Auditing Principle and Practices-II

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CHAPTER TWO
AUDIT OF THE SALES AND COLLECTION CYCLE
Objectives:
After studying this chapter, you should be able to:
1. Identify the accounts and the classes of transactions in the sales and collection cycle.
2. Describe the business functions and the related documents and records in the sales and
collection cycle.
3. Understand internal control and design and perform tests of controls and substantive tests
of transactions for sales.
4. Apply the methodology for controls over sales transactions to controls over sales returns
and allowances.
5. Understand internal control and design and perform tests of controls and substantive tests
of transactions for cash receipts.
6. Apply the methodology for controls over the sales and collection cycle to write-offs of
uncollectible accounts receivable.
7. Develop an integrated audit plan for the sales and collection cycle.
8. Describe the methodology for designing tests of details of balances using the audit risk
model.
9. Design and perform analytical procedures for accounts in the sales and collection cycle.
10. Design and perform tests of details of balances for accounts receivable for each balance-
related audit objective.

Introduction

An audit in which extensive reliance on internal controls in the sales and collection cycle will
likely require the auditor to expand tests of controls and substantive tests of transactions. In other
situations not involving the audit of a public company, the auditor is less likely to rely on internal
controls but will still need to understand the internal controls over sales and cash receipts. It is
important for auditors to know when they should rely extensively on internal controls and when
they should not. This chapter studies assessing control risk and designing tests of controls and

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substantive tests of transactions for each of the classes of transactions in the sales and collection
cycle.

Before studying the process of assessing control risk and designing tests of controls and
substantive tests of transactions for each class of transactions in detail, two related topics are
covered. First, it is important to know the sales and collection cycle classes of transactions and
account balances in a typical company. Second, because a considerable portion of the audit of
transactions in the sales and collection cycle involves documents and records, it is essential to
understand the typical documents and records used in the cycle.

1.1 Accounts and Classes of Transactions in the Sales and Collection Cycle

The overall objective in the sales and collection cycle is to evaluate whether the account balances
affected by the cycle are fairly presented in accordance with generally accepted accounting
principles.

Typical accounts included in the sales and collection cycles are:

1. Sales
2. Cash in bank
3. Accounts receivable
4. Cash discount taken
5. Allowance for uncollectible accounts
6. Sales returns and allowances
7. Bad debt expense

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The nature of the accounts may vary, of course, depending on the industry and client involved.
There are differences in account titles for a service industry, a retail company, and an insurance
company, but the key concepts are the same. To provide a frame of reference for understanding
the material in this chapter, a wholesale merchandising company is assumed.

There are five classes of transactions in the sales and collection cycle

1. Sales (cash and sales on account)

2. Cash receipts
3. Sales returns and allowances
4. Charge-off of uncollectible accounts
5. Estimate of bad debt expense
Note that with the exception of cash sales, every transaction and amount ultimately is included in one of two
balance sheet accounts, accounts receivable or allowance for uncollectible accounts. For simplicity, assume
that the same internal controls exist for both cash and credit sales.

1.2 Business Functions in the Cycle and Related Documents and Records

The sales and collection cycle involves the decisions and processes necessary for the transfer of
the ownership of goods and services to customers after they are made available for sale. It begins
with a request by a customer and ends with the conversion of material or service in to an account
receivable, and ultimately into cash.

There are eight business functions for the sales and collection cycle shown in the third column
of Table 1-1. They occur in every business in the recording of the five classes of transactions in
the sales and collection cycle. Observe in Table 1-1that the first for processes are for recording
sales, whereas every other class of transaction includes only one business function. This section
explains each of the eight business functions and describes typical documents and records for
each function. These documents and records are shown in the fourth column of Table 1-1. It is
essential to understand the business functions and documents and records in a business before
assessing control risk and designing tests of controls and substantive tests of transactions.

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Table 1-1 Classes of transactions, Accounts, Business Functions, and Related Documents and
Records for the Sales and Collection Cycle
Classes of Accounts Business Functions Documents and records
Transactions
Sales Sales Processing customer Customer order
Accounts receivable orders Sales order
Customer order or sales
Granting credit order
Shipping goods Shipping document
Billing customers and Sales invoice
recording sales Sales transaction file
Sales journal or listing
Accounts receivable master
file
Accounts receivable trial
balance
Monthly statements
Cash receipts Cash in bank Processing and Remittance advice
Accounts Receivable recording cash Prelisting of cash receipts
receipts Cash receipts transaction
file
Cash receipts journal or
listing
Sales returns and Sales returns and Processing and Credit memo
allowances allowances recording sales returns Sales returns and
Accounts receivable and allowances allowances journal
Charge-off of Accounts receivable Charging off Uncollectible account
uncollectible Allowance for un collectible uncollectible accounts authorization form

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accounts accounts receivable General journal
Bad debt expense Bad debt expense Providing for debts General journal
Allowance for uncollectible
accounts

Business functions:

1. Processing customer orders: The request for goods by a customer is the starting point
for the entire cycle. Legally, it is an offer to by goods under specified terms. The receipt
of a customer order often results in the immediate creation of a sales order.

The documents and records affected by this business function are customer order and
sales order. A customer order is a request for merchandise by a customer. It may be
received by telephone, letter, through sales people, or through electronic submission of
the customer order through the internet or other network linkage between the supplier and
the customer. A sales order is a document for communicating the description, quantity,
and related information for goods ordered by a customer.

2. Granting Credit: Before sales orders are processed, the credit department must
determine whether goods may be shipped to the customer on open account. In other
words before goods are shipped, a properly authorized person must approve credit to the
customer for sales on account.

3. Shipping goods: This critical function is the first point in the cycle where company
assets are given up. Most companies recognize sales when goods are shipped. Shipping
document is a document prepared to initiate shipment of the goods, indicating the
description of the merchandise, the quantity shipped, and other relevant data. The
original shipping document is sent to the customer, and one or more copies are retained.
It is also used as a signal to bill the customer.

4. Billing customers and recording sales: Because the billing of customers is the means
by which the customer is informed of the amount due for goods, it must be done
correctly and on a timely basis. In most systems, billing of the customer includes
preparation of a multicopy sales invoice and simultaneous updating of the sales

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transactions file, accounts receivable master file, and general ledger master file for sales
and accounts receivable.

Sales invoice is a document indicating the description and quantity of goods sold, the
price, freight charges, insurance, terms, and other relevant data. The sales invoice is the
method of indicating to the customer the amount of a sales and due date of a payment.
The original sales invoice is sent to the customer, and one or more copies are retained.

Sales transaction file is a computer generated file that includes all sales transactions
processed by the accounting system for a period, such as day, week, or month. The
information on the sales transaction file is used for a variety of records, listings, or
reports, depending on the companies needs.

Sales journal or listing is a report generated from the sales transaction file that typically
includes the customer name, date, amount, and account classification or classifications
for each transaction, such as division or product line.

Accounts Receivable master file is a file used to record individual sales, cash receipts,
and sales returns and allowances for each customer and to maintain customer account
balances. The term master file is used in this material to refer to either the computer file
or a print out of that file.

Accounts receivable trial balance is a list of the amount owed by each customer at a
point in time. This is prepared directly from the accounts receivable master file.

Monthly statement is a document sent to each customer indicating the beginning

balance of accounts receivable, the amount and date of each sale, cash payments
received, credit memos issued, and the ending balance due.

5. Processing and Recording cash receipts:

The preceding four functions are necessary for getting the goods into the hands of
customers, properly billing them, and reflecting the information in the accounting
records. The result of these four functions is sales transactions. The remaining four
functions involve the collection and recording of cash, sales returns and allowances,
charge-off of uncollectible accounts, and providing for bad debt expense.

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Processing and recording cash receipts includes receiving, depositing, and recording
cash. Cash includes both currency and checks. The most important concern is the
possibility of theft. Theft can occur before receipts are entered in the records or later. The
most important consideration in the handling of cash receipts is that all cash must be
deposited in the bank at the proper amount on timely basis and recorded in the cash
receipts transaction file, which is used to prepare the cash receipts journal and update the
accounts receivable and general ledger master files. Remittance advices are important for
this purpose.

Remittance Advice is a document that accompanies the sales invoice mailed to the
customer and can be returned to the seller with the cash payment. It is used to indicate
the customer name, the sales invoice number, and the amount of the invoice when the
payment is received.

Prelisting of cash receipts is a list prepared when cash is received by some one who has
no responsibility for recording sales, accounts receivable, or cash and who has no access
to accounting records. It is used to verify whether cash received was recorded and
deposited at the correct amount and on a timely basis.

Cash Receipts Transaction File is a computer-generated file that includes all cash
receipts transactions processed by the accounting system for a period, such as a day,
week, or month. It includes the same type of information discussed for the sales
transaction file.

Cash Receipts Journal or Listing is a report generated from the cash receipts
transaction file that includes all transactions for any time period. The same transactions,
including all relevant information, are included in the accounts receivable master file and
general ledger.

6. Processing and Recording sales Returns and Allowances:

When a customer is dissatisfied with the goods, the seller often accepts the return of the
goods or grants a reduction in the charges. The company normally prepares a receiving
report for the returned goods them to storage. Returns and allowances must be correctly
and promptly recorded in the sales returns and allowances transaction file and the

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account receivable master file. Credit memos are normally issued for returns and
allowances to aid in maintaining control and facilitate record keeping.

Credit memo is a document indicating a reduction in the amount due from a customer
because of returned goods or an allowance granted. It often takes the same general form
as a sales invoice, but it supports reduction in accounts receivable rather than increases.

Sales Returns and Allowances journal is a journal used to records sales returns and
allowances. It performs the same functions as the sales journal. Many companies record
these transactions in the sales journal rather than in a separate journal.

7. Charging off Uncollectible Accounts receivable:

Regardless of the diligence of credit departments, it is not unusual if some customers do

not pay their bills. When the company concludes that an amount is no longer collectible,
it must be charged off. Typically, this occurs after a customer files bankruptcy or the
account is turned over to a collection agency. Proper accounting requires an adjustment
for these uncollectible accounts.

Uncollectible Account Authorization Form is a document used internally to indicate

authority to write an account receivable off as uncollectible.

8. Providing for bad debts:

The provision for bad debts must be sufficient to allow for the current period sales that
the company will be unable to collect in the future. For most companies, the provision
represents a residual, resulting from management’s end-of-period adjustment of the
allowances for uncollectible accounts.

1.3 Methodology for Designing Tests of Controls and Substantive Tests of

Transactions for Sales

The account balances, classes of transactions, business functions, and related documents and
records for the sales and collection cycle were described in earlier section of this chapter. With
this knowledge, it is now appropriate to study the design of tests of controls and substantive tests

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of transactions for each of the five classes of transactions in the cycle. This is the topic for the
remainder of this chapter.

The methodology for obtaining an understanding of internal control and designing tests of
controls and substantive tests of transactions for sales is shown in figure 1-1. The bottom box in
figure 1-1 shows the four evidence decisions the auditor must make. The following sections deal
with each of the parts in figure 1-1, starting with gaining an understanding of internal control for
sales.

Understand internal
control-sales

Assess planed control

risk-sales

Determine
extent of testing
of controls

Design tests of controls Audit procedures

and substantive tests of Sample size
transactions for sales to
meet transaction Items to select
related audit objectives Timing

Figure 1.1 Methodology for designing tests of controls and substantive tests of transactions for
sales
1.3.1 Understand Internal Control for sales

In testing of controls and substantive tests of transactions for sales, the auditor should obtain an
understanding of the internal control for sales and design methodology to test. A typical
approach for sales is to study the client’s flowcharts, prepare an internal control questionnaire,
and perform walk though tests of sales.

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1.3.2 Assess planed control risk for sales

The auditor uses the information obtained in understanding internal control to assess control risk.
There are four essential steps to this assessment.

1. First, the auditor needs a framework for assessing control risk. The framework for all classes
of transaction is the six transaction-related audit objectives. These six objectives are the
same for every audit of the sales.
2. Second, the auditor must identify the key internal controls and deficiencies for sales. The
controls and deficiencies will be different for every audit.
3. After identifying the controls and deficiencies, the auditor associates them with the
objectives.
4. Finally, the auditor assesses control risk for each objective by evaluating the controls and
deficiencies for each objective. This step is critical because it affects the auditor’s decisions
about both tests of controls and substantive tests. It is a highly subjective decision.

We will now examine key control activities for sales:

i. Adequate separation of duties: proper separation of duties is useful to prevent various types
of misstatements both intentional and unintentional. To prevent fraud, it is important that
any one responsible for inputting sales and cash receipts transaction information in to the
computer be denied access to cash. It is also desirable to separate the credit granting
function from the sales function.
ii. Proper authorization: Credit must be properly authorized before a sales takes place; goods
should be shipped only after proper authorization; and prices, including basic terms,
freight, and discount must be authorized.
iii. Adequate documents and records: Adequate record keeping procedures must exist before
most of the transaction related audit objectives can be met. Companies automatically
prepare a multicopy prenumbered sales invoice at the time a customer order is received.
Copies of this document are used to approve credit, authorize shipment, record the number
of units shipped, and bill customer.
iv. Prenumber documents: An important characteristic of documents for sales is the use of
prenumbering which is meant to prevent both the failure to bill or rescored sales and the

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occurrence of duplicate billings and recordings. An example of the use of this control is the
filing, by a billing clerk, of a copy of all shipping documents in sequential order after each
shipment is billed, with someone else periodically accounting for all numbers and
investigating the reason for any missing documents.
v. Monthly statements: sending monthly statements automatically by computer or by someone
who has no responsibility for handling cash or preparing the sales and accounts receivable
records is a useful control; since it encourages a response from customers if the balance is
improperly stated.
vi. Internal verification: the use of computer programs and independent persons for checking
the processing and recording of sales transactions is inessential for fulfilling each of the six
transaction-related audit objectives.

1.3.3 Design test of controls for sales

For each key control, one or more tests of controls must be designed to verify its effectiveness.
In most audits, it is relatively easy to determine the nature of the control. For example, if the
internal control is to initial customer orders after they have been approved for credit, the test of
control is to examine the customer order for the proper initial.

The first three columns of table 1-2 illustrate the design of tests of controls for sales. Column
three in Table 1-2 shows one test of controls for each key internal control in column two.
Observe that the table is organized by transaction related audit objective. For example, the
second key internal control for the existence objective is “sales are supported by authorized
shipping documents and approved customer orders.” The test of control is “examine sales
invoice for supporting bill of lading and customer orders.” For this test, the auditor should start
with sales invoices and examine documents in support of the sales invoices rather than going in
the opposite direction. If the auditor traced from shipping documents to sales invoices, it would
be a test of completeness.

As shown in the third column of table 1-2 for the completeness objective, a common test of
control for sales is to account for a sequence of various types of documents. Accounting for the
sequence of sales invoices selected from the sales journal and watching for omitted and duplicate

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numbers or invoices outside the normal sequence is a test that simultaneously provides evidence
of both the existence and completeness objectives.

The appropriate tests of controls for separation of duties are ordinarily restricted to the auditor’s
observations of activities and discussion with personnel. For example, it is possible to observe
whether the billing clerk has access to cash when incoming mail is opened or cash is deposited. It
is usually also necessary to ask personnel what their responsibilities are and if there are any
circumstances where their responsibilities are different from the normal policy. For example, the
employee responsible for billing customers may state that he or she does not have access to cash.
Further discussion may bring out that when the cashier is on vacation, that person takes over the
cashier’s duties.

Table 1-2: Transaction related to Audit objectives, key Existing Controls, Tests of Controls,
Weakness, and substantive tests of Transactions

Transaction Related Key Existing Control Test Control Deficienci Substantive

Audit objective es Tests of
Transactions

Recorded sales are for -Credit is approved -Examine There is a Account for a
shipments actually automatically by customers order for lack of sequence of
made to customers computer by evidence of internal sale invoices
comparison to Customer approval verificatio Review sales
(existence ) authorized credit n for the Journal and
limits -Examine sales possibility master file for
invoice for of sales unusual
-Sale are supported supporting bill of invoices transaction
by authorized lading and being and amounts.
shipping documents customer order recorded
and approved more than Trace sales
customer orders -Examine file of journal entries
batch totals for once
to supporting
-Batch totals of initials of data documents,
qualities shipped control clerk including
compared with duplicate
quantities billed -Observe whether
monthly statements sales invoice,
-Statements are sent are sent bill of lading,
to customers each sales order,
and customer

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month order.

existing transactions -Shipping documents -Account for a Trace selected

are recorded are prenumbered and sequence of shipping
(completeness) accounted for weekly shipping documents documents to
the sales
-Batch totals of -Examine file of Journal to be
quantities shipped are batch totals for sure that each
compared with initials of data one is
quantities billed control clerk included

Recorded sales are for -Sales are supported -Examine sales Trace entries
the amount of goods by authorized invoice for in sales
shipped and are shipping documents supporting journal to
correctly billed and and approved documents sales invoice
recorded (Accuracy) customer orders
-Batch tools of
quantities sipped are -Examine file of Recomputed
compared with batch totals for prices and
quantities billed initials of data extensions on
control clerk. sales invoice
-Unit selling prices
are obtained from the -Examine the Trace details
price list master file approved price list on sales
of approved prices. for accuracy and
proper  Shippi
-Statements are sent authorization ng
to customers each docum
month. -Observe whether ents
monthly statements
are sent  Sales
order
 Custo
mer
order

Sales transaction are Account Examine document Examine

properly classified classifications are package for internal duplicate
internally verified verification sales invoice
(Classification )
for proper
account
classification

Sales are recorder on Shipping documents Account for There is a Compare date of
the correct dates are prenumbered and sequence of lack of recording of

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(timing) accounted for weekly shipping documents control to sale in sales

by the accountant test for journal with
timely duplicate sales
invoice and bill
recording of lading

Cont’d

Sales transaction -Computer -Examine -Trace selected

are properly automatically evidence that sales invoice
included in the posts account from the sales
accounts transactions to receivable journal to the
receivable master the accounts master file is master file and
file and are receivable reconciled to the test for amount,
correctly master file and general ledger date, and invoice
summarized general ledger number
(posting and -Examine
summarization) -Accounts evidence that -Use audit
receivable account software to foot
master file is receivable and cross- foot
reconciled to the master file is the sales journal
general ledger on reconciled to the and trace total to
a monthly basis general ledger the genera
ledger
-Statements are -Observe
sent to the whether monthly
customers each statements are
month sent

1.3.4 Design substantive tests of transactions for sales

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In table 1-2, the substantive tests of transactions in column 5 are related to the transaction –
related audit objectives in the first column and are designed to determine whether any monetary
misstatements for that objective exist in the transaction .The audit procedures used are affected
by the internal controls and tests of control for the objective. Some of the audit procedures used
when internal controls are inadequate are discussed in a later section.

Determining the proper substantive tests of transactions procedures for sales is relatively difficult
because they vary considerably depending on the circumstances. In subsequent paragraphs, the
procedures often not performed are emphasized because they are the ones requiring an audit
decision. The substantive tests of transactions procedures are discussed in the order of the sales
transaction –related audit objectives in Table 1-2. It should be noted that some procedures fulfill
more than one objective.

Recorded Sales Exist: - for this objective, the auditor is concerned with the possibility of three
types of misstatements: sales being included in the journals for which no shipment was made,
sales recorded more than once, and shipments being made to nonexistent customers and recorded
as sales.

The appropriate substantive tests of transactions for the existence objective depend on where the
auditor believes the misstatements are likely to take place. Many auditors do substantive tests of
transactions for the existence objective only if they believe that a control deficiency exists;
therefore, the nature of tests depends on the nature of the potential misstatement as follows;

Recorded sale for which there was no shipment The auditor can trace from selected entries in
the sales journal to make sure that related copies of the shipping and other supporting documents
exist. If the auditor is concerned about the possibility of a fictitious duplicate copy of a shipping
document, it may be necessary to trace the amounts to the perpetual inventory records as a test of
whether inventory was reduced.

Sale recorded more than once Duplicate sales can be determined by reviewing numerically
sorted list of recorded sales transitions for duplicate numbers. The auditor can also test for the
proper cancellation of shipping documents. Proper cancellation decreases the likelihood that a
shipping document swill be used to record another sale.

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Shipment made to nonexistent customers This type of fraud normally occurs only when the
person recording sales is also in a position to authorize shipments. When internal controls are
weak, it is difficult to detect fictitious shipments.

Another effective approach to detecting the three types of misstatements of sales transactions
discussed previously is to trace the credit in the accounts receivable master file to its source. If
the receivable was actually collected in cash or the goods were returned, there must originally
have been a sale. If the credit was for a bad debt charge-off or a credit memo or if the account
was still unpaid at the time of the audit, intensive follow-up by examining shipping and customer
order documents is required because each of these could indicate an inappropriate sales
transaction.

Existing sales transactions Are Recorded:- In many audits, no substantive tests of transactions
are made for the completeness objective on the grounds that overstatements of assets and income
are a greater concern in the audit of sales transactions than their understatement. If controls are
inadequate, which is likely if the client does no independent internal tracing from shipping
documents to the sales journal, substantive tests are necessary.

An effective procedure to test for unbilled shipments is to trace selected shipping documents
from a file in the shipping departments to related duplicate sales invoices and the sales journal.
To conduct a meaningful test using this procedure the auditor must be confident that all shipping
documents are included in the file. This can be done by accounting for a numerical sequence of
the documents.

Direction of tests it is important that auditors understand the difference between tracing from
source documents to the journals and tracing from the journals back to source documents. The
former is a test for omitted transactions (completeness objective), whereas the latter is a test for
nonexistent transactions (existence objective).

In testing for the existence objective, the starting point is the journal. In testing for the
completeness objective, the likely starting point is the shipping document. A sample of shipping
documents is selected and traced to duplicate sales invoices and the sales journal as a test of
omissions.

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When designing audit procedures for the existence and completeness objectives, the starting
point for tracing the document is essential. This is called the direction of tests. For example, if
the auditor is concerned about the existence objective but traces in the wrong direction (from
shipping documents to the journals), a serious audit deficiency exists.

In testing for the other four transaction- related audit objectives the direction of tests is usually
not relevant. For example, the accuracy of sales transactions can be tested by tracing from a
duplicate sales invoice to a shaping document or vice versa.

Sales are accurately recorded: - The accurate recording of sales transaction concerns shipping
the amount of goods ordered, accurately billing for the amount if goods shipped and accurately
recording the amount billed in the accounting records. Substantive tests to ensure that each of
these aspects of accuracy is correct are ordinarily conducted in every audit.

Typical substantive tests of transactions include recomposing information in the accounting

records to verify whether it is proper. A common approach is to start with entries in the sales
journal and compare the total of selected transactions with accounts receivable master file entries
and duplicate sales invoice. Prices in the duplicate sales invoices are normally compared with
an approved price list, extensions and footings are recomputed, and the details listed on the
invoices are compared with shipping records for description, quantity, and customer
identification, often, customer orders and sales orders are also examined for the same
information

The comparison of tests of controls and substantive tests of transactions for the accuracy
objective is a good example of how audit time can be saved when effective internal controls
exist. It is obvious that the test of control for this objective takes almost no time because it
involves examining only and initial or other evidence of internal verification because the sample
size for substantive testes from performing the test of control because of its lower cost.

Recorded sales Are properly classified: - Charging the correct general ledger account is less of a
problem in sales than in some other transaction cycles, but it is still of some concern. When there
are cash and credit sales, it is important not to debit accounts receivable for a cash sale or to
credit sales for collection of a receivable. It is also important not to classify sales of operating
assets, such as buildings, as sales.

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It is common to test sales for proper classification as part of testing for accuracy. The auditor
examines supporting documents to determine the proper classification of a given transaction and
compares this with the actual account to which it is charged.

Sales are Recorded on the Correct Dates: - sales should be billed and recorded as soon after
shipment takes place as possible to prevent the unintentional omission of transactions from the
records and to make sure that sales are recorded in the proper period. Timely recorded
transactions are also less likely to contain misstatements. At the same time that substantive tests
of transactions procedures for accuracy are being performed, it is common to compare the date
on selected bills of lading or other shipping documents with the date on related duplicate sales
invoices, the sales journal, and the accounts receivable master file.

Sales transactions are properly included in the master file and summarized: - The proper
inclusion of all sales transactions in the accounts receivable master file is essential because the
accuracy of the records affects the client’s ability to collect outstanding receivables. Similarly
sales journal must be correctly totaled and posted to the general ledger if the financial statements
are to be correct. In most audits it is common to perform some clerical accuracy tests such as
footing the journals and tracing the totals and details to the general ledger and the master file to
check whether there are intentional or unintentional misstatements in the processing of sales
transactions. The extent of such tests is affected by the quality of internal controls and can often
be performed in using spreadsheet or generalized audit software.

1.4 Sales Returns and Allowance

The transaction-related audit objectives and the Client’s methods of controlling misstatements
are essentially the same for processing credit memos as those described for sales, with two
important differences. The first relates to materially. In many instances, sales returns and
allowance are so immaterial that they can be ignored in the audit altogether. The second major
difference relates to emphasis on objectives. For sales returns and allowances, the primary
emphasis is normally on testing the existence of recorded transactions as a means of uncovering
any diversion of cash from the collection of accounts receivable that has been covered up by a
fictitious sales return or allowance.

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Although the emphasis for the audit of sales returns and allowances is often on testing the
existence of recorded transactions, the completeness objective is especially important at year-
end. Unrecorded sales returns and allowances can be material and can be used by a company’s
management to overstated net income. The extent of sales returns and potential liability at year-
end varies greatly by industry. Sales returns for mail-order and web-site sales are typically
higher than for in-store sales because the purchaser is not able to physically examine the
merchandise prior to purchasing.

Naturally, the other objective should not be ignored. But because the objectives and
methodology for auditing sales returns and allowances are essentially the same as for sales, we
will not include a detailed study of the area. The reader should be able to apply the same logic to
arrive at suitable controls, tests of controls, and substantive tests of transactions to verify the
amounts.

1.5 Methodology for Designing Tests of Controls and Substantive Tests of

Transactions for Cash Receipts

The same methodology used for designing tests of controls and substantive tests of transaction
for sales is used for cash receipts. Similarly, cash receipts tests of controls and substantive tests
of transactions audit procedures are developed around the same framework used for sales; that is,
given the transaction-related audit objectives, key internal controls for each objective are
determined, tests of control are developed for each control, and substantive tests of transactions
for the monetary misstatements related to each objective are developed. As in all other audit
areas, the tests of controls depend on the controls the auditor has identified, the extent they will
be relied on to reduce assessed control risk, and whether the company being audited is publicly
traded.

The detailed discussion of the internal controls tests of controls and substantive tests of
transactions that was included for the audit of sales is not included for cash receipts. Instead, the
audit procedures that are most likely to be misunderstood are explained in more detail.

An essential part of the auditor’s responsibility in auditing cash receipts is identification of

deficiencies in internal control that increase the likelihood of fraud. The emphasis will be on
those audit procedures that are designed primarily for the discovery of fraud. Those procedures

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that are not discussed are omitted only because their purpose and the methodology for applying
them should be apparent from their description.

1.5.1 Determine Whether Cash Received Was Recorded

The most difficult type of cash defalcation for the auditor to detect is that which occurs before
the cash is recorded in the cash receipts journal or other cash listing, especially if the sale and
cash receipt are recorded simultaneously. For example, if a grocery store clerk takes cash and
intentionally fails to process the receipt of cash on the cash register, it is extremely difficult to
discover the theft. The type of control will, of course, depend on the type of business. For
example, the controls for a retail store in which the cash is received by the same person who sells
the merchandise and ring up the cash receipts should be different from the controls for a
company in which all receipts are received through the mail several weeks after the sales have
taken place.

It is normal practice to trace from prenumbered remittance advices or prelists of cash receipts
journal and subsidiary accounts receivable records as a substantive test of the recording of actual
cash received. This test will be effective only if a cash register tape or some other prelisting was
prepared at the time cash was received.

1.5.2 Prepare Proof of Cash Receipts

A useful audit procedure to test whether all recorded cash receipts have been deposited in the
bank account is a proof of cash receipts. In this test, the total cash receipts recorded in the cash
receipts journal for a given period, such as a month, are reconciled with the actual deposits made
to the bank during the same period. There may be a difference in the two as a result of deposits
in transit and other items, but the amounts can be reconciled and compared. The procedure is not
useful in discovering cash receipts that have not been recorded in the journals or time lags in
making deposits, but it can help uncover recorded cash receipts that have not been deposited,
unrecorded deposits, unrecorded loans, bank loans deposited directly in to the bank account, and
similar misstatements. This somewhat time-consuming procedure is ordinarily used only when
the controls are deficient. In rate instances in which controls are extremely weak, the period
covered by the proof of cash receipts may be the entire year.

1.5.3 Test to Discover Lapping of Accounts Receivable

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Lapping of accounts receivable is the postponement of entries for the collection of receivables to
conceal an existing cash shortage. The defalcation is perpetrated by a person who handles cash
receipts and then enters them into the computer system. He or she defers recording the cash
receipts from one customer and covers the shortage with receipts of another. These in turn are
covered from the receipts of a third customer a few days later. The employee must continue to
cover the shortage through repeated lapping, replace the stolen money, or find another way to
conceal the shortage.

This defalcation can be easily prevented by separation of duties and a mandatory vacation policy
for employees who both handle cash and enter cash receipts into the system. It can be detected
by comparing the name, amount, and dates shown on remittance advices with cash receipts
journal entries and related duplicate deposit slips. Because the procedure is relatively time-
consuming, it is ordinarily performed only when there is specific concern with deficiency in
internal control.

1.6 Audit Tests for Uncollectible accounts

Existence of recorded write-offs is the most important transaction-related audit objective that the
auditor should keep in mind in the verification of the write-off of individual uncollectible
accounts. A major concern in testing accounts charged off as uncollectible is the possibility of
the client covering up a defalcation by charging off accounts receivable that have already been
collected. The major control for preventing this type of misstatement is proper authorization of
the write off of uncollectible accounts by a designated level of management only after a thorough
investigation of the reason the customer has not paid.

Normally, verification of the accounts charged off takes relatively little time. A typical procedure
is the examination of approvals by the appropriate person. For a sample of accounts charged off,
it is also usually necessary for the auditor to examine correspondence in the client’s files
establishing their uncollectibility. After the auditor has concluded that the accounts charged off
by general journal entries are proper, selected items should be traced to the accounts receivable
master file as a test of the records.

1.7 Additional Internal Controls over Accounts Payable

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The preceding discussion emphasized internal controls, tests of controls, and substantive tests of
transactions for the five classes of transaction that affect account balances in the sales and
collection cycle. If the internal controls for these classes of transactions are determined to be
effective and the related substantive tests of transactions support the conclusion, the likelihood of
misstatements in the financial statements is reduced.

In addition, there may be internal controls directly related to account balances that have not been
identified or tested as a part of test of controls or substantive tests of transactions. For the sales
and collection cycle, these are most likely to affect three balance related audit objectives:
realizable value, rights and obligations, and presentation and disclosure.

Realizable value is an essential balance related audit objective for accounts receivable because
collect ability of receivables is often a major financial statement item and has been an issue in a
number of accountants’ liability cases. Therefore, it is common for inherent risk to be high for
the realizable value objective. Several controls are common for the realizable value objective.
One that has already been discussed is credit approval by an appropriate person. A second is the
preparation of a periodic aged accounts receivable trial balance for review and follow up by
appropriate management personnel.

A third control is a policy of charging off uncollectible accounts when they are no longer likely
to be collected.

Right and obligations and presentation and disclosure are rarely a significant problem for
accounts receivable. Therefore, competent accounting personnel are typically sufficient controls
for this two balance related audit objectives.

1.8 Effects of Results of Tests of Controls and Substantive Tests of

Transactions

The results of tests of controls and substantive tests of transactions will have significant effect on
the remainder of the audit, especially on the substantive tests of details of balances. The parts of
the audit most affected by the tests of controls and substantive tests of transactions for the sales
and collection cycle are the balances in accounts receivable, cash, bad debt expense, and
allowance for doubtful accounts. Further more if the results are unsatisfactory, it is necessary to

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do additional substantive testing for the propriety of sales, sales returns and allowances, charge
off of uncollectible accounts and processing of cash receipts. Auditors of public companies must
also consider the impact of unsatisfactory test results on the audit of internal control over
financial reporting.

At the completion of tests of controls and substantive tests of transactions, it is essential to

analyze each exception to determine its cause and the impact of the exception on assessed
control risk, which may affect the supported detection risk and there by the remaining
substantive tests. The most significant effect of the results of the tests of controls and substantive
tests of transactions in the sales and collection is on the confirmation of accounts receivable.

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