Chapter 9 [Auditing the Revenue Cycle]

Question 1

Procedures used to obtain evidence about the existence and valuation of accounts receivable when a positive confirmation is not returned, including examining cash collected after the confirmation date and vouching unpaid invoices to customers’ orders, sales orders, shipping documents, and sales invoices.

Answer 1

Alternative procedures

Question 2

High volume, high velocity, and/or high variety information assets that require new forms of processing to enable enhanced decision making, insight discovery, and process optimization.

Answer 2

Big data

Question 3

A shipping document that describes items being shipped, the shipping terms, and delivery address; a formal legal document that conveys responsibility for the safety and shipment of items to the shipper.

Answer 3

Bill of lading

Question 4

The process of transforming all of the raw data that companies (providers) collect from their various operations into actionable information.

Answer 4

Business intelligence

Question 5

The risk that the seller will be unable to collect the entitled contractual consideration from the customer.

Answer 5

Collectability

Question 6

Differences between a customer’s records and the client’s records reported on positive or negative confirmations.

Answer 6

Exceptions

Question 7

A situation in which the respondent to a confirmation request (in this chapter, an accounts receivable confirmation) responds inaccurately to the audit firm with respect to the information on the confirmation.

Answer 7

False confirmation

Question 8

Quantifiable measures that decision makers can use to evaluate the success of an organization, unit, employee, or account as they seek to meet performance objectives.

Answer 8

Key performance indicators

Question 9

A technique used to cover up the embezzlement of cash whereby a cash collection from one customer is stolen by an employee who takes another customer’s payment and credits the first customer. This process continues, and at any point in time at least one customer’s account is overstated.

Answer 9

Lapping

Question 10

A request to customers asking them to respond directly to the auditor only if they disagree with the indicated balance.

Answer 10

Negative confirmation

Question 11

A request to customers asking them to respond directly to the auditor if they agree or disagree with the indicated balance.

Answer 11

Positive confirmation

Question 12

Equals beginning period reoccurring revenue minus end-of period reoccurring revenue, less any new revenue gained, divided by beginning period revenue. In simpler terms, ____________ helps organization determine the relative extent to which they are losing versus gaining customers.

Answer 12

Revenue attrition

Question 13

The process of receiving a customer’s order, approving credit for a sale, determining whether the goods are available for shipment, shipping the goods, billing the customers, collecting cash, and recognizing the effect of this process on other related accounts.

Answer 13

Revenue cycle

Question 14

An agreement containing contract terms that are not part of the formal contract (often involving rights of return). ________________ increase audit risk because they enable key contract terms affecting revenue recognition to be hidden from the auditor as part of a revenue recognition fraud.

Answer 14

Side letter

Question 15

Confirmation exceptions caused by transactions that are in process at the confirmation date, such as in-transit shipments or payments. These are not misstatements.

Answer 15

Timing differences

Question 16

(T/F) The revenue cycle involves receiving a customer’s order, approving credit for a sale, determining whether the goods are available for shipment, shipping the goods, billing the customer, collecting cash, and recognizing the effect of this process on revenue and other related accounts such as accounts receivable, inventory, and sales commission expense.

Answer 16

TRUE

Question 17

(T/F) In the revenue cycle, the most significant accounts typically include revenue and accounts receivable.

Answer 17

TRUE

Question 18

Which of the following statements is true regarding
assertions in the revenue cycle?

a. It is typical that all five assertions for revenue are
equally important.
b. If a client has an incentive to overstate revenues, the
existence assertion would be more relevant than the completeness assertion.
c. Audit evidence about the existence of revenues is also
the most appropriate evidence about the valuation of
receivables.
d. The allowance for doubtful accounts has important
implications for the ownership assertion of accounts
receivable.

Answer 18

B

Question 19

Which of the following statements is true regarding the
processing and recording of revenue transactions?

a. The accurate recording of revenue transactions is
important for preparing financial statements, but not
important for the client’s management decisions.
b. Invoices should be prepared once the client determines
that the goods ordered by a customer are available.
c. A bill of lading provides documentation that the customer has received the goods.
d. Sales transactions typically begin with the receipt of a
purchase order from a customer.

Answer 19

D

Question 20

(T/F) Channel stuffing is a fraud in the revenue cycle that
involves recording revenue after a customer has requested to purchase the inventory.

Answer 20

FALSE

Channel-stuffing is a means of inflating a company’s revenues or sales immediately prior to a reporting period, such as the end of a fiscal quarter or the fiscal year. It’s done to make it appear that the company’s financial performance is healthier than, in fact, it is.

Question 21

(T/F) If the contract stipulates more than one deliverable,
the client must allocate a separate price to each deliverable.

Answer 21

TRUE

Question 22

Under the FASB’s guidance on revenue recognition, which
of the following is not a criteria that must be met in order
for a contract to exist?

a. The parties have approved it.
b. The auditor has ensured that the contract’s valuation is reasonable in all material respects.
c. The goods and/or services involved are clearly identified.
d. The payment terms are spelled out.
e. There is commercial value to the contract

Answer 22

B

Question 23

Which of the following statements is false regarding the
fraud at ArthroCare?

a. Two of ArthroCare’s sales executives overstated ending inventory that improperly inflated company revenue and earnings.
b. PricewaterhouseCoopers’ audit was deficient for ArthroCare, thereby enabling the fraud to go undetected for a period of time.
c. ArthroCare agreed to pay a $30 million fine to resolve the investigation.
d. ArthroCare is a manufacturer of medical devices, based in Austin, Texas, whose shares are traded on NASDAQ.

Answer 23

A

Two of ArthroCare’s sales executives understated ending inventory that improperly inflated company revenue and earnings.

Question 24

(T/F) Research indicates that a majority of financial statement frauds involve inappropriate recording of revenue.

Answer 24

TRUE

Question 25

(T/F) When assessing fraud risks, the auditor should consider the client’s motivation to increase revenue due to both internal and external pressures.

Answer 25

TRUE

Question 26

Which of the following factors is not a motivation for
clients to fraudulently misstate revenue?

a. Bankruptcy may be imminent.
b. Management bonuses are contingent on a certain revenue goal.
c. Controls over revenue process are ineffective.
d. Management wants to meet publicly announced earnings expectations.

Answer 26

C

Question 27

Which of the following explanations best describes the
purpose of lapping?

a. Lapping is a technique used by client personnel to cover up the embezzlement of cash.
b. Lapping is an approach used by client personnel to eliminate differences between a customer’s records and the client’s records reported on confirmations.
c. Lapping is a procedure used by the auditor to obtain evidence the client’s customer does return a positive confirmation.
d. Lapping is an agreement containing contract terms that are not part of a formal sales contract.

Answer 27

A

Question 28

(T/F) It is not possible for internal controls to mitigate risks
associated with the valuation of accounts receivable.

Answer 28

FALSE

Question 29

(T/F) Diageo made improper cash payments to government officials in Mexico, Brazil, and Argentina during the period 2003–2009, which violated provisions of the Foreign Corrupt Practices Act.

Answer 29

FALSE

Question 30

Which of the following procedures can organizations use
to address credit risk most effectively?

a. An informal credit policy, which may be automated for most transactions, but requires special approval for large and/or unusual transactions.
b. A periodic review of the credit policy by key executives to determine whether changes are dictated either by current economic events or by deterioration of the receivables.
c. Periodic monitoring of receivables for evidence of increased risk, such as increases in the number of days past due or an unusually high concentration in a few key customers whose financial prospects are declining
d. Adequate segregation of duties over fixed assets, with specific authorization to write off fixed assets that have been fully depreciated.

Answer 30

B

Question 31

Which of the following statements about the Medicis fraud is false?

a. In 2012, the PCAOB settled a disciplinary order censuring Ernst & Young (EY), imposing a $2 million penalty against the firm and sanctioning four of its current and former partners.
b. The PCAOB found that EY and its partners failed to properly evaluate a material component of the company’s financial statements—its allowance for doubtful accounts.
c. EY did not properly evaluate Medicis’ practice of reserving for most of its estimated product returns at replacement cost, instead of at gross sales price. It appears that EY accepted the company’s basis for reserving at replacement cost, when the auditors should have known that this approach would not be supported by the audit evidence.
d. The PCAOB investigation revealed that by using replacement cost for the reserve, rather than gross sales price, Medicis’ reported sales returns reserve were materially understated and its reported revenue was materially overstated.
e. All of the above are true.

Answer 31

B

The PCAOB found that EY and its partners failed to properly evaluate a material component of the company’s financial statements—its estimated product returns.

Question 32

(T/F) The auditor might conclude that a heightened risk of
fraud exists if the planning analytical procedures indicate
increases in revenue and net income, but negative cash flow from operations.

Answer 32

TRUE

Question 33

(T/F) When performing planning analytical procedures, the
auditor could perform trend analysis with ratios, but not with account balances.

Answer 33

FALSE

Question 34

Which of the following statements is false regarding planning analytical procedures in the revenue cycle?

a. As revenue is typically regarded as a high-risk account, planning analytical procedures related to revenue are not required.
b. The first step in planning analytical procedures includes developing an expectation of recorded amounts or ratios, and evaluating whether that expectation is precise enough to accomplish the relevant objective.
c. Trend analysis would not be appropriate as a planning analytical procedure in the revenue cycle.
d. All of the above statements are false

Answer 34

D

Question 35

Assume that an auditor expected that the client’s activities related to sales and accounts receivable would be similar to industry averages. Which of the following relationships detected as part of planning analytical procedures would not suggest a heightened risk of material misstatement in the revenue cycle?

a. The number of days’ sales in accounts receivable decreased from 65 days in the prior year to 47 days in the current year. The industry average increased from 45 to 47 days.
b. The gross margin increased from 16.7% to 18.3%, while the industry average changed from 16.7% to 16.3%.
c. Accounts receivable increased 35% over the prior year, while sales stayed relatively stable.
d. All of the above relationships are suggestive of a heightened risk of fraud.

Answer 35

A

Question 36

(T/F) Responding to identified risks in the revenue cycle rarely involves developing an audit approach that contains substantive procedures (e.g., tests of details and, when appropriate, substantive analytical procedures).

Answer 36

FALSE

Question 37

(T/F) While audit firms may have a standardized audit program for the revenue cycle, the auditor should customize the audit program based on the assessment of risk of material misstatement.

Answer 37

TRUE

Question 38

After identifying the risks of material misstatement, the
auditor develops an audit plan in response to those risks. Which of the following plans for testing revenue would be most likely when the auditor believes that control risk is high?

a. The only evidence the auditor plans to obtain is from tests of details.
b. The auditor plans to obtain 40% of the necessary audit evidence from tests of controls, and the remaining 60% from substantive analytical procedures.
c. The auditor plans to obtain the majority of the necessary audit evidence from tests of controls.
d. Any of the above would be an appropriate audit plan if the auditor believes that control risk is high.

Answer 38

A

Question 39

Responding to identified risks involves developing an audit approach that addresses those risks. Which of the following statements about the planned audit approach is true for the revenue cycle?

a. The audit approach needs to include tests of controls, substantive analytical procedures, and tests of details.
b. The audit approach will typically require more evidence for higher risk assertions than lower risk areas.
c. The audit approach should follow the audit firm’s standardized audit program.
d. The sufficiency and appropriateness of selected procedures will not vary across assertions.

Answer 39

B

Question 40

(T/F) In testing controls over whether sales are properly valued, the auditor could take a sample of recorded sales invoices and agree the price on the invoice to an authorized
price list.

Answer 40

TRUE

Question 41

(T/F) Surprisingly, AmTrust’s restatement was followed by a
stock price increase, likely because investors inferred that
by revealing the restatement the company could move
forward with confidence.

Answer 41

FALSE

Question 42

When auditing a nonpublic company, the auditor would
generally make a decision not to test the operating effectiveness of controls in which of the following situations?

a. The preliminary assessment of control risk is high.
b. It is more cost efficient to directly test ending account balances than to test controls.
c. The auditor believes that controls are designed effectively but are not operating as described.
d. All of the above are situations when the auditor would likely not test the operating effectiveness of controls.

Answer 42

D

Question 43

An auditor performs tests of controls in the revenue cycle. First, the auditor makes inquiries of company personnel
about credit-granting policies. The auditor then selects a
sample of sales transactions recorded in the general ledger
and examines documentary evidence of credit approval.
Which of the financial statement assertion(s) does this test
of controls most likely support?

a. Completeness; Valuation or Allocation
b. Valuation or Allocation
c. Completeness
d. None of the above

Answer 43

B

Question 44

(T/F) Auditors in practice commonly use negative confirmations.

Answer 44

FALSE

Question 45

(T/F) A substantive audit procedure that would reveal ownership and related disclosure issues includes scanning the cash receipts journal for relatively large inflows of cash
that from unusual sources.

Answer 45

TRUE

Question 46

To test the completeness of sales, the auditor would select a sample of transactions from which of the following populations?

a. Customer order file.
b. Open invoice file.
c. Bill of lading file.
d. Sales invoice file.

Answer 46

C

Question 47

The auditor is concerned that the client has recorded fictitious sales. Which of the following procedures would
be the best audit procedure to identify fictitious sales?

a. Select a sample of recorded sales invoices and trace to shipping documents (bills of lading and packing slips) to verify shipment of goods.
b. Select a sample of shipping documents (bills of lading) and trace to the sales invoice to determine whether the invoice was properly recorded.
c. Select a sample of customer purchase orders and trace through to the generation of a sales invoice.
d. Select a sample of customer purchase orders to determine whether a valid customer actually exists.

Answer 47

A