Chapter two

Audit of Sales & Collection Cycle

 The Sales and Collection Cycle
Meaning of the Sales and Collection Cycle
• The sales and collection cycle includes all activities involved in:
• Receiving customer orders and approving credit
• Checking availability of goods
• Shipping goods and billing customers
• Collecting cash
• Recording all related transactions in the accounting records
In short: from customer order → to cash collection → to accounting records.
Significance of the Sales and Collection Cycle

• It reflects the core operations of a business.

• Sales transactions are always material to the financial statements.

• Errors or fraud in this cycle directly affect:

• Revenue

• Accounts receivable

• Cash

• Profit

• Because of this, auditors give special attention to this cycle.

Major Audit Risks in the Sales and Collection Cycle

• Auditors mainly focus on revenue recognition risk, such as:

• Overstatement of revenue

• Understatement of revenue

• Recording fictitious sales

• Recording sales in the wrong period (cut-off errors)

Studies by the SEC(Securities and Exchange Commission) show that:

• Most financial statement frauds and audit failures involve revenue misstatements.

• Therefore, the sales and collection cycle must be examined with great care.
❖ Objective of Auditing the Sales and Collection Cycle

The overall objective is to determine whether:

• Account balances affected by the cycle are fairly presented

• Transactions comply with accounting standards

• Revenue is valid, complete, accurate, and properly recorded

 5. Classes of Transactions in the Sales and Collection Cycle

No Class of Transaction Accounts Affected

1 Sales Transactions (cash & credit) Cash, Accounts Receivable, Sales

Cash, Accounts Receivable, Sales Discount, Other

2 Cash Receipts Transactions
Accounts

3 Sales Returns & Allowances Sales Returns & Allowances, Accounts Receivable
4 Write-off of Uncollectible A/R Allowance for Bad Debts, Accounts Receivable
5 Bad Debt Expense Estimation Bad Debt Expense, Allowance for Uncollectible Accounts
Receivables

• Receivables are claims against customers or others for money, goods, or services.

Types of Receivables

• Accounts Receivable
• Based on oral promises to pay
• Arise from credit sales

• Notes Receivable
• Written promises to pay a specific amount on a future date
Trade vs Non-Trade Receivables
Trade Receivables
• Originate from credit sales of goods or services
• Example: customer credit sales
Non-Trade Receivables
• Receivables not related to normal sales, such as:
• Advances to officers and employees
• Advances to subsidiaries
• Security deposits
• Performance guarantees
• Dividends and interest receivable
• Claims against:
• Insurance companies
• Government bodies (tax refunds)
• Common carriers
• Creditors
• Customers for returnable items
Audit Concern:
Trade and non-trade receivables must be shown separately in the financial statements for proper
presentation and disclosure.
Internal Control over Sales & Receivables

1. Internal Controls in Sales

Internal control over sales ensures that:

• Customer orders are checked for correctness

• Credit is approved after checking customer financial condition

• Goods are issued only based on authorized shipping documents

2. Areas Requiring Strong Internal Control

• Shipping function:

• Use pre-numbered shipping documents

• Copies sent to billing department and gatekeeper

• Collection of receivables:

• Proper follow-up of collections

• Ensure collections are recorded in the correct customer account

• Write-off of receivables:

• Write-offs should be approved after review by credit department

• Internal audit of receivables (mainly for large organizations)

3. Indicators of Weak Internal Control
• Shipment to customers without credit approval
• Shipment without informing billing department
• Errors in quantity or price on sales invoices
• Missing or unrecorded sales invoices due to poor serial number control
4. Consequences of Weak Internal Control
• Large losses from uncollectible receivables
• Fraud and misstatements in financial records
5. Key Audit Assertions for Receivables
• Existence – receivables are real
• Completeness – all receivables are recorded
• Rights & obligations – company owns the receivables
• Valuation – receivables are shown at realizable value
• Presentation & disclosure – properly classified and disclosed
B. Audit of Sales Transactions
• Understanding Internal Control
• Auditors use:
• Flowcharts
• Internal control questionnaires
• Walk-through tests
Six Transaction-Related Audit Objectives
1. Existence (Occurrence)
2. Completeness
3. Accuracy
4. Classification
5. Timing
6. Posting and summarization
 Assessing Fraud Risk for A/Receivable

1. Major Fraud Risks

• Incorrect aging of accounts receivable

• Lapping of accounts receivable

• Misclassification of receivables

• Failure to recognize uncollectible accounts

2. Lapping of Accounts Receivable

• Lapping is a fraud technique where cash collected from one customer is stolen and the shortage
is covered using payment from another customer.

Why it happens:

• Lack of separation of duties

• Same person handles cash and records receivables

Effects:

• At least one customer’s account is always overstated

• Embezzlement of cash remains hidden

B. Causes, Prevention, and Detection of Lapping
Causes
• No separation between:
• Handling cash
• Recording cash receipts
Prevention Methods
• Proper separation of duties
• Mandatory employee vacations for those handling cash and records
Detection Methods
• Compare:
• Remittance advices
• Cash receipts journal
• Duplicate deposit slips
• Check consistency of names, dates, and amounts
C. Inherent Risks in Accounts Receivable

• Examples of inherent risks:

• Recording sale of receivables as sales instead of financing

• Misclassification of receivables as current

• Incorrect aging of receivables

• Failure to recognize doubtful accounts

Higher inherent risk = higher chance of material misstatement

D. Auditor’s Focus in Sales & Receivables Cycle

Auditors mainly focus on:

• Controls that prevent or detect embezzlement

• Controls over cutoff

• Controls over allowance for uncollectible accounts

E. Substantive Tests for Accounts Receivable

Two Main Types

• Analytical Procedures (AP)

• Tests of Details of Balances

F. Analytical Procedures for A/R
• Identify unusual fluctuations
• Detect possible misstatements
Timing
• Performed after balance sheet date
• Before tests of details of balances
Application
• Applied to the entire sales and collection cycle
• Receivables Requiring Special Attention
• Large or unusual balances
• Long outstanding balances
• Related-party receivables
• Credit balances in A/R
G. Tests of Details of Accounts Receivable Balance

• Auditors use balance-related audit objectives:

1. Detail Tie-in Objective

• A/R totals must agree with:

• Master file

• General ledger

• Procedure: Reconcile aged trial balance with control account

2. Existence Objective

• Recorded receivables actually exist

• Procedure: Confirmation of accounts receivable

3. Completeness Objective

• All receivables are recorded

• Procedure: Reconcile subsidiary ledger with control account

Hard to detect omissions through confirmations alone

4. Accuracy Objective

• Amounts are correct

• Procedure: Confirmation

• If no response → use alternative procedures:

• Sales invoices
• Shipping documents
• Cash receipts
5. Classification Objective

• Proper classification:

• Trade vs non-trade

• Current vs non-current

• Notes vs accounts receivable

6. Cutoff Objective

• Transactions recorded in correct period

• Errors cause overstatement or understatement

7. Realizable Value Objective

• Receivables shown at amount expected to be collected

• Procedures include:
• Review allowance for doubtful accounts
• Discussion with credit manager
• Review past write-offs
• Examine correspondence files

8. Rights and Obligations Objective

• Company actually owns the receivables

• Procedures:
• Review board minutes
• Confirm with banks
• Examine debt contracts
9. Presentation and Disclosure Objective

• Proper disclosure according to accounting standards

• Includes:

• Revenue recognition policy

• Related-party receivables

• Segregation of significant balances

H. Confirmation of Accounts Receivable

• A confirmation is a direct written response from a third party.

Purpose

• Existence

• Accuracy

• Cutoff

Auditing Standard Requirement

• Auditing standards require confirmation of A/R when practical

 2. Tests of details of A/Receivable

A. When Confirmation of Accounts Receivable Is NOT Appropriate

Auditing standards say confirmation may not be required in these cases:
i. Accounts receivable is immaterial
• The balance is too small to affect users’ decisions.
ii. Confirmation is ineffective
• Expected low response rate
• Excessive delay in receiving replies
iii. Internal control over sales & collections is strong
• Inherent risk is low
• Control risk is low
• Other substantive evidence is sufficient
• In such cases, auditors rely on alternative substantive procedures.
B. Confirmation Decisions
• Auditors must make four key decisions about confirmation.
1. Type of Confirmation (Which form to use?)
a) Positive Confirmation
• Customer must respond whether they agree or disagree
Forms:
• Blank confirmation
• Invoice-based confirmation
More reliable
• Non-response requires follow-up
• More costly
• Second requests
• Follow-ups needed
b) Negative Confirmation

• Customer responds only if they disagree

Less reliable

• No response may mean:

• Agreement, or

• Customer ignored it

Less costly

• No follow-ups required
2. Timing Decision (When to send confirmations?)

Confirmations can be sent:

• At interim date, or

• Close to balance sheet date

Reliability

• Confirmations sent closer to year-end are more reliable

• Interim confirmations require roll-forward procedures

3. Sample Size Decision (How Many Accounts to Confirm?)

• When an auditor plans to send confirmations to customers, one important question is how
many accounts should be selected.
The number of accounts (sample size) is not chosen randomly; it is influenced by several audit
considerations.

• Factors Affecting Sample Size

i) Tolerable Misstatement

• This is the maximum error in accounts receivable that the auditor is willing to accept without
changing the audit opinion.

• Lower tolerable misstatement → Larger sample size

• Higher tolerable misstatement → Smaller sample size

If the auditor wants very accurate results, more accounts must be tested.
ii) Inherent Risk

• Inherent risk is the possibility that errors exist in accounts receivable before considering internal
controls.

• Lower inherent risk → Smaller sample size

• Higher inherent risk → Larger sample size

• If the nature of the business makes errors more likely, the auditor increases testing.

iii) Control Risk

• Control risk refers to the chance that the client’s internal control system will fail to prevent or detect
errors.

• Lower control risk (strong controls) → Smaller sample size

• Higher control risk (weak controls) → Larger sample size

• When controls are reliable, the auditor can test fewer accounts.
iv) Detection Risk from Other Substantive Tests

• Detection risk is the risk that audit procedures will not find existing misstatements.

• Lower achieved detection risk from other tests → Smaller sample size

• Higher detection risk → Larger sample size

• If other audit evidence is strong, fewer confirmations are needed.

v) Type of Confirmation

• The method of confirmation also affects how many accounts must be selected.

• Negative confirmation → Larger sample size required

(Because customers respond only if they disagree, so evidence is weaker.)

• Positive confirmation → Smaller sample size

(Customers must reply whether they agree or disagree, so evidence is stronger.)
4. Selection of Items for Confirmation

Auditors stratify accounts receivable based on:

• Size of balance

• Age of account

Selection Approach

• Larger balances → higher risk → selected first

• Older balances → higher chance of misstatement

• Smaller accounts → still included to ensure coverage

 Analysis of Differences in Confirmation Replies
• When confirmed balances do not agree with client records, auditors investigate.
Common Causes of Differences
1. Payment already made
• Customer paid before confirmation date
• Client failed to record receipt
• Auditor checks for:
• Cash theft
• Lapping
• Cutoff errors
2. Goods not yet received
• Goods in transit
• Client records sale at shipment date
• Customer records purchase upon receipt
3. Goods returned
• Client failed to record credit memo
• Indicates weakness in recording sales returns & allowances
Documentation Requirements for Accounts Receivable

• Audit working papers must include evidence of:

• Tests of allowance for doubtful accounts

• Inquiries about receivables:

• Sold

• Pledged

• Assigned

• Cutoff testing

• Roll-forward procedures (if confirmations sent at interim)

Basic Substantive Procedures for A/R

Auditors document evidence of:

• Substantive analytical procedures

• Unusual or abnormal sales transactions

• Understanding of revenue recognition policy

• Identification of specific items tested

• Results of tests of details

THE END