Lecture Auditing and assurance services (Second international edition) Chapter 10 Auditing the revenue process

In this chapter, the learning objectives are Understand why knowledge of an entitys revenue recognition policies is important to the audit, understand the revenue process, know the types of transactions in the revenue process and the financial statement accounts affected, be familiar with the types of documents and records used in the revenue process,…

Auditing the Revenue Process

Chapter Ten

Revenue Recognition (IAS 18)

Revenue is defined as the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions

from equity participants

Overview of the Revenue Process

Inventory Account

receivable Purchases

Inventory

Cash sales

Cash Sale

Purchases

Credit sales

Cash collection

Credit Sale Credit Sale

Types of Transactions and Financial

Statement Accounts Affected

Three types of transactions are typically processed

by the revenue process:

1 The sale of goods or rendering of a service for

cash or credit

2 The receipt of cash from the customer in

payment for goods or services

3 The return of goods by the customer for credit or

cash

Types of Transactions and Financial

Statement Accounts Affected

The revenue process affects numerous accounts in the financial statements The most significant accounts are:

Flowchart of the Revenue Process:

EarthWear Clothiers

Flowchart of the Revenue Process: EarthWear Clothiers (continued)

Flowchart of the Revenue Process: EarthWear Clothiers (continued)

Types of Documents and Records

Customer Sales Order

Contains the details of the type and quantity of products or services ordered by the customer

and customer information

Customer Sales Order

Contains the details of the type and quantity of products or services ordered by the customer

and customer information

Credit Approval Form

For credit sales, the client must have a formal procedure for investigating the creditworthiness of

the customer

Credit Approval Form

For credit sales, the client must have a formal procedure for investigating the creditworthiness of

the customer

Types of Documents and Records

This document generally serves as a bill

of lading and contains information on the

type of product shipped, the quantity shipped and other relevant information

Shipping Document

This document generally serves as a bill

of lading and contains information on the type of product shipped, the quantity shipped and other relevant information

Types of Documents and Records

Sales Invoice

The document is used to bill the customer This document contains information on the type of product or service, the quantity, the

price and the terms of trade

Sales Invoice

The document is used to bill the customer This document contains information on the type of product or service, the quantity, the

price and the terms of trade

Sales Journal

Once a sales invoice has been issued, the sale

needs to be recorded in the accounting records The sales journal is used to record information about the sales transaction

Sales Journal

Once a sales invoice has been issued, the sale

needs to be recorded in the accounting records The sales journal is used to record information about the sales transaction

Types of Documents and Records

Customer Statement

This document is mailed to the customer and contains details of all sales, cash receipts, and credit memorandum transactions

Customer Statement

This document is mailed to the customer and contains details of all sales, cash receipts, and credit memorandum transactions

Accounts Receivable Subsidiary Ledger

This ledger contains an account and the details of transactions for each customer

Accounts Receivable Subsidiary LedgerThis ledger contains an account and the details of transactions for each customer

Types of Documents and Records

Aged Trial Balance of Accounts

Receivable

This report summarizes all the customer balances in the accounts receivable subsidiary ledger Each account is classified as current or placed into one of

several past due categories

Aged Trial Balance of Accounts

Receivable

This report summarizes all the customer balances in the accounts receivable subsidiary ledger Each account is classified as current or placed into one of

several past due categories

Remittance AdviceThis is usually the part of the customer’s bill that should be returned with the payment

Remittance Advice

This is usually the part of the customer’s bill that should be returned with the payment

Types of Documents and Records

Cash Receipts Journal

This journal is used to record the cash

receipts of the entity

Cash Receipts JournalThis journal is used to record the cash

receipts of the entity

Types of Documents and Records

Write-Off Authorization

This document authorizes the write-off of an uncollectible account receivable Final authorization is generally received from the

treasurer

Write-Off Authorization

This document authorizes the write-off of an uncollectible account receivable Final authorization is generally received from the

treasurer

Major Functions

Order Entry

The initial function in the revenue process is the entry of a new sales order

into the system.

Order Entry

The initial function in the revenue process is the entry of a new sales order

into the system.

Major Functions

Shipping

Goods should not be shipped, nor should services be provided

without proper authorization The

main control is payment or proper credit authorization.

Shipping

Goods should not be shipped, nor should services be provided

without proper authorization The

main control is payment or proper credit authorization.

Billing

The objective of proper billing is to ensure that all goods shipped and all

services rendered are billed to the customer.

Billing

The objective of proper billing is to ensure that all goods shipped and all

services rendered are billed to the customer.

Credit Authorization

The credit authorization process must determine that the customer is able

to pay for the goods or services purchased

Failure to properly authorize credit can lead

to extensive bad debts for the entity.

Credit Authorization

The credit authorization process must determine that the customer is able

to pay for the goods or services purchased

Failure to properly authorize credit can lead

to extensive bad debts for the entity.

Cash Receipts

All cash collected must be properly identified and promptly

deposited intact

at the bank.

Cash Receipts All cash collected must be properly identified and promptly

deposited intact

at the bank.

Accounts Receivable All billings, adjustments, and cash collections must

be properly recorded in the customers’ accounts receivable records.

Accounts Receivable

All billings, adjustments, and cash collections must

be properly recorded in the customers’ accounts receivable records.

General Ledger

As related to the revenue process, the general ledger function must ensure that all revenues, collections, and receivables are properly recorded and classified.

General Ledger

As related to the revenue process, the general ledger function must ensure that all revenues, collections, and receivables are properly recorded and classified.

Major Functions

The Major Functions

Key Segregation of Duties

Inherent Risk Assessment

Control Risk Assessment

Understand and document the revenue process

based on a reliance approach

Plan and perform tests of controls on revenue

transactions

Set and document the control risk for the revenue

process

Control Environment

Understanding the control environment is generally

completed on an overall entity basis

Control Environment

Understanding the control environment is generally

completed on an overall entity basis

Understanding and Documenting

Internal Control

The Entity’s Risk Assessment Process

The auditor must understand how management considers risks that are relevant to the revenue process The auditor should estimate the significance

of the risk and assess the likelihood of occurrence

The Entity’s Risk Assessment Process

The auditor must understand how management considers risks that are relevant to the revenue process The auditor should estimate the significance

of the risk and assess the likelihood of occurrence

Understanding and Documenting

Internal Control

Control Activities

The auditor identifies which controls ensure that the assertions for transactions and events are being met Documentation of the auditor’s understanding of the revenue process can be accomplished by using:

Procedures Narrative Internal control

Information Systems and

Communication

Auditor’s knowledge

Auditor’s knowledge

Process by which sales, cash receipts

and credit memoranda are initiated.

Process by which sales, cash receipts

and credit memoranda are initiated.

Accounting records, supporting documents and accounts that are involved in sales, cash receipts and sales

returns.

Accounting records, supporting documents and accounts that are involved in sales, cash receipts and sales

returns.

The flow of each transaction from initiation to inclusion

in the financial statements.

The flow of each transaction from initiation to inclusion

in the financial statements.

The process used to prepare estimates for bad debts and sales

returns.

The process used to prepare estimates for bad debts and sales

returns.

The auditor must understand how management assesses the design and operation of controls in the revenue process This understanding should include how supervisory personnel review the personnel who perform the controls and evaluate the performance of

the entity’s IT function

Monitoring of Controls

Planning and Performing

Tests of Controls

The auditor systematically examines the client’s revenue process to identify relevant controls that help to prevent, or detect and correct material

misstatements

Observations of the operation of the control.

In order to properlyset control risk theauditor must testcontrols over therevenue process

Such tests may include

In order to properlyset control risk theauditor must testcontrols over therevenue process

Such tests may include

Inquiry of client personnel.

Inspection of documents and records.

Walkthroughs.

Reperformance of the control activities.

Setting and Documenting

the Control Risk

If the results of the tests of controls support the planned level of control risk, the auditor conducts the planned level of substantive procedures for the

account balances

The level of control risk for the revenue process can

be set using either quantitative amounts or qualitative terms such as ‘low,’ ‘medium,’ or ‘high.’

The level of control risk for the revenue process can

be set using either quantitative amounts or qualitative terms such as ‘low,’ ‘medium,’ or ‘high.’

Control Activities and Tests of Controls

– Revenue Transactions

Assertions about Classes of Transactions and Events

for the Period under Audit

Occurrence of Revenue Transactions

The auditor is concerned about two major types

of material misstatements:

1 Sales to fictitious customers

2 Recording revenue when goods have not been shipped or services have not been performed

The auditor needs assurance that all recorded

revenue transactions are valid

The auditor needs assurance that all recorded

revenue transactions are valid

Completeness of Revenue Transactions

The major misstatement that concerns both management and the auditor is that goods are

shipped or services are performed and no

revenue is recognized.

The major misstatement that concerns both management and the auditor is that goods are shipped or services are performed and no

revenue is recognized.

Controls concerning completeness include: (1) accounting for numerical sequence of shipping documents and sales invoices; (2) matching shipping documents with sales invoices;

(3) reconciling sales invoices to daily sales reports; and (4) maintaining and reviewing the open-order file.

Controls concerning completeness include: (1) accounting for numerical sequence of shipping documents and sales invoices; (2) matching shipping documents with sales invoices;

(3) reconciling sales invoices to daily sales reports; and (4) maintaining and reviewing the open-order file.

Authorization and Accuracy of Revenue

The presence of an authorized price list and terms

of trade reduces the risk of inaccuracies The sales invoice should also be verified for mathematical accuracy before being sent to the customer

Cut-off and Classification

of Revenue Transactions

Sales may be recorded in the wrong accounting period unless proper controls are in place All shipping documents should be forwarded to the billing department

Occurrence of Cash Receipts Transactions

The possible misstatement that concerns

the auditor when considering the occurrence assertion is that cash receipts are recorded but not deposited in the

client’s bank account.

Completeness of Cash Receipts and Authorization of Discounts

A major misstatement is that cash or cheques are stolen or lost before being recorded in the cash receipts records Proper segregation of duties and

a lockbox system are strong controls relating to

Accuracy of Cash Transactions

The wrong amount of cash could be recorded from the remittance advice, or the receipt could

be incorrectly processed during data entry

To minimize these types of errors, daily remittance reports should be reconciled to a control listing of remittance advices All bank statements should be

reconciled monthly

Cut-off and Classification of Cash Receipts Transactions

If the client uses electronic fund transfer, a lockbox system or if cash is deposited daily in the bank, there is a small possibility

of cash being recorded in the wrong accounting period.

The auditor seldom has major concerns about cash receipts being recorded in the

wrong financial statement account.

Control Activities and Tests of Controls –

Sales Returns and Allowances

Sales returns and allowances is usually not a material amount in the financial statements However, credit memoranda that are used to process sales returns can also be used to cover an unauthorized shipment of goods or conceal a misappropriation of cash

As a result, all credit memoranda should be

Relating the Assessed Level of Control

Risk to Substantive Procedures

The auditor’s testing of control for revenue processing impacts the detection risk and therefore the level of substantive procedures

impacted by the controls.

Cash

Accounts receivable

Allowance for bad debts

Bad debts expense Sales returns

and allowances

Auditing Accounts Receivable and

Related Accounts

Substantive analytical procedures are used to examine plausible relationships among accounts

receivable and related accounts

Substantive analytical procedures are used to examine plausible relationships among accounts

receivable and related accounts

Tests of details focus on transactions, account balances or disclosures Tests of details concentrate on the ending balance for accounts receivable and related accounts as well as related

disclosures

Tests of details focus on transactions, account balances or disclosures Tests of details concentrate on the ending balance for accounts receivable and related accounts as well as related

disclosures