CHAPTER CHAPTER 14 14 AUDITING AUDITING THE THE REVENUE REVENUE CYCLE CYCLE Fall Fall 2007 2007  Nature of the Revenue Cycle  Inherent Risk Factors  Audit objectives  Control Activities  Standard Substantive Tests Nature Nature of of the the Revenue Revenue Cycle Cycle For a merchandising company, the classes of transactions in the revenue cycle include: credit sales (sales made on accounts), cash receipts (collections on accounts and cash sales), and sales adjustments (discounts, sales returns and allowances, and uncollectable accounts [provisions and writeoffs]) Auditing Auditing the the Revenue Revenue Cycle Cycle Consider: How Can Revenue be Manipulated? Inherent Inherent Risk Risk Assessment Assessment and and Fraud Fraud Considerations Considerations Pressures to overstate revenues to achieve announced revenue or profitability targets Pressures to overstate cash and gross receivables or understate the allowance for doubtful accounts for debt covenant working capital requirements Revenue recognition: ambiguous stds, estimates, complexity of the calculations, rights of return Receivables are factored with recourse: correct classification as a sale vs a borrowing Cash receipts susceptible to misappropriation Sales adjustments can conceal theft Classification of AR as current vs non-current Inherent Inherent Risk Risk Assessment Assessment Understand the Client’s Business and Industry Develop an expectation of total revenues Develop an expectation of gross margin Develop an expectation of net receivables Understanding industry accounting practices Consideration Consideration of of IC: IC: Obtaining Obtaining an an Understanding Understanding and and Assessing Assessing CR CR •Control Environment •Risk Assessment •Information and Communication – – – – Initiate transactions Deliver (receive) goods or services Record Transactions Consideration •Control Activities •Monitoring Credit Credit Sales Sales –– Info Info & & Commun 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 System Flowchart Flowchart –– Initiate Initiate Credit Credit Sales Sales System System Flowchart Flowchart –– Delivery Delivery of of Credit Credit Sales Sales System System Flowchart Flowchart –– Recording Recording Credit Credit Sales Sales Substantive Substantive Tests Tests of of Accounts Accounts Receivable Receivable Figure Figure 14-9 14-9 Analytical Analytical Procedures Procedures Commonly Commonly Used Used to to Audit Audit the the Revenue Revenue Cycle Cycle Figure Figure 14-4 14-4 Substantive Substantive Tests Tests Revenue Revenue and and Receivables Receivables Cycle: Cycle: Cut-off Cut-off Tests Tests Objective: Ensuring recording of transactions in the correct period Types: Sales Credit memos Cash receipts Substantive Substantive Tests Tests of of AR: AR: Confirmations Confirmations Confirm Receivables Confirmation of accounts receivable involves direct written communication between individual customers and the auditor This substantive test is used extensively by the auditor Substantive Substantive Tests Tests of of AR: AR: Confirmations Confirmations Confirmation of receivables is a generally accepted auditing procedure which should be performed unless: AR is immaterial to the financial statements The use of confirmations ineffective 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 Substantive Substantive Tests Tests of of AR: AR: Confirmations Confirmations Forms of Confirmation There are forms of confirmation request: the positive confirmation, which requires the debtor to respond whether or not the balance shown is correct, the negative confirmation, which requires the debtor to respond only when the balance shown is incorrect ... Pressures to overstate cash and gross receivables or understate the allowance for doubtful accounts for debt covenant working capital requirements Revenue recognition: ambiguous stds, estimates,... receivables Understanding industry accounting practices Consideration Consideration of of IC: IC: Obtaining Obtaining an an Understanding Understanding and and Assessing Assessing CR CR •Control Environment... positive confirmation, which requires the debtor to respond whether or not the balance shown is correct, the negative confirmation, which requires the debtor to respond only when the balance shown