audit revenue test
TRANSCRIPT
8/12/2019 Audit Revenue Test
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Revenue cycle accounts – The impo rtance
Sales transactions are always material toa company's financial statements
According to the SEC, a majority of
financial statement manipulations andaudit failures involve overstated revenues
Therefore, revenue cycle accounts must
be examined with great care
Cha
pter 10:
Auditing Revenue andRelated Accounts
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The cycle approach Revenue cycle transactions include all the processes
ranging from the sale to shipping a product, billing thecustomer, and collecting cash
A company's revenue cycle transactions reflects itsoperations
A cycle approach is one way to help the auditor focus onthe important account balances surrounding atransaction to ensure that sufficient audit evidence isgathered and evaluated
Other cycles include:
acquisition and payment of goods and services
Payroll
Financing: debt and equity
Cash and short-term investments
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Business Risk and Business
EnvironmentRevenue recognition
SAS 99 - Consideration of Fraud in a
Financial Statement Audit
Auditor should presume risk of material
misstatement due to fraud related to
revenue recognitionResearch shows over half of frauds
involve overstating revenues
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Some Improper Revenue
Recognition Schemes Recognize revenue on fictitious shipments
Hidden side letters that give customers unlimited right toreturn product
Record consignment sales as final sales Accelerated recognition of sales occurring after year-end
Ship unfinished goods
Ship goods before date agreed to by customer
Create fictitious invoices
Ship goods never ordered
Ship more goods than ordered
Record shipments to company's warehouse as sales
Record shipments of replacement goods as new sales
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What are some fraud risk factors
for revenue recognition? There are a number of types of 'red flags' which
signal the potential for fraud in the financialstatements External risk indicators
Internal red flags
Unusual financial results
Auditor deals with red flags by Examining external pressures that could lead to
financial reporting fraud
Examining the financial statements to determine if
account balances seem out of line
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What analytical analysis can be
done for possible misstatements? Compare client revenue trend with
economic conditions and industry trends
Compare cash flow from operations withnet income
Perform analytical procedures
Ratio analysis
Trend analysis
Reasonableness tests
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Assessment of Environment
Risk Risk assessment is ongoing process in everyaudit
Audit steps to assess environment risk for the
revenue cycle:Update information on business risk
Perform analytical procedures to look forunexpected relationships
Develop understanding of internal controls
Analyze business risk for motivations andmethods to misstate sales
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Document operation of accountingapplications and important controls
Develop preliminary assessment of
environment risk If control risk is high, determine likely types of
misstatements
If control risk is lower, develop procedures to
test operation of controlsPerform tests of controls, document results
Based on the results of testing, reassesscontrol risk
Assessment of Environment
Risk –
Cont’d
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Inherent Risk with Regard to
Sales While sales transactions are routine for
most organizations and do not representan abnormally high risk, for otherorganizations, revenue recognition may becomplicated
Difficult audit issues include:
When to recognize revenues Auditor must understand client's operations and
related GAAP issues
Example: point of sale revenue recognition vs.
percentage of completion
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Impact of any unusual sales terms and whethertitle passed to customer Example: related party transactions
Goods recorded as sales have actually beenshipped
Sales made with recourse or that havesignificant returns
Example: irrevocable right to return goods
The presence of these issues increase inherentr isk and the probabi l i ty of mater ial
misstatement
Inherent Risk with Regard to
Sales –
Cont’d
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Inherent Risk in Receivables Primary risk is net receivables will be overstated,because either receivables have been overstated, or
the allowance for uncollectible accounts has beenunderstated
Risks affecting receivables include: Sales of receivables recorded as sales rather than
financing transactions
Receivables pledged as collateral
Receivables classified as current when likelihood ofcollection is low
Collection of receivable contingent on uncertain futureevents
Payment not required until purchaser sells the
product
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The Control Environment and
Sales An organization's control environment
affects revenue and related transactions
more than most accounts The auditor must consider:
Management's integrity
Financial condition of the organizationFinancial pressures on the organization
Management incentives to achieve financial
results
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Understanding Internal Controls Although the auditor must understand all components of
internal controls, particular attention is paid to significantcontrol procedures and monitoring controls
The auditor obtains an understanding of the controls by Walk-through of the processing of transactions
Inquiry
Observation
Review of client documentation
It is critical this understanding be documented in thework papers
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Understanding Internal Controls (2)
Assertions must be addressed during this phase:
Occurrence, Cutoff, Completeness, Accuracy &
Classification Controls Regarding Returns, Allowances and
Warranties are also important. Abnormal returns
or allowances may be the first sign that a
company has problems Credit Policies are also very important
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Documenting, Testing, and
Assessing Environment Risk Develop understanding of the accounting
system and control procedures
Evidence is gathered through inquiry, review of client
accounting manuals, and review of prior year auditworkpapers
Documentation includes questionnaires, flowcharts,
and narratives
Determine whether the application control proceduresare sufficient to achieve the control objectives
Based on control design, make preliminary
assessment of control risk
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The auditor must document those controls thatsupport an assessment of control risk belowmaximum
If the auditor plans to rely on the internalcontrols, the controls are tested to see if they areoperating as designed
If testing indicates the control is not operating
effectively, Auditor will increase assessed control risk,
lower detection risk, and perform morerigorous substantive testing
If the control is working effectively, control riskassessment is unchanged
Documenting, Testing, and
Assessing Environment Risk (2)
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Linking Environment Risk
Assessment & Substantive Testing The rigor of substantive testing is inversely
related to the assessed level of environment risk
The auditor learns three things during theassessment of environment risk that affects thedesign of substantive audit procedures:The nature of the accounting system, controls
used, and documents generated in the client's
processingExistence of fraud risk factors
Effectiveness of controls and types ofmisstatements likely to occur
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Substantive Testing in the
Revenue Cycle Planning for Direct Tests of Transactions and Account Balances Audit objectives and assertions
Account balance relationships Risk of material misstatement
Composition of the account
Persuasiveness of audit procedures
Cost of audit procedures Timing of audit procedures
Determining optimal mix of audit procedures
Exhibit 10.7 Outlines the relationship between Assertions and
Substantive Tests for the Revenue and Accounts Receivables
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Substantive tests of revenue –
object ive s/issues Assertions related to revenue transactions:
Occurrence: Have the transactions occurredand pertain to the entity
Completeness: Have all transactions beenrecorded
Accuracy: Have transactions been accuratelyrecorded
Cutoff: Have transactions been recorded inthe correct accounting period
Classification: Have transactions been
recorded in the proper accounts
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Substantive Tests of Revenue
for Occurrence and Accuracy Vouch recorded sales transaction back to
customer order and shipping document
Compare quantities billed and shippedwith customer order
Special care should be given to sales
recorded at the end of the year
Scan sales journal for duplicate entries
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Substantive Tests of Revenue
Cutoff Tests Can be performed for sales, sales
returns, cash receipts
Provides evidence whether transactions
are recorded in the proper period
Cutoff period is usually several daysbefore and after balance sheet date
Extent of cutoff tests depends oneffectiveness of client controls
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Substantive Tests of Revenue
Cutoff Tests e.g. Sales cutoff Auditor selects sample of sales recorded during cutoff
period and vouches back to sales invoice andshipping documents to determine whether sales arerecorded in proper period
Cutoff tests assertions of existence and completeness
Auditor may also examine terms of sales contracts
Sales return cutoff Client should document return of goods using
receiving reports Reports should date, description, condition, quantity
of goods
Auditor selects sample of receiving reports issuedduring cutoff period and determines whether credit
was recorded in the correct period
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Substantive Tests of Revenue
for Completeness Use of pre-numbered documents is
important
Analytical procedures
Cutoff tests
Auditor selects sample of shipping
documents and traces them into the sales
journal to test completeness of recording
of sales
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Substantive Tests of Accounts
Receivable - issues
Existence & OccurrenceDoes the receivable exist?
Valuation Are sales and receivables initially recorded at their
correct amount?Will client collect full amount of recorded receivables?
Rights and Obligations Contingent liabilities associated with factor or sales
arrangementsDiscounted receivables
Presentation and Disclosure Pledged, discounted, assigned, or related party
receivables
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Standard Substantive Tests of
Accounts Receivable1. Obtain and evaluate aging of
accounts receivable
2. Confirm receivables with customers
3. Perform cutoff tests
4. Review subsequent collections ofreceivables
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1. Aging Accounts Receivable
Because receivables are reported at net realizable value,auditors must evaluate management estimates ofuncollectible accounts
Auditor will obtain or prepare schedule of aged accounts
receivable If schedule is prepared by client, it is tested for mathematical and
aging accuracy
Aging schedule can be used to Agree detail to control account balance
Select customer balances for confirmation Identify amounts due from related parties for disclosure
Identify past-due balances
Auditor evaluates percentages of uncollectibility
Auditor then recalculates balance in the Allowance
account
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2. Confirming Receivables with
CustomersConfirmations provide reliable external evidence about the
Existence of recorded accounts receivable and
Completeness of cash collections, sales discounts, and
sales returns and allowancesConfirmations are required by GAAS unless one of the
following is present:
Receivables are not material
Use of confirmations would be ineffective Environment risk is assessed as low and sufficient
evidence is available from using other substantive tests
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2.a The Types of ConfirmationsPositive confirmations
Customers are asked to agree the amount on
the confirmation with their accounting records
and to respond directly to the auditor whetherthey agree with the amount or not
Positive confirmation requires a response
If customer does not respond, auditor must usealternative procedures
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Negative confirmations
Customers are asked to respond only if they disagreewith the balance (non-response is assumed to meanagreement)
Less expensive since there are no additional proceduresif customer does not respond
May be used when all of the following are present
Confirming a large number of small customer
balances Environment risk for receivables is assessed as low
Auditor believes customers will give proper attentionto confirmations
2.b The Types of Confirmations
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2.c What’s the follow-up
procedures for non-responses?1. If customer does not respond to positive
confirmation, auditor may send a second, oreven third, request
2. If customer still does not respond, auditor willuse alternative proceduresa) Examine the cash receipts journal for cash collected
after year-end Care is taken to ensure receipt is year-end receivable, not
subsequent saleb) Examine documents supporting receivable
(purchase order, sales invoice, shipping documents)to determine if sale occurred prior to year-end Evidence gathered from internal documents is not
considered as reliable
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2.d What’s the follow-up
procedures for exceptions noted? Customers are asked to agree the amount onthe confirmation to their accounting records;differences are called exceptions
Reasons for exceptions: Timing differences
Disputed items
Customer errors
Client misstatement Because misstatements are projected to the
population of receivables, the auditor mustdetermine the reason for the exception
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Related-Party Receivables Amounts due from related parties should be
separately disclosed
Audit procedures to identify related-party
transactions include:Review SEC filings
Review the accounts receivable subsidiary ledger and
trial balance
Management inquiry
Communicate names of related parties so all audit
team members can be alert for related-party
transactions
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Sold, Discounted, and Pledged
Receivables Receivables sold with recourse, discounted, orpledged as collateral should be disclosed
Audit procedures to identify these items include:
Management inquiryScan cash receipts journal for large cash
inflows from unusual sources
Bank confirmations, which include information
on obligations and terms
Review board of director minutes, whichcontain approval for these items
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Fraud Indicators and Audit Procedures
Potential fraud indicators:
Excessive credit memo or other adjustments to accountsreceivable just after year-end
Customer complaints and discrepancies in receivableconfirmations
Unusual entries to the receivable subsidiary ledger or sales journal
Missing or altered source documents
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Fraud Indicators & Audit Procedures - 2
Potential fraud indicators:
Lack of operating cash flow when operating income has beenreported
Unusual reconciling differences between receivable subsidiary
ledger and control account Sales in the last month with unusual terms
Pre- or post-dated transactions
Unusual adjustments to sales accounts before/after year-end
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Fraud Indicators and Audit Procedures - 3
Substantive procedures that may highlight potential fraudindicators:
Review of source documents including invoices, shippingdocuments, customer purchase orders, etc
Review and analyze credit memos and otheradjustments to receivables
Confirm sales terms with customers
Analyze large or unusual sales made near year-end
Scan the general ledger, receivables subsidiary ledger,and sales journal for unusual activity
Perform analytical review of credit memo and write-offactivity
Analyze recoveries of written-off accounts
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Auditing of Allowance for Doubtful
Accounts Accounts receivable should be reported at their net realizable value
The balance of the allowance for doubtful accounts is estimated anddepends on a number of factors
Understating the allowance overstates net accounts receivable and
net incomeWhere accounts receivable are material, the auditor should obtain
an understanding of how management developed the estimate byusing one or more of these approaches:
Review and test the process used by management to develop the
estimate Test aging schedule
Evaluate estimated percentages of uncollectibility used
Develop an independent model to estimate the accounts
R i b t t h b t ll ti