Auditing & Assurance

Services 8e
Chapter 7

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 Chapter 07
Revenue and Collection Cycle

“What at first was plunder assumed the softer name of

revenue.”
Thomas Paine, English-American political
philosopher and revolutionary (1737-1809)

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Chapter 7 Learning Objectives
1. Describe the revenue and collection cycle, including typical source
documents.
2. Identify significant accounts and relevant assertions related to the
revenue and collection cycle.
3. Discuss the risk of material misstatement in the revenue and collection
cycle, with a specific focus on improper revenue recognition.
4. Identify important internal control activities present in a properly
designed system to mitigate the risk of material misstatements for each
relevant assertion in the revenue and collection cycle.
5. Give examples of tests of controls to test the operating effectiveness of
internal controls in the revenue and collection cycle.
6. Give examples of substantive procedures in the revenue and collection
cycle and relate them to assertions about significant account balances at
the end of the period.
7. Apply your knowledge to perform audit procedures in the revenue and
collection cycle and evaluate the findings of your tests.
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 Revenue
and
Collection
Cycle

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Basic Activities in Revenue and Collection Cycle
The basic activities in the revenue and collection cycle
for a typical manufacturing company include:
1. receiving and processing customer orders;
2. delivering goods and services to customers;
3. billing customers and accounting for accounts
receivable; and
4. collecting and depositing cash received from
customers.

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Sales and Accounts Receivable Processing

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Audit Evidence in Management Reports and
Data Files
• Pending order and back order master file
• Customer master file
• Price list master file
• Sales detail (journal) file
• Sales analysis report
• Accounts receivable listing and aging
• Cash receipts listing
• Customer Statements

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Using the Audit Risk Model
1. Set audit risk at desired levels (normally, low).
2. Assess risk of material misstatement, which incorporates
inherent risk based on the nature of the account balance or
class of significant transactions and control risk based on
gaining an understanding of internal control. Note that AS
2110 indicates that the auditor should presume that there is
a fraud risk involving improper revenue recognition.
3. Set detection risk at the significant account and assertion
level based on the level of audit risk and risk of material
misstatement.

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Inherent Risks
• Improper Revenue Recognition
– Cut-off
– Bill and Hold
– Channel Stuffing

• Returns and Allowances

• Collectability of Receivables

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Significant Accounts and Relevant Assertions in
the Revenue and Collection Cycle

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Revenue Recognition
• Must be (1) realized or realizable and (2) earned
• SEC guidance (SAB 104)
– Persuasive evidence of an arrangement exists;
– Delivery has occurred or services have been rendered;
– The seller's price to the buyer is fixed or determinable; and
– Collectability is reasonably ensured.

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Revenue from Contracts with Customers
FASB 5-step process for revenue recognition (ASC 606):
1. Identify the contract(s) with a customer.
2. Identify the performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance
obligations in the contract.
5. Recognize revenue when (or as) the entity satisfies a
performance obligation.

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What Can Go Wrong in the Revenue and
Collection Cycle?

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Revenue
Recognition
Rogues

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Revenue and Collection Cycle: Key Control
Procedures
• Separation of Duties
– Separate functions for recording, authorization, custody
• Authorization of Transactions
– Write-offs
– EDI transactions
– Credit checks prior to approval of sale
– Pricing
• Access to Assets
– Shipping department
– Lock box account
• Adequate Documents and Records
– Pre-numbered sales orders, shipping documents (bills of lading), sales invoices
– Remittance advice
• Independent Checks on Performance
– A/R subsidiary ledger to general ledger
– Monthly statement to customer
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Internal Control Activities in the Revenue and
Collection Cycle

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Tests of Controls in Revenue and Collection
Cycle

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Dual Direction of Test Audit Sample

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Other Tests of Controls in the Revenue Cycle
• Completeness of revenue and accounts receivable
• Accuracy of revenue and accounts receivable
• Accuracy of revenue
• Cutoff of revenue
• Classification of accounts receivable

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Substantive Procedures in the Revenue and
Collection Cycle

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Substantive Procedures in the Revenue and
Collection Cycle (continued)

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Auditing Accounts Receivable
• Test Accounts Receivable Aged Trial Balance
• Confirm balances
• Perform analytical procedures
• Test sales cut-off

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Analytical Procedures
• Sales Revenue
– Comparisons with previous periods
– Comparisons with industry
• Allowance for Doubtful Accts, Bad Debt Expense
– Bad Debt Expense as a percentage of Sales
– Allowance for Doubtful Accounts as a percentage of Gross
Receivables
• Accounts Receivable
– Days Sales in Accounts Receivable
– Accounts Receivable Turnover

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Using Confirmations
• Primarily for verifying existence
• Factors likely to affect the reliability of confirmations
– Previous audit experience
– Intended recipient of the confirmation
– Type of information being confirmed

• Auditor may confirm entire balances or

individual transactions
– Type of confirmation being sent

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Types of Confirmations
• Positive Confirmations
– small number of accounts are involved
– large number of errors are anticipated

• Negative Confirmations
– the combined assessed level of inherent and control risk is low
– a large number of small balances is involved
– the auditor has no reason to believe that the recipients of the
requests are unlikely to give them consideration.
• Blank Confirmations should be used if the recipient is likely to
return a positive confirmation without verifying the accuracy
of the information.

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Matters Related to Confirmations
• There are three sets of circumstances that could justify the
omission of the confirmation of a client's accounts receivable:
– Not material to the financial statements
– If the risk of material misstatement is low
• the assessed level of evidence from analytical procedures and other tests
of details is sufficient to reduce audit risk to an acceptably low level
• confirmation of accounts receivable may be inefficient
– Confirmation of accounts receivable is expected to be ineffective
(based on previous years' audit experience)

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Other Matters Related to Confirmations
• All confirmations returned by the post office as non-
deliverable must be investigated
• Responses to positive and blank confirmations
provide more reliable evidence than negative non-
responses
• Recipients of accounts receivable confirmations
might not report understatements
• Auditors must have heightened professional
skepticism for electronic responses (fax or e-mail)
– Verify that the response came from an appropriate person
at the employer
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Other Matters Related to Confirmations
(continued)
• Non-response to Positive/blank confirmation
requests
– Follow up with second and sometimes third requests.
– A lower than expected response rate could be indicative of
fictitious customer accounts
– Alternative procedures
• Non-response to negative confirmation requests
– Only limited evidence concerning financial statement
assertions
– Alternative procedures are not necessary for unreturned
negative confirmation requests
• Follow-up on all exceptions
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Accounts Receivable Aged Trial Balance

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 Positive
Confirmation
Letter

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 Negative
Confirmation
Letter

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Responses to Positive Confirmations

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Sales Cutoff Procedures
• Used to verify whether Sales/Revenues recorded in the
correct accounting period
– Holding the books open

• Examine sales invoices and shipping documents shortly prior

to and after year-end
• Examine returns after year-end

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Alternative Procedures
• Vouch subsequent cash collections
– usually sufficient evidence of existence, valuation
• Examine shipping documents
– Especially BOL (third-party evidence)
• Examine client-generated supporting documentation, such as
invoices
– Depends on internal controls
• Inspect correspondence files

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Uncollectible Accounts
• Inspect customer files for collectability
• Recalculate allowance and bad debt expense
• Verify reasonableness of allowance and bad debt
expense
• Inspect documentation for appropriateness of
accounts written off
– Inspect documentation for additional collection
procedures
– Inspect documentation for appropriate authorization

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Application in the Field—
Data and Analytics and the use of IDEA

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PCAOB Inspections and the Revenue and
Collections Cycle

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PCAOB Inspections and the Revenue and
Collections Cycle (continued)

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