Audit of the sales and collection cycle: Tests of controls and substantive tests of

transactions

Accounts and classes of transactions in the sales and collection cycle

There are five classes of transactions in the sales and collection cycle:
 Sales (cash and sales on account)  Write-off of uncollectible accounts
 Cash receipts  Estimate of bad debt expense
 Sales returns and allowances

Business functions in the cycle and related documents and records

There are eight business functions within the sales and collection cycle:
 Processing customer orders  Processing and recording sales
 Granting credit returns and allowances
 Shipping goods  Writing off uncollectible accounts
 Billing customers and recording receivable
sales  Providing for bad debts
 Processing and recording cash
receipts
Methodology for Designing Tests of Controls and Substantive Tests of Transactions for Sales
 Understand Internal Control—Sales: To gain an understanding, the auditor can use the
client’s flowchart or other documentation and perform walkthrough tests.
 Assess Planned Control Risk—Sales: There are four steps to this process:
1. Determine a framework for assessing control risk, which is provided by the
transaction-related audit objectives.
2. Identify key internal controls and deficiencies for sales.
3. Associate the key internal controls and deficiencies with the audit objectives.
4. Assess control risk for each objective by evaluating controls and deficiencies.
The key control activities for sales:
a) Adequate Separation of Duties—Proper separation of duties helps to prevent
misstatements due to both errors and fraud.
b) Proper Authorization—The auditor is concerned about authorization at three
points:
c) Credit must be properly authorized before a sale takes place.
d) Goods should be shipped only after proper authorization.
e) Prices, including basic terms, freight, and discounts, must be authorized.
f) Adequate Documents and Records—May be paper or electronic.
g) Pre-numbered Documents—This helps prevent both the failure to bill and
duplicate billings and recordings.
h) Monthly Statements—This is a useful control because it encourages customers
to respond if their balance is incorrect.
 i) Internal Verification Process—Can be manual or computerized.
Assess control risk for each objective by evaluating controls and deficiencies.
 Determine Extent of Tests of Controls—After key controls and deficiencies are
identified, auditors assess control risk and determine the extent of tests of controls.
 Design Tests of Controls for Sales
Design Substantive Tests of Transactions for Sales—Substantive tests are designed for
each transaction-related audit objective, including:
1. Recorded Sales Occurred—There are three types of possible misstatements:
a) Sales included in the journals for which no shipment was made
b) Sales recorded more than once
c) Shipments made to nonexistent customers and recorded as sales
2. Existing Sales Transactions Are Recorded—This is less likely to be tested because
the risk of overstatement of sales is more likely than understatement.
3. Direction of Tests—The direction of the test fulfills different objectives:
a) Tracing—From source documents to the journals tests for omitted transactions
(completeness objective)
b) Vouching—From the journals back to the source documents tests for nonexistent
transactions (occurrence objective)
4. Sales Are Accurately Recorded—Auditor concerns:
a) Shipping the amount of goods ordered
b) Accurately billing for the amount of goods shipped
c) Accurately recording the amount billed in the accounting records
5. Sales Transactions Are Correctly Included in the Master File and Correctly
Summarized
6. Recorded Sales Are Correctly Classified
7. Sales Are Recorded on the Correct Dates
8. Summary of Methodology for Sales:
a) Transaction-related audit c) Tests of controls
objectives d) Deficiencies
b) Key existing controls e) Substantive tests
9. Design and Performance Format Audit Procedures—Properly designed and
formatted audit programs do the following:
a) Eliminate duplicate procedures
b) All procedures on any one document are completed at the same time
c) Enables the most effective order in which to perform procedures

SALES returns and allowances

Transaction-related audit objectives are essentially the same for credit memos as those for
processing sales, with two notable differences:
 Materiality. Sales returns and allowances are often so immaterial that auditors can ignore
  Emphasis on the occurrence objective. Auditors usually emphasize testing recorded
transactions to uncover any theft of cash in the collection of accounts receivable that was
covered up by fictitious sales returns or allowances.

Methodology for designing tests of controls and substantive tests of transactions for cash receipts
Auditors use the same methodology for tests of controls and substantive tests of transactions for
cash receipts as they use for sales:
 Determine key internal controls for each audit objective.
 Design tests of control for each control used to support reduced control risk.
 Design substantive tests of transactions to test for monetary misstatement for each objective.
Determine Whether Cash Received Was Recorded—It is difficult to detect theft if cash when it
occurs before the cash is recorded. Pre-numbered remittance advices and prelists of cash receipts
are usually tested against journals, but this is effective only if the prelist was prepared when the
receipt was received.
Prepare Proof of Cash Receipts—Total cash receipts recorded in the journal for a specific period
is compared with the amount of cash deposited in the bank during the same period.
Test to Discover Lapping of Accounts Receivable—Lapping is postponing entries for cash
receipts to conceal an existing cash shortage. This can be easily prevented by adequate
separation of duties.

Audit tests for uncollectible accounts

Similar to sales returns and allowances, the auditor’s concern in the write-off of uncollectible
accounts is the possibility that write-offs are used to cover up embezzlement of cash receipts.
The auditor is also concerned with the balance-related objective of the realizable value of net
accounts receivable. Two controls that address this issue:
 The preparation of a periodic aged accounts receivable trial balance for review and
follow-up by appropriate management personnel.
 A policy of writing off uncollectible accounts when they are no longer likely to be
collected.

Effect of results of tests of controls and substantive tests of transactions

The results of the tests of controls and substantive tests of transactions have a significant effect
on the remainder of the audit.
If the test results are unsatisfactory, it will be necessary to do additional substantive testing.
The most significant effect of the results of the tests of controls and substantive tests of
transactions in the sales and collections cycle is on the confirmation process. The type of
confirmation, the size of the samples, and the timing are all affected.