10-1

Chapter Ten
Auditing the Revenue
Process

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 10-2

Revenue Recognition

Revenue is defined as inflows or other enhancements

of assets of an entity or settlements of its liabilities (or
a combination of both) from delivery or producing
goods, rendering services, or other activities that
constitute the entitys major or central operations.

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 10-3

Overview of the Revenue Process

Cash Sale Credit Sale

Cash
Purchases collection Purchases

Inventory
Cash Account
sales receivable

Inventory
Credit sales

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 10-4

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.

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 10-5

Types of Transactions and Financial

Statement Accounts Affected
The revenue process affects numerous accounts in the
financial statements. The most significant accounts are:
Type of Transaction Account Affected
Sales transactions Trade accounts receivable
Sales
Allowance for uncollectible accounts
Bad-debt expense
Cash receipts transactions Cash
Trade accounts receivable
Cash discounts
Sales return and allowance Sales returns
transactions Sales allowances
Trade accounts receivable

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 10-6

Revenue Process EarthWear Clothiers

Order Entry Department
By mail
or fax

Customer
sales order
A

By phone To the IT Department

Input
or internet

Error A
Correction If a new customer, a credit check
is run by the Credit Department.
Otherwise, credit is checked by IT
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 10-7

Revenue Process EarthWear Clothiers

IT Department
Customer Inventory
Price Open
Inventory orders Open
orders

From order entry Data validation Batched Shipping

department program nightly program

To order entry Error

department Report

To shipping
department
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 10-8

Revenue Process EarthWear Clothiers

Shipping Department

From shipping Approved The shipping ticket forwarded to

department shipping ticket the customer contains quantity
and price of each item purchased.

Ship goods

Approved
shipping ticket
Input to the billing program

To customer A
with goods

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 10-9

Revenue Process EarthWare Clothiers

IT Department

A weekly open order report is prepared

Open and reviewed by billing department.
orders Outstanding orders are investigated.

Shipping
transactions Inventory

Billing Accounts receivable

A
program update

Sales For receivables

Invoice processing

Customer B
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 10-10

Revenue Process EarthWear Clothiers

IT Department
Accounts receivable

Shipping Remittance
transactions Sales transactions

Accounts receivable Weekly or Accounts receivable

B
update Monthly reporting

D
Daily shipping Daily sales Daily remittance
listing report report
To cash receipts
department
To sales department C
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 10-11

Revenue Process EarthWear Clothiers

IT Department
Accounts receivable

Remittance transactions

Shipping transactions General ledger

Reports
Sales journal
Accounts receivable Weekly or Cash receipts journal
D reporting Monthly Aged trial balance
Sales summary
Remittance summary
Journal entry summary
Customer statements

Customer

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 10-12

Revenue Process EarthWear Clothiers

Cash Receipts Department IT Department
From bank

Remittance Remittance
advice Accounts advice
transactions receivable transactions

Error
correction
Cash
remittance B
C update

Daily remittance Error

From bank
report report

Remittance Reconciled by cash

advice listing receipts clerks
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 10-13

Types of Documents and Records

Customer Sales Order

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

Credit Approval Form

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

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 10-14

Types of Documents and Records

Open-Order Report
A report of all customer orders for which processing
has not been completed.

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.

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 10-15

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 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.

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 10-16

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.

Accounts Receivable Subsidiary Ledger

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

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 10-17

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.

Remittance Advice
This is usually the part of the customers bill that
should be returned with the payment.

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 10-18

Types of Documents and Records

Cash Receipts Journal

This journal is used to record the cash receipts of the
entity.

Credit Memorandum
This document is used to record credits for the return
of goods by a customer.

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 10-19

Types of Documents and Records

Write-Off Authorization
This document authorizes
Order Entry
the write-off of an
uncollectible account The initial function in the
receivable. Final revenue process is the entry
authorization is generally of a new sales order into the
received from the treasurer. system.

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 10-20

Types of Documents and Records

Credit Authorization
Shipping
The credit authorization
process must determine that Goods should not be
the customer is able to pay shipped, nor should services
for the goods or services be provided without proper
purchased. Failure to authorization. The main
properly authorize credit can control is payment or proper
lead to extensive bad debts credit authorization.
for the entity.

Billing
The objective of proper billing is to ensure that all goods
shipped and all services rendered are billed to the customer.
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 10-21

Types of Documents and Records

Cash Receipts Accounts Receivable
All cash collected must be All billings, adjustments, and
properly identified and cash collections must be
promptly deposited intact at properly recorded in the
the bank. 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.
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 10-22

Key Segregation of Duties

Segregation of Duties for Revenue and Accounts

Receivable Functions by Department
Department
Order Accounts Cash
Revenue and Accounts Receivable Entry Credit Shipping Receivable Receipts IT
Receiving and preparing customer order X
Approving credit X
Shipping goods to customer X
Preparing customer invoice X X
Updating accounts receivable records for sales X X
Receiving customer's remittance X
Updating accounts receivable for remittance X X
Preparing accounts receivable aged trial balance X X

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 10-23

Inherent Risk Assessment

The four inherent risk factors that may affect the

revenue process are:
1. Industry-related factors.
2. The complexity and contentiousness of revenue
recognition issues.
3. The difficulty of auditing transactions and account
balances.
4. Misstatements detected in prior audits.

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 10-24

Control Risk Assessment

Understanding and documenting the revenue

process based on a reliance approach.

Planning and performing tests of controls on

revenue transactions.

Setting and documenting the control risk for the

revenue process.

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 10-25

Understanding and Documenting Internal

Control

Control Environment
Understanding the control environment is generally
completed on an overall entity basis.

The Entitys 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.

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 10-26

Understanding and Documenting Internal

Control
Control Procedures
The auditor identifies what controls ensure that the
assertions for transactions and events are being met.
Documentation of the auditors understanding of the
revenue process can be accomplished by using:

Procedures Narrative Internal control

Flowcharts
manuals descriptions questionnaires

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 10-27

Information Systems and Communication

Process by which sales, The flow of each

cash receipts, and credit transaction from initiation
memoranda are initiated. to inclusion in the financial
statements.

Auditors
knowledge

Accounting records,
supporting documents, and The process used to
accounts that are involved in prepare estimates for bad
sales, cash receipts, and sales debts and sales returns.
returns.

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 10-28

Monitoring of Controls

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 entitys IT function.

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 10-29

Planning and Performing Tests of

Controls

The auditor systematically examines the clients revenue

process to identify relevant controls that help to prevent,
or detect and correct material misstatements.

Inquiry of client personnel.

In order to properly
set control risk the Inspection of documents and records.
auditor must test
controls over the Observations of the operation of the control.
revenue process.
Such tests may Walkthroughs.
include . . . Reperformance of the control procedures.
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 10-30

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.

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 10-31

Control Procedures and Tests of Controls

Revenue Transactions
Assertions about Classes of Transactions and Events for
the Period under Audit
All revenue and cash receipt transactions and events
Occurrence that have been recorded have occurred and pertain to
the entity.

Completeness
All revenue and cash receipt transactions and events
that should have been recorded have been recorded.
All revenue and cash receipts transactions and events
Authorization
are properly authorized.
Amounts and other data relating to recorded revenue
Accuracy and cash receipt transactions and events have been
recorded appropriately.

Cutoff All revenue and cash receipt transactions and events

have been recorded in the correct accounting period.
All revenue and cash receipt transactions and events
Classification
have been recorded in the proper accounts.
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 10-32

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.

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 10-33

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.

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.

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 10-34

Authorization of Revenue Transactions

Possible misstatements due to improper authorization

include shipping goods to or performing services for
customers who are bad credit risks and making sales at
unauthorized prices or terms.

Test policies and procedures

relating to authorization of
revenue transactions.

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 10-35

Accuracy of Revenue Transactions

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.

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 10-36

Cutoff 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 daily.

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 10-37

Classification of Revenue Transactions

The use of a chart of accounts and proper

codes for recording transactions should
provide adequate assurance about the proper
classification of revenue transactions.

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 10-38

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 clients bank account.

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 10-39

Completeness of Cash Receipts

Transactions
A major misstatement is that cash or checks
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 completeness.

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 10-40

Authorization of Cash Discounts

Terms of trade generally include discounts for

payment within a specified period as a way of
encouraging customers to pay on time.

2/10, n/30

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 10-41

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.

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 10-42

Cutoff of Cash Receipts Transactions

If the client uses 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.

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 10-43

Classification of Cash Receipts

The auditor seldom has major concerns about

cash receipts being recorded in the wrong
financial statement account.

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 10-44

Control Procedures 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 properly authorized.

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 10-45

Relating the Assessed Level of Control

Risk to Substantive Procedures
The auditors testing of control for revenue
processing impacts the detection risk and
therefore the level of substantive procedures
impacted by the controls.

Accounts
Cash
receivable
Allowance
Bad debts
for bad
expense
debts
Sales returns
and
allowances

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 10-46

Auditing 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.

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 10-47

Substantive Analytical Procedures

Ratios used for comparative purposes include:
1. Receivables turnover and days outstanding in
accounts receivable.
2. Aging categories on aged trial balance of accounts
receivable.
3. Bad-debts expense as a percent of revenue.
4. Allowance for uncollectible accounts as a percent
of accounts receivable or credit sales.
5. Large account balances compared to last period.

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 10-48

Tests of Details of Transactions, Account

Balances, and Disclosure
For Accounts Receivable, Allowance for Uncollectible
Accounts, and Bad-Debt Expense
A sample of transactions from the sales journal should
Occurrence be traced to the sales invoice, customer order, and
shipping document.
A sample of shipping documents should be traced to
Completeness
related sales invoice and customer's account.
Authorization Compare prices and terms for sample of sales
and Accuracy invoices with authorized price list.

Cutoff From a sample, compare date of sales invoice with

date of shipment and date sale was recorded.
Classification
For a sample of sales invoices, determine that each is
properly classified in the revenue accounts.
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 10-49

Completeness

The auditors primary concern is whether all

accounts receivable have been included in the
accounts receivable subsidiary ledger and the
general ledger accounts receivable account.

Reconciliation of the aged

trial balance to the general
ledger account should
detect an omission of a
receivable from either the
subsidiary or general ledger.

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 10-50

Cutoff
The cutoff test attempts to determine whether all
revenue transactions and related accounts
receivable are recorded in the proper period.
12/31/06

Test a few shipping Test a few shipping

documents just prior documents just after
to year-end. year-end.

Are all transactions tested

recorded in the proper period?
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 10-51

Rights and Obligations

The auditor must determine that all accounts

receivables are owned by the entity. This is usually
not a problem, however, in some cases, accounts
receivable may be sold or factored with or without
recourse.

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 10-52

Valuation and Allocation

Accounts receivable should be shown on the

balance sheet at net realizable value (gross amount
less allowance for uncollectible accounts).

The auditor must verify the adequacy

of the allowance for uncollectible
accounts. The first step is to prepare an
aged trial balance and discuss results
with the credit manager. Next, a
comparison with last years results
should be examined.

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 10-53

Classification and Understandability

The major issues related to presentation,

disclosure, and classification are:
1. Identifying and reclassifying any material credits
contained in accounts receivable.
2. Segregating short-term and long-term
receivables.
3. Ensuring that different types of receivables are
properly classified.

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 10-54

The Confirmation Process Accounts

Receivables
Confirmation is the process of obtaining
information from third parties about the account
receivable balance. Confirmation is a good source
of evidence about the validity of the account
receivable. The confirmation process should be
controlled by the auditor.

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 10-55

Types of Confirmations

Positive Confirmation Negative Confirmation

Requests that customers Requests that the

indicate whether they customer respond only
agree with the amount when they disagree with
due to the client. A the amount due to the
response is expected client. Negative
whether the customer confirmations are used
agrees or disagrees with when the client has many
the balance indicated. small account balances
and control risk is
assessed as low.

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 10-56

Timing

Accounts receivable may be confirmed at an interim

date or at year-end. The confirmation request
should be sent soon after the end of the accounting
period in order to maximize the response rate.

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 10-57

Confirmation Procedures

The auditor should mail the confirmation requests

outside the clients facilities. A record should be
maintained of the confirmations mailed and those
returned. A second request may be necessary in
some cases.
For each exception received, the
auditor should examine the reasons for
the difference between the balance on
the clients books and the balance
indicated by the customer.

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 10-58

Alternative Procedures

When the auditor does not receive responses

to positive confirmations, alternative audit
procedures are used. These alternative
procedures include:
1. Examination of subsequent cash receipts.
2. Examination of customer orders, shipping documents,
and duplicate sales invoices.
3. Examination of other client documentation.

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 10-59

Evaluating the Audit Findings

When the auditor has completed the planned
substantive procedures, the likely misstatement
(projected misstatement plus an allowance for
sampling risk) for accounts receivable is determined.
Likely misstatement Likely misstatement
less than tolerable greater than tolerable
misstatement misstatement

Accept the account Account is not fairly

as fairly presented presented.

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 10-60

End of Chapter 10

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