Chapter 11

Auditing the Revenue

Process

The Audit Process

Overview of Audit and Assurance

(Chapter 1)

Professionalism and Professional Responsibilities

(Chapter 2)

Client Acceptance/Continuance and Risk Assessment

(Chapters 3 and 4)

Gaining an Identify Significant

Set Planning
Understanding of Accounts and
Materiality
the Client Transactions

Gaining an Understanding of
Make Preliminary Risk
the System of Internal Control
Assessments
(Chapter 6)

Develop Responses to Risk and an Audit Strategy

Audit Data Analytics

Audit Evidence
(Chapter 5)

(Chapter 7)
Performing Tests of Controls Performing Substantive Procedures
(Chapter 8) (Chapter 9)

Audit Sampling for Substantive Tests

(Chapter 10)

Auditing the Auditing the Purchasing Auditing the Balance Sheet

Revenue Process and Payroll Processes and Related Income Accounts
(Chapter 11) (Chapter 12) (Chapter 13)

Completing and Reporting on the Audit

(Chapters 14 and 15)

Procedures Performed Near Drawing Audit

Reporting
the End of the Audit Conclusions

11-1
11-2  C h a pte r 11 Auditing the Revenue Process

Learning Objectives

LO 1 Explain the nature of the revenue process. LO 6 Evaluate control activities for sales adjustment
transactions and revenue process disclosures.
LO 2 Evaluate how an auditor’s understanding of
an entity and its environment affects audit planning LO 7  Determine how to design and perform tests of
decisions in the revenue process. controls in the revenue process and connect the results
of control testing to audit strategy.
LO 3  Determine inherent risk for various assertions in
the revenue process. LO 8 Assess detection risk and design substantive
LO 4 Evaluate control activities for credit sales tests, including audit data analytics, to address various
transactions. assertions in the revenue process.

LO 5 Evaluate control activities for cash receipt transactions.

Auditing and Assurance Standards

PCAOB Auditing Standards Board

AS 2310 The Confirmation Process AU-C 505 External Confirmations

Cloud 9 - Continuing Case

Sharon Gallagher (audit manager), Josh Thomas (audit senior), carefully plan the audit of the revenue process. The company has
and Suzie Pickering (audit staff) are discussing the audit of reve- set aggressive goals to increase market share in a very competi-
nues for Cloud 9. Previously, Suzie learned that senior members of tive industry. Suzie recognizes that she needs to complete work in
management, including a number in the accounting and finance understanding the business and industry to evaluate the results
section, will receive stock options if revenue targets are reached. of analytical procedures relative to revenues and receivables.
In addition, the company is opening a new company-owned store Sharon asks Josh and Suzie to suggest other key factors the audit
in a major market. The audit team is considering what other aspects team will have to consider when designing the substantive proce-
of the business and industry Suzie needs to understand in order to dures for the revenue process.

Chapter Preview: Audit Process in Focus

Finding an appropriate combination of audit procedures to achieve a low level of audit
risk at an acceptable cost is a constant challenge facing most audit teams. This chapter
focuses on making decisions about appropriate audit procedures in the revenue process.
We begin with a discussion of the nature of the revenue process. We then address the pro-
cess of understanding the entity and its environment in the context of the revenue process
and using this knowledge to assess inherent risk in the revenue process. The chapter then
moves on to a discussion of evaluating internal controls in the revenue process, including
understanding entity-level controls, understanding the document trail, evaluating what can
go wrong (WCGW), identifying controls to test, performing tests of controls, and evaluating
control risk and the risk of fraud. At this point, the auditor often confirms or revises his or
her preliminary audit strategy and then executes substantive tests to reduce audit risk to an
acceptable level. This chapter will walk you through key audit decisions in the context of
the revenue process.
   Nature of the Revenue Process  11-3

Nature of the Revenue Process

LEA RNING OBJECTI VE 1

Explain the nature of the revenue process.

An entity’s revenue process consists of activities related to credit sales with customers
and the collection of accounts receivable. For a merchandising company, the classes of
transactions in the revenue process include (1) credit sales, (2) cash receipts (collection
of receivables and cash sales), and (3) sales adjustments (discounts, sales returns and
allowances, and adjustments for bad debts). These transactions are depicted in Illustra-
tion 11.1.

Revenue Transactions Debit Credit ILLUSTRATION 11.1  

Revenue transactions
Credit sales Accounts Receivable Sales
Cost of Goods Sold Inventory
Cash receipts (primarily focused Cash Accounts Receivable
on collection of receivables) Sales Discounts
Sales adjustment transactions
  Sales returns and allowances Sales Returns and Accounts Receivable
Allowances
  Provision for bad debts Bad Debt Expense Allowance for Doubtful
Accounts
  Write-off of bad debts Allowance for Doubtful Accounts Receivable
Accounts

For companies that sell goods or services on account, there is significant interaction be-
tween sales and accounts receivable. If revenue is recognized prematurely, both sales and
accounts receivable will be overstated. The same interaction also exists between cash receipt
transactions and accounts receivable, and a misstatement of cash receipts will result in a mis-
statement of accounts receivable. Further, if discounts are given for early payment, sales dis-
counts are recorded when recording the cash receipt and reducing a customer’s receivable.
The highest volume of transactions usually occurs with credit sales and cash receipts, as well
as a series of transactions that fall under the broad category of sales adjustment transactions:
sales returns and allowances, the provision for bad debts, and the write-off of bad debts. Usu-
ally, sales returns represent a much smaller volume of transactions. Further, a critical aspect of
sales return transactions is the receipt of returned goods in the warehouse. Transactions pro-
viding for bad debts, or the write-off of receivables, often occur during month-end or quarter-
end adjustments. Finally, three of these accounts, inventory, cost of goods sold, and cash, are
also affected by transactions in other processes. The audit of these accounts is deferred to
Chapter 13.
The auditor should obtain sufficient appropriate evidence for the transaction classes,
balances, and disclosures outlined in Illustration 11.2. While the auditor must obtain
sufficient appropriate evidence for all assertions, the auditor is often concerned about the
overstatement of revenues and receivables. Hence, the auditor is particularly concerned
about the occurrence, accuracy, and cutoff of revenues, and the existence, right to, and
valuation and allocation of receivables. The discussion in this chapter will focus primarily
on credit sales transactions (rather than on cash sales).
11-4  C h a pte r 11 Auditing the Revenue Process

ILLUSTRATION 11.2   Key revenue process assertions

Relevant Transaction Classes Relevant Account Balances Relevant Disclosures

Sales Accounts receivable Receivable disclosures
Cash receipts Allowance for doubtful accounts Revenue disclosures
Sales adjustment transactions
• Sales returns and allowances
• Adjustment for bad debts
• Write-off of bad debts

Assertions Assertions Assertions

Occurrence Existence Occurrence and rights and
Completeness Rights and obligations obligations
Accuracy Completeness Completeness
Cutoff Valuation and allocation Classification and
Classification • Valuation at historical cost understandability
• Valuation at net realizable value Accuracy and valuation

Before You Go On
1.1 Identify two major transaction classes with significant volumes of transactions in the revenue
process.
1.2 Explain the interaction of sales and cash receipts with accounts receivable. Further, if cash
receipts are understated, what are the implications for accounts receivable?
1.3  What is the usual timing of recording charges to bad debt expense?

Understanding the Entity and Its Environment

LEA RNING OBJECTI VE 2

Evaluate how an auditor’s understanding of an entity and its environment affects
audit planning decisions in the revenue process.

Chapters 3 and 4 explained the importance of understanding the entity and its environment,
and how this understanding is important to assessing inherent risk. As inherent risk factors
vary from industry to industry, from client to client, and from year to year, each audit must be
custom-made to address unique risks. The following discussion will address the importance of
understanding the entity and its environment in the context of the revenue process, analytical
procedures commonly used in the revenue process, other issues associated with the entity and
its environment, and the resultant assessment of inherent risk.

Understanding the Client’s Revenue Process

The process of earning and recognizing revenues will vary from entity to entity. It is partic-
ularly important that the auditor be knowledgeable about the entity, how the entity earns
revenues, and what particular revenue recognition issues may be relevant to the entity. Under-
standing how the entity earns and recognizes revenues assists the auditor in:

•  Developing an expectation of total revenues by understanding the client’s capacity, mar-

ketplace, and customers.
   Understanding the Entity and Its Environment  11-5

•  Developing an expectation of gross margin by understanding the client’s market share

and competitive advantage in the market.
•  Developing an expectation of net receivables based on the average collection period for
the client and for the industry.

In addition, the process of generating revenues drives many expenses (e.g., cost of goods sold
or selling expenses), so understanding the revenue process assists in developing expectations
of the entity’s expenses associated with other transaction processes and assessing the risk that
unaudited earnings contain material misstatements.
Illustration 11.3 illustrates the importance of understanding the revenue process for
five different industries, which will be discussed in this chapter, as well as Chapters 12 and
13. These industries were chosen for their variety based on the North American Industry
Classification System (NAICS). These include the manufacture of oil and gas field machin-
ery and equipment (NAICS 333132), the manufacture of electronic computer equipment
(NAICS 334111), supermarkets and other grocery stores (NAICS 445110), hotels and motels
(NAICS 721110), and colleges, universities, and professional schools (NAICS 611310). These
examples define a wide spectrum of underlying business practices and an equally wide spec-
trum of risk for the auditor. The auditor would normally obtain this understanding through
previous experience with the entity; information from trade associations, business period-
icals, and newspapers; and from publishers of industry information such as Robert Morris
Associates or Value Line.

ILLUSTRATION 11.3   Understanding an entity’s revenue process

Developing a Knowledgeable
Perspective About the Entity’s
Financial Statements (Median Assessing the Risk of Material
Example Industry Traits Industry Data) Misstatement
Oil and Gas Field Machinery and   Sales to Total Assets: 1.6 • Concerns about terms of sales and moving
Equipment Manufacturing Sales to Net Fixed Assets: 10.3 inventory during a period of low oil prices
• Tied to extract industries that are depen- Gross Profit: 36.9% • Sales may be dependent on policies of foreign
dent on oil prices Net Operating Profit: 12.0% governments
Collection Period: 61 days
• Depends on opportunities for export and • Collection risk associated with selling to foreign
competitive pricing entities
Electronic Computer Manufacturing Sales to Total Assets: 2.7 • Significant revenue recognition issues associated
• Sells products ranging from network Sales to Net Fixed Assets: 49.2 with bundled products
servers to personal computers and tablets Gross Profit: 39.2% • Cash collection may precede revenue recognition
Net Operating Profit: 5.2% resulting in unearned revenues
• Consulting services may represent a
Collection Period: 41 days
significant component of revenues • Competitive environment significantly affects
• Margins depend on competing technologies selling prices and gross margins
•  Normal concerns about collection risk
Supermarkets and Other Grocery Stores Sales to Total Assets: 2.7 •  Sales volume coverage of fixed costs
• Numerous products where product Sales to Net Fixed Assets: 5.3 • Gross margins related to product mix and space
differentiation is difficult Gross Profit: 26.7% utilization
Net Operating Profit: 1.5%
• Companies are improving margins by leasing • Receivables usually relate to pharmacy
Collection Period: 4 days
space to banks and coffee companies receivables from insurance companies and
• Intense competition from club stores and miscellaneous trade receivables
other competitors
Hotels and Motels Sales to Total Assets: .5 • Revenue recognition for accounting for hotel
•  Importance of brand development Sales to Net Fixed Assets: .6 transactions versus property ­management
Gross Profit: Not Reported • Revenue tied to sales volumes, prices, and
• Generates revenues from hotel occupancy
Net Operating Profit: 17.2% occupancy rates
and services (food and conferences),
Collection Period: 2 days
franchise fees, and property management • Major hotel companies that enter into agreements
to manage properties for others experience a
higher degree of collection risk

(continued)
11-6  C h a pte r 11 Auditing the Revenue Process

ILLUSTRATION 11.3   (continued)

Developing a Knowledgeable
Perspective About the Entity’s
Financial Statements (Median Assessing the Risk of Material
Example Industry Traits Industry Data) Misstatement
Colleges, Universities, and Professional Sales to Total Assets: .5 •  Revenue recognition is straightforward
Schools Sales to Net Fixed Assets: 1.0 •  Low collection risk if accredited
• Concerns about the degree of tuition Gross Profit: Not Reported
• Business risk associated with high fixed costs and
discounting through scholarships Net Operating Profit: 10.2%
enrollment declines
Collection Period: 16 days
• Importance of accreditation and access to
federal student loans
• Enrollment sensitive to demographics and
unemployment levels

It is important for the auditor to understand the nature of the client’s revenue process. The
demand for oil and gas field machinery equipment can be significantly impacted by (1) oil
prices or decisions made by foreign countries to invest in or support oil and gas extraction, or
(2) political factors that influence a government’s ability to sell oil and gas. The companies
that manufacture computers may bundle services and service contracts with their products
resulting in more complex revenue recognition accounting. While the accounting for revenues
in the grocery industry might be uncomplicated, hotel and motel operations may include man-
aging properties for others, which requires recognition of only the management commission
and not the gross receipts of the managed properties. Therefore, the audit of each company
must be custom-made, and inherent risks will often differ from one audit to the next. Finally,
understanding an entity's revenue process provides the basis for developing expectations about
revenue and receivables that an auditor uses in performing analytical procedures.

Analytical Procedures
Analytical procedures are required in every audit as part of the risk assessment process
during audit planning, which often occurs during the client’s second or third quarter. They
are cost-effective, and they are often effective in identifying potential misstatements in the
financial statements. The most effective analytical procedures rely on the auditor’s knowl-
edge of the business and industry. Some example analytical procedures that may apply to
the revenue process are presented in Illustration 11.4.

ILLUSTRATION 11.4   Analytical procedures commonly used for the revenue process

Ratio Formula Audit Significance

Sales to capacity Net sales Helpful in assessing the reasonableness of total revenues.
Nonfinancial measure of capacity
Market share Client’s net sales Helpful in assessing the reasonableness of both total
Net sales of industry revenues and gross margins. Larger market share is often
associated with larger gross margins.
Sales to total assets Sales This ratio is useful for manufacturing and other asset-based
Average total assets companies. Describes the relationship between assets and sales
revenues.

Accounts receivable growth to

sales growth (Accounts receivableCurrent Year
Accounts receivablePrior Year )
 − 1
Ratios larger than 1.0 indicate that receivables are growing
faster than sales. Large ratios may indicate possible collec-
tion problems.

( SalesCurrent Year
SalesPrior Year )
 − 1

Accounts receivable turnover

in days 365 days ÷   ( Net credit sales
Average net receivables ) Useful in comparing with industry averages. Longer collection
periods may indicate collection problems. Prior experience and
current sales volumes may be useful in estimating current net
receivables.

(continued)
   Understanding the Entity and Its Environment  11-7

ILLUSTRATION 11.4   (continued)

Ratio Formula Audit Significance

Uncollectible accounts Uncollectible accounts expense Useful in evaluating the reasonableness of uncollectible
expense to net credit sales Net sales accounts expense. Smaller ratios may indicate an inadequate
provision for uncollectible accounts.
Uncollectible accounts Uncollectible accounts expensePrior Year Useful in evaluating the reasonableness of prior period’s
expense to accounts receivable Actual accounts receivable write-offsCurrent Year uncollectible accounts expense. Smaller ratios may indicate
write-offs an inadequate estimation process.
New product revenues to total Revenues from new products Companies with a high proportion of revenues from new
revenues introduced during the year products may earn a premium gross margin due to their
Total revenues ability to innovate.

The first step in performing analytical procedures is obtaining an understanding of total

revenues given (1) the client’s capacity and (2) the client’s marketplace for those products. The
auditor should understand the entity’s capacity, which is the maximum volume of sales that it
could generate if it fully utilized its facilities and employees to manufacture and deliver products
and services. Auditors should be sensitive to the volume of sales that an entity records given its
maximum capacity, the number of shifts that an entity operates, and seasonal variations in the
industry. In today’s audit environment, effective analysis of either analytical procedures or data
analytics is tied directly to the auditor’s business acumen. It is much more effective to evaluate
total revenues against a measure of business activity than to compare current revenues with
prior-year revenues. Auditors must be sensitive to how the business environment is changing,
not just how the financial numbers are changing. Therefore, the auditor will often tailor analyt-
ical procedures to the client’s industry that compare revenues with measures of the process that
produces revenues. For example, the auditor might evaluate the following trends:

•  Revenue per number of manufacturing employee labor hours, for a labor-intensive man-
ufacturing process.
•  Revenue to plant assets in a capital-intensive manufacturing process.
•  Revenue per square foot of retail space for a grocer.
•  Revenue compared to occupancy rates for industries such as hotels or airlines.
•  Revenue per student for a college.

When evaluating these trends, the auditor must also be sensitive to seasonal demand or
other trends in the marketplace for the client’s products. For example, the auditor must be able
to assess the reasonableness of revenue increases for a household appliance manufacturer when
national housing starts are declining, or the reasonableness of occupancy rates and room prices
for a hotel chain when new competitive properties have entered key markets. One important
analytical procedure is understanding the client’s market share, which compares the client’s
revenues with total revenues in the market for the client’s product. This is particularly important
because companies with dominant market shares often obtain premium gross margins.
Finally, it is important for the auditor to evaluate the client’s accounts receivable turnover
in days, or average collection period, and be able to compare the collection period with indus-
try norms. Companies may be able to speed up collection times when products are in high
demand. Increases in the client’s collection period indicate that receivables are growing faster
than sales volumes, which consumes operating cash flows and may lead to liquidity problems.
It is particularly important in growth companies for auditors to monitor the entity’s collection
period because any growth in sales is usually accompanied by receivable growth that con-
sumes operating cash. If receivables are growing faster than sales, it may be an indication that
the company is accomplishing sales growth by taking on increased credit risk.
Other analytical procedures an auditor might assess in the revenue process include:

•  Sales turnover, a ratio of sales to average total assets.

•  Trends in gross margins compared with trends in market share.
•  Estimates of accounts receivables given knowledge of the company’s sales volumes,
prices, and historical collection period.
11-8  C h a pte r 11 Auditing the Revenue Process

•  Comparison of accounts receivables to the receivables estimate in the company’s cash

budgets.
•  Uncollectible accounts expense to net credit sales.
•  Uncollectible accounts expense to actual uncollectible accounts written off.

Other Considerations Regarding the Entity

and Its Environment
Recall from Chapter 4 (see Illustration 4.1) that there are numerous issues an auditor should
understand about the entity and its environment. Illustration 11.5 summarizes revenue issues
that have not yet been covered in this chapter, and it provides examples of the settings in which
these factors might lead to either a higher assessment of inherent risk or a lower assessment of
inherent risk. It is important for auditors to recognize that these factors may change for a given
client over time and that each audit should be viewed independently from previous audits.

ILLUSTRATION 11.5   Understanding the entity and its environment in the revenue process

Key Factors Regarding the

Higher Inherent Risk Entity and Its Environment Lower Inherent Risk
Significant legal compliance issues exist when Compliance with laws and Nominal legal compliance issues exist when
making sales, delivering on contracts, and regulations making and collecting sales.
collecting sales (e.g., HIPAA compliance in the
medical industry, or legal compliance in defense
contracting).
The client only informally compares revenues Client performance measurement The client carefully monitors revenue
with underlying business activity. recognized compared to underlying
business activity.
A significant amount of revenue transactions Related party transactions There are few or no revenue transactions
is with affiliated companies or other related with affiliated companies or other related
parties. parties.
There is little or no independent oversight of Corporate governance There is strong corporate governance
management, the revenue accounting process, with oversight of revenue recognition
or accounting estimates in the revenue process. and accounting estimates in the revenue
process.
Revenue recognition is complex and requires Month-end, quarter-end, and Revenue recognition is not complicated and
significant adjustments at period-end. year-end closing procedures requires little period-end adjustment, if any.

Audit Reasoning Example Indicators of Misstatements in the

Revenue Process

Chris Spenser is the senior on the audit of Cloud Materials, Inc. (CMI). CMI manufactures a va-
riety of computer hardware used in server farms and computer networks, and this year it started
bundling software with the products to more seamlessly handle the problems associated with large
data storage and retrieval. CMI is also starting to invest in data analytics software to better serve
its clients. Chris has noticed two significant warning signs: (1) the company has improved its gross
margins to a point where they are significantly above industry averages, and (2) the company is sig-
nificantly lagging behind the rest of the industry in collecting its receivables. Chris wonders if this
makes sense in a price-competitive industry. Is the combination of increasing gross margins and
increasing collection periods a sign of premature revenue recognition? As Chris talks about this
with his audit manager, they decide that these are warning signs that need specific investigation.
They need to determine if the system of internal control kept up with changes in business prac-
tices. Also, they need to focus attention on how revenue is recognized on bundled hardware and
software sales, as well as whether there have been significant profit increases in the fourth quarter.
   Inherent Risks in the Revenue Process  11-9

Before You Go On
2.1 Explain how auditing the revenue process might be different for a hotel client than for an oil
and gas field equipment manufacturer.
2.2 Assume that, when performing analytical procedures, an auditor notices that revenue grows
10% while receivables grow at a 30% rate. What assertions might be misstated?
2.3 Explain how quarter-end closing procedures might increase inherent risk in the revenue
process.

Inherent Risks in the Revenue Process

LEA RNING OBJECTI VE 3

Determine inherent risk for various assertions in the revenue process.

In assessing inherent risk for revenue process assertions, the auditor should consider pervasive
factors that may affect assertions in several processes, including the revenue process, as well as
factors that may pertain only to specific assertions in the revenue process. Accounting for var-
ious revenue transactions under ASC 606 Revenue from Contracts with Customers is complex;
revenue should only be recognized when a company satisfies its performance obligations. This
is particularly true when there are multiple performance obligations, such as when the sale
of goods and services are bundled together. Further, management often has more incentive to
overstate revenues than to understate revenues. Factors that incentivize management to mis-
state revenue process assertions and commit fraudulent financial reporting include:

•  Pressures to overstate revenues to achieve revenue or profitability targets that were not
achieved in reality owing to such factors as global, national, or regional economic condi-
tions; the impact of technological developments on the entity’s competitiveness; or poor
management.
•  Pressures to overstate cash and gross receivables or understate the allowance for doubt-
ful accounts in order to report a higher level of working capital in order to meet debt
covenants.

The auditor should maintain an appropriate attitude of professional skepticism and be

alert to some of the following devices that have been used by companies to overstate revenues:
consignment sales, refund rights, and bill-and-hold transactions. consignment sales  may occur
Consignment sales. Sale arrangements that have the characteristics of a consignment in a transaction between a man-
sale include giving the buyer a lengthy right of return, having substantial payment made upon ufacturer and a wholesaler, when
the resale of the product, requiring sellers to repurchase inventory at a specified price, or the seller retains title to inventory
allowing the buyer not to assume risks of ownership due to future pricing concessions. For in the wholesaler’s possession,
example, if a manufacturer promises a wholesaler future price concessions based upon hold- and the sale is completed when
the wholesaler sells the inventory
ing and financing costs for the length of time between purchase and sale, the sale should be
forward; a consignment sale may
accounted for as a consignment sale, and revenue should be deferred.
be created in economic substance
Refund rights. When rights of return exist or are likely to be accepted, a reasonable when the terms of sale create
estimate of refunds should be made when revenue is recognized. In determining the amount uncertainties about whether the
of the estimated refunds, management should consider competition, obsolescence, and the wholesaler assumes risk of own-
length of time over which the product can be returned. However, if a reasonable estimate ership upon receipt of goods
cannot be made, revenue should not be recognized until the material uncertainty is resolved. refund rights  a sale is made
Further, if a seller changes the right of return near the end of the period to offer more gener- with the right to return the goods
ous terms, the seller should not be able to recognize revenue until material uncertainties are for a full refund, even if the goods
resolved and subsequent cash collections are assured. are not defective
11-10  C h a pte r 11  Auditing the Revenue Process

bill-and-hold transactions  a Bill-and-hold transactions. These are transactions in which a company bills cus-
customer is billed for goods, but tomers without shipping goods. Sunbeam Corporation was the first to use this method to
goods are not shipped; account- inflate revenue. For example, assume that a manufacturer leases a portion of its facility
ing principles have very narrow to a customer and records revenue on sales to this customer when products are delivered
criteria for when revenue can be
to the customer’s portion of the facility. The SEC now has very strict rules for revenue
recognized for a bill-and-hold
recognition related to bill-and-hold sales. ASC 606 Revenue from Contracts with Customers
transaction; the transaction must
be initiated by the customer, and also has specific conditions that must be met for the seller to recognize revenues.
the customer must have a sound Problems associated with booking consignment sales, refund rights, and bill-and-hold
economic reason for purchasing transactions usually result in problems associated with the occurrence of revenues and the
the goods and asking the seller to existence of receivables.
continue to hold the goods An additional problem that auditors have experienced involves the correctness of gross
gross sales  total revenues sales. Many companies, particularly growth companies, pay considerable attention to top-
before any deductions, such as line revenues. Companies may award bonuses based on gross revenues, and companies have
deductions for sales returns and been valued based on multiples of revenues. Consider the hotel chain that manages proper-
allowances ties that it does not own. It should not record revenues from managed properties in a simi-
lar fashion to owned properties and then record related expenses of property management.
Rather, management should record revenue only in the amount of the commission earned.
Recently, Groupon restated earnings when it went public because it had booked revenue
in the amount of the gross value of products sold through Groupon, rather than merely
the commission that Groupon received on the sale of the product for customers. In this
case, there was an overstatement of revenues and an overstatement of expenses. Operating
income was correctly reported, but significant misreporting of the amounts of revenues and
expenses existed. In the Groupon case, the problem is with the occurrence of revenue and
the occurrence of expenses.
Other factors that contribute to misstatements in the revenue process include the
following:

•  The volume of sales, cash receipts, and sales adjustment transactions is often high, result-
ing in numerous opportunities for errors to occur.
•  The timing and amount of revenue to be recognized (occurrence and cutoff of revenues)
may be contentious owing to factors such as complex accounting standards, the need
to make estimates, the complexity of the calculations involved, and purchasers’ rights
of return.
•  When receivables are factored with recourse, the classification of the transaction as a sale
may be incorrect.
•  Receivables may be misclassified as current or noncurrent owing to difficulties in esti-
mating the likelihood of collection within the next year or events upon which collection
is contingent.
•  Cash receipt transactions generate liquid assets that are particularly susceptible to misap-
propriation (completeness of revenues or cash receipts).
•  Sales adjustment transactions may be used to conceal thefts of cash received from cus-
tomers by overstating discounts, recording fictitious sales returns (occurrence or accuracy
of discounts or sales returns), or writing off customers’ balances as uncollectible (occur-
rence of write-off of accounts receivable).

Because of the variety and potential magnitude of the misstatements that can occur
in the absence of effective controls, the auditor must always give careful consideration to
inherent risks in the revenue process. Risks associated with revenue recognition are such
that auditors often consider the occurrence of revenues and the existence of receivable
assertions to be a significant inherent risk. In many cases, management adopts extensive
internal controls to address these issues through its own risk assessment procedures.
Finally, when auditors perform analytical procedures during risk assessment, they should
develop a skill in analyzing the likely assertions that might be misstated based on the data. For
example, consider the information in Illustration 11.6. Take a moment, study the data, and
consider what assertions might be at an increased risk of misstatement.
   Inherent Risks in the Revenue Process  11-11

Current Year Prior Year ILLUSTRATION 11.6  

$000 Percentage $000 Percentage Example analytic procedures
in the revenue process
Revenues $5,638 100.0% $3,780 100.0%
Cost of goods sold $2,691 47.7% $1,975 52.2%
  Gross profit $2,947 52.3% $1,805 47.8%

Accounts receivable, net $1,335 $837

Revenue growth   49%   33%

Accounts receivable growth   59%   30%
Cost of goods sold growth   36%   34%

Accounts receivable turnover in days   86 days   81 days

Inventory turnover in days 180 days 189 days

The data show a company that is clearly experiencing rapid growth. Revenues have
grown by nearly 50%, receivables are growing faster than sales, and gross margins are improv-
ing. This fast growth, combined with the slow accounts receivable turnover, should cause the
auditor to heighten professional skepticism with respect to revenue recognition. Recognizing
revenues without shipping goods will cause gross margins to improve and accounts receivable
turnover in days to slow. The significant accounts receivable growth should also cause con-
cerns about the collectibility of receivables. In summary, significant inherent risks exist for
the occurrence of revenues, the existence of receivables, and for the valuation of receivables
at their net realizable value.

Audit Reasoning Example  Right of Return and Revenue Recognition

Keila Hirata is a senior auditor on Eastern Automotive, a small automotive parts company. She
has worked on this audit since she started with the audit firm, and she has developed a good
understanding of the company and its market. She has been monitoring the company’s monthly
financial statements and has been watching a build-up in inventory. Two months before year-end,
she talks to Eastern’s CFO about the problem; the CFO is wondering if Eastern will have to start
marking down inventory to move it out. Then in the last month of the year, inventory drops, rev-
enue increases, and things look normal again. However, looking at the results of a data analytics
test, Keila notices that more goods have been shipped in the last month than have been ordered
by customers. What would explain this? Digging deeper in the shipping department, she finds
several large shipments to some of Eastern Automotive’s larger customers. The problem is that
the goods have not been ordered by the customers. Keila finds that the goods were shipped with a
full right of return if the customer cannot sell the products forward. This is a significant revenue
recognition problem that will result in taking revenue and receivables off the books and putting
inventory back on the books with a concurrent reduction in cost of sales.

Professional Environment  Restatements of Revenues

Audit Analytics1 recently reported a summary of restatements recognition of revenue. Many of these restatements originated from
due to revenue recognition issues for a 17-year period ending a failure to properly interpret sales contracts for hidden rebates,
in 2017. The revenue recognition issues consist of misstatements returns, or barter or resale clauses. Some of the restatements also
in approach, understanding, or calculation associated with the relate to the treatment of sales returns, credit, and other allowances.

1
Don Whalen, Olga Usvyatsky, and Dennis Tanona, 2017 Financial Restatements, A Seventeen Year Comparison
(Audit Analytics: Sutton, MA, 2018).
11-12  C h a pte r 11  Auditing the Revenue Process

Disclosure Year 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Revenue restatements 169 194 226 173 173 120 86 86 89 90 119 104 90 96 77
% of all financial 21.4% 20.4% 14.3% 9.3% 13.5% 12.4% 10.4% 10.1% 10.5% 10.6% 13.6% 12.1% 11.9% 14.1% 13.9%
statement restatements

Overall, restatements due to revenue recognition problems amounted to only about 10.5% of all restatements, and from 2013
were the second most common source of restatements during onward revenue restatements have increased, ranging from 11.9%
the 17-year period. In the early years of this time series, revenue to 14.1% of all restatements. Based on restatements of earnings
restatements amounted to over 20% of all restatements. In the due to revenue recognition problems, revenue recognition contin-
subsequent period, revenue restatement declined as a percent- ues to be a significant inherent risk.
age of total restatements. From 2009–2012, revenue restatements

Cloud 9 - Continuing Case

As Josh and Suzie review what they know about Cloud 9’s busi- sive in its forecasting and overestimated the demand for certain
ness and industry, they know that senior employees will receive products. Suzie is concerned about how this might affect account-
stock options if revenue targets are met. Those targets are asso- ing in the revenue process. Josh also wants Suzie to pay careful at-
ciated with opening a new company-owned store and making tention to period-end closing procedures. Finally, Josh asks Suzie
more sales through existing channels. Analytical procedures per- to think about the assertions where inherent risk will be high or
formed during interim planning show that inventory levels have maximum. Then, they can consider what they know about Cloud
increased. Further investigation has revealed that, while the econ- 9’s system of internal control when assessing the overall risk of
omy has been strong, the company appears to have been aggres- material misstatement.

Before You Go On
3.1 Explain how sales adjustment transactions may be used to conceal thefts of cash.
3.2 Ron Fisher owns Fisher’s Bar and Grill. Ron is particularly concerned about generating ad-
equate cash flow but also places a real emphasis on minimizing the entity’s income taxes.
If you were to audit Fisher’s Bar and Grill, address the inherent risks that might exist in the
revenue process.

Control Activities for Credit Sales

LEA RNING OBJECTI VE 4

Evaluate control activities for credit sales transactions.

Recall from the section “Entity-Level Internal Controls” in Chapter 6 that when evaluating
internal controls in the revenue process, it is important to understand a number of entity-
level controls. Entity-level controls establish a background and environment for transaction-
level controls. For example, the control environment may enhance or negate the effective-
ness of transaction-level controls. A key control environment factor in reducing the risk
of fraudulent financial reporting through the overstatement of revenues and receivables is
management’s adoption of and adherence to high standards of integrity and ethical ­values.
   Control Activities for Credit Sales  11-13

One related aspect is eliminating incentives that encourage dishonest reporting, such as man-
agement’s undue emphasis on meeting unrealistic sales or profit targets. Another related as-
pect is the supporting activities of an effective board of directors and audit committee. The
auditor might also be interested in how the entity’s risk assessment process responds to risks
that arise from changed circumstances, such as implementing new accounting standards for
revenue transactions. The discussion for the remainder of the chapter focuses on transaction-
level controls.
Recall from Chapter 6 that the process used for developing an audit strategy for various
assertions involves the following six steps:

1.  Understanding the flow of transactions in a given transaction process.

2. Identifying what can go wrong from initiating the transaction to the recording in the
general ledger. The auditor needs to link what can go wrong to assertions.
3.  Assessing whether controls exist to mitigate what can go wrong.
4.  Identifying relevant controls, performing tests of controls, and evaluating results.
5. Reporting internal control weaknesses to those charged with governance of the entity,
based on controls that are absent or controls that are not operating effectively.
6.  Determining an audit strategy at the assertion level.

Now think about the five industries that were mentioned at the beginning of this chap-
ter. Is it reasonable to expect that the flow of transactions would be the same for a manufac-
turer of oil and gas field equipment as for a grocery store or a hotel? The following examples
are more likely to fit a manufacturing company that sells manufactured goods on credit.
However, be alert to comments that might apply to a retail grocer, a hotel chain, or a college/
university. Auditors usually understand the flow of transactions in a given process by per-
forming a walkthrough of a transaction process, such as the sales process or the cash re-
ceipts process. The walkthrough is important as different companies often have different
documents and transaction flows. During a walkthrough, the auditor will interview client
personnel, review the documents and electronic files used by the client, and understand
how the entity uses information technology to support transaction-level controls. The
auditor will ask questions of the entity’s personnel about their understanding of their
responsibilities. Through inquiry and observation, the auditor obtains an understanding
of transaction-level controls as well as the adequacy of segregation of duties. The discus-
sion below provides examples of the flow of transactions in the credit sales process from
initiating a transaction, to exchanging title to a good or service, to recording the transac-
tion in the general ledger. This is followed by a discussion of the flow of transactions in
the cash receipts processes. These two transaction streams often have a high volume of
transactions.

Example Transaction Flows—Sales Process

The transaction flow in a typical sales process for a client that sells goods includes processing
and approving credit and sales orders, shipping goods, invoicing customers, and recording
sales and trade receivables. The transaction flow for a client that sells services is similar, but
instead of shipping goods, the client performs the services. When selling services, recordkeep-
ing regarding services performed (number of rooms used daily at a hotel or course enrollment
at a college) is important to documenting the revenue process.
Common documents and files that are found in the process of selling goods include:

Source Documents and Related Electronic Files

•  Customer master file—Usually part of the sales process database with information on
approved customers, customer shipping and billing information, and the customer credit
limit. Access to the customer master file and changes to this file should be tightly con-
trolled by the entity.
•  Master price file—Usually part of the sales process database with information on approved
prices and discounts, such as volume discounts, that are allowed for any customer.
11-14  C h a pte r 11  Auditing the Revenue Process

•  Sales order—Client-prepared prenumbered document that includes customer informa-

tion, description and quantity of what was ordered, and terms of sale.
•  Bill of lading—Client’s shipping document that serves as acknowledgement of receipt of
goods for delivery by a freight carrier.
•  Packing slip—Client-prepared document with the details of items included in a shipment.

Recording Document

•  Sales invoice—Client-prepared document stating the particulars of a sale, including the

amount owed, terms, and date of sale. It is used to bill customers, and it provides the basis
for recording a sale in the sales journal.
•  Sales journal—The journal of original entry where each sale is recorded.

Important Databases or Other Documents

•  Sales process database—Electronic files that accumulate data on sales, cash receipts, and
accounts receivables.
•  Monthly statements of receivable balances—Client-prepared report sent to each customer
showing the beginning receivable balance, transactions during the month, and the end-
ing receivable balance (even if it is zero).

An example of how these documents commonly flow is illustrated in Illustration 11.7.

Illustration 11.7 is followed by a brief discussion of how credit sales are processed in many
companies. It is helpful to understand the documents and what information might be included

illustration 11.7   Example flow of transactions for credit sales

Process Documents Files and Databases

Authorization
Receive customer Customer
order for goods Master
master
price list
file

Prepare internal Sales process

Sales order and G/L database
sales order

Shipping
Prepare shipping
Sales process
documents and Packing slip Bill of lading
and G/L database
ship goods
Recording
Prepare sales invoice
Sales invoice
to bill customer
Sales process
and G/L database

Record in sales
journal

Post to general
ledger

Record in A/R Monthly

subsidiary ledger statement
   Control Activities for Credit Sales  11-15

on each document. The flow of transactions that is visualized in this illustration might be
represented by documents being received from, or sent to, the customer in either paper or
electronic form (by way of electronic data interchange). Nevertheless, the following functions
are standard functions in the revenue process.

Initiating and Authorizing Credit Sales

Initiating a transaction represents the process of agreeing to sell goods or services to an inde-
pendent third party (or to a related party).
Accepting customer orders. Sales orders from customers should be accepted only in ac-
cordance with management’s authorized criteria. The criteria generally provide for specific
approval of the order in the sales order department, using a software application to determine
that the customer exists in a customer master file with approved credit limits. If the customer
is not in the master file, many companies ask for a credit card, or they ship on a collect-on-
delivery basis to establish a history with a new customer. In many companies, the next step
involves the client preparing a prenumbered sales order form. The prenumbered sales order
form enables following each transaction from initiation, to delivery of goods or services, to
recording the sale, to receipt of final consideration. The sales order represents the start of the
transaction trail of documentary evidence. Information on open (unfilled) and filled sales
orders is usually maintained in appropriate electronic files and monitored to ensure ordered
goods are shipped to customers. Usually, the software can be programmed to compare a cus-
tomer’s outstanding receivable balance, plus the anticipated sale, with the customer’s credit
limit in the approved customer master file. Segregating responsibility for initiating a sale and
approving sales that exceed a credit limit prevents sales personnel from subjecting the com-
pany to undue credit risks to boost sales.
Approving credit. Today, most companies ask first-time customers to pay in cash, pay on a
cash-on-delivery basis, or pay with credit cards or some form of electronic funds transfer. This
allows the company to make the sale and begin to establish a relationship with new custom-
ers. After some history with a new customer, a company may begin steps to approve credit in
small amounts and increase credit limits based on a customer’s payment history. Controls over
approving credit are designed to reduce the risk of initially recording a revenue transaction
at an amount in excess of the amount of cash expected to be realized from the transaction.
Thus, these controls also relate to the valuation and allocation assertion associated with the
allowance for uncollectible accounts.

Shipping Goods
Delivery of goods or services is the economic event that results in a change in title and estab-
lishes revenue recognition and the right to a receivable.
Filling sales orders. Company policy generally prohibits the release of any goods from
the warehouse without an approved sales order. Further, the software may be programmed to
match items taken from the perpetual inventory with items on an approved sales order. This
control procedure is designed to prevent the unauthorized removal of items from inventory.
The warehouse may receive an electronic copy of the approved sales order as authorization to
fill the order and release the goods to the shipping department. When goods are pulled from
inventory, a packing slip is normally produced to detail the items that will be shipped to the
customer and the quantity of each item shipped.
Shipping sales orders. Segregating the responsibility for shipping from approving and fill-
ing orders helps to prevent shipping clerks from making unauthorized shipments. In addition,
an important manual control requires that shipping clerks make independent checks to de-
termine (1) that goods pulled from the warehouse are accompanied by appropriate authoriza-
tion, and (2) that the order was properly filled (goods taken from the warehouse agree with the
details of the sales order). The shipping function also involves preparing multicopy shipping
documents, such as a bill of lading. Shipping documents are often produced by the software
application using order information already in the program and adding appropriate shipping
data such as quantities shipped, carrier, freight charges, and so on. Daily software application
checks are often run to (a) account for all shipping documents, (b) determine that all sales
11-16  C h a pte r 11  Auditing the Revenue Process

orders result in shipments, and (c) determine that a sales invoice was subsequently prepared
for each shipping document. These checks provide an important control for the completeness
assertion.

Recording Sales
The process of recording sales involves preparing and sending prenumbered sales invoices
to customers (billing customers) and recording sales invoices accurately and in the proper
accounting period (recording sales). The auditor’s primary concerns regarding recording
sales are that sales invoices are recorded accurately and in the proper period. The latter
pertains to when the revenue is earned, which is usually when the goods are shipped. The
auditor’s primary concerns regarding billing are that customers are billed (1) for all ship-
ments, (2) only for actual shipments (no duplicate billings or fictitious transactions), and
(3) at authorized prices.

Identify What Can Go Wrong (WCGW) and Identify

Key Controls—Credit Sales and Accounts Receivable
Once the auditor understands the flow of transactions, the auditor should evaluate what can
go wrong, identify potential controls that management has placed in operation, and then
choose key controls to test. Illustration 11.8 summarizes the flow of transactions through
the revenue process, key documents and files, what can go wrong, and example controls
for a manufacturing client making credit sales. There is likely to be a different analysis of
what can go wrong for a hotel that receives cash in advance of providing the service and
has significant unearned revenues. As you review Illustration 11.8, notice that most of the
controls are IT application controls; try to associate particular controls with the assertions
being controlled.

ILLUSTRATION 11.8   Credit sales transactions—WCGW and example controls

Documents  
Transaction and Files Risks (WCGW) Example Control
Initiating credit Customer master Sales may be made to Only a limited number of individuals can change the
sales file unauthorized customers. customer master file and all file changes are reviewed
by appropriate levels of management. These duties
should be segregated from shipping goods or recording
transactions.
Sales order Sales may be made to The software application matches the customer on
unauthorized customers. the sales order with the customer master file.
Sales order Sale may be made without The software application matches amount of sales
credit approval. order with credit authorization on the customer
master file.
Appropriate level of regular review of sales analysis
(by product, division, salesperson or region) and
comparisons with budgets.
Delivering goods Perpetual inventory Goods may be released from The software application matches all goods pulled
warehouse for unauthorized from inventory (perpetual inventory) to approved
orders. sales orders.
Bill of lading and Products may be shipped The software application generates packing slip and
packing slip without shipping documents delivery documentation when order is processed.
being generated.
Bill of lading and Goods ordered may not be The software application prints a report of all unfilled
packing slip shipped. sales orders.
(continued)
   Control Activities for Credit Sales  11-17

ILLUSTRATION 11.8   (continued)

Documents  
Transaction and Files Risks (WCGW) Example Control
Recording sales Sales invoice and Some shipments may not be The software application prints a report of all goods
sales process billed. shipped but not billed.
database Invoices are prenumbered and accounted for.
The software application prints a report of all bills of
lading not matched with sales invoices.
Sales invoice and Billing may be made for ficti- The software application matches sales invoice
sales process tious transactions, or duplicate information with underlying shipping information.
database billing may be made.
Sales invoice and Sales invoices may be recorded The software application matches sales invoice date
sales process in the incorrect accounting with accounting period in which goods are shipped.
database period.
Sales invoice and Sales invoices may be recorded The software application matches sales invoice
sales process in the incorrect amount quantities with shipping information and prices
database (incorrect quantities or prices). with master price list.
Sales invoice and Invoices may not be The software application checks run-to-run total of
sales process journalized or posted to beginning receivables, plus sales transactions with the
database customer accounts. sum of ending receivables.
Sales invoice and Sales invoices may be billed to The software application matches customer number
sales process the wrong customer. on sales invoice with customer number of sales order
database and bill of lading.
Monthly receivable Customers may be billed An individual reviews monthly statements to custom-
statements incorrect amounts. ers before they are mailed, reporting any exceptions
to a designated accounting supervisor not otherwise
involved in the execution or recording of revenue
process transactions.
Statements are mailed monthly, with follow-up on
customer complaints independent from the recording
process.

Many clients build in redundant controls such that if one control does not find a mis-
statement, another control will detect the problem. However, auditors cannot efficiently test
all controls that exist. The auditor will find a key control by identifying the most important
control for each assertion. Following are example key controls that auditors often identify. The
examples rely significantly on IT application controls to flag potential misstatements. The au-
ditor should understand the logic behind the IT application controls and how client personnel
manually follow up on exceptions on a timely basis.
Completeness of sales. The software application starts with a population of daily shipping
documents and develops a one-for-one match with sales invoices to ensure that each shipment
results in a sales invoice. A report is generated daily of any shipments that have not resulted
in a recorded sales invoice.
Occurrence of sales. The software application starts with the population of daily sales in-
voices and develops a one-for-one match with underlying shipping documents to ensure that
each sales invoice is supported by a bill of lading. A report is generated daily of any sales
that are not supported by shipments. Many larger companies that are heavily computerized
have a control that does a three-way match. A “three-way match” means matching a sales
invoice with underlying shipping documents and the customer’s sales order. In many compa-
nies where title passes when goods are shipped, revenue is appropriately recognized when all
three sets of documents match. Nevertheless, the auditor should always be alert to changes in
the terms of sale that might mean revenue should not be recognized, even though goods have
been shipped.
Accuracy of sales. The software application starts with the population of daily sales in-
voices and compares quantities with the underlying packing slips, compares prices to the un-
derlying sales order, and checks the mathematical accuracy of the sales invoice. A report is
11-18  C h a pte r 11  Auditing the Revenue Process

generated daily of any prices or quantities on the sales invoices that are not supported by
underlying documents or files.
Cutoff of sales. The software application starts with the population of daily sales invoices and
compares the date on the sales invoice with the date on the underlying bill of lading. A report is
generated daily of any sales invoices not recorded in the same accounting period as the shipment.
Classification of sales and receivables. The software application starts with the population
of daily sales invoices and compares customer numbers with the sales order. Both customer
account coding and general ledger coding are compared with the sales order if a sales invoice
bills for both goods and services, as these need to be recorded in separate accounts. A report
is generated daily of any sales invoices showing incorrect account coding, for example, billing
the wrong customer or recording revenue for selling goods when services are sold.
Existence of receivables, valuation of receivables at historic cost, and possible completeness of
accounts receivable. Monthly statements are sent to customers. An independent process is set
up so that customers can lodge a complaint with a person in the company who is independent
of recording sales and receivables. Customers will complain if they are billed for items that
were not ordered or not received.
Rights and obligations of accounts receivable. If receivables are factored or sold with re-
course, an independent process is set up to monitor monthly statements received from the
factoring agent and monitor payments made by customers to the factoring agent (or payments
made to the client in error).

Before You Go On
4.1 How are financial statements misstated if there is a material misstatement in the complete-
ness assertion regarding credit sales? Describe a key control to detect and correct this problem.
4.2 How are financial statements misstated if there is a material misstatement in the occurrence
assertion regarding credit sales? Describe a key control to detect and correct this problem.
4.3 How are financial statements misstated if there is a material misstatement in the existence of
accounts receivable? Describe a key control to detect and correct this problem.

Control Activities for Cash Receipts

LEA RNING OBJECTI VE 5

Evaluate control activities for cash receipt transactions.

The cash receipts function involves the following subfunctions: (1) receiving cash, (2) deposit-
ing cash, and (3) recording the receipts. As in the case of credit sales transactions, segregation
of duties in performing these subfunctions is an important internal control. Today, many cash
receipts involve the electronic transfer of funds. Funds are received directly by the bank, and
the bank establishes controls over receiving cash. Alternatively, customers may send checks to
a client, and the client sets up a lockbox opened by the bank. In this case, the checks are once
again received directly by the bank, which is responsible for both receiving and depositing cash.
This system is described in the following section, “Example Transaction Flows—Cash Receipts.”
If a company receives cash or checks directly from customers (such as at a college/university),
it must establish initial control over the receipt of cash. In this case, the client creates its own
remittance report (independent of the process of recording cash) and makes a detailed list of
customers who paid via cash or check and the amounts received. A major risk in processing
cash receipt transactions is the possible theft of cash before a record is made of the cash receipt;
thus, control procedures should provide reasonable assurance that documentation establishing
accountability is created at the moment cash is received and cash is subsequently safeguarded.
   Control Activities for Cash Receipts  11-19

Example Transaction Flows—Cash Receipts

Common documents and files that are found in the cash receipts process include:
Source Documents
•  Remittance advice—A document received from the customer showing details of payments
made by the customer.
•  Remittance report from the bank—A document prepared by the bank showing the details
of electronic funds transfers received by the bank from customers.
•  Bank deposit slip—A receipt from the bank showing the total amount deposited to the
client’s account at the bank.
Recording Cash Receipts
•  Daily remittance report (or daily cash receipts journal)—A daily report showing cash re-
corded in the cash receipts journal that identifies customers making payments on account
and the amounts received. This report could be prepared by a bank or prepared by a client
that receives cash and checks from customers.
Important Databases or Other Documents
•  Sales process database—Electronic files accumulating data on sales, cash receipts, and
accounts receivables.
•  Monthly statements of receivable balances—A report sent to each customer showing the begin-
ning receivable balance, transactions during the month, and the ending receivable balance.
An example of how these documents commonly flow through the cash receipts process is
presented in Illustration 11.9. Illustration 11.9 is followed by a brief discussion of how cash
receipts may be processed in many companies.

illustration 11.9   Example flow of transactions for cash receipts

Process Documents Files and Databases

Receiving
and Electronic funds Remittance
depositing transfer directly to report Deposit
cash bank from bank slip

or

Remittance
Check sent to
report Remittance
lockbox Deposit
from bank advice
slip

Recording

Prelist of Daily remittance Customer

Sales process
cash receipts report master
and G/L database
file

Record in cash
receipts journal

Post to general
ledger

Record in A/R Monthly

subsidiary ledger statement
11-20  C h a pte r 11  Auditing the Revenue Process

Receiving Cash
A major risk in processing cash receipt transactions is the possible theft of cash before or after
a record of the receipt is made. Control procedures should provide reasonable assurance that
documentation establishing accountability is created at the moment cash is received and that
the cash is subsequently safeguarded.
Electronic funds transfer and lockboxes. Today, the most common form of cash receipts
involves either electronic funds transfer (EFT) or physical checks received directly by the
lockbox system  cash is bank through a lockbox system. With an electronic transfer of funds, cash goes from the
received at a post office box that customer’s bank account to the client’s bank account. However, the U.S. economy still uses
is controlled by the client’s bank; written checks in significant amounts. Companies that receive checks often receive them
the bank picks up the mail daily through a lockbox (a post office box that is controlled by the company’s bank). The bank
(or more frequently) and deposits picks up the mail daily, deposits the checks in the client’s bank account, and sends to the
the checks in the company’s bank
client the remittance advices, a remittance report listing each individual cash receipt, and a
account
deposit slip. When the bank receives electronic funds transfers, the bank also prepares a re-
mittance report listing each individual cash receipt and a deposit slip. The remittance report
is used by the client as a source document to record cash receipts and update accounts receiv-
able. These systems expedite the depositing of funds from customers, permit the company to
receive credit for the receipts sooner, and provide external evidence of the existence of the
transactions. They also eliminate the risk of theft of the receipts by company employees or
the failure to record cash receipts.
Cash received by the company. It is less common for larger companies to process their
own mail receipts, but this continues to occur in small businesses, governments, and not-
for-profit organizations. In these cases, an independent individual with cashier responsi-
bilities should (1) immediately restrictively endorse checks for deposit only (increasing the
likelihood that receipts will be deposited and recorded) and (2) list the checks on a remit-
tance report. The latter may be done manually or using software. Immediate preparation
of the remittance report establishes accountability for the receipts and provides a batch or
control total for use in independent checks on the completeness and accuracy of processing
cash receipts. Remittance advices received with the checks, and a copy of the remittance re-
port, are then forwarded to the client’s accounting department for use in updating customer
accounts.
Over-the-counter receipts. For over-the-counter receipts, a cash register or point-of-sale
terminal is indispensable. These devices provide:

•  Immediate visual display for the customer of the amount of the cash sale and the cash
tendered.
•  A printed receipt for the customer and an internal record of the transaction on an elec-
tronic file or a tape locked inside the register.
•  Printed control totals of the day’s receipts processed on the device.

The customer’s expectation of a printed receipt and supervisory surveillance of over-

the-counter sales transactions helps to ensure that all cash sales are processed through the
cash registers or terminals (completeness and accuracy of cash received). In addition, super-
visors may be assigned responsibility for performing independent checks on the accuracy
of cash count sheets and verifying agreement of cash on hand with the totals printed by
the register or terminal. The cash, count sheets, and register- or terminal-printed totals are
then forwarded to the cashier’s department for further processing and inclusion in the bank
deposit.
Proper physical controls over cash also require that all cash receipts be deposited
daily. This control reduces the risk that receipts will not be recorded, and the resulting
bank deposit record establishes evidence of the occurrence of the recorded transactions.
When over-the-counter and mail receipts are received by the cashier, an independent
check should be made to determine their agreement with the accompanying cash count
sheets and remittance report, respectively. The totals for each are then entered on a daily
cash summary, and the deposit is prepared. After making the deposit, the daily cash sum-
mary and validated deposit slip should be forwarded to general accounting for posting to
accounts receivable.
   Control Activities for Cash Receipts  11-21

Recording Cash Received

Recording cash receipts involves journalizing cash received by a bank, over the counter,
and by mail and posting receipts to customer accounts. Controls should ensure only valid
receipts are entered, all actual receipts are entered, and entries are at the correct amounts.
Over-the-counter receipts are generally recorded in general accounting based on the daily
cash summary received from the cashier. In most cases, a company will receive an electronic
file from the bank that it may use to update the sales and accounts receivable database. If
cash or checks are received by the entity, it is common for accounts receivable clerks to use
software to enter cash received from an internal prelist into the sales and accounts receiv-
able database.

Granting Cash Discounts

Cash discounts are commonly granted for timely receipt of payments from customers, such
as a 1% discount granted if cash is received within 10 days of the invoice date. Trade terms
are often stated on the invoice and the software application can test the appropriateness and
the accuracy of the discount by comparing the cash receipts date with the invoice date and
recomputing the cash discount.

Identify WCGW and Identify Key

Controls—Cash Receipts
Once the auditor understands the flow of transactions for cash receipts, the auditor should
evaluate what can go wrong, identify potential controls management has placed in operation,
and then identify key controls the auditor wants to test. Illustration 11.10 summarizes the
flow of transactions through the revenue process, key documents and files, what can go
wrong, and example controls. As you review Illustration 11.10, try to associate particular con-
trols with the assertions they are controlling.

ILLUSTRATION 11.10   Cash receipts transactions: WCGW and example controls

Documents
Transaction and Files Risks (WCGW) Example Control
Receiving and Remittance advice Mail receipts may be lost or Electronic funds transfer directly to bank or
depositing from customer, bank misappropriated after receipt. establish a lockbox arrangement with the bank.
cash remittance report, Cash may be taken (skimmed) or not
deposit slip be deposited intact daily.
Inappropriate cash discounts may be The client’s software application can recalculate
taken by customers. cash discounts taken by customers.
Cash received Cash sales may not be recorded. Use of cash registers or point-of-sale devices.
by the client
Prelist of cash receipts Mail receipts may be lost or Immediate preparation of prelist of mail
misappropriated after receipt. receipts. Restrictive endorsement of checks
immediately upon receipt.
Prelist of cash receipts, Checks received may not agree with Independent check of agreement of remittance
remittance advices prelist of cash. advices with prelist of cash received.
Cash depos- Bank deposit slip, Cash may not be deposited intact daily. Independent check of agreement of prelist of
ited by the prelist of cash receipts, cash receipts or bank remittance report with
client bank remittance report validated deposit slip.
Recording Sales database, prelist Cash receipts may be recorded in error. Software agreement of amounts journalized
cash receipts of cash receipts, bank and posted with the prelist of cash receipts or
remittance report bank remittance report.
Independent bank Errors may be made in journalizing Preparation of periodic independent bank
reconciliation cash receipts. reconciliations.
Monthly statement to Receipts may be posted to the wrong Mailing of monthly statements to customers.
customers customer account.
11-22  C h a pte r 11  Auditing the Revenue Process

As noted earlier, auditors cannot efficiently test all controls that exist. Instead, auditors
will find a few key controls and attempt to identify the most important control for each asser-
tion. Following are example key controls auditors often test for cash receipts transactions. The
examples rely significantly on IT application controls to flag potential misstatements. In this
case, the auditor must understand both the IT control and how clients manually follow up on
exceptions on a timely basis.
Completeness of cash receipts. The software application compares each item in the bank re-
mittance report (or the prelist of cash receipts if cash and checks are received by the client) to de-
velop a one-for-one match with recorded cash receipts in the daily remittance report. An exception
report is generated daily of any cash receipts that have not been recorded. However, the strength
of these controls depends on adequate segregation of duties and controls establishing immediate
recorded accountability for all cash receipts to prevent the diversion or skimming of cash receipts.
Occurrence of cash receipts. The software application starts with the population of daily cash
receipts recorded in the daily remittance report (daily cash receipts journal) and develops a one-
for-one match with the bank remittance report (or prelist of cash received). An exception report
is generated daily of any recorded cash receipts not supported by the bank remittance report.
Accuracy of cash receipts. The software application starts with the population of daily cash re-
ceipts recorded in the daily remittance report (daily cash receipts journal) and compares the dollar
amount of each recorded cash receipt with the bank remittance report (or prelist of cash received).
The accuracy of any discounts for early payment by customers is double-checked by the software
application. An exception report is generated daily for any recorded values of cash received not sup-
ported by a remittance report or for inappropriate discounts taken by customers for early payment.
Cutoff of cash receipts. The software application starts with the population of daily cash
receipts recorded in the daily remittance report (daily cash receipts journal) and compares the
date recorded in the daily remittance report with the date received and deposited by the bank
(or date on the prelist of cash receipts). An exception report is generated daily for any cash
receipts recorded in the incorrect time period.
Classification of cash receipts. The software application starts with the population of daily
cash receipts recorded in the daily remittance report (daily cash receipts journal) and com-
pares customer account numbers on the daily remittance report (cash receipts journal) with
the customer numbers on the bank remittance report. An exception report is generated daily
of any cash receipts posted to the incorrect customer.

Audit Reasoning Example  Diverting Cash Receipts

Lucas (audit manager) and Robert (audit staff) are working on the audit of a political campaign.
Robert has just assessed control risk as low for cash receipts. Lucas asks Robert: “Did you consider
the highest risk of fraud in cash receipts happens when an individual is able to divert cash receipts
before funds are deposited and recorded in the accounting records? I recall reading a story about a
campaign treasurer who received a donation and diverted it for personal use, without depositing
the funds in the political campaign. Do you think this could be a problem?” Robert responds that
he had not considered cash being diverted before being received by the client. Lucas goes on, “We
have several clients who own restaurant chains. Do you think this is a problem for them?” Robert
thinks for a moment and then responds. “Now that I think about it, this is a problem. I recall
paying for a meal at a small restaurant in cash and getting change, but not a receipt. I guess that
also is a way to divert cash and not record the transaction. I suppose the completeness assertion is
a high inherent risk assertion for most restaurants.” Lucas responds, “You are right, Robert. Now
let’s go back and revisit this campaign’s internal control over collecting cash.”

Before You Go On
5.1 How are financial statements misstated if there is a material misstatement in the completeness
assertion regarding cash receipts? Describe a key control to detect and correct this problem.
5.2 How are financial statements misstated if there is a material misstatement in the cutoff
assertion regarding cash receipts? Describe a key control to detect and correct this problem.
   Control Activities for Sales Adjustments and Revenue Process Disclosures   11-23

Control Activities for Sales Adjustments

and Revenue Process Disclosures
LEA RNING OBJECTI VE 6
Evaluate control activities for sales adjustment transactions and revenue process
disclosures.

Sales adjustments involve adjustments for goods returned by the customer, discounts given
to customers associated with defects in goods received by the customer, and period-end
adjustments to record a provision for bad debt expense or to record the write-off of accounts
receivable. Important documents and records used in processing sales adjustments include
the following:

•  Sales return authorization—A form showing the description, quantity, and other
data pertaining to goods the customer is authorized to return. It serves as the basis
for initiating the sales return and internal processing of the customer return by the
seller.
•  Authorization for accounts receivable write-off—A form showing the procedures taken to
attempt collection and to document authorization of accounts receivable write-off.
•  Receiving report—A report prepared on the receipt of goods from customers showing the
kinds and quantities of goods received.
•  Credit memo—A form stating the particulars of a credit to accounts receivable,
includ­ing the specific items returned, prices, and amount credited to a customer’s
account. It provides the basis for recording the sales return or a sales adjustment for
damaged goods.
•  Journal entry—A document used to record adjustments such as a provision for bad debt
expense or an accounts receivable write-off in the general ledger.
•  Cash receipts journal—A journal listing cash receipts from cash sales and collections on
accounts receivable.

In many companies, the number and dollar value of sales adjustments is immaterial. How-
ever, in some companies, the potential for misstatements resulting from errors and fraud in
the processing of these transactions is considerable.

Granting Sales Returns and Allowances

The possibility of fictitious sales adjustment transactions being recorded is a primary concern
because it may be used to conceal fraud in processing cash receipts. For example, an employee
might misappropriate cash received from a customer and cover up the fraud by writing a
credit memo to reduce the receivable from the customer. Accordingly, control activities useful
in reducing the risk of fraud focus on establishing the occurrence of such transactions and
include the following:

•  All sales returns should be authorized by sales management.

•  Goods should be received only with a proper sales return authorization, and an indepen-
dent count of goods returned should be recorded on a receiving report.
•  The software application should match the credit memo information with the sales order,
authorization of sales return, and receiving report.
11-24  C h a pte r 11  Auditing the Revenue Process

Further, there should be adequate segregation of duties for authorizing sales returns, receiv-
ing goods, and recording credit memos. Usually, the business unit that makes the sale will
have the responsibility of authorizing sales adjustment transactions.
When there is the potential for material misstatements from sales adjustments trans-
actions, the auditor should obtain an understanding of all relevant aspects of the internal
control components and consider the factors that affect the risk of such misstatements. If a
provision for sales returns is estimated at quarter-end, management should establish controls
to ensure adjustments are made based on reliable information and adjustments are consistent
disclosure committee  a from quarter to quarter. In larger public companies, a disclosure committee reviews these
committee often led by the CFO estimates if they could aggregate with other adjustments to an amount that is material to the
or chief legal officer with the financial statements. A disclosure committee is typically led by the CFO and includes individ-
purpose of helping ensure that uals in management who are knowledgeable about the condition of the company and required
financial statement disclosures financial reporting disclosures relevant to the revenue process.
are accurate, complete, and fairly
presented in all material respects

Determining Uncollectible Accounts

Strong internal controls over the write-off of uncollectible accounts are important to prevent
write-offs from being used to conceal fraud in processing cash receipts. For example, an em-
ployee might misappropriate cash received from a customer and cover up the fraud by writing
off the customer’s account against the allowance for uncollectible accounts. Strong internal
controls include:

•  All write-offs of uncollectible accounts should be authorized by an appropriate level of

management and supported by documentation, such as correspondence with the cus-
tomer or collection agencies.
•  Journal entries for write-offs should be reviewed by management to ensure the appropri-
ateness of the transaction.

In addition, management should establish controls over accounting estimates such as

the provision for bad debt expense. Management should ordinarily establish a process for
monitoring aging and the collectibility of receivables. Hindsight should be used to evaluate
the adequacy of prior provisions for bad debt expense compared with subsequent receivables
that went uncollectible. It is essential that the data used to develop a provision for bad debt
expense (the history of accounts written off) be reliable. In addition, a qualified and indepen-
dent disclosure committee should review the allowance on a regular basis. These controls are
necessary to determine the adequacy of the allowance.

Other Controls in the Revenue Process

The previous discussion focused on controls over transactions. It is also important to control
balances and disclosures. The primary account balance in the revenue process is accounts
receivable. If strong controls exist over credit sales, cash receipts, and sales adjustments, the
accounts receivable balance should also be controlled, as it is the product of recording these
transactions. Most companies control the completeness, existence, and valuation of receiv-
ables at historical cost by sending monthly statements to customers. The function of following
up on issues raised by customers should be independent of accounts receivable personnel.
Controls over the rights and obligations assertion relate to whether the company has a
legal claim to receivables. A company normally gives up claims to collection of receivables
when it sells the receivables or pledges receivables as collateral. These transactions may not
exist in many entities. However, if an entity sells its receivables with recourse, it should keep a
documentary record of receivables that have been sold. This record should be compared with
monthly statements sent by a bank or factoring company. This provides an independent check
on the accuracy of the company’s records.
Finally, management should establish controls over the occurrence and rights and obliga-
tions of disclosures, the completeness of disclosures, the classification and understandability
  Tests of Controls in the Revenue Process and Audit Strategy   11-25

of disclosures, and the accuracy and valuation of information included in disclosures. Com-
mon disclosures in the revenue process include:
•  Reclassification of material credit balances in accounts receivable as accounts payable.
•  Segregation of short-term trade receivables from long-term trade receivables.
•  Disclosure of major customers.
•  Disclosure of sales by geographic regions or major product lines.
•  Disclosure of receivables from officers, directors, employees, or related parties.
Public companies normally accomplish this task with a disclosure committee that works with
the CFO or controller to review disclosures. Many companies use a current GAAP disclosure
checklist to assist in this process.

Before You Go On
6.1 Explain the fraud that might be covered up by granting inappropriate sales adjustments or
by inappropriately writing off accounts receivable. Describe an internal control to detect and
correct this problem.
6.2 Explain appropriate controls over journal entries to provide for bad debt expense.
6.3 Explain an appropriate control over revenue process disclosures.

Tests of Controls in the Revenue Process and

Audit Strategy

LEA RNING OBJECTI VE 7

Determine how to design and perform tests of controls in the revenue process and
connect the results of control testing to audit strategy.

The following discussion identifies potential tests of controls that may be used to determine if
a client’s controls in the revenue process are effective. Once the auditor has evaluated the
quality of the system of internal control, the audit team is in a good position to evaluate the
opportunity for fraud risk. The fraud risk assessment should be approached with professional
skepticism. Finally, this section focuses on the links between risk of material misstatement
(RMM) and subsequent strategy for substantive testing.

Tests of Controls in the Revenue Process

Most auditors plan to test controls in the revenue process because of the high volume of
routine transactions in this process. Public company auditors test controls to support an
opinion on internal control. Auditors of private companies will test controls that appear to
be effective because of the audit efficiencies that exist when the client has effective controls
in place.
If the client relies on IT controls and the auditor plans to assess control risk as low for
revenue process assertions, the auditor will usually:

•  Test the effectiveness of IT general controls.

•  Use generalized audit software to evaluate the effectiveness of IT application controls.
11-26  C h a pte r 11  Auditing the Revenue Process

•  Test the effectiveness of manual procedures to follow up on exceptions identified by IT

application controls.

The auditor will usually test the effectiveness of IT general controls as part of testing
entity-level controls. For example, when testing the control environment, the auditor might
pay particular attention to making inquiries and collecting supporting evidence regarding
employee awareness of IT security issues. If the auditor is testing issues regarding controls
over program changes, the auditor might determine how program access is controlled and
monitored, look at logs of program access or incident reports, and talk to users about their
involvement in program changes affecting their responsibilities. The auditor will want to pay
attention to segregation of duties regarding access to programs and access to data, the effec-
tiveness of password controls, and the follow-up of any incident reports regarding unautho-
rized access. The auditor will also want to understand controls over back-up and recovery of
programs and data, and test the effectiveness of these controls. These tests are often performed
by an IT audit specialist.
Auditors often use test data to test IT application controls and determine whether ex-
pected results appear on exception reports. For example, in the revenue process, the auditor
might submit:

•  A missing or invalid customer code.

•  An invalid product code.
•  An order that exceeds a customer’s credit limit.
•  Transactions reporting shipments in quantities different from the amount ordered (both
over and under).
•  Prices, vendor numbers, or other information on sales invoices that do not match infor-
mation on the sales order.
•  Invoice quantities that do not match quantities on shipping documents.

The auditor might also use generalized audit software to perform sequence checks and
print lists of sales orders, shipping documents, or sales invoices whose numbers are missing
in designated sequences of prenumbered documents.
Finally, the auditor will need to test the appropriateness of manual follow-up of excep-
tions noted by the software application. If exception reports are printed daily, the auditor
might select a sample of exception reports to determine if exceptions are cleared on a timely
basis. The auditor might make inquiries of personnel responsible for clearing exceptions to de-
termine their awareness of the types of misstatements that might appear on exception reports.
The auditor should also follow through on previously noted exceptions to determine they were
cleared appropriately and on a timely basis.

Fraud Risk Assessment

After evaluating inherent risk and control risk, the auditor is in a position to evaluate fraud
risk. The auditor will consider incentives and pressures on management that may push
management toward fraudulent financial reporting, such as the nature of management
compensation plans, or whether management is trying to show a growth trend to investors
or meet previously forecasted revenue targets. The auditor should also be alert to situations
where an employee may have personal reasons to misappropriate assets, such as affording
the costs of private schools or universities. Ultimately, a key aspect of fraud risk relates to
the opportunity that may or may not present itself based on the quality of the system of
internal control. An auditor’s concerns are heightened when the control environment is
weak, or control activities are nonexistent. In not-for-profit organizations, smaller com-
panies, or governments, segregation of duties may be weak or nonexistent. In these cases,
lapping  a scheme where an
accounting clerk incorrectly the auditor with appropriate professional skepticism should consider fraud risk to be high.
classifies cash receipts from one A common scheme to conceal the misappropriation of cash receipts is called lapping.
customer to another in order to The opportunity for a lapping scheme begins when a customer pays cash toward an accounts
cover up the diversion of funds receivable balance. Then, an employee steals the cash that is received from the customer. Say
from a customer for personal gain an employee is able to steal a $1,000 payment from Customer A. To prevent Customer A from
  Tests of Controls in the Revenue Process and Audit Strategy   11-27

complaining, when $1,500 is received from Customer B, it is accounted for as $1,000 from
Customer A and $500 from Customer B. Subsequently, the accounts receivable clerk must
cover the shortage from Customer B with funds from another customer, and so on. Sometimes
the fraudster can solve the problem of keeping this going by falsifying a sales adjustment to re-
duce the receivable, or by writing off part of a customer’s balance through a journal entry. The
auditor should be alert to the possibility of fraud when a cash receipt is credited to the wrong
customer, or there is little or no justification for a sales adjustment or receivable write-off.

Audit Data Analytics as a Risk Assessment

Procedure
Audit data analytics is often used to identify transactions or balances with a significant risk of
material misstatement. The first step in planning the use of ADA is determining the overall
purpose of the test. This first step requires business acumen, knowledge of the client, and
an understanding of how ADA might be effective in the audit of revenues and receivables.
For example, if the client is in the construction industry (using the percentage-of-completion
method for revenue recognition), the auditor might use ADA to investigate work in progress
and the gross margins on each project in the fourth quarter compared to gross margins on
completed projects. This may be a way to identify projects with unusually high (or low) gross
margins and focus more tests of details on these contracts.
Alternatively, if the auditor is concerned about fraud risk and premature revenue recognition,
the auditor might use ADA to identify customers with no sales representatives assigned to the
customer, sales transactions with no sales commissions codes, or customers having no cash
receipts during the period. Because anomalies may vary significantly from one client to the
next, ADA are often custom-made to the client’s circumstances.

Audit Reasoning Example Detailed Analysis of Contracts Reveals

Problems at a Construction Company

Toni Koyama is working on the audit of a construction company. Shortly after the fourth quarter
ended, Toni ran some data analytics and has the following information:
Quarter 1 Quarter 2 Quarter 3 Quarter 4
Gross margin on work in progress 15.5% 15.9% 16.6% 18.9%
Gross margin on completed contracts 20.8% 20.1% 12.3% 6.9%

Toni notes the gross margin on completed contracts declines quarter by quarter. Gross mar-
gin on work in progress actually increases in the fourth quarter. Toni wonders where to look next.
Receivables from customers are increasing, and work in progress inventory is also increasing. Toni
is now concerned in two ways. Does the client have a problem with (1) premature revenue recog-
nition, (2) the capitalization of costs that should be expensed, or (3) both? Two risks have clearly
been identified. Now, more tests of details of revenues recognized along with work in progress
inventory are warranted.

The Risk of Material Misstatement and

Audit Strategy
Once the auditor has tested internal controls, the auditor will determine whether the auditor’s
expectations regarding the effectiveness of internal controls are confirmed. Tests of controls
are performed when the auditor expects that internal controls are effective. If the auditor’s
expectations regarding effective controls are not confirmed, the auditor will need to evaluate
the significance of the deficiencies noted and determine if the client has a compensating con-
trol in place that the auditor might rely on. If no compensating control exists, the auditor will
need to revise the audit strategy as control risk is now higher than initially planned, determine
11-28  C h a pte r 11  Auditing the Revenue Process

if fraud risk is increased as a result of the internal control deficiency, and determine how to
revise planned substantive tests for the revenue process. The auditor may need to change
the timing of planned substantive tests related to an assertion from interim testing to testing
year-end balances. The auditor may also have to consider increasing sample sizes when
sampling is involved. If internal controls related to an assertion are ineffective, the auditor
will need to communicate significant deficiencies or material weaknesses to management
and to those charged with governance of the entity.

Cloud 9 - Continuing Case

As Josh and Suzie consider the risk of material misstatement, c­ ontrols and the fact that tested transactions were recorded cor-
Suzie notes they have conducted extensive testing of Cloud 9’s rectly. As they plan substantive tests, Josh confirms that Suzie is
controls over sales, cash receipts, and sending monthly state- thinking correctly, and that they have already done significant
ments to customers, and many of these were dual-purpose tests. tests of transactions at an interim date. They will, however, need
Therefore, they have assurance about both the quality of internal to update these tests for the period remaining in the fiscal year.

Before You Go On
7.1 If the auditor has identified an IT application control related to the completeness of revenues,
and IT general controls have already been determined to be effective, suggest how the auditor
might test the effectiveness of such IT application controls and related manual follow-up.
7.2 Explain lapping. What might be evidence that lapping has occurred?
7.3 Assume an auditor is auditing a private company that sells computer hardware and offers
servicing contracts to maintain the computer. If internal controls are weak, what are the
implications for developing an audit strategy in the revenue process?

Substantive Tests for the Revenue Process

LEA RNING OBJECTI VE 8
Assess detection risk and design substantive tests, including audit data analytics, to
address various assertions in the revenue process.

At this stage the auditor has evaluated inherent risks, evaluated and tested the system of inter-
nal control in the revenue process, and developed an audit strategy. What remains is perform-
ing substantive tests. The following discussion focuses on identifying the appropriate substan-
tive tests for relevant assertions in the revenue process. It further addresses performing initial
procedures, performing analytical procedures as a substantive test, considering when the au-
ditor would want to audit an entire population, performing tests of details of transactions,
performing tests of details of account balances, and performing tests of details of presentation
and disclosure assertions. Illustration 11.11 presents a suggested audit program for substan-
tive tests of revenue process assertions, which is followed by a discussion of each of the steps.
The audit procedures in Illustration 11.11 are most likely to be associated with manufac-
turing companies or wholesalers. If the auditor is auditing a retail grocery store, it is unlikely
to have significant receivables. A hotel is more likely to have significant unearned revenue
than accounts receivable, and the auditor will have to determine the best way to evaluate un-
earned revenues. Finally, a college is less likely to have significant receivables from students.
In many cases, students use student loans from sources other than the college or university.
   Substantive Tests for the Revenue Process  11-29

ILLUSTRATION 11.11   Substantive tests in the revenue process

Relevant
Category Substantive Test Assertion
Initial 1.  Obtain an understanding of the business and industry and determine: All
procedure a.  the significance of revenues and accounts receivable to the entity
b.  key economic drivers that influence the entity’s sales, margins, and collections
c.  standard trade terms in the industry, including seasonal dating, collections period, etc.
d.  the extent of concentration of activity with customers
2. Perform initial procedures on accounts receivable balance and records that will be subjected to Valuation and
further testing. allocation, Rights
a.  Trace beginning balance for accounts receivable to prior year’s working papers. and obligations
b. Scan the activity in the general ledger account for accounts receivable and investigate entries
that appear unusual in amount or source.
c. Obtain accounts receivable trial balance and determine that it accurately represents the Valuation and
underlying accounting records by: allocation
i. footing the trial balance and determining agreement with (1) the total of the subsidiary led-
ger or accounts receivable master file, and (2) the general ledger balance
ii. verifying agreement of customer balances listed on the trial balance with those included in
the subsidiary ledger or master file
Analytical 3.  Perform analytical procedures: All
procedures a. Develop an expectation for accounts receivable using knowledge of the entity’s business
activity, market share, normal trade terms, and its history of accounts receivable turnover
in days.
b.  Calculate ratios:
i.  compare sales to the entity’s capacity
ii.  compare sales growth and receivable growth
iii.  accounts receivable turnover in days
iv.  uncollectible accounts expense to net credit sales
v.  uncollectible accounts expense to accounts receivable write-offs
c. Analyze ratio results relative to expectations based on prior years, industry data, budgeted
amounts, or other data.
Tests of 4.  Vouch a sample of recorded revenue process transactions to supporting documentation. Occurrence,
details of a. Vouch recorded revenue transactions to supporting sales invoices, shipping documents, and sales Accuracy,
transactions orders. Cutoff,
Classification
b. Vouch cash receipt transactions to supporting bank remittance reports and remittance
advices.
c. Vouch sales adjustment transactions to authorizations for sales returns and allowances or
uncollectible account write-offs.
5. Trace a sample of revenue transactions from shipments to recording in the sales journal. Also trace Completeness
a sample of cash receipts and sales returns to their recording in the accounting records.
6.  Perform cutoff test for sales and sales returns. Cutoff
a. Select a sample of recorded sales transactions from several days before and after year-end and
examine supporting sales invoices and shipping documents to determine sales were recorded in
the proper period.
b. Select a sample of credit memos issued after year-end, examine supporting documentation such
as dated receiving reports, and determine that returns were recorded in the proper period. Also
consider whether volume of sales returns after year-end suggest possibility of unauthorized
shipments before year-end.
7.  Perform cash receipts cutoff test. Cutoff
a. Observe that all cash received through the close of business on the last day of the fiscal year is
included in cash on hand or deposits in transit and that no receipts of the subsequent period are
included, or
b. Scan documentation such as daily cash summaries, duplicate deposit slips, and bank statements
covering several days before and after year-end for proper cutoff.
(continued)
11-30  C h a pte r 11  Auditing the Revenue Process

ILLUSTRATION 11.11   (continued)

Relevant
Category Substantive Test Assertion
Tests of details 8.  Confirm accounts receivable. Existence,
of balances a.  Determine the form, timing, and extent of confirmation requests. Valuation and
allocation,
b.  Select and execute sample and investigate exceptions.
Completeness
c. For positive confirmation requests for which no reply was received, perform alternative
follow-up procedures:
• Vouch subsequent cash receipts identifiable with items comprising account balance at
confirmation date to supporting documentation.
• Vouch items comprising balance at confirmation date to documentary support such as sale
orders and shipping documents.
9.  a.  Inquire about the sale, factoring, or pledging of accounts receivable. Rights and
b. Send confirmations to entities that have purchased accounts receivable or hold accounts obligations
receivable as collateral.
10.  Evaluate adequacy of allowance component for each aging category and in the aggregate. Valuation and
a.  Foot and crossfoot the aged trial balance of receivables and agree total to the general ledger. allocation
b.  Vouch amounts in aging categories for a sample of accounts to supporting documents.
c.  For past–due accounts:
• Examine evidence of collectibility, such as correspondence with customers and outside
collection agencies, credit reports, and customers’ financial statements.
• Inquire about collectibility of accounts with appropriate management personnel.
d. Evaluate management’s process for estimating the allowance for doubtful accounts using
hindsight.
e.  Evaluate the adequacy of the allowance given information about
• industry trends
• aging trends
• collection history for specific customers
Tests of 11.  Compare statement presentation with GAAP.
details of a. Compare disclosures related to existence and rights and obligations of receivables to the results Occurrence and
presentation of tests performed above. rights and
and obligations
disclosure
b. Verify that receivables are properly identified and classified as to type and expected period of Classification and
realization. understandability
c. Verify whether there are credit balances that are significant in the aggregate and that should Classification and
be reclassified as liabilities. understandability
d. Verify the appropriateness of disclosures and accounting for related party, pledged, assigned, or Occurrence and
factored receivables. rights and
obligations
e. Verify the need for disclosures regarding significant customers or sales by line of business. Completeness
f. Evaluate the completeness of presentation and disclosures for receivables in drafts of financial Completeness
statements to determine conformity to GAAP by reference to disclosure checklist.
g. Read disclosures and independently evaluate their understandability.
h. Vouch the accuracy of receivable disclosures to tests performed above. Classification and
understandability,
Accuracy and
valuation

Initial Procedures
The starting point for every audit test is obtaining an understanding of the business and industry.
As previously discussed, it is important to understand the entity’s policies regarding revenue rec-
ognition, as well as the entity’s underlying economic drivers that impact total revenues and gross
margin. The auditor should also understand standard trade terms, industry and client collection
   Substantive Tests for the Revenue Process  11-31

experience, seasonal aspects of the industry, and the extent of concentration of business with
particular customers. This knowledge provides the context for evaluating the results of analyti-
cal procedures, tests of controls, and substantive tests. For example, the evidence obtained when
performing detail tests of transactions and balances, such as invoice prices or size of receivables
for particular customers, should be consistent with expectations about industry competitiveness,
the entity’s productive time capacity, and the existence of major customers.
An important initial procedure for verifying accounts receivable and the related allow-
ance account is tracing the current period’s beginning balances to the ending audited balances
in the prior year’s working papers (when applicable). Next, the current period’s activity in the
general ledger control account and related allowance account should be scanned for any signif-
icant entries that are unusual in nature or amount and that may require special investigation.
For example, the auditor should investigate any receivables and revenues that are not booked
by way of recording sales invoices in the sales journal. In addition, a listing of all customer
balances, called an accounts receivable trial balance, is obtained (usually in digital form). The
auditor uses generalized audit software to foot the accounts receivable trial balance and the
total should be compared with (1) the total of the subsidiary ledger or master file from which
it was prepared and (2) the general ledger control account. The auditor should also compare a
sample of the customer balances shown on the trial balance with that in the subsidiary ledger
and vice versa to determine that the trial balance is an accurate and complete representation
of the underlying accounting records. It can then serve as the physical representation of the
population of accounts receivable to be subjected to further substantive testing.
Alternatively, the auditor can produce the accounts receivable trial balance directly from
the client’s master file using audit software. If the auditor can obtain the client’s records in
­machine-readable form, the auditor can also use generalized audit software to identify sig-
nificant customers, analyze the volume of transactions with customers, and identify unusual
transactions or a high volume of transactions near year-end. The initial procedures in verify-
ing the accuracy of the trial balance and determining its agreement with the general ledger
balance relate primarily to the valuation and allocation assertion.

Substantive Analytical Procedures

As discussed extensively in Chapter 9, auditors can use analytical procedures as a substantive
procedure to gather evidence in support of assertions related to account balances or transactions.
However, analytical procedures are not required to be used as a substantive procedure.
Illustration 11.4 provided examples of analytical procedures that are commonly used in the
revenue process. When these analytical procedures are used during risk assessment, the audi-
tors are using data up through the clientʼs second quarter and possibly into the third quarter.
If analytical procedures are used as a substantive procedure during risk response, the auditors
are using data through the clientʼs third quarter or even the entire year if it is after year-end.
Therefore, when used as a substantive procedure, the auditor typically has more data to an-
alyze and can develop more precise expectations of the accounts receivable balance, of the
relationship of accounts receivable to sales, and of the clientʼs gross margins.
The auditor may also want to develop analytical procedures that are custom-made for the
client. The more reliable the data, and the more predictable the analytical model, the more
assurance the auditor might obtain from substantive analytical procedures, thus reducing the
extent of tests of details of transactions or balances. For example, analytical procedures com-
paring production with revenues may be an effective way to test the completeness of sales and
receivables. If these procedures show that sales are consistent with capacity utilization, the
auditor can reduce the extensiveness of tests of transactions.

Audit Data Analytics as a Substantive Test

The right ADA may be a very effective substantive test of details. For example, many public util-
ities have a very high percentage of customers that pay the amount billed each month. Matching
subsequent cash receipts with billings may be a very effective way of testing the occurrence of
revenue and the existence of receivables for consumers that may not respond to confirmations.
The auditor may also learn a great deal by following up on customers with no payments.
11-32  C h a pte r 11  Auditing the Revenue Process

If a merchandising client has strong internal controls, the auditor might consider matching
electronic information from the sales order, the shipping documents, and the sales invoice to
test the occurrence and completeness of revenue. The ­effectiveness of this procedure might
depend on how often items are backordered. Each time an item must be backordered, and an
order is not shipped in its entirety, the transaction will likely require further investigation.

Tests of Details of Transactions

Tests of details of transactions may be performed during interim work along with tests of
controls in the form of dual-purpose tests. Alternatively, tests of details of transactions may
be performed separately. This section describes key tests of details of transactions and the
assertions they are designed to test. Further, this section describes cutoff tests that are usually
performed as part of year-end work.

Vouch Revenue Transactions

To vouch revenue transactions, the auditor will select a sample of sales invoices (see Illustra-
tion 11.7) to vouch to the supporting source documents to provide evidence pertaining to the
occurrence, accuracy, classification, and cutoff assertions. Credit memos can be vouched to
receiving reports and sales adjustment authorizations. These tests will be performed more ex-
tensively when the applicable level of detection risk to be achieved is low, when confirmation
procedures are not practicable, or to supplement confirmation procedures.
Transactions might be selected for vouching by way of a random sample. Alternatively,
the auditor might use ADA to screen 100% of transactions and identify unusual transactions
that do not fit the norm for the company. Determining what fits or does not fit the norm is
a matter of considerable professional judgment that relies on the auditor’s knowledge of the
company and the industry. For example, the auditor of a hotel might review all transactions to
identify unusual amounts of revenues per room and follow up on only high-risk transactions.
The auditor would then vouch the group of high-risk (unusual) transactions.

Trace Revenue Transactions

To test the completeness assertion, the auditor should trace a sample of sales, cash receipts,
and sales adjustment transactions to their recording in the accounting records. For sales, the
auditor should start with a sample of shipping documents (see Illustration 11.7) and trace
transactions to the sales journal. For cash receipts, the auditor would sample items from the
prelist of cash (see Illustration 11.9) and trace them forward to the cash receipts journal. For
sales returns, the auditor would normally start with the sale returns authorization and trace
forward to the receiving report and the entry in accounting records. The completeness of sales
returns may be a particular concern if management has incentives to overstate revenues, and
internal controls over sales returns are weak.

Perform Cutoff Tests for Sales and Sales Returns

The sales cutoff test is designed to obtain reasonable assurance that (1) sales and accounts re-
ceivable are recorded in the accounting period in which the transactions occurred and (2) the
corresponding entries for inventories and cost of goods sold are made in the same period.
Sales should be recorded in the period in which legal title to the goods passes to the buyer.
FOB shipping point  title When goods are shipped from inventory FOB (free on board) shipping point, title passes
passes from seller to buyer when on the date of shipment. When the terms of sale are FOB destination, title does not pass
goods are shipped
until the buyer receives the goods. As a practical matter, the seller may add one to a few days
FOB destination  title passes to the shipping date to estimate the date the goods will arrive at their destination as a basis for
from seller to buyer when goods determining the date on which to record the sale.
arrive at the customer’s The sales cutoff test is made as of the balance sheet date. For sales of goods from inven-
warehouse tory, the test involves comparison of a sample of recorded sales from the last few days of the
current period and the first few days of the next period with shipping documents to determine
whether the transactions were recorded in the proper period. When prenumbered shipping
documents are issued in sequence and the auditor is on hand to observe the number of the
last shipping document used in the current period, he or she should make a record of these
   Substantive Tests for the Revenue Process  11-33

numbers in the audit documentation. The auditor can subsequently determine that each sales
transaction recorded prior to year-end is supported by a shipping document with a number is-
sued in the current period and that each sales transaction recorded after year-end is supported
by a shipping document with a number issued in the subsequent period. Illustration 11.12
provides some examples of potential sales cutoff issues, assuming the shipping terms are FOB
shipping point. For a calendar-year client, if January sales are recorded in December, there is
a misstatement of the occurrence assertion. Conversely, if December sales are not recorded
until January, there is a misstatement of the completeness assertion.

Date on the Shipping Date on the ILLUSTRATION 11.12    

Documents Sales Invoice Potential Misstatement Potential sales cutoff issues

December 30, 2022 December 31, 2022 No problem

December 30, 2022 January 3, 2023 Completeness of revenues and receivables
January 3, 2023 December 30, 2022 Occurrence of revenues and existence of receivables

The sales return cutoff test is similar and is particularly directed toward the possibility
that returns made prior to year-end are not recorded until after year-end, resulting in the
overstatement of receivables and sales. The correct timing can be determined by examining
dated receiving reports for returned merchandise and correspondence with customers. The
auditor should also be alert to the possibility that an unusually heavy volume of sales returns
after year-end (perhaps up to the end of fieldwork and report date) could signal unauthorized
shipments before year-end to inflate recorded sales and receivables.

Perform Cash Receipts Cutoff Test

The cash receipts cutoff test is designed to obtain reasonable assurance that cash receipts are
recorded in the accounting period in which they are received. A proper cutoff at the balance
sheet date is essential to the correct presentation of both cash and accounts receivable. For
example, if December collections from customers are not recorded until January, accounts
receivable will be overstated and cash will be understated at the balance sheet date. Conversely,
if January collections from customers are recorded in December, cash will be overstated and
accounts receivable will be understated. Thus, this test relates to the existence or occurrence
and completeness assertions for both cash and accounts receivable. When most cash receipts
are received by way of electronic funds transfer or through a lockbox, the process begins by
reconciling the timing of receipt by the bank with recording in a cash receipts journal. The
objective of this procedure is to determine that the deposit slip total agrees with the receipts
shown on the daily cash summary, and that individual cash receipts are properly allocated to
each customer in the correct time period.

Tests of Details of Balances

Two primary sets of procedures in this category of substantive tests for accounts receivable
are discussed below: (1) confirmation of receivables and the related follow-up procedures and
(2) procedures for evaluating the adequacy of the allowance for uncollectible accounts.

Confirmation of Accounts Receivable

Confirmation of accounts receivable involves direct written communication between the
client’s customers and the auditor. The confirmation of receivables is a generally accepted
audit procedure. PCAOB AS 2310 The Confirmation Process and AU-C 505 External Confirma-
tions state there is a presumption that the auditor will request the confirmation of receivables
during an audit unless:

•  Accounts receivable are immaterial to the financial statements.

•  The use of confirmations would be ineffective as an audit procedure.
11-34  C h a pte r 11  Auditing the Revenue Process

•  The auditor’s assessed level of risk of material misstatement at the relevant assertion
level is low, and the other planned substantive procedures address the assessed risk.

An auditor who does not request confirmation of receivables should document in the
working papers how he or she overcame the presumption that confirmations should be re-
quested. For example, the auditor might state the conclusion, based on the prior year’s audit
experience on that engagement, that it is expected the responses would be unreliable or the
response rates would be inadequate in the current year.
Occasionally, clients have prohibited auditors from confirming any or certain accounts
receivable. Complete prohibition represents a serious limitation on the scope of the audit that
generally results in a disclaimer of opinion on the financial statements. The effect of partial
prohibition should be evaluated on the basis of management’s reasons and whether the audi-
tor can obtain sufficient evidence from other auditing procedures. Finally, the auditor must
make a decision about the use of positive or negative confirmations. The section “Confirmation”
in Chapter 5 discussed the difference between positive and negative confirmations, and the
desirability of using positive confirmations in most circumstances.
Illustration 11.13 provides an example of a positive confirmation. While confirmations
are signed by the client, they should be controlled and mailed by the auditor. Today, there are
services that can assist the auditor in providing electronic delivery and receipt of confirmations.
A positive confirmation sent electronically will be similar to the confirmation shown in Illustra-
tion 11.13. However, the service allows for the customer to send an electronic response securely
and confidentially to the audit firm. The use of electronic confirmations is increasing rapidly.

ILLUSTRATION 11.13    
Example positive confirmation G.J. Manufacturing
P.O. Box 1922, Denver, Colorado 80123

Industrial Automotive
P.O. Box 131
Spring Green, Wisconsin 53558

This request is being sent to you to enable our independent auditors to confirm the correctness of
our records. It is not request for payment.

Our records on December 31, 2022, showed an amount of $16,421.08 receivable from you. Please
confirm whether this agrees with your records on that date by signing and returning this form
directly to our auditors. An addressed envelope is enclosed for this purpose. If you find any differ-
ence, please report details directly to our auditors in the space provided below.

Emily Paulson
Chief Financial Officer

The above amount is correct. □

The above amount is incorrect for the following reasons:

Signature and Title of Individual Responding to the Confirmation:

Date:

Please examine this carefully and advise our auditors as to any exceptions at the following
address:
Bell & Bowerman, LLP
Certified Public Accountants
822 17th St., Suite 2200
Denver, CO 80202
A self-addressed envelope is enclosed for your convenience.

THIS IS NOT A REQUEST FOR PAYMENT

   Substantive Tests for the Revenue Process  11-35

Timing and Extent of Requests  When the level of detection risk is low, the auditor
ordinarily requests confirmation of receivables as of the balance sheet date. If the risk of
material misstatement is low, the auditor is willing to accept a higher level of detection risk,
and the confirmation date may be one or two months earlier. In such a case, the auditor is
expected to evaluate material changes between the confirmation date and balance sheet date.
In some cases, the auditor may elect to reconfirm accounts with unusual changes during the
roll-forward period.
The extent of confirmation requests, or sample size, is related to the factors discussed
in Chapter 10 (Illustration 10.4). Stratification may also affect sample size. For example, au-
ditors frequently seek confirmation of all accounts in excess of a certain dollar amount (less
than or equal to tolerable misstatement) and select a random sample of all other accounts.
Sample size may be determined judgmentally or with the aid of a statistical sampling plan, as
explained in Chapter 10.

Disposition of Exceptions  Confirmation responses will inevitably contain some excep-

tions. Exceptions may be attributed to goods in transit from the client to customers, returned
goods, payments in transit from customers to the client, items in dispute, errors, and irregular-
ities. All exceptions should be investigated by the auditor and their resolution indicated in the
auditor’s documentation. For example, an auditor might vouch customer payments in transit
to cash receipts after confirmation date by the client.

Alternative Procedures for Dealing with Nonresponses  When no response has

been received after a confirmation request to a customer, alternative procedures should or-
dinarily be performed. The two main alternative procedures are (1) examining subsequent
collections and (2) vouching open invoices comprising customer balances. The best evidence of
existence and collectibility is the receipt of payment from the customer. Before the conclusion
of the audit fieldwork, the client will receive payments from many customers on amounts owed
at the confirmation date. The matching of such collections back to unpaid invoices comprising
the customers’ balances at the confirmation date establishes the existence and collectibility of
the accounts. In performing this test, the auditor should recognize the possible adverse implica-
tions of collections that cannot be matched to specific transactions or balances. For example, a
round sum amount may, on investigation, reveal items in dispute, and token payments on large
balances may indicate financial instability on the part of the customer. If the customer has not
paid the receivable, the auditor can vouch the receivable to underlying customer orders and
shipping documentation to provide evidence that the receivable exists.
Professional standards acknowledge that the omission of such procedures may be
acceptable when both of the following conditions apply:

•  There are no unusual qualitative factors or systematic characteristics related to the non-
responses, such as that all nonresponses pertain to year-end transactions.
•  The nonresponses, projected as 100% misstatements to the populations and added to the
sum of all other unadjusted differences, would not affect the auditor’s decision about
whether the financial statements are materially correct.

Audit Reasoning Example  Evaluating Confirmation Exceptions

Brian McIntosh is working on accounts receivable confirmations. Confirmations are sent as
of the interim date of October 31 on a December 31 year-end client. One confirmation comes
back with the customer claiming it was overbilled on an October 29 invoice and the receivable
is overstated as of October 31. Upon investigation with the client, Brian discovers that the
error was actually recognized by the client before the customer noted it, and the client issued
a credit memo on November 4. Brian also recognizes that in spite of the client’s efforts, this
is evidence of a misstatement as of October 31; this will have to be analyzed as a misstate-
ment in the sample, and the misstatement will be projected on the unsampled portion of the
population.
11-36  C h a pte r 11  Auditing the Revenue Process

Summarizing and Evaluating Results  The auditor’s working papers should contain a
summary of results from confirming accounts receivable. The summary should provide data
on:

•  The number and dollar value of confirmations sent and responses received.
•  The proportion of the population total covered by the sample.
•  The relationship between the audited and book values of items included in the sample.

Statistical and nonstatistical procedures may be used to project misstatements found in the
sample to the population, as explained in Chapter 10. The combined evidence from the confir-
mations, alternative procedures performed on nonresponses, and other tests of details and ana-
lytical procedures are evaluated to determine whether sufficient evidence has been obtained to
support management’s assertions about gross accounts receivable. Illustration 11.14 provides
an abbreviated example of a working paper evaluating confirmations. (Note: This supports the
analysis working paper shown in Illustration 10.14.)

ILLUSTRATION 11.14   Evaluation of individual confirmations

Client: G.J. Manufacturing Bell & Bowerman, LLP Prepared by: W.M.F. 2/8/23
Period-end: 12/31/22 Reviewed by: C.W.B. 2/18/23
Evaluation of Confirmation Results Reference: B-3
Objective: Evaluation of Accounts Receivable Confirmations
Confirmation # Book Value Confirmed Value Audited Value Misstatement Explanation
1 $165,000 $165,000 $165,000
2 310,000 300,000 300,000 $10,000 $10,000 of goods returned. Received on
Stratum 1
12/29/22. Credit memo issued 1/3/23.
10 187,500 NR 187,500 ¥,€
11 42,000 NR 42,000 ¥,€
12 20,000 20,000 20,000
Stratum 2

25 35,000 25,000 25,000 10,000 Goods were billed at the incorrect

price, resulting in an overcharge of
$10,000.
26 12,000 2,000 2,000 10,000 Incorrect quantity entered on invoice
resulting in an overcharge of $10,000.
Stratum 3
27 7,600 7,600 7,600
50 5,400 5,400 5,400
Legend:
NR No response from customer
¥ Vouched to bill of lading
€ Vouched to subsequent cash receipt

Applicability to Assertions  Confirmations are the primary source of evidence in meet-

ing the existence assertion for accounts receivable. Acknowledgment of the debt by the cus-
tomer in the response confirms that the client has a legal claim on the customer. This test
also provides evidence concerning the rights and obligations assertion. The confirmation of
accounts receivable is not a request for payment, so it does not provide evidence as to the
collectibility of the balance due. However, the responses may reveal previously paid items
   Substantive Tests for the Revenue Process  11-37

or disputed items that affect the proper valuation of the amount due. While confirmations
may provide indications of collectibility problems, the confirmation of accounts receivable
relates only to the valuation and allocation assertion for gross accounts receivables. When a
customer’s response indicates agreement with the book balance, there is evidence that the bal-
ance is complete. However, the evidence about the completeness assertion is limited because
(1) unrecorded receivables cannot be confirmed and (2) customers are more likely to report
errors of overstatement than errors of understatement.

Evaluating the Allowance for Doubtful Accounts

The key accounting estimate involved in the revenue process is the allowance for doubtful
accounts. Audit procedures for this accounting estimate include:

•  Using generalized audit software to foot and crossfoot the aged trial balance of accounts
receivable and agreeing the total to the general ledger balance.
•  Testing the accuracy of the client’s aging by vouching to underlying sales invoices and
shipping documents.
•  Considering evidence concerning the collectibility of past-due amounts by, for example,
inspecting correspondence from customers.
•  Identifying customers with past-due balances and calculating credit histories for custom-
ers with past-due balances.
•  Evaluating prior estimates of uncollectible accounts with subsequent experience and the
benefit of hindsight.
•  Using the evidence obtained above to assess the reasonableness of the percentages used
to compute the allowance component required for each aging category and the adequacy
of the overall allowance.

Auditing the allowance for doubtful accounts may be a good place to use ADA to
evaluate the adequacy of the allowance for doubtful accounts. Consider this example in
the context of Illustration 7.8. The auditor can use generalized audit software to generate
an aging of the client’s master file. The auditor can then use the same aging to identify
customers that do not fit the norm for the client’s normal collection history (e.g., over
90 past due). Within this population of customers taking over 90 days to pay, the audi-
tor might identify customers that normally take 90 to 120 days to pay, but pay regularly.
This would be an acceptable variation from the norm. Alternatively, the auditor wants to
pay close attention to customers that demonstrate deteriorating payment history as the
year progresses. For this final grouping, auditors might also examine correspondence with
customers or correspondence with outside collection agencies, review customers’ credit
reports and financial statements, and discuss the collectibility of specific accounts with
appropriate management personnel. Ultimately, the auditor must determine if the poten-
tial misstatement of the allowance for doubtful accounts could aggregate to an amount
greater than or equal to tolerable misstatement. Finally, the auditor may want to use as
much hindsight as possible to evaluate whether outstanding receivables are subsequently
collected.
The allowance for uncollectible accounts is an accounting estimate made by manage-
ment that involves both objective and subjective considerations. In essence, it is a prospective
estimate of receivables that will not be collected in the future. The auditor’s responsibility
is to judge the reasonableness of the allowance and the related provision for uncollectible
accounts expense. From the aging data, information about collectibility, and analysis of the
client’s prior experience with uncollectible accounts, the auditor can assess the reasonable-
ness of management’s method used to determine an appropriate allowance. An important
aspect of evaluating prior experience with the entity involves using hindsight to evaluate prior
estimates of the allowance and subsequent experience in collecting receivables outstanding
at the date of the estimate. When the client’s controls over (1) granting credit and (2) writing
off uncollectible accounts are strong, fewer substantive tests will be required in making this
assessment than when controls are weak.
11-38  C h a pte r 11  Auditing the Revenue Process

Tests of Details of Presentation and Disclosure

Illustration 11.11 describes a number of tests of disclosures for the revenue process. It is
common for auditors who are knowledgeable about the company and accounting principles
to carefully read the financial statements and related disclosures. The auditor who reads the
financial statements might also use a disclosure checklist to ensure that all required disclo-
sures are present. For example, auditors should be alert to the following issues if they are
material:

•  Classification and disclosure requirements include proper identification and classifica-

tion for receivables, such as separating trade receivables from other receivables such as
receivables from employees, officers, affiliated companies, and other related parties that
should be separately disclosed.
•  Credit balances in accounts receivable (customers who overpay) should be reclassified as
current liabilities.
•  GAAP requires proper classification of receivables not due within one year to be classi-
fied as noncurrent.
•  GAAP requires disclosures concerning the pledging, assigning, or factoring of receiv-
ables.
•  Disclosures may be required regarding significant customers or sales by significant lines
of business.

Evidence relevant to these matters might be obtained by inquiring of management and

reviewing minutes of board of directors’ meetings and loan agreements. Evidence is also ob-
tained through the audit procedures performed to test other assertions.

Cloud 9 - Continuing Case

Josh and Suzie are finalizing their plans for substantive tests. A will use generalized audit software to evaluate the allowance for
significant number of tests of transactions were accomplished doubtful accounts by analyzing every account over 90 days past
with dual-purpose tests for testing controls, and additional tests due to determine if some customers regularly take long times to
of transactions will be planned after the end of the year for the pay and are low credit risk, or if customers are showing signs of
portion of the year that was not covered by tests of controls. They deteriorating payment history and are high credit risk. At this
plan to send positive confirmations at two months prior to year- point they believe they have a plan for the remaining substantive
end, and they will use a service that allows for electronic submis- tests. Now it is time to perform the substantive tests and draw an
sion of confirmations by customers. They also concluded that they audit conclusion.

Before You Go On
8.1 What is involved in vouching sales transactions to supporting documentation? What docu-
ments would the auditor look at when vouching sales transactions and what assertions are
met by vouching sales?
8.2 What cutoff tests are performed for sales and cash receipts? How are they performed and
what assertions are met by these tests?
8.3 When positive confirmations are used, how does the auditor deal with nonresponses?
8.4 What steps should the auditor perform when auditing the accounting estimate associated
with the allowance for doubtful accounts?
8.5  List several common disclosures required for sales or accounts receivable.
   Learning Objectives Review  11-39

Learning Objectives Review

a discussion of key controls that are often found related to relevant
1  Explain the nature of the revenue process. assertions for credit sales and accounts receivable.

The revenue process includes three major classes of transactions: 5  Evaluate control activities for cash receipt transac-
(1) credit sales, (2) cash receipts, and (3) sales adjustments. The pri- tions.
mary balance sheet account in the revenue process is accounts re-
ceivable, net of the allowance for doubtful accounts. Illustration 11.1
This section continues the discussion of understanding the flow of
summarizes the transactions that go through the revenue process,
transactions related to cash receipts. While many companies now re-
and Illustration 11.2 identifies the assertions relevant to the revenue
ceive cash either by electronic funds transfer or a lockbox, this section
process. Remember, the auditor must obtain sufficient appropriate
also discusses how a company should establish initial control over
evidence for each material assertion, and an audit strategy for one as-
cash and checks if they are received directly from customers. Illus-
sertion may be different from the audit strategy for another assertion.
tration 11.10 summarizes what can go wrong in the process of receiv-
ing cash along with common controls that might mitigate these risks.
2  Evaluate how an auditor’s understanding of an entity This section concludes with a discussion of key controls that might be
and its environment affects audit planning decisions in found related to relevant cash receipt transaction assertions.
the revenue process.
6  Evaluate control activities for sales adjustment trans-
Different companies in different industries experience various risks actions and revenue process disclosures.
associated with the revenue process. Revenue recognition is more
problematic in some industries, and some industries have signifi- The final section on revenue transactions discusses common docu-
cant transactions that result in cash collection in advance of earning ments found when goods are returned, and credit is given to custom-
revenues. Illustration 11.3 provides examples of five different indus- ers. Common controls over granting credit for sales returns and allow-
tries and how knowledge of the entity and its environment can be ances, controls over determining uncollectible accounts, controls over
used to develop expectations of the financial statements and to as- selling receivables, and controls over disclosures are also discussed in
sess the risk of material misstatement. This section also addresses this section of the chapter.
common analytical procedures that (1) help the auditor understand
the business and (2) may identify significant inherent risks in the 7  Determine how to design and perform tests of con-
financial statements. Illustration 11.5 provides examples of other
trols in the revenue process and connect the results of
key factors associated with understanding the entity and its envi-
ronment and how these factors may influence inherent risk in the control testing to audit strategy.
revenue process.
This final section related to controls in the revenue process discusses
the process of testing the controls identified for relevant assertions in
3  Determine inherent risk for various assertions in the
the financial statements. Remember, when the entity relies on signifi-
revenue process. cant IT application controls, the auditor must test (1) the effectiveness
of IT general controls, (2) the effectiveness of the IT application con-
Common inherent risks in the revenue process relate to the occur- trols, and (3) the effectiveness of manual procedures to follow up on ex-
rence of revenue and the existence of receivables. This section reviews ceptions. Once the auditor has evaluated controls, the auditor should
a number of methods that have been used by companies to overstate consider fraud risk in the revenue process. The discussion related to
revenues. This section also provides an example of how analytical fraud risk addresses the risk of lapping techniques, its tie to misappro-
procedures might flag an increased risk of material misstatement for priation of cash, and various risks of fraudulent financial reporting
some revenue process assertions. In using professional skepticism, an techniques that the auditor should be alert to. Once the auditor has
auditor should be able to recognize factors that increase inherent risk determined the risk of material misstatement of each assertion, the
in the revenue process, so that the audit is responsive to these risks. auditor can make decisions about what substantive tests to perform,
the timing of substantive tests, and the extent of substantive tests.
4  Evaluate control activities for credit sales transac-
tions. 8  Assess detection risk and design substantive tests,
including audit data analytics, to address various asser-
Each entity has a unique system of internal control that is tailored to tions in the revenue process.
the entity’s business model and how it brings in revenues. It is impor-
tant for the auditor to (1) understand the flow of transactions in the The final section of this chapter outlines common substantive tests in
revenue process, (2) identify what can go wrong in the revenue pro- the revenue process. Illustration 11.11 provides a common audit pro-
cess, and (3) assess whether the client has controls to mitigate what gram for substantive tests that might be found in the revenue process,
can go wrong. Illustration 11.7 provides an example of the flow of and this section explains the importance of each of these tests. The
transactions for credit sales; Illustration 11.8 addresses what can go section also reviews professional standards related to sending con-
wrong in the process of making credit sales and common controls that firmations to customers and the importance of follow-up procedures
might be found to mitigate these risks. This section concludes with when customers fail to respond to confirmations.
11-40  C h a pte r 11  Auditing the Revenue Process

Key Terms Review

Bill-and-hold transactions FOB destination Lapping
Consignment sales FOB shipping point Lockbox system
Disclosure committee Gross sales Refund rights

Audit Decision-Making Example

Background Information •  The company generates a monthly aging of accounts receiv-

Assume that, for the third year, you are auditing sales and ac- able report.
counts receivable of the manufactured products division of •  The company sends monthly statements to customers.
United Plastics, Inc. (UPI). You know the following from your •  An individual independent of sales, accounts receivable, and
risk assessment procedures. cash receipts is assigned to follow-up exceptions noted by the
software application. Manual follow-up appears to be effec-
•  The CFO implemented a new computerized account-
tive based on system walkthrough.
ing system during the prior fiscal year. Tests of controls
performed in the prior year’s audit showed that IT ap-
plication controls were designed effectively and operated Identify the Issues
effectively. Develop an audit strategy for the occurrence of revenues and the
•  UPI is experiencing significant competition from overseas. existence of receivables.
As a result, UPI extended an unlimited right-of-return pol-
icy to two months to keep sales volume at an economical Gather Information and Evidence
level since there has been a decline in demand for the Important information includes:
company’s manufactured products. This change was made
•  The unlimited two-month right of return policy affects reve-
with the knowledge and agreement of the UPI board of
nue recognition. No internal controls appear to address this
directors.
issue.
•  All sales are booked upon shipment with sales terms of FOB
•  Bonuses provide incentives for management to maximize
shipping point.
revenues.
•  Management continues to receive significant bonuses based
•  Prior experience shows that internal controls are effective
on attaining sales volume and profitability targets.
(except for new policies regarding right of return).
•  The company has strong controls over cash receipts.
•  Current-year tests of IT general controls show that general
•  An IT specialist has determined that UPI’s IT general con- controls are strong.
trols are strong.
•  A preliminary evaluation based on system walkthrough
•  During the current-year system walkthrough, you learned show a number of programmed control procedures in the
the company has placed in operation the following pro- revenue process.
grammed control activities: exceptions are printed on an ex-
•  Manual follow-up appears to be effective based on system
ception report and the transactions are held in a suspense
walkthrough.
file for follow-up. Manual follow-up procedures appear to be
effective based on a system walkthrough.
•  The amount of a sale plus the customer’s accounts receivable Analysis and Evaluation of Alternatives
balance are compared with the customer’s credit limit before
•  Significant inherent risk indicators include (1) the new pol-
a sales order is approved.
icy regarding extended right of return and (2) bonuses for
•  All goods taken from inventory are matched with approved maximizing revenues.
sales order information.
•  With the exception of problems associated with the right of
•  The software application compares quantities on every sales return, internal controls appear to be strong. However, reve-
invoice against shipping information and prices are checked nue appears to have been booked when goods were shipped.
against the master price file.
•  For sales made during the last two months, consider using
•  The software application compares the date on the sales ADA to match cash receipts with sales. Any sales in the last
invoice with the date on shipping records. two months that have not been sold through by customers
•  The software application matches every sales invoice with (for which cash has been received) should be treated as con-
an underlying bill of lading, and then it electronically flags signment sales. Revenue cannot be booked and inventory
the bill of lading so it cannot be matched with another sales should be placed back on the books using information from
invoice. the sales system.
   Multiple-Choice Questions  11-41

Conclusions Regarding Internal Controls and Audit customers disputing items on monthly statements indicating
Strategy in the Revenue Process a breakdown in internal control.
•  Detection risk. Plan to send confirmations to customers
•  Inherent risk assessment. Assess inherent risk at the maxi- at an interim date if preliminary assessment of internal
mum due to right-of-return issues and incentives for man- controls is confirmed. Receivables confirmed also repre-
agement to overstate revenues (and receivables). sent a test of transactions for sales confirmed. Plan to use
•  Control risk and planned tests of controls. Plan to test the fol- ADA to match cash receipts with all sales made during
lowing IT application controls related to revenues and sales: the last two months. Any sales in the last two months
(1) comparison of date on sales invoice with date on shipping that have not been sold through by customers (for which
records, (2) match of every sales invoice with underlying bill cash has been received), should be treated as consignment
of lading, (3) sending of monthly statements to customers. sales. Revenue cannot be booked and inventory should be
Also, plan to test manual follow-up of exceptions noted by placed back on the books using information from the sales
the software application. Review any correspondence with system.

CPAexcel
CPAexcel questions and other resources are available in WileyPLUS.

Multiple-Choice Questions
1.  (LO 1)  An auditor wants to determine that all sales adjustments b.  Sales declined by 2% and receivables declined by 7% from year
are recorded. This relates to which of the following transaction-class one to year two.
assertions? c.  Sales grew by 10% and receivables declined by 2% from year
a.  Occurrence. one to year two.
b.  Completeness. d.  Sales grew by 5% and receivables grew by 17% from year one
c.  Accuracy. to year two.

d.  Classification. 5.  (LO 3)  An audit client that manufactures and sells goods to a net-
work of authorized dealers may create the equivalent of a consign-
2.  (LO 1)  If a customer pays its receivable in full but a client fails to
ment sale if the client:
record cash received from the customer, which of the following ac-
count balance assertions related to accounts receivable is misstated? a.  only allows goods to be returned if they are damaged.

a.  Completeness. b.  allows a cash discount if the receivable is paid within
30 days.
b.  Rights and obligations.
c.  allows an unconditional right of return at any time until the
c.  Valuation at net realizable value.
goods are sold by the dealer.
d.  Existence.
d.  ships goods only on a collect on delivery (C.O.D.) basis.
3.  (LO 2)  Assume that an auditor is auditing a public company cli- 6.  (LO 4)  Which of the following control activities would most
ent that manufactures computer hardware and markets significant likely assure that no fictitious billings have been posted to the sales
maintenance and consulting services. The auditor should be con- journal?
cerned about which of the following?
a.  The accounts receivable master file is compared with the
a.  Appropriate accounting for commissions on sales. general ledger control account.
b.  Significant revenue issues associated with bundling products b.  Each shipment on credit is supported by a prenumbered sales
and services. order.
c.  More than the usual concern about collection risk. c.  The software application compares each sales invoice
d.  Significant concerns about the completeness of revenues. with the supporting shipping documents and notes any
4.  (LO 2)  An auditor is studying a ratio of accounts receivable discrepancies.
growth rate to sales growth rate. Which of the following indicates a d.  The software application compares prices on the sales in-
potential risk of collection problem in accounts receivable? voices with prices on the master price list and notes any
a.  Sales grew by 10% and receivables grew by 11% from year one discrepancies.
to year two.
11-42  C h a pte r 11  Auditing the Revenue Process

7.  (LO 4)  Which of the following control activities would be a rea- b.  the sales manager.
sonable control over the accuracy of recorded sales? c.  the accounts receivable supervisor.
a.  The software application matches sales invoice quantities with d.  the credit manager.
the underlying packing slip and prices with the sales order.
11.  (LO 7)  Which of the following situations increases the risk of
b.  The software application prints a report of unfilled sales
fraud due to “lapping?”
orders.
a.  The sales manager can approve credit limits for customers.
c.  The software application prints a report of all bills of lading
not matched with a sales invoice. b.  The accounts receivable clerk also has responsibilities for
writing a sales invoice.
d.  The software application matches the customer number
on the sale invoice with the customer number on the sales c.  The shipping clerk in the warehouse has read-only access to
order. sales orders.

8.  (LO 4)  Which of the following is a good example of an IT applica- d.  The accounts receivable clerk also has responsibilities for
tion control over the occurrence of revenue transactions? receiving cash.

a.  Physical access to computer systems is limited only to specific 12.  (LO 8)  A cutoff test designed to detect credit sales made before
personnel who work in the revenue process. the end of the fiscal year that have been recorded in the subsequent
year provides assurance about which of the following management
b.  The software application compares information on a sales in-
assertions?
voice with information from the bill of lading to ensure that sales
invoices are only prepared for actual shipments. Any exceptions a.  Completeness.
are not processed and are set aside for manual follow-up. b.  Occurrence.
c.  Computer system changes to the revenue program must be c.  Accuracy.
tested and authorized before they are allowed to be used with
live data. d.  Classification.

d.  Strong segregation of duties exists between computer opera- 13.  (LO 8)  When sending positive confirmations, which of the fol-
tions and computer program development. lowing would not be an appropriate way to address nonresponse by
a customer?
9.  (LO 5)  A small manufacturing company makes only credit sales.
If cash receipts from sales are misappropriated, which of the follow- a.  Search for evidence of subsequent cash receipt from the
ing acts would most likely conceal this fraud? customer.

a.  Understating the accounts receivable control account. b.  Match open invoices to underlying bills of lading and
customer orders.
b.  Understating the accounts receivable subsidiary ledger.
c.  If the customer’s account balance is individually im-
c.  Overstating the sales journal.
material, conclude that no further work or analysis is
d.  Understating the cash receipts journal. necessary.
10.  (LO 6)  Sound control activities dictate that defective merchan- d.  Assume that the nonresponse is 100% in error and project the
dise returned by customers should be presented initially to: misstatement on the population.
a.  the receiving department.

Review Questions
R11.1  (LO 1)  If there is a completeness problem with cash receipts, ucts on credit. Identify the documents involved and explain the process
are accounts receivable overstated or understated? Explain. from authorizing the transaction through recording in the general ledger.
R11.2  (LO 1)  List three common revenue recognition problems. Il- R11.7  (LO 4)  Explain a sound control over revenue recognition in
lustrate each with an example. the process of making credit sales for a manufacturing company.
R11.3  (LO 2)  How might the risk of material misstatement in the R11.8  (LO 4)  Identify a risk of fraudulent financial reporting in the
revenue process differ for a manufacturer of oil and gas field machin- revenue process. Describe a sound internal control that would detect
ery equipment and a retail grocer? and correct the misstatement on a timely basis.
R11.4  (LO 2)  Identify one or two financial ratios that you believe R11.9  (LO 5)  Identify a risk of misappropriation of assets in the rev-
would be useful in identifying revenue recognition problems. Explain enue process. Describe a sound internal control that would detect and
your reasoning. correct the misstatement on a timely basis.
R11.5  (LO 3)  Explain two common inherent risks in the revenue R11.10  (LO 5)  Briefly explain a likely flow of transactions related
process and explain how each risk is likely to affect the financial state- to receiving cash from a customer received by way of electronic funds
ments (e.g., identify the accounts that are likely to be overstated or transfer, from the customer’s payment being made through recording
understated and explain why). in the general ledger.
R11.6  (LO 4)  Briefly explain a likely flow of transactions related to au- R11.11  (LO 5)  Explain a sound control over the completeness of cash
thorizing and recording credit sales for a manufacturer that sells its prod- receipts associated with the situation described in the previous question.
  Analysis Problems  11-43

R11.12  (LO 6)  Explain a sound control over a public company’s process R11.15  (LO 8)  Explain an effective substantive test related to the
for controlling the appropriateness of the allowance for doubtful accounts. cutoff of sales at year-end.

R11.13  (LO 7)  Assume you are auditing a public company with R11.16  (LO 8)  Develop an example of the use of audit data analyt-
sound IT controls over the occurrence of revenue. Describe the IT con- ics in the audit of accounts receivable.
trol over the occurrence of revenue and how you would test the control.
R11.17  (LO 8)  Explain the audit procedures used to test the adequacy
R11.14  (LO 8)  Explain several important initial procedures in the of the allowance for doubtful accounts.
revenue process. Why should these be performed prior to other sub-
stantive procedures?

Analysis Problems
AP11.1  (LO 1, 2)  Basic   Understanding the entity and its environment  Your client is a regional
motel chain. It owns 27 properties in your region and manages another 40 properties for absentee owners.
All the motels are located on interstate highways and achieve at least 60% of capacity on a regular basis. In
the past, many motels have been fully booked during the summer travel season; however, the economy
has taken a turn for the worse and people are traveling less.

Required
Explain how your knowledge of the business and industry would impact your audit of total revenues and
accounts receivable for the client.

AP11.2  (LO 2)  Moderate   Analytical procedures  The following data was taken from the produc-
tion and accounting records for Casuccio Manufacturing, Inc.

Unaudited Audited Audited

2023 2022 2021
Operating Data
Capacity in units 450,000 450,000 450,000
Production in units 450,000 400,000 300,000
Inventory in units 32,000 28,000 21,000
Financial Data ($000)
Total revenues $ 35,200 $ 27,500 $ 21,200
Total assets $ 23,000 $ 19,500 $ 15,700
Accounts receivable, net $ 5,900 $ 4,300 $ 3,900
Bad debt expense $ 175 $ 135 $ 105
Accounts receivable written off $ 165 $ 125 $ 100

Required
a.  Calculate the following ratios for 2023, 2022, and 2021:
1.  Sales to total assets.
2.  Sales to production.
3.  Revenue per unit sold.
4.  Accounts receivable growth to sales growth.
5.  Uncollectible accounts expense to net credit sales.
6.  Uncollectible accounts expense to accounts receivable written off.
7.  Accounts receivable turnover in days.

b. 1.  Describe the implications of the resulting ratios for the auditor’s audit strategy for the year 2023.
2.  What specific assertions are likely to be misstated?
3.  How should the auditor respond in terms of potential audit tests?

AP11.3  (LO 5)  Moderate   Controls over cash receipts  You have been asked by the board of trust-
ees of a local church to review its accounting procedures. As a part of this review, you have prepared the
11-44  C h a pte r 11  Auditing the Revenue Process

following comments relating to the collections made at weekly services and recordkeeping for members’
contributions:
1. The church’s board of trustees has delegated responsibility for financial management and audit of
the financial records to the finance committee. This group prepares the annual budget and approves
major disbursements but is not involved in collections or recordkeeping. No audit has been con-
sidered necessary in recent years because the same trusted employee has kept church records and
served as financial secretary for 15 years.
2. The collection at the weekly service is taken by a team of ushers. The head usher counts the col-
lection in the church following each service. He then places the collection and a notation of the
amount counted in the church safe. The next morning, the financial secretary opens the safe and
counts the collection again. She withholds about $100 to meet cash expenditures during the coming
week and deposits the remainder of the collection intact. To facilitate the deposit, members who
contribute by check are asked to make their checks payable to “cash.”

Required
Describe the weaknesses and recommend improvements in procedures for collections made at weekly
services. Organize your answer using the following format:

Weakness Recommended Improvement(s)

AP11.4  (LO 8)  Moderate   Substantive tests of accounts receivable  The following situations were
not discovered by an inexperienced staff auditor in the audit of the Parson Company.
1. Several accounts were incorrectly aged in the client’s aging schedule.
2. The accounts receivable turnover ratio was far below expected results.
3. Goods billed were not shipped.
4. Some year-end sales were recorded in the wrong accounting period.
5. Several sales were posted for the correct amount but to the wrong customers in the accounts
receivable ledger.
6. The allowance for uncollectible accounts was understated.
7. Several sales were entered and posted at incorrect amounts.
8. Mathematical errors were made in totaling the accounts receivable ledger.
9. An unrecorded sale at the balance sheet date was collected in the next month.
10. Several fictitious sales were recorded.
11. The pledging of some customer accounts as security for a loan was not reported in the balance
sheet.
12. Some year-end cash receipts were recorded in the wrong accounting period.

Required
(Use a tabular format for your answers with one column for each part.)
a.  Identify the substantive test that should have detected each error.
b.  For each substantive test identified in a., indicate the account balance assertion to which it
pertains.

AP11.5  (LO 3, 8)  Challenging   Fraud   Research   Inflating advertising revenues—Homestore,

Inc.  In 2003, the Securities and Exchange Commission released an Accounting and Auditing Enforcement
Release (AAER) describing charges and discipline against five former executives of Homestore, Inc.,
including the company’s former CEO and CFO. The charges claim the executives developed a scheme to
inflate advertising revenues.

Required
Find and read the 2003 AAER related to Homestore, Inc. Explain the scheme that the company used to
inflate advertising revenues. What is meant by the term “round-trip” transactions? How were the com-
pany’s vendors involved?
  Audit Decision Cases  11-45

Audit Decision Cases

King Companies, Inc.
Questions C11.1 and C11.2 are based on the following case.

King Companies, Inc (KCI) is a private company that owns five auto parts stores in urban Los Angeles,
California. KCI has gone from two auto parts stores to five stores in the last three years, and it plans con-
tinued growth. Eric and Patricia King own the majority of the shares in KCI. Eric is the chairman of the
board of directors of KCI and CEO, and Patricia is a director as well as the CFO. Shares not owned by Eric
and Patricia are owned by friends and family who helped the Kings get started. Eric started the company
with one store after working in an auto parts store. To date, he has funded growth from an inheritance
and investments from a few friends. Eric and Patricia are thinking about expanding by opening three to
five additional stores in the next few years.
In October 2021, Eric approached your accounting firm, Thornson & Danforth, LLP, to conduct an
annual audit of KCI for the year ended December 31, 2022. KCI has not been audited before, but this year
the audit has been requested by the company’s bank because of anticipated bank loans and by a new
private equity investor that has just acquired a 20% share of KCI.
KCI employs 20 full-time staff. These workers are employed in store management, sales, parts delivery,
and accounting. About 40% of KCI’s business is retail walk-in business, and the other 60% is regular
customers where KCI delivers parts to their locations and bills these customers on account. During peak
periods, KCI also uses part-time workers.
Eric is focused on growing revenues. In his opinion, revenue growth is particularly important to
obtaining bank financing. Patricia trusts the company’s workers to work hard for the company, and she
feels they should be rewarded well. The accounting staff, in particular, is very loyal to the company. Eric
tells you that accounting staff enjoy their jobs so much they have never taken any annual vacations, and
hardly any workers ever take sick leave.
There are two people currently employed as accounting staff, the most senior of whom is Jonathan
Jung. Jonathan heads the accounting department and reports directly to Patricia. He is in his late fifties
and hopes to retire in two or three years and move away from Los Angeles. Jonathan keeps a close watch
on accounting and does many activities himself; including opening mail, cash receipts and vendor pay-
ments, depositing funds received, performing reconciliations, posting journals, and performing the payroll
function. His second employee, Abby Owens, is a recent college graduate who just passed the CPA exam.
Abby is responsible for the payroll functions and posting all journal entries into the accounting system.
Jonathan and Abby often help each other out in busy periods.

C11.1  (LO 3, 5)  Challenging   Fraud risk

a.  Analysis: Consider the risk of fraud regarding the diversion of cash receipts from customers. How does
this impact your decisions regarding which audit procedures to perform, the timing of audit proce-
dures, or the extent of procedures associated with auditing revenue assertions? If cash were diverted
from customers, how might Eric or Patricia identify the problem?
b.  Analysis: Explain your assessment of the risk associated with fraudulent financial reporting. How
does this impact your decisions regarding which audit procedures to perform, the timing of audit
procedures, or the extent of procedures associated with auditing revenue assertions?

C11.2  (LO 8)  Challenging   ADA   Audit data analytics for revenue  Analysis: You have been
asked by your audit manager to consider how the audit firm might audit revenues by using audit data
analytics to evaluate 100% of the revenue transactions. Where do you feel that it would be most effective
to audit 100% of the transactions using ADA? In addition to the sales information, what other informa-
tion should you consider in your analysis? Develop a specific audit strategy for how you would screen
100% of the revenues, how you would identify exceptions, and how you might consider what would be
acceptable variations from your expectation norm versus unacceptable variations.

Mobile Security, Inc.

Question C11.3 is based on the following case.

Mobile Security, Inc. (MSI) has been an audit client of Leo & Lee, LLP for the past 12 years. MSI is a small,
publicly traded aviation company based in Cleveland, Ohio, where it manufactures high-tech unmanned
aerial vehicles (UAV), also known as drones, and other surveillance and security equipment. MSI’s prod-
ucts are primarily used by the military and scientific research institutions, but there is growing demand
for UAVs for commercial and recreational use. MSI must go through an extensive bidding process for
11-46  C h a pte r 11  Auditing the Revenue Process

large government contracts. Because of the sensitive nature of government contracts and military prod-
uct designs, both the facilities and records of MSI must be highly secured.
In October 2022, MSI installed a new cloud-based inventory costing system to replace a system that
had been developed in-house. The old system could no longer keep up with the complex and detailed
manufacturing costing process that provides information to support competitive bidding. MSI’s IT de-
partment, together with the consultants from the software company, implemented the new inventory
costing system which went live on December 1, 2022. Key operational staff and the internal audit team
from MSI were significantly engaged in the selection, testing, training, and implementation stages.
The inventory costing system uses various manufacturing costing and unit of production inputs to
calculate and produce a database of all product costs and recommended sales prices. It also integrates
with the general ledger each time there are product inventory movements such as purchases, sales, waste,
and damaged inventory losses.
The following list of sales invoices are entered in the sales journal for the months of June 2023 and
July 2023, respectively. All goods are shipped FOB shipping point.

Sales Sales Cost of

Invoice Invoice Merchandise
Amount Date Sold Date Shipped
June
a. $ 30,000 June 21 $20,000 June 29
b. 20,000 June 30 8,000 June 20
c. 10,000 June 29 6,000 June 30
d. 40,000 June 30 24,000 July 3
e. 100,000 June 30 56,000 June 30 (shipped to consignee)
July
f. $ 60,000 June 30 $40,000 July 1
g. 40,000 July 2 23,000 July 1
h. 80,000 July 3 55,000 June 30

C11.3  (LO 8)  Challenging   Public Company   Sales cutoff tests  Analysis and evaluation: Analyze
the eight transactions shown above. Based on a sales cutoff analysis, record necessary adjusting journal
entries at June 30 in connection with the foregoing data.

Brookwood Pines Hospital

Question C11.4 is based on the following case.

Goodfellow & Perkins LLP is a successful mid-tier accounting firm with a large range of clients across Texas.
During 2022, Goodfellow & Perkins gained a new client, Brookwood Pines Hospital (BPH), a private, not-for-
profit hospital. The fiscal year-end for Brookwood Pines is June 30. You are performing the audit for the 2023
fiscal year-end.
The healthcare industry can be very complicated, especially in the area of billing for services pro-
vided. BPH contracts with private physician groups who use the hospital facilities, equipment, and nurs-
ing staff to treat patients. The physicians in the private group are not employees of the hospital; they are
simply using the hospital facilities to treat patients. For example, a group of urologists have their own
practice, separate from the hospital, where they treat patients. If one of the patients needs a surgical pro-
cedure that must be done at a hospital, then the attending urologist will approve the paperwork required
to admit the patient to BPH. BPH offers inducements to the urologists so they will refer patients to BPH
rather than a competing hospital. One of the inducements BPH offers is free office space in the hospital
for the doctors to use when they are treating patients in the hospital.
After the doctor and hospital services are provided to the patient, the patient and/or the patient’s
insurance company is billed. The doctor will bill for the services he or she provided, and the hospital
will bill for the use of hospital facilities and staff. Doctors and hospitals bill using a coding system that is
standardized across the healthcare industry and consists of three main code sets: ICD, CPT, and HCPCS.
Using a coding system is more efficient and data-friendly compared to writing a narrative about the
procedures performed. However, the coding system is very complex, with thousands of different codes
for medical procedures and diagnoses. To complicate matters even more, for patients who are covered by
government-sponsored Medicare or Medicaid, doctors and hospitals must adhere to complicated govern-
ment regulations surrounding billings to Medicare and Medicaid.
As healthcare costs continue to rise each year, BPH administrators struggle to maintain consistent
profitability. They look for ways to keep costs low and also to collect from patients and insurance companies
  Audit Decision Cases  11-47

as quickly as possible. In addition, BPH must have a strong risk management team to handle unique situations
that may occur in hospitals such as malpractice lawsuits and periodic inspections by the state department
of health and hospitals. Negative publicity for BPH could lead to decreased revenues if physicians decide to
contract with a competing hospital.

C11.4  (LO 8)  Challenging   ADA   Auditing the existence of accounts receivable  Analysis:
Brookwood Pines Hospital has receivables from both insurance companies and from consumers. In the
past, only one in four confirmations has been returned. Internal controls have been tested and are strong.
How might audit data analytics be used to collect evidence regarding the existence of accounts receiv-
able? Develop a specific audit strategy for how you would screen 100% of the revenues (of a particular
type), how you would identify exceptions, and how you might consider what would be acceptable varia-
tions from your expectation norm versus unacceptable variations.

Cloud 9 - Continuing Case

Assume that you are preparing to confirm accounts receivable at $30,500, as a shipment of shoes was not received until
December 31, 2022, which is one month prior to the fiscal year- January 2, 2023. Further investigation showed that the cus-
end of January 31, 2023. The book value of gross accounts receiv- tomer ordered the goods on December 31, 2022, and they
able is $71,622,804. Complete the following requirements related were not counted in inventory when the inventory was taken
to the confirmation of receivables for Cloud 9 based on previous on that date. The freight carrier came by late in the day
work and the following information. and picked up the goods, even though the warehouse was
normally shut down for inventory on December 31, 2022.
Required The goods were shipped FOB shipping point. The receiv-
a.  Using PPS sampling, determine the sample size that you able was paid in full on January 29, 2022.
want to use for sending accounts receivable confirmations. •  Customer No. 00651 disputed receivables in the amount of
Draw on the information you learned about PPS sampling in $250,750, as it had been paid on December 30, 2022. The
Chapter 10. The book value of accounts receivable before the check from Customer No. 00651 was received and depos-
allowance for doubtful accounts is $71,622,804. You make ited by Cloud 9 on January 3, 2022. The book value of the
the following assumptions: receivable for Customer No. 00651 at December 31, 2022,
•  You set tolerable misstatement for accounts receivable at was $250,750.
$3,500,000. •  Customer No. 00850 disputed the balance on the confirma-
•  Expected misstatement = $750,000. tion of $35,700 in its entirety. Further investigation showed

•  Risk of incorrect acceptance = 37%.

that the balance was charged to the wrong customer. Goods
were shipped to Customer No. 00580. On January 3, 2022,
Given these parameters: the error was discovered. A credit memo was issued to Cus-
1. What do you believe to be appropriate qualitative assump- tomer No. 00850 and an invoice was sent to Customer No.
tions for inherent risk and control risk given the risk of 00580, which was paid in full on January 27, 2022.
incorrect acceptance used? •  No response was received from Customer No. 10141.
2.  What do you calculate for sample size? Goods in the amount of $944,232 were shipped on Novem-
ber 1, 2022. Additional goods in the amount of $131,824
3.  What do you calculate for sampling interval?
were shipped on December 12, 2022. The receivable bal-
b.  After discussion of the sample size with Josh Thomas, the audit ance was $1,076,056 at December 31, 2022. A review of the
team sets tolerable misstatement at $3,000,000, expected mis- cash receipts journal showed that a check for $944,232 was
statement at $1,750,000, and risk of incorrect acceptance at deposited on January 24, 2022. Another check for $131,824
37%. You use a sample size of 73 confirmations. The sampling was received on February 1, 2023.
interval is $981,134. You may assume that except for the follow- •  Customer No. 21287 disputed receivables in the amount
ing, you received confirmations from customers that showed of $755 claiming that it did not receive a promised 1% dis-
no exceptions. Determine whether the following conditions count associated with the first shipment to a new customer.
represent errors for purposes of your evaluation. Based on your The book value of the receivables for Customer No. 21287
evaluation and the parameters of the sample you designed at December 31, 2022 was $75,500. The customer subse-
above, evaluate the result of confirming accounts receivable. quently paid $74,745 on January 29, 2022, and Cloud 9
•  Customer No. 00030 disputed the price on stock number issued a credit memo in the amount of $755.
11205, which was priced at $75 per item and should have 1. Determine the amount of misstatement for each cus-
been priced at $60 per item on 1200 items. Cloud 9 issued a tomer listed above.
credit memo for $18,000 on January 7, 2023. The book val-
2. Determine the upper misstatement limit.
ue of the receivable for Customer No. 00030 at December
31, 2022, was $130,500. 3. Draw a conclusion about whether the existence
assertion for accounts receivable is presented fairly at
•  Customer No. 00158 with a receivable balance of $730,225 December 31, 2022.
on December 31 disputed receivables in the amount of