Chapter Two

Audit of Sales and Collection Cycle

2.1. Overview of the Cycle
 The overall objective in the audit of sales and
collection cycle is to evaluate whether the account
balances affected by the cycle are fairly presented in
accordance with accounting standards.
 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
conversion of material or service into an account
receivable, and ultimately into cash.
 2.2. Key Internal Control
1. Internal Controls for Sales Class of Transactions
 For classes of transactions, there are five applicable assertions:
1. Cut-off (trxns and events have been recorded in correct
accounting prd),
2. Classification (transactions are correctly classified),
3. Completeness (Existing transactions are recorded),
4. Occurrence (recorded transactions have occurred during the
period), and
5. Accuracy (recorded transactions are accurate).
 IC pertaining to occurrence assertion is that each sales trxn is
supported by necessary documents, such as approved sales order,
shipping documents, and invoice.
 Cont…
 Other internal company controls include:
 Requiring approval for selling goods to new customers,
 Sending out monthly statements to customers;
 Complaints received being independently followed up,
and
 Reviewing exception reports that include large or
unusual sales trxns.
 In terms of completeness assertion, shipping
documents are typically sequentially pre numbered so
that any duplicate transaction or a missing transaction
can be properly accounted for.
 Auditor will start from source documents & confirm
whether all transactions are fully recorded on the
ledger.
2. Internal Controls for Cash Receipts
Some ICs for cash receipts class include
segregation of duties b/n cash handler and record
keeper, and monthly bank reconciliations.
These two controls pertain mainly to the
occurrence assertion.
In terms of completeness assertion, monthly
customer statements are a strong control, as well
as use of remittance invoices or pre-listing of cash,
and the reconciliation of the documents with
deposit slips.
Business functions in the cycle
Before auditors can assess control risk and design
tests of controls and substantive tests of
transactions, they need to understand the
business functions and documents and records in
a business.
Business functions in the sales and collection cycle
involves the decisions and processes necessary for
the transfer of 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 into an
account receivable, and ultimately into cash.
There are eight business functions for the sales
and collection cycle are:
1. Processing customer orders,
2. Granting credit,
3. Shipping goods,
4. Billing customers and recording sales,
5. Processing and recording cash receipts,
6. Processing and recording sales returns and
allowances,
7. Writing off uncollectible accounts receivable,
8. Providing for bad debts.
 Business functions
1. Processing Customer Orders: Legally, it is an offer to buy goods under
specified terms.
 Receipt of customer order often results in immediate creation of sales
order.
2. Granting credit: before goods are shipped, properly authorized person
must approve credit to customer for sales on account.
 Weak practices in credit approval often result in excessive bad debts and
A/R that may be uncollectible.
3. Shipping goods: this critical function is the first point in the cycle at which
the company gives up assets.
 Most companies recognize sales when goods are shipped.
 Shipping document, which is often a multi-copy bill of lading, is essential
to proper billing of shipments to customers.
 One type of shipping document is a bill of lading, which is a written
contract b/n the carrier and the seller of goods.
 Often, bills of lading include only number of boxes or pounds shipped,
rather than complete details of quantity and description.
 It is often transmitted electronically, once goods have been shipped, and
automatically generates related sales invoice as well as entry in sales
journal
4. Billing customers and recording sales: billing customers means
by which customer is informed of the amount due for goods, it
must be done correctly and on a timely basis.
 The most important aspects of billing are:
 All shipments made have been billed (completeness).
 No shipment has been billed more than once (occurrence).
 Each one is billed for the proper amount (accuracy).
5. Processing & recording cash receipts: the four sales transaction
functions are necessary for getting the goods into the hands of
customers, correctly billing them, and reflecting the infn in the
accounting records.
 Processing and recording cash receipts includes receiving,
depositing, and recording cash.
 Cash includes currency, checks, and electronic funds transfers.
 The most important concern is the possibility of theft.
 It is important that all cash receipts are deposited in the bank at
the proper amount on a timely basis & recorded in cash receipts
trxn file.
6. Processing & recording sales returns & allowances: when a customer is
dissatisfied with goods, seller often accepts the return of goods or grants a
reduction in the charges.
 Company prepares a receiving report for returned goods and returns
them to storage.
 Returns & allowances are recorded in sales returns and allowances
transaction file, as well as A/R master file.
 Credit memos are issued for returns & allowances to aid in maintaining
control.
7.Writing off uncollectible A/R: regardless of diligence of credit dep′ts,
some customers do not pay their bills.
 After concluding that an amount cannot be collected, the company must
write it off. Typically, this occurs after a customer files for bankruptcy or
the account is turned over to a collection agency.
8. Providing for bad debts: b/se companies cannot expect to collect on
100% of their sales, accounting principles require them to record bad debt
expense for the amount they do not expect to collect
They occur in every business in recording of the five classes of trxns in
the sales and collection cycle.
 Documents and Records for Sales
1. Customer Order: a request for merchandise by a customer.
2. Sales Order: used to communicate description, quantity & related
specification of goods ordered.
3. Shipping Document: a document prepared to initiate shipment of goods
4. Sales invoice: a document indicating the description and quantity of goods
sold, price, freight charges, insurance, terms & other relevant data
5. Sales transaction file: a computer generated file that includes all sales
transaction processed by the accounting system for a period
6. Sales journal or listing: a report generated from sales transaction file that
typically includes customer name, date, amount & account classification(s)
for each trxn, such as division/product line.
7. A/R master file: a file used to record individual sales, cash receipts, and sales
returns and allowances for each customer and to maintain customer
account balances.
8. Monthly Statement: a document sent by mail or electronically to each
customer, indicating the beginning balance of their A/R, amount and date of
each sale, payments received, credit memos issued, and ending balance
due.
 Documents and Records for Cash Receipts
1.Remittance advice: is a document mailed to customer & typically returned to the
seller with customer’s payment.
 Indicates customer name, sales invoice number and amount of the invoice.
2. Prelisting of Cash receipts: prepared when cash is received by someone who has
no responsibility for recording sales, A/R, 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 amounts and on a timely basis.
3. Cash receipts transaction: a computer-generated file that includes all cash
receipts trxns processed by accounting system for a period such as a day, week, or
month.
 It includes the same type of information as the sales transaction file.
4. Cash receipts Journal or Listing: This listing or report is generated from cash
receipts trxn file and includes all trxns for a time period.
 Documents and Records for Sales Return and Allowance
Credit Memo: indicates a reduction in the
amount due from a customer b/se of returned
goods or an allowance.
Sales returns and allowances Journal: is a journal
used to record sales returns and allowances.
 It performs the same function as the sales
journal.
 Documents and Records for Uncollectible
accounts & Bad debts
 Uncollectible account authorization Form: is a
document used internally to indicate authority to write
A/R off as uncollectible.
 B/se companies cannot expect to collect on 100% of
their sales, accounting principles require them to record
bad debt expense for the amount they do not expect to
collect.
 Most companies record this transaction at the end of
each month/quarter.
2.3. Test of Controls and Substantive Test of Transactions
for Sales
Methodology for designing Test of Transactions
for sales
1. Understanding Internal Control-Sales: How do auditors
obtain an understanding of internal control?
 Using one typical approach for sales, auditors study
client’s flowcharts, make inquiries of client using IC
questionnaire, & perform walkthrough tests of sales.
2. Assess Planned Control Risk-Sales: auditor uses infn
obtained in understanding IC to assess control risk.
 Auditor assesses control risk for each objective by
evaluating controls and deficiencies for each objective.
 Knowledge of these control activities assists in identifying
the key controls and deficiencies for sales.
 Adequate Separation of Duties: Proper separation of
duties helps to prevent various types of misstatements
due to both errors and fraud.
 Cont….
 Proper Authorization auditor is concerned about authorization at three
key points
1.Credit must be properly authorized before a sale takes place.
2.Goods should be shipped only after proper authorization.
3.Prices, including basic terms, freight, & discounts, must be authorized.
 Adequate Documents and Records adequate record-keeping
procedures must exist before most of the trxn related audit objectives
can be met.
 Pre-numbered Documents: is meant to prevent both failure to bill or
record sales and occurrence of duplicate billings and recordings.
 Monthly Statements: Sending monthly statements is a useful control
b/se it encourages customers to respond if the balance is incorrectly
stated.
 Internal Verification Procedures: Computer programs or independent
personnel should check that processing and recording of sales
transactions fulfill each of the six transaction related audit objectives.
 Cont….
3)Determine Extent of Testing Controls
» For audits of accelerated filer public companies, auditor must perform extensive
tests of key controls & evaluate the impact of deficiencies on auditor’s report on IC
over financial reporting.
» For audits of non-accelerated filers and non-public companies depends on
effectiveness of controls and the extent to which auditor believes they can be relied
on to reduce control risk.
4)Design Tests 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 test of the control
from the nature of the control.
5) Design Substantive Tests of Transactions for Sales
» In deciding substantive tests of transactions, auditors commonly use some
procedures on every audit regardless of the circumstances, whereas others are
dependent on adequacy of the controls and results of tests of controls.
» Determining proper substantive tests of trxns procedures for sales is relatively
difficult b/se they vary considerably depending on circumstances
 Substantive Tests of Transaction Audit
Procedures
1. Recorded Sales Occurred
 For this objective, auditor is concerned with possibility of 3 misstatements:
 Sales included in the journals for which no shipment was made.
 Sales recorded more than once.
 Shipments made to nonexistent customers and recorded as sales.
 The first two types of misstatements can be due to an error or fraud.
 The last type is always a fraud.
 Potential consequences of all the three are significant b/se they lead to an
overstatement of assets and income
2.Recorded Sale for Which There Was No Shipment
 Auditor can vouch selected entries in sales journal to related copies of shipping
and other supporting documents to make sure they occurred.
3.Sale Recorded More Than Once
 Duplicate sales can be determined by reviewing a numerically sorted list of
recorded sales transactions for duplicate numbers.
 Auditor can also test for proper cancellation of shipping documents.
 Proper cancellation decreases likelihood that a shipping document will be used
to record another sale.
 Cont..
4.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.
 Deficient ICs make it difficult to detect fictitious shipments, such
as shipments to other locations of the company.
 To test for non-existent customers auditor can:
1. Trace customer infn non sales invoice to customer master file.
2. Trace the credit in A/R master file to its source.
 These revenue frauds are often referred to as “sham sales.”
5. Existing Sales Transactions Are Recorded
 In many audits, no substantive tests of trxns are done for
completeness objective.
 This is b/se overstatements of assets and income from sales trxns
are more likely than understatements, and overstatements also
represent a greater source of audit risk.
 Direction of Testing
 Tracing from source documents to the journals
 Tracing from the journals back to source documents
 The former tests for omitted transactions
(completeness objective);
 The latter tests for nonexistent transactions (occurrence
objective).
 When designing audit procedures for occurrence &
completeness objectives, the starting point for the test
is essential.
 This is called the direction of tests.
 As illustrated in the above figure for example, if auditor is
concerned about the occurrence objective but tests in the
wrong direction (from shipping documents to the
journals), a serious audit deficiency exists.
 Sales Returns and Allowances
 Transaction-related audit objectives & client’s
methods of controlling misstatements are essentially
the same for processing credit memos as those
described for sales, with two differences.
 The first is materiality.
 In many instances, sales returns & allowances are so
immaterial and auditor can ignore them.
 The second difference is emphasis on the occurrence
objective.
 For sales returns & allowances, auditors usually
emphasize testing recorded transactions to uncover
any theft of cash from the collection of A/R that was
covered up by a fictitious sales return or allowance.
Methodology for designing tests of controls and substantive tests of
transactions for cash receipts
 Auditors use the same methodology for designing tests of
controls & substantive tests of transactions for cash
receipts as they use for sales
 Cash receipts tests of controls and substantive tests of
transactions audit procedures are developed around the
same framework used for sales, but of course the specific
objectives are applied to cash receipts.
 Given trxn-related audit objectives, auditor follows this
process:
1. Determine key ICs for each audit objective
2. Design tests of control for each control used to support
reduced control risk
3. Design substantive tests of trxns to test for monetary
misstatements for each objective
 Substantive Audit Procedures for Cash Receipts
 Determine Whether Cash Received Was Recorded:
 The most difficult type of cash embezzlement for auditors to detect is when it
occurs before cash is recorded in cash receipts journal or other cash listing,
especially if sale & cash receipt are recorded simultaneously.
 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.
 Test to Discover Lapping of A/Receivable:
 is postponement of entries for collection of receivables to conceal existing cash
shortage.
 Embezzlement is perpetrated by a person who handles cash receipts and then
enters them into the computer system.
 This embezzlement 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 name, amount and dates shown on
remittance advices with cash receipts journal entries and related duplicate
deposit slips.
 Audit tests for the write-off of uncollectible
accounts
 Auditor’s primary concern in audit of write-off of uncollectible
A/R is the possibility of client personnel covering up an
embezzlement by writing off AR that have already been
collected (occurrence transaction-related audit objective).
 The major control for preventing this fraud is proper
authorization of write-off of uncollectible accounts by a
designated level of management only after a thorough
investigation of the reason the customer has not paid.
 Estimation of bad debt expense, which is the 5th class of
transactions in the sales and collection cycle, relates to write-off
of uncollectible.
 However, b/se estimation of bad debts is based on year-end A/R
balances, auditor evaluates the estimate for uncollectible
accounts as part of the tests of details of ending A/R balances.
 2.4. Tests of Details of Balances
 Appropriate evidence to be obtained from tests of
details of balances must be decided on an objective-
by-objective basis.
 B/se several interactions affect the need for evidence
from test of details of balances, this audit decision
can be complex.
 In designing tests of details of balances for A/R,
auditors must satisfy each of the eight balance-
related audit objectives
 These eight general objectives are the same for all
accounts.
 Specifically applied to A/R, they are called A/R
balance-related audit objectives and are as follows:
 A/R balance-related audit objectives
1. A/R in an aged trial balance agree with related
master file amounts, and the total is correctly
added and agrees with general ledger (Detail tie-in)
2. Recorded A/R exist (Existence)
3. Existing A/R are included (Completeness)
4. A/R are accurate (Accuracy)
5. A/R are correctly classified (Classification)
6. Cut- off for A/R is correct (Cutoff)
7. A/R is stated at realizable value (Realizable value)
8. Client has rights to A/R (Rights)
Methodology for Designing Tests of Details of
Balances for A/R
 Financial Reporting Standards

 Financial reporting standards for receivables

require:
 Separation of trade from non – trade receivables.
 Assurance of ownership disclosure.
 Assurance of collectability of receivables.
 Assurance of consideration for returns and
allowances.
 Appropriate classification of current and non -
current.
 Audit Program for Receivables and Sales Transactions
 The following audit procedures are typical of the work done in verification
of notes, A/R and sales transaction.
1. Obtain an understanding of IC for receivables and sales.
 Auditors’ consideration of ICs over receivables & sales may begin with
preparation of a written narrative or flow chart and completion of an internal
control questionnaire.
2. Auditors’ confirm their understanding of sales and collection cycle, they
will observe whether there is appropriate segregation of duties, and
enquire as to who performed various functions throughout the year.
3. Assess control risk and design additional tests of controls
 After obtain understanding of client’s IC for receivables & sales trxns,
auditors perform their initial assessment of control risk for the variant
financial statement assertions.
4. Perform additional tests and controls:
 Tests directed towards the effectiveness of control help to evaluate the
client’s IC, and determine extent to which auditors are justified in reducing
their assessed levels of control risk for assertion about receivables & sales
accounts.
 Substantive Tests
1. Obtain an aged trail balance of trade A/Rand analyses of other A/R and
reconcile to ledgers.
 When trial balances or analyses of A/R are furnished to auditors by client’s employees, some
independent verification of listings is essential.
2. Obtain analyses of N/R and related interest.
3. Inspect notes on hand and confirm those not on hand with holders.
4. Confirm receivables with debtors.
5. Receive the year-end cutoff/limit of sales transactions.
6. Perform analytical procedures for A/R, sales, N/R, and interest revenue.
7. Verify interest earned on notes and accrued interest receivable.
8. Evaluate the propriety of the client’s A/R and sales.
9. Determine adequacy of allowance for uncollectible accounts.
10. Ascertain whether any receivables have been pledged.
11. Investigate fully any notes or A/R from related parties.
12. Evaluate financial statement presentation and disclosure
END OF CHAPTER TWO!