Chapter 09 - Slides - To Accompany Lecture Videos 11e

CHAPTER
9 Auditing the Revenue Cycle
Johnstone, Auditing: A Risk-Based Approach, 11th Edition. ©2019 Cengage. All Rights Reserved. May
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not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Learning Objectives (LO 1-5)
LO 1 Identify the significant accounts, disclosures, and relevant
assertions in the revenue cycle.
LO 2 Identify and assess inherent risks of material misstatement
in the revenue cycle.
LO 3 Identify and assess fraud risks of material misstatement in
the revenue cycle.
LO 4 Identify and assess control risks of material misstatement
in the revenue cycle.
LO 5 Describe how to use planning analytical procedures to
identify possible material misstatements for revenue cycle
accounts, disclosures, and assertions.
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Learning Objectives (LO 6-9)
LO 6 Determine appropriate responses to identified risks of
material misstatement for revenue cycle accounts,
disclosures, and assertions.
LO 7 Determine appropriate tests of controls and consider the
results of tests of controls for revenue cycle accounts,
LO 8 Determine and apply sufficient appropriate substantive
audit procedures for testing revenue cycle accounts,
LO 9 Apply the frameworks for professional decision making and
ethical decision making to issues involving the audit of
revenue cycle accounts, disclosures, and assertions.
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What Do You Think? (p. 402)
● Zynga’s 2016 Def 14-A (proxy statement) reveals that Zynga
paid EY approximately $4.6 million in audit and audit-related
fees. Think about this very challenging revenue recognition
situation, while simultaneously considering the audit firm
portfolio management discussion that we presented in
Chapters 1 and 5.
● Why do you think that EY is willing to take the risk of providing an
unqualified opinion on financial statements for which revenue
recognition is such a unique and challenging undertaking?
● What auditing procedures over revenue recognition might enable EY
to gain comfort that revenue, is indeed, properly valued?
● Speculate on EY’s decision to publish revenue recognition guidance
in this particular valuation space.
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Exhibit 9.1
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Exhibit 9.2
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An Overview of the Audit Opinion Formulation
Process in the Revenue Cycle
● Auditing the revenue cycle
● Risk assessment procedures
● Tests of controls
● Substantive procedures
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Inherent Risks: Revenue
● Timing of revenue recognition
● Criteria for Revenue Recognition
1. Identify the contract with the customer
2. Identify the performance obligations
3. Determine the transaction price
4. Allocate the transaction price to the deliverables
5. Recognize revenue when (or as) you satisfy performance
obligations
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Inherent Risks: Accounts Receivable
● Some inherent risks affecting receivables include:
● Receivables are pledged as collateral against specific loans with
restricted use (disclosures of such restrictions are required).
● Receivables are incorrectly classified as current when the
likelihood of collection during the next year is low.
● Collection of a receivable is contingent on specific events that
cannot currently be estimated.
● Payment is not required until the purchaser sells the product
to its end customers.
● Accounts receivable are aged incorrectly, and potentially
uncollectible amounts are not recognized.
● Orders are accepted from customers with poor credit, but the
allowance for doubtful accounts is not increased accordingly.
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Identifying Fraud Risks
● Research indicates that over 60% of frauds involve
inappropriate revenue recognition.
● Virtually every client has revenue, so identifying fraud
risks relating to revenue recognition is critical.
● Auditing standards state that auditors should ordinarily
presume there is a risk of material misstatement caused
by fraud relating to revenue recognition.
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How Do Fraudsters Perpetrate their Schemes?
(assertion that is violated)
● Recognizing revenue on shipments that never occurred or that occurred after the
end of the period (existence)
● Utilizing hidden side letters to avoid recording terms allowing sales returns (a side
letter is an agreement about contractual terms that is OUTSIDE the contract and is
therefore easy to hide from the auditor) (completeness, valuation)
● Recording consignment sales as final sales (rights)
● Shipping unfinished products, those that the customer never ordered, or before the
customers agreed to delivery (existence)
● Creating fictitious invoices (existence)
● Recording shipments to the company’s own warehouse as outside sales (existence)
● Shipping goods that had been returned and recording the reshipment as a sale of
new goods before issuing credit for the returned sale (existence, completeness–
sales returns, valuation)
● Incorrect aging accounts receivable and not recording write-downs of potentially
uncollectible amounts (valuation)
● Recording sales orders as completed sales (existence)
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Lapping
● A technique used to cover up the embezzlement of cash.
● A cash collection from one customer is stolen by an
employee who takes another customer’s payment and
credits the first customer.
● This process continues, and at any point in time at least
one customer’s account is overstated.
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Identifying Fraud Risk Factors
● Assessing motivation to enhance revenue because of either internal
or external pressures
● Reviewing the financial statements through planning analytical
procedures to identify account balances that differ from
expectations or general trends in the economy
● Recognizing that not all of the fraud will be instigated by
management
● Becoming aware of representations made by management to
analysts
● Determining whether the company’s accounting is being
investigated by organizations such as the SEC
● Considering management compensation schemes, especially those
that rely on stock options and therefore current stock prices
● Determining whether accounting functions are centralized, and if
not centralized, assessing if the decentralization is appropriate
● SEE FRAUD BRAINSTORMING RESEARCH PAPER
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Identifying Control Risks
● Requires understanding of internal controls for integrated audits and
financial statement only audits
● Such understanding is gained by:
● Walkthrough of the process (definition: a control in which the auditor
follows a transaction from its origination to financial records; it includes
tests such as inquiry, observation, inspecting documents, and
reperformance).
● Inquiry
● Observation
● Review of client’s documentation
● At account and assertion levels auditor considers:
● Entity-wide controls
● Commitment to financial accounting competencies
● Independence of the board of directors
● Transaction controls
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Purpose of Controls Related to Existence
● Providing reasonable assurance that sale and accounts
receivable are recorded only when:
● Shipment has occurred
● Primary revenue producing activity has been performed
● Mitigating risk that unearned revenues are improperly
recorded
● Distributing monthly statements to customers
● Ensuring that unusual transactions require a high level of
management review and that top-line journal entries
have a segregation of duties for review
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Controls Related to Completeness
● Using prenumbered shipping documents and sales
invoices and the subsequent accounting for all numbers
● Entering sales into the computer system and immediately
assigning a unique identification number
● Reconciling shipping records with billing records
● Monitoring and review of transactions
● Reconciling inventory with sales
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Controls Related to Valuation
● Limiting access to the files to authorized individuals
● Printing a list of changed prices for review by the
department that authorized the changes
● Reconciling input with printed output reports to assure
that all changes were made and no unauthorized ones
were added
● Limiting authorization privileges to those individuals with
the responsibility for pricing
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Exhibit 9.7
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Exhibit 9.8
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Considering the Results of Tests of Controls
● IF Auditor identifies control deficiencies:
● Assess to determine their severity
● Modify the preliminary control risk assessment
● Document the implications of control deficiencies
● IF Auditor does not identify any control deficiencies:
● Determine that preliminary assessment of control risk as low is
still appropriate
● Determine the extent that controls can provide evidence on
correctness of account balances
● Determine planned substantive audit procedures
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Obtaining Substantive Evidence About Accounts,
Disclosures, and Assertions in the Revenue Cycle
● Substantive tests in the revenue cycle typically provide
evidence that:
● Sales transactions do exist (i.e., no recording of fictitious sales)
and are properly valued
● Accounts receivable exist
● The balance in the allowance for doubtful accounts is
reasonable so that valuation is appropriate
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Exhibit 9.9
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What Do You Think? (p. 436)
● Read the feature about Sunrun, Inc. and SolarCity Corp.
● Put yourself in the perspective of these companies.
● Why can you empathize with their reluctance to provide
detailed disclosure on cancellations?
● Now put yourself in the perspective of the SEC and
investors.
● Why would detailed information about cancellations be
useful?
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Accounts Receivable: Substantive Procedures
● Starting point is an aged trial balance
● The auditor uses the aged trial balance to:
● Agree the detail to the balance in the control account
● Select customer balances for confirmation
● Identify amounts due from officers, employees, or other
related parties or any nontrade receivables that need to be
separately disclosed in the financial statements
● Help determine the reasonableness of the allowance for
doubtful accounts by identifying past-due balances
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Accounts Receivable: Substantive Tests of Details—
Confirmations
● Aging schedule
● Positive confirmations
● Negative confirmations
● Comparing positive and negative confirmations
● The confirmation process
● Sample selection
● Sampling unit
● Undeliverable confirmations
● Follow-up to nonresponses for positive confirmation
● Follow-up procedures for exceptions noted on positive confirmations
● Follow-up procedures for negative confirmations
● Additional procedures when confirmations are sent at an interim
date
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Exhibit 9.10
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Exhibit 9.11
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Exhibit 9.12
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Accounts Receivable: Substantive Procedures for the
Allowance Account
● Determining reasonableness of client’s estimate of
allowance for doubtful accounts is a difficult task
● Client’s estimate must reflect:
● Economic status of client’s customers
● Current economic conditions
● An informed expectation about potential default on payment
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CHAPTER

9 Auditing the Revenue Cycle

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