CHAPTER 10

AUDITING THE REVENUE PROCESS

Answers to Review Questions
10-1 FASB Statement of Financial Accounting Concepts No. 5, "Recognition and
Measurement in Financial Statements of Business Enterprises" (CON5), requires that
before revenue is recognized (recorded) it must be realized and earned. Revenues are
realized when the products or services are exchanged for cash, a promise to pay cash, or
other assets that can be converted into cash. Revenues are earned when the entity has
substantially completed the earnings process, which generally means the product has
been delivered or the service has been provided.
10-2 The credit authorization function has the responsibility for monitoring customer
payments. An aged trial balance of accounts receivable should be prepared and reviewed
by the credit authorization function. Payment should be requested from customers who
are delinquent in making payments for goods or services. The credit function is usually
responsible for preparing a report of customer accounts that may require write-off as bad
debts. However, the final approval for writing off an account should come from an
officer of the company who is not responsible for credit or collections.
10-3 When the client does not have adequate segregation of duties or if collusion is
suspected, the possibility of a defalcation is increased. An employee who has access to
both the cash receipts and the accounts receivable records has the ability to steal cash and
manipulate the accounting records to hide the misstatement. This is sometimes referred
to as lapping. When lapping is used, the perpetrator covers the cash shortage by applying
cash from one customer's account against another customer's account. If the auditor
suspects that this has occurred, the individual cash receipts have to be traced to the
customers' accounts receivable accounts to ensure that each cash receipt has been posted
to the correct account. If the cash receipt is posted to a different account, this may
indicate that someone is applying cash to different accounts to cover a cash shortage.
10-4 Industry-related factors such as the profitability and health of the industry in
which the entity operates, the level of competition within the industry, and the industry's
rate of technological change affect the potential for misstatements in the revenue process.
The level of governmental regulation (e.g., by the Food and Drug Administration) within
the industry may also affect sales activity. Finally, most states have consumer protection
legislation that may affect product warranties, returns, financing, and product liability.
Such industry-related factors directly impact the auditor's inherent risk assessment for the
authorization and valuation audit objectives.
The presence of misstatements in previous audits is a good indicator that
misstatements are likely to be present during the current audit. If misstatements were
present in previous audits, the auditor should assess inherent risk to be high.

10-5 For each major class of transactions in the revenue process, the auditor needs to
obtain the following knowledge:
How sales, cash receipts, and sales returns and allowances transactions are initiated.
The accounting records, supporting documents, and accounts that are involved in
processing sales, cash receipts, and sales returns and allowances transactions.
The flow of each type of transaction from initiation to inclusion in the financial
statements, including computer processing of the data.
The process used to prepare estimates for accounts such as the allowance for
uncollectible accounts and sales returns.
10.6

Two important controls for processing of credit memoranda for sales returns and
allowances transactions are: (1) Each credit memorandum should be approved by
someone other than the individual who initiated it and (2) a credit for returned
goods should be supported by a receiving document indicating that the goods
have been returned.

10-7 The analytical procedures that can be used to test revenue-related accounts and
the possible misstatements that can be detected by each analytical procedure are:
Analytical Procedure

Possible Misstatement Detected

Revenue:
Comparison of gross profit percentage by
product line with previous years' and/or
industry data.

Unrecorded (understated) revenue

Fictitious (overstated) revenue
Changes in pricing policies
Product-pricing problems

Comparison of reported revenue to budgeted

revenue.
Accounts Receivable, Allowance for
Uncollectible Accounts, and Bad-Debt
Expense:
Comparison of receivables turnover and days
outstanding in accounts receivable to
previous years' and/or industry data.
Comparison of aging categories on aged trial
balance of accounts receivable to previous
years.
Comparison of bad-debt expense as a percentage
of revenue to previous years' and/or industry
data.

Under- or overstatement of
allowance for uncollectible
accounts and bad-debt
expense

Comparison of the allowance for uncollectible

accounts as a percentage of accounts
receivable or credit sales to previous years'
and/or industry data.
Examination of large customer accounts
individually and comparison to previous year.
Sales Returns and Allowances, and Sales
Commissions:
Comparison of sales returns as a percentage of
revenue to previous years' and/or industry
data.

Under- or overstatement of sales

returns

Comparison of sales discounts as a percentage of

revenue to previous years' and/or industry
data.

Under- or overstatement of sales

discounts

Estimation of sales commissions expense by

multiplication of net revenue by the average
commission rate and comparison to recorded
sales commission expense.

Under- or overstatement of sales

commission expense and
related accrual

10-8 The auditor verifies the accuracy of the aged trial balance using the following
steps. First, a copy of the aged trial balance of accounts receivable is obtained from the
client and the total balance is compared to the accounts receivable general ledger balance.
Second, a sample of customer accounts selected for proper inclusion in the aged trial
balance. For each selected customer account, the auditor traces the customer's balance
back to the subsidiary ledger detail and verifies the total amount and the amounts
included in each column for proper aging. These two steps mainly describe a manual
approach to testing accuracy. A second approach would involve the use of computerassisted audit techniques. If the general controls over IT are adequate, the auditor can use
a generalized audit software package to perform the steps described in the first approach
to examine the accuracy of the aged trial balance generated by the client's accounting
system.

10-9 Three factors that affect the reliability of accounts receivable confirmations are:
The type of confirmation request.
Prior experience on the client or similar engagements.
The intended respondent.
The types of confirmations include positive and negative confirmations.
Generally, positive confirmations are considered more reliable because the recipient is
required to respond to the auditor regardless of whether a misstatement exists or not.
Prior experience with the client in terms of confirmation response rates, misstatements
identified, and the accuracy of returned confirmations should be considered when
assessing the reliability of accounts receivable confirmations. For example, if response
rates were low in prior audits, the auditor might consider obtaining evidence using
alternative procedures. Finally, the intended respondents to accounts receivable
confirmations may vary from individuals with little accounting knowledge to highly
qualified accounting personnel in large corporations. The auditor should consider the
respondent's competence, knowledge, ability, and objectivity when assessing the
reliability of confirmation requests.
10-10 A positive accounts receivable confirmation requests that the customer indicate
whether or not it is in agreement with the amount due to the client stated in the
confirmation. Thus, a response is required regardless of whether the customer believes
that the amount is correct or incorrect. A negative confirmation requests that the
customer respond only when it disagrees with the amount due to the client.
Positive confirmations are generally used when an account contains large
individual balances or if errors are anticipated because control risk was judged to be high.
Negative confirmation requests are used when there are a large number of accounts with
small balances, control risk is assessed to be low, and the auditor believes that the
customers will devote adequate attention to the confirmation.
10-11 Other types of receivables that the auditor should examine include:
Receivables from officers and employees
Receivables from related parties
Notes receivable
The auditor would confirm and evaluate each type of receivable for collectibility.
The transactions that result in receivables from related parties are examined to determine
if they were at "arm's length." Notes receivable would also be confirmed and examined
for repayment terms and whether interest income has been properly recognized.

Answers to Multiple-Choice Questions

10-12
10-13
10-14
10-15
10-16
10-17

C
B
B
D
C
B

10-18
10-19
10-20
10-21
10-22
10-23

A
A
C
A
A
B