Chapter 12 reading guide

Question 1

Can you identify typical source documents, accounting records and types of transactions in the sales
cycle and the collection cycle? (just sales cycle) 5 documents, 4 records, 3 transactions

Answer 1

documents:
- customer order/ PO
- sales order
- shipping document/ bill of landing
- sales invoice
- credit memo

accounting records:
- sales journal
- accounts receivable subsidiary ledger
- general ledger
- price list master file

typical transactions
1. recording sales transactions
2. recording slaes returns and allowances
3. recording bad debt expense and write-offs

Question 2

Can you identify typical source documents, accounting records and types of transactions in the sales
cycle and the collection cycle? (just collection cycle) 4 documents, 3 records, 4 transactions

Answer 2

documents:
- remittence advice
- cheque or electronic payment record
- deposit slip/ bank statement
- cash receipts prelist

records:
- cash receipts journal
- accounts receivable subsidiary ledger
- bank reconciliation file

typical transactions
1. recording cash collections from customers
2. applying cash to specific A/R balances
3. recording write offs of uncollectible accounts
4. reconciling bank deposits with receipts and a/r

Question 3

What are the primary assertions for accounts receivable? For revenue? sales returns and allowances?

Answer 3

accounts receivable: existence and valuation

revenue: occurence and cut-off

sales returns and allowances: cut off and completeness

Question 4

What are the common types of revenue manipulation? 7

Answer 4

1. fictitious or sham sales (occurence assertion)
   - sale never happened
2. premature revenue recognition (occurence and cut off)
   - recorded before earned, for example enron and blockbuster, unearned revenue was recorded
3. round tripping/ recording loans as sales (occurence assertion)
   - fake reciprocal transactions
4. improper cut off sales (cut off assertion)
   - sales in the wrong period
   - recording sales that happened in jan but in december
5. improper “bill and hold” sales (occurnce and cut off)
   - recognizing revenue before delivery of items
6. side arrangements or hidden terms (occurnece assertion)
   - delay or cancel the earning process
   - for example giving buyers the right to return unsold goods while still recognizing the sale
7. manipulation of adjustments and estimates
   - returns and allowances understated (completeness)
   bad debt expense understated (valuation and existence for A/r)

Question 5

What are common analytics performed in planning the audit of the revenue cycle? What possible misstatements could be identified and what assertion? In addition to completion of ratios and prior period comparisons, what else should the auditor
do/consider? (only the first two questions on this one)

Answer 5

Precodure:
- Evaluate the ratio of returns and allowances to sales
- possible misstatements: could indicate unusual sales arrangements and possible over or understatement of revenue
- assertion: occurence or completeness

Procedure:
- compare bad debt expense as a percentage of gross sales with that of previous years
- possible misstatement: uncollectible A/R that have not been provided for could indicate understatement of a/r
- assertion: valuation (net realizable)

Procedure:
- compare number of days that accounts receivable are outstanding with that of previous years
- possible misstatement: overstatement or understatement of allowance for uncollectible accounts and bad dept expense
- assertion: valuation

Procedure:
- compare aging categories as a percentage of a/r with those of previous years
- possible misstatements: over or understatement of allowance for uncollectible accounts and bad debt expense
- assertion: valuation

Procedure:
- compare allowance for uncollectible accounts as a percentage of accounts receivable with that of the previous years
- possible misstatement: over or understatement of allowance for uncollectible accounts
- assertion: valuation

Procedure:
- evaluate cash receipts collected after year end to cash receipts during the year
- possible misstatements: if slow, may indicate special sales arrangements and potential overstatement of revenue
- assertion: occurence

Question 6

What are common analytics performed in planning the audit of the revenue cycle? What possible misstatements could be identified and what assertion? In addition to completion of ratios and prior period comparisons, what else should the auditor
do/consider? (only the third question on this one, 5 things)

Answer 6

1. compare client data with industry and non financial data
2. use disaggregated or trend analystics
3. investigazte unsual relationships
4. evaluate the nature of the client’s business model
5. review internal policies and incentives

Question 7

For the revenue cycle name the 5 audit objectives/ assertions, provide examples of a key control for each transaction-related audit objective.
For each key control identified, provide a procedure that could test the control. 5

Answer 7

Occurrence:
example: shipping records and sales invoices cannot be produced if custmer number is invalid
test: use test data and observe rejection of invalid customer numbers when entered by client staff into system

completeness:
example: computer checks for gaps in shipping document numbers and prints report of missing numbers for independent follow up
test: inspect report of missing shipping document numbers for evidence of independent follow up

accuracy:
example: invoices are prepared using authorized prices, terms, freight, and discounts established in master files
test: test access controls, seeing who can override or change the master file documents

cut-off:
example: invoices are prepared using a date equal to the shipping date, or specify the shipping date on the invoice
test: compare dates of recorded sales transactions with dates on shipping records

classification:
Example: an adequate chart of accounts is used
test: inspect the chart of accounts and see their accuracy and adequacy

Question 8

For cash receipts (collection), provide examples of a key control for each transaction-related audit
objective. For each key control identified, provide a procedure that could test the control. 6

Answer 8

occurence
example: accountant independently reconciles bank account
test: observe seperation of duties or independent reconciliation of bank account

completeness:
example: batches of totals of cash receipts are compared to computer summary reports
test: examine file of batch total for electronic signature

accuracy:
example: regular reconciliation of bank accounts
test: inspect monthly bank reconciliations

cut off
example: procedures require recording of cash receipts on a daily basis
test: observe unrecorded cash at any point in time

classification
example: use of adequate chart of accounts or automatic posting to specified accounts
tests: review chart of accounts and computer assigned posting accounts

presentation
example: cfo reviews financial statements for required disclosure
test: examine documentation supporting controller’s review and approval of financial statements

Question 9

Explain the importance of proper credit approval for sales on the auditor’s assessment of internal
control of the sales cycle. 4

Answer 9

1. prevents uncollectible accounts and misstatements
2. supports key assertions
3. indicator of a strong control environment
4. auditor’s perspective (helps auditor see us as trustworthy)

Question 10

If valuation of accounts receivable at year end was expected to be a major concern, what internal
controls would mitigate the risk that accounts receivable were inappropriately valued? 4

Answer 10

Regular review of the aged accounts receivable listing to identify overdue or doubtful accounts

mamagement approval of write offs and adjustments to the allowance for doubtful accounts

credit approvals and limits to prevent sales to high risk customers

periodic comparison of actual bad debts to estimates to assess reasonableness for AFDA

Independent review of estimates and assumptions used in determining collectability

Question 11

What is the key date that auditors should be concerned with when testing cut-off of revenue? How
do sales returns and allowances affect cut-off testing?

Answer 11

key date: transactions just before and after year end to ensure sales are recorded in the correct period

sales returns and allowances: must be reviewed near year end because late recorded returns and allowances can indicate improper revenue recognition

Question 12

Describe some of the differences between positive and negative confirmations and when each type
of confirmation should be used. 3 points each

Answer 12

positive:
- sent to debtor asking to cnfirm whether the stated balance is correct or incorrect
- provide stronger, more reliable evidence because a response is required
- use it when individual balances are large, accounts are in dispute, or threre is a high risk of misstatement

negative:
- reqest response only if the debtor disagrees with the stated balance
- less relaible (debtor may ignore the reuest) but less costly
- used when inherent and control risks are low, many small balances exist, and the auditor expects good internal controls and high response rates

Question 13

What would you do if management would not allow confirmation on particular account balances? CAS 505 4things

Answer 13

1. inquire about management’s reasons for refusal and evaluate whether they are valid or reasonable
2. assess implications for fraud risk
3. perform alternative audit procedures
4. consider the effect on the audtor’s risk assessment and opinion - if satisfactory alternative evidence cannot be obtained, it may lead to a scope limitation and possible qualified or disclaimer opinion

Question 14

How does an auditor maintain control of the confirmation process? 4

Answer 14

• preparing and mailing the confirmation requests themselves
• ensuring confirmations are sent directly to the customers and returned directly to the auditor
• monitoring all responses, following up on non-responses, and performing alternative procedures if needed
• reconciling and resolving any differences between the custmer’s reply and the client’s records

Question 15

Describe alternative audit procedures performed when positive confirmations are not returned. What
source documents would be examined (inspected) when positive confirmations are not returned? 1 must, three documents

Answer 15

auditor performs alternative audit procedures to obtain evidence of A/R existence and valuation such as

• inspecting subsequent cash receipts
• examining shipping documents to verify goods were delivered
• reviewing sales invoices and customer orders to confirm legitimate sales

Question 16

Describe alternative audit procedures that would be performed when positive confirmations are sent
and are returned with differences. What source documents would be examined (inspected) when
positive confirms are returned with differences? 2 musts, 4 source documents

Answer 16

must:
- investigate and reconcile discrepancies between customer response and client records
- determine whether difference is due to timing or recording error
(timing is payments in transfer or goods in transit)

source documents inspected:
- customer correspondence. explaining the difference
- subsequenct cash receipts
- sales invoices and shipping documents
- credit memos or adjustments

Question 17

If specific fraud risk factors are present, what are some additional substantive procedures that could
be performed on the revenue cycle? 6 things

Answer 17

proof of cash receipts

extended cutoff testing

detailed review of sales returns and allowances

examine unsual or large journal entries

compares sales and cost trends

confirm with customers