Chapter 12 - Audit of the Revenue Cycle

Question 1

What is the revenue cycle? When does it start and when does it end?

Answer 1

The revenue cycle involves the decisions and processes necessary for the transfer of the ownership of goods and services to customers after they are made available for sale.

It begins with a request by a customer (or a customer selecting and picking up a product) and ends with the conversion of material or service into an account receivable or cash.

Question 2

What are the 5 classes of transactions in the revenue cycle?

Answer 2

1. Sales
2. Cash receipts
3. Sales returns and allowances
4. Charge-off of uncollectible accounts
5. Bad-debt expense

Question 3

What are some preliminary analytical procedures that can be performed on the revenue cycle? What is the possible misstatement that could be identified?

Answer 3

• Evaluate the ratio of returns and allowances to sales (could indicate unusual sales arrangements)
• Compare bad debt expense as a percentage of gross sales with that of previous years (uncollectible A/R that have not been provided for)
• Compare number of days that A/R are outstanding with that of previous years (overstatement or understatement of allowance for uncollectible accounts and bad debt expense)

Question 4

What is the requirement of auditors for fraud risk related to revenues?

Answer 4

The auditor is required to presume that there are risks of fraud with respect to revenue recognition (overstatement of revenue) for all clients.

Question 5

What are the important accounts and assertions in the revenue cycle? (5)

Answer 5

1. Occurrence of revenue
2. Revenue cutoff
3. Sales returns and allowances cutoff
4. Existence of accounts receivable
5. Valuation of accounts receivable (in some cases)

Question 6

What are some examples of fraud schemes and what assertions to they impact?

Answer 6

• Fictitious revenues or sham sales (occurrence)
• Premature revenue recognition (occurrence and cutoff)
• Recording loans as sales (occurrence)

Question 7

What are some inherent risk factors affecting A/R and what assertions do they impact?

Answer 7

• Long-term receivables are classified as current (Classification)
• Receivables are pledged as collateral, assigned to someone else, factored, or sold (Rights and obligations)
• Sales are made to customers with high credit risk (Valuation)

Question 8

What are they key controls in the revenue cycle? Provide examples.

Answer 8

1. Segregation of duties (separate sales data from entry of cash receipts, separate credit limit approval from sales)
2. Proper authorization (approving credit prior to sales, approval of sale prices, terms, and changes)
3. Adequate documents and records (sequentially numbered documents)
4. Independent verification (matching of orders to shipments to invoices)

Question 9

Describe the importance of the DIRECTION of tests for the occurrence and completeness assertions for revenue.

Answer 9

When tracing from source shipping documents to the journals, the purpose of the test is for omitted transactions (completeness).

In contrast, when vouching from the journals back to supporting documents, the purpose is to test for nonexistent transactions (occurrence).

Question 10

What 3 potential misstatements is the auditor concerned about when designing tests for OCCURRENCE of revenues?

Answer 10

• Sales being included in journals for which no shipment was made
• Sales recorded more than once (duplicates)
• Shipments made to nonexistent customers and recorded as sales (fictitious sales).

Question 11

What is a positive confirmation?

Answer 11

A letter, addressed to the debtor, requesting that the recipient indicate directly on the letter whether the stated account balance is correct or incorrect and, if incorrect, by what amount.

Question 12

What is a negative confirmation?

Answer 12

A letter, addressed to the debtor, requesting a response only if the recipient disagrees with the amount of the stated account balance

Question 13

List the five categories of transactions. For each category, describe how the completeness audit objective would apply to the transaction.

Answer 13

1. Sales: Are all sales recorded?
2. Cash receipts: Is all received cash recorded?
3. Sales returns and allowances: Are sales returns and allowances recorded and matched to the appropriate sales?
4. Write-offs of uncollectible accounts: Are such write-offs recorded for all accounts that are no longer collectable?
5. Bad-debt expense: Does bad-debt expense cover all accounts that are no longer considered to be collectable?

Question 14

Why is occurrence a high-risk assertion for revenue?

Answer 14

In general, this is an assertion that has a high risk because the common frauds occur related to revenue recognition. It is generally related to organizations with complex revenue contracts where there is judgment involved with regards to revenue recognition.

Question 15

Why is accounts receivable often an important account to audit?

Answer 15

Accounts receivable is typically one of the largest accounts on the balance sheet if a company sells goods on credit.

Question 16

Why is valuation a high-risk assertion for accounts receivable?

Answer 16

Judgments are involved in valuing the collectability of accounts receivable, which makes this assertion more prone to error. Also, if management chooses to engage in revenue manipulation, one way to do so is by manipulating the bad-debts allowance.

Question 17

Which balance-related audit objectives are not affected by control risk for classes of transactions? Why?

Answer 17

Valuation and rights and obligations. Sales transactions are tested throughout the year, whereas these three assertions are normally tested only at the end of the year or for the balances shown on the financial statements under audit.

Question 18

What is the major risk for sales returns?

Answer 18

Sales returns could occur after the year-end and be recorded in the incorrect period, resulting in overstatement of sales for the period under audit.

Question 19

Why is completeness a risk for cash receipts?

Answer 19

Cash could be stolen and not recorded in the accounts.

Question 20

How are uncollectible accounts related to fraud risks?

Answer 20

Unauthorized write-offs of uncollectible accounts could be used to conceal theft of cash.

Question 21

When deciding upon which controls to test, the auditor considers cost-effectiveness. Which types of controls are likely the least costly to test? Justify your response.

Answer 21

Programmed controls are often least costly to test, as the auditor needs to test only a few transactions to ensure that the programs are functioning as designed.

Question 22

A company’s sales have declined, while the bad-debt expense and accounts receivable have increased. What do these changes tell you?

Answer 22

(1) Customers are not paying as well as they have in the past, or (2) accounts receivable and bad debts are overstated.

Question 23

ABC Co. has about 300 accounts receivable balances from a variety of businesses, ranging in size from about $500 to $250,000. What types of confirmations would be sent? Justify your response.

Answer 23

Positive confirmations would be used because the individual balances are relatively high in amount, and there are a limited number of accounts.