Auditing the Revenue

Cycle

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Cycles
• Auditors typically group financial statement accounts into
cycles.
• A cycle is a set of accounts that are logically grouped in the
internal control system.
• Most audit firms recognize four cycles:
o Revenue and Collection Cycle (This lecture)
o Acquisition and Expenditure Cycle (Lecture 12)
o The Production Cycle
o Finance and Investment Cycle

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Understand the Sales Process

Product Payment
• Cash/credit cards
(retail)
• On credit/account
(wholesale)
o Who gets credits?
Goods or One-stage or o Approval process
service? multistage?
o Payment terms
Understand the Sales Process

Delivery Salespeople
• Are there salespeople?
• How are they paid?
o Fixed salary/hourly
wage
Take it with them? Delivery o Commissions
Client?
Courier company? o Bonus
Basic Activities in Revenue and Collection Cycle
The basic activities in the revenue and collection cycle
for a typical manufacturing company include:
1. receiving and processing customer orders;
2. delivering goods and services to customers;
3. billing customers and accounting for accounts
receivable; and
4. collecting and depositing cash received from
customers.

©McGraw-Hill Education. 7-5

 Start

Salesperson
A typical sales
Customers
select items scans ID process for retail
Scan barcode of
the items Price list

Total for sales

Cash Receive cash Accounting

Payment
and get the Information
type
change
System
Credit card
Charge credit Generate Dr. Cash
card receipt Cr. Sales

Receipt

To customers
 Order via
website
Exceed the Print order
limit details
Credit
Deny the
limit
order
check Pick/pack
Within the list
limit
Process AIS
the order Collect
No
items
Yes

Items
match
A typical sales process
for wholesale Attach label
to box

Mark order
as ready for
delivery

Obtain
Dr. A/R
customer Deliver item
Cr. Sales signature
Using the Audit Risk Model
Risk of Material
Misstatement (RMM)
The risk that the material
misstatement is not
detected by the auditor’s
own procedures

Audit Inherent Control Detection

Risk Risk Risk Risk

The risk that a material The risk that the material

misstatement will even misstatement would not be
occur prevented or detected by
client internal controls

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 Inherent Risks

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Inherent Risks
• Improper Revenue Recognition
– Cut-off
– Bill and Hold
– Channel Stuffing

• Returns and Allowances

• Collectability of Receivables

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Significant Accounts and Relevant Assertions in
the Revenue and Collection Cycle

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Revenue Recognition
• Must be (1) realized or realizable and (2) earned
– Persuasive evidence of an arrangement exists;
– Delivery has occurred or services have been rendered;
– The seller's price to the buyer is fixed or determinable; and
– Collectability is reasonably ensured.

©McGraw-Hill Education. 7-12

What Can Go Wrong in the Revenue and
Collection Cycle?

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 Control Risks

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Key Control Procedures
• Separation of Duties
– Separate functions for recording, authorization, custody
• Authorization of Transactions
– Write-offs
– Electronic Data Interchange (EDI) transactions
– Credit checks prior to approval of sale
– Pricing
• Access to Assets
– Shipping department
– Lock box account
• Adequate Documents and Records
– Pre-numbered sales orders, shipping documents (bills of lading), sales invoices
– Remittance advice
• Independent Checks on Performance
– A/R subsidiary ledger to general ledger
– Monthly statement to customer

©McGraw-Hill Education. 7-15

 Consider: What controls does the client have?

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 Consider: What controls does the client have?

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 Quiz 1
Which of the following is the best reason for prenumbering in
numerical sequence such as sales orders, shipping documents,
and sales invoices?
A. Enables company personnel to determine the accuracy of
each document
B. Enables personnel to determine the proper period recording
of sales revenue and receivables
C. Enables personnel to check the numerical sequence for
missing documents and unrecorded transactions
D. Enables personnel to determine the validity of recorded
transactions

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Test of Controls
• Auditors usually take a sample
• There are several ways to select an audit sample, such as
random selection, systematic selection and haphazard
selection.
– Random selection: each item is chosen randomly and entirely by
chance, such that each item has the same probability of being chosen.
– Systematic selection: a type of probability sampling method in which
sample members from a larger population are selected according to a
random starting point but with a fixed, periodic interval.
– Haphazard selection: a sampling method that does not follow any
systematic way of selecting participants.
• An example of Haphazard Sampling would be standing on a busy corner during rush
hour and interviewing people who pass by.

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Tests of Controls

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Tests of Controls

©McGraw-Hill Education. 7-21

 Quiz 2
The control procedure “credit sales approved by credit
department” is directed toward which transaction assertion?
A. Occurrence
B. Completeness
C. Accuracy
D. Cutoff

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 Detection Risk

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 Determine Detection Risk

Lower Detection Risk Higher Detection Risk

Allowed Allowed
Nature More effective tests Less effective tests
Timing Testing at year-end Testing at interim
Extent More tests Fewer tests

Substantive Procedures
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 Substantive Procedures
• Substantive procedures (or substantive tests) are those
activities performed by the auditor to detect material
misstatement or fraud at the assertion level.
Substantive Procedure

Substantive Analytical Estimate of an Recorded

Procedure (SAP) account balance

Tests of Details Directly test

transactions

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 Quiz 3
Auditors sometimes use comparisons of ratios as audit evidence.
An unexplained decrease in the ratio of gross profit to sales may
suggest which of the following possibilities?
A. Unrecorded purchases
B. Unrecorded sales
C. Merchandise purchases being charged to selling and general
expense
D. Fictitious sales

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Substantive Procedures - Revenue

©McGraw-Hill Education. 7-27

Substantive Procedures - Revenue

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Substantive Procedures - Revenue

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Substantive Procedures - A/R

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Using Confirmations
• Primarily for verifying existence
• Factors likely to affect the reliability of confirmations
– Previous audit experience
– Intended recipient of the confirmation
– Type of information being confirmed

• Auditor may confirm entire balances or

individual transactions
– Type of confirmation being sent

©McGraw-Hill Education. 7-31

Types of Confirmations
• Positive Confirmations
– small number of accounts are involved
– large number of errors are anticipated

• Negative Confirmations
– the combined assessed level of inherent and control risk is low
– a large number of small balances is involved
– the auditor has no reason to believe that the recipients of the
requests are unlikely to give them consideration.

• Blank Confirmations should be used if the recipient is likely to

return a positive confirmation without verifying the accuracy
of the information.

©McGraw-Hill Education. 7-32

 Quiz 4
When auditing the revenue and collection cycle, auditors
normally select balances to confirm from the
A. Sales journal
B. Accounts receivable listing
C. General ledger
D. Cash receipts listing

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Substantive Procedures - A/R

©McGraw-Hill Education. 7-34

 Quiz 5
An audit team is auditing sales transactions. One step is to vouch
a sample of debit entries from the accounts receivable subsidiary
ledger back to the supporting sales invoices. The purpose of this
audit procedure is to establish that
A. All sales have been recorded
B. All sales invoices have been properly posted to customer
accounts
C. Entries in the accounts receivable subsidiary ledger were
properly invoiced

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Test of controls vs Substantive Tests