McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 07 Revenue and Collection Cycle

Learning Objectives
1.
2. 3. 4.

5.

Discuss inherent risks related to the revenue and collection cycle with a focus on improper revenue recognition Describe the revenue and collection cycle, including typical source documents and control procedures. Give examples of tests of controls over customer credit approval, delivery, and accounts receivable accounting Give examples of substantive procedures in the revenue and collection cycle and relate them to assertions about account balances at the end of the period. Describe some common errors and frauds in the revenue and collection cycle, and design some audit and investigation procedures for detecting them.

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Overall Audit Approach

CONTROL RISK
Low Low High Detection Risk Moderate to High Detection Risk Moderate Detection Risk Moderate Moderate to High Detection Risk Moderate Detection Risk Low to Moderate Detection Risk High Moderate Detection Risk Low to Moderate Detection Risk Low Detection Risk

INHERENT RISK
Moderate

High

INHERENT RISKS:
Improper Revenue Recognition Cut-off Bill and Hold Channel Stuffing Returns and Allowances Collectibility of Receivables
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Revenue Recognition
Must be (1) realized or realizable and (2) earned SEC guidance (SAB 104)
Persuasive evidence of an arrangement exists, Delivery has occurred or services have been rendered, The seller's price to the buyer is fixed or determinable, and Collectibility is reasonably assured

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REVENUE AND COLLECTION CYCLE: Key Control Procedures

SEGPARATION OF DUTIES
Separate functions for recording, authorization, custody

AUTHORIZATION OF TRANSACTIONS
Write-offs EDI transactions Credit checks prior to approval of sale

Pricing

ACCESS TO ASSETS
Shipping department Lock box account ADEQUATE DOCUMENTS AND RECORDS
Pre-numbered sales orders, shipping documents (bills of lading), sales invoices Remittance advice A/R subsidiary ledger to general ledger Monthly statement to customer

INDEPENDENT CHECKS ON PERFORMANCE

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Audit Evidence in Management Reports and Data Files

Pending order master file Credit check/approval files Price list master file Sales detail file (sales journal) Sales analysis report Accounts receivable aged trial balance Cash receipts listing Customer Statements
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Other Controls
No sales order without customer order. Credit approval. Restricted access to inventory. Restricted access to terminals and invoices. All documentation in order to record sales. Proper dating. Invoices compared to BOLs and orders. Pending order files reviewed.
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AUDITING ACCOUNTS RECEIVABLE Test Accounts Receivable Aged Trial Balance (Exhibit 7.8) Confirm balances. Perform analytical procedures Test sales cut-off

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USING CONFIRMATIONS
Especially useful for verifying EXISTENCE. Factors likely to affect the reliability of confirmations Previous audit experience Intended recipient of the confirmation Type of information being confirmed The auditor may confirm entire BALANCES or individual TRANSACTIONS. Type of confirmation being sent

TYPES OF CONFIRMATIONS
Positive Confirmations small number of accounts are involved large number of errors are anticipated Negative Confirmations the combined assessed level of inherent and control risk is low 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. Blank Confirmations should be used if the recipient is likely to return a positive confirmation without verifying the accuracy of the information.

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CONFIRMATION CONSIDERATIONS

Responses to positive and blank confirmations provide more reliable evidence than negative non-responses. Recipients of accounts receivable confirmations might not report understatements. Auditors must have heightened professional skepticism for electronic responses (fax or e-mail). Non-response to Positive/blank confirmation requests Follow up with second and sometimes third requests. A lower than expected response rate could be indicative of fictitious customer accounts. Alternative procedures. Non-response to negative confirmation requests Only limited evidence concerning financial statement assertions. Alternative procedures are not necessary for unreturned negative confirmation requests. Follow-up on all exceptions

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ALTERNATIVE PROCEDURES
Vouch subsequent cash collections
usually sufficient evidence of existence, valuation.

Examine shipping documents Examine client-generated supporting documentation, such as invoices.

Depends on internal controls

Inspect correspondence files

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Other Matters Related to Confirmation

There are three sets of circumstances that could justify the omission of the confirmation of a client's accounts receivable.
Not material to the financial statements. If the RISK OF MATERIAL MISSTATEMENT is low, and the assessed level of evidence from analytical procedures and other tests of details is sufficient to reduce audit risk to an acceptably low level, confirmation of accounts receivable may be inefficient. Confirmation of accounts receivable is expected to be ineffective (based on previous years' audit experience).

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UNCOLLECTIBLE ACCOUNTS
Inspect customer files for collectibility Recalculate ALLOWANCE and BAD DEBT EXPENSE Verify reasonableness of ALLOWANCE and BAD DEBT EXPENSE Verify appropriateness of accounts written off
Verify attempts to collect receivable Verify authorization is appropriate.

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ANALYTICAL PROCEDURES
Sales Revenue
Comparisons with previous periods Comparisons with industry

Allowance for Doubtful Accts, Bad Debt Expense

Bad Debt Expense as a percentage of Sales Allowance for Doubtful Accounts as a percentage of Gross Receivables

Accounts Receivable
Days Sales in Accounts Receivable Accounts Receivable Turnover

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SALES CUTOFF PROCEDURES

Used to verify whether Sales/Revenues recorded in the CORRECT ACCOUNTING PERIOD. Examine SALES INVOICES and SHIPPING DOCUMENTS shortly prior to and after year-end. Examine returns after year-end.

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