CH 14

CHAPTER 14
AUDITING THE REVENUE CYCLE

Learning Check
14-1.
14-2.
a.
The revenue cycle includes the activities involved in the exchange of goods and
services with customers and the realization of the revenue in cash.
b.
The classes of transactions in this cycle for a merchandising company are sales, sales
adjustments, and cash receipts. The primary accounts affected by these transactions
are sales, accounts receivable, cost of sales, inventory, cash, sales discounts, sales
returns and allowances, bad debts expense, and allowance for uncollectable accounts
a.
Specific audit objectives for the revenue cycle are derived from the five categories of
management's financial statement assertions.
b.
Specific audit objectives for credit sales transactions include the following:
Specific Audit Objectives
Transaction Objectives
Occurrence. Recorded sales transactions represent goods shipped or services provided
during the period.
Recorded cash receipt transactions represent cash received during the period.
Recorded sales adjustment transactions during the period represent authorized
discounts, returns and allowances, and uncollectable accounts.
Completeness. All sales cash receipts and sales adjustments made during the period
were recorded.
Accuracy. All sales and cash receipts and sales adjustments are accurately valued
using GAAP and correctly journalized, summarized and posted.
Cutoff. All sales, cash receipts and sales adjustments have been recorded in the correct
accounting period.
Classification. All sales, cash receipts, and sales adjustments have been recorded in
the proper accounts.
Balance Objectives
Existence. Accounts receivable representing amounts owed by customers exists at the
balance sheet date.
Completeness. Accounts receivable include all claims on customers at the balance
sheet date.
Rights and Obligations. Accounts receivable at the balance sheet date represent legal
claims of the entity on customers for payment.
Valuation and Allocation. Accounts receivable represents gross claims on customers
at the balance sheet date and agrees with the sum of the accounts receivable subsidiary
ledger. The allowance for uncollectable accounts represents a reasonable estimate of
the difference between gross receivables and their net realizable value.
Solutions Manual to Modern Auditing: Copyright
2005, John Wiley and Sons, Inc.
14-1
Disclosure Objectives
Occurrence and Rights and Obligations. Disclosed revenue cycle events and
transactions have occurred and pertain to the entity.
Completeness. All revenue cycle disclosures that should have been included in the
financial statements have been included.
Understandability. Revenue cycle information is appropriately presented and
information in disclosures is understandable to users.
Accuracy and Valuation. Revenue cycle information is disclosed accurately and at
appropriate amounts.
14-3. Following are a few examples of differences between how the auditor might use the
knowledge of the entity and its environment for a computer company v. a hotel.
a.
Certain balance sheet accounts like accounts receivable and inventories are going to
be very significant for the computer manufacturer, but relatively immaterial for the
hotel. The computer company is also likely to have a higher ratio of sales to fixed
assets, or sale to total assets, than the hotel.
b.
The computer company auditor will have significant issues associated with the risk
of misstatement with respect to the existence of receivables and inventories that are
not present for the hotel. The computer company auditor will also have to address
valuation and allocation issues associated with the collectability of receivables and
lower of cost or market of inventories that are insignificant for the hotel. The hotel
will have a potential risk of material misstatement in terms of how it accounts for
revenues from properties that it manages for others, as opposed to properties that it
owns.
14-4. Factors that might motivate management to deliberately misstate revenue cycle assertions
include:
Pressures to overstate revenues in order to report achieving announced revenue or
profitability targets or industry norms that were not achieved in reality owing to such
factors as global, national, or regional economic conditions, the impact of technological
developments on the entity's competitiveness, or poor management.
Pressures to overstate cash and gross receivables or understate the allowance for
doubtful accounts in order to report a higher level of working capital in the face of
liquidity problems or going concern doubts.
Factors that might contribute to unintentional misstatements in revenue cycle assertions
include:
The volume of sales, cash receipts, and sales adjustments transactions is often high,
resulting in numerous opportunities for errors to occur.
The timing and amount of revenue to be recognized may be contentious owing to factors
such as ambiguous accounting standards, the need to make estimates, the complexity of
the calculations involved, and purchasers' rights of return.
14-2
14-5. a.
Following are example analytical procedures that the auditor might use to estimate
total revenue for a household appliance manufacturer and for an airline.
Industry
Household Appliance Mfg.
Airline
b.
Two analytical procedures that the auditor might use to estimate gross margin for
company might include.
Analytic Procedure
Compare historical trends in
market share and gross margin
with current unaudited data.
Evaluate the percentage of
revenues coming from new
products.
c.
Possible Analytical Procedures

Use past ratio of net sales to capacity with
adjustments for capacity changes.
Use a combination of past ratios of market
share with adjustments of current changes in
market share. Requires knowledge of the
total market size in the industry.
Estimate net revenues using information on
utilization of capacity (airline seat miles) and
average revenue per seat.
Audit Significance
Companies with commanding market shares
often are able to obtain larger gross margins.
Companies with a high proportion of revenues
from new products may earn premium gross
margins due to the ability to innovate.
Two analytical procedures that the auditor might use to estimate net receivables and
the allowance for doubtful accounts for company might include.
Analytic Procedure
Accounts receivable turn days
Evaluate the entities history of

uncollectable accounts expense
to net credit sales, with
adjustment for economic
conditions
Audit Significance
Understanding a companys history of accounts
and sales volume can assist the auditor in
evaluating net receivables and the adequacy of
the allowance for doubtful accounts.
This procedure is primarily related to the
adequacy of the allowance for uncollectable
accounts. The above history of accounts
receivable turn days would be most useful for
evaluating estimating gross receivables given
sales.
14-6. Several control environment factors and their applicability to revenue cycle assertions are:
Integrity and ethical values - reduction of risk of overstatement of revenues

and receivables by eliminating incentives to dishonest reporting.
14-3
Commitment to competence - by chief financial officers and accounting

personnel.
Management's philosophy and operating style - conservatism in developing
such accounting estimates as the allowance for uncollectable accounts and
allowance for sales returns.
Human resource policies and practices - bonding of employees who handle
cash
14.7.
The following table summarizes the functions that apply to credit sales transactions, the
department that performs the functions, and the principal documents or records produced in
performing the function.
Department that
Principal documents and records
Function
performs function
produced in performing the function.
Initiating credit Sales department
Documents
sales
Customer Order
Credit department
Sales Order
Computer Files and Records
Customer Master File (with credit
information) and Accounts Receivable
Master File.
Perpetual Inventory
Authorized Price List
Open Order File
Delivering good Warehousing and shipping
and services
department for goods.
Line operating departments
for services.
Recording sales
Accounting (Billing)
Documents
Shipping documents
Reports of unfilled orders and back orders
Open Order File
Perpetual Inventory
Shipping File
Documents
Sales Invoice
Sales Reports and Sales Journal
Various Exception Reports
Monthly Customer Statements
Sales Transaction File
Accounts Receivable Master File
14-4
14-8. In order to assess control risk as low based on programmed control procedures the auditor
should test the following.
Control
Programmed control procedures
Computer general control
procedures
Manual follow-up procedures.
Importance to Control Risk Assessment

If a programmed control procedure in critical to a low
control risk assessment then the auditor should directly
test the control procedure.
In order to obtain assurance that the programmed
control procedure functions effectively throughout the
period the auditor also needs to these the effectiveness
of computer general control procedures.
Programmed controls usually report exceptions noted
when performing the control. As a result auditors also
need to test the effectiveness of manual controls that
follow-up on reported exceptions.
14-9. The following tables describes programmed controls for a typical manufacturing company.
Potential
Programmed Control
CAATs (Assuming Test Data)
Misstatement
a. Sales invoices may The computer compares
Submit test data for a
not be recorded.
entries in the sales journal
transaction that has shipping
with underlying shipping
information, both with and
information. All shipping
without a supporting sales
documents must be matched invoice.
with a sales invoice.
b. Sales invoice may
The computer compares
Submit test data with dates on
be recorded in the
dates on the sales invoice
sales invoices that both do and
wrong accounting
with dates on shipping
do not match with dates on
period.
documents.
related shipping files.
c. A fictitious sales
The computer will not
Submit test data with sales
invoice, or a sales
prepare a sale invoice
invoice information that both is
transaction for
without underlying
and is not supported by
which revenue
information on shipping
underlying shipping
should not be
files.
information.
recognized, is
recorded.
d. Sales are made
The computer searches a
Submit test data for sales orders
without credit
field for appropriate credit
that both are and are not
approval.
authorization before an order supported by appropriate credit
is placed on an open order
authorization.
file.
e. A sales invoice has The computer matches
Submit test data for sales
incorrect quantities quantities on a sales invoices invoices that both do and do not
or prices.
with underlying shipping
match underlying shipping
information and matches
information and authorized
prices with an authorized
price lists.
14-5
Potential
Misstatement
f.
Sales invoices may

not be posted or
may not be
journalized
g.
Sales invoices may

be posted to the
wrong customers
accounts.
Programmed Control
price list.
The computer checks run-torun totals of beginning
accounts receivable balances,
plus sales transactions, with
the ending receivable
balances.
The computer matches
customer information on the
sales invoice with the master
customer file, the sales order,
and the shipping documents.
CAATs (Assuming Test Data)

Submit test data for batches that
with complete and incomplete
data sets in terms of completed
transactions.
Submit test data with underlying
information that both does and
does not match with information
on previously created sales
order and shipping files.
14-10. A common management control involves having managers with responsibility for sales to
review daily or weekly sales reports to assess the reasonableness of recorded sales. Further
management responsible for warehousing and shipping should review daily or weekly sales
and inventory movement reports to assess the reasonableness of recorded sales and
inventory removed from the perpetual inventory.
14-11. The sub-functions involved in cash receipts include (1) receiving cash receipts, (2)
depositing cash in bank, and (3) recording the cash receipts.
14-12. a.
Two important controls pertaining to cash sales and the transaction class audit
objectives to which they relate are:
The customer's expectation of a printed receipt and supervisory surveillance of
over the counter sales transactions helps to ensure that all cash sales are
processed through the cash registers or terminals - completeness.
Independent check by supervisor on the accuracy of cash count sheets, and
verification of agreement of cash on hand with totals printed by a cash register or
terminal - existence or occurrence and valuation or allocation.
b.
Two important controls pertaining to the initial handling of mail receipts are (1)
immediate restrictive endorsement of checks received and (2) preparation of a multicopy listing (prelist) of mail receipts.
14-13. a.
A lockbox is a post office box that is controlled by the company's bank. The bank
picks up the mail daily, credits the company for the cash, and sends the remittance
advices to the company for use in updating accounts receivable. This system
eliminates the risk of diversion of the receipts by company employees and failure to
record the receipts.
b.
Depositing receipts intact daily means that all receipts are deposited; that is, cash
disbursements should not be made out of undeposited receipts. This control reduces
14-6
the risk that receipts will not be recorded (completeness), and the resulting bank
deposit record establishes the existence or occurrence of the transactions.
14-14. Four controls that can aid in preventing or detecting errors or irregularities in recording cash
receipts are summarized below along with potential tests of controls:
Control
Independent check of agreement of
validated deposit slip with daily cash
summary.
Computer check of information
included in the cash receipts journal
with information from prelist.
Preparation of periodic independent

bank reconciliations.
Mailing of monthly statements to
customers.
14-15. a.
b.
14-16. a.
Test of Control
Inspect a sample of daily cash summaries and
examine evidence of agreement with validated
deposit slip by responsible employee.
Use CAATs to test computer matching of
information from cash receipts journal with
electronic prelist. Also follow-up on how
exceptions are reported and examine evidence or
correction of errors reported on exception
reports.
Examine a sample of periodic bank
reconciliations. Make inquiries about bank
reconciliation procedures and test accuracy on a
sample basis.
Observe the mailing of monthly statements to
customers. Make inquiries about procedures to
follow-up on issues raised by customers, and
examine reports or other evidence of follow-up.
The functions pertaining to sales adjustments transactions are: granting cash

discounts; granting sales returns and allowances; and determining uncollectable
accounts.
The following three types of controls pertaining to sales adjustments transactions
have as their common focus establishing the validity, or existence of occurrence, of
such transactions:
Proper authorization of all sales adjustments transactions.
The use of appropriate documents and records, particularly the use of an
approved credit memo for granting credit for returned or damaged goods, and an
approved write-off authorization memo for writing off uncollectable customer
accounts.
Segregation of duties for authorizing sales adjustment transactions and handling
and recording cash receipts.
The accounts receivable balance is a function of the transactions that are posted to
the account, namely credit sales, cash receipts, and sales adjustments. A sound
system of internal controls over these three transaction cycles that ensure the
completeness and accuracy of these transactions, should also ensure the
completeness and accuracy of account receivable.
14-7
b.
The primary control over the balance involves sending monthly statements to
customers and having an independent function to receive and follow-up on any
issues raised by customers.
c.
The rights and obligations assertion for accounts receivable involves selling, or
factoring, cash receipts. If an entity sells its receivables, it should keep a
documentary record of the receivables that have been sold or pledged, and have a
process for following up on collection of those receivables and the reduction of the
related liability to the factoring agent. These records should be compared with
monthly statements received from a bank or factoring agent.
d.
Public companies normally control establish controls over the presentation and
disclosure assertion and related audit objectives through an effective and independent
disclosure committee. The disclosure committee should have individuals who are
knowledgeable about GAAP and the transactions being processed.
14-17. The following table provides example controls and tests of controls for each assertion (and
transaction level audit objective) related to credit sales and cash receipts. Examples
emphasize programmed control procedures where appropriate. Student should note that
tests of controls should also emphasize testing computer general controls, observing
exception reports, and testing manual follow-up of items that appear on exception reports.
Credit Sales
Assertion (Audit Objective)
Existence and Occurrence
(Occurrence)
Control
Computer matches sales invoice
information with underlying shipping
information.
Completeness (Completeness)
Computer prints a report of all goods

shipped but not billed.
Existence and Occurrence /

Completeness (Cutoff)
Comparison of invoice date with the

accounting period when goods were
shipped.
Computer matches sales prices with
authorized price list and sales order.
Valuation and Allocation

(Accuracy)
Presentation and Disclosure
(Classification)
Computer matches customer number

on sales invoice with customer
number on sales order.
Rights and Obligations
If an entity sells its receivables, it

should keep a documentary
record of the receivables that have
been sold and it should compare
that record with monthly
statements received from a
factoring company.
Test of Controls
Submit test data where invoice data does
not match with underlying shipping
information.
Submit test data with shipments that have
not been billed to test accuracy of report of
all good shipped but not billed.
Submit test data with shipments in one
period and billing in the subsequent period.
Submit test data with invoice prices that do
not match the authorized price list or sales
order.
Submit test data the customer information
on the sales invoice does not match the
underlying sales order.
Observe and reperform procedures for
documenting receivables that have been
factored or sold.
Cash Receipts
14-8
Assertion (Audit Objective)

(Occurrence)
Completeness (Completeness)
Existence and Occurrence /
Completeness (Cutoff)
(Accuracy)
(Classification)
14-18. a.
Control
Independent check of agreement
of cash and checks with cash
count sheets and prelist.
Preparation of periodic
independent bank reconciliations.
Mailing of statements to
customers.
If an entity sells its receivables, it
should keep a documentary
record of the receivables that have
been sold and it should compare
that record with monthly
statements received from a
factoring company.
Test of Controls
Observe and reperform manual controls to
check independent check of the prelist with
the cash receipts journal.
Observe and test the accuracy of
independent bank reconciliations.
Make inquiries about mailing of monthly
statements to customers. Observe notes
and procedures used to follow-up upon
questions raised by customers.
Observe and reperform procedures for
documenting receivables that have been
factored or sold.
The transaction classes that should be considered in assessing control risk for
accounts receivable assertions are: credit sales, cash receipts, and sales adjustments.
b.
In assessing control risk for the existence or occurrence account balance assertion for
accounts receivable, the following transaction class control risk assessments should
be considered:
Existence or occurrence for sales transactions that increase accounts receivable.
Completeness for cash receipts and sales adjustments transactions that decrease
accounts receivable.
c.
A revised acceptable level of detection risk for tests of details and a revised level of
substantive tests must be determined for an assertion when the relevant final or
actual inherent risk assessments, control risk assessments, and analytical procedure
risk assessments, differ from the planned assessed levels.
14-9
14-19. The following table explains some example preliminary audit strategies for each financial
statement assertion in the context of the audit risk model.
Assertion
Existence and
Occurrence
Completeness
Rights and
Obligations
Valuation and
Allocation
Presentation and
Disclosure
Inherent Risk
Control Risk
Maximum due
to revenue
recognition
problems.
Moderate. Not
a significant
inherent risk.
Low if internal
controls over the
occurrence of
sales are strong.
Low if internal
controls over the
occurrence of
sales are strong.
Moderate to
high depending
on the entitys
ability to
generate
operating cash
flow.
High or
maximum due
to subjective
nature of
allowance.
Inherent risk is
usually high or
maximum.
Moderate to high
depending on
internal controls.
However, control
are more
nonroutine than
routine.
Moderate to high
depending on
internal controls
over collection
of receivables.
Moderate to high
depending on
internal controls
over disclosures.
Analytic Procedures
Risk
Moderate to high
depending on
reliability of
expectation model.
Moderate to high
depending on
reliability of
expectation model.
Moderate to high
depending on
reliability of
expectation model.
Moderate to high
depending on
reliability of
expectation model.
Maximum: Analytical
procedures are not
directed at testing
disclosures.
Test of Details Risk

Moderate which will allow for smaller
sample sizes and changing the timing of
confirmations of receivables. It will
also reduce the extent of cutoff tests.
Moderate to high which will allow for
smaller sample sizes and changing the
timing of confirmations of receivables.
It will also reduce the extent of cutoff
tests.
Low: Consider confirming with
factoring agent and search for large
unusual cash receipts.
The auditor can test the accuracy of

receivables at gross value with
confirmation. The auditor should
consider extensive tests of the
allowance after year-end.
Maximum to High. It is often cost
effective to substantively test
disclosures which are not complex for
receivables.
14-20. In vouching recorded accounts receivable transactions to supporting documentation, a

sample of debits to customers' accounts is compared to data on supporting sales invoices and
matching shipping documents, sales orders, and customer orders. The evidence obtained
pertains primarily to specific audit objectives derived from the existence or occurrence,
rights and obligations, and valuation or allocation assertions for accounts receivable.
14-21. Both the sales cutoff test and the cash receipts cutoff test pertain to accounts receivable. The
sales cutoff test involves:
Examining shipping documents for several days before and after the cutoff date to
determine the date and terms of shipment.
Tracing shipping documents to sales and inventory records to establish that the entries
were made in the correct accounting period.
Inspecting invoices for a period of time before and after the cutoff date to ascertain the
validity and propriety of the shipments and corresponding entries.
Inquiring of management about any direct shipments by outside suppliers to customers
and determining the appropriateness of related entries.
In performing a cash receipts cutoff test, the auditor may be present at the balance sheet date
to personally observe the promptness of the cutoff. In particular, the auditor determines that
14-10
all collections received prior to the close of business are included in cash on hand or in
deposits in transit and are credited to accounts receivable. Alternatively, the auditor may
review the daily cash summary and validated deposit slip for the last day of the year.
Both cutoff tests relate to the occurrence and completeness audit objectives for accounts
receivable.
14-22. a.
It may not be necessary to confirm accounts receivable when:

The balance is immaterial to the financial statements.
The use of confirmations would be ineffective as an audit procedure.
The auditor's combined assessment of inherent risk and control risk is low, and
that assessment, made in conjunction with the evidence expected to be provided
by analytical procedures or other substantive tests of details, is sufficient to
reduce audit risk to an acceptably low level for the applicable financial statement
assertions.
b.
Factors to be considered in choosing the form of confirmation request are (1) the
acceptable level of detection risk and (2) the composition of the customer balances.
The positive form is used when detection risk is low or individual customer balances
are relatively large. The negative form should be used only when all three of the
following conditions apply:
The acceptable level of detection risk for the related assertions is moderate or
high.
A large number of small balances is involved.
The auditor has no reason to believe that the recipients of the requests are
unlikely to give them consideration.
c.
When no response is received after the second or third positive confirmation request
to a customer, the auditor should apply such alternative procedures as (1) examining
subsequent collections and (2) vouching open invoices comprising the customer's
balance. Alternate procedures may be omitted when both of the following conditions
apply:
There are no unusual qualitative factors or systematic characteristics related to
the nonresponses, such as that all nonresponses pertain to year-end transactions.
The nonresponses, projected as 100% misstatements to the population and added
to the sum of all other unadjusted differences, would not affect the auditor's
decision about whether the financial statements are materially misstated
14-23. a.
b.
The aged trial balance is used primarily in assessing the adequacy of the allowance
for uncollectable accounts.
Procedures applied to the aged trial balance include (1) footing and crossfooting the
aged trial balance and comparing the total to the general ledger balance for accounts
receivable and (2) testing the aging of the amounts shown in the aging categories by
examining supporting documentation such as dated sales invoices.
14-11
c.
After testing the accuracy of the aged trial balance the auditor should perform the
following procedures to draw a conclusion about the fair presentation of the
allowance for doubtful accounts.
Examine past due accounts for evidence of collectability such as correspondence
with customers and outside collection agencies, credit reports, and customers
financial statements.
Discuss collectability of accounts with appropriate management personnel.
Evaluated managements process for estimated the allowance for doubtful
accounts using hindsight.
Evaluate the adequacy of the allowance given information about industry trends,
aging trends, and collection history for specific customers.
d.
Hindsight allows auditors to evaluate the reasonableness of managements process

for estimating the allowance for doubtful accounts. The reliability of managements
process for developing this accounting estimate can be gauged by evaluating
estimates in prior periods and the degree to which those estimates accurately
estimated subsequent uncollectable accounts.
14-24. GAAP disclosure for accounts receivable include:

Disclosure of receivables from employees, officers, affiliated companies and other
related parties.
Appropriate classification of material credit balances.
Appropriate classification of current and noncurrent receivables.
Disclosure of pledging, assigning, or factoring receivables.
Comprehensive Questions
14-25. (Estimated Time: 15 Minutes)
The auditor should consider separately audit the revenues associated with the 27 owned
properties and the 40 managed properties.
Revenues for the 27 owned properties represent direct revenues of the motel chain. The
auditor might consider evaluating the summer season separate from the balance of the year
as the auditor will expect occupancy to be high during that time of year and the auditor will
also expect that revenues should reflect higher rates. The auditor would also expect that for
the balance of the year occupancy should be lower and revenues per night will be reduced
due to significant price competition. Knowledge of the industry will be particularly helpful
in gauging the reasonableness of occupancy rates and revenues per unit.
Revenues for the 40 managed hotels will likely be related to management fees based on
revenues earned for absentee owners. The auditor needs to consider the same issues as
14-12
above, but also need to determine the appropriateness of the management fee based on the
contract with absentee owners.
14-26. (Estimated time - 25 minutes)
1.
The following table provides the solutions to the quantitative requirements in parts a
through g.
2.
Receivables are growing faster than sales. In addition, Sales price per unit has gone
up and the ratio of sales to total assets has increased. This might be evidence of
problems with revenue recognition. In addition, during this period of accounts
receivable growth, accounts receivable turn days increased during the last year, and
the uncollectable account expense to account receivable write-off has gone down.
The auditor should also consider whether the allowance for doubtful accounts is
adequate.
14-27. (Estimated time - 20 minutes)
1.
2.
3.
4.
Internal Control Questionnaire

Question
Are cash registers or point-of-sale devices used for over-the-counter sales?
Is there periodic surveillance of cash sales procedures?
Are customers who pay by check required to provide identification?
Are checks restrictively endorsed on receipt?
Yes
No
14-13
5. Is a receipt produced by the cash register given to each customer?

6. Is an independent check made of agreement of cash and checks on hand with
cash count sheets and cash register readings?
7. Is cash deposited intact daily?
8. Is an independent check made of agreement of daily cash register summaries
with validated deposit slips?
9. Is an independent check made of agreement of amounts journalized with daily
cash register summaries and validated deposit slips?
10. Are periodic independent bank reconciliations made?
11. Are employees who handle cash bonded?
14-28. (Estimate Time: 30 Minutes)
Weakness
Financial secretary exercises too much
control over collections.
Recommended Improvement
To extent possible, financial secretary's
responsibilities should be confined to record
keeping.
Finance committee is not exercising its

assigned responsibility for collections.
Finance committee should assume a more

active supervisory role.
The auditing function has been assigned to

the finance committee, which also has
responsibility for the administration of the
cash function. Moreover, the finance
committee has not performed the auditing
function.
The head usher has sole access to cash
during the period of the count. One person
should not be left alone with the cash until
the amount has been recorded or control
established in some other way.
The collection is vulnerable to robbery
while it is being counted and from the
church safe prior to its deposit in the bank.
An audit committee should be appointed to

perform periodic auditing procedures or
engage outside auditors to perform the
procedures.
The head usher's count lacks usefulness

from a control standpoint because he
surrenders custody of both the cash and the
record of the count.
Contributions are not deposited intact.
The number of counters should be increased

to at least two, and cash should remain under
joint surveillance until counted and recorded
so that any discrepancy will be brought to
attention.
The collection should be deposited in the
bank's night depository immediately after the
count. Physical safeguards, such as locking
and bolting the door during the period of the
count, should be instituted. Vulnerability to
robbery will also be reduced by increasing
the number of counters.
The financial secretary should receive a copy
of the collection report for posting to the
financial records. The head usher should
maintain a copy of the report for use by the
audit committee.
Contributions should be deposited intact. If it
14-14
Weakness
Recommended Improvement
There is no assurance that amounts
is considered necessary for the financial
withheld by the financial secretary for
secretary to make cash expenditures, she
expenditures will be properly accounted for. should be provided with a cash working
fund. The fund should be replenished by
check based upon a properly approved
reimbursement request and satisfactory
support.
Members are asked to draw checks to
Members should be asked to make checks
"cash", thus making the checks completely payable to the church. At the time of the
negotiable and vulnerable to
count, ushers should stamp the church's
misappropriation.
restrictive endorsement (For Deposit Only)
on the back of the check.
No mention is made of bonding.
Key employees and members involved in
receiving and disbursing cash should be
bonded.
Written instructions for handling cash
Because much of the work in cash
collections apparently have not been
collections is performed by unpaid,
prepared.
untrained church members, often on a shortterm basis, detailed written instructions
should be prepared.
14-29. (Estimated Time: 30 minutes)
a.
Consolidated Electricity Company: Cash Receipts Flowchart
Documentary
Audit Trail
Key Reports
Computer Programs and Files
Customer
Payment
Remittance
Advice
CASH RECEIPTS
PROGRAM:
Updates AR Master
File and Daily
Transaction Tape.
Also Produces
Deposit Slip for
Cash Received
Data
Entry
at
CRT
Accounts
Receivable
File
rece Cash
Receipts
Transaction
File
Deposit
Slip
14-15
b.
Yes, the new cash receipts procedures have created some systems and internal
control problems. These problems include the following:
There are some potential control problems in the data entry procedures. The CRT
operator should be restricted to cash receipts processing activities. There should
be safeguards to detect or prevent unauthorized entries to the system.
The old master file records are destroyed in the update process. The company
should keep a backup of the accounts receivable file in case the file is destroyed.
This can be accomplished by periodically dumping the accounts receivable file
on magnetic tape or another disk
There is no assurance that all cash receipts have been entered correctly into the
system. There should be some independent computation of batch and/or hash
totals involving the remittance advices and the number of transactions so that a
comparison at the conclusion of processing would reveal omissions or errors
The remittance advices The remittance advices are destroyed the next day, which
probably is too soon. Any errors or operator alterations not discovered by the end
of the next business day would be difficult to trace and correct.
14-30. (Estimated Time 25 Minutes)

a. Substantive Test
Vouch aged trial balance to
supporting documentation
Apply analytical procedures
Vouch recorded receivables to
Perform sales cutoff test
Confirm accounts receivable
Vouch aged trial
balance to supporting
documentation
Vouch recorded receivables to
Verify accuracy of accounts
receivable trial balance and
agreement with general ledger
control
Examine subsequent
b. Financial Statement
Assertion
Valuation or allocation
c. Type of Evidence
Documentary
Existence or occurrence,
completeness, valuation or
allocation
rights and obligations,
valuation or allocation
completeness
All except presentation and
disclosure.
Analytical
rights and obligations,
valuation or allocation
Documentary
Documentary
Documentary
Documentary
Confirmation
Documentary
Mathematical
14-16
a. Substantive Test
collections or allocation
Confirm accounts receivable
Compare statement
presentation with GAAP
Perform cash receipts cutoff
test
b. Financial Statement
Assertion
completeness, valuation
All except presentation and
disclosure
Presentation and
disclosure
completeness
c. Type of Evidence
Confirmation
Documentary
Documentary
14-31. (Estimated Time 20 minutes)

Schedule of Adjustments
14-32.
15 minutes)
a.
Transaction
D
E
F
H
Total
Cost of Goods
Sales
Sold
Under Over
Under Over
4,000
2,400
10,000
5,600
6,000
8,000
14,000 14,000
5,600
Adjusting Entry
Inventory
DR
5,600
CR
(Estimated time King might

justify omitting the
confirmation of
Cycle's accounts
receivable when:
Th
e
5,600
b.
balance is immaterial to the financial statements.

The use of confirmations would be ineffective as an audit procedure.
The auditor's combined assessment of inherent risk and control risk is low, and
that assessment, made in conjunction with the evidence expected to be provided by
analytical procedures or other substantive tests of details, is sufficient to reduce
audit risk to an acceptably low level for the applicable financial statement
assertions.
In designing confirmation requests, the auditor considers the acceptable level of

detection risk needed to be achieved, the composition of the client's customer balances,
and the likelihood that the customers will conscientiously respond. The positive form is
used when detection risk is low or individual customer balances are relatively large.
The negative form should be used only when all three of the following conditions
apply:
The acceptable level of detection risk for the related assertions is moderate or
high.
A large number of small balances is involved.
The auditor has no reason to believe that the recipients of the requests are
unlikely to give them consideration.
14-17
c.
When no response is received after the second or third positive confirmation request
to a customer, the auditor should apply such alternative procedures as (1) examining
subsequent collections and (2) vouching open invoices comprising the customer's
balance. Alternate procedures may be omitted when both of the following conditions
apply:
There are no unusual qualitative factors or systematic characteristics related to
the nonresponses, such as that all nonresponses pertain to year-end transactions.
The nonresponses, projected as 100% misstatements to the population and added
to the sum of all other unadjusted differences, would not affect the auditor's
decision about whether the financial statements are materially misstated.
Cases
14-33. (Estimated Time 30 Minutes)
Accounts Receivable Gros s

Allowance for Uncollectable Accounts
Net Receivables
Total Assets
Total Revenues
Uncollectable Accounts Expense
Writeoff of Accounts Receivable
Year 5
Unaudited
535,000
($14,500)
520,500
2,200,000
2,700,000
33,750
22,600
Yar 4
Unaudited
295,000
($6,400)
288,600
1,800,000
2,050,000
25,625
24,500
Year 3
Unaudited
265,000
($5,275)
259,725
1,500,000
1,750,000
21,875
22,500
Year 2
Unaudited
207,500
($5,900)
201,600
1,200,000
1,400,000
17,500
17,000
a. Selected Ratios
Sales to average total as sets
Industry Median
Difference
1.35
1.25
0.10
1.24
1.23
0.01
1.30
1.29
0.01
1.27
1.26
0.01
AR Growth to Sales Growth
2.53
0.65
1.15
1.13
55
47
8
49
48
1
48
47
1
48
47
1
AR collection period
Industry Median
Difference
Uncollectable account expense to net credit sales
Industry Median
Difference
Uncollectable account expense to bad debt writeoffs
b.
1.25%
1.50%
-0.25%
1.25%
1.30%
-0.05%
1.25%
1.25%
0.00%
1.25%
1.25%
0.00%
1.493
1.046
0.972
1.029
Year 1
Unaudited
175,000
($5,400)
169,600
1,000,000
1,200,000
15,000
14,000
The unaudited figures for Aurora Manufacturing, Inc. show the following:
There was a significant increase in sales compared to total assets, particularly when
compared to industry averages. This is an indication of possible existence and
occurrence problems as past history of the ratio of total assets to sales would predict
14-18
lower sales levels. The auditor should expand the scope of accounts receivable
confirmations.
The collection period is increasing relative to industry averages and past history.
Further, accounts receivable are growing faster than sales. The Aurora continues to use a
historical rate of 1.25% of credit sales to provide for uncollectable accounts while
industry trends show an increase in the rate of bad debts to credit sales. The is an
indication of possible problems of associated with the net realizable value of receivables.
The auditor needs to expand the scope of tests of collection of current receivables, the
allowance for uncollectable accounts, and the provision for bad debt expense.
Comprehensive Cases
14-34. See separate file with answers to the comprehensive case related to the audit of Mt. Hood
Furniture that is included with this chapter.
14-19
Professional Simulation
Analytical
Procedures
Situation
Internal
Controls
Risk
Assessment
Audit
Procedures
To:
Audit File
Re:
Analytical procedures
From: CPA Candidate
Ratio
Accounts Receivable Turn Days
Sales and Accounts Receivable
Growth Rates
Sales to Net Fixed Assets
Unaudited Ratio
54 days
Sales Growth: 7%
Accounts Receivable
Growth: 14%
10.0
Auditors Expectation Range

42 days 48 days
Sales Growth: 6% - 9%
Accounts Receivable Growth: 6% 9%
6.0 8.0
The above analytical procedures show that receivables are growing faster than sales, the ratios of
accounts receivable turn day and sales to net fixed assets are both significantly larger than the
auditors expectation. The most likely misstatement due to the potential overstatement of both sales
and receivables relates to the occurrence of sales and the existence of receivables due to revenue
recognition problems. The increase in accounts receivable turn days also points to possible
problems with the valuation of receivables at net realizable value due to the understatement of the
allowance for doubtful accounts.
14-20
Internal
Controls
Situation
Analytical
Procedures
Risk
Assessment
Audit
Procedures
Assertion
A.
B.
Completeness
C.
D.
E.
Identify the appropriate assertion for each of the following internal controls. Check all that apply.
(A)
(B)
(C)
(D)
(E)
Internal Control
1.
The computer prints a report of all shipments that
have not resulted in a sales invoice.

2.
The computer matches the date on the bill of
lading with the accounting period when the sales

invoice is recorded.
3.
The computer matches prices on the sale invoice
with prices on the master price list.

4.
The computer matches the customer number on
the sales invoice with the customer number on the

master customer file.
5.
The computer compares control totals on
shipping documents with corresponding control

totals
Risk
Assessment
Situation
Analytical Internal
Procedures Controls
Audit
Procedures
To:
Audit File
Re:
Control Risk Assessment
From: CPA Candidate
Based on the following assessments the auditor should assess control risk as moderate for the
purpose of considering the controls over the accounts receivable balance. Accounts receivable is
affected by the existence and occurrence assertion for credit sales (low in this case) and the
completeness control related to cash receipts (moderate in this case) and sales return (low in this
case). A conservative risk assessment would be to use a moderate risk assessment for control risk
when planning the confirmation of accounts receivable.
14-21
Control Risk
Assessment
Low
Control
The computer matches sales invoice information with underlying shipping
information.
The computer matches sales prices with the authorized price list.
A prelist is prepared for cash receipts and compared with deposit slips.
The computer prepares a daily report of authorized sales returns that have not
resulted in a receiving report or a credit memo.
Low
Moderate
Low
Audit
Procedures
Situation
Analytical Internal
Procedures Controls
Risk
Assessment
Audit procedure
A.
B.
C.
D.
E.
F.
G.
H.
I.
J.
Select a sample of recorded sales transactions from several days before and after year-end and examining
supporting sale invoices and shipping documents to determine that sales were recorded in the proper period.
Trace beginning balance for accounts receivable to the prior years working papers.
Send positive confirmations for accounts receivable and follow-up on disputed confirmations.
Trace a sample of revenue transactions from shipments to recorded sales invoices in the sale journal.
Determine whether there are credit balances that are significance in the aggregate that should be reclassified as
liabilities.
Send confirmations to entities that have purchased accounts receivable.
Compare uncollectable accounts expense to net credit sales.
Review activity in the general ledger account for accounts receivable and investigate entries that appear
unusual in amount or source.
Use generalized audit software to recompute the aging of accounts receivable and investigate the credit history
of accounts that are over 60 days past due.
Observe that all cash received through the close of business on the last day of the fiscal year is include in cash
on hand or deposits in transit and that now receipts of the subsequent period are included.
Determine the audit procedure that best addresses the following risks.
Risk
1.
2.
3.
4.
5.
Recorded sales may not represent goods shipped during the

year.
The allowance for doubtful accounts may not reasonably
estimate the difference between gross receivables and their net
realizable value.
All sales during the period may not be recorded.
All legal claims on accounts receivable are adequately
disclosed.
Accounts receivable information may not be appropriately
classified and presented in the financial statements.
(A)
(F)
(B)
(G)
(C)
(H)
(D)
(I)
(E)
(J)
14-22

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CHAPTER 14

AUDITING THE REVENUE CYCLE

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Possible Analytical Procedures

Evaluate the entities history of

Integrity and ethical values - reduction of risk of overstatement of revenues

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Commitment to competence - by chief financial officers and accounting

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Importance to Control Risk Assessment

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Sales invoices may

Sales invoices may

CAATs (Assuming Test Data)

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Preparation of periodic independent

The functions pertaining to sales adjustments transactions are: granting cash

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Computer prints a report of all goods

Existence and Occurrence /

Comparison of invoice date with the

Valuation and Allocation

Computer matches customer number

Rights and Obligations

If an entity sells its receivables, it

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Assertion (Audit Objective)

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Test of Details Risk

The auditor can test the accuracy of

14-20. In vouching recorded accounts receivable transactions to supporting documentation, a

2005, John Wiley and Sons, Inc.

It may not be necessary to confirm accounts receivable when:

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

Hindsight allows auditors to evaluate the reasonableness of managements process

14-24. GAAP disclosure for accounts receivable include:

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

14-27. (Estimated time - 20 minutes)

Internal Control Questionnaire

Solutions Manual to Modern Auditing: Copyright

2005, John Wiley and Sons, Inc.

5. Is a receipt produced by the cash register given to each customer?

Finance committee is not exercising its

Finance committee should assume a more

The auditing function has been assigned to

An audit committee should be appointed to

The head usher's count lacks usefulness

Solutions Manual to Modern Auditing: Copyright

The number of counters should be increased

2005, John Wiley and Sons, Inc.

Consolidated Electricity Company: Cash Receipts Flowchart