Review Qustions

10-1

Accounting standards determine when to recognize revenue. Discuss when

revenue should be recognized.

Answer :
As a general rule revenue is recognized when the earnings process is complete.International
Accounting Standard (IAS) 18 Revenue states that revenue is recognised when it is probable
that future economic benefits will flow to the entity and these benefits can be measured
reliably. For example, revenues from the sale of goods are recognised once delivery has taken
place, the risk has been transferred, and the entity has established a receivable due by
customer. IAS 18 provides the following criteria for revenue recognition:

The entity has transferred to the buyer the significant risks and rewards of ownership of
the goods.
The entity retains neither continuing managerial involvement to the degree usually
associated with ownership nor effective control over the goods sold.
The amount of revenue can be measured reliably.
It is probable that the economic benefits associated with the transaction will flow to the
entity.
The costs incurred or to be incurred in respect of the transaction can be measure reliably.

10-2

Describe the credit functions duties for monitoring customer payments and
handling bad debts.

Answer :
The credit authorization function has the responsibility for monitoring customer payments.
An aged trial balance of accounts receivable should be prepared and reviewed by the credit
authorization 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 a client does not adequately segregate duties, the possibility of cash being
stolen before it is recorded is increased. If the auditor suspects that this type of
defalcation is possible, what type of audit procedures can he or she use to test
this possibility?

Answer :

10-4

the auditor needs to understand how selected inherent risk factors affect the
transactions processed by the revenue process. Discuss the potential effect that

industry-related factors and misstatement detected in prior periods haveon the

inherent risk assessment for the revenue process.
Answer :
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 industrys rate of technological
change affect the potential for misstatements in the revenue process. The level of
governmental regulation (e.g. by a medicine control agency) within the industry may also
affect sales activity. Finally, most countries have consumer protection legislation that may
affect product warranties, returns, financing and product liability. Such industry-related
factors directly impact the auditors inherent risk assessment for the authorization and
valuation auditobjectives.
The presence of misstatements in previous audits is a good indicator that misstatements are
likely to be present during the current audit. If misstatements were present in previous audits,
the auditor should assess inherent risk to be high.
10-5

in understanding the accouting systems in the revenue process, the auditor

typically performs a walk-through to gain knowledge of the system. What
knowledge should the auditor try to obtain about the accounting system?

Answer :
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

what are the two major controls for sales return and allowances transactions?

Answer :
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 supportedby a
receiving document indicating that the goods have been returned.
10-7

list four analytical procedures that can be used to test revenue-related accounts.
What potential misstatement are indicated by each of these analytical
procedures?

Answer :

Substantive Analytical Procedure

Possible Misstatement Detected

Revenue :

Comparison of gross profit percentage by product Unrecorded (understated) revenue Fictitious (overst
line with previous years and/or industry data.
revenue Changes in pricing policies Product-pr
Comparison of reported revenue to budgeted problems
revenue.
Accounts Receivable, Allowance for Uncollectible Accounts, and Bad-Debt Expense:

Comparison of receivables turnover and days Under- or overstatement of allowance for uncollec
outstanding in accounts receivable to previous years accounts and bad-debt expense
and/or industry data.
Comparison of aging categories on aged trial balance
of accounts receivable to previous years.
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 revenue
to previous years and/or industry data.
Comparison of sales discounts as a percentage of
revenue to previous years and/or industry data.
Estimation of sales commissions expense by
multiplication of net revenue by the average
commission rate and comparison to recorded sales
commission expense.

10-8

Under- or overstatement of sales returns.

Under- or overstatement of sales discounts.
Under- or overstatement of sales
commission expense and related accrual.

Describe how the auditor verifies the accuracy of aged trial balance.

Answer :

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 client and thetotal
balance is compared to the accounts receivable general ledger balance. Second, a sample of
customer accounts selected for proper inclusion in the aged trial balance. For eachselected
customer account, the auditor traces the customers balance back to the subsidiaryledger
detail and verifies the total amount and the amounts included in each column for properaging.
These two steps mainly describe a manual approach to testing accuracy. A secondapproach
would involve the use of computer-assisted audit techniques. If the general controlsover IT
are adequate, the auditor can use a generalized audit software package to perform thesteps
described in the first approach to examine the accuracy of the aged trial balancegenerated by
the clients accounting system.
10-9

list and discuss the three factors mentioned in the chapter that may affect the
reliability of confirmations of account receivable.

Answer :
Three factors that affect the reliability of accounts receivable confirmations are:
The type of confirmation request.
Prior experience on the client or similar engagements.
The intended respondent.
The types of confirmations include positive and negative confirmations. Generally, 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 client 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 companies. The auditor should
consider the respondents competence, knowledge, ability and objectivity when assessing the
reliability of confirmation requests.
10-10 Distinguish between positive and negative confirmations. Under what
circumstances would positive confirmations be more appropriate than negative
confirmations?
Answer :
A positive accounts receivable confirmation requests that the customer indicate whether or
not it is in agreement with the amount due to the client stated in the confirmation. Thus, a
response is required regardless of whether the customer believes that the amount is correct
orincorrect. A negative confirmation requests that the customer respond only when it
disagreeswith the amount due to the client.Positive confirmations are generally used when an
account contains large individual balances orif errors are anticipated because control risk was
judged to be high. Negative confirmationrequests are used when there are a large number of
accounts with small balances, control riskis assessed to be low, and the auditor believes that
the customers will devote adequate attention to the confirmation.

10-11 Identify three other types of receivables the auditor should examine. What audit
procedures would typically be used to audit other receivables?
Answer :
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 arms length. Notes receivable would also be confirmed and examined for
repayment terms and whether interest income has been properly recognized.
Problems
10-12 For each of the following situation indicate how and/or when the client should
recognize the revenue. Justify your decision.
1. Your client, thompson telecom, maintains an inventory of telecommunications
equipment. Bayone Telephone Company placed an order for 10 new transformers
valued at 5 million and thomson delivered them just prior to 31 december.
Thompsons normal business practise for this class of customer is to enter into a
written sales agreement that requires the signatures of all the authorized
representatives of thompson and its customer before the contract is binding.
However, bayone has not signed the sales agreement because it is awaiting the
requisite approval by the legal department. Bayones purchasing department has
orally agreed to the contract and the purchasing manager has assured you that the
contract will be approved the first week of next year.
2. Best products is a retailer of appliances that offer layaway sales to its
customer twice a year. Best retains the merchandise, sets it aside in its inventory,
and collects a cash deposit from the customer. The customer signs an installment
note at the time the initial deposit is received, but no payments are due until 30
days after delivery.
3. Daves Discount stores is a discount retailer who generates revenue from the
sale of membership fees it charges customers to shop at its stores. The
membership arrangement requires the customer to pay the entire membership fee
( usually 48 ) at the beginning of the arrangement. However, the customer can
unilaterally cancel the membership arrangement and the receive a refund of the
unused portion. Daves estimates that 35 per cent of the customer will cancel their
membership before the end of the contract.
Answer :

 1. IAS 18 states that revenue is recognized when the entity has transferred to the buyer
the significant risks and rewards of ownership of the goods. The assessment of when an
entity has transferred the significant risks and rewards of ownership to the buyer requires
an examination of the circumstances of the transaction. In Thompsons 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. Bayonnes execution of the sales agreement after the end of
the quarter causes the transaction to be considered a transaction of the subsequent period
by accounting standards such as IAS 18.
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, accounting standards such as IAS 18 would not allow
recognition of the revenue.
It would not be appropriate for Daves to recognize the membership fees as 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 Daves 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 full 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.

10-17 You are engaged to audit the ferrick corporation for the year ended 31 december
2009. only merchandise shipped by the ferrick corporation to customers up to and
including 30 december 2009 has been eliminated from inventory. The inventory as
determined by
physical inventory count has been recorded on the books by the
company s controller. No perpetual inventory records are maintained. All sales are
made in an FOB-shipping point basis. You are to assume that all purchase invoices
have been correctly recorded. The following lists of sales invoices are entered in the
sales journal for the months of december 2009 and january 2010, respectively.
No
Dec 2009
A
B
C

Sales invoice Sales Invoice Cost of Merchandise Date Shipped

Amount
Date
Sold
3000
2000
1000

21 Dec
31 Dec
29 Dec

2000
800
600

31 Dec
13 Dec
30 Dec

D
4000
E
10000
Jan 2010
F
6000
G
4000
H
8000
* Shipped to consignee
Required:

31 Dec
30 Dec

2400
5600

9 Jan
29 Dec*

31 Dec
2 Jan
3 Jan

4000
2300
5500

30 Dec
2 Jan
31 Dec.

You are to ensure that there is proper cut-off of sales and inventory. If an item is not properly
recorded, prepare the necessary adjusting entries.
Answer :
A. Since the goods were shipped on 31 December, 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 9 Januari, 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

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 30 December, the following entry
is necessary:
Sales

10,000

Inventory

5,600

Accounts receivable

10,000

Cost of merchandise sold

5,600

 F. This sale should be recorded in the current fiscal year. Since the merchandise was
shipped on 30 December,it was not included in the physical inventory. Thus the
following adjusting entry is necessary:
Accounts receivable

6,000

Sales

6,000

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

H. Since the merchandise was shipped on 31 December, 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:
Accounts receivable

8,000

Cost of merchandise sold

5,500

Sales

8,000

Inventory

5,500