Topic 2: AUDITING THE REVENUE

PROCESS
By
K.I.Matolla
 Introduction
• For many companies, revenue is one of the
largest accounts in the financial statements
and it is an important driver of a company's
operating results.
• Historically, many fraudulent financial
reporting cases have involved intentional
misstatement of revenue.
 Nature of The Revenue Cycle
• For a merchandising company, the classes of
transactions in the revenue cycle include:
1. credit sales (sales made on accounts),
2. cash receipts (collections on accounts and
cash sales), and
3. sales adjustments (discounts, sales returns
and allowances, and uncollectible accounts
[provisions and write-offs])
 Revenue Recognition
• Revenue is recognized when; it is realizable and
when it is earned.
• Revenue generally is realized or realizable and
earned when all of the following criteria are met:
– 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.
– Collectability is reasonably ensured.
 Basic activities in revenue cycle
• Excluding cash collection system the
sales/revenue system mainly include four
activities
– Receiving and processing customer orders, including
credit approval;
– Delivering/Dispatching goods and services to
customers;
– Billing/invoicing customers and accounting for
accounts receivable; and
– Collecting and depositing cash
 Recall
• Audit risk is defined as the risk that auditors will
issue an unqualified opinion on financial
statements that contain a material misstatement.
• Three types of Audit risk
– Inherent risk - a material misstatement relating to the
financial reporting process
– Control risk - the client’s internal controls do not
prevent or detect (control risk) and
– Detection risk - that the auditors’ substantive
procedures do not detect.
 Recall cont.
• It is relevant to address the relevant assertions
• See ISA 315- for definition
• For example match the following assertions and
accounts; sales and accounts receivable v/s
existence, completeness and occurrence
• Note;
– financial statement assertion is relevant if it has a
“reasonable possibility of containing a misstatement or
misstatements that would cause the financial
statements to be materially misstated”.
 FINANCIAL STATEMENTS ASSERTIONS
• Rights and obligations – does the client own or have other
rights over the assets and have a genuine obligation to pay
liabilities?
• Valuation – are assets or liabilities included at appropriate
amounts?
• Allocation – are account balances included in appropriate
accounts?
• Classification and understandability – are items in the
financial statements disclosed under appropriate headings and
in such a way that they can be readily understood by readers?
• Accuracy – are the amounts disclosed in the financial
statements appropriate
 FINANCIAL STATEMENTS ASSERTIONS

• Occurrence – did the transaction actually take place?

• Completeness – are all transactions or balances that
should be included in the financial statements, actually
included?
• Accuracy – are the amounts correct?
• Cutoff – are transactions accounted for in the correct
period?
• Classification – are transactions recorded in the proper
accounts?
• Existence – do the assets or liabilities actually exist?
 Significant Accounts and Relevant Assertions in the
Revenue and Collection Cycle
account assertion
Revenue Occurrence

completeness
cutoff
Accounts Receivable Existence
completeness
valuation
 How Can Revenue be Manipulated?
• Basing on the basic activities in revenue cycle, lets now look on
control objectives and associated risks in each activity.
• RECEIVING ORDER FROM CUSTOMERS
 Orders received from new customers should be evaluated, and credit
limit be provided upon proper authorization: as there is a risk that
orders may be accepted from new customers without checking
customer references and credit limit be provided without proper
authorization.
 Orders to be accepted from existing customers should not exceed their
credit limit: as there is a risk that orders are taken beyond customers
credit limit
 The customer should be given a discount upon proper authorization: as
there is a risk that discount are given without a proper authorization.
 Cont….
DELIVERING/DISPATCHING GOODS AND SERVICES TO
CUSTOMERS
 Goods for all approved orders should be dispatched: as there
is a risk that for some customers goods are not dispatched or
dispatched twice
 Goods should be dispatched to customers who have sufficient
credit: as there is a risk that goods are dispatched to
customers without sufficient credit
 All dispatched goods should reach the customers safely and
within the prescribed time: as there is a risk that some
customers may claim that goods are not received by them
 Cont…
Billing/Invoicing Customers and Accounting for Accounts
Receivable
 Invoices should be produced for all goods dispatched: as there is a risk that
invoices may not be produced or produced for goods not dispatched
 All invoices and credit notes should appropriately be recorded in the system:
there is a risk that some invoices & credit notes be unrecorded in the system
 All invoices& credit notes should be recorded in the proper customer a/c:
there is a risk that invoices are recorded in wrong a/c
 There should be a proper consideration before writing off uncollectable
debts: there is a risk that debts may be written off as bad without proper
consideration
 Goods returned should be properly accounted: as there is a risk that sales
may be misstated if returns are not properly accounted.
 summary
account assertion Risk
Revenue occurrence Mgt overstate sales
Mgt fails to approximate
return
completeness Not all sales are recorded
cutoff Sales been recorded in
incorrect period
Accounts receivable existence A/R be overstated from
actual sales
completeness Not all A/R recorded
valuation Not included in
appropriate amount and
Valuation adjustment not
recorded propely
 Risk of Material Misstatement
We have said revenue is recognized when; it is realizable and
when it is earned.
• Most challenging area
– Collectability of Accounts Receivable
– Customer Returns and Allowances
• The assessment of the risk of material misstatement is
completed to help form the basis for determining;
– the nature, timing, and extent of substantive testing.
• Risk of material misstatement at the assertion level is
comprised of both
– inherent risk and
– control risk for each relevant assertion
 Inherent Risk
• We just said the reason to assess inherent risk
– to determine where in the financial statements it
is reasonably possible that a material
misstatement could enter the process before the
consideration of any internal controls.
• Then most important is to gain an
understanding of internal control
 Review- Internal control
• Auditors typically achieve an understanding of
controls by completing a walkthrough of the
processes in the revenue and collection cycle.
• To do so, the auditor identifies the points in
the process where a misstatement might
occur and
• then identifies the control activities that have
been placed in operation to mitigate these
risks.
 Review- Internal control cont.
• Example; One control that the auditor would
expect management to implement involves
periodic reconciliation of debits to accounts
receivable to sales invoices, customer
purchase orders, and shipping documents.
• If management regularly evaluates the validity
of recorded accounts receivable, fewer errors
can proceed through the accounting system
undetected.
Controls at accounts and assertion level
• An initial overall control - is the level of
separation of duties in the revenue cycle.
– Is it economic reasonable to have complete
separation of duties in small business?
– Most important is to obtain reasonable assurance
that financial controls are intact when duties are
not appropriately separated
 Controls at accounts and assertion level
cont.
• Ensuring that all three of these primary documents
are pre-numbered, and the numerical sequence is
checked
– What assertion does this assist?
• Verifying the dates on the documents
– What assertion does this assist?
• collectability of receivables – be considered on
regular basis and evaluate the adequacy of
allowances for sales returns and discounts.
– What assertion does this assist?
 Task
• Find other control activities that should
generally be in place to prevent and detect
errors or fraud in revenue and collection cycle,
remember to consider the assertion that it will
assist.
• Why should always auditor perform
substantive procedure in revenue cycle?
 Note
• Auditors should also perform a walkthrough
to verify that they understand each of the
process activities.
 Test of Controls
• Auditors can perform tests of controls to determine
whether company personnel are properly
performing controls that are said to be in place.
• In general, the procedures used in tests of controls
are;
– client inquiry,
– observation,
– inspection of documents and records,
– Re-performance, and
– walkthroughs.
 Recall - audit evidence
• The audit processes to gather evidence on the
assertions in account balances are called
substantive procedures.
• Substantive procedures differ from tests of controls
in their basic purpose.
• Substantive procedures are designed to obtain
direct evidence about the amounts in account
balances, while tests of controls are designed to
obtain evidence about the company’s performance
of its own control activities.
 Tests of controls related to assertions
• Completeness of revenue and accounts
receivable—Examine evidence of client review
and follow-up of sales data related to specific
classes of products or locations.
• Accuracy of revenue and accounts receivable
—Vouch prices to approved price listing.
Tests of controls related to assertions cont.

• Accuracy of revenue— Observe client

comparing shipping quantities to quantities
recorded as sold. Examine evidence of client
making the comparison.
• Cutoff of revenue— Trace shipping date on
shipping documents to sales invoice date.
• Classification of accounts receivable— Trace
posting of intercompany sales, sales returns,
etc., to sales.
Summary – control risk assesment
• Two phases;
– obtaining an understanding of the company’s
controls and
– The process of obtaining evidence from actual
tests of controls
 Analytical procedure
• See ISA 520
• Substantive procedure can be classified as
– substantive analytical procedures and
– substantive tests of details
• Analytical procedure-the auditor substantiates
an account or disclosure by developing an
independent estimate of the amount and then
compare the recorded balance to the
estimate.
 Analytical procedure cont.
• Analytical procedure to be performed depends on the
circumstances and nature of business
• Analytical procedures can be performed through the following
ways:
- Trend analysis; this is analysis of changes on account
balance over time, it can either be % change or absolute change
- Ratio analysis; this involves comparison on the basis of
particular benchmark of calculated financial ratio
-Reasonable test; this is the analysis of accounts or changes
in accounts btn accounting period which involves developing a
model to form expectations about financial or non-financial
information
 Analytical procedure cont
• Analyze items overtime and make comparison,
consider industry comparison too
• Most relation to consider, receivables
turnover, amount of past due receivables,
gross margin ratio, sales/asset ratios etc
• NOTE; the key issue of analytical procedure in
auditing is comparison
 Conformation of Accounts Receivable
• It is mandatory
• However not all the time; reason not to
– receivables are not material;
– confirmations would be ineffective, based on
prior-years’ experience or knowledge that
responses could be unreliable; and
– analytical procedures and other substantive
procedures provide sufficient, competent
evidence.
 Conformation cont.
• Confirmations provide evidence of existence
as well as rights and obligations of accounts
and notes receivable.
• However, they do not provide strong evidence
on the valuation of accounts receivable.
• How do we get accounts for conformation?
 Conformation cont.
• A specific technique used to test for the existence
and obligation/rights of receivables is a direct
circularization. This is conducted as follows:
a. Obtain listing of trade receivables as at the
confirmation date.
b. Agree total to Nominal Ledger.
c. Review for any obvious omissions/mis-
statements by comparing this year’s list with last
year’s.
 Conformation cont.
d. Select a sample of accounts for confirmation.
Select the sample from the following balances:
– Old, unpaid amounts, Credit balances ,Nil
balances, Material balances and then Letter should
be written on the client's paper, signed by the client
with a copy of the current statement attached. It
should request that the reply be sent direct to the
auditor and reply paid envelopes should be sent.
e. After reasonable period, send 'follow-up' request
 Conformation cont.
• There are two primary methods of confirming
accounts receivable:
– positive confirmations
– negative confirmations.
• A positive confirmation asks the customer to
respond whether the balance is correct or incorrect.
• The negative confirmation asks for a response only if
something is wrong with the balance; thus, lack of
response to negative confirmations is considered
evidence that the account is fairly stated.