Chapter 14 Audit of the Sales and Collection Cycle

Key objectives: 1. Identify the accounts and classes of transactions in the sales and collection cycle. 2. Describe the business functions and related documents and records in the sales and collection cycle. 3. Understand internal control and design appropriate tests of controls and substantive tests of transactions for sales. 4. Understanding the accounting and controls for sales returns and allowances. 5. Understand internal control and design appropriate tests of controls and substantive tests of transactions for cash receipts. 6. Understanding the accounting and controls for write-offs of uncollectible accounts. Introduction to Transactions The accounting for these transactions should be familiar. Sales and cash receipts are examined simultaneously because they are interrelated, and both affect accounts receivables. (Tests applied to each balance/transaction in parentheses.)
Accounts receivable Beginning Cash receipts balance (PY) (TOT) Sales on account (TOT) Ending balance (TODB) Sales returns and allowances Bad debt charge-off

Sales returns and bad debts are non-cash credits to accounts receivable (TOT and TODB). Both activities and ending balanced are tested using analytical procedures.

2.

Documents in the cycle - The attached chart (p. 106-107) can be used to familiarize you with the documents in the cycle when studying Table 14-2 and Table 14-3 in the text. We are especially interested in controls associated with each document.

Documents in Sales Cycle Document Customer order Controls (objective) Comments Process is initiated with the customer order. The customer order is not primary for the existence assertion (shipping document is). Order could be received by mail, phone, over the internet, or through EDI. Credit approval and authorization of shipment (occurrence). Sales orders should receive approval prior to shipment, including authorization of credit (specific or general). Credit should be authorized by someone independent of sales (often done automatically by computer). (1) Credit approval process affects extent of net realizable value tests (test of allowance for doubtful accounts). Shipper is primary evidence of occurrence, because all recorded sales should be supported by a shipper. Account for numerical sequence to ensure completeness (all shippers should result in a sales invoice). The sales invoice is the main document for the recording of sales. Accounting for the sequence of sales invoices in the sales journal also assures completeness by determining that all sales were recorded. (2) Sales invoices are recorded in the sales journal. Posted to the G/L, usually monthly. With computerized system, individual entries should also be posted automatically to the A/R subledger. Source document for returns and allowances. Returns should be supported by a receiving report; other allowances should be properly

Sales order

Shipping document (bill of lading)

Checking of quantities (accuracy). Account for sequence (completeness).

Sales invoice

Matched with shipper (occurrence). Prices, quantities and extensions checked (accuracy). Account for sequence (completeness). Footings and postings checked (posting and summarization). Posted as soon as possible after goods are shipped (timeliness).

Sales journal

Credit Memo

Proper approval (occurrence). Receiving report for returned goods

Document

Controls (objective) (occurrence).

Comments authorized. Testing depends upon materiality of amounts.

(1) Audit software such as ACL can test for shipments exceeding credit limits. Note that the credit limit must be approved by someone independent of sales. (2) Duplicates and gaps in shipping documents and sales invoices can be checked using audit software.

Documents in Cash Receipts Cycle

Document Cash receipt prelist

Controls (objective) Prepared by someone independent of accounts receivable, often an administrative assistant or someone with no accounting duties (completeness).

Comments Beginning of cash receipts cycle, and point where cash enters business. Establishes record of cash received to prevent theft. Checks should also be restrictively endorsed at this point. This assumes payment by mail, usually in the form of a check. Checks can also be sent directly to a lockbox, or wire transferred. Different controls are necessary for firms that receive payments in cash.

Remittance advice

Document that accompanies payment by check - often the lower portion of the check (completeness and accuracy). The remittance advice is also important evidence of the occurrence of a cash receipt because the other evidence (the check) is deposited. The actual cash receipts should be deposited usually on a daily basis (timeliness)

Additional evidence of amount of cash received. When no remittance advice is received, it is customary for the person who prelists cash to prepare one.

Cash receipts journal

Posting and summarization checked (P&S). CR recorded at time of receipt (timeliness) Reconciled to the general ledger by someone independent of sales and cash receipts (posting and summarization, as well as other objectives) Should be authorized

The cash receipts journal is used to record individual cash receipts. Individual cash receipts are automatically posted by computer to individual customer A/R. The accounts receivable subledger is important because it is the interface between the sales and cash receipts cycle. The reconciliation of the subledger to the general ledger is an important control. Company should have proper

Accounts receivable sub ledger

Bad debt

Document charge-off

Controls (objective) (occurrence)

Comments

procedures to charge-off accounts. Should be authorized by someone independent of authorization of credit and recording of sales. Note: it also critical that the bank reconciliation be performed by an independent person.

3.

Approach to Cycle a. b. Identify controls (if any) for each objective. Design tests of controls (assuming costeffectiveness) for key controls. (Designing the TOC is easy, once the control has been identified). c. d. Design appropriate substantive tests of Tests should be sufficient to meet each objective.

transactions.

4.

Miscellaneous Focuses a. Three authorizations are very important for the valuation and existence objectives:

Credit

Shipment of goods Pricing

b.

Renumbered documents (especially shippers) for completeness.

c.

Monthly statements - Independently mailed statements will help detect misstatements, especially overstatements and mispostings, such as:
Sale or cash receipt posted to incorrect

account
Cash receipt not credited to account

5.

Direction of Tests

The main concern with the direction of tests is usually whether it can be used to infer existence or completeness.

1. From a journal to source document (concerned with

recorded amounts) = Occurrence

2. From a source document to journal (concerned with

unrecorded amounts) = Completeness Another way to view this issue is:

1. Occurrence - Concerned with overstatements. 2. Completeness - Concerned with

understatements. Hence, auditors are usually more concerned with existence for accounts receivable, and completeness for accounts payable.

It may help to view the cycle as a sequence of steps and documents.

Direction of Tests for Sales

Customer Order Complete Shipping Document Duplicate Sales Invoice Occurren ce Start Sales Journal = A/R Master File ness Start

Posting and Summarization General Ledger

Selecting a sample for tests: 1. Sampling from the sales journal (sales invoices) can

be used to satisfy any objective, except completeness

(a sample drawn from sales invoices can't be used to test completeness, because they are already recorded). 2. Sampling from shippers can be used to satisfy any except occurrence (since the shipper

objective,

establishes existence, it can't be used as the sample to test for existence).Therefore, a sample selected from either shippers or sales invoices could be used for a pricing test, etc.) 3. Sampling from sales invoices is essentially the same

as sampling from the sales journal, as they should be identical. The auditor may account for a sequence of sales invoices as a completeness test. Accounting for a sequence of sales Invoices in sales journal Completeness Trace sales invoices to shippers (or examine Sequence of invoices noting shippers) Occurrence 7. Sales returns and allowances Recording - theoretically should be matched with

sale. In practice returns and allowances are recorded as they occur. This does not present a problem, if there are no significant returns after year-end. Authorization - Returned goods should be sent to the

receiving department, and a receiving report prepared. Other allowances should be specifically authorized.

Objectives Transactions - focus is on the occurrence of returns

and allowances since they can be used to hide theft of cash. Balances In the year-end tests of accounts

receivable, the focus is on completeness, since the failure to record returns overstates accounts receivable. The significance of sales returns and allowances

determines the extent to which they are tested. 8. Cash receipts cycle The same methodology can be applied to studying the

cash receipts cycle. Cash receipt cycle is easier because it involves fewer documents. Some key points: Critical audit point - when cash first enters

organization. Mail should be opened, cash prelisted, and restrictively endorsed by someone independent of receivable functions. Prelist should be compared to deposits A bank lockbox can be used to eliminate the need for

company employees to handle mail receipts - checks are sent directly to the bank. This prevents employee theft of checks, but is not cost-effective for many companies. Therefore, to ensure completeness of cash receipts:

1. 2.

Lockbox is first-best choice (ignoring cost) Independent prelist if lockbox not feasible Over-the-counter cash - For organizations which

receive revenue in the form of cash, it must be reconciled to cash register tapes or other records supporting sales. Best way to hide theft of cash receipts is to not record the sale Bank accounts and A/R sub ledger independently

reconciled. Review for large non-cash credits, such as returns and

allowances, and bad debt write-offs

Sales Cycle Illustrative Substantive Tests of Transactions

Objective Recorded sales exist (occurrence) Existing sales are recorded (completeness) Sales are recorded at proper amounts (accuracy) Sales are properly classified

Procedure Trace from sales journal or invoice to shipper. Trace from shippers to recorded sales (invoice or journal) Recomputed quantities and extensions (reperformance). Agree price to price list. Check documents supporting sale for proper account distribution in sales journal.

Comment Almost always done, even if controls are effective. Probably not necessary if tested controls. Normally done. Can reduce sample size if controls exist. Not normally an important issue.

Sales are timely recorded

Compare dates on shipper with sales invoice and entry in sales journal

Really a test of control.

Sales are summarized

Foot sales journal and trace to entry in general ledger. Test reconciliation of A/R sub ledger to general ledger.

Generally always done.