Ch 7 Flashcards
Inherent risk
Risk that material misstatement enters the financial reporting
process
What does the audit risk model allow auditors to do?
Allows auditors to control audit risk to desired levels
3 steps to use audit risk model to plan engagement
1 set audit risk at desired levels (normal, low)
2 assess risk of material misstatement
3 determine detection risk based on level of audit risk and risk
Of material misstatement
How is risk of material misstatement assessed in the 2nd step of the audit risk model? 2 things
1 incorporates inherent risk based on nature of account balance Or class of significant transactions
2 incorporates control risk based on gaining understanding of
Internal control
AU 240
Requires consideration of revenue as fraud risk
And documentation if revenue is not a fraud risk
The components of audit risk model are assessed for each individual…
Relevant assertion
Existence assertion is important for…
Accounts receivable
The occurrence assertion is important for…
Sales
If audit team members estimate that control risk may be below the maximum risk, they need to…
Perform tests of controls to confirm control activities are operating
Effectively
And auditors initial strategy is sound
If the tests of controls reveal that control risk is higher than originally estimated, the audit team would…
Decrease detection risk and modify nature, timing and extent of further audit testing
Management may overstate both sales and receivables by adding fictitious transactions or inflating actual sales. This can be done by holding books open past the end of the period. There is no advantage to omitting sales or receivables transactions.
Which of the 5 transaction assertions, have high risk, medium risk or low risk for revenues and receivables?
High: Occurrence, cutoff, accuracy
Medium: classification
Low: completeness
Management may overstate balance in both sales and receivables by including fictitious transactions or inflating transaction values. Therefore, the risk of overstated balances in both sales and receivables is high. Management can include sales or receivables for which it does not have rights to collect (ex. Remaining performance). Omitting existing sales or receivables from account balances provides no advantage.
Which of the 4 balance assertions, have high risk, medium-high risk or low risk for revenues and receivables?
High: existence, valuation/allocation
Medium-high: rights and obligations
Low: completeness
Frauds have occurred through misapplication of revenue recognition principles resulting in nonexistent and overvalued revenues and receivables or misclassification of items (ex unearned revenue as earned). Auditors must carefully review footnotes regarding revenues, receivables and returns and allowances.
Which of the 5 presentation and disclosure assertions, have high risk, medium risk, medium or low risk for revenues and receivables?
High: occurrence, accuracy/valuation allocations
Medium-high: rights and obligations
Medium: classification/understandability
Low: completeness
Revenue recognition
Recording revenues in entity’s books
2 requirements for revenues to be recognized
1 realized or realizable
2 earned
When are revenues considered to have been earned?
When entity has substantially accomplished what it must do to
Be entitled to benefits (represented by revenues)
SEC believes that revenue is generally realized or realizable and earned when all 4 criteria are met
1 persuasive evidence of arrangement exists
2 delivery has occurred or services have been rendered
3 seller’s price to buyer is fixed and determinable
4 collectability is reasonably ensured
In 2010, Revenue recognition was the number one cause for…
Financial restatements
What 4 kinds of companies have higher likelihood of inflating revenues?
1 with related party transactions
2 complex transactions
3 reciprocal transactions
4 developing companies valued by revenues
Collectibility of accounts receivable
Portions of accounts receivable will not be paid and must be
estimated in allowance for doubtful accounts
4 reasons estimation of the allowance for doubtful accounts can be subjective and difficult for the client and auditor
1 client changes products
2 client changes credit policies
3 client changes customer base
4 changing economic conditions
Customer returns and allowances, when are they difficult to estimate for auditors?
When clients have informal right or return agreements with
customers
Unknown to auditors
What 3 specific informal customer returns and allowances can be difficult to estimate?
1 rights of return
2 warranties
3 other potential obligations
4 basic activities in revenue and collection cycle?
1 receiving and processing customer orders (including credit
Approval)
2 delivering goods and services to customers
3 billing customers and accounting for A/R
4 collecting and depositing cash from customers
What are entity level controls of management in the revenue process? 2
1 management should have process for continually reviewing
revenue and comparing it to budgets and forecasts
2 management should constantly scrutinize total write offs of A/R,
Merchandise returns and timeliness of collections
Name physical controls over inventory and warehouses that include entity level controls
1 badges
2 restricting access to facilities
3 further restriction of access within facilities
Companies are directly linked to production schedules in their customers computer files :Electronic data interchange, for what purpose?
Ability to ship goods automatically as customer needs them
Customer orders, shipping documents and invoices should be in renumbered sequence so system can check the sequence and determine whether transactions have not been recorded.
What assertion is this checking?
2) or have been duplicated. What assertion is this checking?
Completeness assertion
2) occurrence assertion
Price list master file
Authorization in system where File continues product unit prices for billing customers
Persons who have power to alter file have power to authorize
Price changes and customer billings
Delivering goods and services to customers: proper authorization is important, what should employees performing each of these steps do?
Employees should sign transfer documents so they are held
Accountable
Bill of lading
Form that carrier signs to verify goods are shipped
Packing slip
Describes goods being shipped
Often included in shipment
When a delivery or shipment is complete, the system finishes the transaction by…
Filing a shipment record
And preparing the final invoice for the customer
How is the final invoice prepared for the customer recorded as?
Recorded as sales revenue and accounts receivable
Delivering goods and services to customers: Where does physical custody of inventory goods start?
2) what happens upon authorization of shipping order? 2 things
Starts in storeroom or warehouse where inventory is kept
2) a) custody us transferred to shipping department upon
authorization of shipping order
B) shipping order permits inventory clerk to release goods
To shipping department
Sales invoice
Bill sent to customer that indicates amount due
Any person who has the power to alter shipping transactions or change the invoice before it is mailed to the customer should not have any…
Authorization, custody or recording responsibilities
Access to accounts receivable records implies the power to alter them directly or enter transactions to alter them. Personnel with this oiler have a combination of…
Authorization and recording responsibility
It’s important to backup A/R records otherwise…
The customer is less likely to pay
How is reconciliation of accounts receivable accomplished? 3 things
1 preparing trial balance of A/R subsidiary ledger
2 adding it
3 comparing total with control account balance
Pending order master file
Sales transactions that were initiated but are not yet completed
Not recorded as sales so kept in pending order master file
Pending orders should be reviewed for evidence of the…
Completeness of recorded sales and accounts receivable
What are not considered good credit checks?
Credit checks based on dated or incomplete info
Price list master file, define
2 What must it be compared to for accuracy?
Computerized system that produces customer invoices
automatically
2 computer file can be compared to official price source for
Accuracy
Sales Detail (Journal) File, what do detailed sales entries include? 2 things
Shipping references and dates
Aged trial balance
Schedule that lists each individual receivable and indicates whether
It is current or past due and if past due for how long
The total should equal A/R and general ledger balance
Cash receipts journal
Contains all the detailed entries for cash deposits and credits
To various accounts
The cash receipts journal contains adjusting and correcting entries that can result from the bank reconciliations. Why are these entries important?
They might signal types of accounting errors or manipulations
That occur in the cash receipts listing
The best control over whether cash is received and recorded is…
The customer statements
Revenue and collection cycle: Control risk assessment is important because it governs the…
Nature, timing and extent of further testing that will be applied in the audit of account balances in revenue and collection cycle
6 important accounts included in control risk assessment for revenue and collection cycle?
1 cash in bank 2 A/R 3 allowance for doubtful accounts 4 bad debts expense 5 sales revenue 6 sales returns, allowances and discounts
Proper separation involves different people and different departments performing the sales and credit authorization; custody of goods and cash; record keeping for sales, receivables, inventory and cash receipts. Combinations of 2 or more of these responsibilities in 1 person, office or computerized system may lead to…
Errors or fraud
Control activity to prevent fraud/error: no sales order should be entered without a…
Customer order
Control activity to prevent fraud/error: a credit check code or manual signature should be…
Recorded for authorization
Control activity to prevent fraud/error: access to inventory and the shipping area should be…
Restricted to authorized persons
Control activity to prevent fraud/error: access to billing terminals and blank invoice forms should be…
Restricted to authorized personnel
Control activity to prevent fraud/error: accountants should be instructed to record sales and accounts receivable when…
All supporting documentation of shipment is in order
Control activity to prevent fraud/error: care should be taken to record sales and receivables as of the date the goods and services were…
Shipped and cash receipts on date payments were received
Control activity to prevent fraud/error: customer invoices should be compared with bills of lading and customer orders to determine that the customer is…4 things
1 sent the goods ordered
2 at proper location
3 at proper prices
4 and proper quantity being billed is same quantity shipped
Control activity to prevent fraud/error: pending order files should be reviewed frequently to avoid…
Failure to bill and record shipments
Error control log monitored by information systems supervisor
Ensures errors found in control activities are corrected
Information about a company’s controls is often gathered by completing…
An internal control questionnaire
What should auditors perform to verify they understand control activities?
A walk through
Walkthrough: revenue and collection cycle 7 things
1 following sale from initial customer order 2 through credit approval 3 billing 4 delivery of goods 5 entry in sales journal 6 entry in subsidiary A/R 7 collection and deposit of cash
5 actions for testing controls in revenue and collection cycle
1 vouching 2 tracing 3 observing 4 scanning 5 recalculating
If personnel at company aren’t performing their control activities effectively, what do auditors need to do?
Design substantive procedures to try to detect whether control
Failures have produced materially misstated account balances
Revenue and collection cycle: Occurrence
Sales and related events that have been recorded have occurred
And pertain to the entity
Revenue and collection cycle: Completeness
All sales and related events that should have been recorded
Have been recorded
Revenue and collection cycle: accuracy
Amounts and other data related to sales transactions and events
have been recorded properly
Revenue and collection cycle: cutoff
Sales and related events have been recorded in the correct
Period
Revenue and collection cycle: classification
Sales and related events have been recorded in proper accounts
Control activity: invoices supported by customer purchase orders. Bills of lading or other shipping documents exist for all invoices.
Test of control: check agreement of sales in sales detail file to invoices, supporting shipping documents, and customer purchase orders for customer name, product description, terms, dates and quantities.
What assertion is being tested?
Occurrence
Control activity: invoices, shipping documents, and sales orders are prenup reed and the numerical sequence is checked.
Test of control: scan documents for numerical sequence. Observe client checking sequence. Trace shipping document to recording in sales detail file.
What assertion is being tested?
Completeness
Control activity: credit sales are approved by credit department.
Test of control: examine invoice for credit approval
What assertion is being tested?
Accuracy
Control activity: prices used to prepare invoices are from authorized price schedule.
Test of control: compare prices to approved price listing
What assertion is being tested?
Accuracy
Control activity: date of shipping document is compared to invoice date.
Test of control: compare shipping date on shipping documents with sales invoice date. Check FOB terms.
What assertion is being tested?
Cutoff
Control activities: sales to subsidiaries and affiliates are classified as intercompany sakes and receivables. Credit sales are posted to customers’ individual accounts.
Test of controls: trace posting of intercompany sales, sales returns to sales
What assertion is being tested?
Classification
Control activity: recorded sales in sales revenue account file are supported by invoices.
Test of controls: vouch debits from A/R accounts to supporting sales invoices
What assertion is being tested?
Occurrence
Control activity: invoice quantities are compared to shipment and customer order quantities.
Test of control: observe client comparing shipping quantities. Examine evidence of client making comparison.
What assertion is being tested?
Accuracy
Control activity: overall comparisons of sales are made periodically by a statistical or product line analysis.
Test of control: examine evidence of client review and follow up of analytical sales data.
What assertion is being tested?
Completeness
Control activity: prices and mathematical accuracy are independently checked after invoice is prepared.
Test of control: recalculate price extensions and discounts. Examine evidence of client checking prices.
What assertion is being tested?
Accuracy
Dual direction testing, Involves selecting samples to obtain evidence about control over… 2 things
Completeness in one direction
And control over occurrence in the other direction.
Dual direction testing: completeness direction
Determines whether all transactions that occurred were recorded
(None omitted)
Dual direction testing: occurrence direction
Determines whether recorded transactions represent valid Economic events (actual sales)
When examining if the sale occurred, what order documents are vouched?
What order are they traced?
Vouched from sales invoice journal to shipping documents
Traced from Shipping documents to sales invoice journal
If control risk is assessed to be very low…
2) what does this result in?
The substantive procedures on account balances can be reduced
2) Resulting in audit efficiencies
Example of substantive procedures on account balances being reduced
A/R confirmations can be sent on a date prior to year end
And sample size can be small
Posting sales without shipping documents, charge customers wrong prices, record credits to customers without supporting documentation.
All of the above are examples of…
Weakness in controls
How can substantive procedures be designed to lower risk of failing to detect material misstatement in account balances?
Confirmation procedure must be scheduled for year end
Sample of customer accounts must be large
Substantive procedure: confirm a sample of accounts receivable and perform follow up procedures if necessary.
What assertion about an account balance is being tested?
Existence: accounts receivable exist
Substantive procedures: inquire whether any receivables have been sold or factored.
Review bank confirmations, loan agreements, and minutes if the board for indications of pledged, discounted, or assigned receivables.
What assertion about an account balance is being tested?
Rights and obligations: the entity holds or controls the rights to A/R
Substantive procedures: perform sales cutoff tests.
Include a sample of zero balance accounts in the confirmation process.
What assertion about an account balance is being tested?
Completeness: all receivables that should have been recorded are recorded.
Substantive procedures: obtain an aged trial balance of individual customer accounts and test the aging.
Compare current year write off experience to the prior year allowance for bad debts.
Examine cash receipts after the balance sheet date for collections on past due accounts.
What assertion about an account balance is being tested?
Valuation or allocation: receivables are included in financial
statements at appropriate amounts
Any resulting valuation adjustments are properly recorded
Substantive procedures: for large past due accounts, obtain financial statements or credit reports and discuss with the credit manager
Calculate an allowance estimate using prior relations if write-offs and sales, taking current economic events under consideration.
What assertion about account balances is being tested?
Valuation or allocation: receivables are included in financial
statements at appropriate amounts
Any resulting valuation adjustments are properly recorded
What 5 ratios are used to test reasonableness of data for the revenue and collection cycle and are compared to historical prices?
1 receivables turnover 2 days' sales in recievables 3 amount past due receivables 4 gross margin ratio 5 sales/assets ratios
In general, the use of confirmations for A/R is considered…
A required audit procedure by audit standards
If auditor decides not to confirm A/R, what is required to justify the auditor’s position?
Burden of proof is on the auditors
They should document justifications
3 reasons that could allow auditors to justify why they don’t confirm accounts receivable?
1 receivables aren’t material
2 confirmations would be ineffective/ unreliable from prior
experience
3 analytical procedures and other substantive procedures
Provide sufficient, competent evidence
Confirmations provide evidence of…
2) and to a limited extent…
Existence
2) valuation of A/R
Positive confirmation
Asks customer to respond whether the balance is correct or
Incorrect
Ex. Blank form (customers asked to fill it in themselves)
Negative confirmation
Ask customer for a response only if something is wrong with
Balance
Lack of a response in a negative confirmation is evidence of what?
Evidence that the account is fairly stated
Confirmations should normally be addressed to…
The customer’s accounts payables department
When a confirmation is performed at an interim date, the following 4 procedures should be considered
1 obtain summary of receivables transactions from interim date
To year end date and review unusual items
2 vouch elected sample of transactions from period
3 obtain year end trial balance of receivables, compare to interim
Trial balance, examine large variations
4 consider additional confirmations if balances significantly increased
3 alternative procedures when clients can’t return confirmations
Examine:
1 subsequent cash receipts
2 sales orders, invoices and shipping documents
3 correspondence files for past due items
A particularly effective test that is often done even if a confirmation exists is…
Examining subsequent cash receipts
The audit team must review accounts for collectibility and determine adequacy of the allowance for doubtful accounts in support of which assertion?
Valuation assertion
Sales cutoff tests
Tests that ensure that sales are recorded in proper period
Generally when they are shipped
An that cost of sales is recorded and removed from inventory
Factor
The action to sell accounts receivable to another party (the factor)
At a discount from face value
In order to receive cash immediately
2 Examples of sales cut off tests
1 Tracing shipping documents before and after year end to sales
Journal
2 Credit memos for returns after year end are vouched to receiving
Reports
2 Presentation disclosure requirements for revenue and collection cycle
1 amount of allowance for doubtful accounts
2 revenue recognition policies
Substantive procedures
Audit processes to gather evidence on the assertions in account
Balances
Dual purpose procedure
Audit procedure that simultaneously serves substantive purpose
And the test of controls purpose
Substantive purpose
Obtain direct evidence about dollar amounts in account balances
Test of controls purpose
Obtain evidence about the company’s performance of its
Own control activities
Bill and hold
Fraudulent financial reporting activity by which company recognizes
A sale even though it doesn’t ship merchandise to customer
But holds merchandise in its wear house
