CHAPTER 14 AUDITING THE REVENUE CYCLE Fall 2007 u Nature of the Revenue Cycle u Inherent Risk Factors u Audit objectives u Control Activities u Standard

CHAPTER 14CHAPTER 14AUDITING THE REVENUE CYCLEAUDITING THE REVENUE CYCLE

Fall Fall 20072007

CHAPTER 14CHAPTER 14AUDITING THE REVENUE CYCLEAUDITING THE REVENUE CYCLE

Fall Fall 20072007

Nature of the Revenue Cycle Inherent Risk Factors Audit objectives Control Activities Standard Substantive Tests

For a merchandising company, the classes of transactions in the revenue cycle include:1. credit sales (sales made on accounts),2. cash receipts (collections on accounts and

cash sales), and3. sales adjustments (discounts, sales

returns and allowances, and uncollectable accounts [provisions and writeoffs]).

Nature of the Revenue Nature of the Revenue CycleCycle

Nature of the Revenue Nature of the Revenue CycleCycle

Auditing the Revenue CycleAuditing the Revenue CycleAuditing the Revenue CycleAuditing the Revenue Cycle

Consider: How Can Revenue be Manipulated?

1. Pressures to overstate revenues to achieve announced revenue or profitability targets.

2. Pressures to overstate cash and gross receivables or understate the allowance for doubtful accounts for debt covenant working capital requirements.

3. Revenue recognition: ambiguous stds, estimates, complexity of the calculations, rights of return.

4. Receivables are factored with recourse: correct classification as a sale vs. a borrowing.

5. Cash receipts susceptible to misappropriation.6. Sales adjustments can conceal theft.7. Classification of AR as current vs. non-current

Inherent Risk Assessment and Inherent Risk Assessment and Fraud ConsiderationsFraud Considerations

Inherent Risk Assessment and Inherent Risk Assessment and Fraud ConsiderationsFraud Considerations

Understand the Client’s Business and Industry

1. Develop an expectation of total revenues

2. Develop an expectation of gross margin

3. Develop an expectation of net receivables

4. Understanding industry accounting practices.

Inherent Risk AssessmentInherent Risk AssessmentInherent Risk AssessmentInherent Risk Assessment

Consideration of IC: Obtaining an Understanding and

Assessing CR

Consideration of IC: Obtaining an Understanding and

Assessing CR•Control Environment•Risk Assessment•Information and Communication

– Initiate transactions– Deliver (receive) goods or services– Record Transactions– Consideration

•Control Activities•Monitoring

Credit Sales – Info & Commun.Credit Sales – Info & Commun.Credit Sales – Info & Commun.Credit Sales – Info & Commun.

Common Documents and Records• Customer Order• Sales Order• Shipping Documents (Bill of Lading and

Packing Slip)• Sales Invoice• Authorized Price List• Sales Journal• Customer Master File• Accounts Receivable Master File• Customer Monthly Statement

System Flowchart – Initiate Credit Sales

System Flowchart – Initiate Credit Sales

System Flowchart – Delivery of Credit Sales

System Flowchart – Delivery of Credit Sales

System Flowchart – Recording Credit Sales

System Flowchart – Recording Credit Sales

Cash Receipts – Info & Commun. Cash Receipts – Info & Commun. Cash Receipts – Info & Commun. Cash Receipts – Info & Commun.

Common Documents and Records• Remittance advice• Prelist• Cash count sheets• Daily cash summary• Validated deposit slip• Cash receipts journal

Control Activities — Control Activities — Sales Adjustment Sales Adjustment

TransactionsTransactions

Control Activities — Control Activities — Sales Adjustment Sales Adjustment

TransactionsTransactionsSales adjustment transactions involve

the following:1. Granting cash discounts2. Granting sales returns and

allowances (credit memo)3. Determining uncollectable accounts

(write-off authorization memo)

Substantive Tests of Substantive Tests of Revenues and ReceivableRevenues and Receivable

Substantive Tests of Substantive Tests of Revenues and ReceivableRevenues and Receivable

Important Concept: The sales that are most likely to represent potential misstatements are the uncollected sales. To design substantive tests for these accounts, the auditor must first determine the acceptable level of tests of details risk for each significant related objective.

Standard Substantive Tests Standard Substantive Tests for Revenues & Receivablesfor Revenues & ReceivablesStandard Substantive Tests Standard Substantive Tests for Revenues & Receivablesfor Revenues & Receivables

1. Initial procedures2. Analytical procedures3. Tests of transactions

a) Test details of sales transactionsb) Cut-off testing

– Sales– Cash Receipts– Credit Memos

4. Tests of balancesa) Confirmationsb) Estimates

5. Presentation and disclosure

Substantive Tests of Substantive Tests of Accounts ReceivableAccounts Receivable

Figure 14-9Figure 14-9

Substantive Tests of Substantive Tests of Accounts ReceivableAccounts Receivable


Analytical Procedures Commonly Used to Analytical Procedures Commonly Used to Audit the Revenue CycleAudit the Revenue Cycle


Analytical Procedures Commonly Used to Analytical Procedures Commonly Used to Audit the Revenue CycleAudit the Revenue Cycle


Substantive Tests Revenue and Substantive Tests Revenue and Receivables Cycle: Cut-off TestsReceivables Cycle: Cut-off TestsSubstantive Tests Revenue and Substantive Tests Revenue and Receivables Cycle: Cut-off TestsReceivables Cycle: Cut-off Tests

Objective: Ensuring recording of transactions in the correct period

Types:1. Sales2. Credit memos3. Cash receipts

Substantive Tests of AR: Substantive Tests of AR: ConfirmationsConfirmations


Confirm ReceivablesConfirmation of accounts receivable involves direct written communication between individual customers and the auditor. This substantive test is used extensively by the auditor.

Confirmation of receivables is a generally accepted auditing procedure which should be performed unless: 1. AR is immaterial to the financial

statements.2. The use of confirmations ineffective.3. Inherent risk and control risk are low

enough and analytical procedures expected to be effective enough to get audit risk to an acceptably low level.



Forms of ConfirmationThere are 2 forms of confirmation

request:1. the positive confirmation, which

requires the debtor to respond whether or not the balance shown is correct,

2. the negative confirmation, which requires the debtor to respond only when the balance shown is incorrect.

