REVENUE RECOGNITION Revenue is defined as the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants. Overview of the Revenue Process Purchases Inventory Credit sales Account receivable Cash collection Purchases Inventory Cash sales Cash Sale Credit Sale Types of documents and records Customer Sales Order Contains the details of the type and quantity of products or services ordered by the customer. Credit Approval Form For credit sales, the client must have a formal activity (procedure) for investigating the creditworthiness of the customer. Open-Order Report A report of all customer orders for which processing has not been completed.
Shipping Document This document generally serves as a bill of lading and contains information on the type of product shipped, the quantity shipped and other relevant information. Sales Invoice The document is used to bill the customer. This document contains information on the type of product or service, the quantity, the price and the terms of trade. Sales Journal Once a sales invoice has been issued, the sale needs to be recorded in the accounting records. The sales journal is used to record information about the sales transaction.
Customer Statement This document is mailed to the customer and contains details of all sales, cash receipts, and credit memorandum transactions. Accounts Receivable Subsidiary Ledger This ledger contains an account and the details of transactions for each customer. Aged Trial Balance of Accounts Receivable This report summarizes all the customer balances in the accounts receivable subsidiary ledger. Each account is classified as current or placed into one of several past due categories. Types of Documents and Records Shipping Goods should not be shipped, nor should services be provided without proper authorization. The main control is payment or proper credit authorization. Billing The objective of proper billing is to ensure that all goods shipped and all services rendered are billed to the customer. Credit Authorization The credit authorization process must determine that the customer is able to pay for the goods or services purchased. Failure to properly authorize credit can lead to extensive bad debts for the entity. Assertions about Classes of Transactions (Revenue cycle) Occurrence All revenue and cash receipt transactions and events that have been recorded have occurred and pertain to the entity. Completeness All revenue and cash receipt transactions and events that should have been recorded have been recorded. Accuracy Amounts and other data relating to recorded revenue and cash receipt transactions and events have been recorded appropriately. Cutoff All revenue and cash receipt transactions and events have been recorded in the correct accounting period. Classification All revenue and cash receipt transactions and events have been recorded in the proper accounts. Occurrence The auditor is concerned about two major types of material misstatements: 1. Sales to fictitious customers. 2. Recording revenue when goods have not been shipped or services have not been performed. The auditor needs assurance that all recorded revenue transactions are valid. In order to prevent fictitious sale, below control procedures should be practiced by management: Segregation of duties ( shipping function & order entry & billing function) Sales recorded only with approved customer order and shipping document Customer monthly statements handled independently
Completeness The major misstatement that concerns both management and the auditor is that goods are shipped or services are performed and no revenue is recognized. Control procedure to prevent violation of completeness: Maintain numerical sequence of document ( shipping document & sales invoice) Shipping documents matched to sales invoices Sales invoices reconciled to daily sales report
Accuracy The presence of an authorized price list and terms of trade reduces the risk of inaccuracies. The sales invoice should also be verified for mathematical accuracy before being sent to the customer.
Control procedure to prevent violation of valuation & allocation: Sales invoice must always agreed to shipping document and customer order for product type and quantity, mathematical accuracy of sales invoice verified Reconcile sales invoice to daily sales report
Cutoff
Sales may be recorded in the wrong accounting period. Possible misstatements Control procedure Revenue transactions recorded in the wrong period All shipping documents forwarded to the billing function daily Daily billing of goods shipped Classification The use of a chart of accounts and proper codes (for a different products) for recording transactions should provide adequate assurance about the proper classification of revenue transactions.
Understanding and Documenting Internal Control The auditor identifies what controls ensure that the assertions for transactions and events are being met. Documentation of the auditors understanding of the revenue process can be accomplished by using: Procedures manuals Narrative descriptions Flowcharts Internal control questionnaires Substantive Procedures
Select a sample of sales transactions from sales journal and trace sales invoices back to customer orders and shipping documents Occurrence Trace a sample of shipping documents to the details in the SI and to the sales journal and debtors subsidiary Completeness Compare prices and terms on a sample of SI with the authorized price list and terms of trade Accuracy Compare dates on a sample of SI with the dates of shipment and with the dates they were recorded in the sales journal Cutoff Examine a sample of SI for proper classification in to revenue accounts Classification Assertions about classes of transactions Management assertions about account balances (Account Receivable) Recorded account receivable and related balances exist Existence The entity holds or controls the rights to the AR Rights & obligations All AR that should have been recorded have been recorded Completeness AR & related accounts are included in the f/s at appropriate amounts Valuation & allocation Substantive Procedures
Obtain confirmation for a selected sample of accounts receivable Existence Review bank confirmations for any liens on receivables Rights and obligations Obtain aged trial balance of accounts receivable and agreeing of total to general ledger Completeness Examination of a sample of sales invoices and shipping documents for a few days before and after year-end for recording sales in proper period. Cutoff Evaluate the results of the confirmations of selected account receivables Valuation & allocation Assertions about account balances The Confirmation Process Confirmation is the process of obtaining information from third parties about the account receivable balance.
Confirmation is a good source of evidence about the validity of the account receivable. The confirmation process should be controlled by the auditor.
Type of confirmation
Positive Confirmation
Requests that customers indicate whether they agree with the amount due to the client. A response is expected whether the customer agrees or disagrees with the balance indicated. Negative Confirmation
Requests that the customer respond only when they disagree with the amount due to the client. Negative confirmations are used when the client has many small account balances and control risk is assessed as low.
Confirmation Procedures The auditor should mail the confirmation requests outside the clients facilities. A record should be maintained of the confirmations mailed and those returned. A second request may be necessary in some cases. For each exception received, the auditor should examine the reasons for the difference between the balance on the clients books and the balance indicated by the customer. Timing difference Goods delivered to wrong customer Invoice sent to wrong customer Fictitious sale Goods not received by customer Timing difference Cash misappropriate Payment applied to wrong customer account Payment not recorded in entitys sale Incorrect quantity or price Recording the error Processing error Price of goods in dispute Goods damage in transit Amount dispute Examples of exceptions to confirmation requests In some circumstances, sending confirmation is not reliable: The response rates would be inadequate. The responses are expected unreliable. Inadequacy of information.
Alternative Procedures When the auditor does not receive responses to positive confirmations, alternative audit procedures are used. These alternative procedures include: 1. Examination of subsequent cash receipts. 2. Examination of customer orders, shipping documents and duplicate sales invoices. 3. Examination of other client documentation. Evaluating the Audit Findings When the auditor has completed the planned substantive procedures, the likely misstatement for accounts receivable is determined. Likely misstatement* less than tolerable misstatement Likely misstatement* greater than tolerable misstatement Accept the account as fairly presented Account is not fairly presented. The end