audit of the sales and collection cycle

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					                                          Chapter 14
                                     Audit of the Sales and
                                       Collection Cycle

Key objectives:

1.   Identify the accounts and classes of transactions in the sales and collection cycle.
2.   Describe the business functions and related documents and records in the sales and
     collection cycle.
3.   Understand internal control and design appropriate tests of controls and substantive tests of
     transactions for sales.
4.   Understanding the accounting and controls for sales returns and allowances.
5.   Understand internal control and design appropriate tests of controls and substantive tests of
     transactions for cash receipts.
6.   Understanding the accounting and controls for write-offs of uncollectible accounts.

1.   Introduction to Transactions (Figure 14-1, p. 442 of text)

     The accounting for these transactions should be familiar.
     Sales and cash receipts are examined simultaneously because
     they are interrelated, and both affect accounts receivables.
     (Tests applied to each balance/transaction in parentheses.)

                          Accounts receivable
           Beginning                Cash receipts (TOT)
           balance (PY)
                                    Sales returns
                                    and allowances
           Sales on
           account (TOT)
                                    Bad debt
           balance (TODB)

     Sales returns and bad debts are non-cash credits to accounts
     receivable (TOT and TODB). Both activities and ending balanced
     are tested using analytical procedures.

2.   Documents in the cycle - The attached chart (p. 106-107)
     can be used to familiarize you with the documents in the
     cycle when studying Table 14-2 and Table 14-3 in the text.
     We are especially interested in controls associated with each

                                     Documents in Sales Cycle

   Document              Controls (objective)                            Comments
Customer order                                         Process is initiated with the customer order.
                                                       The customer order is not primary for the
                                                       existence assertion (shipping document is).
                                                       Order could be received by mail, phone, over
                                                       the internet, or through EDI.
Sales order         Credit approval and                Sales orders should receive approval prior to
                    authorization of shipment          shipment, including authorization of credit
                    (occurrence).                      (specific or general). Credit should be
                                                       authorized by someone independent of sales
                                                       (often done automatically by computer). (1)
                                                       Credit approval process affects extent of net
                                                       realizable value tests (test of allowance for
                                                       doubtful accounts).
Shipping            Checking of quantities             Shipper is primary evidence of occurrence,
document            (accuracy).                        because all recorded sales should be supported
(bill of lading)    Account for sequence               by a shipper.
                    (completeness).                    Account for numerical sequence to ensure
                                                       completeness (all shippers should result in a
                                                       sales invoice).
Sales invoice       Matched with shipper               The sales invoice is the main document for the
                    (occurrence).                      recording of sales. Accounting for the
                    Prices, quantities and             sequence of sales invoices in the sales journal
                    extensions checked                 also assures completeness by determining that
                    (accuracy).                        all sales were recorded. (2)
                    Account for sequence
Sales journal       Footings and postings checked      Sales invoices are recorded in the sales
                    (posting and summarization).       journal. Posted to the G/L, usually monthly.
                    Posted as soon as possible after   With computerized system, individual entries
                    goods are shipped (timeliness).    should also be posted automatically to the A/R
Credit Memo         Proper approval (occurrence).      Source document for returns and allowances.
                    Receiving report for returned      Returns should be supported by a receiving
                    goods (occurrence).                report; other allowances should be properly
                                                       authorized. Testing depends upon materiality
                                                       of amounts.

(1) – Audit software such as ACL can test for shipments exceeding credit limits. Note that the credit
      limit must be approved by someone independent of sales.
(2) – Duplicates and gaps in shipping documents and sales invoices can be checked using audit

                                 Documents in Cash Receipts Cycle

  Document              Controls (objective)                            Comments
Cash receipt      Prepared by someone                 Beginning of cash receipts cycle, and point
prelist           independent of accounts             where cash enters business.
                  receivable, often an                Establishes record of cash received to prevent
                  administrative assistant or         theft. Checks should also be restrictively
                  someone with no accounting          endorsed at this point.
                  duties (completeness).
                                                      This assumes payment by mail, usually in the
                                                      form of a check. Checks can also be sent
                                                      directly to a lockbox, or wire transferred.
                                                      Different controls are necessary for firms that
                                                      receive payments in cash.
Remittance        Document that accompanies           Additional evidence of amount of cash
advice            payment by check - often the        received. When no remittance advice is
                  lower portion of the check          received, it is customary for the person who
                  (completeness and accuracy).        prelists cash to prepare one.

                  The remittance advice is also
                  important evidence of the
                  occurrence of a cash receipt
                  because the other evidence (the
                  check) is deposited.

                  The actual cash receipts should
                  be deposited - usually on a daily
                  basis (timeliness)
Cash receipts     Posting and summarization           The cash receipts journal is used to record
journal           checked (P&S).                      individual cash receipts. Individual cash
                  CR recorded at time of receipt      receipts are automatically posted by computer
                  (timeliness)                        to individual customer A/R.
Accounts          Reconciled to the general           The accounts receivable subledger is
receivable        ledger by someone independent       important because it is the interface between
subledger         of sales and cash receipts          the sales and cash receipts cycle. The
                  (posting and summarization,         reconciliation of the subledger to the general
                  as well as other objectives)        ledger is an important control.
Bad debt          Should be authorized                Company should have proper procedures to
charge-off        (occurrence)                        charge-off accounts. Should be authorized by
                                                      someone independent of authorization of
                                                      credit and recording of sales.

     Note: it also critical that the bank reconciliation be performed by an independent person.

3.   Approach to Cycle (Walk through Table 14-2)

     a.    Identify controls (if any) for each objective.
     b.    Design tests of controls (assuming cost-effectiveness)
           for key controls. (Designing the TOC is easy, once the
           control has been identified).
     c.    Design appropriate substantive tests of transactions.
     d.    Tests should be sufficient to meet each objective.

4.   Miscellaneous Focuses

     a.    Three authorizations are very important for the
           valuation and existence objectives:

                Credit
                Shipment of goods
                Pricing

     b.    Prenumbered documents (especially shippers) for

     c.    Monthly statements - Independently mailed statements
           will help detect misstatements, especially overstatements
           and mispostings, such as:

              Sale or cash receipt posted to incorrect account
              Cash receipt not credited to account

5.   Direction of Tests

     A frequent CPA exam question is the objective of a test, or
     what can be inferred from a specific test (see problem 14-27).
     The main concern with the direction of tests is usually whether
     it can be used to infer existence or completeness.

          From a journal to source document (concerned with
           recorded amounts) = Occurrence
          From a source document to journal (concerned with
           unrecorded amounts) = Completeness

     Another way to view this issue is:

          Occurrence - Concerned with overstatements.
          Completeness - Concerned with understatements.

     Hence, auditors are usually more concerned with existence for
     accounts receivable, and completeness for accounts payable.

 It may help to view the cycle as a sequence of steps and documents.

                      Direction of Tests for Sales

                            Shipping                Start
                            Document                  

                           Sales Invoice
      Occurrence               Sales                  
        Start                 Journal                   

                                                        
Posting and               General Ledger    =      A/R Master
Summarization                                         File

 Selecting a sample for tests: (Described further in Chapter 15 - see
 problem 15-27 (a,b))

 1.      Sampling from the sales journal (sales invoices) can be used to
         satisfy any objective, except completeness (a sample drawn from
         sales invoices can't be used to test completeness, because they are
         already recorded).

 2.      Sampling from shippers can be used to satisfy any objective,
         except occurrence (since the shipper establishes existence, it
         can't be used as the sample to test for existence).

         Therefore, a sample selected from either shippers or sales
         invoices could be used for a pricing test, etc.)

     3.    Sampling from sales invoices is essentially the same as
           sampling from the sales journal, as they should be identical.
           The auditor may account for a sequence of sales invoices as a
           completeness test.

          Accounting for a sequence of sales
           invoices in sales journal                       Completeness
          Trace sales invoices to shippers (or examine
           sequence of invoices noting shippers)            Occurrence

Multiple Choice 14-27 (a)

To minimize failures to post invoices to the AR subledger, the auditor
would select a sample from:

1.   Customer order file.
2.   Bill of lading file.
3.   Customer AR master file.
4.   Sales invoice file.

Multiple Choice 14-23 (a)

An auditor is performing STOT for sales. Tracing debit entries in the AR
master file back to sales invoices establishes:

1.   Sales invoices represent existing sales.
2.   All sales have been recorded.
3.   Sales invoices have been properly posted to customer accounts.
4.   Debit entries in the AR master file are supported by sales invoices.

6.   Substantive tests of transactions - Although we have discussed
     TOC more that STOT, they are very important in the audit. The
     table on page 113 of the notes indicates some specific STOT for
     sales. The primary focus is on occurrence.

          Usual test is to trace sales to shipping documents.
          In some circumstances, the auditor may also trace the sale to
           reductions in inventory records or subsequent cash receipts as
           further verification of the validity of the sale.

Multiple Choice 14-23 (b)

To verify that all sales transactions have been recorded, STOT should be
performed on a sample drawn from:

1.   Entries in the sales journal.
2.   Billing clerk's file of sales orders.
3.   Duplicate sales invoices for which sequence has been accounted.
4.   Shipping clerk's file of bills of lading.

Multiple Choice 14-22 (c)

A sales invoice for $5200 was correctly computed, but key entered as
$2500 in the journal and AR master file. The customer remitted $2500,
the amount on the monthly statement. This error would most likely be
detected by:

1.   Prelistings and control totals are used to control postings.
2.   Invoice extensions are independently checked.
3.   Customer statements are verified and mailed by someone other than
     the bookkeeper.
4.   Unauthorized deductions are investigated

7.   Sales returns and allowances

     a.    Recording - theoretically should be matched with sale. In
           practice returns and allowances are recorded as they occur.
           This does not present a problem, if there are no significant
           returns after year-end.

           Why might there be excessive returns shortly after year-end?

     b.    Authorization - Returned goods should be sent to the
           receiving department, and a receiving report prepared. Other
           allowances should be specifically authorized.

     c.    Objectives

                Transactions - focus is on the occurrence of returns and
                 allowances since they can be used to hide theft of cash.
                Balances - In the year-end tests of accounts receivable,
                 the focus is on completeness, since the failure to record
                 returns overstates accounts receivable.

           The significance of sales returns and allowances determines
           the extent to which they are tested.

Multiple Choice 14-22 (a)

A company received a large sales return in the last month of the year, but
the credit memo wasn't prepared until after the auditors completed field
work. The returned goods were included in inventory. This error would
most likely be detected by:

1.    Aged AR trial balance is prepared.
2.    Credit memos are prepared and accounted for.
3.    Reconciliation of the AR trial balance and general ledger is
4.    Receiving reports are prepared and accounted for.

8.    Cash receipts cycle

      The same methodology can be applied to studying the cash receipts
      cycle. Cash receipt cycle is easier because it involves fewer
      documents. Some key points:

      a.    Critical audit point - when cash first enters organization.

            Mail should be opened, cash prelisted, and restrictively
            endorsed by someone independent of receivable functions.

                 Prelist should be compared to deposits

            A bank lockbox can be used to eliminate the need for company
            employees to handle mail receipts - checks are sent directly to
            the bank. This prevents employee theft of checks, but is not
            cost-effective for many companies.
            Therefore, to ensure completeness of cash receipts:

                 Lockbox is first-best choice (ignoring cost)
                 Independent prelist if lockbox not feasible

      b.    Over-the-counter cash - For organizations which receive
            revenue in the form of cash, it must be reconciled to cash
            register tapes or other records supporting sales.

            Best way to hide theft of cash receipts is to not record the

      c.    Bank accounts and A/R subledger independently reconciled.

      d.    Review for large non-cash credits, such as returns and
            allowances, and bad debt writeoffs (why?)

                                          Sales Cycle
                        Illustrative Substantive Tests of Transactions

 Objective                     Procedure                         Comment
 Recorded sales exist          Trace from sales journal or       Almost always done, even if
 (occurrence)                  invoice to shipper.               controls are effective.
 Existing sales are recorded   Trace from shippers to            Probably not necessary if
 (completeness)                recorded sales (invoice or        tested controls.
 Sales are recorded at         Recompute quantities and          Normally done. Can reduce
 proper amounts (accuracy)     extensions (reperformance).       sample size if controls exist.
                               Agree price to price list.
 Sales are properly            Check documents supporting        Not normally an important
 classified                    sale for proper account           issue.
                               distribution in sales journal.
 Sales are timely recorded     Compare dates on shipper          Really a test of control.
                               with sales invoice and entry in
                               sales journal
 Sales are summarized          Foot sales journal and trace to   Generally always done.
                               entry in general ledger.

                               Test reconciliation of A/R
                               subledger to general ledger.

Discussion Case – Howard Street Jewelers

Homework Problems

14-26 (c,d,e)
Sales Tests of Transactions (Collected)

Sample Multiple Choice (Text)
14-21 (a), (b), (c)
14-22 (a), (b), (c)
14-23 (a), (b), (c)
14-27 (a), (b), (c)

Problem 14-26
      a.     Objective 1      A given sale is recorded more than once, or a sale is recorded for which
                              a shipment was not made.
             Objective 2 A shipment took place for which no sale was recorded.
             Objective 3 A sales journal was incorrectly footed, or a sales transaction was posted
                              to the incorrect customer account.
      b.     The first objective deals with overstatement of sales resulting from recording sales for
             which no shipment had occurred. The second objective concerns understatement of
             sales. It results from a shipment that has not been recorded.
      c.     Procedures 2, 3, and 4 are tests of controls. Procedures 1, 5, and 6 are substantive tests
             of transactions.

                           (1)                   (2)
                                                                        POSTING AND
                       OCCURRENCE           COMPLETENESS

  SUBSTANTIVE              Procedure             Procedure                 Procedure
 TEST OF TRANS                 6                     1                         5
     TEST OF               Procedure             Procedure                 Procedure
    CONTROL                    2                     4                         3


                                                              NATURE OF MISSTATEMENT

       2         A shipping document is attached to          To prevent billing to a customer or
                 each duplicate sales invoice.               recording a sale for which no
                                                             shipment has been made.
       3         An independent person traces from the       Preventing misstatements in failure
                 sales journal to the accounts receivable    to post to the accounts receivable
                 master file. A tick mark is shown in        master file, posting to the wrong
                 the margin of the sales journal after a     customer, at the wrong amount, or
                 transaction is traced.                      at the wrong date.

       4         At the time of billing, the duplicate       The failure to bill customers for
                 sales invoice number is written on the      shipments actually made.
                 bottom left-hand corner of each
                 shipping document. Periodically, the
                 entire sequence of shipping documents
                 is accounted for and each is examined
                 to make certain there is an invoice
                 number, which indicates that a given
                 shipment has been billed.
                           Sales Test of Transactions Problem - Fall 2009

Name: _________________________________

      Procedure                                 Type of test   Transaction objective
 1.   Account for sequence of shippers       Test of control   Completeness
      noting invoice is attached
 2.   Account for sequence of sales
      invoices noting shipper is attached
 3.   Compare quantity and description on
      shipper with sales invoice
 4.   Trace from sales journal to master
 5.   Examine sales return for approval
 6.   Trace for prelisting of cash to cash
      receipts journal.
 7.   Examine sales order for evidence of
      credit authorization.


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