 A/R and Sales are audit areas in Sales and collection

cycle.
The Sales and Collection Cycle
 This Cycle includes all of the following processes:
 Receiving a customers order
 Approving credit for a sale
 Determining whether goods are available for sale
 Shipping the goods
 Billing the customers
 Collecting cash
 Recognizing the effect of these processes in accounting records

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Significance of the sales and
collection cycle:
 A company’s sales and collection
cycle reflects its operations.
 This makes sales transactions to be
always material/significant to the
company’s financial statement
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Major Risks on which auditors focus in this
cycle
 The risk related to revenue recognition (usually
overstating revenue)
 SEC studies show, the majority of financial
statement manipulations and audit failures
involve misstatement of revenue (particularly
overstatements of revenues), which implies that
sales and collection cycle must be examined with
great care.
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The overall objective in the audit of
the sales and collection cycle:
 The objective of audit of the sales
and collection cycle is to evaluate
whether the account balances affected
by the cycle are fairly presented in
accordance with accounting
standards.

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Five Classes of transactions in sales and Accounts in each classes of
collection cycle transactions in sales and
collection cycle
1. Sales Transaction ( Cash and on account sales) •Cash, A/R, Sales

2. Cash Receipts Transaction: Collections from all •Cash, A/R, Sales discount,
sources, collection of AR with or with no discount; other accounts
3. Sales Returns and Allowances Transaction •Sales returns and allowances
and A/R
4. Write off of uncollectible A/R Transaction - •Allowance for Bad debt
expense, A/R

5. Estimate of Bad Debt Expense Transaction •Bad debt expense,

Allowance for uncollectible
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accounts 5
 Receivableinclude not only trade receivables
but also a variety of miscellaneous claims –
non trade receivables also related party
transactions

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 Beforeassessing control risks and designing
tests of controls and substantive tests of
transactions for an audit area, auditors are
required to understand the business
functions and documents and records in a
business.

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-Processing Customer Orders –requires
understanding customers request
-Sales Order-used to communicate
customers request
-Granting Credit-requires checking the credit
worthiness of the customers
-Shipping Goods-critical function to
recognize revenue, then shipping
Document is prepared as an evidence
- Billing Customers and Recording Sales
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 The most important aspects of billing are:
 All shipments made have been billed
(completeness)
 No shipment has been billed more than once
(occurrence)
 Each one is billed for the proper amount
(accuracy)

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-Processing and Recording Cash Receipts:
- The most important concern is the possibility
of theft. Theft can occur before receipts are
entered in the records or later.
- It is important that all cash receipts are
deposited in the bank at the proper amount
on a timely basis and recorded in the cash
receipts transaction file

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-Sales Invoice
-Sales Transaction file
-Sales Journal or Listing:
-Accounts Receivable Master File:
-Accounts Receivable Trial Balance:
-Monthly Statement:
-Remittance advice
-Prelisting of Cash Receipts:
-Cash Receipts Transaction File:
-Cash Receipts Journal or Listing:
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Internal Controls are needed to ensure the fair presentation
of
 Controlling Customers Orders –check the correctness of
customer specification
 Credit approval: check the financial condition of the
customer before approving credit
 Issuance of merchandise: issue merchandise based on
authorized shipping documents
 The shipping function-Prepare pre-numbered shipping
documents in copies (for billing section, for gate keepers)
 Collections of Receivables: Follow up collection, check if
collection is recorded on the right customers account
 Write off of Receivables: write off should be after
adequate review by credit department
 Internal audit of Receivables:-Have an internal audit of
receivables (this applies to large organization)
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 The overall objective in the audit of the sales
and collection cycle is to evaluate whether
the account balances affected by the cycle
are fairly presented in accordance with
accounting standards.
Auditors achieve this purpose by:
 Determining the adequacy of internal control
system over sales and collection cycle
 Testing the financial statement assertion
relevant to receivables and sales
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Auditors are required to check the adequacy if I/C and apply
procedures to substantiate that:
 The recorded receivables are valid (existence and rights).
 All receivables are recorded (completeness).
 Receivable records and supporting schedules are
mathematically correct and agree with general ledger
accounts (clerical accuracy).
 The valuation of receivables approximates their realizable
value.
 The presentation and disclosure of receivables is
adequate, including the separation of receivables into
appropriate categories, and adequate reporting of any
receivables pledged as collateral and related party
receivables.

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Preparation of audit program begins with assessment of risk:
-Inherent risk –major risk is related to revenue recognition
Fraud risk-Some of the fraud risks are:
 Recognition of revenue on shipments that never occurred
(recording & reporting fictitious sale)
 Recording consignment sales as final sales
 Creation of fictitious invoices
 Early recognition of sales that occurred after end of fiscal
period
 Shipment of unfinished product
 Recording shipments to company’s own warehouse as sales
 Recording purchase orders as completed sales

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Major Fraud risk related to Receivables
 Incorrect aging of accounts receivable

 Lapping: Technique used to cover up

embezzlement of cash (Stealing cash collection
from a customer and crediting him from another
customer's payment . This process continues and
at least one customer’s account is always
overstated. Lapping occurs when duties are
inadequately segregated
.
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Causes, prevention and detection methods for Lapping of
AR
Causes: Absence of separation of duties of handling cash
and entering data to computer increases the possibility of
lapping of A/R
 Lapping of A/R is prevented by:
 Separating duties
 Arranging mandatory vacation policy for employees
who both handle cash and enter cash receipts into the
system.
 Lapping of A/R is detected by:
 Comparing the name, amount, and dates shown on
remittance advices with cash receipts journal entries
and related For
duplicate
class of 2018 deposit slips 17
Assessing inherent risk for AR
 For example, the following risks are inherent to AR, thus
auditors are required to identify them:
 Sales of receivables recorded as sales rather than financing
transactions
 Receivables incorrectly classified as current when the likelihood
of collection during next year is low,
 Collection of receivable contingent on future events that cannot
currently be estimated,
 AR aged incorrectly and potentially uncollectible amounts are not
recognized
Presence of inherent risks increase the probability of material
misstatement
Assessing inherent risks help auditors to assess control risk.
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Assessing control risk for the sales and collection cycle
 As compared to other cycles, controls over sales and cash
receipts and the related AR is reasonably effective in most
companies since keeping accurate records helps them to
maintain good relations with customers.
Thus auditors focus on assessing risks only on the
following:
1. Controls that prevent or detect embezzlements
2. Controls over cutoff (cuttoff helps to show transactions
and balances in proper period)
3. Controls related to the allowance for uncollectible
accounts
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Control risk-
- Controls are designed to minimize potential
risks.
- To assess control risk, auditors are required
to have an understanding of internal controls
(its strength and weakness) through
procedures such as walkthrough of process,
inquiry, observation and review of
documentation.
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Indicators of weak internal control over this area
include:
 Shipment of merchandise to customers whose
credit standing has not been approved
 Shipment of merchandise without giving notice
to the billing department (Shipment exist but no
credit sales)
 Error in recording quantity and selling price on
sales invoice
 Failure to control sales invoices by serial number,
where some may be lost without recording the
accounts receivable
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 Absence or inadequate internal control over
sales and receivables will result in large losses
of receivables and misstated balance of sales
and receivables.

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Types of A/R that deserve auditors attention
 In addition to analytical procedures, auditors should also
review the following: (receivables that need auditors
attention)
 Accounts receivable for large and unusual amounts, such as
large balances,
 Accounts that have been outstanding for a long time,
 Receivables from affiliated companies, officers, directors,
and other related parties, and
 Credit balances in A/R.

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 Two interrelated audit procedures, tests of
control and tests of details of financial
balances are applied.
 Tests of controls for the sales and collection
cycle are intended to determine the
effectiveness of internal control and to test
the substance of the transactions which are
produced by this cycle.

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-Test of control include activities such as:
- -Examining sales invoices used as an evidence
for entries recorded in sales journal,
- - Reconciling cash receipts, or
- - Reviewing the approval credit, .

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 The results of the tests of controls will
determine subsequent procedures, sample
size, timing and particular items selected for
the tests of details of financial balances
 effective internal control will result in reduced
detailed tests of balance
 Ineffective internal control results in more
tests of details of balances

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Tests of details of financial balances (Substantive
tests)
 Tests of details of financial balances are designed to
determine the reasonableness of the balances in
sales, accounts receivable, and other account
balances which are affected by the sales and
collection cycle.
 Such tests include:
 confirmation of accounts receivable, and
 examining documents supporting the balance in these
accounts.
Tests of details of financial balances follow tests of control;
the result of tests of control determines the extent of the
detailed tests.
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 Before applying the tests of details, auditors
apply analytical procedures to identify
unusual differences.
 The results of analytical procedures also
determine the extent of detailed tests.
 If analytical procedures reveal unusual
differences, there will be more detailed tests.
 Link ch 3\Table 2.doc

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 Sales returns occur when customers are dissatisfied with
the goods
 Document prepared as an evidence-Credit memos
 Focus area of audit:
1. Existence of sales returns and allowance (existence
objective)
 It is essential to ensure that all sales and returns and
allowances are approved by appropriate personnel, this is
because:
 A theft of cash from AR account can be covered up by a
fictitious sales return or allowance
 Thus, existence objective is an auditors focus area
 Credit memo is the main document auditors refer for this
transaction

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2. Completeness of sales returns and
allowance (Completeness objective)
 It is essential to ensure that all sales and
returns a allowances are recorded, this is
because:
 Company’s management may use unrecorded
sales return or allowance to overstate net income
 Thus, it is essential to ensure that pre-
numbered documents (Credit memos) are
used and that all are accounted for.
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Audit tests for the write-off of uncollectible accounts
 The auditors primary concern is on occurrence
transaction-related audit objective-does the write-off
really occurred?
 This is due to the possibility that client personnel may
cover up an embezzlement by writing off accounts
receivable that have already been collected
Method of preventing this fraud:
 Proper authorization of write-off of A/R by the
management after a through analysis of the reason
why the customer is unable to pay
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-Another focus area of audit is to check if provisions
recorded for bad debts are adequate (not to overstate
A/R)

Figure 2.3 Methodology for Designing Tests of

Controls and Substantive Tests of Transactions for
SalesLink ch 3\Table 2.doc

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Summary of the Methodology for Designing Tests of Controls and
Substantive Tests of Transactions for Sales

-Understand Internal Control

(by flowchart, internal control question are..)
Assessing Planned Control Risk— Sales
This requires using the six transactions related audit
objectives as a framework to identify the key internal
controls and deficiencies for sales
- After identifying the controls and deficiencies, the
auditor associates them with the objectives.
The auditor assesses control risk for each objective by
evaluating the controls and deficiencies for each
objective. This step is critical because it affects the
auditor’s decisions about both tests of controls and
substantive Fortests. It is a highly subjective decision. 33
class of 2018
Summary of the Methodology for Designing Tests of Controls and
Substantive Tests of Transactions for Sales

Link ch 3\Table 2.doc (four colmns)

▪ Key Controls


1. Adequate Separation of Duties

2. Proper Authorization
3. Adequate Documents and Records
4. Pre numbered Documents
5. Monthly Statements:
6. Internal Verification Procedures
Then the auditor determines the extent of reliance on
control system
For Public companies-auditors do more tests of control
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..Summary of the Methodology for Designing Tests of Controls and
Substantive Tests of Transactions for Sales

Designing Tests of Controls for Sales

-For each key control (eg. Separation of duty..)
Testing procedures are designed.
-The test varies depending on the nature of control
-eg: existence of separation of duty is checked by
observation, document verification

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Summary of the Methodology for Designing Tests of Controls and
Substantive Tests of Transactions for Sales

Designing Substantive Tests of Transactions for Sales

 The substantive tests of transactions are related to
the transaction-related audit objectives and are
designed to determine whether any monetary
misstatements for that objective exist in the
transaction.
 Determining the proper substantive tests of
transactions procedures for sales is relatively difficult
because they vary considerably depending on the
circumstances.

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Summary of the Methodology for Designing Tests of Controls and
Substantive Tests of Transactions for Sales

Substantive Tests of Transactions for Sales under Special audit

(fraud audit)
-This tests are needed when internal control for sales are
found to be weak. Examples:
 Checking Recorded Sales Occurred/Occurrence
Objective- For this objective, the auditor is
concerned with the possibility of three types of
misstatements:
 Sales included in the journals for which no shipment was
made.(error/fraud)
 Sales recorded more than once.(error/fraud)
 Shipments made to nonexistent customers and recorded
as sales.(fraud)
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Summary of the Methodology for Designing Tests of Controls and
Substantive Tests of Transactions for Sales

Common Types of Substantive Tests of Transactions for Sales

(for normal audit)
1. Recorded Sale for Which There Was No Shipment:
If the auditor is concerned about the possibility of a fictitious
duplicate copy of a shipping document, it may be necessary
to trace the amounts to the perpetual inventory records as a
test of whether inventory was reduced.
2. Sale Recorded More Than Once-check the sequence of
invoices and shipping documents and properly cancel each
other
1. 3.Shipment Made to Nonexistent Customers:
occurs only when the person recording sales is also in a position
to authorize shipments (lack of proper control-separation of
duty)
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Summary of the Methodology for Designing Tests of Controls and
Substantive Tests of Transactions for Sales

4. Existing Sales Transactions Are Recorded:-

completeness test

Direction of Tests
1. Tracing from source documents to the journals
(Completeness test)
1. Vouching from the journals back to source
documents (Occurrence test)

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Summary of the Methodology for Designing Tests of Controls and
Substantive Tests of Transactions for Sales

5. Sales Are Accurately Recorded (Accuracy objective)

Involves checking accuracy in:
 Shipping the amount of goods ordered
 billing for the amount of goods shipped
 recording the amount billed in the accounting
records
6. Sales Transactions Are Correctly Included in the
Master File and Correctly Summarized (posting and
summarization objective)

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Summary of the Methodology for Designing Tests of Controls and
Substantive Tests of Transactions for Sales

Accuracy test also involves:

-Recorded Sales Are Correctly Classified
(eg if sales of assets other than inventory are
recorded as sales)
-Sales Are Recorded on the Correct Dates

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Summary of the Methodology for Designing Tests of balance

Summary of Methodology for Designing Tests of

Details of Balances for Accounts Receivable
Link ch 3\Figure 1.doc
These methods are designed to check the eight balance
related audit objectives
 1. Detail tie-in
 2. Recorded accounts receivable exist (Existence)
 3. Existing accounts receivable are included (Completeness)
 4. Accounts receivable are accurate (Accuracy)
 5. Accounts receivable are correctly classified (Classification)
 6. Cutoff for accounts receivable is correct (Cutoff)
 7. Accounts receivable is stated at realizable value (Realizable value)
 8. The client has rights to accounts receivable (Rights)

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..Summary of the Methodology for Designing Tests of balance

Design and Perform Analytical Procedures (Phase III)

- Analytical procedures are often done during three
phases of the audit: during planning, when
performing detailed tests, and as a part of completing
the audit
Link ch 3\AP for sales.doc

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Designing Tests of Details of Balances
 In many cycles, tests of details of balances focus on balance sheet
accounts
 But in the sales and collection cycle, income statements accounts
are not ignored because of their significance
Eg. Confirmation of receivables indicate an overstatement caused
by error in billing. This error overstates both A/R and Sales balance
Framework for testing details of AR balance
 Auditors use balance related objectives as a framework in testing
details of AR balance
 (Existence, completeness, accuracy, realizable value, detail tie
in,cut off, Rights to A/R)

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Confirmation of Accounts Receivable
 Confirmation is a direct written response from a
third party in paper or electronic form
Purpose of accounts receivable confirmation
 The primary purpose of accounts receivable
confirmation is to satisfy the existence, accuracy,
and cutoff objectives.
Auditing Standards (AICPA) Requirement
about Confirmation
 When practical, auditing standards require the
confirmation of AR.
For class of 2018 45
However, auditing standards state confirmation may
not be appropriate in the following cases:
 If AR is immaterial
 If the auditor considers confirmation ineffective
because of delay and low response rate
 It the client internal control for sales and collection
cycle is effective (if The combined level of inherent
risk and control risk is low and other substantive
evidence can be accumulated to provide sufficient
evidence)

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Confirmation decision
1. Decision on the types of confirmation (which form of
confirmation to use?)
 Positive Confirmation (Blank, Invoice.)
 Negative Confirmation
Comparison
In terms of reliability
 A positive confirmation is more reliable because if not responded, a
follow up can be made
 In the case of negative confirmation, failure to respond may be
considered as a correct response even if it is ignored by the debtor
In terms of cost
 Negative confirmations cost less because there are no second requests
and no follow-up of non-responses.

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2. Timing decision (when to send and its effect
on reliability)
 Confirmation can be sent on interim period (due to
the need to complete the audit on time) or at time
closer to the balance sheet date
 Confirmation sent as close to the balance sheet date
as possible are more reliable than those sent in
interim period

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3. Sample size decision (how much should be the sample size?)
 The following factors affect sample size decisions:
▪ Tolerable misstatement (low tolerable misstatement results in larger
sample size)
▪ Inherent risk ( relative size of total accounts receivable, number of
accounts, prior-year results, and expected misstatements) (low Inherent
risk results in smaller sample size)
▪ Control risk (low control risk results in smaller sample size)
▪ Achieved detection risk from other substantive tests ( extent and results of
substantive tests of transactions, analytical procedures, and other test of
details) (low achieved detection risk results in smaller sample size)
▪ Type of confirmation ( negative confirmations normally requires a large
sample size)

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4. Selection of the Items for testing (How do
auditors select AR for confirmation?)
 Auditors stratify/segment AR based on dollar
size of individual accounts and the length of time
an account has been outstanding.
 They usually select larger and older balances
since the possibility of containing misstatements
is high
 However, AR in other segments are also be
included

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 Analysis of Differences
 When there is a difference between the AR balance
confirmed and that is shown on the record, auditors
analyze the cause for the difference
 Timing difference is a common cause for the
difference. Common causes of difference include:
▪ Payment Has Already Been Made: this is usually
occurs when the customer has paid before the date of
the confirmation, but the collection was not recorded
by the client on the date of confirmation
(auditors should check if there is an intent of cash
theft, lapping of AR and check also the cutoff for
cash receipt)
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 Goods Have Not Been Received: These differences normally
result because of goods on transit.
 The client records the sale at the date of shipment and the
customer records the acquisition when the goods are received.
 The Goods Have Been Returned: Client’s failure to record a
credit memo (the improper recording of sales returns and
allowances) may cause this difference. It needs investigation
 Clerical Errors and Disputed Amounts: Customers may state
that there was an error in the price charged for the goods, the
goods are damaged, the proper quantity of goods was not
received, and so forth. These differences also require
investigation
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 DOCUMENTATION REQUIREMENTS FOR
ACCOUNTS RECEIVABLE
 Tests of adequacy of allowance for doubtful accounts
 Details on inquires made regarding whether receivables
are sold, pledged, or assigned
 Cutoff tests
 Evidence of roll-forward procedures if confirmations
were sent at an interim date

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 DOCUMENTATION RELATED TO THE REVENUE
SUBSTANTIVE PROCEDURES
 Substantive analytical procedures performed
 Unusual sales transactions
 Information indicating an understanding of client’s revenue
recognition policies
 Identification of specific items tests
 Relevant information on tests of details

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