Lecture 5
Audit of the Sales and Collection Cycle

Summary of the Audit Process
Phase 1 Plan and design an audit approach
1. Accept client and perform initial planning 2. Understand client’s business and industry 3. Assess client business risk 4. Perform preliminary analytical procedures 5. Set materiality & assess acceptable audit risk and inherent risk 6. Understand internal control and assess control risk 7. Gather information to assess fraud risk 8. Develop overall audit plan and audit program

Phase 2 Perform tests of controls & substantive tests of transactions
Plan to reduce assessed level of control risk? No Yes

Phase 3 Perform analytical procedures and tests of details of balances
1. Perform analytical procedures 2. Perform tests 3. Perform additional tests of details of balances

Phase 4 Complete the audit & issue an audit report
1. Perform tests for presentation & disclosure 2. Accumulate final evidence 3. Evaluate results 4. Issue Audit Report 5. Communicate with audit committee & management

1. Perform test of controls 2. Perform substantive tests of transactions 3. Assess likelihood of misstatements in financial statements

Accounts in the Sales and Collection Cycle
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Sales and Sales returns Transaction
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Accounts Sales Accounts receivable

Business Functions Processing customer orders Granting credit Shipping goods Billing customers and recording sales

Documents & Records Customer order Sales order Customer or sales order Shipping documents Sales invoice Sales transaction file Sales journal or listing Accounts receivable master file Accounts receivable trial balance Monthly statement Credit memo Sales return and allowances journal

Sales returns and allowances

Processing and recording sales returns and allowances

Cash receipts Transaction
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Accounts Cash in bank Accounts receivable

Business Functions Processing and recording cash receipts

Documents & Records Remittance advice Prelisting of cash receipts Cash receipts transaction file Cash receipts journal or listing

Bad Debt Expense Transaction
Accounts Bad debt expense Business Functions Writing off bad debts Documents & Records Bad debt write off authorisation form General journal General journal General journal

Provision for doubtful debts Accounts receivable

Providing for doubtful debts

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Methodology for designing Controls and Substantive Tests
Understand internal control – sales
Assess planned control risk – sales Determine extent of testing controls Design tests of controls and substantive tests of transactions for sales to meet transactionrelated audit objectives Audit procedures Sample size Items to select

Timing

Obtain and document Internal Controls Sales
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1. Prepare Flowchart of documents, sequential flow and internal controls 2. Complete an Internal Control Questionnaire 3. Review and update previous years’ documentation 4. Make Inquiries of relevant personnel 5. Examine appropriate documents and records 6. Observe the activities and operations 7. Perform walkthrough

Understanding the system of Internal Controls
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Assess Planned Control Risk – Sales
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1. Framework for assessing control risk 2. Identify key internal controls and deficiencies 3. Associate controls and deficiencies with the objectives 4. Assess control risk for each objective

Framework for assessing control risks

Identify key controls & deficiencies – Sales
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     

Adequate separation of duties Proper authorization Adequate documents and records Pre-numbered documents Monthly statements to customers Internal verification procedures – eg independent checking of numerical sequence of pre-numbered invoices

Evaluating Significant Control Deficiencies
10-13

Tests of control and Substantive tests of transactions for sales
Transaction related audit objectives Occurrence Recorded sales are for shipments actually made to non fictitious customers Key existing controls Credit is approved automatically by computer by comparison to authorised credit limit Sales are supported by authorised shipping documents and approved customer order Test of controls Deficiencies Substantive test of transactions Account for a sequence of sales invoices Examine customer order for evidence of credit approval Lack of verification for the possibility of sales being recorded more than once

Examine sales invoice for supporting bill of lading and customer order

Review sales journal and master file for unusual transactions Trace sales journal entries to all supporting documents

Statements are sent Observe to customers each whether monthly month statements are sent

Direction of Tests for Sales
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Revenue Misstatement Techniques
14-16

Sham sales

Improper sales cutoff

Premature revenue recognition Channel stuffing eg Bristol Myers Bill and hold

Improper % of completion

Fraudulent Techniques

Conditional sales Round-tripping loans as sales Consignment sales

Summary of Methodology for sales
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1. Identify key transaction-related audit

objectives
2. Determine key existing controls 3. Design tests of controls to verify effectiveness 4. Evaluate any control deficiencies

5. Determine extent of substantive tests of transactions Tests of control and Substantive tests of transactions for Cash receipts
Transaction related audit objectives Completeness Cash received is recorded in the cash receipt journal Key existing controls Test of controls Deficiencies Substantive test of transactions Obtain prelisting of cash receipts and trace amounts to the cash receipt journal Prelisting of cash receipts is prepared Observe prelisting of cash receipts Prelisting of cash is not used to verify recorded cash receipts

Cheques are restrictively endorsed

Observe endorsement of incoming cheques
Observe whether monthly statements are sent Examine file of batch totals for initials of data control clerk

Compare the prelisting with the duplicate deposit slip

Statements are sent to customers each month Batch totals of cash receipts are compared to computer summary reports

Sampling
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



Non sampling risk – risk that audit tests do not uncover existing exceptions in the sample due to auditor’s failure or ineffective audit procedures Sampling risk – risk that an auditor reaches an incorrect conclusion because the sample is not representative of the population. Controlled by  Adjusting sample size  Using appropriate method of selecting sample

Statistical Vs Non-statistical sampling
Similarities of both approaches:
Step 2 Step 1

Plan the sample

Select the sample and perform the tests

Step 3

Evaluate the results

Statistical sampling allows the quantification of sampling risk in planning the sample (Step 1) and evaluating the results (Step 3) In nonstatistical sampling those items that the auditor believes will provide the most useful information are selected

Probabilistic Versus Nonprobabilistic Sample Selection
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Non Probabilistic
 

Block sample selection - the selection of several items in sequence Haphazard sample selection - the selection of items without any conscious bias on the part of the auditor. A simple random sample - every possible combination of elements in the population has an equal chance of constituting the sample via the use of random number tables Systematic sample selection -The auditor calculates an interval and then selects the items for the sample based on the size of the interval Probability proportional to size sample selection - Divide the population into subpopulations and take larger samples from the subpopulations with larger sizes.

Probabilistic






Application of Non statistical sampling
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1. State the objectives

8. Estimate the population exception rate

9. Determine the initial sample size

2. Decide whether audit sampling applies 3. Define attributes and exception

7. Specify acceptable risk of overreliance

10. Select the sample

6. Specify the tolerable exception rate

11. Perform the audit procedures

14. Decide acceptability

4. Define the population

5. Define the sampling limit

12. Generalise to the population

13. Analyse exceptions

Effect on Sample Size of Changing Factors
15-23

Type of change

Effect on initial sample size

Increase acceptable risk of overreliance
Increase tolerable risk rate

Increase estimated population exception rate Increase population size (minor)

Application of Statistical Attributes sampling
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1. State the objectives

8. Estimate the population exception rate

9. Determine the initial sample size

2. Decide whether audit sampling applies 3. Define attributes and exception

7. Specify acceptable risk of overreliance

10. Select sample using probabilistic methods 11. Perform the audit procedures

4. Specify the tolerable exception rate

14. Decide acceptability

4. Define the population

5. Define the sampling limit

12. Generalise to the population

13. Analyse exceptions

Summary of Audit Sampling Steps
15-25

To/From Step 6 Compare

Plan the sample (Steps 1-9) Select the sample (Step 10)

From Step 12

Computed upper exception rate

Perform the tests (Step 11)
Evaluate the results (Steps 12-14)

Number of exceptions in sample and actual sample size

To Step 14

To Step 12

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Effect of Results of Controls and Substantive Tests of Transactions
The parts of the audit most affected by the tests for the sales and collection cycle are:

Accounts receivable

Allowance for doubtful accounts

Bad debt expense Cash

Accounts Receivable Balance-related Audit Objectives
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Balance related audit objectives Existence

Applied to accounts receivables Recorded accounts receivable exists

Completeness
Accuracy Cutoff Valuation Ownership Classification

Existing accounts receivable are included
Accounts receivables individual balances are accurate Accounts receivables relate to transactions in the correct period Values are correct and necessary provision for doubtful debts made Client has the rights to the receivables Accounts are correctly classified

Detail tie in

Total of individual accounts receivables agrees with the master file and general ledger

Summary of the Audit Process
Phase 1 Plan and design an audit approach
1. Accept client and perform initial planning 2. Understand client’s business and industry 3. Assess client business risk 4. Perform preliminary analytical procedures 5. Set materiality & assess acceptable audit risk and inherent risk 6. Understand internal control and assess control risk 7. Gather information to assess fraud risk 8. Develop overall audit plan and audit program

Phase 2 Perform tests of controls & substantive tests of transactions
Plan to reduce assessed level of control risk? No Yes

Phase 3 Perform analytical procedures and tests of details of balances
1. Perform analytical procedures 2. Perform tests 3. Perform additional tests of details of balances

Phase 4 Complete the audit & issue an audit report
1. Perform tests for presentation & disclosure 2. Accumulate final evidence 3. Evaluate results 4. Issue Audit Report 5. Communicate with audit committee & management

1. Perform test of controls 2. Perform substantive tests of transactions 3. Assess likelihood of misstatements in financial statements

Methodology for Designing Tests of Details of Balances for Accounts Receivable
Phase III

Design and perform analytical procedures for accounts receivable

Design tests of details of accounts receivable balance to satisfy balance-related objectives

Audit procedures

Sample size

Items to select

Timing

Selected Comparative Information
Percent Percent change 31/12/13 change 31/12/12 2011- 31/12/11 ($000) 2012-13 ($000) 2012 ($000) Sales 144,328 Gross margin 39,845 Accounts receivable 20,197 Bad debt expense 3,323 Total current assets 51,027 Total assets 61,367 Net earnings 5,681 Number of accounts receivable 258 Number of accts. rec. with balances over $100,000 37 9.0 9.6 7.3 (2.1) 14.0 (7.0) 21.9 16.7 15.6 132,421 36,350 18,827 3,394 44,779 66,021 4,659 221 7.0 7.0 14.1 7.3 6.6 8.0 39.0 5.7 123,737 33,961 16,505 3,162 41,989 61,147 3,351 209

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6.7

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Analytical Procedures for the Sales and Collection Cycle
Analytical Procedure Compare gross margin percentage with previous years Possible Misstatement Overstatement or understatement of sales and accounts receivable

Compare sales by month over time
Compare sales returns and allowances as a percentage of gross sales with previous years Compare individual customer balances with previous years Compare bad debt expense as a percentage of gross sales with previous years Compare no. of days in accounts receivables related turnover with previous years Compare allowance for uncollectible accounts as a percentage of accounts receivable with previous years Compare ageing categories as a percentage of accounts receivable with previous years Compare write off of uncollectible accounts as a percentage of total accounts receivable with previous years

Overstatement or understatement of sales and accounts receivable
Overstatement or understatement of sales returns and accounts receivable Overstatement or understatement of sales and accounts receivable Overstatement or understatement of bad debt expense and accounts receivable Overstatement or understatement of bad debt expense and accounts receivable Overstatement or understatement of bad debt expense and accounts receivable Overstatement or understatement of bad debt expense and accounts receivable Overstatement or understatement of bad debt expense and accounts receivable

Analytical Procedures: Sales and Collection Cycle

Audit Procedures for the Sales and Collection Cycle
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Balance related audit objective Existence The accounts receivable on the aged listing exists

Audit Procedures Confirm all accounts over RM100k and a non statistical sample of the remainder using positive confirmation Perform alternative procedures for all confirmations not returned on the first or second request Review accounts receivable balances for large and unusual amounts

Types of Confirmation
 Positive confirmation  Follow up procedures for confirmations not returned  Subsequent cash receipts  Duplicate invoices  Shipping documents Blank confirmation form Invoice confirmation Negative confirmation  Risk of material misstatement is low  Large number of small account balances  Expected low exception rate  Expect adequate consideration from recipients

  

Positive Confirmation

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Negative Confirmation

Tests of Details of Balances and Controls, and Substantive Tests of Transactions
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Differences among tests
Type of Test Controls What It Measures Effectiveness of controls Monetary correctness of transactions

Transactions

Balances

Existence of material misstatements

Evidence Planning Worksheet

Relationship among key evidence related items
Phases of the Audit Process
Phase 1 Plan & design of audit approach Phase 2 Perform tests of controls & substantive tests of transactions Transaction related

Audit Objectives

Types of Tests
Risk assessment

Evidence Decisions
• Audit procedures • Timing • Audit procedures • Timing • Sample size • Items to select

Types of Evidence
Documentation Inquiries Analytical procedures Documentation Inquiries Observation Reperformance Recalculation

1. Tests of controls 2. Substantive tests of transactions

Phase 3 Perform analytical procedures & tests of details of balances
Phase 4 Complete the audit & issue an audit report

Balance related

1. Analytical procedures 2. Details of balances

• Audit procedures • Timing • Sample size • Items to select

Physical inspection Documentation Confirmation Inquiries Observation Reperformance Recalculation
Documentation Inquiries Analytical procedures

Presentation and disclosure related

1. Analytical procedures 2. Details of balances

• Audit procedures • Timing • Sample size • Items to select

End of Lecture
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