Ch. 7 HW Solutions - Edward Lynch PDF

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CHAPTER 07Revenue and Collection CycleLEARNING OBJECTIVESReview CheckpointsMultiple ChoiceExercises, Problems, and Simulations Describe the revenue and collection cycle, including typical source documents. 1, 2, 3, 4, 5 33 76 Identify significant accounts and relevant assertions related to the reven...

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Chapter 07 - Revenue and Collection Cycle

CHAPTER 07 Revenue and Collection Cycle LEARNING OBJECTIVES Review Checkpoints

Multiple Choice

Exercises, Problems, and Simulations

1. Describe the revenue and collection cycle, including typical source documents.

1, 2, 3, 4, 5

2. Identify significant accounts and relevant assertions related to the revenue and collection cycle.

6, 7, 8

3. Discuss the risk of material misstatement in the revenue and collection cycle, with a specific focus on improper revenue recognition.

9, 10, 11

34, 40, 42, 44, 58, 61, 62

72, 74

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.

12, 13, 14

37, 38, 39, 50, 56, 59

64, 65, 69, 73

15, 16, 17, 18, 27

55

66, 71, 75, 78, 79

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.

19, 20, 21, 22, 23, 24, 25 26

35, 41, 43, 45, 46, 47, 48, 49, 51, 53, 54, 57, 60, 63

67, 68, 70, 80

7. Apply your knowledge to perform audit procedures in the revenue cycle and evaluate the findings of your tests.cycle and design some audit and investigation procedures for detecting them.

28, 29, 30, 31, 32

33

76

36, 52

77, 78, 79, 80

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Chapter 07 - Revenue and Collection Cycle

SOLUTIONS FOR REVIEW CHECKPOINTS 7.1

The basic sequence of activities and accounting in a revenue and collection cycle is: a. b. c. d. e.

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 accounts receivable. Collecting cash and depositing it in the bank. Accounting for cash receipts. Reconciling bank statements.

7.2

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.)

7.3

Access to computer terminals should be restricted so that 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.

7.4

Auditors could examine these files for evidence of:   

7.5

7.6

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 indicates 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.

According to the professional standards, an account is significant and a financial statement assertion is relevant if it has a “reasonable possibility of containing a misstatement that would cause the financial statements to be materially misstated.”

7.7 Occurrence of revenue is considered a significant account and relevant assertion for several reasons:  The magnitude of revenue is often substantial indicating that recorded revenues are generally material.  Management has an incentive to overstate revenues, thus the occurrence assertion is relevant.  Stakeholders focus on revenue as a performance measure, therefore the account is significant to users of the financial statements. 7.8

The inherent risk for the existence assertion for accounts receivable is often higher than inherent risk for the completeness assertion because management has an incentive to overstate accounts receivable. It is important to place emphasis on the existence assertion because auditors have often been sued for malpractice by providing unqualified reports on financial statements that overstated assets and revenues and understated expenses. For example, credit sales recorded too early (e.g., a fictitious sale) result in overstated accounts receivable and overstated sales revenue.

7.9

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.

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Chapter 07 - Revenue and Collection Cycle

7.10

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, markets often value companies based on a multiple of its revenue instead of net income.

7.11

New companies often do not show a profit during their first few years. Therefore, creditors and investors often place more emphasis on the revenues, especially looking for revenue growth that might lead to future profitability. Knowing this, management could try to inflate revenues.

7.12

To ensure completeness of recorded revenue, all invoices, shipping documents, and sales orders should be prenumbered, and the numerical sequence should be checked on a timely basis.

7.13

In a standard revenue cycle, a three-way match of a customer purchase order, evidence of shipment (perhaps a bill of lading), and a customer invoice provides the best evidence of a completed sale. A company should generally not recognize revenue until all three documents are present. This control will provide assurance about the occurrence of revenues and the existence of accounts receivable.

7.14

Entity level controls provide an additional level of assurance for the auditor related to control risk. For example, if the client has a strong audit committee, this provides additional assurance that appropriate oversight is being conducted internally. Control risk assessment should always be conducted in a top-down approach, with entity level controls considered initially.

7.15

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:

7.16



No sales order should be entered without a customer order.



A credit-check code or manual signature should be recorded by an authorized person.



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.



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 assure 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 in a timely manner to avoid failure to bill the customer and record shipments



Bank statements should be reconciled in detail monthly. The purpose of the walkthrough 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. In a walkthrough of a sales transaction, auditors take a small sample (usually 1–3 items) 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, and 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 to ensure proper procedures are taking place.

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Chapter 07 - Revenue and Collection Cycle

7.17

In general, the types of procedures in tests of controls over the operating effectiveness involve vouching, tracing, observing, scanning, and recalculating.

7.18

Dual direction tests of controls sampling refers to procedures that test file contents in two “directions”: the occurrence direction and the completeness direction. The occurrence direction involves 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.

7.19

Accounts receivable is often the debit entry when Sales Revenue is recognized – particularly if the sale is being recognized fraudulently. In these cases, cash would not be received, so the fictitious balance would end up in accounts receivable. As a result, auditors are concerned about the validity or existence of accounts receivable. Note that auditors are also concerned about the valuation assertion for accounts receivable – just because someone owes a company money does not mean they will pay that amount.

7.20

These procedures are usually the most useful for auditing the existence assertion: Confirmation. Letters of confirmation asking for a report of the balances owed to the company can be sent to customers. Verbal Inquiry. Inquiries to management usually do not provide very convincing evidence about existence and ownership. However, inquiries about the company’s agreements to pledge or sell with recourse accounts receivable in connection with financings should always be made. Examination of Documents (vouching). Evidence of existence can be obtained by 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 estimates of doubtful accounts.

7.21

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 nonfinancial data such as units sold, number of customers, sales commissions, and so on. These comparisons can be made by product, period, geographic region, or salesperson.

7.22

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 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.

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Chapter 07 - Revenue and Collection Cycle

7.23

Justifications for the decision not to use confirmations for trade accounts receivable in a particular audit include (a) receivables are not material, (b) confirmations would be ineffective based on prior years’ experience or knowledge that responses could be unreliable, and (c) analytical procedures and other substantive procedures provide sufficient, competent evidence.

7.24

Auditors need to take special care in examining sources of accounts receivable confirmation responses. Auditors need to control the confirmations, including the addresses to which they are sent. History is full of cases in which confirmations were mailed to company accomplices who had provided false responses. The auditors should carefully consider features of the reply such as postmarks, FAX, and email responses, letterhead, electronic mail, telephone number, 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 crisscross directory to determine the location of a respondent).

7.25

When positive confirmations are not returned, the auditor should perform the following procedures: a. Send second and even third requests. b. Apply subsequent cash receipts. c. Examine sales orders, invoices, and shipping documents. d. Examine correspondence files for past due accounts.

7.26

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 the 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 nonpayment 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 or her estimate to the balance in the allowance account and proposes an adjusting entry for the difference.

7.27

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.

7.28

In the Canny Cashier case, if someone other than 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 bank deposit slips to cash remittance reports did not match.

7.29

To prevent the cash receipts journal and recorded cash sales from reflecting more than the amount shown on the daily deposit slip, internal controls should ensure that receipts are recorded daily and are complete. A careful bank reconciliation by an independent person may detect such errors.

7.30

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.

7.31

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.

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Chapter 07 - Revenue and Collection Cycle

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 that is too high. 7.32

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.

SOLUTIONS FOR MULTIPLE CHOICE QUESTIONS 7.33

a.

Incorrect

b. c.

Correct Incorrect

d.