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CHAPTER 4
Performing audit procedures for main
financial statement cycles

- Audit of sales and receivables

- Audit of acquisition and payment cycle, and inventory
(read chapter 12, Jubb et al, 2012)
- Audit of cash (read chapter 13, Jubb et al, 2012)
- Audit of property, plant and equipment (read chapter
14, Jubb et al, 2012)
 Overview of the revenue cycle
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 Receive customer purchase order

 Check inventory status
 Obtain credit approval
 Prepare shipping and packing documents
 Ship and verify shipment of goods
 Prepare the invoice
 Receive payment
 Consider the risk of misstatement in the revenue cycle
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 While sales transactions are routine for most organisations and

do not represent an abnormally high risk, for other
organisations, revenue recognition may be complicated.
Difficult audit issues include:
 When client should recognise revenues
 Auditor must understand client's operations and related
Accounting Standard/GAAP issues
 Example: point of sale revenue recognition vs. percentage of
completion
 Consider the risk of misstatement in the revenue cycle
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 Impact of any unusual sales terms and whether title passed to

customer
 Example: related party transactions
 Goods recorded as sales have been shipped
 Sales made with recourse or that have significant returns
 Example: irrevocable right to return goods
 Inherent risk in receivables
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• The primary risk is that net receivables will be overstated,

because either receivables have been overstated, or the
allowance for doubtful accounts has been understated.
• The risks affecting receivables include:
– sales of receivables recorded as sales rather than financing
transactions;
– receivables pledged as collateral;
– receivables classified as current when likelihood of collection
is low;
– collection of receivable contingent on uncertain future events;
– payment not required until purchaser sells the product
• consignment goods.
 Fraud risks related to revenue recognition
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 Methods used to inflate revenue

• Recognition of revenue on shipments that never
occurred;
• Hidden ‘side letters’ giving customers an irrevocable
right to return the product;
• Recording consignment sales as final sales;
• Early recognition of sales that occurred after the end of
the fiscal period;
• Shipment of product before customers wanted or
agreed to delivery;
 Fraud risks related to revenue recognition
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Methods Used to Inflate Revenue (cont.)

• Creation of fictitious invoices;
• Shipment to customers that did not place an order;
• Shipment of more product than the customer ordered;
• Recording shipments to the company’s own warehouse as sales;
• Shipping goods that have been returned and recording the
reshipment as a sale of new goods before issuing credit for the
returned sale.
 External and internal risk factors
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 External
 Financial analyst expectations
 Industry trends
 Investigations

 Internal
 Management remuneration schemes
 Expiration of share options
 Accounting is not centralised
 Weak controls
 CFO does not have an accounting background
 Use of share options to increase market value
 Perform tests of controls
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Control Objective Examples of Tests of Controls

controls
1. Recorded a. Sales recorded a. Sample recorded
transactions are only with valid sales transactions
authorized and customer order and vouch back
actually occurred and shipping to source
document. documents.
b. Credit is b. Compare each
approved before customer’s
shipment balance with its
credit limit.
 Perform tests of controls
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Control Examples of controls Tests of Controls

Objectives
2. Sales are a. Sales are recorded upon a. Review monitoring
recorded in entries of customer orders controls (e.g.
the correct and shipping information. management’s
accounting Transactions entered, but review of
period not yet processed, are transactions entered
identified for an exception into the system and
report and followed up. not shipped and
b. Monthly statements are sent invoiced).
to customers. A group b. Review nature of
independent of those complaints received.
recording the transactions Investigate to
receives and follows up determine if there is
complaints. a pattern.
 Perform tests of controls
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Control Examples of controls Tests of Controls

Objectives
3. All sales a. Pre-numbered shipping a. Review
are recorded documents and invoices reconciliations to
which are periodically determine that
accounted for. control is working.
b. Monitoring: b. Review
transactions are management
reviewed, compared reports and
with budgets and evidence of
differences are actions taken.
investigated.
 Perform tests of controls
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Control Examples of controls Tests of Controls

Objectives
4. Sales are Sales price comes from Test access controls. Take a
accurately authorized sales price sample of recorded sales
recorded list maintained on the invoices and trace price
computer. back to authorized list.
5. Sales are a. Chart of accounts is a. Take a sample of
correctly up to date and used. transactions and trace to
classified b. Computer program general ledger to see if
is tested before properly classified.
implementation. b. When testing general
controls, determine that
controls over program
changes are working.
 Analytical procedures
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 Compare revenue trend with industry trends

 Compare cash flow from operations with net income
 Ratio analysis
 Gross margin
 Turnover of receivables
 Average balance per customer
 Receivables as a percentage of current assets
 Ageing of receivables
 Allowance for uncollectible receivables as a percentage of AR
 Bad debt expense of a percentage of net credit sales
 Sales in the last month to total sales
 Sales discounts to credit sales
 Returns and allowances as a percentage of sales
 Reasonableness tests: estimate formula, regression analysis
 Tests of details
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Audit objective Tests of details

Existence/occurrence: 1. Trace recorded sales to sales invoices, customer
Recorded sales and orders and bills of lading.
accounts receivable are 2. Confirm balances or unpaid invoices with
valid. customers.
3. Examine subsequent collections.
4. Scan sales journal for duplicate entries
Completeness: All sales 1. Account for sequence of sales invoices in sales
are recorded journal.
2. Trace bill of lading to sales invoice and sales
journal
Rights and obligations: 1. Inquire of management
Discounted receivables are 2. Obtain confirmations from the client’s banks and
properly accounted for other financial institutions about discounted AR
 Tests of details
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Audit objective Tests of details

Accuracy and 1. Verify clerical accuracy and agree sales
classification: Sales invoices with supporting documents (e.g.,
and receivables are authorized price list, customer orders,
accurately recorded and shipping document).
and classified to 2. Trace sales invoices to sales journal and
correct accounts customer’s ledger.
3. Confirm balances or unpaid invoices
with customers.
4. Foot sales journal and AR trial balance,
and reconcile them with relevant control
accounts.
 Tests of details
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Audit objective Tests of details

Cut-off: Sales and 1. A sample of sales transactions are
accounts receivable selected from the cut-off period to
are recorded in determine the correct time period of
correct accounting recording by looking at the shipping
period terms and shipment dates.

Valuation: Accounts Obtain a copy of a detailed aged

receivable are accounts receivable trial balance from the
reasonably valued client, check the accuracy of ageing, and
determine the reasonableness of allowance
for uncollectible AR.
 Tests of details
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Audit objective Tests of details

Presentation and 1. Obtain confirmations from the client’s banks
disclosure: and other financial institutions about
Pledged, pledged and discounted receivables.
discounted and 2. Review loan agreements and minutes of
related party board meetings to investigate pledged and
accounts discounted receivables.
receivables, and 3. Review trial balance of accounts receivable
revenue for related parties.
accounting policies 4. Review revenue accounting policies for
are properly appropriateness and consistency.
disclosed.
 Confirming receivables with customers
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 Confirmations provide reliable external evidence about the:

 existence of recorded accounts receivable
 completeness of cash collections, sales discounts, and sales
returns and allowances.
 Confirmations are required unless one of the following applies:
 the receivables are not material
 the use of confirmations would be ineffective
 the combined inherent and control risk is assessed as low
and sufficient evidence is available from using other
substantive tests.
 Select customers and time point to obtain confirmation
of accounts receivable
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 Customers firstly selected to send confirmation letters are those

have large ending balance, large transactions, or unchanged
balance during the accounting period. Then, random sampling
is applied for the rest population.
 Confirmation letters are usually sent to customers after the
year-end. The confirmation may be obtained prior to the year-
end if the material misstatement risk for accounts receivable is
assessed as low.
 Types of confirmations
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Positive confirmations
 Customers are asked to agree the amount on the confirmation
with their accounting records and to respond directly to the
auditor whether they agree with the amount or not.
 Positive confirmation requires a response.
 If customer does not respond, auditor must use alternative
procedures.
 Types of confirmations (cont.)
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Negative confirmations
 Customers are asked to respond only if they disagree with the
balance (non-response is assumed to mean agreement)
 Less expensive since there are no additional procedures if
customer does not respond
 May be used when all of the following are present
 Confirming a large number of small customer balances;
 Combined inherent and control risk for receivables is
assessed as low;
 Auditor believes customers will give proper attention to
confirmations.
 Follow-up procedures for non-responses
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 If customer does not respond to positive confirmation request the

auditor may send a second, or even third request.
 If customer still does not respond, auditor will use alternative
procedures.
 Examine the cash receipts journal for cash collected after year-
end.
 Care is taken to ensure receipt is year-end receivable, not
subsequent sale.
 Examine documents supporting receivable (customer purchase
order, sales invoice, shipping documents) to determine if sale
occurred prior to year-end.
 Follow-up procedures for exceptions noted
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• Customers are asked to agree the amount on the

confirmation to their accounting records; differences are
called exceptions.
• Reasons for exceptions:
– Timing differences
– Disputed items
– Customer errors
– Client misstatement
• Because misstatements are projected to the population of
receivables, the auditor must determine the reason for the
exception.