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Lecture 9

Lecture 9 - Auditng Revenue and Cash.docx

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LECTURE 9 – AUDITING REVENUE AND CASH AUDITING FOR REVENUE Types Of Tests 1. Procedures to gain understanding of IC 2. Tests of controls 3. Substantive tests of transactions 4. Analytical procedures 5. Tests of details of balances Mix of Tests  Auditor needs combination of all tests for each a/c.  Basis decision on IC system, costs of tests, inherent risk  Tests of controls & substantive tests of transactions performed for transactions in cycle  Analytical procedures – both transactions & ending balances  Tests of details of balances – on ending balances Costs of Tests  Least cost: o Analytical procedures o Understanding & testing IC system o Substantive tests of transactions o Tests of details of balances Cycle Transactions  Revenue  Acquisition of and payment for goods and services  Payroll  Financing: debt and capital  Cash and short-term investments Draw slide 8 here Internal Control Objectives  Occurrence o Looking for existence  Completeness o Looking for omissions  Accuracy These 5 assertions test the account balances o Current customer numbers/dates  Cutoff o Correct accounting period  Classification o Correct account in income statement or balance sheet / recorded in the correct place Overview of Revenue Cycle  Receive customer purchase order  Check inventory stock status o Generate back order if item not in stock  Obtain credit approval  Prepare shipping and packing documents  Ship and verify shipment of goods  Prepare the invoice  Send monthly statements to customers  Receive payment Revenue Recognition  AASB 118: o The risks & rewards of ownership are transferred. o There is no longer management or control over goods. o The revenue amount can be measured reliably. o It is probable that economic benefits will be collected. o The costs of the transaction can be measured reliably. Methods Used to Inflate Revenue  Recognition of revenue on fictitious shipments  Arrangements that give customers unlimited right to return product  Recording consignment sales as final sales  Early recognition of sales occurring after year-end  Shipment of unfinished goods  Shipment of goods before date agreed by customer  Creation of fictitious invoices  Shipment of goods never ordered  Shipment of more goods than ordered  Recording shipments to company warehouse as sales  Recording shipments of replacement goods as new sales  Related party transactions Fraud Risk Factors: Revenue Recognition (Required by ASA 240)  There are a number of types of ‘red flags’ which signal the potential for fraud in the financial statements: o External risk indicators o Internal red flags  Management compensation  Market expectations  Industry trends  Exploitation of share options o Unusual financial results.  The auditor deals with red flags by: o Examining external pressures that could lead to financial reporting fraud o Examining financial statements to determine if account balances seem out of line.  Must address these issues – otherwise results in negligence Analysis for Likely Misstatements  Compare client revenue trend with economic conditions and industry trends.  Compare cash flow from operations with net income.  Perform analytical procedures o Ratio analysis o Trend analysis o Reasonableness tests Assessment of Environment Risk  Risk assessment is an ongoing process in every audit.  Audit steps to assess environment risk for the revenue cycle: 1 Update information on business risk 2 Perform analytical procedures to look for unexpected relationships 3 Develop understanding of internal controls 4 Analyse business risk for motivations and methods to misstate sales 5 Document operation of accounting applications and important controls 6 Develop preliminary assessment of environment risk 7 If control risk is high, determine likely types of misstatements  Less control testing and more substantive testing 8 If control risk is lower, develop procedures to test operation of controls  More control and less substantive testing 9 Perform tests of controls and document results 10 Based on the results of testing, reassess control risk Inherent Risk: Sales  Sales transactions are routine for most organisations and do not represent an abnormally high risk  Difficult audit issues include: o When to recognise revenues  Example: construction industry – point of sale revenue recognition vs. Percentage of completion o The impact of any unusual sales terms and whether title has passed  Example: related party transactions o Goods recorded as sales have been shipped o Treatment of sales made with recourse or that have significant returns  Example: irrevocable right to return goods  The presence of these issues increases inherent risk and the probability of material misstatement. Inherent Risk: Receivables  Primary risk is that net receivables will be overstated, either because they are overstated or provision for d/debts has been understated.  Risks affecting receivables include: o Sales of receivables recorded as sales rather than financing transactions o Receivables pledged as collateral o Receivables classified as current when likelihood of collection is low o Collection of receivable contingent on uncertain future events o Payment not required until purchaser sells the product. The Control Environment and Sales  An organisation’s control environment affects revenue and related transactions more than most accounts.  The auditor must consider: o Management’s integrity o Financial condition of the organisation o Financial pressures on the organisation o Management incentives to achieve financial results. Developing and Understanding Internal Controls  The auditor obtains an understanding of the controls by o Walk-through of the processing of transactions o Inquiry o Observation o Review of client documentation.  This understanding must be documented in the work papers.  Internal control procedures should be sufficient to ensure that management assertions are achieved: o Existence/occurrence: only valid sales are recorded when shipment has occurred and the primary revenue producing activity has been performed (AASB 118). o Completeness: all valid sales transactions are recorded. o Rights/obligations. o Accuracy/valuation. o Presentation and disclosure. Monitoring Controls  Designed to signal failures in transaction processing and determine if timely, corrective action is taken.  Monitoring controls applicable to revenue transactions include: o Comparing sales and cost of goods sold with budgeted amounts o Exception reports generated to identify unusual transactions o Internal audit of revenue cycle controls o Computer reconciliation of transactions entered with transactions processed o Monitoring of accounts receivable for quality  Aging of debts o Independent follow-up on customer complaints  Provisions/warranties – control over returns o GST audits. Documenting, Testing and Assessing Environment Risk  Develop understanding of the accounting system and control procedures.  Evidence is gathered through inquiry, review of client accounting manuals and review of prior year audit  Documentation includes questionnaires, flowcharts and narratives.  Determine whether the application control procedures are sufficient to achieve the control objectives.  Based on control design, make a preliminary assessment of control risk.  The auditor must document controls that support an assessment of control risk below maximum.  If the auditor plans to rely on the internal controls, the controls are tested to see if they are operating as designed.  If testing indicates the control is not operating effectively, the auditor increases assessed control risk, lowers detection risk and performs more rigorous substantive testing  If the control is working effectively, control risk assessment is unchanged. Linking Environment Risk Assessment and Substantive Testing  The rigour of substantive testing is inversely related to the assessed level of environment risk  The auditor learns three things during the assessment of environment risk that affect the design of substantive audit procedures: o The nature of the accounting system, controls used and documents generated in the client’s processing o Existence of fraud risk factors o Effectiveness of controls and types of misstatements likely to occur. Substantive Testing in the Revenue Cycle  Planning for direct tests of transactions and account balances o Audit objectives and assertions o Account balance relationships o Risk of material misstatement o Composition of the account o Persuasiveness of audit procedures o Cost of audit procedures o Timing of audit procedures o Determining optimal mix of audit procedures Substantive Testing of Revenue  Assertions related to revenue transactions: o Occurrence: Have the transactions occurred and do they pertain to the entity? o Completeness: Have all transactions been recorded? o Accuracy: Have transactions been accurately recorded? o Cutoff: Have transactions been recorded in the correct accounting period? o Classification: Have transactions been recorded in the proper accounts? Occurrence, Accuracy and Validation  Vouch recorded sales transaction back to customer order and shipping document.  Compare quantities billed and shipped with customer order.  Special care should be given to sales recorded at the end of the year.  Scan sales journal for duplicate entries. Cutoff Tests  Cutoff tests: o Can be performed for sales, sales returns, cash receipts o Provide evidence of whether transactions are recorded in the proper period.  Cutoff period is usually several days before and after balance sheet date.  Extent of cutoff tests depends on effectiveness of client controls. Sales Cutoff  Auditor selects sample of sales recorded during cutoff period and vouches back to sales invoice and shipping documents to determine whether sales are recorded in proper period.  Cutoff tests assertions of existence and completeness.  Auditor may also examine terms of sales contracts. Sales Return Cutoff  Client should document return of goods using receiving reports.  Reports should date, description, condition and quantity of goods.  Auditor selects sample of receiving reports issued during cutoff period and determines whether credit was recorded in the correct period. Completeness  Use of pre-numbered documents is important.  Analytical procedures.  Cutoff tests.  Auditor selects sample of shipping documents and traces them into the sales journal to test completeness of recording of sales. Substantive Tests of Accounts Receivable  Valuation o Are sales and receivables initially recorded at their correct amount? Correct sales price? o Will client collect full amount of recorded receivables?  Rights and obligations o Contingent liabilities associated with factor or sales arrangements o Discounted receivables  Presentation and disclosure o Pledged, discounted, assigned or related party receivables Standard Accounts Receivable Audit Procedures  Obtain and evaluate ageing of accounts receivable.  Confirm receivables with customers.  Perform cutoff tests.  Review subsequent collections of receivables. Aging Accounts Receivables  Because receivables are reported at net realisable
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