipts, and credit memorandum transactions.

Accounts Receivable Subsidiary Ledger

This ledger contains an account and the details of transactions for each customer.

Accounts Receivable Subsidiary Ledger

This ledger contains an account and the details of transactions for each customer.

Types of Documents and Records

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Aged Trial Balance of Accounts Receivable

This report summarizes all the customer balances in the accounts receivable subsidiary ledger. Each account is classified as current or placed into one of several past due categories.

Aged Trial Balance of Accounts Receivable

This report summarizes all the customer balances in the accounts receivable subsidiary ledger. Each account is classified as current or placed into one of several past due categories.

Remittance Advice

This is usually the part of the customer’s bill that should be returned with the payment.

Remittance Advice

This is usually the part of the customer’s bill that should be returned with the payment.

Types of Documents and Records

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Cash Receipts Journal

This journal is used to record the cash receipts of the entity.

Cash Receipts Journal

This journal is used to record the cash receipts of the entity.

Credit Memorandum

This document is used to record credits for the return of goods by a customer.

Credit Memorandum

This document is used to record credits for the return of goods by a customer.

Types of Documents and Records

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Write-Off Authorization

This document authorizes the write-off of an uncollectible account receivable. Final authorization is generally received from the treasurer.

Write-Off Authorization

This document authorizes the write-off of an uncollectible account receivable. Final authorization is generally received from the treasurer.

Types of Documents and RecordsLO# 4

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The Major FunctionsFunctions of the Purchasing Process

Order entry Acceptance of customer orders for goods and services into the system in accordance with management criteria.

Credit authorizationAppropriate approval of customer orders for creditworthiness.

Shipping Shipping of goods that has been authorized.

BillingIssuanace of sales invoices to customers for goods shipped or services provided; also, processing of billing adjustments for allowances, discounts, and returns.

Cash receipts Processing of the receipt of cash from customers.

Accounts receivableRecording of all sales invoices, collections, and credit memoranda in individual customer accounts.

General ledgerProper accumulation, classification, and summarization of revenues, collections, and recivables in the financial statement accounts.

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Key Segregation of DutiesLO# 6

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Inherent Risk Assessment

The four inherent risk factors that may affect the revenue process are:1. Industry-related factors.

2. The complexity and contentiousness of revenue recognition issues.

3. The difficulty of auditing transactions and account balances.

4. Misstatements detected in prior audits.

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Control Risk Assessment

Understand and document the revenue process based on a reliance approach.

Plan and perform tests of controls on revenue transactions.

Set and document the control risk for the revenue process.

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Plan and Perform Tests of Controls

The auditor systematically examines the client’s revenue process to identify relevant controls that help to prevent,

or detect and correct, material misstatements.

In order to properlyset control risk theauditor must testcontrols over therevenue process.Such tests may

include . . .

In order to properlyset control risk theauditor must testcontrols over therevenue process.Such tests may

include . . .

Inquiry of client personnel.

Inspection of documents and records.

Observations of the operation of the control.

Walkthroughs.

Reperformance of the control procedures.

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Control Activities and Tests of Controls – Revenue Transactions

Assertions about Classes of Transactions and Events for the Period under Audit

OccurrenceAll revenue and cash receipt transactions and events that have been recorded have occurred and pertain to the entity.

Completeness All revenue and cash receipt transactions and events that should have been recorded have been recorded.

AuthorizationAll revenue and cash receipts transactions and events are properly authorized.

AccuracyAmounts and other data relating to recorded revenue and cash receipt transactions and events have been recorded appropriately.

Cutoff All revenue and cash receipt transactions and events have been recorded in the correct accounting period.

Classification All revenue and cash receipt transactions and events have been recorded in the proper accounts.

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Occurrence of Revenue Transactions

The auditor is concerned about two major types of material misstatements:1. Sales to fictitious customers.

2. Recording revenue when goods have not been shipped or services have not been performed.

The auditor needs assurance that all recordedrevenue transactions are valid.

The auditor needs assurance that all recordedrevenue transactions are valid.

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Completeness of Revenue Transactions

The major misstatement that concerns both management and the auditor is that goods are

shipped or services are performed and no revenue is recognized.

The major misstatement that concerns both management and the auditor is that goods are

shipped or services are performed and no revenue is recognized.

Controls concerning completeness include: (1) accounting for numerical sequence of shipping documents and sales invoices, (2) matching shipping documents with sales invoices, (3) reconciling sales invoices to daily sales reports, and (4) maintaining and reviewing the open-order file.

Controls concerning completeness include: (1) accounting for numerical sequence of shipping documents and sales invoices, (2) matching shipping documents with sales invoices, (3) reconciling sales invoices to daily sales reports, and (4) maintaining and reviewing the open-order file.

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Authorization and Accuracy of Revenue Transactions

Possible misstatements due to improper authorization include shipping goods to, or performing services for,

customers who are bad credit risks and making sales at unauthorized prices or terms.

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The presence of an authorized price list and terms of trade reduces the risk of

inaccuracies. The sales invoice should also be verified for mathematical accuracy before

being sent to the customer.10-20

Cutoff and Classification of Revenue Transactions

Sales may be recorded in the wrong accounting period unless proper controls are in place. All

shipping documents should be forwarded to the billing department daily.

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The use of a chart of accounts and proper codes for recording transactions should provide

adequate assurance about the proper classification of revenue transactions.

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Occurrence of Cash Receipts Transactions

The possible misstatement that concerns the auditor when considering the occurrence

assertion is that cash receipts are recorded but not deposited in the client’s bank account.

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Completeness of Cash Receipts and Authorization of Discounts

A major misstatement is that cash or checks are stolen or lost before being recorded in the cash

receipts records. Proper segregation of duties and a lockbox system are strong controls relating to

completeness.

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2/10, n/302/10, n/30Terms of trade generally include discounts for payment within a specified period as a way of

encouraging customers to pay on time.10-23

Accuracy of Cash TransactionsThe wrong amount of cash could be recorded

from the remittance advice, or the receipt could be incorrectly processed during data entry. To

minimize these types of errors, daily remittance reports should be reconciled to a control listing of remittance advices. All bank statements should be

reconciled monthly.

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Cutoff and Classification of Cash Receipts Transactions

If the client uses a lockbox system or if cash is deposited daily in the bank, there is a small

possibility of cash being recorded in the wrong accounting period.

LO# 9

The auditor seldom has major concerns about cash receipts being recorded in the wrong

financial statement account.10-25

Control Activities and Tests of Controls – Sales Returns and

AllowancesSales returns and allowances is usually not a material amount in the financial statements. However, credit memoranda that are used to

process sales returns can also be used to cover an unauthorized shipment of goods or conceal a misappropriation of cash. As a result, all credit

memoranda should be properly authorized.

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Relating the Assessed Level of Control Risk to Substantive

ProceduresThe auditor’s testing of controls for revenue processing impacts the detection risk and

therefore the level of substantive procedures impacted by the controls.

CashAccountsreceivable

Allowancefor baddebts

Bad debtsexpense

Sales returnsand

allowances

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Auditing Accounts Receivable and Related Accounts

Substantive analytical procedures are used to examine plausible relationships among accounts receivable and

related accounts.

Substantive analytical procedures are used to examine plausible relationships among accounts receivable and

related accounts.

Tests of details focus on transactions, account balances, or disclosures. Tests of details concentrate on the

ending balance for accounts receivable and related accounts as well as related disclosures.

Tests of details focus on transactions, account balances, or disclosures. Tests of details concentrate on the

ending balance for accounts receivable and related accounts as well as related disclosures.

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Substantive Analytical Procedures

Ratios used for comparative purposes include:

Ratios used for comparative purposes include:1. Receivables turnover and days outstanding

in accounts receivable.

2. Aging categories on aged trial balance of accounts receivable.

3. Bad-debts expense as a percent of revenue.

4. Allowance for uncollectible accounts as a percent of accounts receivable or credit sales.

5. Large account balances compared to last period.

1. Receivables turnover and days outstanding in accounts receivable.

2. Aging categories on aged trial balance of accounts receivable.

3. Bad-debts expense as a percent of revenue.

4. Allowance for uncollectible accounts as a percent of accounts receivable or credit sales.

5. Large account balances compared to last period.

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Tests of Details of Transactions, Account Balances, and Disclosure

OccurrenceA sample of transactions from the sales journal should be traced to the sales invoice, customer order, and shipping document.

Completeness A sample of shipping documents should be traced to related sales invoice and customer's account.

Authorization and Accuracy

Compare prices and terms for sample of sales invoices with authorized price list.

Cutoff From a sample, compare date of sales invoice with date of shipment and date sale was recorded.

Classification For a sample of sales invoices, determine that each is properly classified in the revenue accounts.

For Accounts Receivable, Allowance for Uncollectible Accounts, and Bad-Debt Expense

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Completeness and Accuracy

The auditor’s primary concern is whether all accounts receivable have been included in the accounts receivable subsidiary ledger and the general ledger accounts receivable account.

Reconciliation of the aged trial balance to the general ledger account should detect an omission of a receivable from either the subsidiary or general ledger.

Reconciliation of the aged trial balance to the general ledger account should detect an omission of a receivable from either the subsidiary or general ledger.

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CutoffThe cutoff test attempts to determine whether all

revenue transactions and related accounts receivable are recorded in the proper period.

12/31/10

Test a few shipping documents just prior to year-end.

Test a few shipping documents just after year-end.

Are all transactions tested recorded in the proper period?

Are all transactions tested recorded in the proper period?

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Existence and Rights and Obligations

Existence is one of the more important assertions for accounts receivable because the auditor wants assurance

that this account balance is not overstated through the inclusion of fictitious customer accounts or amounts.

Confirmation is the major audit procedure used for testing this assertion.

LO# 13

The auditor must determine that all accounts receivables are owned by the entity. This is usually not a problem,

however, in some cases, accounts receivable may be sold or factored with or without recourse.

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Omitting Confirmations

Accounts receivable are immaterial. The use of confirmations would not

be effective. IR and CR are assessed “low” and

evidence gathered from other substantive tests is sufficient to reduce AR to an acceptably low level.

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Types of Confirmations

Positive Confirmation

Requests that customers indicate whether they agree with the amount due to the client. A response is expected whether the customer agrees or disagrees with the balance indicated.

Positive Confirmation

Requests that customers indicate whether they agree with the amount due to the client. A response is expected whether the customer agrees or disagrees with the balance indicated.

Negative Confirmation

Requests that the customer respond only when they disagree with the amount due to the client. Negative confirmations are used when the client has many small account balances and control risk is assessed as low.

Negative Confirmation

Requests that the customer respond only when they disagree with the amount due to the client. Negative confirmations are used when the client has many small account balances and control risk is assessed as low.

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Confirmation Procedures

The auditor should mail the confirmation requests outside the client’s facilities. A record should be maintained of the confirmations mailed and those returned. A second request may be necessary in some cases.

For each exception received, the auditor should examine the reasons for the difference between the balance on the client’s books and the balance indicated by the customer.

For each exception received, the auditor should examine the reasons for the difference between the balance on the client’s books and the balance indicated by the customer.

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Alternative Procedures

When the auditor does not receive responses to positive confirmations, alternative audit procedures are used. These alternative

procedures include:

When the auditor does not receive responses to positive confirmations, alternative audit procedures are used. These alternative

procedures include:1. Examination of subsequent cash receipts.

2. Examination of customer orders, shipping documents, and duplicate sales invoices.

3. Examination of other client documentation.

1. Examination of subsequent cash receipts.

2. Examination of customer orders, shipping documents, and duplicate sales invoices.

3. Examination of other client documentation.

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Valuation and Allocation

Accounts receivable should be shown on the balance sheet at net realizable value (gross amount

less allowance for uncollectible accounts).

The auditor must verify the adequacyof the allowance for uncollectibleaccounts. The first step is to prepare anaged trial balance and discuss resultswith the credit manager. Next, a comparison with last year’s results should be examined.

The auditor must verify the adequacyof the allowance for uncollectibleaccounts. The first step is to prepare anaged trial balance and discuss resultswith the credit manager. Next, a comparison with last year’s results should be examined.

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Evaluating the Audit FindingsWhen the auditor has completed the planned

substantive procedures, the likely misstatement (projected misstatement plus an allowance for

sampling risk) for accounts receivable is determined.

Likely misstatementless than tolerable

misstatement

Likely misstatementgreater than tolerable

misstatement

Accept the accountas fairly presented.Accept the accountas fairly presented.

Account is not fairlypresented.

Account is not fairlypresented.

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