CHAPTER 14

AUDITING THE REVENUE CYCLE

Learning Check
14-1.

14-2.

a.

The revenue cycle includes the activities involved in the exchange of goods and
services with customers and the realization of the revenue in cash.

b.

The classes of transactions in this cycle for a merchandising company are sales, sales
adjustments, and cash receipts. The primary accounts affected by these transactions
are sales, accounts receivable, cost of sales, inventory, cash, sales discounts, sales
returns and allowances, bad debts expense, and allowance for uncollectible accounts

a.

Specific audit objectives for the revenue cycle are derived from the five categories of
management's financial statement assertions.

b.

Specific audit objectives for credit sales transactions include the following:
Recorded sales transactions represent goods shipped during the period (existence
or occurrence).
All sales transactions that occurred during the period have been recorded
(completeness).
The entity has the rights to receivables resulting from recorded credit sales
transactions (rights and obligations).
All sales transactions are correctly journalized, summarized, and posted
(valuation or allocation).
The details of sales transactions support their presentation in the financial
statements including their classification and related disclosures (presentation and
disclosure).

14-3. It may be appropriate to allocate a proportionately larger share of tolerable misstatement to

accounts receivable because of high risk of misstatements in this account and the high costs
of applying certain procedures used in auditing receivables (such as sending and processing
confirmation requests). This simply means that the auditor chooses to allow relatively more
of the total tolerable misstatement (financial statement materiality) remain undetected in
accounts receivable where they are more costly to detect than misstatements in some other
accounts. Nevertheless, tolerable misstatement must still be sensitive to the amount of
misstatement that might influence the decisions of financial statement users.
14-4. Factors that might motivate management to deliberately misstate revenue cycle assertions
include:

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Pressures to overstate revenues in order to report achieving announced revenue or

profitability targets or industry norms that were not achieved in reality owing to such
factors as global, national, or regional economic conditions, the impact of technological
developments on the entity's competitiveness, or poor management.
Pressures to overstate cash and gross receivables or understate the allowance for
doubtful accounts in order to report a higher level of working capital in the face of
liquidity problems or going concern doubts.

Factors that might contribute to unintentional misstatements in revenue cycle assertions include:
The volume of sales, cash receipts, and sales adjustments transactions is often high,
resulting in numerous opportunities for errors to occur.
The timing and amount of revenue to be recognized may be contentious owing to factors
such as ambiguous accounting standards, the need to make estimates, the complexity of
the calculations involved, and purchasers' rights of return.
14-5. a.

Following are example analytical procedures that the auditor might use to estimate
total revenue for a household appliance manufacturer and for an airline.
Industry
Household Appliance Mfg.

Airline

b.

Two analytical procedures that the auditor might use to estimate gross margin for
company might include.
Analytic Procedure
Compare historical trends in
market share and gross margin
with current unaudited data.
Evaluate the percentage of
revenues coming from new
products.

c.

Possible Analytical Procedures

Use past ratio of net sales to capacity with
adjustments for capacity changes.
Use a combination of past ratios of market
share with adjustments of current changes in
market share. Requires knowledge of the
total market size in the industry.
Estimate net revenues using information on
utilization of capacity (airline seat miles) and
average revenue per seat.

Audit Significance
Companies with commanding market shares
often are able to obtain larger gross margins.
Companies with a high proportion of revenues
from new products may earn premium gross
margins due to the ability to innovate.

Two analytical procedures that the auditor might use to estimate net receivables and
the allowance for doubtful accounts for company might include.
Analytic Procedure

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Accounts receivable turn days

Evaluate the entities history of

uncollectible accounts expense
to net credit sales, with
adjustment for economic
conditions

Understanding a companys history of accounts

and sales volume can assist the auditor in
evaluating net receivables and the adequacy of
the allowance for doubtful accounts.
This procedure is primarily related to the
adequacy of the allowance for uncollectible
accounts. The above history of accounts
receivable turn days would be most useful for
evaluating estimating gross receivables given
sales.

14-6. Several control environment factors and their applicability to revenue cycle assertions are:

Integrity and ethical values - reduction of risk of overstatement of revenues

and receivables by eliminating incentives to dishonest reporting.
Commitment to competence - by chief financial officers and accounting
personnel.
Management's philosophy and operating style - conservatism in developing
such accounting estimates as the allowance for uncollectible accounts and
allowance for sales returns.
Human resource policies and practices - bonding of employees who handle
cash
14.7.

The following table summarizes the functions that apply to credit sales transactions, the
department that performs the functions, and the principal documents or records produced in
performing the function.
Department that
Principal documents and records
Function
performs function
produced in performing the function.
Initiating credit Sales department
Documents
sales
Customer Order
Credit department
Sales Order
Computer Files and Records
Customer Master File (with credit
information) and Accounts Receivable
Master File.
Perpetual Inventory
Authorized Price List
Open Order File

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Department that
Function
performs function
Delivering good Warehousing and shipping
and services
department for goods.
Line operating departments
for services.

Recording sales

Accounting (Billing)

Principal documents and records

produced in performing the function.
Documents
Shipping documents
Reports of unfilled orders and back orders
Computer Files and Records
Open Order File
Perpetual Inventory
Shipping File
Documents
Sales Invoice
Sales Reports and Sales Journal
Various Exception Reports
Monthly Customer Statements
Computer Files and Records
Sales Transaction File
Accounts Receivable Master File

14-8. In order to assess control risk as low based on programmed control procedures the auditor
should test the following.
Control
Programmed control procedures
Computer general control
procedures
Manual follow-up procedures.

Importance to Control Risk Assessment

If a programmed control procedure in critical to a low
control risk assessment then the auditor should directly
test the control procedure.
In order to obtain assurance that the programmed
control procedure functions effectively throughout the
period the auditor also needs to these the effectiveness
of computer general control procedures.
Programmed controls usually report exceptions noted
when performing the control. As a result auditors also
need to test the effectiveness of manual controls that
follow-up on reported exceptions.

14-9. The following tables describes programmed controls for a typical manufacturing company.
Potential
Programmed Control
CAATs (Assuming Test Data)
Misstatement
a. Sales invoices may The computer compares
Submit test data for a
not be recorded.
entries in the sales journal
transaction that has shipping
with underlying shipping
information, both with and
information. All shipping
without a supporting sales
documents must be matched invoice.
with a sales invoice.

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b.

c.

d.

Potential
Misstatement
Sales invoice may
be recorded in the
wrong accounting
period.
A fictitious sales
invoice, or a sales
transaction for
which revenue
should not be
recognized, is
recorded.
Sales are made
without credit
approval.

e.

A sales invoice has

incorrect quantities
or prices.

f.

Sales invoices may

not be posted or
may not be
journalized

g.

Sales invoices may

be posted to the
wrong customers
accounts.

Programmed Control

CAATs (Assuming Test Data)

The computer compares

dates on the sales invoice
with dates on shipping
documents.
The computer will not
prepare a sale invoice
without underlying
information on shipping
files.

Submit test data with dates on

sales invoices that both do and
do not match with dates on
related shipping files.
Submit test data with sales
invoice information that both is
and is not supported by
underlying shipping
information.

The computer searches a

field for appropriate credit
authorization before an order
is placed on an open order
file.
The computer matches
quantities on a sales invoices
with underlying shipping
information and matches
prices with an authorized
price list.
The computer checks run-torun totals of beginning
accounts receivable balances,
plus sales transactions, with
the ending receivable
balances.
The computer matches
customer information on the
sales invoice with the master
customer file, the sales order,
and the shipping documents.

Submit test data for sales orders

that both are and are not
supported by appropriate credit
authorization.
Submit test data for sales
invoices that both do and do not
match underlying shipping
information and authorized
price lists.
Submit test data for batches that
with complete and incomplete
data sets in terms of completed
transactions.
Submit test data with underlying
information that both does and
does not match with information
on previously created sales
order and shipping files.

14-10. A common management control involves having managers with responsibility for sales to
review daily or weekly sales reports to assess the reasonableness of recorded sales. Further
management responsible for warehousing and shipping should review daily or weekly sales
and inventory movement reports to assess the reasonableness of recorded sales and
inventory removed from the perpetual inventory.
14-11. The sub-functions involved in cash receipts include (1) receiving cash receipts, (2)
depositing cash in bank, and (3) recording the cash receipts.

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14-12. a.

Two important controls pertaining to cash sales and the transaction class audit
objectives to which they relate are:
The customer's expectation of a printed receipt and supervisory surveillance of
over the counter sales transactions helps to ensure that all cash sales are
processed through the cash registers or terminals - completeness.
Independent check by supervisor on the accuracy of cash count sheets, and
verification of agreement of cash on hand with totals printed by a cash register or
terminal - existence or occurrence and valuation or allocation.

b.

Two important controls pertaining to the initial handling of mail receipts are (1)
immediate restrictive endorsement of checks received and (2) preparation of a multicopy listing (prelist) of mail receipts.

14-13. a.

A lockbox is a post office box that is controlled by the company's bank. The bank
picks up the mail daily, credits the company for the cash, and sends the remittance
advices to the company for use in updating accounts receivable. This system
eliminates the risk of diversion of the receipts by company employees and failure to
record the receipts.

b.

Depositing receipts intact daily means that all receipts are deposited; that is, cash
disbursements should not be made out of undeposited receipts. This control reduces
the risk that receipts will not be recorded (completeness), and the resulting bank
deposit record establishes the existence or occurrence of the transactions.

14-14. Four controls that can aid in preventing or detecting errors or irregularities in recording cash
receipts are summarized below along with potential tests of controls:
Control
Independent check of agreement of
validated deposit slip with daily cash
summary.
Computer check of information
included in the cash receipts journal
with information from prelist.

Preparation of periodic independent

bank reconciliations.
Mailing of monthly statements to
customers.

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Test of Control
Inspect a sample of daily cash summaries and
examine evidence of agreement with validated
deposit slip by responsible employee.
Use CAATs to test computer matching of
information from cash receipts journal with
electronic prelist. Also follow-up on how
exceptions are reported and examine evidence or
correction of errors reported on exception
reports.
Examine a sample of periodic bank
reconciliations. Make inquiries about bank
reconciliation procedures and test accuracy on a
sample basis.
Observe the mailing of monthly statements to
customers. Make inquiries about procedures to
follow-up on issues raised by customers, and
examine reports or other evidence of follow-up.

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14-15. a.

The functions pertaining to sales adjustments transactions are: granting cash

discounts; granting sales returns and allowances; and determining uncollectible
accounts.

b.

The following three types of controls pertaining to sales adjustments transactions

have as their common focus establishing the validity, or existence of occurrence, of
such transactions:
Proper authorization of all sales adjustments transactions.
The use of appropriate documents and records, particularly the use of an
approved credit memo for granting credit for returned or damaged goods, and an
approved write-off authorization memo for writing off uncollectible customer
accounts.
Segregation of duties for authorizing sales adjustment transactions and handling
and recording cash receipts.

14-16. a.

The transaction classes that should be considered in assessing control risk for
accounts receivable assertions are: credit sales, cash receipts, and sales adjustments.

b.

In assessing control risk for the existence or occurrence account balance assertion for
accounts receivable, the following transaction class control risk assessments should
be considered:
Existence or occurrence for sales transactions that increase accounts receivable.
Completeness for cash receipts and sales adjustments transactions that decrease
accounts receivable.

c.

A revised acceptable level of detection risk for tests of details and a revised level of
substantive tests must be determined for an assertion when the relevant final or
actual inherent risk assessments, control risk assessments, and analytical procedure
risk assessments, differ from the planned assessed levels.

14-17. In vouching recorded accounts receivable transactions to supporting documentation, a

sample of debits to customers' accounts is compared to data on supporting sales invoices and
matching shipping documents, sales orders, and customer orders. The evidence obtained
pertains primarily to specific audit objectives derived from the existence or occurrence,
rights and obligations, and valuation or allocation assertions for accounts receivable.
14-18. Both the sales cutoff test and the cash receipts cutoff test pertain to accounts receivable. The
sales cutoff test involves:
Examining shipping documents for several days before and after the cutoff date to
determine the date and terms of shipment.
Tracing shipping documents to sales and inventory records to establish that the entries
were made in the correct accounting period.
Inspecting invoices for a period of time before and after the cutoff date to ascertain the
validity and propriety of the shipments and corresponding entries.

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Inquiring of management about any direct shipments by outside suppliers to customers

and determining the appropriateness of related entries.
In performing a cash receipts cutoff test, the auditor may be present at the balance sheet date
to personally observe the promptness of the cutoff. In particular, the auditor determines that
all collections received prior to the close of business are included in cash on hand or in
deposits in transit and are credited to accounts receivable. Alternatively, the auditor may
review the daily cash summary and validated deposit slip for the last day of the year.
Both cutoff tests relate to the existence or occurrence and completeness assertions for
accounts receivable.
14-19. a.

It may not be necessary to confirm accounts receivable when:

The balance is immaterial to the financial statements.
The use of confirmations would be ineffective as an audit procedure.
The auditor's combined assessment of inherent risk and control risk is low, and
that assessment, made in conjunction with the evidence expected to be provided
by analytical procedures or other substantive tests of details, is sufficient to
reduce audit risk to an acceptably low level for the applicable financial statement
assertions.

b.

Factors to be considered in choosing the form of confirmation request are (1) the
acceptable level of detection risk and (2) the composition of the customer balances.
The positive form is used when detection risk is low or individual customer balances
are relatively large. The negative form should be used only when all three of the
following conditions apply:
The acceptable level of detection risk for the related assertions is moderate or
high.
A large number of small balances is involved.
The auditor has no reason to believe that the recipients of the requests are
unlikely to give them consideration.

c.

When no response is received after the second or third positive confirmation request
to a customer, the auditor should apply such alternative procedures as (1) examining
subsequent collections and (2) vouching open invoices comprising the customer's
balance. Alternate procedures may be omitted when both of the following conditions
apply:
There are no unusual qualitative factors or systematic characteristics related to
the nonresponses, such as that all nonresponses pertain to year-end transactions.
The nonresponses, projected as 100% misstatements to the population and added
to the sum of all other unadjusted differences, would not affect the auditor's
decision about whether the financial statements are materially misstated

14-20. a.

The aged trial balance is used primarily in assessing the adequacy of the allowance
for uncollectible accounts.

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b.

Procedures applied to the aged trial balance include (1) footing and crossfooting the
aged trial balance and comparing the total to the general ledger balance for accounts
receivable and (2) testing the aging of the amounts shown in the aging categories by
examining supporting documentation such as dated sales invoices.

c.

After testing the accuracy of the aged trial balance the auditor should perform the
following procedures to draw a conclusion about the fair presentation of the
allowance for doubtful accounts.
Examine past due accounts for evidence of collectability such as correspondence
with customers and outside collection agencies, credit reports, and customers
financial statements.
Discuss collectability of accounts with appropriate management personnel.
Evaluated managements process for estimated the allowance for doubtful
accounts using hindsight.
Evaluate the adequacy of the allowance given information about industry trends,
aging trends, and collection history for specific customers.

d.

Hindsight allows auditors to evaluate the reasonableness of managements process

for estimating the allowance for doubtful accounts. The reliability of managements
process for developing this accounting estimate can be gauged by evaluating
estimates in prior periods and the degree to which those estimates accurately
estimated subsequent uncollectible accounts.

14-21. GAAP disclosure for accounts receivable include:

Disclosure of receivables from employees, officers, affiliated companies and other
related parties.
Appropriate classification of material credit balances.
Appropriate classification of current and noncurrent receivables.
Disclosure of pledging, assigning, or factoring receivables.

Objective Questions
14-22.
14-23.
14-24.
14-25.

1.c
1.c
1.a
1.d

2.d
2.d
2.b
2.a

3.a
3.a
3.c
3.a

4.d
4.d
4.d
4.d

5.b
5.b
5.b

Comprehensive Questions
14-26. (Estimated Time: 15 Minutes)

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The auditor should consider separately audit the revenues associated with the 27 owned
properties and the 40 managed properties.
Revenues for the 27 owned properties represent direct revenues of the motel chain. The auditor
might consider evaluating the summer season separate from the balance of the year as the auditor
will expect occupancy to be high during that time of year and the auditor will also expect that
revenues should reflect higher rates. The auditor would also expect that for the balance of the year
occupancy should be lower and revenues per night will be reduced due to significant price
competition. Knowledge of the industry will be particularly helpful in gauging the reasonableness
of occupancy rates and revenues per unit.
Revenues for the 40 managed hotels will likely be related to management fees based on
revenues earned for absentee owners. The auditor needs to consider the same issues as
above, but also need to determine the appropriateness of the management fee based on the
contract with absentee owners.
14-27. PROBLEM 14-27 WAS INCLUDED IN THE TEXT IN ERROR. THE FLOWCHART ON
PAGE 584 DOES NOT GO WITH THIS PROBLEM. INQDEQUATE INFORMATION IS
AVAILABLE FOR STUDENTS TO SOLVE THE PROBLEM. THE AUTHORS AND
JOHN WILEY EXTEND THEIR APPOLOGIES.
14-28. (Estimated time - 20 minutes)
Internal Control Questionnaire
Question
Yes
1. Are cash registers or point-of-sale devices used for over-the-counter sales?
2. Is there periodic surveillance of cash sales procedures?
3. Are customers who pay by check required to provide identification?
4. Are checks restrictively endorsed on receipt?
5. Is a receipt produced by the cash register given to each customer?
6. Is an independent check made of agreement of cash and checks on hand with
cash count sheets and cash register readings?
7. Is cash deposited intact daily?
8. Is an independent check made of agreement of daily cash register summaries
with validated deposit slips?
9. Is an independent check made of agreement of amounts journalized with daily
cash register summaries and validated deposit slips?
10. Are periodic independent bank reconciliations made?
11. Are employees who handle cash bonded?

No

14-29. (Estimate Time: 30 Minutes)

Weakness
Financial secretary exercises too much
control over collections.

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Recommended Improvement
To extent possible, financial secretary's
responsibilities should be confined to record
keeping.

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Weakness

Recommended Improvement

Finance committee is not exercising its

assigned responsibility for collections.

Finance committee should assume a more

active supervisory role.

The auditing function has been assigned to

the finance committee, which also has
responsibility for the administration of the
cash function. Moreover, the finance
committee has not performed the auditing
function.
The head usher has sole access to cash
during the period of the count. One person
should not be left alone with the cash until
the amount has been recorded or control
established in some other way.
The collection is vulnerable to robbery
while it is being counted and from the
church safe prior to its deposit in the bank.

An audit committee should be appointed to

perform periodic auditing procedures or
engage outside auditors to perform the
procedures.

The number of counters should be increased

to at least two, and cash should remain under
joint surveillance until counted and recorded
so that any discrepancy will be brought to
attention.
The collection should be deposited in the
bank's night depository immediately after the
count. Physical safeguards, such as locking
and bolting the door during the period of the
count, should be instituted. Vulnerability to
robbery will also be reduced by increasing
the number of counters.
The head usher's count lacks usefulness
The financial secretary should receive a copy
from a control standpoint because he
of the collection report for posting to the
surrenders custody of both the cash and the financial records. The head usher should
record of the count.
maintain a copy of the report for use by the
audit committee.
Contributions are not deposited intact.
Contributions should be deposited intact. If it
There is no assurance that amounts
is considered necessary for the financial
withheld by the financial secretary for
secretary to make cash expenditures, she
expenditures will be properly accounted for. should be provided with a cash working
fund. The fund should be replenished by
check based upon a properly approved
reimbursement request and satisfactory
support.
Members are asked to draw checks to
Members should be asked to make checks
"cash", thus making the checks completely payable to the church. At the time of the
negotiable and vulnerable to
count, ushers should stamp the church's
misappropriation.
restrictive endorsement (For Deposit Only)
on the back of the check.
No mention is made of bonding.
Key employees and members involved in
receiving and disbursing cash should be
bonded.
Written instructions for handling cash
Because much of the work in cash

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Weakness
collections apparently have not been
prepared.

Recommended Improvement
collections is performed by unpaid,
untrained church members, often on a shortterm basis, detailed written instructions
should be prepared.

14-30. (Estimated Time: 30 minutes)

a.

Consolidated Electricity Company: Cash Receipts Flowchart

Documentary
Audit Trail

Key Reports

Computer Programs and Files

Customer
Payment

Remittance
Advice

CASH RECEIPTS
PROGRAM:
Updates AR Master
File and Daily
Transaction Tape.
Also Produces
Deposit Slip for
Cash Received

Data
Entry
at
CRT

Accounts
Receivable
File

rece Cash
Receipts
Transaction
File

Deposit
Slip
b.

Yes, the new cash receipts procedures have created some systems and internal
control problems. These problems include the following:
There are some potential control problems in the data entry procedures. The CRT
operator should be restricted to cash receipts processing activities. There should
be safeguards to detect or prevent unauthorized entries to the system.
The old master file records are destroyed in the update process. The company
should keep a backup of the accounts receivable file in case the file is destroyed.
This can be accomplished by periodically dumping the accounts receivable file
on magnetic tape or another disk
There is no assurance that all cash receipts have been entered correctly into the
system. There should be some independent computation of batch and/or hash
totals involving the remittance advices and the number of transactions so that a
comparison at the conclusion of processing would reveal omissions or errors

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14-12

The remittance advices The remittance advices are destroyed the next day, which
probably is too soon. Any errors or operator alterations not discovered by the end
of the next business day would be difficult to trace and correct.

14-31. (Estimated Time 25 Minutes)

a. Substantive Test
Vouch aged trial balance to
supporting documentation
Apply analytical procedures
Vouch recorded receivables to
supporting documentation
Perform sales cutoff test
Confirm accounts receivable
Vouch aged trial
balance to supporting
documentation
Vouch recorded receivables to
supporting documentation
Verify accuracy of accounts
receivable trial balance and
agreement with general ledger
control
Examine subsequent
collections or allocation
Confirm accounts receivable
Compare statement
presentation with GAAP
Perform cash receipts cutoff
test

b. Financial Statement
Assertion
Valuation or allocation

c. Type of Evidence
Documentary

Existence or occurrence,
completeness, valuation or
allocation
Existence or occurrence,
rights and obligations,
valuation or allocation
Existence or occurrence,
completeness
All except presentation and
disclosure.
Valuation or allocation

Analytical

Existence or occurrence,
rights and obligations,
valuation or allocation
Valuation or allocation

Documentary

Existence or occurrence,
completeness, valuation
All except presentation and
disclosure
Presentation and
disclosure
Existence or occurrence,
completeness

Documentary

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Documentary
Documentary
Confirmation
Documentary

Mathematical

Confirmation
Documentary
Documentary

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14-32. (Estimated Time 20 minutes)

Schedule of Adjustments

Cost of
Goods Sold
Transaction
Under Over Under Over
A
2,000
D
4,000
5,600
E
10,000
F
6,000
H
8,000
5,500
Total
14,000 14,000 7,500 5,600
Adjusting Entry
1,900
Cost of Goods Sold
1,900
Inventory
Sales

14-33. (Estimated time - 15 minutes)

a.
King might justify omitting the confirmation of Cycle's accounts receivable when:
The balance is immaterial to the financial statements.
The use of confirmations would be ineffective as an audit procedure.
The auditor's combined assessment of inherent risk and control risk is low, and
that assessment, made in conjunction with the evidence expected to be provided by
analytical procedures or other substantive tests of details, is sufficient to reduce
audit risk to an acceptably low level for the applicable financial statement
assertions.
b.

In designing confirmation requests, the auditor considers the acceptable level of

detection risk needed to be achieved, the composition of the client's customer balances,
and the likelihood that the customers will conscientiously respond. The positive form is
used when detection risk is low or individual customer balances are relatively large.
The negative form should be used only when all three of the following conditions
apply:
The acceptable level of detection risk for the related assertions is moderate or
high.
A large number of small balances is involved.
The auditor has no reason to believe that the recipients of the requests are
unlikely to give them consideration.

c.

When no response is received after the second or third positive confirmation request
to a customer, the auditor should apply such alternative procedures as (1) examining
subsequent collections and (2) vouching open invoices comprising the customer's
balance. Alternate procedures may be omitted when both of the following conditions
apply:

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There are no unusual qualitative factors or systematic characteristics related to

the nonresponses, such as that all nonresponses pertain to year-end transactions.
The nonresponses, projected as 100% misstatements to the population and added
to the sum of all other unadjusted differences, would not affect the auditor's
decision about whether the financial statements are materially misstated.

14.34. (Estimated Time 25 Minutes)

a.

There are two forms of accounts receivable confirmation requests; the positive form
and the negative form. A positive form asks the debtor to respond whether or not the
debtor is in agreement with the information on the confirmation request. A negative
form asks the debtor to respond only if the debtor disagrees with the information on
the confirmation request. The negative form generally requires follow-up by the
auditor in the form of practicable alternative procedures that are used to obtain
necessary evidence. The use of the positive form is preferable when individual
account balances are relatively large, when there is reason to believe that there may
be a substantial number of accounts in dispute or with inaccuracies or irregularities.
The negative form is useful when internal control surrounding accounts receivable is
considered to be effective, a large number of small balances is involved, and the auditor
has no reason to believe that persons receiving the requests are unlikely to give them
consideration.

b.

A debtor's acknowledgement of indebtedness does not indicate whether the

indebtedness is collectible. A good indicator of collectability is an aging schedule.
Generally, the older an account is, the less likely it will be collected. An aging
schedule should segregate past due and current accounts. Dodge should review,
analyze, and interpret the aging schedule to determine whether the client's allowance
for uncollectible accounts is adequate. Material differences, if any, should be
adjusted by the client. In connection with the aging review and interpretation, Dodge
should investigate all accounts receivable losses of preceding periods and the amounts
of uncollectible accounts charged off in the current period to determine if the bad
debt rate is increasing and if charge-offs because of uncollectability are properly
approved. After a review of correspondence, minutes, and collection procedures, and
after discussions with the appropriate client credit and collection officials, Dodge
should prepare an estimate of the possible collection losses and compare the estimate
to the amount of the recorded allowance. Where necessary Dodge should review
client credit files as well as reports of external credit agencies. Dodge should also
examine subsequent cash receipts to ascertain what portion of amounts owing at the
balance sheet date have actually been collected in the subsequent period.

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14-35. (Estimated Time 30 Minutes)

Basic Receivable Audit Test
Test the mathematical
accuracy of the accounts
receivable subsidiary ledger.
Select individual customer
accounts for confirmation.

Examine cash receipts and

sales cutoff.
Analyze accounts receivable
for slow paying customers
and past due accounts.
Age the accounts receivable.
Print confirmation request.

Identify credit balances.

Select individual sales
transactions and cash receipt
transactions for additional
audit procedures.

How General-Purpose Computer

Software Package and Tape of Accounts Receivable
Data Might be Useful
Mathematically compute the total amount owed by each
customer. The total is the sum of all unpaid items less
cash receipts during the current month.
The selection of individual accounts for confirmation
may be made either by making a simple random sample
or a stratified sample. Individual customers with
balances in excess of a specified dollar amount may be
selected. A random sample of other accounts may be
selected. Accounts with past-due, outstanding balances
may be selected, as well as accounts with any other
characteristics of interest to the auditor.
Listing a sample of items on the accounts receivable file
for which the date of last sale and the date of last cash
receipt are immediately prior to the confirmation date.
Listing of customers and open items on the accounts
receivable file for which the date of last payment or ratio
of month's payments to balance owed indicates a slowpaying customer or past-due amounts.
The open, or unpaid, invoices in the accounts receivable
file may be aged by current, 30 days, 60 days, and other
time periods for which the items are past due.
By utilizing especially prepared, preprinted forms, the
confirmation request may be printed, together with the
envelope in which it is to be mailed. Second request and
control copies may be printed simultaneously.
Accounts having credit balances in accounts receivable
may be listed.
For selected accounts, the auditor may have listing
prepared of individual items composing the accounts
receivable balance. This information is useful, for
instance, in following up on "no-replies" to confirmation
requests.

Solutions Manual to Modern Auditing: Copyright

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Cases
14-36. (Estimated Time 30 Minutes)

Accounts Receivable Gros s

Allowance for Uncollectable Accounts
Net Receivables
Total Assets
Total Revenues
Uncollectable Accounts Expense
Writeoff of Accounts Receivable

Year 5
Unaudited
535,000
($14,500)
520,500
2,200,000
2,700,000
33,750
22,600

Yar 4
Unaudited
295,000
($6,400)
288,600
1,800,000
2,050,000
25,625
24,500

Year 3
Unaudited
265,000
($5,275)
259,725
1,500,000
1,750,000
21,875
22,500

Year 2
Unaudited
207,500
($5,900)
201,600
1,200,000
1,400,000
17,500
17,000

a. Selected Ratios
Sales to average total as sets
Industry Median
Difference

1.35
1.25
0.10

1.24
1.23
0.01

1.30
1.29
0.01

1.27
1.26
0.01

AR Growth to Sales Growth

2.53

0.65

1.15

1.13

55
47
8

49
48
1

48
47
1

48
47
1

AR collection period
Industry Median
Difference
Uncollectable account expense to net credit sales
Industry Median
Difference
Uncollectable account expense to bad debt writeoffs

b.

1.25%
1.50%
-0.25%

1.25%
1.30%
-0.05%

1.25%
1.25%
0.00%

1.25%
1.25%
0.00%

1.493

1.046

0.972

1.029

Year 1
Unaudited
175,000
($5,400)
169,600
1,000,000
1,200,000
15,000
14,000

The unaudited figures for Aurora Manufacturing, Inc. show the following:
There was a significant increase in sales compared to total assets, particularly when
compared to industry averages. This is an indication of possible existence and
occurrence problems as past history of the ratio of total assets to sales would predict
lower sales levels. The auditor should expand the scope of accounts receivable
confirmations.
The collection period is increasing relative to industry averages and past history.
Further, accounts receivable are growing faster than sales. The Aurora continues to use a
historical rate of 1.25% of credit sales to provide for uncollectable accounts while
industry trends show an increase in the rate of bad debts to credit sales. The is an
indication of possible problems of associated with the net realizable value of receivables.
The auditor needs to expand the scope of tests of collection of current receivables, the
allowance for uncollectable accounts, and the provision for bad debt expense.

Solutions Manual to Modern Auditing: Copyright

2000, John Wiley and Sons, Inc.

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14-37. See separate file with answers to the comprehensive case related to the audit of Mt. Hood
Furniture that is included with this chapter.
14-38. See separate file with answers to the comprehensive case related to the audit of Mt. Hood
Furniture that is included with this chapter.
14-39. See separate file with answers to the comprehensive case related to the audit of Mt. Hood
Furniture that is included with this chapter.

Research Questions
For the reasons specified in the introduction to this manual, solutions are not provided for this
category of questions.

Solutions Manual to Modern Auditing: Copyright

2000, John Wiley and Sons, Inc.

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