II. REVENUE CYCLE

A. SALES Under strong internal control, segregation of the functions in a sales transaction should exist as follows:

1. Preparation of the Sales OrderThe sales function begins with the receipt of a customer purchase order by the sales department. If it is determined that the order can be filled, a serially numbered sales order is prepared and sent to the credit department for approval.

2. Credit ApprovalThe credit department determines whether or not the customer may receive goods on open account. If the order is approved, a copy of the approved sales order is sent to the shipping department, the billing department, and the accounting department.

3. ShipmentIn the shipping department, a serially numbered bill of lading is prepared and a copy is sent to the customer. The goods are shipped, and at this point a receivable arises.

4. BillingThe billing department prepares a serially numbered sales invoice. Shipping documents, sales orders, and invoices are compared to assure that all shipments were based on valid customer orders and were properly billed. Prices and discounts are applied to the invoice, and necessary extensions and footings are computed. The invoice is then sent to the customer and to the accounts receivable department.

5. AccountingThe sale is entered into the sales journal, and a receivable is recorded.

B. ACCOUNTS RECEIVABLE

1. Sales A receivable is recorded in the accounts receivable control account in the general ledger and in the accounts receivable subsidiary ledger. Periodically, an independent person should reconcile these two records.

2. Collection of Cash ReceiptsWhen payment is received from the customer, the receivable is eliminated.

3. Uncollectible ReceivablesAn aging schedule is prepared and sent to the credit department for use in carrying out its collection program. At some point, uncollectible receivables should be written off. Controls for writing off receivables include proper authorization (by the treasurer) and recordkeeping. Without proper control, amounts subsequently collected easily could be misappropriated by employees.

a. The auditor observes the preparation of the aging schedule as part of the study of internal control.

4. Sales ReturnsReturned goods must be examined to ensure that they correspond with the reason for return before credit is given. A serially numbered receiving report may be used as a sales return slip. Once the return is approved, the related receivable is eliminated.

a. Credit memos should not be prepared by individuals who collect or receive cash payments on accounts receivable; to do so would be an inadequate segregation of duties.

5. Sales DiscountsSales discount procedures and records should be reviewed to ensure that discounts are properly given and recorded. This ensures that receivables are not overstated.

C. CASH RECEIPTS

1. Collection of Cash Receipts

Incoming mail must be opened by a person who does not have access to the accounts receivable ledger. The receipts should be listed in detail with one copy and the actual receipts sent to the cashier to prepare the bank deposit, another copy sent to the accounts receivable department for entry in the accounts receivable subsidiary records, and a third copy sent to the accounting department for entry in the general ledger accounts receivable control account. The accounts receivable department should match the details from the bank deposit ticket with the details from the remittance advices. This will reveal any discrepancies. Cash collections should be restrictively endorsed upon receipt and deposited daily. Devices such as cash registers or lock boxes should be used as safeguards.

TESTS OF CONTROLS RELATED TO THE REVENUE CYCLE

1. Testing Controls Related to Sales

Department Control Procedure Test of Control Procedure

Order & Credit

1. 1. Prepare prenumbered sales order.2. 2. Perform credit check (authorization).3. 3. Approve credit for returns.

4. Follow up on old or past-due accounts.1.Initiate write-offs, which should be approved

by the treasurer.

· Inquire about credit procedure for new customers (valuation).

· From a population of approved sales orders (and returns), select a sample and examine documents for evidence of credit check (valuation).

Warehouse & Shipping

1.Receive approved sales order from credit dept (must have approved sales order before release of goods from warehouse).

2.Pull inventory from warehouse and release to shipping.

3.Perform independent check of goods received from warehouse and approved sales orders in shipping department.

1. Prepare prenumbered bill of lading.

· Observe warehouse personnel filling sales orders (existence).

· Observe physical controls over inventory.

· Observe evidence of independent checks (existence).

· Inspect a sample of prenumbered shipping documents and:– Agree to sales order (existence).– Account for prenumbering

(completeness).

Billing/Accounts Receivable

1.Match shipping documents and sales orders before preparing invoice.

1. Periodically account for allprenumbered shipping documents.

2.Perform independent check of sales order pricing.

3. Prepare prenumbered sales invoice.2. Batch and total invoices.

4.Update A/R master file. Agree input to invoice batch totals.

3. Print sales journal.5.Print sales summary. Agree to invoice batch

totals (independent check).6. Mail monthly customer statements.

· Vouch a sample of sales invoices (select approved sales orders from the sales journal) to shipping documents and approved sales orders (existence).

· Trace a sample of shipping documents (selection from prenumbered shipping

documents) to sales invoice, sales journal, and A/R master file (completeness).

· Observe procedure. Reperform procedures for a sample period (completeness).

· Reperform pricing check: From a sample of sales invoices, check pricing with master price list (valuation).

· Observe procedure and reperform (valuation).

· Observe mailing (existence,completeness, valuation).

Accounting 1. Receive sales summary.2. Perform independent check of invoice batch totals

and sales summary.3. Review sales account classifications.4. Post to G/L.

5. Follow-up customer exceptions (independent check).

· Observe and reperform (valuation,existence, completeness).

· Observe and reperform (reportpresentation).

· Inspect customer exception file and disposition (existence, completeness, rights, valuation).

NOTE: A formal audit program can be prepared organized by assertion and sample population.

SEGREGATION OF DUTIES:· Authorization: Sales Order & Credit, Treasurer· Recordkeeping: Billing/Accounts Receivable/Accounting· Custody: Warehouse & Shipping

2. Testing Controls Related to Collections

Department Control Procedure Test of ControlMailroom 1.Separate checks and remittance

advices.2.Stamp restrictive endorsement on

checks.3.Prepare prelisting of checks

received.4.Forward checks to Cashier.

Forward remittance advices to A/R. Forward prelisting to Accounting, Cashier, and Accounts Receivable.

· Inspect checks prior to deposit forendorsement (completeness).

Observe preparation of prelisting (existence, completeness, valuation).

Cashier 1. Receive checks and prepare deposit.2.Prepare daily cash summary (copy to A/R

and Accounting).3. Deliver checks to bank.

File validated deposit slip.

Observe preparation of cash summary(existence, completeness, valuation).Inspect deposit slip and compare to cash summary (existence, completeness, valuation).

Accounts Receivable 1.Match remittance advices and check deposit summary.

2. Update A/R master file.3.Print CR journal/Updated A/R master file.4. Print CR summary (copy to

Accounting).

Observe procedure (completeness).

Accounting 1. Independent check: Compare the cash summary (Cashier), the prelisting of checks (Mailroom), and the CR

summary (A/R).2. Post G/L.

Prepare bank reconciliation

· Inspect evidence of independent check(existence, completeness, valuation).

· Reperform independent check for selected dates (existence, completeness, valuation).

· Inspect bank reconciliation (existence, completeness, valuation).

SEGREGATION OF DUTIES:· Recordkeeping: Accounts Receivable/Accounting· Custody: Mailroom & Cashier (Treasurer)

AUDIT PROCEDURES RELATED TO THE REVENUE CYCLE

1. Sales

The auditor should verify that recorded sales are based on approved sales orders and shipping documents. The auditor must also determine that all sales are recorded at the appropriate amount and in the proper period.

a. Books and Records

The auditor should match the sales invoices with supporting shipping documents. The auditor should compare the sales journal with the subsidiary ledgers, test the mathematical accuracy of the trial balance, and compare the total in subsidiary ledgers with the general ledger.

b. Cutoff

Sales invoices before and after year-end should be examined. In addition, the auditor should analyze sales returns after year-end.

2. Accounts Receivable

The auditor should review the accounts receivable schedule for accuracy and collectibility.

a. Confirmation

Confirmation of receivables (covered later) is considered to be a generally accepted auditing procedure.

b. Adequacy of Uncollectible Accounts

Calculations should be made to determine the adequacy of the allowance for uncollectible accounts. An aging schedule of accounts receivable should be constructed. Tests of the adequacy of the allowance relate to the financial statement assertion of valuation and allocation.

3. Cash Receipts

A. AUDIT PROCEDURES RELATED TO CASH

Cash is an integral part of both the revenue and expenditure cycles. The cash account should be reviewed to verify the accuracy of the account and to detect theft and any evidence of kiting or lapping. The auditor should look at all bank reconciliations and confirmations.

The auditor should obtain bank cutoff statements and, if there is more than one cash account, the auditor should prepare bank transfer schedules for transfers between accounts.

1. Internal Control

Internal control over the handling of cash is one of the most critical areas of the audit. Proper segregation of duties relating to cash demands that close consideration be given to check-writing authority. Separation of cash handling, recordkeeping, and reconciliation of bank statements should exist as well as separation of petty cash activities. Good internal control for cash would include the use of a voucher system for cash disbursements.

2. Cutoff

The auditor should obtain cutoff bank statements ten to fifteen days after year-end. The auditor should verify the cutoff of cash receipts and cash disbursements and examine all wire and interaccount cash transfers close to year-end.

3. Books and Records

Auditors should foot and crossfoot all books and records. They should mathematically test calculations in the cash journals, vouch postings to ledger accounts, reconcile bank statements, and verify cash transactions in one or more expense accounts. Auditors should also compare the cash receipts journal with deposit slips for chosen test periods.

4. Evidence: Internal and External (Simultaneous Verification)

The auditor should examine all internal evidence. This would include counting the cash on hand and reconciling it with the journals.

Procedures used to obtain external evidence would include confirming amounts on deposit with banks, confirming all securities on deposit, and obtaining bank cutoff statements.

5. Related Accounts

Almost all asset, liability, and expense accounts are related to the cash disbursement function. Specific attention should be devoted to petty cash, payroll, purchases, and miscellaneous expenses. These accounts should be reconciled to the appropriate supporting journals.

6. Identification and Prevention of Fraudulent Schemes with Respect to Cash

a. Lapping

(1)Definition

The theft of cash is often concealed by failing to account for cash receipts. The most common of these methods is known as lapping. Lapping involves withholding current receipts of cash or checks and not recording them. The unrecorded receipt is covered by applying a subsequent receipt to the previously unrecorded account.

(2)How to Prevent and Detect Lapping

Some of the safeguards against lapping include independent comparison of recorded cash receipts with funds actually deposited, separation of incoming receipts from subsidiary accounts receivable remittance advices, comparison of the details of bank deposits and the details of remittance credits, provision of timely statements, and confirmation of customer balances. One of the best methods to guard against lapping is use of a "lock box" system. In this system, customers send their payments directly to the bank, which prevents company employees from having access to payments received.

One of the best methods to detect lapping is to compare the dollar amounts and dates on the bank deposit slips with customer remittance credits recorded in the accounts receivable ledger. Any lapping not using exact replacement dates and amounts would be detected.

b. Kiting

(1)Definition

Kiting occurs when a check drawn on one bank is deposited in another bank and no record is made of the disbursement in the balance of the first bank. Kiting may be used to cover a cash shortage or to pad a company's cash position.

(2)How to Detect Kiting

To detect kiting effectively, the cash deposits in transit at the end of a period and the paid checks returned with the bank statements of the next period must be examined. This is accomplished by preparing a bank transfer schedule. A bank transfer schedule compares the dates checks are drawn (on the disbursing bank account) to the dates checks are deposited (in the receiving bank account). Kiting is indicated when the date stamped by the receiving bank on the rear of the returned (paid) check precedes the date on which the disbursement was recorded.

7. Transfer Schedules, Bank Confirmations, and Bank Statements

a. The auditor's main emphasis in testing cash is on the verification of the ending balances (existence) and on the detection of theft or kiting. Since cash is such an active account, most evidence will be gathered with respect to ending balances rather than individual transactions. Special attention should also be paid to cash handling and internal controls. The auditor's sources of evidence will include bank transfer schedules (kiting test), bank confirmations, bank reconciliations, and cutoff bank statements.

b. The standard bank confirmation should be sent to all banks with whom the client has done business during the year, regardless of whether there is a year-end balance to confirm. This is done because the bank confirmation, in addition to verifying year-end balances, also provides evidence about actual loans and contingent liabilities, discounted notes, pledged collateral, and guarantee or security agreements.

Substantive tests of revenue

Assertions related to revenue transactions: Occurrence: Have the transactions occurred and pertain to the entity Completeness: Have all transactions been recorded Accuracy: Have transactions been accurately recorded Cutoff: Have transactions been recorded in the correct accounting period Classification: Have transactions been recorded in the proper accounts

Substantive Tests of Revenue for Occurrence, Accuracy, and ValuationVouch recorded sales transaction back to customer order and shipping document

Compare quantities billed and shipped with customer order Special care should be given to sales recorded at the end of the year Scan sales journal for duplicate entries

Substantive Tests of Revenue Cutoff TestsCan be performed for sales, sales returns, cash receipts

Provides evidence whether transactions are recorded in the proper period Cutoff period is usually several days before and after balance sheet date Extent of cutoff tests depends on effectiveness of client controls Sales cutoff

Auditor selects sample of sales recorded during cutoff period and vouches back to sales invoice and shipping documents to determine whether sales are recorded 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 issued during cutoff period and determines whether

credit was recorded in the correct period

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

Substantive Tests of Accounts Receivable Existence & OccurrenceValuation

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 arrangements Discounted receivables

Presentation and Disclosure· Pledged, discounted, assigned, or related party receivables

Substantive test of AR Obtain and evaluate aging of accounts receivable Confirm receivables with customers Perform cutoff tests Review subsequent collections of receivables

Aging Accounts Receivable

Because receivables are reported at net realizable value, auditors must evaluate management estimates of uncollectible 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

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 allowances

Confirmations 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

Types of Confirmations

Positive confirmations Customers are asked to agree the amount on the confirmation with their accounting records and

to respond directly to the auditor whether they agree with the amount or not Positive confirmation requires a response If customer does not respond, auditor must use alternative procedures

Negative confirmations Customers are asked to respond only if they disagree with the balance (non-response is assumed

to mean agreement) Less expensive since there are no additional procedures if 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 attention to confirmations

Follow-up procedures for non-responsesIf customer does not respond to positive confirmation, auditor may send a second, or even third, requestIf customer still does not respond, auditor will use alternative procedures

Examine the cash receipts journal for cash collected after year-end Care is taken to ensure receipt is year-end receivable, not subsequent sale

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

Follow-up procedures for exceptions noted

Customers are asked to agree the amount on the confirmation to their accounting records; differences are called exceptionsReasons for exceptions:

Timing differences Disputed items Customer errors Client misstatement

Because misstatements are projected to the population of receivables, the auditor must determine the reason for the exception

Related-Party ReceivablesAmounts due from related parties should be separately disclosedAudit 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

Sold, Discounted, and Pledged ReceivablesReceivables sold with recourse, discounted, or pledged as collateral should be disclosedAudit procedures to identify these items include:

Management inquiry Scan cash receipts journal for large cash inflows from unusual sources Bank confirmations, which include information on obligations and terms Review board of director minutes, which contain approval for these items

Fraud Indicators and Audit Procedures

Potential fraud indicators: Excessive credit memo or other adjustments to accounts receivable just after year-end Customer complaints and discrepancies in receivable confirmations Unusual entries to the receivable subsidiary ledger or sales journal Missing or altered source documents Lack of operating cash flow when operating income has been reported 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 just before or after year-end

Substantive procedures that may highlight potential fraud indicators: Review of source documents including invoices, shipping documents, customer purchase orders, etc Review and analyze credit memos and other adjustments 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-off activity Analyze recoveries of written-off accounts

Auditing of Allowance for Doubtful Accounts

Accounts receivable should be reported at their net realizable valueThe balance of the allowance for doubtful accounts is estimated and depends on a number of factorsUnderstating 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 by using 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 Review subsequent events such as subsequent collections on account