Solution manual auditing and services 2e by louwers chap007

Chapter 07 - Revenue and Collection Cycle CHAPTER Revenue and Collection Cycle LEARNING OBJECTIVES Review Checkpoints Exercises, Problems, and Simulations Discuss inherent risks related to the revenue and collection cycle with a focus on improper revenue recognition 1, 2, 59 Describe the revenue and collection cycle, including typical source documents and controls 4, 5, 6, 7, 54, 55, 61, 63, 64, 66 Give examples of tests of controls over customer credit approval, delivery, and accounts receivable accounting 9, 10, 11, 12, 13, 14 56, 65 Give examples of substantive procedures in the revenue and collection cycle and relate them to assertions about account balances at the end of the period 15, 16, 17, 18, 19, 20, 21, 22 57, 58, 60, 61, 67, 68, 69, 70 Describe some common errors and frauds in the revenue and collection cycle, and design some audit and investigation procedures for detecting them 23, 24, 25 26, 27, 28 59, 62, 65, 71 SOLUTIONS FOR REVIEW CHECKPOINTS 7.1 Revenue recognition refers to including revenue in the financial statements According to GAAP, this is done when revenues are (1) realized or realizable and (2) earned 7.2 Revenue recognition is used as a primary means for inflating profits for several reasons First, it is not always straightforward when revenues have been earned Sales can be structured with return provisions, or can have other performance provisions attached Second, the timing of shipments at year end may be easy to falsify Third, companies are often valued at multiples of revenue instead of net income 7.3 “Bill and Hold” sales are recognized when sales are billed, thus creating a receivable, but the goods are held by the seller until the customer actually wants them 7-1 Chapter 07 - Revenue and Collection Cycle 7.4 The basic sequence of activities and accounting in a revenue and collection cycle is: Receiving and processing customer orders Entering data in an order system and obtaining a credit check Delivering goods and services to customers Authorizing release from storekeeping to shipping to customer Entering shipping information in the accounting system Billing customers, producing sales invoices Accounting for customer trade accounts receivable Collecting cash and depositing it in the bank Accounting for cash receipts Reconciling bank statements 7.5 When documents such as sales orders, shipping documents, and sales invoices are prenumbered, someone can later account for the numerical sequence and determine whether any transactions have failed to be recorded (Completeness assertion.) 7.6 Access to computer terminals should be controlled so only authorized persons can enter or change transaction data Access to master files is important because changes in them affect automatic computer controls, such as credit checking and accurate inventory pricing 7.7 Auditors could examine these files for evidence of: • • • 7.8 7.9 7.10 Unrecorded sales — pending order master file, Inadequate credit checks — credit data/check files Incorrect product unit prices — price list master file With a sample of customer accounts receivable: Find the support for debit entries in the sales journal file Expect to find evidence (copy) of a sales invoice, shipping document, and customer order The sales invoice showing recording on the shipping date Find the support for credit entries in the cash receipts journal file Expect to find a remittance advice (entry on list), which corresponds to detail on a deposit slip, on a deposit actually in a bank statement for the day posted in the customers’ accounts The account balances in a revenue and collection cycle include: • Cash in bank • Accounts receivable • Allowance for doubtful accounts • Bad debt expense • Sales revenue • Sales returns, allowances, discounts These specific control procedures (in addition to separation of duties and responsibilities) should be in place and operating in a control system governing revenue recognition and cash accounting: No sales order should be entered without a customer order A credit-check code or manual signature should be recorded by an authorized means Access to inventory and the shipping area should be restricted to authorized persons Access to billing terminals and blank invoice forms should be restricted to authorized personnel 7-2 Chapter 07 - Revenue and Collection Cycle Accountants should be instructed to record sales and accounts receivable when all the supporting documentation of shipment is in order, and care should be taken to record sales and receivables as of the date goods and services were shipped, and cash receipts on the date the payments are received Customer invoices should be compared with bills of lading and customer orders to determine that the customer is sent the goods ordered at the proper location for the proper prices and that the quantity being billed is the same as the quantity shipped Pending order files should be reviewed timely to avoid failure to bill and record shipments Bank statements should be reconciled in detail monthly 7.11 In a “walk through” of a sales transaction, auditors take a single example of a sales transaction and trace it from the initial customer order through credit approval, billing, and delivery of goods, to the entry in the sales journal and subsidiary accounts receivable records, then its subsequent collection and cash deposit Sample documents are collected and employees in each department are questioned about their specific duties The information gained from documents and employees can be compared to answers obtained on an internal control questionnaire The purpose of the “walk through” is to obtain an understanding of the transaction flow, the control procedures, and the populations of documents that may be utilized in tests of controls 7.12 The assertions made about classes of transactions and events in the revenue and collection cycle are: Sales and related events that have been recorded have occurred and pertain to the entity All sales and related events that should have been recorded have been recorded Amounts and other data related to sales transactions and events have been recorded properly Sales and related events have been recorded in the correct period Sales and related events have been recorded in the proper accounts 7.13 In general, the actions in tests of controls involve vouching, tracing, observing, scanning, and recalculating 7.14 Dual direction tests of controls refers to procedures that test file contents in two “directions” — the occurrence direction and the completeness direction The occurrence direction is a sample from the account balance (e.g sales revenue) vouched to supporting sales and shipping documents for evidence of occurrence The completeness direction is a sample from the population that represents all sales (e.g shipping document files) traced to the sales journal or sales account for evidence that no transactions (shipments, sales) were omitted 7.15 It is important to place emphasis on the existence assertion because auditors have often gotten into malpractice trouble by giving unqualified reports on financial statements that overstated assets and revenues and understated expenses For example, credit sales recorded too early (fictitious sales?) result in overstated accounts receivable and overstated sales revenue 7.16 These procedures are usually the most useful for auditing the existence assertion: Confirmation Letters of confirmation can be sent customers, asking for a report of the balances owed the company Verbal Inquiry Inquiries to management usually not provide very convincing evidence about existence and ownership However, inquiries should always be made about the company’s agreements to pledge or sell with recourse accounts receivable in connection with financings 7-3 Chapter 07 - Revenue and Collection Cycle Examination of Documents (Vouching) Evidence of existence can be obtained examining shipping documents Examination of loan documents may yield evidence of the need to disclose receivables pledged as loan collateral Scanning Assets are supposed to have debit balances A computer can be used to scan large files of accounts receivable, inventory, and fixed assets for uncharacteristic credit balances The names of debtors can be scanned for officers, directors, and related parties, amounts for which need to be reported separately or disclosed in the financial statements Analytical Procedures Comparisons of asset and revenue balances with recent history might help detect overstatements Relationships such as receivables turnover, gross margin ratio and sales/asset ratios can be compared to historical data and industry statistics for evidence of overall reasonableness Account interrelationships also can be used in analytical review For example, sales returns and allowances and sales commissions generally vary directly with dollar sales volume, bad debt expense usually varies directly with credit sales volume, and freight expense varies with the physical sales volume Accounts receivable write-offs should be compared with earlier estimate of doubtful accounts 7.17 Comparison of sales and accounts receivable to previous periods provides information about existence Other useful analytical procedures include receivables turnover and days of sales in receivables, aging, gross margin ratio, and sales/asset ratios, which can be compared to historical data and industry statistics for evidence of overall reasonableness Auditors may also compare sales to non-financial data such as units sold, number of customers, sales commissions, etc These comparisons can be made by product, period, geographic region, or salesperson 7.18 A “positive” confirmation is a request for a response from an independent party whom the auditor has reason to expect is able to reply A “negative” confirmation is a request for a response from the independent party only if the information is disputed Negative confirmations should also be sent only if the recipient can be expected to detect an error and reply accordingly They are normally used for accounts with small balances when control risk is low 7.19 Justifications for the decision not to use confirmations for trade accounts receivable in a particular audit include: (1) receivables are not material, (2) confirmations would be ineffective, based on prior years’ experience or knowledge that responses could be unreliable, and (3) analytical procedures and other substantive procedures provide sufficient, competent evidence 7.20 Special care in examining sources of accounts receivable confirmation responses: Auditors need to control the confirmations, including the addresses to which they are sent Experience is full of cases where confirmations were mailed to company accomplices, who provided false responses The auditors should carefully consider features of the reply such as postmarks, FAX and telegraph responses, letterhead, electronic mail, telephone, or other characteristics that may give clues to indicate false responses Auditors should follow up electronic and telephone responses to determine their origin (for example, returning the telephone call to a known number, looking up telephone numbers to determine addresses, or using a criss-cross directory to determine the location of a respondent) 7.21 When positive confirmations are not returned the auditor should perform the following procedures: Send second and even third requests Apply subsequent cash receipts Examine sales orders, invoices and shipping documents, and Examine correspondence files for past due accounts 7-4 Chapter 07 - Revenue and Collection Cycle 7.22 To determine the adequacy of the allowance for doubtful accounts, the auditor reviews subsequent cash receipts from the customer, discusses unpaid accounts with the credit manager and examines the credit files These should contain customer’s financial statements, credit reports and correspondence between the client and the customer Based on this evidence, the auditor estimates the likely amount of non-payment for the customer, which is included in the estimate of the allowance for doubtful accounts In addition, an allowance should be estimated for all other customers, perhaps as a percentage of the current accounts and a higher percentage of past due accounts The auditor compares his/her estimate to the balance in the allowance account and proposes an adjusting entry for the difference 7.23 Dual-direction testing involves selecting samples to obtain evidence about control over completeness in one direction and control over occurrence in the other direction The completeness direction determines whether all transactions that occurred were recorded (none omitted), and the occurrence direction determines whether recorded transactions actually occurred (were valid) An example of the completeness direction is the examination of a sample of shipping documents (from the file of all shipping documents) to determine whether invoices were prepared and recorded An example of the occurrence direction is the examination of a sample of sales invoices (from the file representing all recorded sales) to determine whether supporting shipping documents exist to verify the fact of an actual shipment The content of each file is compared with the other 7.24 In the “Canny Cashier”, if someone other that the assistant controller had reconciled the bank statement and compared the details of bank deposit slips to cash remittance reports, the discrepancies could have been noted and followed up The discrepancies were that customers and amounts on the two did not match 7.25 To prevent the cash receipts journal and recorded cash sales from reflecting more than the amount shown on the daily deposit slip, the internal control system should provide that receipts be recorded daily and intact A careful bank reconciliation by an independent person could detect such errors 7.26 Confirmations to taxpayers who had actually paid their taxes would have produced exceptions, complaints, and people with their counter receipts These results would have revealed the embezzlement 7.27 Auditors might have obtained the following information: Inquiries: Personnel admitting the practices of backdating shipping documents in a “bill and hold” tactic, or personnel describing the 60-day wait for a special journal entry to record customer discounts taken Tests of controls: The sample of customer payment cash receipts would have shown no discount calculations and authorizations, leading to inquiries about the manner and timing of recording the discounts Observation: When observing the physical inventory-taking, special notice should be taken of any goods on the premises but excluded from the inventory These are often signs of sales recorded too early Confirmations of accounts receivable: Customers who had not yet been given credit for their discounts can be expected to take exception to a balance too large 7.28 The auditors would have known about the normal Friday closing of the books for weekly management reports, and they could have been alerted to the possibility that the accounting employees overlooked the once-a-year occurrence of the year end date during the week 7-5 Chapter 07 - Revenue and Collection Cycle SOLUTIONS FOR MULTIPLE CHOICE QUESTIONS 7.29 a Incorrect b c Correct Incorrect d Incorrect 7.30 a b c d incorrect incorrect correct incorrect This only initiates the earnings process, it doesn’t complete it This is often the case, but it depends on shipping terms This is often the same as the bill of lading date Under accrual accounting, the company doesn’t have to wait for the check to record revenue 7.31 a Incorrect b c d Correct Incorrect Incorrect This would not have the outstanding balance; however, there are some times when the auditor confirms the sale instead of the amount receivable This would have the balance for confirming This would not have the individual customer balance This would not have the balance outstanding 7.32 a b c d Incorrect Incorrect Incorrect Correct This is an essential part of the cycle This is an essential part of the cycle Cash is affected by the collections Even though this involves shipments, it is considered part of the expenditure and disbursement cycle 7.33 a b c d Incorrect Incorrect Correct Incorrect The sale could occur but not be approved for credit The approval has nothing to with completeness Credit approval helps ensure the sale will be collectible Credit approval will not affect when revenue is earned 7.34 a b c d Incorrect Incorrect Correct Incorrect The general ledger bookkeeper doesn’t have access to the customer accounts There’s no advantage to separating access to checks and currency Nobody in the company has access to cash, therefore it cannot be stolen Normally checks are made payable to company That doesn’t prevent lapping 7.35 a Correct b c d Incorrect Incorrect Incorrect Impropriety of write-offs can be controlled by the review and approval by someone outside the credit department Even write-off of old receivables can conceal a cash shortage The cashier could be the cause of the shortage Write offs should be separated from the sales function a b Incorrect Correct c d Incorrect Incorrect 7.36 Allowances can be made for anticipated returns if the earning process is substantially complete The earning process is complete at this point Under accrual accounting, the cash does not have to be collected, only collectible This is usually the method for determining “b” but the shipment might be FOB destination This would increase gross profit Less sales revenue and correct amount of cost of goods sold results in less gross profit, therefore the ratio of gross profit to sales will decrease (Actually, the gross profit numerator will decrease at a greater rate than the sales denominator in the ratio, causing the ratio to decrease.) This would increase gross profit This would increase sales and cost of sales, and the ratio would not change If cost of sales is not recorded, gross profit would increase 7-6 Chapter 07 - Revenue and Collection Cycle 7.37 a b c d Incorrect Incorrect Incorrect Correct This doesn’t verify that the sales invoices represent actual shipments This would require tracing from shipping documents to invoices This would require tracing from invoices to customer accounts The direction of the test establishes support for recorded amounts 7.38 a Incorrect d Correct Using the sales returns account would raise the least suspicion because this account is more commonly linked to accounts receivable A bookkeeper could steal money and “write off” to unsuspecting customer’s balance with a fictitious “sales return.” 7.39 a b c d Incorrect Incorrect Correct Incorrect The payment is probably in transit The shipment is probably in transit This should have been recorded as a reduction to the receivable by 12/31 This occurred after the end of the period 7.40 a b c d Incorrect Incorrect Correct Incorrect The aged trial balance provides only indirect evidence about controls The aged trial balance provides no evidence about accuracy The age of accounts is an indication of credit losses The aged trial balance provides no evidence about existence 7.41 a b Incorrect Correct c d Incorrect Incorrect Lapping pertains to cash receipts, not sales False sales journal entries made near the end of the year may have shipping or other documents that reveal later dates or show lack of sufficient documentation See answer a This step would not detect misappropriation of merchandise a b c Incorrect Incorrect Correct d Incorrect 7.43 c Correct Checking the sequence for missing numbers identifies documents not yet fully processed in the revenue cycle It does not provide evidence about accuracy, cutoff or occurrence 7.44 a Correct b c Incorrect Incorrect d Incorrect The accounts receivable debits are supposed to represent sales that have been ordered by customers and actually shipped to them This is not evidence about occurrence This provides some evidence about existence, but even if the receivables haven’t been paid, they may still be valid These file will likely not provide evidence about specific sales a Incorrect b Correct c d Incorrect Incorrect 7.42 7.45 Receiving a confirmation is not proof the customer will pay Confirmation will not detect if the receivables were sold or factored Accounts receivable confirmation enables recipients to respond that they owe the company or that they dispute or disagree with the amount the company says they owe Confirmation provides only indirect evidence that controls are working This is an important assertion, but financial statement users are less likely to be damaged if assets are found that have not been recorded Financial statement users are more likely to be damaged if assets are found not to exist Ownership is important, but doesn’t matter if the assets don’t exist Presentation and disclosure assertion is important, but not as important as existence for asset accounts 7-7 Chapter 07 - Revenue and Collection Cycle 7.46 c Correct 7.47 a b c Correct Incorrect Incorrect d Incorrect a Correct b Incorrect c Incorrect d Incorrect a Incorrect b Incorrect c d Correct Incorrect a b Incorrect Correct c d Incorrect Incorrect a Correct b c d Incorrect Incorrect Incorrect a b c Incorrect Incorrect Correct d Incorrect 7.48 7.49 7.50 7.51 7.52 Mainly because the other three choices are listed as appropriate work to Also, customers are likely to ignore negative confirmations after earlier responding to positive confirmations The auditor assumes customers are likely to respond to errors Because negative confirmations offer higher risk of material misstatement should be low when they are used Because negative confirmations offer higher detection risk, risk of material misstatement should be low when they are used Shipments are traced to customers’ invoices (This does not imply that the invoices were recorded in the sales journal.) See (a) above The invoice copies need to be traced to the sales journal and general ledger to determine whether the shipments were recorded as sales Recorded sales were shipped is not established because the sample selection is from shipments, not from recorded sales See (c) above Salespeople could write off accounts for their friends to keep them from having to pay The credit manager may propose write-offs to reduce days outstanding and make him/her look better The Treasurer or another high-ranking manager should approve write-offs The cashier could take receipts and write-off the balance A second request is the first step that should be performed As the confirmations are a sample of the account balance, even immaterial items should be followed up as they represent other balances in the universe of receivables Shipping documents should be examined to test existence of the receivable Client correspondence files may also provide evidence the receivable exists Not recording sales on account in the books of original entry is the most effective way to conceal a subsequent theft of cash receipts The accounts will be incomplete but balanced, and procedures applied to the accounting records will not detect the defalcation The control account wouldn’t match the total of customer accounts Customers would catch the overstatement when examining their statements This is a possibility, but (a) is a better answer There is less likelihood of getting caught if the sale is never recorded The stolen cash wouldn’t be in either of these documents Lapping is not accomplished through write-offs Lapping is the delayed recording of cash receipts to cover a cash shortage Current receipts are posted to the accounts of customers who paid one or two days previously to avoid complaints (and discovery) when monthly statements are mailed The best protection is for the customers to send payments directly to the company’s depository bank The next best procedure is to assure that the accounts receivable clerk has no access to cash received by the mail room Thus, the duties of receiving cash and posting the accounts receivable ledger are segregated See answer (a) 7-8 Chapter 07 - Revenue and Collection Cycle 7.53 a b Incorrect Correct c Incorrect d Incorrect A negative confirmation might be used if control risk is low As detection risk is lower for positive confirmations than negative confirmations, a positive confirmation is more likely when inherent risk is high Whether the account is due or not usually doesn’t affect the type of confirmation However if it is long past due, a positive confirmation is more appropriate This is a possible choice; however, even positive confirmations may be problematic with related parties SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS 7.54 Control Objectives and Procedures Associations a “Occurrence” Sales recorded, goods not shipped b “Completeness” Goods shipped, sales not recorded c “Accuracy” Goods shipped to a bad credit risk customer d “Accuracy” Sales billed at the wrong price or wrong quantity e “Classification” Product line A sales recorded as Product line B f “Completeness” Failure to post charges to customers for sales g “Cutoff” January sales recorded in December CONTROL PROCEDURES Sales order approved for credit X Prenumbered shipping doc prepared, sequence checked X Shipping document quantity compared to sales invoice X X Prenumbered sales invoices, sequence checked X Sales invoice checked to sales order X Invoiced prices compared to approved price list X General ledger code checked for sales product lines X Sales dollar batch totals compared to sales journal X X Periodic sales total compared to same period accounts X receivable postings 10 Accountants have instructions to date sales on the date of X shipment 11 Sales entry date compared to shipping doc date X 12 Accounts receivable subsidiary totaled and reconciled to X accounts receivable control account 13 Intercompany accounts reconciled with subsidiary company X records 14 Credit files updated for customer payment history X 15 Overdue customer accounts investigated for collection X X X 7-9 X X X X Chapter 07 - Revenue and Collection Cycle 7.54 Control Objectives and Procedures Associations (Continued) EXHIBIT 7.54-1 Blank form for Students a b c d e f g 10 11 12 13 14 15 7.55 Sales recorded, goods not shipped Goods shipped, sales not recorded Goods shipped to a bad credit risk customer Sales billed at the wrong price or wrong quantity Product line A sales recorded as Product line B Failure to post charges to customers for sales January sales recorded in December CONTROL PROCEDURES Sales order approved for credit Prenumbered shipping doc prepared sequence checked Shipping document quantity compared to sales invoice Prenumbered sales invoices, sequence checked Sales invoice checked to sales order Invoiced prices compared to approved price list General ledger code checked for sales product lines Sales dollar batch totals compared to sales journal Periodic sales total compared to same period accounts receivable postings Accountants have instructions to date sales on the date of shipment Sales entry date compared to shipping doc date Accounts receivable subsidiary totaled and reconciled to accounts receivable control account Intercompany accounts reconciled with subsidiary company records Credit files updated for customer payment history Overdue customer accounts investigated for collection Control Assertion Associations Error Assertions Sales recorded, goods not shipped Occurrence Goods shipped, sales not recorded Completeness Goods shipped to a bad credit risk customer Valuation Sales billed at the wrong price or wrong quantity Valuation Product A sales recorded as Product line B Classification Failure to post charges to customers for sales Completeness January sales recorded in December Cutoff 7-10 Chapter 07 - Revenue and Collection Cycle 7.59 Overstated Sales and Accounts Receivable AUDIT APPROACH Objective: Obtain evidence to determine whether sales were recorded in the proper period and whether gross accounts receivable represented the amounts due from customers at year end Control: Sales terms should be properly documented Accounting treatment, including billing at agreed-upon prices, should follow the terms of the sale If the risks and rewards of ownership have not been transferred to the customer, or the price has not been reliably determined, or the collectibility of the amount is seriously in doubt or not estimable, an accrual sale should not be recognized Recorded sales should be supported by customer orders and agreements Shipping documents should be sufficient to show actual shipment or a legitimate field warehousing arrangement Tests of Controls: Questionnaires and inquiries should be used to determine the company’s accounting policies If the auditors not know about “bill and hold” practices, they should learn the details For detail procedures: Select a sample of recorded sales, and examine them for any signs of unusual sales terms Vouch them to customer orders and other sales agreements, if any Vouch them to shipping documents, and examine the documents for external reliability—recognizing blank spaces (carrier name, date) and company representative’s signature (two places, both company and carrier) Compare prices asked in customers’ orders to prices charged on invoices These tests follow the vouching direction—starting with data that represent the final recorded transactions (sales) and going back to find originating supporting source documents These procedures might reveal some transactions of the problem types—bill and hold, and overbilling The last month of the fiscal year (although a typical seasonal low month) could be targeted for greater attention because the sales are much higher than the previous January and because the auditors want to pay attention to sales cut-off in the last month Select a sample of shipping documents, trace them to customer orders, and trace them to invoices and to recording in the accounts receivable with proper amounts on the proper date These tests follow the tracing direction—starting with data that represent the beginning of transactions (orders, shipping) and tracing them through the company’s accounting process If extra attention is given in January for cut-off reasons, this sample might reveal some of the problem transactions Audit of Balance: Confirm a sample of customer accounts Follow up exceptions noted by customers relating to bill and hold terms, excessive prices, and double billing Even a few exceptions raise red flags for the population of receivables Use analytical comparison on comparative month’s sales Investigate any unusual fluctuations (e.g January this year much larger than January last year, the reversal month next year with negative sales) The January comparative increase in sales should cause auditors to extend detail procedures on some of the month’s transactions 7-14 Chapter 07 - Revenue and Collection Cycle 7.59 Overstated Sales and Accounts Receivable (Continued) DISCOVERY SUMMARY The auditors performed a detail sales cut-off test on January sales, selecting a sample of recorded sales However, they did not notice the significance of “bill and hold” marked on the invoices, and they did not figure out the meaning of the blank spaces and duplicate company employee signatures on the shipping documents In the following year’s audit, they tested sales transactions in a month when the prior year’s bill and hold sales were reversed They noticed the discrepancy but were told that it involved various billing errors They did not connect it with reversal of the prior year’s sales The auditors confirmed a judgment sample of large accounts receivable balances Twelve replies were received on 103 confirmations Six of the replies were from “bill and hold” customers who listed discrepancies The auditors followed up the six by examining sales invoices and shipping documents They did not grasp the significance of the “bill and hold” stamps or the features of the shipping documents described earlier Three confirmation responses indicated the customers did not owe the amounts The auditors relied on Mattel internal documents to decide that the customers were wrong They did not examine the sales orders that indicated that these customers had a right of cancellation The auditors did not perform month-by-month analytical sales comparisons with the prior year Thus they did not recognize the significant fluctuations in the comparative January sales In the next year’s audit, they did not recognize the significant comparative decrease in month’s sales for the months when the prior year bill and hold sales were reversed 7.60 CAATs Application—Receivables Confirmation File 7.61 Information Master File—Debtor Name Name of Debtor Address of Debtor Master File—Account Detail Customer Account Number Balance (gross) Discount Available to Customer Audit Simulation: Rock Island Quarry—Evidence Collection in an Online System This case is a summary of an actual situation and should be used to generate discussion of how auditors must adapt to a changing environment The solution suggested here represents the preliminary response by the audit firm involved You and your students will likely generate additional responses a Program change controls—The primary concern is the security of the programs that process the quarry transactions at the quarry’s computers and at the home office Assuming the auditors can test and evaluate these programs, the concern is how changes are made in a controlled, authorized fashion The auditors need assurance that the same programs are used by all locations throughout the period 7-15 Chapter 07 - Revenue and Collection Cycle b 7.61 Access controls—Who is authorized to operate the quarry computers and how are unauthorized personnel prevented from operations? Although not mentioned in the case, access should be controlled through the use of a weigh master’s identification number and password (changed periodically) Physical access should also be evaluated Are the computers kept in a locked, secure area? Sales transaction program controls—The system described is not unlike any on-line sales order entry system Certain edit or validation controls should be incorporated such as: (a) limit tests (for impossible weights and out-of-range numbers for rock grade), (b) missing data tests (all fields have data), (c) valid character and sign tests (appropriate fields numeric and positive) and (d) sequence tests (transaction numbers in sequence, by quarry) Completeness controls—The system has to contain controls that ensure all transactions sent by the quarries are received at the home office These can be as simple as a signal sent back to the quarry microcomputer that the sale was received and as complex as the microcomputer accumulating control totals that are matched to home office control totals at the end of the day In such distributed systems, the computers would most likely store all transactions (keep an onsite log) until receipt is confirmed A transaction numbering scheme can also ensure that no transactions were missed The implication of the programs residing in the computers at the quarries is that programs may be changed there as well as from the home office Therefore, the change controls mentioned above are important, as well as how program modifications are made to the quarry computers Obviously, several sites will have to be visited Audit Simulation—Rock Island Quarry—Evidence Collection in an Online System (Continued) c Auditors debate whether “documentary evidence” includes evidence in computer-readable form The authors believe such evidence should be considered documentary evidence The problem then becomes one of whether this computer-readable evidence will be available during the period under audit In all probability, a log of all incoming transactions is captured at the home office so that a complete audit trail exists The auditors need to request these logs be retained If the logs are available, generalized audit software can be used to select samples to be printed If the logs are not retained, sampling will have to be done during transaction occurrence rather than after the fact This would involve selected testing throughout the audit period The system described would also be appropriate for CAATs A final point to have the class discuss is what is likely to happen when one of the computers goes down at one of the quarries or the entire network is down Rock Island will have to provide manual backup procedures and such procedures are normally not well controlled and thus become subject to errors and frauds 7.62 Organizing a Risk Analysis TO: FROM: DATE: SUBJECT: Senior Internal Auditor Director of Internal Auditing November 31, 199X Risk analysis of accounts receivable accounting These questions are for your guidance 7-16 Chapter 07 - Revenue and Collection Cycle The Problem Total patient accounts receivable have increased steadily and rapidly for eight months Our last audit of this area was 10 months ago A favorable report is in the working paper file I can see no apparent reason for the increase because the number of beds, the occupancy rate, the billing rates and the insurance contracts have not changed What Financial/Economic Events Have Occurred in the Last 10 Months? Are a greater number of patients uninsured? Is a larger number or greater dollar amount overdue? Have any accounts been written off in the last 10 months? Number? Dollar amount? Which accounts are presently considered doubtful of collection? Why? Have patients complained about their bills? Who Does the Accounting? Are new people doing the accounting? Who is the accounting manager now? Did resigned employees give reasons? What Data Processing Procedures and Policies Are in Effect? 1a 1b 2a 2b 3a 3b 3c What are the current procedures for billing patients? What changes have been made in the last 10 months? What are the current procedures for recording changes and collections? What changes have been effected in the last 10 months What are the credit and collection policies? Are they being followed? What changes have been effected in the last 10 months? How is the Accounts Receivable Accounting Done? 7.63 Has the accounting been put on computer within the last 10 months? How many employees handle the accounting? Computer Noncomputer _ Study and Evaluation of Management Control TO: FROM: DATE: SUBJECT: Internal Audit Staff Senior Internal Auditor July Comparison standards for study and evaluation of management risk mitigation control policies 7-17 Chapter 07 - Revenue and Collection Cycle To audit the performance of management controls, you will need to know quantitative standards of acceptable performance Standards for two policies are described in this memo I Sales are billed to customers accurately and promptly A Accuracy Policy Standard: No more than three percent of the sales invoices are figured with errors of either quantity or unit price or extension error amounting to over $1 per invoice Audit Procedures: B Audit for accuracy by selecting a sample of recorded sales invoices and (a) vouch the customer name to supporting purchase orders and shipping documents, (b) vouch the quantity shipped to supporting shipping documents, (c) trace the unit price to the approved price list, and (d) recalculate the extensions, including shipping charges and sales tax Document all errors over $1 per invoice Audit for completeness by selecting a sample of shipping documents and tracing to recorded sales invoices Audit for accuracy (related to shipping quantities, primarily) by confirming a sample of customers’ balances (or individual unpaid invoices) and look for customer disagreements Promptness Policy Standard: Sales invoices are to be entered in the sales journal and in customers’ accounts with a (mailing) date no later than one day after shipment Audit procedure: Using the samples in procedures #1 and #2 above, compare the sales journal record date and the date shown in customers’ accounts with the shipment date Document the number and extent of time lags exceeding one day Inquire about the mailing date 7.63 Study and Evaluation of Management Control (Continued) II Accounts receivable are aged and followed up to ensure prompt collection A Accounts Receivable Aging Policy Standard: A complete and accurate aged trial balance is prepared monthly showing receivables in categories (a) Current, (b) 31-59 days overdue, (c) 60-89 days overdue and (d) more than 90 days overdue 7-18 Chapter 07 - Revenue and Collection Cycle Audit Procedures: B Inspect the aged trial balances to determine whether they were actually prepared each month Audit for completeness by comparing the trial balance total to the general ledger control account (Foot each, if necessary.) Audit for accuracy by selecting a sample of customer accounts and tracing aged data from the customers’ ledger accounts to the aged trial balance This is the important direction for the procedures because incorrect “underaging” thwarts the collection effort (Selecting a sample of noncurrent aging data from the trial balance will not enable you to detect noncurrent amounts incorrectly aged as current.) Follow-up For Prompt Collection Policy Standard: Credit department personnel are supposed to receive the trial balance within five days after each month-end, and send different letters within five business days of receiving the aged trial balance for accounts as they become longer overdue, and turn accounts over to an outside collection agency when they are over 90 days past due After 60 days, further credit is cut off and customers are put on a cash basis Audit Procedure: Inspect the aged trial balances for indication of preparation date or a “date received” stamp by the credit department to determine promptness of transmittal within five days after each month-end For a sample of past due amounts in different months, inspect copies of the letters sent to customers and (a) observe whether the right standard letter was sent and (b) the date Document exceptions to type of letter and mailing delay Inspect correspondence relevant to determining date that over-90 day accounts were turned over to an outside agent Inspect notices of credit cut-off for customers with over-60 day balances and inspect the trial balance for evidence of new credit mistakenly extended to such customers Using the sample of #2, verify the accuracy of the subsequent collections report prepared by the credit department by vouching the data therein to cash receipts records 7-19 Chapter 07 - Revenue and Collection Cycle 7.64 Audit Simulation: Cash Receipts and Billing Control Dealing with these weaknesses gives students an opportunity to think about fraud possibilities that could occur with and without collusion among these four employees A useful discussion of intentional frauds can be built around the weaknesses and possibilities shown below in the AICPA CPA Examination answer to this problem CREDIT MANAGER • approves credit without reference to rating agencies (e.g Dun & Bradstreet) • approves credit without using any established credit limits or policy • nobody supervises the credit-granting function and nobody reviews the results of the credit manager’s credit decisions ACCOUNTS RECEIVABLE SUPERVISOR • Can alter the details of customer charges (authorize-initiate transactions) and prepare invoices and records based on the alterations (a form of recordkeeping in this system) • Does not use a control total (e.g., daily batch financial total) of the charge forms in comparison to the total on the invoices and nobody else knows whether the totals agree • Does not reconcile the accounts receivable subsidiary ledger with the control account balance (therefore can “write off” accounts for friends because nobody reconciles the totals and nobody compares the actual write-offs to the bookkeeper’s authorizations) (also the A/R supervisor can simply not put a contractor’s balance on the report of overdue balances and therefore permit the contractor to obtain additional credit past the standard six-month period) CASHIER • Has custody of cash and controls the recordkeeping (the latter by sending the bookkeeper the only documents—the remittance advices and daily cash register summary— available for recording the cash receipts) • Can alter or delay the bookkeeper’s cash information because no one else has the verified deposit slip or the list of checks for comparison • Performs the bank reconciliation, which is not compatible with the cash custody and recordkeeping duties (can alter the reconciliation to cover up cash shortages) BOOKKEEPER • Authorizes account write-offs according to a fixed policy (six-month nonpayment period) without reference to knowledge of reasons or details (and apparently without further correspondence with the contractor) • The six month grace period is too long, and credit may be granted for awhile when it is not justified • Can control the credit-refusal process by not notifying the credit manager of the overdue accounts • Can authorize and actually write off accounts without supervision (has the incompatible duties of authorization-initiation of write-off orders and actually making entries in the records) 7-20 Chapter 07 - Revenue and Collection Cycle 7.65 Test of Controls and Errors/Frauds Controlled access to blank sales invoices a Observation Visit the storage location yourself and see if unauthorized persons could obtain blank sales invoices Pick some up yourself to see what happens b Someone could pick up a blank and make out a fictitious sale However, getting it recorded would be difficult because of the other controls such as matching with a copy from the shipping department (Thus a control access deficiency may be compensated by other control procedures.) Sales invoices check for accuracy a Vouching and Recalculation Select a sample of recorded sales invoices and vouch quantities thereon to bills of lading, vouch prices to price lists, and recalculate the math b Errors on the invoice could cause lost billings and lost revenue or overcharges to customers which are not collectible (thus overstating sales and accounts receivable) Duties of accounts receivable bookkeeper a Observation and Inquiry Look to see who is performing bookkeeping and cash functions Determine who is assigned to each function by reading organization charts Ask other employees b The bookkeeper might be able to embezzle cash and manipulate the accounting records to give the customer credit and hide the theft (Debit a customer’s payment to Returns and Allowances instead of to cash, or just charge the control total improperly.) Customer accounts regularly balanced with the control account a Recalculation Review the client’s working paper showing the balancing/reconciliation Do the balancing yourself b Accounting entries could be made inaccurately or incompletely and the control account may be overstated or understated 7-21 Chapter 07 - Revenue and Collection Cycle 7.66 Kaplan CPA Simulation: Internal Control Questionnaire Sales and Accounts Receivable Internal Control Questionnaire Responses Strength Southland deposits its cash receipts on a daily basis The daily deposit of cash is an important control relating to the revenue and collection cycle Strength Access to the price master file is restricted to authorized personnel only Proper authorization and access to the price list reduces the occurrence of fraudulent or inaccurate sales transactions (reduces “revenue leakage”) Weakness The accounts receivable manager approves the write-offs of uncollectible receivables The approval of accounts receivable write-offs should be performed by an individual independent of the sales and account receivable system, such as the controller Neither Southland’s president is the primary check signer and is also responsible for mailing the checks The president signing and maintaining responsibility for mailing the checks is a control over the cash disbursements system, not the sales and accounts receivable system Weakness The warehouse manager matches the pre-numbered shipping documents with entries in the sales journal While the matching of the shipping documents to the sales journal entries should provide assurance that all shipped items have been recorded as sales, the warehouse manager is not the appropriate person to perform the function since he is not independent of the shipping activity This represents improper segregation of duties Neither The voucher register is reconciled to the control accounts by an independent individual on a monthly basis A voucher register relates to the cash disbursement/accounts payable system, not the sales and accounts receivable system Strength Customer orders are agreed to an approved customer list The comparison of customer orders with the approved customer list will provide assurance that credit sales are made only to customers that have been granted credit (increases likelihood of ultimate collectibility) Strength Total amounts recorded in the accounts receivable ledger from remittance advices are compared to the appropriate bank deposit slip Comparing the amounts recorded in the accounts receivable ledger to the bank deposit should reveal incorrect postings to accounts receivable since any differences would likely be investigated Weakness Disagreements with customers generated by the monthly statements that are sent by the client are resolved by the sales manager The sales manager should not be responsible for resolving billing disagreements with customers because he is not independent from the sales and accounts receivable process 7-22 Chapter 07 - Revenue and Collection Cycle 7.67 Kaplan CPA Simulation: Confirmation Form a b Most receivables are collected by Norman, Inc within 30 days of billing Negative The number of days sales in accounts receivable has gone up by a relatively large amount since last year because the sales figure has grown Positive The CPA firm’s assessment of inherent risk in the area of accounts receivable was higher than had been anticipated Positive The CPA firm is particularly concerned about obtaining sufficient evidence in connection with the existence assertion for the company’s receivables Positive The CPA firm’s assessment of control risk in the area of accounts receivable was lower than had been anticipated Negative The company had only a few receivables but most have relatively high balances Positive Analytical procedures were performed early in the audit and the accounts receivable balance was determined to be within the auditor’s anticipated range Negative Confirmation of accounts receivable is normally performed in all audit engagements to help gain sufficient evidence about these balances, especially in connection with the existence assertion However, in very specific circumstances, omission of the confirmation can be justified The most normal situation would be where such accounts are immaterial If credit sales are only a minor part of the organization’s revenues, the accounts receivable total may not be large enough to warrant the time and effort of confirmation In addition, in some cases, the reliability of such confirmations is not strong enough to require the effort If the firm will have difficulty getting the confirmation to a customer official who has knowledge of the balance or who will spend the time to determine the correct balance, little is gained by confirmation For example, confirmations sent to the United States government usually provide no corroborating evidence and, therefore, should not be relied on in an audit Finally, if the assessment of the client company’s inherent risk and control risk is especially low, the firm may be able to obtain sufficient audit evidence in order to provide by other means 7-23 Chapter 07 - Revenue and Collection Cycle 7.68 Kaplan CPA Simulation: Alternative Procedures a Option Procedure Do Not Perform Compare the percentage of accounts receivable to sales for the audit period to prior years Obtain an understanding of unusual or unexpected variances Comparing the percentage of accounts receivable to sales is merely an analytical review procedure Since analytical review procedures only provide circumstantial evidence, they are more appropriate for supporting assertions in which potential misstatements are not apparent from examining detailed evidence or when detailed evidence is not available When testing accounts receivable for the existence assertion, detailed evidence (such as subsequent payments from customers) should be obtained to ensure a higher level of assurance Perform For the non-replying customers, search the accounts receivable detailed listing for cash receipts received after the confirmation date Trace the cash receipt to supporting documentation to determine if payment applies to the account receivable balance as of the confirmation date Alternative procedures generally include reviewing subsequent cash collections and tracing them to a particular item on the accounts receivable listing to provide evidence that the specific account receivable does exist Do Not Perform Review the aged trial balance for material past due accounts Perform Review the allowance for doubtful accounts activity subsequent to year end to determine whether the unconfirmed accounts receivable were subsequently written off Reviewing the aged trial balance will not provide evidence of the existence assertion It will, however, provide evidence with respect to the net realizable value (valuation assertion) since it relates to the collectibility of accounts receivable Identifying accounts receivable balances that were subsequently written off after the confirmation date could reveal that the unconfirmed account receivable did actually exist at the confirmation date Additionally, because of the subsequent write-off, it is possible that there may have been a valuation impairment of that receivable at the confirmation date However, to test the valuation assertion would require a different set of procedures and would not provide further evidence to support existence Do Not Perform Review the aged trial balance for material past due accounts Reviewing the aged trial balance will not provide evidence of the existence assertion It will, however, provide evidence with respect to the net realizable value (valuation assertion) since it relates to the collectibility of accounts receivable Do Not Perform Perform test of controls for the sales/accounts receivable/cash receipts system to confirm the effectiveness of accounting system Test of controls not provide direct evidence of the existence assertion They are performed to determine whether reliance may be placed on a particular control and relate to the internal control assessment prior to beginning field work 7-24 Chapter 07 - Revenue and Collection Cycle 7.68 Kaplan CPA Simulation: Alternative Procedures (Continued) b Option Procedure True The evidence gathered via the standard audit procedures for accounts receivable will support that Amberly’s sales returns are properly valued Evidence supporting the valuation of sales returns will be gained via the audit procedures for accounts receivable Specifically, audit procedures for the allowance for doubtful accounts should reveal any material misstatements of sales and/or sales returns False Vouching expenses, performed as part of the search for unrecorded liabilities, should uncover any material misclassifications of expenses that occurred during the year Vouching expenses performed as part of the search for unrecorded liabilities will only uncover any material misclassifications of expenses that occurred during the year and were paid subsequent to year end To gain assurance that expenses were not misclassified for the entire year, the auditor must vouch a sample of expenses based on materiality levels True An unexplained increase in the gross profit ratio may suggest the presence of unrecorded expenses An unexplained increase in the gross profit ratio may suggest the presence of unrecorded expenses in COGS since unrecorded expenses would understate total expenses and falsely increase the profitability ratios (i.e., net income) False Amberly’s bill and hold transactions may increase audit risk because the sales may be understated at the end of the year Amberly’s bill and hold transactions may increase audit risk because such transactions may result in sales being overstated at year end Bill and hold transactions usually involve selling products for large discounts to retailers and holding them (perhaps in third-party warehouses) to be delivered at a later date Clearly the risk is of prematurely recorded or uncollectible sales c To: From: Controller, Amberly Partner, Rapport Negative confirmations solicit a response from the customer only if the reported balance is incorrect While it is a less-costly approach because second and third confirmation requests are not sent out, it provides lower quality of evidence since an explicit corroboration of existence is not received Negative confirmations are typically used for small balances that are not old and when both the inherent risk and control risk are assessed as low Positive confirmations request the customer to verify whether a particular accounts receivable balance is correct Since an explicit response is received in all cases, positive confirmations are viewed as a better technique Positive confirmations are generally used for large balances, old balances, or where the risk of error is high 7-25 Chapter 07 - Revenue and Collection Cycle We have chosen to use positive confirmations to prove the existence of your accounts receivable since the individual balances are large and are generally older 7.69 Kaplan CPA Simulation: Timing of Confirmations To: From: The Audit Team of Western In-Charge Auditor, Ridge Accounts receivable are usually confirmed early in audit as part of interim procedures unless inherent and/or control risks are high In such a case, confirmation is carried out closer to year- end instead This is Ridge’s first audit of Western and there are a large number of account receivable accounts, therefore, inherent risk is assessed as high The clerk is responsible for virtually all aspects of the accounts receivable/cash receipts cycle, thus control risk is also assessed as high Due to the overall audit risk assessment as high, it is more appropriate for Ridge to confirm accounts receivable balances at year-end 7.70 Kaplan CPA Simulations: Audit Evidence and the Confirmation Process a Corroborating evidence includes the books of original entry, general and subsidiary ledgers and accounting manuals False AU 326 distinguishes between underlying accounting data and all corroborating (supporting) information available to the auditor Books of original entry, general and subsidiary ledgers and accounting manuals are all examples of underlying accounting data All other things being equal, as the acceptable level of detection risk increases, an auditor will have to increase the extent of substantive tests by increasing the sample sizes used for testing False When the acceptable level of detection risk increases, it means that the auditor is more willing to accept the risk that the audit procedures will lead to an improper conclusion that no material misstatement exists when in fact it does exist This means that less substantive testing is required and thus, the sample sizes will generally be decreased Often an auditor must settle for relying on persuasive rather than convincing evidence for individual financial statement assertions AU 326 requires the auditor to use professional judgment to obtain sufficient competent evidential matter to form an opinion on the financial statements Due to time and cost limitations imposed on the auditor, it often means that gathering persuasive evidence (still reliable but somewhat less reliable than convincing evidence) will have to suffice 7-26 True Chapter 07 - Revenue and Collection Cycle It is possible to completely avoid the confirmation process if inherent and control risks are assessed as low True The statement is true For example, when inherent and control risks are low for cash, the auditor might inspect client-provided bank statements rather than directly confirming cash balances with the bank 7.70 Kaplan CPA Simulations: Audit Evidence and the Confirmation Process (part a, Continued) The auditor should use the positive form of confirmation request when there are a large number of small balances involved False The auditor should use the negative form of confirmation request when there are a large number of small balances involved The negative form requests the recipient to respond only if s/he disagrees with the information stated on the requested Therefore, the willingness for an auditor to accept a “no response” as confirmation of a large balance is not prudent in terms of managing audit risk Use of the positive form of confirmation should occur when there are large balances involved; the respondent should be asked to fill in the amount(s) owing In order to increase audit efficiency, the auditor should delegate some of the control over the confirmation requests and the responses to the internal audit department of the firm being audited False Per AU 330, the auditor should maintain control over the confirmation requests and the responses at all times In order to maintain proper independence/objectivity over the confirmation process, none of the related auditor’s duties should be delegated to the company’s internal audit department b To: From: Vincent Lau, CPA Chung, CPA Bill and hold transactions and Channel stuffing (trade loading) Bill and hold transactions are those which a customer agrees to purchase goods but the seller retains physical possession until the customer requests shipment to designated locations Because delivery has not yet occurred, such transactions not ordinarily qualify for revenue recognition However, the seller may artificially inflate revenues by recording the sale and then physically storing the inventory in an alternate location (unknown to the auditor) until the customer requests shipment Channel stuffing (trade loading) is a marketing practice that suppliers sometimes use to boost sales by inducing distributors to buy substantially more inventory than they can promptly resell This may artificially inflate revenues in the current period as future revenues may be lower than normal as the distributors will not need to buy…Or it could result in more sales returns 7-27 Chapter 07 - Revenue and Collection Cycle Related Parties Transactions should reflect their substance (rather than merely their legal form) Important audit procedures to detect related-party transactions include: 7.71 Ask client directly for the names of related parties, Review Board of Directors’ minutes Review SEC filings and financial statement footnotes, Review the nature of transactions with major customers and suppliers, Review accounting records for large and/or nonrecurring transactions, Review confirmations of loans receivable and payable for guarantees Mini-Case: Confirmations NOTE TO INSTRUCTOR: For this assignment, question from this Mini-Case is applicable When receiving a questionable piece of evidence, the auditor should follow up immediately to corroborate the evidence In this case, the auditors should have followed up immediately by telephone using a phone number obtained from a nonclient source (e.g., an international telephone book or Internet Web site) The audit team should also have requested that, in addition to the faxed copy, the original confirmation be mailed directly to them In terms of evidence, a signed original is preferable to a faxed confirmation for billions of dollars 7-28 ... Revenue and Collection Cycle 7.4 The basic sequence of activities and accounting in a revenue and collection cycle is: Receiving and processing customer orders Entering data in an order system and. .. sales and receivables as of the date goods and services were shipped, and cash receipts on the date the payments are received Customer invoices should be compared with bills of lading and customer... entire network is down Rock Island will have to provide manual backup procedures and such procedures are normally not well controlled and thus become subject to errors and frauds 7.62 Organizing