Accounts Receivable, Notes Receivable and Revenue

1
Accounts Receivable, Notes Receivable and Revenue
Chapter 11
2
Sales Cycle and impacted accounts

• Balance sheet
• Cash
• Accounts receivable
• Allowances for
• Returns
• Doubtful accounts
• Rebates/discounts
• Inventory
• Accrued revenue
• Deferred revenue
• Warranty reserve
• Others?

• Income statement
• Sales
• Sales discounts
• Returns and allowances
• Cost of goods sold
• Bad debt expense
• Warranty expense

3
Objectives for the Audit of Receivables and
Revenue

• Consider inherent risks of receivables and
  revenue, including fraud risks.
• Integrity of management
• Financial condition of organization
• Financial pressures faced
• Earnings expectations
• Debt covenant compliance
• Management incentives and compensation
• Consider control risk for receivables and revenue.

4
Criteria for Recognition of Revenue

• Persuasive evidence of an arrangement exists
• Delivery has occurred or services have been
  rendered
• The sellers price to the buyer is fixed or
  determinable
• Collectibility is reasonably assured
• Source SEC Staff Accounting Bulletin No.
  101.

5
Inherent risk revenue recognition issues

• Existence of unusual terms
• Has title really passed to the customer?
• What it the proper point in time when revenue
  should be recognized?
• Were all goods recorded as sales
• Actually shipped?
• Shipped when wanted by customers?
• New items? (not used or refurbished unless
  explicitly marked)
• Were there sales transactions made with recourse?
• Has there been an abnormal or unpredictable
  amount of sales returns?

6
Potential Revenue Recognition Problems

• Sales with unusual right to return
• Side agreements
• Franchise fees
• Bill and hold transactions
• Sales using notes with unusual interest rates
• Percentage-of-completion method of revenue
  recognition
• Multiple element agreements

7
Control risk Managements assertions

• Existence and Occurrence
• Revenues are recorded only when the revenue
  principle has been met.
• Authorization is appropriate for the type of
  transaction
• There are specific control activities related to
  sales returns and allowances
• Each transaction is uniquely identified and
  recorded timely
• Completeness
• All valid transactions should be recorded
• Rights and obligations
• Controls should exist to ensure that the recorded
  assets resulting from revenue transactions belong
  to the client

8
Control risk Managements assertions

• Valuation
• Sales are made from authorized price lists
• Unusual price or sales terms are properly
  approved and recorded
• Presentation and disclosure
• Comprehensive chart of accounts is used
• Employees are adequate trained
• Supervisory review made of complex or unusual
  transactions
• Policies and procedures manuals support standard,
  complex and unusual transactions

9
Internal Control Over the
Revenue Cycle

• Controlling customers orders
• Credit approval
• Issuing merchandise
• Shipping
• Billing
• Adjustments to sales and receivables

10
Revenue Cycle Controls

• Segregation of duties--sales and collections
• Matching of sales invoices and shipping documents
• Clerical accuracy checks on invoices
• Credit approval for sales transactions
• Mailing of monthly statements
• Reconciliation of bank accounts
• Use of control listing of cash receipts
• Use of budgets and analysis of variances
• Control over shipping and billing documents
• Use of authorized credit memoranda
• Use of chart of accounts and review of account
  codings

11
Confirmation of Receivables

• Receivables should be confirmed, unless
• Accounts receivable are immaterial,
• The use of confirmations would be ineffective, or
• The auditors combined assessment of inherent and
  control risk is low, and audit risk can be
  reduced to acceptably low level with substantive
  tests

12
Flowchart of the Confirmation Process
A

Prepare and Mail the Requests
Send 2nd requests for positive confirmations
Perform alternative procedures for non-respondents
Resolve exceptions
Document the procedures and results
13
Substantive Tests of Receivables and Revenue

• Obtain aged listing of receivables and reconcile
  to ledgers
• Obtain analyses of notes and related interest
• Inspect notes on hand and confirm those held by
  others
• Confirm receivables with debtors
• Review the cutoff of revenue transactions
• Perform analytical procedures
• Review significant year-end sales contracts
• Verify interest earned
• Evaluate the propriety of accounting for revenue
  transactions
• Evaluate accounting estimates related to revenues
• Determine the adequacy of the allowance for
  uncollectible accounts
• Ascertain the existence of pledged receivables
• Investigate receivables from related parties
• Evaluate the business purpose of significant and
  unusual sales transactions
• Evaluate financial presentation and disclosure

14
Substantive testing audit objectives and
assertions

• Existence and occurrence
• Confirmations
• Examination of documents
• Completeness
• Client control procedures
• Analytic tests tests of cutoff
• Valuation
• Confirmations
• Examination of documents
• Rights and obligations
• Examination of documents
• Confirmations
• Presentation and disclosure
• Amounts pledged, discounted or assigned related
  party transactions, concentrations of risk
• Examination of documents
• Inquiries

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Substantive testing Sales

• Cut-off tests
• To test if sales are recorded in the right period
• Tendency is for sales to be overstated
• Greatest risk is at quarter/year end
• Select a sample of sales transactions before and
  after year end
• Examine shipping dates and terms to determine if
  sales are recorded in the right period
• Analytical procedures
• Signal for potential misstatements
• Corroborate other evidence obtained
• Check for reasonableness of income statement
  amounts

16
Substantive testing allowance for doubtful
accounts

• Highly judgmental
• Economic status of clients customers
• Current economic conditions
• Expectations about default on payments
• Recompute allowance using clients method
• Agree with assumptions?
• Consistency?
• Calculate allowance using independent model
  developed by auditor
• Review a sample of write-offs
• Are control procedures followed?
• What do write-offs tell you?