Auditing: The Art and Science of Assurance Engagements: Fifteenth Canadian Edition

Auditing: The Art and Science of Assurance
Engagements
Fifteenth Canadian Edition
Chapter 12
Audit of the Revenue Cycle
Copyright © 2022 Pearson Canada Inc. 12 - 1

Cycle Approach to Segmenting an Audit
• A common way to divide an audit is to keep closely
related types (or classes) of transactions and account
balances in the same segment. This is called the cycle
approach.

Cycle Approach to Segmenting an Audit:
Financial Statement Cycles
• There are five basic cycles:
– Revenue and collection
– Acquisition and payment
– Human resources and payroll
– Inventory and distribution
– Capital acquisition and repayment

Learning Objectives
1. Understand and explain the revenue and cash
collection process and key controls.
– Design tests of control
2. Identify inherent risk factors and determine
significant risks and fraud risks in the revenue cycle.
3. Use professional judgment to develop an audit
approach (strategy) for the revenue cycle.
4. Design substantive tests to address the various
assertions in the revenue cycle.

The Sales and Collection Cycle
• Classes of transactions in the revenue cycle
– Sales
– Cash collection
– Sales returns and allowances
– Charge-off of uncollectible accounts and bad-debt
expense

Classes of transactions
• Make cash sales of $100
Dr Cash $100
Cr Revenue $100
• Make sales of $100 on account with a 2% discount
(Gross method)
Dr Accounts receivable $100
Cr Revenue $100
Upon the receipt of cash payment
Dr Cash $98
Dr Cash discount $2 (contra revenue)
Cr Accounts receivable $100
Classes of transactions
• Make sales of $100 on account
Dr Accounts receivable $100
Cr Revenue $100
• $5 of goods / services is returned
Dr Sales returns and allowances $5 (contra revenue)
• Expect $20 to be uncollectible
Dr Bad debt expense $20
Cr Allowance for doubtful accounts $20 (contra asset)
• Confirm $15 is uncollectible
Dr Allowance for doubtful accounts $15
Classes of Transactions and Account
Balances in the Revenue Cycle

Overview of the Revenue and Cash
Collection Process
• Revenue and Cash Collection Process
– Begins with a request by a customer (or a customer
selecting and picking up a product)
– Ends with the conversion of material or service into
cash or writeoff of uncollectible accounts receivable.

Classes of Transactions, Accounts Balances,
and Disclosures in the Revenue Cycle
• The business functions for the revenue cycle include:
– Processing Customer Orders
– Granting Credit
– Shipping Goods
– Billing Customers and Recording Sales
– Processing and Recording Cash Receipts
– Processing and Recording Sales Returns and Allowances
– Writing Off Uncollectible Accounts Receivable

Processing Customer Orders
• The Sales Department receives a customer order,
which is an offer to buy goods under specified terms.
• After the receipt of the customer order, a number of
authorizations are required.
– Customer status, credit status, price, and availability of
inventory need to be verified before a sales order can be
created.

Key Internal Control 1
• Approval is required to commence selling goods to a
new customer, to set up a new customer in the master
files, or to change semipermanent billing information.
– Weak practices can result in the set-up of fictitious
customers
– Relevant assertions: Sales – occurrence; AR –
existence, valuation
• Test of control
– Inspect master file change forms for authorization

Master Customer File Example

• Credit is approved before shipment takes place.
– The Credit Department, or a designated person, must
approve credit to the customer for sales on account
– Weak practices in credit approval can result in excessive
uncollectible accounts receivable.
– Salespeople do not perform the credit check because
their performance incentives would likely impact their
credit decisions. (Segregation of duty)
– Relevant assertions: Revenue – occurrence, A/R –

• Test of control
– Inquire of managers to verify that salespeople do not
perform the credit check
– Observe a designated person approve credit
– Inspect customer sales order for credit approval
– Use test data to verify the programmed control that
customers exceeding their credit limits will have their
orders rejected

Processing Customer Orders
• Once the customer order is approved, the
system
– Creates a sales order
 Shows description, quantity, and related
information for goods, and indicates credit
approval
– Transmits a packing slip to the Inventory and
Shipping Departments

Shipping Goods
• A packing slip
– Shows the goods descriptions and quantity to be
shipped
– Authorizes the Inventory Department to release
goods to the Shipping Department
– Authorizes the Shipping Department to release
goods to carriers

Sales Order Example

Packing Slip Example

Shipping Goods
• The Shipping Department ships the goods and
generates copies of a bill of lading:
– The bill of lading serves as evidence of the
actual delivery / shipment of goods
– A copy of the bill of lading is sent to the
customer to indicate delivery / shipment
– A copy of the bill of lading is sent to the Billing
Department for the department to generate a
sales invoice

Bill of Lading Example

• Shipping records and sales invoices cannot be produced if
the customer number is invalid.
– Weak practices can result in goods shipped to fictitious
customers
– Relevant assertion: Sales – occurrence; A/R –
• Test of control
– Observe rejection of invalid customer numbers when
entered by client staff into online system.

• Shipping documents are (1) numbered sequentially and (2)
accounted for periodically so that the system can
determines whether any transactions have not been
completed
– Weak practices can result in goods not being shipped
– Relevant assertion: Sales – completeness, A/R –
completeness
• Test of control
– Inspect the integrity of numerical sequence of shipping
documents using block test.
– Inspect report of missing shipping document numbers for
evidence of independent follow-up.
Billing the Customer and Recording the
Sales
• The Billing Department generates copies of
sales invoices:
– A sales invoice is a document or electronic record
indicating the description and quantity of goods sold,
the price, freight charges, insurance, terms, and other
relevant data.
– The sales invoice is the method of indicating to the
customer the amount of a sale and the payment due
date.
– Companies send the original to the customer, and
retain one or more copies.
Invoice Example

• Invoices are (1) numbered sequentially and (2) accounted
for periodically so that the system can determines whether
any transactions have not been completed
– Weak practices can result in shipments not being
invoiced and recorded
– Relevant assertion: Sales – completeness; A/R –
completeness
• Test of control
– Inspect the integrity of numerical sequence of invoices
using block test.
– Inspect report of missing invoice numbers for evidence of
independent follow-up.
• Invoices are prepared using authorized prices, terms,
freight, and discounts established in master files.
– Weak practices can result in invoice containing
incorrect prices, terms, freight, and discounts
– Relevant assertion: Sales – accuracy, A/R – valuation
• Test of control
– Take a sample of invoices and trace back to authorized
master files.

Master Price File
Example

• Invoices are prepared using a date equal to the shipping
date (or specify the shipping date on the invoice).
– Weak practices can result in sales being recorded in
the incorrect fiscal periods
– Relevant assertion: Sales – cutoff
• Test of control
– Compare invoice dates with dates on shipping records.

Sales
• The Accounting Department receives the sales
order, shipping documents, and invoice, then
updates the following files
– Sales transactions file
 Used to generate Sales Journal
– Accounts receivable master file
 Used to generate (1) Accounts Receivable
Trial Balance and (2) Monthly Statement
– General ledger
Sales
• Sales transactions file
– Includes all sales transactions processed by
the accounting system for a period
– It includes all information entered into the
system and information for each
transaction, such as customer name, date,
amount, account classification or
classifications, salesperson, and commission
rate

Sales
• Sales journal
– Generated from the sales transaction file
– Includes the customer name, date, amount, and
account classification or classifications for each
transaction, such as division or product line.
– Identifies whether the sale was for cash or accounts
receivable.
– The same transactions included in the journal or listing
are also posted simultaneously to the general ledger
and, if they are on account, to the accounts receivable
master file.
Sales Journal Example

• Three-way match: Recording of sales is supported by
authorized sales orders, invoices, and shipping documents
– Weak practices can result in fictitious sales or
inaccurate sales information being recorded
– Relevant assertion: Sales – occurrence, accuracy;
A/R – existence, valuation
• Test of control
– Select a sample of journal entries and inspect the
supporting sales order, shipping documents, and invoices

Three-Way Match
• Sales order: Customer name, item description, unit price,
number of items, date, approver signature, reviewer
signature
• Invoice: Customer name, Item description, unit price,
number of items, date
• Shipping documents: Customer name, Item description,
number of items, date

• Management reviews sales, cost of sales, gross margin
analytical reports for reasonableness.
– Weak practices can result in fictitious sales or
inaccurate sales information being recorded
– Relevant assertion: Sales – occurrence, accuracy;
A/R – existence, valuation
• Test of control
– Inspect analytical reports for evidence of management
review

Sales
• Accounts receivable master file
– Records individual sales, cash receipts, and sales
returns and allowances for each customer
– A printout of the accounts receivable master file shows,
by customer, the beginning balance in accounts
receivable, each sales transaction, sales returns and
allowances, cash receipts, and the ending balance.
– The total of the individual account balances in the
master file equals the total balance of accounts
receivable in the general ledger.

A/R Master File Example

Sales
• Accounts receivable trial balance / aging schedule
– Generated from the Accounts Receivable Master File
– Shows the total receivable from each customer at a
point in time
– Is usually an aged trial balance that includes the total
balance outstanding and the number of days the
receivable has been outstanding, grouped by
category of days (such as less than 30 days, 31 to 60
days, and so on)

A/R Trial Balance

• Sales journal and A/R aging schedule are reconciled to the
general ledger
– Weak practice could result in failure to detect incorrectly
booked journal entries (e.g., A/R was updated but general
ledger was not – leading to incomplete G/L)
– Relevant assertion: Sales – occurrence,
completeness; A/R – existence, completeness
• Test of control
– Inspect reconciliation schedules

Sales
• The Billing Department sends Monthly
Statement to customers
– Generated from the accounts receivable
master file
– Indicates the beginning balance of the account
receivable, the amount and date of each sale,
cash payments received, credit memos issued,
and the ending balance due

Monthly Statement Example

• Monthly statements are sent to customers; complaints
receive independent follow-up.
– Weak practice could result in
 Fictitious sales being recorded
 Inaccurate sales being recorded;
 Sales recorded in the wrong period;
 Failure to record cash payments; embezzlement of cash
– Relevant assertion:
 Sales – occurrence, accuracy, cutoff;
 A/R – existence, valuation;
 Cash – completeness
• Test of control
– Observe whether statements are mailed
– Inspect customer correspondence files

Processing and Recording Cash Receipts
• A designated person receives cash
– Remittance advice is a letter sent by a customer to a
supplier to inform the supplier that their invoice has
been paid. If the customer is paying by cheque, the
remittance advice often accompanies the cheque
– Prepares a prelisting of cash receipts
• Another designated person deposits cash
– Send deposit slip to the Accounting Department
• The Accounting Department records cash
– Cash Receipts Transaction File, Cash Journal, A/R
Transaction File, A/R Trial Balance, General Ledger are
updated Copyright © 2022 Pearson Canada Inc. 12 - 46
Remittance Advice
Example

Cash Receipts Prelist Example

• Use a prelisting of cash to document cash receipts; the
person who documents cash receipts cannot deposit cash
or record accounting entries
– Weak practice could result in failure to record cash
payments; embezzlement of cash
– Relevant assertion: Cash – completeness; A/R –
valuation
• Test of control
– Observe to verify the segregation of duty

• Internal verification that the total cash deposit equals
recorded cash receipts
– Relevant assertion: Cash – completeness, valuation;
A/R – valuation
• Test of control
– Inspect verification reports for evidence of properly review
– Reperform the reconciliation by comparing total deposits
with total cash receipts
– Inspect evidence for follow-up actions for exceptions
Lapping: Fraud
• Lapping can happen if the person who handles cash
receipts are allowed to record accounting entries
– The postponement of entries for the collection of
receivables to conceal the embezzlement of cash; a
common type of defalcation
– Customer X sends in a cheque to cover invoice #1. A
clerk cashes it and keeps the money.
– When Company Y sends in a cheque for invoice #2,
the clerk applies this money to invoice #1.
– When Company Z sends in a cheque for invoice #3,
the clerk applies this money to invoice #2, and so on.

• Accountant independently and periodically performs bank
reconciliations to ensure that cash on the financial
statement is reconciled to the cash balance in the bank; a
separate employee or accounting manager reviews and
approves the bank reconciliations
– Weak practice could result in failure to detect
misstatements in the cash balances
– Relevant assertion: Cash – existence, completeness
• Test of control
– Inspect bank reconciliations for evidence of proper review
– Reperform bank reconciliations
Processing and Recording Sales Returns and
Allowances
• The Billing Department issues credit memos are
issued for returns and allowances and send the
memos to the Accounting Department
– A credit memo indicates a reduction in the amount due
from a customer because of returned goods or an
allowance.
– It often takes the same general form as a sales invoice
• The Accounting Department updates the sales
returns and allowances transaction file (and returns
and allowances journal), the accounts receivable
transaction file, and the general ledger
Credit Memo
Example

• Issuance of credit memos is properly authorized; people
who have access to incoming customer payments are not
allowed to authorize credit memos
– Relevant assertion: Cash – completeness; A/R –
valuation
• Test of control
– Observe that employees who handle cash payments
cannot authorize credit memos
– Inspect credit memo for proper approval
Writing Off Uncollectible Accounts
Receivable
• The Billing Department reviews and approves
writeoff of accounts receivable as uncollectible
– Uncollectible Account Authorization Form is used
internally to indicate authority to write an account
receivable off as uncollectible
– Send the form to the Accounting Department
• The Accounting Department updates the allowances
for doubtful allowance transaction file, the accounts
receivable transaction file, the general ledger

Receivable Write-off
Authorization Form Example

• Write-offs must be approved by a responsible officer after a
review of Credit Department recommendations and supporting
evidence; people who have access to incoming customer
payments are not allowed to authorize writeoffs
– Relevant assertion: Cash – completeness; A/R – valuation
• Test of control
– Observe that employees who handle cash payments cannot
authorize writeoffs
– Inspect uncollectible account authorization forms for proper
approval
Quiz
• A document prepared for shipment of the goods sold
using a trucking company is called the
• A) sales order.
• B) bill of lading.
• C) sales invoice.
• D) customer order.

Quiz
• A document prepared for shipment of the goods sold
using a trucking company is called the
• A) sales order.
• B) bill of lading.
• C) sales invoice.
• D) customer order.

Quiz
• Poor controls over credit limit approval or in changing
the credit limit in the master file may result in
• A) confused and frustrated customers.
• B) incomplete sales records.
• C) financial statement errors for sales and AR
accounts.
• D) excessive bad debts and uncollectible accounts
receivable.

Quiz
• Poor controls over credit limit approval or in changing
the credit limit in the master file may result in
• A) confused and frustrated customers.
• B) incomplete sales records.
• C) financial statement errors for sales and AR
accounts.
• D) excessive bad debts and uncollectible
accounts receivable.

Quiz
• A document sent to each customer showing his or her
beginning accounts receivable balance and the
amount and date of each sale, cash payment
received, credit memo issued, and the ending balance
is the
• A) accounts receivable subsidiary ledger.
• B) monthly statement.
• C) remittance advice.
• D) sales invoice.

Quiz
• A document sent to each customer showing his or her
beginning accounts receivable balance and the
amount and date of each sale, cash payment
received, credit memo issued, and the ending balance
is the
• A) accounts receivable subsidiary ledger.
• B) monthly statement.
• C) remittance advice.
• D) sales invoice.

Quiz
• Which of the following internal control procedures will most likely
prevent the concealment of a cash shortage resulting from the
improper write-off of a trade account receivable?
• A) Write-offs must be approved by a responsible officer after a review
of credit department recommendations and supporting evidence.
• B) Write-offs must be supported by an aging schedule showing that
only receivables overdue several months have been written off.
• C) Write-offs must be approved by the cashier who is in a position to
know if the accounts receivable have, in fact, been collected.
• D) Write-offs must be authorized by company field sales employees
who are in a position to determine the financial standing of the
customers.

Quiz
• Which of the following internal control procedures will most likely
prevent the concealment of a cash shortage resulting from the
improper write-off of a trade account receivable?
• A) Write-offs must be approved by a responsible officer after a
review of credit department recommendations and supporting
evidence.
• B) Write-offs must be supported by an aging schedule showing that
only receivables overdue several months have been written off.
• C) Write-offs must be approved by the cashier who is in a position to
know if the accounts receivable have, in fact, been collected.
• D) Write-offs must be authorized by company field sales employees
who are in a position to determine the financial standing of the
customers.
Quiz
• Which of the following control procedures may prevent
the failure to bill customers for some shipments?
• A) Each shipment should be supported by a
prenumbered sales invoice that is accounted for.
• B) Each sales order should be approved by
authorized personnel.
• C) Sales journal entries should be reconciled to daily
sales summaries.
• D) Each sales invoice should be supported by a
shipping document.
Quiz
• Which of the following control procedures may prevent
the failure to bill customers for some shipments?
• A) Each shipment should be supported by a
prenumbered sales invoice that is accounted for.
• B) Each sales order should be approved by
authorized personnel.
• C) Sales journal entries should be reconciled to daily
sales summaries.
• D) Each sales invoice should be supported by a
shipping document.
Identifying Inherent Risk Factors and
Determine Significant Risks
• As part of audit planning, the auditor would perform
preliminary analytical procedures to highlight potential
misstatements.
• Analytical procedures are also helpful in highlighting
potential warning signals or symptoms of revenue
fraud.
• Analytical procedures should also compare client data
with industry performance data as well as nonfinancial
data.

Identifying Inherent Risk Factors and Determine
Significant Risks: Analytical Procedures for Planning
the Revenue Cycle
Analytical Procedure for Planning Possible Misstatement Assertion
Evaluate the ratio of returns and Could indicate unusual sales Occurrence or
allowances to sales arrangements & possible over or completeness
understatement of revenue
Compare bad-debt expense as a Uncollectible accounts receivable that Valuation (net
percentage of gross sales with that have not been provided for could realizable)
of previous years indicate understatement of accounts
receivable
Compare number of days that Overstatement or understatement of Valuation
accounts receivable are outstanding allowance for uncollectible accounts
with that of previous years and bad-debt expense
Compare aging categories as a Overstatement or understatement of Valuation
percentage of accounts receivable allowance for uncollectible accounts
with those of previous years and bad-debt expense

Identifying Inherent Risk Factors and Determine
Significant Risks: Analytical Procedures for Planning
the Revenue Cycle
Analytical Procedure for Possible Misstatement Assertion

Planning
Compare allowance for Overstatement or understatement Valuation
uncollectible accounts as a of allowance for uncollectible
percentage of accounts accounts
receivable with that of previous
years
Evaluate cash receipts collected If slow, may indicate special sales Occurrence
after year-end to cash receipts arrangements and potential
during the year overstatement of revenue

Understand the Applicable Accounting
Framework
• To be able to assess the client’s revenue recognition
policy, the auditor must be knowledgeable about
the client’s business model, the industry, and the
client’s different types of sales or service contracts.
– This includes understanding the client’s key products
and services that affect revenue, including key
contractual arrangements.
• Complicated sales arrangements increase risk of
material misstatement increases

Identifying Inherent Risk Factors:
Revenue
• Management usually has incentives to overstate
revenue
– Compensation
– Earnings targets
• The primary relevant assertions for revenue are:
– Occurrence: Do the recorded sales exist?
– Accuracy: Are the sales recorded in the correct
amounts?
– Cutoff: Are sales recorded in the correct fiscal period?
Did the management prematurely recognize revenue?

Accounts Receivable
• The primary relevant assertions for Accounts
Receivable are:
– Existence: Directly related to occurrence of sales—if
a valid sale transaction did not occur, then a valid
receivable balance does not exist
– Valuation: Are accounts receivable balances
collectible?

Accounts Receivable
• Inherent risk factors affecting accounts receivable:
– Receivables are pledged as collateral, assigned to
someone else, factored, or sold (restrictions must be
disclosed).
– Collection of the receivable is contingent upon future
events (for example, certain royalty arrangements).
 Payment is not required until the purchaser sells to its
end customers.
– Sales are made to customers with high credit risk.

Accounts Receivable
• Factoring
– The client sells its accounts receivable to a third party
(called a factor) at a discount for cash advances.
– Factoring enhances the client’s cash flow
– Relevant assertion: Rights and obligations
 Does the client still have rights to the accounts
receivable balances (do customers owe the client or the
factor)?

Significant Risk
• Significant risk an identified risk of material misstatement
assessed at the upper end of the spectrum of inherent risk
• This is due to the degree to which inherent risk factors
affect the combination of the likelihood and the
magnitude of a potential misstatement.
• The risk of fraud is a significant risk. (CAS240)
• Significant risks require special attention in the audit.

Significant Risk

Determine Significant Risks: Examples
• Orders are shipped to a customer with a bad credit
rating.
• There is incorrect recognition of revenue percentage
for long-term contracts or complex revenue
arrangements.
• Sales are recorded twice or accidentally omitted.
• Sales are recorded for the incorrect quantity or the
incorrect price.

Determine Fraud Risks: Examples
• Inventory is stolen and the sale is recorded as a
fictitious sale (no shipping document).
• Revenue is recorded when goods have not been
shipped / delivered.
– “Bill and hold” sales. Companies may make
arrangements with customers for early billing and then
hold the goods for shipping. Unless the customer has
requested such an arrangement and there appears to
be a legitimate business reason, these types of
arrangements generally do not meet the revenue
recognition criteria

• Fictitious revenue transactions are recorded and
reported.
• Subsequent period revenue is deliberately recorded in
the current period.
• Goods never ordered by the customer are shipped.
• Lapping

• Channel stuffing
– A company ships more goods to distributors and
retailers along the distribution channel than end-users
are likely to buy in a reasonable time period.
– This is usually achieved by offering lucrative incentives,
including deep discounts, rebates, and extended
payment terms, to persuade distributors and retailers to
buy quantities in excess of their current needs.
– Distributors retain the right to return any unsold
inventory. “Stuffing” accelerates revenue recognition to
reach short-term revenue and earnings targets, and as
such, misleading to investors.
Channel Stuffing: Example
• To meet earnings targets, a chairmaker near the end
of its fiscal year induces its customer, a retailer, to buy
3000 chairs by giving the retailer (1) a 50% price
discount, and (2) the right to return any unsold chairs,
even though the retail expects to sell only 1000 chairs
• The chairmaker fraudulently inflates its sales in the
current fiscal year because the 2000 chairs in excess
of market demand will be returned to the chairmaker –
the future sales of the 2000 chair is never going to
materialize

Quiz
• Your audit client has many different types of accounts
receivable: Canadian, American, and other international
accounts; and short-term and long-term accounts. There
are also some sales on consignment. The company has
used forward exchange contracts to reduce its exposure
due to foreign exchange fluctuations. How will this affect
the audit engagement?
• A) control risk will increase
• B) inherent risks of error will decrease
• C) risk of material misstatement increases
• D) audit risk will be increased
Quiz
• Your audit client has many different types of accounts
receivable: Canadian, American, and other international
accounts; and short-term and long-term accounts. There
are also some sales on consignment. The company has
used forward exchange contracts to reduce its exposure
due to foreign exchange fluctuations. How will this affect
the audit engagement?
• A) control risk will increase
• B) inherent risks of error will decrease
• C) risk of material misstatement increases
• D) audit risk will be increased
Quiz
• Which of the following revenue manipulations affects the
cutoff assertion?
• A) avoiding recording of returns and allowances for the
year
• B) recording subsequent period sales as current period
sales
• C) understatement of bad debts
• D) creation of fictitious sales that are misclassified as
revenue

Quiz
• Which of the following revenue manipulations affects the
cutoff assertion?
• A) avoiding recording of returns and allowances for the
year
• B) recording subsequent period sales as current
period sales
• C) understatement of bad debts
• D) creation of fictitious sales that are misclassified as
revenue

Quiz
• Which of the following actions is more likely to be a
result of error rather than fraud?
• A) consignment sales are knowingly recorded as
revenue
• B) orders are shipped to a customer with a bad credit
rating
• C) fictitious revenue transactions are recorded and
reported
• D) subsequent period revenue is deliberately recorded
in the current period
Quiz
• Which of the following actions is more likely to be a
result of error rather than fraud?
• A) consignment sales are knowingly recorded as
revenue
• B) orders are shipped to a customer with a bad
credit rating
• C) fictitious revenue transactions are recorded and
reported
• D) subsequent period revenue is deliberately recorded
in the current period
Determine the Extent of Tests of Controls
• Auditors must determine the cost-benefit of testing
controls—meaning whether substantive tests will be
reduced sufficiently to justify the cost of performing
tests of controls.
• If yes, choose Combined audit approach
• If no, choose Substantive audit approach

Substantive Tests
• Substantive Analytical Procedures
– Favorable results from substantive analytical
procedures can reduce the extent of test of detail
• Tests of Detail

Substantive Analytical Procedure Possible Misstatement
Compare gross margin percentage with Overstatement or understatement of
that of previous years (by product sales and accounts receivable
line). (fictitious revenue or errors in sales
pricing).
Compare sales by month (by product Overstatement or understatement of
line) over time. sales and accounts receivable (cutoff
errors).
Compare inventory in a distribution Indicator of channel stuffing.
channel with amounts for prior
periods.
Compare discounts to previous Could indicate unusual sales
periods. arrangements.
Compare sales credits, returns, and Understatement or overstatement of
allowances as a percentage of gross sales returns and allowances, and
sales with previous years’ (by product accounts receivable (timing errors).
line).
Compare individual customer balances Misstatements in accounts receivable
over a stated amount with that of and related income statement
previous years. accounts (inadequate bad-debt
allowance or overstated sales).

Design Substantive Tests: Direction of Tests
for Completeness and Occurrence
• When designing audit procedures for the occurrence
and completeness assertions, the direction of the
tests is essential:
– When tracing from source shipping documents to the
journals, the purpose of the test is for omitted
transactions (completeness).
– In contrast, when vouching from the journals back to
supporting documents, the purpose is to test for
nonexistent transactions (occurrence).

Design Substantive Tests:
Revenue: Occurrence Assertion
• When designing tests for occurrence, the auditor is
concerned about the following potential
misstatements:
– Sales being included in journals for which no shipment
was made;
– Sales recorded more than once (duplicates); and
– Shipments made to nonexistent customers and
recorded as sales (fictitious sales).

Revenue: Occurrence Assertion
• Test of detail - Vouching
– Select a sample of transactions from the sales journal
– Obtain and inspect the corresponding supporting
documents to validate the occurrence of transactions
 Sales order
 Invoice
 Shipping documents – evidence that goods were
shipped / delivered
– Packing slip
– Bill of lading
 Cash payment – evidence that the sales were finalized

Revenue: Completeness Assertions
• Completeness Assertion: all revenues are recorded
• Tests of detail
– Tracing: Select a sample of supporting documents and
traced them to sales journal validate the completeness
of transactions

Revenue: Accuracy Assertion
• Accuracy Assertion: shipping the correct amount of goods
ordered, using the correct price when billing for the amount of
goods shipped, and accurately recording the amount billed in
the accounting records
• Test of detail
– Select a sample of transactions from the sales journal
– Obtain and inspect the corresponding supporting
documents to validate the amounts of sales recorded
 Prices and quantities in sales order, invoices, shipping
documents should agree with each other
 Recalculation: The total amounts (Prices x quantities)
agree with recorded sales balances in the sales journal
Revenue: Cutoff Assertions
• Cutoff Assertion: Sales are recorded in the correct fiscal
period.
• Test of detail
– Block selects a block of invoices, receiving documents, and
shipping documents spanning both sides of the year-end
date to ensure that the transactions were recorded in the
proper period.

Block Sample Selection

A/R: Existence Assertion
• Existence assertion: Customers and accounts
receivable balances from each customer exist.
• Test of detail:
– Obtain the aged accounts receivable trial balance
– Agree the accuracy between subledger and general
ledger
– Vouching
– External confirmation

• Vouching
– Select a sample of A/R balances from the aged
accounts receivable trial balance and traced them to
supporting documents to validate the existence of the
balances
 Sales order, invoice, shipping document
 Cash receipts and bank statement after year-end for
proof of payment received after year-end
– E.g., if an A/R balance of $100k exists as of year-end, the
client should receive the cash receipt after year-end

• External confirmation assumptions
– The person (customer) returning the confirmation is
independent of the company being audited and will
provide an unbiased response
– The person (customer) returning the confirmation has
knowledge of the account and the intent of the
confirmation

• External confirmation – types
– A positive (accounts receivable) confirmation is a
communication addressed to the debtor requesting him
or her to confirm directly with the auditor whether the
balance as stated on the confirmation request is
correct or incorrect.
– A negative confirmation is a communication addressed
to the debtor but requests a response only when the
debtor disagrees with the stated amount.

Positive
confirmation

Negative confirmation

• External confirmation – types
– A positive confirmation is more reliable evidence
because the auditor can perform follow-up procedures
if a response is not received from the debtor.
 Perform vouching as a follow-up procedure
– With a negative confirmation, failure to reply cannot be
regarded as a correct response because the debtor
may have ignored the confirmation request.

• External confirmation – timing
– The most reliable evidence from confirmations is
obtained when they are sent as close to the balance
sheet date as possible.

Accounts Receivable: Valuation
• Valuation assertion: Is the A/R balance collectible?
• Test of detail
– Obtain the aged accounts receivable trial balance
– For A/R balances outstanding for a long time:
 Obtain cash receipts and bank statement after year-end
for proof of payment received after year-end
 Inspect documentation that supports how management
determined the amount that it deems collectible or not
 Inspect to verify that the amounts deemed uncollectible
by management are recorded in the allowance for
doubtful accounts

A/R: Rights and Obligations
• Rights and Obligations—Does the client engage in
factoring?
• Test of detail:
– Inquire of management and inspect minutes of
directors’ meetings to determine whether the
receivables have been pledged as collateral, assigned
to someone else, factored, or sold at discount
– External confirmation to verify that customers owe the
A/R balances to the client

Revenue and A/R: Presentation
• Presentation — information about the revenue cycle
is fairly presented and disclosed in the financial
statements
• Test of detail:
– Evaluate the adequacy and understandability of the
presentation of the revenue recognition policy.
– Evaluate the understandability and completeness of the
footnotes for accounts receivable
– Read management’s discussion and analysis
(MD&A) to determine whether there are any
inconsistencies with the financial statements
Quiz
• There are two important assumptions that underly the auditor's use of
external confirmations. The first is that the person returning the
confirmation is independent of the company and so will provide an
unbiased response. The second is that
• A) only authorized employees of the company have prepared the
response.
• B) the person completing the response has carefully checked the data
being confirmed.
• C) the respondent has not been coerced or bribed to respond to the
confirmation.
• D) adequate controls exist at the client company to prevent
unauthorized responses.

Quiz
• There are two important assumptions that underly the auditor's use of
external confirmations. The first is that the person returning the
confirmation is independent of the company and so will provide an
unbiased response. The second is that
• A) only authorized employees of the company have prepared the
response.
• B) the person completing the response has carefully checked the
data being confirmed.
• C) the respondent has not been coerced or bribed to respond to the
confirmation.
• D) adequate controls exist at the client company to prevent
unauthorized responses.

Quiz
• To determine whether sales transactions have been
recorded in the proper accounting period, the auditor
performs cutoff tests. Which of the following best describes
the overall approach used when performing cutoff tests?
• A) Ascertain that management's letter of representation
includes the statement that transactions have been
accounted for in the proper accounting period.
• B) Analyze transactions occurring within a few days before
and after year-end.
• C) Confirm year-end transactions with regular customers.
• D) Examine cash receipts in the subsequent period.
Quiz
• To determine whether sales transactions have been
recorded in the proper accounting period, the auditor
performs cutoff tests. Which of the following best describes
the overall approach used when performing cutoff tests?
• A) Ascertain that management's letter of representation
includes the statement that transactions have been
accounted for in the proper accounting period.
• B) Analyze transactions occurring within a few days
before and after year-end.
• C) Confirm year-end transactions with regular customers.
• D) Examine cash receipts in the subsequent period.
Quiz
• To test for recorded sales for which there were no
actual shipments, the auditor traces from the
• A) bill of lading to the sales journal.
• B) sales journal to the shipping documents.
• C) sales journal to the accounts receivable subsidiary
ledger.
• D) bill of lading to the supporting customer order and
sales order.

Quiz
• To test for recorded sales for which there were no
actual shipments, the auditor traces from the
• A) bill of lading to the sales journal.
• B) sales journal to the shipping documents.
• C) sales journal to the accounts receivable subsidiary
ledger.
• D) bill of lading to the supporting customer order and
sales order.

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Auditing: The Art and Science of Assurance

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Analytical Procedure for Possible Misstatement Assertion

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