Auditing and Assurance Services A Systematic Approach 9th Edition Messier Solutions Manual

Chapter 10 - Auditing the Revenue Process
CHAPTER 10
AUDITING THE REVENUE PROCESS
Answers to Review Questions
10-1 FASB Statement of Financial Accounting Concepts No. 5, "Recognition and

Measurement in Financial Statements of Business Enterprises" (CON5), requires that
before revenue is recognized (recorded) it must be realized or realizable and earned.
Revenues are realized when the products or services are exchanged for cash, a promise to
pay cash, or other assets that can be converted into cash. Revenues are earned when the
entity has substantially completed the earnings process, which generally means the
product has been delivered or the service has been provided.
10-2 The credit function has the responsibility for monitoring customer payments. An aged
trial balance of accounts receivable should be prepared and reviewed by the credit
function. Payment should be requested from customers who are delinquent in making
payments for goods or services. The credit function is usually responsible for preparing a
report of customer accounts that may require write-off as bad debts. However, the final
approval for writing off an account should come from an officer of the company who is
not responsible for credit or collections.
10-3 When the entity does not have adequate segregation of duties or if collusion is suspected,
the possibility of a defalcation is increased. An employee who has access to both the cash
receipts and the accounts receivable records has the ability to steal cash and manipulate
the accounting records to hide the misstatement. This is sometimes referred to as
lapping. When lapping is used, the perpetrator covers the cash shortage by applying cash
from one customer's account against another customer's account. If the auditor suspects
that this has occurred, the individual cash receipts have to be traced to the customers'
accounts receivable accounts to ensure that each cash receipt has been posted to the
correct account. If the cash receipt is posted to a different account, this may indicate that
someone is applying cash to different accounts to cover a cash shortage.
10-4 Industry-related factors such as the profitability and health of the industry in which the
entity operates, the level of competition within the industry, and the industry's rate of
technological change affect the potential for misstatements in the revenue process. The
level of governmental regulation (e.g., by the Food and Drug Administration) within the
industry may also affect sales activity. Finally, most states have consumer protection
legislation that may affect product warranties, returns, financing, and product liability.
Such industry-related factors directly impact the auditor's inherent risk assessment for the
authorization and valuation assertions.
The presence of misstatements in previous audits is a good indicator that misstatements

are likely to be present during the current audit. If material misstatements were present in
previous audits, the auditor should assess inherent risk to be high.
10-1
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10-5 The auditor needs to obtain the following knowledge for each major class of transactions
in the revenue process when performing a walkthrough:
• How sales, cash receipts, and sales returns and allowances transactions are initiated.
• The accounting records, supporting documents, and accounts that are involved in
processing sales, cash receipts, and sales returns and allowances transactions.
• The flow of each type of transaction from initiation to inclusion in the financial
statements, including computer processing of the data.
• The process used to prepare estimates for accounts such as the allowance for
uncollectible accounts and sales returns.
10-6 Two important controls for processing of credit memoranda for sales returns and
allowances transactions are: (1) each credit memorandum should be approved by
someone other than the individual who initiated it and (2) a credit for returned goods
should be supported by a receiving document indicating that the goods have been
returned.
10-7 The analytical procedures that can be used to test revenue-related accounts and the
possible misstatements that can be detected by each analytical procedure are (also see
Table 10-9):
Analytical Procedure Possible Misstatement Detected
Revenue:
Comparison of gross profit percentage by Unrecorded (understated) revenue
product line with previous years' and/or Fictitious (overstated) revenue
industry data. Changes in pricing policies
Product-pricing problems
Comparison of reported revenue to budgeted
revenue.
Accounts Receivable, Allowance for

Uncollectible Accounts, and Bad-Debt
Expense:
Comparison of receivables turnover and days Under- or overstatement of
outstanding in accounts receivable to allowance for uncollectible
previous years' and/or industry data. accounts and bad-debt
expense
Comparison of aging categories on aged trial
balance of accounts receivable to previous
years.
10-2
Comparison of bad-debt expense as a percentage

of revenue to previous years' and/or industry
data.
Comparison of the allowance for uncollectible

accounts as a percentage of accounts
receivable or credit sales to previous years'
and/or industry data.
Examination of large customer accounts

individually and comparison to previous
year.
Sales Returns and Allowances and Sales

Commissions:
Comparison of sales returns as a percentage of Under- or overstatement of sales
revenue to previous years' and/or industry returns
data.
Comparison of sales discounts as a percentage of Under- or overstatement of sales

revenue to previous years' and/or industry discounts
data.
Estimation of sales commissions expense by Under- or overstatement of sales

multiplication of net revenue by the average commission expense and
commission rate and comparison to recorded related accrual
sales commission expense.
10-8 The auditor verifies the accuracy of the aged trial balance using the following steps. First,
a copy of the aged trial balance of accounts receivable is obtained from the entity and the
total balance is compared to the accounts receivable general ledger balance. Second, a
sample of customer accounts is selected from the aged trial balance. For each selected
customer account, the auditor traces the customer's balance back to the subsidiary ledger
detail and verifies the total amount and the amounts included in each column for proper
aging. These two steps mainly describe a manual approach to testing accuracy. A second
approach would involve the use of computer-assisted audit techniques. If the general
controls over IT are adequate, the auditor can use a generalized audit software package to
perform the steps described in the first approach to examine the accuracy of the aged trial
balance generated by the entity's accounting system.
10-3
10-9 Three factors that affect the reliability of accounts receivable confirmations are:
• The type of confirmation request.
• Prior experience on the entity or similar engagements.
• The intended respondent.
The types of confirmations include positive and negative confirmations. Positive

confirmations are considered more reliable because the recipient is required to respond to
the auditor regardless of whether a misstatement exists or not. Prior experience with the
entity in terms of confirmation response rates, misstatements identified, and the accuracy
of returned confirmations should be considered when assessing the reliability of accounts
receivable confirmations. For example, if response rates were low in prior audits, the
auditor might consider obtaining evidence using alternative procedures. Finally, the
intended respondents to accounts receivable confirmations may vary from individuals
with little accounting knowledge to highly qualified accounting personnel in large
corporations. The auditor should consider the respondent's competence, knowledge,
ability, and objectivity when assessing the reliability of confirmation requests.
10-10 A positive accounts receivable confirmation requests that the customer indicate whether
or not it is in agreement with the amount due to the entity stated in the confirmation.
Thus, a response is required regardless of whether the customer believes that the amount
is correct or incorrect. A negative confirmation requests that the customer respond only
when it disagrees with the amount due to the entity.
Positive confirmations are generally used when an account contains large individual
balances or if errors are anticipated because control risk is assessed to be high. Negative
confirmation requests are used when there are a large number of accounts with small
balances, control risk is assessed to be low, and the auditor believes that the customers
will devote adequate attention to the confirmation.
10-11 Other types of receivables that the auditor should examine include:
• Receivables from officers and employees.
• Receivables from related parties.
• Notes receivable.
The auditor would confirm and evaluate each type of receivable for collectibility. The
transactions that result in receivables from related parties are examined to determine if
they were at "arm's length." Notes receivable would also be confirmed and examined for
repayment terms and whether interest income has been properly recognized.
10-4
Answers to Multiple-Choice Questions
10-12 c 10-18 b
10-13 d 10-19 a
10-14 c 10-20 c
10-15 b 10-21 a
10-16 a 10-22 a
10-17 d 10-23 b
Solutions to Problems
10-24 1. The guidance provided by SAB No. 101 would preclude recognition of revenue on
this transaction in the current period. Thomson’s business practice of requiring a
written sales agreement for this class of customer, persuasive evidence of an
arrangement would require properly authorized personnel of the customer have
executed final agreement. Bayone’s execution of the sales agreement after the end of
the quarter causes the transaction to be considered a transaction of the subsequent
period. The auditor would need to obtain and review the final agreement.
2. Provided that other criteria for revenue recognition are met, Best Products should
recognize revenue from sales of its layaway program upon delivery of the
merchandise to the customer. Until then, the amount of cash received should be
recognized as a liability. Because Best Products retains the risk of ownership of the
merchandise, receives only a deposit from the customer, and does not have an
enforceable right to the remainder of the purchase price, SAB No. 101 would not
allow recognition of the revenue. The auditor would need to review Best Products’
policies for the layaway plan and review a sample of customer installment notes.
3. It would not be appropriate for Dave’s to recognize the membership fees as earned
revenue upon billing or receipt of initial fee with a corresponding accrual of
estimated costs to provide the membership services. This conclusion is based on
Dave’s remaining and unfulfilled contractual obligation to perform services
throughout the remaining period. Therefore, the earnings process, irrespective of
whether a cancellation clause exists, is not complete. Additionally, the ability of the
member to receive a partial refund of the membership fee up to the last day of the
membership term raises uncertainty as to whether the fee is fixed or determinable at
any point before the end of the term. The auditor would need to review Dave’s
membership fee policies and examine the company’s estimate of customer
cancellations.
10-5
10-25 The following weaknesses were identified by Smith in the existing control system over
cash admission fees along with the related recommendation for improvement:
Weakness Recommendation
1. There is no segregation of 1. One clerk (the collection clerk) should
duties between persons collect admission fees and issue
responsible for collecting prenumbered tickets. The other clerk (the
admission fees and persons admission clerk) should authorize
responsible for authorizing admission upon receipt of the ticket or
admission. proof of membership.
2. An independent count of 2. The admission clerk should retain a portion
paying patrons is not made. of the prenumbered admission ticket
(admission ticket stub).
3. There is no proof of accuracy 3. Admission ticket stubs should be reconciled
of amounts collected by the with cash collected by the treasurer each
clerks. day.
4. Cash receipts records are not 4. The cash collections should be recorded by
promptly prepared. the collection clerk daily on a permanent
record that will serve as the first record of
accountability.
5. Cash receipts are not promptly 5. Cash should be deposited at least once each
deposited. Cash should not be day.
left undeposited for a week.
6. There is no proof of accuracy 6. Authenticated deposit slips should be
of the amounts deposited. compared with daily cash collection
records. Discrepancies should be promptly
investigated and resolved. In addition, the
treasurer should establish a policy that
includes an analytical review of cash
collections.
7. There is no record of the 7. The treasurer should issue a signed receipt
internal accountability for for all proceeds received from the
cash. collection clerk. These receipts should be
maintained and periodically checked
against cash collection and deposit records.
10-26 a. 1
b. 3
c. 4
d. 6
e. 5
10-6
10-27 a. In addition to sending second requests, Signoff-On can perform the following audit
procedures:
• Examination of subsequent cash receipts.
• Examination of the customer orders, shipping documents, and duplicate sales
invoices.
• Examination of other entity documentation.
b. Of the three procedures listed, examination of subsequent cash receipts provides the
highest quality evidence. If the customer has paid the accounts receivable, it
provides strong evidence that the receivable was valid.
10-28 The working paper contains the following deficiencies:

• The working paper was not initialed and dated by the audit assistant.
• Negative confirmations not returned cannot be considered to be accounts "confirmed
without exception."
• The two positive confirmations that were sent but were unanswered are not accounted
for.
• There is no documentation of alternate procedures, possible scope limitation, or other
working paper reference for the six accounts selected for confirmation that the client
asked the auditor not to confirm.
• The dollar amount and percentage of the six accounts selected for confirmation that
the client asked the auditor not to confirm is omitted from the "Dollars" columns for
the "Total selected for testing."
• The "Dollars-Percent" for "Confirmation Requests-Negatives" is incorrectly calculated
at 10 percent.
• There is no indication of follow-up or cross-referencing of the account confirmed-
related-party transaction.
• The tick mark "‡" is used but is not explained in the tick mark legend.
• There is no explanation for proposed disposition of the ten differences aggregating
$12,000.
• The overall conclusion reached is not appropriate.
• There is no notation that a projection from the sample to the population was made.
• There is no reference to second requests.
• Cross-referencing is incomplete, such as the eighteen "Differences reported and
resolved, no adjustment" and "Confirmation Requests" to the confirmation control
schedule.
10-7
10-29 In order to determine whether lapping exists, Stanley would test the aging of accounts
receivable and then:
• Mail positive accounts receivable confirmation requests directly to all customers with
old balances.
• Investigate all exceptions noted on confirmations.
• Obtain authenticated deposit slips directly from the bank.
• Compare individual customers' names, dates, and amounts shown on the customer's
remittance advices with the names, dates, and amounts recorded in the cash receipts
journal, individual customer ledger accounts, and deposit slips (if practicable).
• Verify the propriety of noncash credits to accounts receivable (e.g., sales discounts,
sales returns, bad-debt write-offs).
• Perform a surprise inspection of deposits.
• Foot the cash receipts journal, the customers' ledger accounts, and the accounts
receivable control account.
• Reconcile the total of the individual customers' accounts with the accounts receivable
control account.
• Compare information in copies of monthly customers' statements with information in
customers' ledger accounts.
10-30 In evaluating proper sales cutoff, three points should be noted: (1) The book-to-physical
adjustment has already been made by the client, (2) all sales are made FOB shipping (title
passes to the customer at the time the goods are shipped), and (3) goods on hand on
January 31 are included in the physical inventory.
a. Since the goods were shipped on December 31, they were included in the physical
inventory at the end of the fiscal year. Since the sale should be recognized in the
current fiscal year, the following adjustment is necessary:
Cost of merchandise sold 2,000

Inventory 2,000
b. This sale is properly recorded as a current-fiscal-year sale. However, the auditor

should inquire as to why there was such a delay in processing the sales invoice.
c. The sale is properly recorded in the current year.
d. Since the goods were not shipped until January 9, they would have been included in
the physical inventory. However, the sale was recorded as a current-fiscal-year sale.
Therefore, the sale should be reversed since title has not passed to the customer. The
following adjusting entry should be made:
Sales 4,000
Accounts receivable 4,000
10-8
e. Since this transaction is a shipment of merchandise to a consignee, no sale should be

recognized. Since the goods were not on hand on December 31, the following entry is
necessary:
Sales 10,000
Inventory 5,600
f. This sale should be recorded in the current fiscal year. Since the merchandise was
shipped on December 30, it was not included in the physical inventory. Thus, the
following adjusting entry is necessary:

Sales 6,000
g. This transaction is correctly recorded as a sale in the next period.
h. Since the merchandise was shipped on December 31, it should be recorded as a sale in
the current fiscal year. It was also included in the physical inventory because it was on
hand on that date. Thus, the following adjusting entry is necessary:

Sales 8,000
Inventory 5,500
Solutions to Discussion Cases
10-31 The listed conditions are the important conceptual criteria that should be used in
evaluating any purported bill and hold sale. In some circumstances, a transaction may
meet all the factors listed above but not meet the requirements for revenue recognition. In
applying the above criteria to a purported bill and hold sale, the auditor should also
consider the following factors and evidence related to each factor:
1. The date by which the seller expects payment, and whether it has modified its
normal billing and credit terms for this buyer;
2. The seller's past experiences with, and pattern of, bill and hold transactions;
3. Whether the buyer has the expected risk of loss in the event of a decline in the
market value of the goods;
10-9
4. Whether the seller's custodial risks are insurable and insured;
5. Whether APB Opinion 21, pertaining to the need for discounting the related
receivables, is applicable; and
6. Whether extended procedures are necessary in order to assure that there are no
exceptions to the buyer's commitment to accept and pay for the goods sold, i.e.,
that the business reasons for the bill and hold have not introduced a contingency to
the buyer's commitment.
10-32 a. Friendly Furniture carried insurance coverage for property loss at replacement value
and business interruption insurance for lost production. Because the property loss is
covered at replacement value, which exceeds carrying value, the recognition of both a
reimbursement for costs incurred and a gain contingency should be considered.
Before deciding on when to recognize proceeds from insurance coverage, it is
necessary to consider whether the amount of proceeds is a gain contingency, which
generally cannot be recognized under GAAP. The gain must be realized before
recognition is permitted. FASB ASC Topic 450, "Contingencies," reaffirms the
principle on the recognition of gain contingencies.
The first issue that needs to be considered is the timing of recognition for some or
all of the insurance proceeds that Friendly Furniture is entitled to and expects to
receive. There is no specific guidance in the authoritative literature on when it is
appropriate to recognize insurance proceeds. SFAC No. 5, "Recognition and
Measurement in Financial Statements of Business Enterprises," provides some
conceptual guidance. The companywill likely want to recognize the estimated
proceeds from insurance coverage at the earliest possible date to offset losses, if any,
from the destruction of fixed assets and inventory as well as from lost production.
There are a number of points in time when the insurance proceeds may be
recognized. The most conservative approach—the one likely to be least favored by the
company and the least likely to be a gain contingency—would be when the proceeds
are received. This would result in a cash basis of accounting and would not be
supported by SFAC No. 6, "Elements of Financial Statements." The other extreme
would be recognition of the insurance proceeds before verification of coverage or
admission of liability by the insurance carrier. This is the most aggressive approach
and the most likely to result in recognition of a gain contingency.
There are two other alternatives: (1) recognition when the company has been able
to determine that coverage exists and has been able to develop a minimum estimate of
the amount to be recovered or (2) when the insurance carrier has admitted liability. A
decision as to which of those alternatives should be used needs to be based on the
company's ability to estimate the proceeds as reliably as possible. If the insurance
company has admitted to a liability, Friendly Furniture would have a good basis for
recognizing the minimum amounts subject to an evaluation of the reliability of the
estimates and the probability of collection.
10-10
One possible answer is to recognize insurance proceeds (a receivable from the

insurance company) in Friendly Furniture's financial statements at June 30 in the
following manner: credit a portion of business interruption insurance to cost of sales
and recognize in other income a gain that consists of the estimated minimum amount
that the replacement cost insurance proceeds exceed the net book value of equipment
and inventory destroyed and unallocated proceeds from business interruption
insurance.
b. The auditor can perform the following procedures to support the amount recorded for
the receivable:
• Examine the inventory records, including the perpetual and physical inventory, to
determine the cost of the inventory destroyed by the flood.
• Examine the appraisal reports to test the fair market value of the inventory
destroyed.
• Examine the property, plant, and equipment subsidiary records to determine the
cost (book value) of the equipment destroyed.
• Examine the appraisal reports to test the fair market value of the equipment
destroyed.
• Examine the entity's and insurance company's calculation of the amount of income
to be recognized as a result of the business interruption.
Solution to Internet Assignments

10-33 It is difficult to get information directly on some of EarthWear’s competitors. Lands’
End is now part of Sears. Eddie Bauer is part of The Spiegel Group. The Spiegel
Group’s annual report states that revenue from catalog and e-commerce sales is
recognized at time of shipment. Spiegel also states that it reserves for returns at the time
of sale based on projected returns. Timberland reports that it recognizes revenue at the
time of shipment, but there is no disclosure on returns. L.L. Bean and Patagonia are
privately held companies and there are no publicly available financial statements.
10-34 A search of the SEC’s website should identify a recent company that has been cited by
the SEC for revenue recognition issues.
10-11

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Chapter 10 - Auditing the Revenue Process

Answers to Review Questions

10-1 FASB Statement of Financial Accounting Concepts No. 5, "Recognition and

The presence of misstatements in previous audits is a good indicator that misstatements

Accounts Receivable, Allowance for

Comparison of bad-debt expense as a percentage

Comparison of the allowance for uncollectible

Examination of large customer accounts

Sales Returns and Allowances and Sales

Comparison of sales discounts as a percentage of Under- or overstatement of sales

Estimation of sales commissions expense by Under- or overstatement of sales

The types of confirmations include positive and negative confirmations. Positive

Answers to Multiple-Choice Questions

10-28 The working paper contains the following deficiencies:

Cost of merchandise sold 2,000

b. This sale is properly recorded as a current-fiscal-year sale. However, the auditor

c. The sale is properly recorded in the current year.

e. Since this transaction is a shipment of merchandise to a consignee, no sale should be

Accounts receivable 6,000

g. This transaction is correctly recorded as a sale in the next period.

Accounts receivable 8,000

Solutions to Discussion Cases

4. Whether the seller's custodial risks are insurable and insured;

One possible answer is to recognize insurance proceeds (a receivable from the

Solution to Internet Assignments

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