Ch 11 - Auditing the Revenue Process

Question 1

Chapter Overview

Answer 1

Revenue Process Overview

Understanding the Entity/Environment

Inherent & Fraud Risk for Revenue Process

Control Activities for Revenue Process

Testing Controls for Revenue Process

Substantive Tests for Revenue Process

Question 2

What transactions are part of the revenue process?

Answer 2

• Sales
• Cash Receipts / Collecting from customers
• Sales adjustments – adjust for uncollectible A/R (allowances)
• Write-Off A/R
• Discounts
• Returns

Question 3

What accounts are part of the revenue process?

Answer 3

• Sales Revenue
• COGS
• Allowance for Doubtful Accounts
• Accounts Receivable
• Sales Returns & Allowances

Question 4

What assertions do you think are especially important for revenue?

For accounts receivable?

Answer 4

Revenue ➡ Occurrence
Revenue ➡ Accuracy
Revenue ➡ Cut-Off

Accounts Receivable ➡ Existence
Accounts Receivable ➡ Valuation

Question 5

With respect to the revenue process, what do we need to gain an understanding of?

Answer 5

• How an entity earns revenue / their environment
• Develop expectations of sales, gross margins, receivables, etc.

Customers, sales capacity, marketplace, and competition in the industry

Does the company sell a product or a service?
- This will impact how we audit a particular area

Who are their customers?

How do they sell their product?
In what kind of marketplace?

What’s the competition in the industry? - A more competitive industry may increase the risk and incentive of misreporting.

Question 6

How do we assess the risk and reasonableness of accounts balances in the risk assessment phase?

Answer 6

Analytical procedures

➡ Audit Data Analytics (ex. Cluster analysis across product type or location and look at gross margins or sales numbers)

Question 7

Your client is a large national hotel chain. It owns 57 properties and manages another 40 properties for absentee owners. Hotels are full-service hotels including restaurants, reception halls, etc.

Given your knowledge of the business and industry, what might impact your expectation about revenue for the year?

Answer 7

• Big events
• Where are these locations and are people traveling there for various other reasons
• Economic conditions of the locations or the country as a whole
• People travel when they have money and when the economy is going well
• Other changes within the industry and how that might impact your sales – Air BnB

Question 8

Your client is a large national hotel chain. It owns 57 properties and manages another 40 properties for absentee owners. Hotels are full-service hotels including restaurants, reception halls, etc.

When evaluating revenue, what measure might you compare revenue with? Example (revenue per _____).

Answer 8

Occupancy rate – when people stay, you have more revenue

Question 9

Your client is a large national hotel chain. It owns 57 properties and manages another 40 properties for absentee owners. Hotels are full-service hotels including restaurants, reception halls, etc.

Other than room rates, how else might the motel chain earn revenue?

Answer 9

• Conferences and weddings
• Bar/restaurant
• Need to evaluate whether these other sources of revenue are material enough to test

Question 10

What is an inherent risk?

Answer 10

The susceptibility of an assertion to a misstatement that could be material

Question 11

What are some of the significant inherent risks in the revenue process?

Answer 11

Occurrence of revenue and existence of receivables due to the incentives to overstate

Question 12

Why is the occurrence of revenue and the existence of receivables inherent risks in the revenue process?

Answer 12

There are incentives to overstate these accounts

Question 13

What do inherent risks vary upon?

Answer 13

The incentives to overstate:

• the industry’s competitive condition
• management compensation incentives
• complexity of the revenue recognition process

Question 14

How may a company try to overstate revenue?

Answer 14

Through:

• consignment sales
• refund rights
• bill and hold transactions
• recording gross (instead of net) sales

Question 15

Generally, what is the fraud risk (high, medium, low) for the revenue process?

Answer 15

High

• The company wants higher earnings and net income and lower expenses ➡ Incentive to tamper with revenue because it will inflate earnings faster

Question 16

What are the two “types” of fraud?

Answer 16

• Fraudulent financial reporting (manipulating accounting numbers to inflate earnings)
• Misappropriation of assets (theft)

Question 17

Which one of the below “types” of fraud is more likely to affect sales revenue? Cash?

• Fraudulent financial reporting
• Misappropriation of assets

Answer 17

Sales Revenue ➡ Fraudulent financial reporting (overstate earnings)

Cash ➡ Misappropriation of assets (theft)

Question 18

Example for Right of Return and Revenue Recognition

Answer 18

Keila Hirata is a senior on Eastern Automotive, a small automotive parts company. She has worked on this audit since she started with the audit firm, and she has developed a good understanding of the company and its market. She has been monitoring the company’s monthly financial statements and has been watching a build-up in inventory.

Two months before year-end, she talks to Eastern’s C F O about the problem, and the C F O is wondering if Eastern will have to start marking down inventory to move it out. Then in the last month of the year, inventory drops, revenue increases, and things look normal again. However, looking at the results of a data analytics test, Keila notices that more goods have been shipped in the last month than have been ordered by customers. What would explain this?

Digging deeper in the shipping department, she finds several large shipments to some of Eastern Automotive’s larger customers. The problem is that the goods have not been ordered by the customers. Keila finds that the goods were shipped with a full right of return if the customer cannot sell the products forward. This is a significant revenue recognition problem that will result in taking revenue and receivables off the books and putting inventory back on the books with a concurrent reduction in the cost of sales.

Question 19

What type of control activities are important in the revenue process?

Answer 19

Both entity level (tone at the top, independence of the board) and transaction-level controls

Question 20

How do we gain an understanding of the controls?

Answer 20

Perform a walkthrough to understand transaction flow and transaction- level controls

The flow will be different for each company

Question 21

Example of a control for the completeness of sales?

verify we are not missing some sales

Answer 21

Control: Each shipment automatically results in a sales invoice (which is recorded as a sale)

How to test this?
Use audit software to verify that all shipments are recorded in the sales ledger

Question 22

Example of a control for the completeness of sales?

verify we are not missing some sales

Answer 22

Control: Daily report of shipments that were associated with a sales invoice. Examine exceptions.

How to test this?
Obtain sample of exception reports. Verify that all exceptions are included on the report. Verify that exceptions are appropriately followed up on and resolved.

Question 23

Example of a control for the occurrence of sales?

recorded sales truly happened

Answer 23

Control: All sales invoices must match to shipping documents (like bill of lading) and customer orders

How to test this?
???

Question 24

Example of a control for the occurrence of sales?

recorded sales truly happened

Answer 24

Control: Shipping clerks independently verify that the order was properly filled (actually sending out products).

How to test this?
???

Question 25

What controls might we have relating to the accuracy of sales?

(sales are at the correct amount)

Answer 25

???

Question 26

Example of a control for the cut-off of sales?

sales are in the correct period

Answer 26

Control: Timed bill of ladings are compared with sales invoices (and sales ledgers)

How to test this?
Observe a sample of shipments and bill of ladings to verify that they are time-stamped appropriately. Review that the bill of lading and sales invoices are on the same date.

Question 27

Example of a control for the classification of sales and receivables?

Answer 27

Control: Software matches product code to sales type code and reports differences (e.g., must disclosure of sales by segments)

How to test this?
Use audit software to verify that matching is appropriate.

Question 28

Examples of controls for the existence and valuation of accounts receivables?

Answer 28

Control: Process exists so that customers can report incorrect balances. Complaints are investigated and resolved.

How to test this?
Call the customer line to verify it exists. Obtain a list of customer complaints and follow a sample of complaints to make sure issues were resolved.

Control: Software reconciles sales with cash receipts and outstanding AR.

How to test this?

Use audit software to verify reconciliation. Verify all exceptions were examined and addressed.

Question 29

Example of a control for the rights and obligations of accounts receivables?

(we have the right to the receivables)

Answer 29

Control: Accounting manager undertakes a monthly review to monitor factored receivables arrangements and verify receivables are reported properly.

How to test this?
Inquire about process to address factored receivables. Review documentation of this review.