Department of Accounting and Finance, CoBE of Salale University/2024

CHAPTER TWO
2. AUDIT OF THE SALES AND COLLECTION CYCLE: TESTS OF
CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS
2.1. Tests of controls and substantive tests of transactions
The overall objective in the audit of the sales and collection cycle is to evaluate whether the
account balances affected by the cycle are fairly presented in accordance with generally accepted
accounting principles.
Controls in Revenue Cycle/ objectives
The control over revenue shall be to ensure the following objectives
 Transactions are properly authorized
 Recorded transactions are valid
 Valid, authorized transactions are recorded
 Transactions are recorded accumulates
 Assets (cash, inventory, & date) are safeguarded from loss or theft.
 Business activities are performed efficiently & effectively
Application of Control in sales order
In Auditing revenue cycle the auditor should obtain information regarding:
 The flow of sales transactions through the accounting system.
 The extent to which EDP is used in processing sales transactions
 The basic structure of accounting control.
2.1.1. Accounts and Classes of Transactions
The accounts that are included in the sales and collection cycles are:
o Sales (cash and sales on accounts)
o Cash receipts
o Sales return and allowances
o Charge-off uncollectible accounts, and
o Bad debt expenses
There are differences in account titles for service industries, retail companies, and insurance
companies but the key concepts are the same. To provide a frame of reference for understanding
of this chapter, wholesale merchandising companies are assumed.

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All types of audit tests such as tests of controls, substantive tests of transactions, analytical
procedures and tests of details of balances are used extensively in the audit of the sales and
collection cycle. Tests of controls are used primarily to test the effectiveness of internal controls
over the above stated five classes of transactions in the cycle. Substantive tests of transactions
are used both to test the effectiveness of internal controls and to test the dollar amount of these
same classes of transactions. Analytical procedures are used to test the relationships among the
account balances in the cycle, both to each other and to prior years’ balances. Tests of details of
balances are used to verify ending account balances, primarily accounts receivable.
Nature of the sales and collection Cycle
The sales and collection cycle involves the decisions and processes necessary for the transfer of
ownership of goods and services to customers after they are made available for sale. It begins
with a request by a customer and ends with the conversion of material and service into an
account receivable, and ultimately into cash.
The basic sales and collection cycle of business activities are:

Sales order entry (1) Cash collection (4)

Sales and Collection Cycle

Shipping (2) Billing & Accounts receivable (3)

2.1.2. Business Functions and the related documents and records

The business functions for a cycle are the key activities that an organization must complete to
execute and record business transactions.

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Some of the typical business functions for the sales and collection cycle are:
i. Processing customer orders
ii. Granting credit
iii. Shipping goods
iv. Billing customers and recording sales
v. Processing and recording cash receipts
vi. Processing and recording sales return and allowances
vii. Charging-off uncollectible account receivable, and
viii. Providing for bad debts.
i. Processing customer orders: the request for merchandise is the starting point for
the entire cycle. Legally, it is an offer to buy goods under specified terms. The receipt of
customer order often results in the immediate creation of sales order. The documents and
records are: customer order and sales order.
Customer order- is a request for merchandise by a customer. It may be received by
telephone, letter, and a printed form that has been sent to prospective and existing
customers, through salespeople or in other ways.
Sales order- is a document for communicating the description, quantity, and related
information for goods ordered by a customer. This is frequently used to indicate credit
approval and authorization for shipment.
ii. Granting credit: before goods are shipped, a properly authorized person must
approve credit to customers for sales on account. Weak practices in credit approval
frequently results in excessive bad debts and account receivables that may be
uncollectible.
Shipping goods: is the first point in the cycle where company assets are given up. Most
companies recognize sales when goods are shipped. A shipping document is prepared at
the time of shipment.
iii. Shipping documents- is a document prepared to initiate shipment of goods,
indicating the description of merchandise, the quantity shipped, and other relevant data.
The original is sent to customer and one or more copies are retained. It is also used as a
signal to bill customer. One type of shipping document is a Bill of loading, which is a
written contract between the carrier and seller of the receipt and shipment of goods.

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iv. Billing Customers and Recording Sales: Billing of the customer is the means by
which the customer is informed of the amount due for the goods. The most important
aspects of billing are making sure that all shipments made have been billed, no shipment
has been billed more than once, and each one is billed for the proper amount. The
documents and records are: Sales invoice, Sales Journal, Summary sales Report, account
Receivable Master File, Account Receivable Trial Balance, and Monthly Statement.
Sales Invoice- is a document that indicates the description and quantity of goods sold, the
price including freight, insurance, terms and other relevant data. Typically, it is a method
of indicating to the customer the amount of sale and due date of payment. The original is
sent to customer and one or more copies are retained.
Sales Journal- is a journal for recording sales transactions. A detailed sales journal
includes each sales transaction. It usually indicates gross sales for different
classifications, such as product lines, the entry to accounts receivable and miscellaneous
debits and credits. It also includes sales returns and allowances transactions.
Summary Sales Report – is a computer generated document that summarizes sales for a
period. The report typically includes information analyzed by key components such as
sales person, product and territory.
Account Receivable Master File- is a file used for recording individual sales, cash
receipts, and sales returns and allowances for each customer and maintains customer
account balances. Account Receivable Master File is sometimes called the account
receivable subsidiary ledger or sub ledger. The total of individual account balances in the
master file must equals to the total balances of accounts receivable in the general ledger.
Accounts Receivables Trial Balance- is a list of the amount owed by each customer at a
point in time. This is prepared directly from the accounts receivable master file. It is most
often an aged trial balance, showing how old the accounts receivable components of each
customer’s balances are as of report date.
Monthly Statement- is a document sent to each customer indicating the beginning
balance of accounts receivable, the amount and date of each sale, cash payments
received, credit memos issued, and the ending balances due. It is , in essence, a copy of
the customer’s portion of the accounts receivable master file
v. Processing and Recording Cash Receipts- includes: receiving, depositing and
recording cash. Cash includes both currency and checks. The most important concern is
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the possibility of theft. Theft can occur before receipts are entered in the records or later.
The most important consideration in the handling of cash receipts is all cash must be
deposited in the bank at the proper amount on timely basis and recorded in the cash
receipts transaction file. The documents and records are: Remittance advice, prelisting of
cash receipts, and cash receipts journal.
Remittance Advice- is a document that accompanies the sales invoice mailed to the
customer and can be returned to the seller with the cash payment. It is used to indicate the
customer name, the sales invoice number, and the amount of the invoice when the
payment is received.
Prelisting Cash Receipts- is a list prepared by an independent person (someone who
does not have access to cash and who has no responsibility for recording sales or account
receivables) when cash is received. It is used to verify whether cash received was
recorded and deposited at the correct amounts and on timely basis.
Cash Receipts Journal- is a journal for cash receipts from collections, cash sales, and all
other cash receipts. It indicates total cash received, the credit to accounts receivable at the
gross amount of original sales, trade cash discount taken, and other debits and credits.
vi. Processing and Recording Sales Returns and Allowances: when the customer
is dissatisfied with the goods, the seller frequently accepts the return of the goods and
grants a reduction in the charges. Business entities normally prepare a receiving report for
the returned goods and return them to storage. Return and Allowances must be correctly
and promptly recorded in the sales returns and allowances transaction file and the
accounts receivable master file. Credit memos are normally issued for returns allowances
to aid in maintaining control and to facilitate record keeping.
Credit memo: is a document that indicates a reduction in the amount due from a
customer because of returned goods or an allowance granted.
Sales Return and Allowances Journal: is a journal for recording sales return and
allowances.
vii. Charging-off Uncollectible Accounts Receivables: when the company concludes
that an amount is no longer collectible, it must be charged off or written-off.
Uncollectible Account Authorization Form: is a journal for recording sales returns and
allowances.

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viii. Providing for Bad Debts: the provision for bad debts must be sufficient to allow
for the current period sales that the company will be unable to collect in the future.
2.1.3. Methodology for Designing Tests of Controls and Substantive Tests of Transactions
for Sales
The methodology for obtaining an understanding of internal control and designing tests of
controls and substantive tests of transactions for sales are:
o Understand internal control over sale
o Assess planned control risk related to sale
o Evaluate cost-benefit of testing controls, and
o Design tests of controls and substantive tests of transactions for sales to meet transaction-
related audit objectives
These Methodologies are presented in the following figure as follows

Understand Internal
Control-Sale

Assess planned control

risk-Sale

Evaluate cost-
benefit of
testing controls

Design test of Audit

controls and Procedures
substantive tests of Sample Size
transactions for sales Items to select
to meet transaction Timing
related audit
Fig: Methodology for Designing Tests of Controls and Substantive Tests of Transactions for Sale

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Understand internal control over Sales: A typical approach for the understanding of internal
control for sales is to study the clients’ flow chart, prepare an internal control questionnaire, and
perform walk-through tests of sales.
Summary of Transaction-Related Audit Objectives, Key Controls, Tests of Controls, and
Substantive Tests of Transactions for Sales

Transaction-
Related Audit Common substantive
Objectives Key Internal Control Common Tests of Control tests of Transactions
Recorded sales Recording of sales is Examine copies of sales Review the sales
are for supported by authorized invoices for supporting bills of journal, general
shipments shipping documents and lading and customers’ order. ledger, and account
actually made to approved customer receivable master file
existing orders. Examine customer order for or trial balance for
customers Credit is authorized credit approval. large or unusual items
(Existence) before shipments take Trace sales journal
place. Account for integrity of entries to copies of
Sales invoices are numerical sequence of sales sales orders, sales
prenumbered and invoices. invoices, and shipping
properly accounted for. Examine printouts of documents.
Only customer numbers transactions rejected by the Trace shipping
existing in the computer computer as having non- documents to entry of
data files are accepted existence customer numbers shipments in perpetual
when they are entered inventory records.
Observe whether statements are Trace credit entries in
Monthly statements are mailed and examine customer the account
sent to customers correspondence file. receivables master file
to existing sources.
Existing Sales Shipping documents are Account for integrity of Trace shipping
Transactions are pre-numbered and numerical sequence of shipping documents to resultant
Recorded accounted for. documents sales invoices and
(completeness) Sales invoices are pre- Account for integrity of entry into sales journal
numbered and accounted numerical sequence of sales and accounts
for. invoice. receivable master file.
Recorded sales Determination of prices, Examine copies of sales invoices Recomputed
are for the terms, freight, and for proper authorization. information on sales
amount of goods discounts is properly invoices.
shipped and are authorized. Examine indication of internal Trace entries in sales
correctly billed Internal verification of verification on affected journal to sales
and recorded invoice preparation. documents invoices.
(accuracy) Approved units selling Examine approved computer Trace details on sales
prices are entered into the printout of unit selling price invoices to shipping
computer and used for all Examine file of batch totals for documents, approved

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sales. initials of data control clerk; price lists, and

Batch totals are compared compare totals to summary customers’ orders.
with computers summary report
reports.

Sales Use of adequate chart of Review chart of accounts for Examine documents
transactions are accounts. adequacy. supporting sales
properly transactions for proper
classified Internal review and Examine indication of internal classification.
(Classification) verification verification on affected
documents
Sales are Procedures requiring Examine documents for unbilled Compare dates of
recorded on the billing and recording of shipments and unrecorded sales. record sales
correct date sales on daily basis as transactions with dates
(Timing) close to time of Examine indication of internal on shipping records.
occurrence as possible. verification on affected
Interval verification. documents.
Sales Regular monthly Observe whether statements are Foot journals and
transactions are statements to customers. mailed. trace postings to
properly Internal verification of general ledger and
included in the accounts receivable Examine indication of internal accounts receivable
accounts master files contents. verification. master file.
receivable Comparison of accounts
master file and receivable master file or Examine initials on general
are correctly trial balance totals with ledger account indicating
summarized general ledger balance. comparison
(Posting and
Summarization
)

Assess Planned Control Risk for Sales: the auditor uses the information obtained in
understanding internal control to asses control risk. There are four essential steps to this
assessment. These steps are:
First, the auditor needs a framework for assessing control risk. The framework for all classes of
transactions is the six transaction-related audit objectives (Existence, Completeness, accuracy,
Classification, timing and posting and summarization).
Second, the auditor must identify the key internal controls and weaknesses for sales.
Third, after identifying the controls and weaknesses, the auditor associates them with the
objectives.

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Finally, the auditor assesses control risk for each objective by evaluating the controls and
weaknesses for each objective. This step is a critical one because it affects the auditor’s decisions
about both tests of control and substantive tests. It is a highly subjective decision.
Evaluate Cost-benefit of Testing Controls: after the auditor has identified the key internal
controls and weaknesses and assessed control risk, it is appropriate to decide whether substantive
tests will be reduced sufficiency to justify the cost of performing tests of control.
Design Tests of Controls and Substantive Tests of Transactions for Sales:
Design Tests of Controls for Sales: For each control the auditor plans to rely on to reduce
assessed control risk, he or she must design one or more tests of controls to verify its
effectiveness. In most audits it is relatively easy to determine the nature of the control. For
example, if the internal control is to initial customer orders after they have been approved for
credit, the test of control is to examine the customer order for a proper initial.
A test of control for sales to account for a sequence of various types of documents such as
duplicate sales invoices selected from the sales journal, watching for omitted and duplicate
numbers or invoices outside the normal sequence. This test simultaneously provides evidences of
both the existence and completeness objective.
Design Substantive Tests of Transactions for Sales: in deciding on substantive tests of
transactions, some procedures are commonly employed on every audit regardless of the
circumstances, whereas others are dependent on the adequacy of the controls and the results of
the tests of controls. The purpose of these tests is to determine whether there is monetary
misstatement in sales transaction. In carrying out the substantive tests, the auditor should check:
 Recorded sale for there was no shipment
 Sales recorded more than once
 Shipment made to nonexistence customers
 Existing sales transactions are recorded
 Sales are accurately recorded
 Recorded sales are properly classified
 Sales are recorded on the correct dates, and
 Sales transactions are properly included in the master file and correctly summarized.
2.2. Completing the tests in the Sales and Collection Cycle: Accounts Receivable
2.2.1. Methodology for Designing Tests of Details of Balances

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The methodology for designing tests of details of balances for accounts receivable are:
o Set materiality and assess acceptable audit risk and inherent risk for accounts receivable
o Assess control risk for sales and collection cycle
o Design and perform tests of controls and substantive tests of transactions for the sales and
collection cycle
o Design and perform analytical procedures for accounts receivables balance, and
o Design details of accounts receivables balance to satisfy balance related audit objectives
Set materiality and assess Acceptable Audit Risk and Inherent Risk:
Setting materiality starts with the auditor deciding the preliminary judgment about materiality for
the entire financial statements. It also includes allocating the preliminary judgment amount to
each significant balance sheet account, including accounts receivable. This allocation is called
setting tolerable misstatements.
Acceptable audit risk is assessed for the financial statements as a whole and is not allocated to
various accounts or objectives.
Inherent risk is assessed for each objective for an account such as accounts receivable.
Accounts Receivable Balance-Related Audit Objectives
The nine general balance-related audit objectives are also applied to accounts receivable.
These are:
1) Detail tie-in – accounts receivable in the aged trial balance agree with related master file
amounts, and the total is correctly added and agrees with general ledger
2) Existence – recorded account receivable exist
3) Completeness – existing accounts receivable included
4) Accuracy – accounts receivable are accurate
5) Classification – accounts receivables are properly classified
6) Cutoff - cutoff for accounts receivable correct
7) Realizable Value – accounts receivable is stated at realizable value
8) Rights – the client has rights to the accounts receivable
9) Presentation and Disclosure – accounts receivable presentation and disclosure are
proper
Conformation of Accounts Receivable
One of the most important audit procedures is the conformation of accounts receivable. The
primary purpose of accounts receivable conformation is to satisfy the existence, accuracy, and
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cutoff objectives. Conformation of accounts receivable and physical examination of inventory

are the two major audit procedures required by AICPA. However, SAS67 permits auditor to give
unqualified audit report even when accounts receivables are not confirmed in any of the
following three conditions:
 Accounts receivables are immaterial;
 The auditor considers confirmation ineffective evidence because response rates will
likely be inadequate or unreliable; and
 The combined level of inherent risk and control risk is low and other substantive
evidence can be accumulated to provide sufficient evidence.
If the auditor decides not to confirm accounts receivable, the justification for doing so must be
documented in the working paper.
Confirmation Decisions
In performing confirmation procedures, the auditors must decide the type of confirmation to use,
timing of the procedures, sample size, and individual items to select.
Type of confirmation
Two common types of confirmation are used for confirming accounts receivable: Positive and
Negative confirmation.
A positive confirmation is a communication addressed to the debtors requesting him/her to
confirm directly whether the balance as stated on the confirmation request is correct or incorrect,
if incorrect by what amount. The second type of positive confirmation, often called blank
confirmation form, does not state the amount on the confirmation but requests the recipient to fill
in the balance or furnish other information.
A negative confirmation is a letter addressed to the debtor, requesting a response only if the
recipient disagrees with the amount of the stated account balance.
A positive confirmation is more reliable evidence because the auditor can perform follow-up
procedures if a response is not received from the debtor. With a negative confirmation, failure to
reply must be regarded as a correct response, even though the debtor may have ignored the
confirmation request.
According to SAS 67, it is acceptable to use negative confirmation only when all of the
following circumstances are present:
 Accounts receivable are made up of a large number of small amounts

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 Combined assessed control risk and inherent risk is low

 There is no reason to believe that the recipients of the confirmation are unlikely to give
them consideration

Follow-up on Non-Responses
When positive confirmations are used, SAS 67 requires follow-up procedures for confirmations
not returned by the customer or debtor. It is common to send second and sometimes even third
requests for confirmations. Even with these efforts, some customers do not return the
confirmation, so it is necessary to follow-up with alternative procedures. The objective of
alternative procedures is to determine by a means other than confirmation whether the non-
confirmed accounts existed and was properly stated at the confirmation date.
For any positive confirmation not returned, the following documentations can be examined to
verify the existence and accuracy of individual sales transactions making up the ending balance
in accounts receivable.
 Subsequent cash receipts
 Duplicate sales invoice
 Shipping documents, and
 Correspondence with clients
Analysis of Differences
When the confirmation requests are returned by the customer, it is necessary to determine the
reason for any reported differences. In many cases, they are caused by timing differences
between the client’s and the customer’s records. It is important to distinguish between these and
exceptions, which represent misstatement of the accounts receivable balance.
The most commonly reported types of differences in confirmation are:
 Payment has already made
 Goods have not been received
 Goods have been returned, and
 Clerical errors and disputed amounts

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