Audit of the Revenue Cycle

Test of Controls

Typical Transactions in the Sales and Collection Cycle

Five major classes of Transactions:• Sales

• Cash receipts

• Sales returns and allowances– Technically two distinct transactions

• The write-off of uncollectible accounts

• Bad-debt expense

2

An Overview of Functions, Documents, and Accounting Systems

• Order Entry Department– The starting point

23

Sales order 1

3

Signed by the customer, except for telephone or

internet orders.

Credit Manager signs the sales order for credit

approval

It is important to notice the separate departments. It shows good segregation of duties.

= Good control point

By phone, internet or

mail

Okra Development Corp. Copy

8924 Bailey Road Purchase Order 6-3378Salem, OR 92117 Date: August 5, 201X

Ship By: September 12, 201XTerms: 2/10, n/30

FOB Shipping PointTo: Ship to: Faragut Sales, Inc. Okra Development Corp.3812 Briar Drive 8924 Bailey Road, Salem, OR 92115 Salem, OR 92117

Quantity

10

Number

Model 317

Price

48.00

Amount

480.00

Description

Roller Bearing for

Model 3118 Ripper

Purchase order number must appearon all shipments and invoices Ordered By

Margaret Spangler

4

5

Prenumbered Sales Order. Controlled numerically

• Shipping involves the Shipping Department

Approved Sales Order

Prepare Multi-Part Bill of Lading

Order Entry

Common Carrier

Customer

Billing and A/R

6

Approved by Credit Manager.

Always useful to have a numerical file. Kept in

Shipping. Dept.

A legal document that the carrier is required to have.

7

Prenumbered Bill of Lading. Controlled numerically

• Sales order & Bill of Lading goes to• Billing/Accounts Receivable Department

Prepare Sales Invoice & Sales

Summary

SO

BL

INV

INV

INV

Shipping Department

N

Cost Department for Perpetual Inventory

Customer

Sales Summary

General Accounting

8

A numerical file that shows approval of the sale, proof of shipment, and billing. Good for testing internal controls.

Summary by invoice number.

AuthorizedPrice List

Pricing checked. Account coding

checked.

Faragut Sales, Inc. D8-9912Copy

3812 Briar Drive, Salem, OR 92115

Sales Invoice

Sold Shipped to Freight Bill No.Okra Development Corp. 8924 Bailey Road 229-2374418924 Bailey Road Salem, OR 92117Salem, OR 92117

FOB Shipping Point

10 Model 317 48.00 480.00

Quantity We are pleased to serve you Price Amount

Pricing and Math J.D.Account CodingS.A.L.

9

Key controls. Initials are evidence of control being performed. In

total or sample.

Prenumbered Sales Invoice. Controlled numerically

10

Remittance Advice

Remittance Advice

• Cash Collection• Receptionist/Mail Room Clerk

Prepare List of Cash Received

(2 copies)

Invoice Copy

Cheque

Customer

Invoice

Cheque

List

List

Control Copy to General Accounting

Cashier

11

Deposits prepared by a person separate from the one who opens the mail.

Two separate listing going to two different

places for later cross checking

12

Notice the complete details on the

remittance Advice

If the remittance advice is not returned, the person opening the mail should prepare one so that each cheque received is represented by a remittance advice complete with all pertinent details.

15642September 5, 201X

Cash Receipts ListingFountain City Warehouse x,400.00

Charlotte Sawyers, Inc. x,295.00

Brown, Inc. 1,200.00

Okra Development Corp. x,470.40

Toil Incorporated x,490.00

Harreleson Hardware 1,872.80

Barnaby Sales, Inc. x,982.00

Hartfords x,x92.00

5,802.20

Preparer

J.T.Lockett September 5, 201X

Cash SummaryCash Receipts Listing 5,802.20

Over-the-counter cash receipts 3,130.40

8,932.60

x,120.00

x,x98.32

x,x23.66

x,842.33

x,988.11

3,130.40

Adding Machine Tape

13

All cash receipts should be listed on the pre-listing from the remittance advices.

Also called a pre-listing of cash receipts

Remittance Advice

Remittance Advice

• Cash must be deposited in the Bank • Cashier

14

Once again, a separate dept.

Distribution going to separate depts. For

reconciliation

All cash receipts should be deposited daily

Prepare Deposit Slip & Cash

Receipts Summary

List of Receipts

Invoice Copies

Cheques

Mail Clerk

List of Receipts

CR Summary

CR Summary

Cheques

Deposit Slip

General Accounting

A/R to update A/R Sub-Ledger

Bank

15

Prepared by cashier, separate from the receipt of cash by

Receptionist

P.L. Initialed by cashier

Page 112 CASH RECEIPTS JOURNAL

Date Customer Name Cash Sales Account ReceivableDiscount Credit

August 25 Okra Development Corp. 470.40 9.60 480.00

16

• The Accounts Receivable Sub-Ledger must be updated• A/R Department

17

Daily remittance list compared to duplicate deposit slip received from bank by person independent of either function.

Duplicate Deposit Slip

Remittance Advice

Post to the Customer Account & Prepare

Trial Balance

List of Receipts

CR Summary

Trial Balance

General Accounting for comparison to the G/L

D

Notice that the posting to the accounts is separate from

collection of cash, and deposit in the bank.

Bank

Subsidiary customer

accounts posted from remittance

advices.

Cashier

• The Role of General Accounting

Post to the General Ledger

Sales Summary

A/R Dept.

List of Receipts

CR Summary

Mail Clerk

Cashier

18

Post to the general ledger using data

obtained from other depts.

Subsidiary customer accounts posted from remittance advices.

There should be a monthly reconciliation of control account to customers' individual accounts and bank statement reconciled promptly.

Typical Documents and Records• Sale is initiated with a

• What documents accompany the sale?

• Routine reports– include a sales journal

– aged accounts receivable trial balance

– Anything else?

19

The Accounts of the Sales and Collection Cycle

Gross sales

CashSales

Sales onAccount

Accounts receivable

Cash receipts

Sales returns and allowances

Charge-off of uncollectible accounts

Beginning balance

Sales on account

Ending balance

Allowance for uncollectible accounts

Beginning balance

Bad debts

Ending balance

Charge off of uncollectible accounts

Cash in bank

Cash discounts taken

Bad debts

Sales returns and allowances

20

Methods of Recording Transactions

• Manual recording

• Entered in batches

• Recorded one transaction at a time

21

Control Differences Between Batch and Online Systems

Batch systems:• Transactions readily

traced

• Groups of transactions are totaled

Online systems:• Transactions recorded one

at a time

• Document sequencing is important

22

Batch systems:• one erroneous transaction

• Error follow-up is required

Online systems:• Focus is on preventing

errors

• Input edit check for valid customer data and reasonableness

Control Differences For Error Detection and Correction

23

Batch and Online Systems: Segregation of Duties

Batch systems:• Separate

• Reconciliation and error follow-up

Online systems:• In decentralized systems

• Use passwords to separate

24

Risk Assessment and the Sales CycleWhy do risk assessment?

Remember that as risk increases

Risk Type Impact upon Sales and Collection Cycle

Client business risk Increased client business risk could lead to greater risks of misstatement of sales.

Audit risk As audit risk decreases, the level of assurance required increases, and the extent of testing required increases.

Inherent risk - overall As inherent risk increases, the extent of testing required increases; inherent risks associated with the handling of cash directly affect certain audit assertions in sales (e.g. completeness).

Risk of material misstatement - overall

Management biases due to bonus incentives or stated earnings forecasts could increase the extent of testing.

Risk of fraud - overall Poor fraud risk management could result in increased risk of fraud, with a need to increase the extent of testing.

Identify significant risks Revenue recognition is considered a significant risk unless the auditor has evidence to the contrary; this means that controls over revenue recognition need to be assessed and increased testing is required of assertions that affect revenue recognition.

25

Effect of General Controls• General controls

– Are pervasive and affect multiple transaction cycles

– Typical examples of general controls

26

• If general controls are good,– the auditor may be able to rely upon them

• If general controls are poor

27

Methodology for Designing Tests of Controls for Sales

Understand general controls - sales

Understand internal control and evaluate design effectiveness - sales

Assess planned control risk; identify and assess risks of

material misstatement - sales

Evaluate cost-benefit of testing controls

Design tests of controls for sales to meet transaction-

related audit objectives

Audit procedures

Sample size

Items to select

Timing

By assertion:

28

Documentation of Internal Controls• Internal controls need to be documented

• The auditor focuses on

• What type of controls can these be?

29

Key Controls for Sales• Segregation of Duties

– requires that different individuals be assigned responsibility for different elements of related activities, particularly those involving authorization, custody, or recordkeeping

• Authorization– Proper authorization of transactions and activities helps ensure that all company activities adhere to established

guide lines unless responsible managers authorize another course of action.

• Documents and Records– Adequate documents and records provide evidence that financial statements are accurate.

30

• Internal verification– Independent checks on performance, which are carried out by employees who did not do the work being

checked, help ensure the reliability of accounting information and the efficiency of operations.

• Prenumbered documents

• Monthly statements

31

• Application Controls– These are computer internal controls– Edit checks for key fields can be verified by classifying the transactions on the values for the field.

32

Tests of Internal Controls

• Once the key controls have been identified, the auditor can decide

• Tests of internal controls will be devised for

33

Examples of Internal Control using the Occurrence Assertion

• Manual Control

• Key control: credit is approved before shipment takes place.– The manual control?

• Possible test of control

34

Automated Batch• Occurrence assertion

• Key control: Orders causing balances to exceed credit limits are printed on an exception report

• Possible test of control:

35

Automated Online• Occurrence assertion

• Key control: Orders causing balances to exceed credit limits are held in a separate transaction file

• Possible test of control:

36

Interdependent• Occurrence Assertion

• Key control: Orders causing balances to exceed the credit limit are printed on an exception report and must be approved by a credit manager

• Possible test of control:

37

Manual, Automated and Interdependent Controls

From the previous examples, it can be seen that:– Manual controls are controls performed entirely by people

– Automated controls (batch or online) are performed only by computerized systems

– Interdependent controls rely upon computer processes (automation) but a person must also be involved to fully perform the control

38

Direction of Testing

Tracing

Vouching

39

• Tracing– Goes from the start of the transaction to the posting

– Is this a test for overstatement or understatement of sales?

• Vouching– Goes from the general ledger or sales journal back to the original

document

40

Typical Concerns for Tests of Sales

1. Recorded sales occurred– Occurrence

– Auditor is concerned with following possible misstatements• Recorded sale for which there was no shipment

• Sale recorded more than once

• Shipment made to non-existent customer

41

2. Existing sales transactions are recorded– Completeness assertion

– Want to test for unbilled shipments

– Are shipping documents complete?

3. Recorded Sales are accurately recorded– Measurement assertion

42

4. Recorded sales are properly classified• Ensure correct entry into the general ledger

5. Sales transactions are properly updated in the master file and correctly summarized• Accuracy of the master file is essential

6. Sales are recorded on the correct dates• Sales must be billed as soon as shipment takes place

• Remember all the tests can be dome with the same sample of sales invoices and shipping documents

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Typical Controls and Tests for Cash ReceiptsTransaction-Related Audit Objective Key Internal Control General Tests of Controls Quantitative/Dual-Purpose Test of Controls

Recorded cash receipts are for funds actually received by the company (occurrence)

Separation of duties between handling cash and record keeping or data entry

Independent reconciliation or review of bank accounts.

Observe separation of duties.

Observe independent reconciliation of bank account.

Review the cash receipt journal, general ledger, and accounts receivable master file or trial balance for large and unusual amounts.Trace from cash receipts listing to duplicate deposit slip and bank statements

Cash received is recorded in the cash receipts journal (completeness).

Separation of duties between handling cash and record keeping.Use of remittance advices or a prelisting of cash.Immediate endorsement of incoming cheques.Internal verification of the recording of cash receipts.Regular monthly statements to customers.

Discussion with personnel and observation.As above.

Observe immediate endorsement of incoming cheques.Examine indication of internal verification.Observe whether monthly statements are sent to customers.

Trace from remittances or prelisting to duplicate bank deposit slip and cash receipts journal.Review reconciliation reports of credit card or electronic funds transfer receipts.

Cash receipts are deposited and recorded at the amount received (accuracy).

Approval of cash discounts.

Regular reconciliation of bank accounts.Comparison of batch totals with duplicate deposit slips and computer summary reports.

Examine remittance advices for proper approval.Review monthly bank reconciliations.Examine file of batch totals for initials of data control clerk; compare totals with summary reports.

Examine remittance advices and sales invoices to determine whether discounts allowed are consistent with company policy.

Cash receipts are properly classified (classification).

Use of adequate chart of accounts or automatic posting to specified accounts.

Review chart of accounts and computer-assigned posting accounts.

Examine documents supporting cash receipts for proper classification.

Cash receipts are properly included in the customer master file and are correctly summarized (posting and summarization).

Regular monthly statements to customers.Use of properly approved master file change forms.Comparison of customer master file or aged accounts receivable trial balance totals with general ledger balance.

Observe whether statements are mailed.

Examine master file change forms for proper authorization.Examine documentation verifying that comparison was complete,

Foot journals, and trace postings to general ledger and accounts receivable master file.

Cash receipts are recorded on correct dates (timing).

Procedure requiring recording of cash receipts on a daily basis.

Observe unrecorded cash at any point in time.

Compare dates of deposits with dates in the cash receipts journal.

44

Frequency of Testing of Internal Controls

• Is an auditor allowed to use the results of prior testing in a current audit?

• In this case, which type of controls must be tested annually?

• Which type of controls could potentially be tested every three years?

45

Testing of Interdependent Controls

• The interdependent control has two parts:– A function performed– A function performed

• It is only possible to rely upon the automated function if:

• Both parts of the control must be tested to enable

46

What if Control Testing Yielded Many Errors?

• The first step is to determine whether the errors or exceptions– were due to a particular circumstance

– or restricted to a particular time period

47

• If the errors are systemic

• If this alternative control achieves the same purpose and is functioning correctly

• If no compensating control?

48

Material Error

• If there is no compensating control

• Want to quantify the extent of the error.

49

Results of Quantifying the Error

• If it turns out that the results of the weakness could result in immaterial error

• If a material error could result

50

Performing the Audit Program

• The initial audit program is organized by audit assertion

• In performing for maximum efficiency

• The use of automated working paper software facilitates this process.

51

Computer-Assisted Audit Tests

• Where there are a large number of transactions

• E.g. In internal controls testing, the auditor could use automated sampling routines

52

Suitability of Test Data

• Batch systems: – Test data may be inappropriate

• Online systems– Test data is useful

53

Suitability of Generalized Audit Software

• Best suited for analytical review, tests of detail, or dual-purpose tests, for example:

54

Problem 11-1, Page 472Cash Receipts: Control Objectives and Control ExamplesRequired:Prepare a table similar to Exhibit 11-4 on internal control for cash receipts.

55

General Specific

Validity 1

Completeness 2

Authorization 3

Accuracy 4 .

Classification 5

Accounting 6

Proper period 7

Problem 2The following are auditor judgments and audit sampling results for six populations. Assume large population sizes.

1 2 3 4 5 6

EPER (in percentage) 2 0 3 1 1 8

TER (in percentage) 6 3 8 5 20 15

ARACR (in percentage) 5 5 10 5 10 10

Actual sample size 100 100 60 100 20 60

Actual number of exceptions in the sample

2 0 1 4 1 8

REQUIREDa.For each population, did the auditor select a smaller sample size than is indicated by using attribute sampling tables for determining sample size? Evaluate, selecting either a larger or smaller size than those determined in the tables.b.Calculate SER and CUER for each population.c.For which of the six populations should the sample results be considered unacceptable? What options are available to the auditor?d.Why is analysis of the exceptions necessary even when the populations are considered acceptable?

56

EXPECTED POPULATION DEVIATION RATE (IN PERCENTAGE)

TOLERABLE DEVIATION RATE (IN PERCENTAGE)

2 3 4 5 6 7 8 9 10 15 20

5 PERCENT RISK OF OVER RELIANCE (ARACR)

0.00 149 99 74 59 49 42 36 32 29 19 14

0.25 236 157 117 93 78 66 58 51 46 30 22

0.50 . 157 117 93 78 66 58 51 46 30 22

0.75 . 208 117 93 78 66 58 51 46 30 22

1.00 . . 156 93 78 66 58 51 46 30 22

1.25 . . 156 124 78 66 58 51 46 30 22

1.50 . . 192 124 103 66 58 51 46 30 22

1.75 . . 227 153 103 88 77 51 46 30 22

2.00 . . . 181 127 88 77 68 46 30 22

2.25 . . . 208 127 88 77 68 61 30 22

2.50 . . . . 150 109 77 68 61 30 22

2.75 . . . . 173 109 95 68 61 30 22

3.00 . . . . 195 129 95 84 61 30 22

3.25 . . . . . 148 112 84 61 30 22

3.50 . . . . . 167 112 84 76 40 22

3.75 . . . . . 185 129 100 76 40 22

4.00 . . . . . . 146 100 89 40 22

5.00 . . . . . . . 158 116 40 30

6.00 . . . . . . . . 179 50 30

7.00 . . . . . . . . . 68 37

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2 3 4 5 6 7 8 9 10 15 2010 PERCENT RISK OF OVER RELIANCE (ARACR)

0.00 114 76 57 45 38 32 28 25 22 15 11

0.25 194 129 96 77 64 55 48 42 38 25 18

0.50 194 129 96 77 64 55 48 42 38 25 18

0.75 265 129 96 77 64 55 48 42 38 25 18

1.00 . 176 96 77 64 55 48 42 38 25 18

1.25 . 221 132 77 64 55 48 42 38 25 18

1.50 . . 132 105 64 55 48 42 38 25 18

1.75 . . 166 105 88 55 48 42 38 25 18

2.00 . . 198 132 88 75 48 42 38 25 18

2.25 . . . 132 88 75 65 42 38 25 18

2.50 . . . 158 110 75 65 58 38 25 18

2.75 . . . 209 132 94 65 58 52 25 18

3.00 . . . . 132 94 65 58 52 25 18

3.25 . . . . 153 113 82 58 52 25 18

3.50 . . . . 194 113 82 73 52 25 18

3.75 . . . . . 131 98 73 52 25 18

4.00 . . . . . 149 98 73 65 25 18

4.50 . . . . . 218 130 87 65 34 18

5.00 . . . . . . 160 115 78 34 18

5.50 . . . . . . . 142 103 34 18

6.00 . . . . . . . 182 116 45 25

7.00 . . . . . . . . 199 52 25

7.50 . . . . . . . . . 52 25

8.00 . . . . . . . . . 60 25

8.50 . . . . . . . . . 68 32

EPDR

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SAMPLE SIZEACTUAL NUMBER OF DEVIATIONS FOUND

0 1 2 3 4 5 6 7 8 9 10

5 PERCENT RISK OF OVER RELIANCE

25 11.3 17.6 . . . . . . . . .

30 9.5 14.9 19.5 . . . . . . . .

35 8.2 12.9 16.9 . . . . . . . .

40 7.2 11.3 14.9 18.3 . . . . . . .

45 6.4 10.1 13.3 16.3 19.2 . . . . . .

50 5.8 9.1 12.1 14.8 17.4 19.9 . . . . .

55 5.3 8.3 11.0 13.5 15.9 18.1 . . . . .

60 4.9 7.7 10.1 12.4 14.6 16.7 18.8 . . . .

65 4.5 7.1 9.4 11.5 13.5 15.5 17.4 19.3 . . .

70 4.2 6.6 8.7 10.7 12.6 14.4 16.2 18.0 19.7 . .

75 3.9 6.2 8.2 10.0 11.8 13.5 15.2 16.9 18.4 20.0 .

80 3.7 5.8 7.7 9.4 11.1 12.7 14.3 15.8 17.3 18.8 .

90 3.3 5.2 6.8 8.4 9.9 11.3 12.7 14.1 15.5 16.8 18.1

100 3.0 4.7 6.2 7.6 8.9 10.2 11.5 12.7 14.0 15.2 16.4

125 2.4 3.7 4.9 6.1 7.2 8.2 9.3 10.3 11.3 12.2 13.2

150 2.0 3.1 4.1 5.1 6.0 6.9 7.7 8.6 9.4 10.2 11.0

200 1.5 2.3 3.1 3.8 4.5 5.2 5.8 6.5 7.1 7.7 8.3

59

Sample size ACTUAL NUMBER OF DEVIATIONS FOUND

0 1 2 3 4 5 6 7 8 9 1010 PERCENT RISK OF OVER RELIANCE

20 10.9 18.1 . . . . . . . . .

25 8.8 14.7 19.9 . . . . . . . .

30 7.4 12.4 16.8 . . . . . . . .

35 6.4 10.7 14.5 18.1 . . . . . . .

40 5.6 9.4 12.8 15.9 19.0 . . . . . .

45 5.0 8.4 11.4 14.2 17.0 19.6 . . . . .

50 4.5 7.6 10.3 12.9 15.4 17.8 . . . . .

55 4.1 6.9 9.4 11.7 14.0 16.2 18.4 . . . .

60 3.8 6.3 8.6 10.8 12.9 14.9 16.9 18.8 . . .

70 3.2 5.4 7.4 9.3 11.1 12.8 14.6 16.2 17.9 19.5 .

80 2.8 4.8 6.5 8.3 9.7 11.3 12.8 14.3 15.7 17.2 18.6

90 2.5 4.3 5.8 7.3 8.7 10.1 11.4 12.7 14.0 15.3 16.6

100 2.3 3.8 5.2 6.6 7.8 9.1 10.3 11.5 12.7 13.8 15.0

120 1.9 3.2 4.4 5.5 6.6 7.6 8.6 9.6 10.6 11.6 12.5

160 1.4 2.4 3.3 4.1 4.9 5.7 6.5 7.2 8.0 8.7 9.5

200 1.1 1.9 2.6 3.3 4.0 4.6 5.2 5.8 6.4 7.0 7.6

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Problem 11-3, Page 474

Cash Receipts: Weaknesses and Recommendations.The Pottstown Art League operates a museum for the benefit and enjoyment of the community. During hours when the museum is open to the public, two volunteer clerks positioned at the entrance collect a $5 admission fee from each nonmember patron. Members of the Art League are permitted to enter free of charge on presentation of their membership cards.At the end of each day, one of the clerks delivers the proceeds to the treasurer. The treasurer counts the cash in the presence of the clerk and places it in a safe. Each Friday afternoon, the treasurer and one of the clerks deliver all the cash held in the safe to the bank, and they receive an authenticated deposit slip that provides the basis for the weekly entry in the cash receipts journal.The board of directors of the Pottstown Art League has identified a need to improve the system of internal control over cash admissions fees. The board has determined that the cost of installing turnstiles or sales booths or otherwise altering the physical layout of the museum will greatly exceed any benefits that may have derived. However, the board has agreed that the sale of admission tickets must be an integral part of its improvement efforts.Required:The board of directors has requested your assistance. Prepare a report for presentation and discussion at their next board meeting that identifies the weaknesses in the existing system of cash admission fees and suggest recommendations. (AICPA adapted.)

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