Audit of the Revenue and Collection Cycle (ARCC): Tests of Controls and Substantive Tests of Transactions PLANNING The audit begins in the planning stage. This stage involves the evaluation of whether the auditor should accept or retain the client organization. The auditor will verify that there is no potential conflict of interest between the auditor and the client, establish the terms of the engagement, and determine the requirements for the audit team. RISK ASSESSMENT In order to make the above planning decisions, the independent auditor will gather information to inform themselves of the nature of the organization’s operations, its industry, commercial environment, and management teams aiming to identify the risks that might lead to material misstatements in the financial statements. In addition, the audit team is likely to request preliminary financial reports to determine the amount, depth, and breadth of work required for the audit, while identifying higher risk areas that require more of the independent auditor’s attention during the course of the audit field work. AUDIT STRATEGY FORMATION After the major risk areas have been identified, the auditor will develop an overall audit strategy, including a detailed audit plan in response to the risks discovered in the assessment. The strategy includes the timing and nature of testing procedures, degree of reliance on the organization’s internal controls, and assignment of tasks to members of the audit team. COLLECTION OF EVIDENCE The next stage of the audit is typically completed at the office of the client and is usually referred to as “fieldwork”. During this stage, the auditor will gather evidence to assess whether financial processes are functioning as expected and also to verify the validity of transactions in the organization’s accounting system. This audit evidence is collected by the independent auditor through two means of audit testing; 1. Substantive testing – which generally includes a combination of; a. physically observing inventories b. verifying records that support balances c. interviewing third parties and confirming transactions d. verifying calculations of financial statement figures 2. Controls testing – which generally includes the review of systems of internal control that aid in the efficient monitoring of such processes as the authorization of transactions, division of managerial and administrative responsibilities, and account reconciliation. COMPLETION Once the auditor has gathered sufficient appropriate evidence to reach a conclusion on the fairness of the financial statements, an audit report is drafted with the corresponding audit opinion. It is important to realize that an audit is not simply about verifying figures on the financial statements; it involves a continuous interaction between the client organization and the independent auditor before, during, and after the process of completing a financial statement audit. The result provides value-added insight to the organization through the provision of professional advice to decision makers in areas where management can improve internal processes or controls. This, along with satisfying their stakeholders’ need for reliable, comparable and timely information helps make the organization more efficient in their operations and accurate in their reporting. The Audit of the Revenue and Collection Cycle (ARCC): Tests of Controls and Substantive Tests of Transactions Definition of terms: Internal control - is a process effected by an entity’s board of directors, management, and other personnel designed to provide reasonable assurance regarding the achievement of objectives in the following categories: (a) reliability of financial reporting, (b) effectiveness and efficiency of operations, and (c) compliance with applicable laws and regulations. Tests of Controls or Compliance Tests – These are audit procedures designed to evaluate the operating effectiveness of controls in preventing, or detecting and correcting, material misstatements at the assertion level. Substantive Procedures – These are audit procedures designed to detect material misstatements at the assertion level. Substantive procedures comprise: (a) Tests of details (of classes of transactions; account balances and disclosures) – It involves obtaining evidential matter on the items (or details) involved in an account balance or class of transactions. Test of transactions involves tests of processing of individual transactions by inspection of the documents and accounting records involved in the processing. For example, tracing a sample of receiving reports to the purchase journal to see whether receipts of merchandise have been recorded as purchases. Test of Balances are tests applied directly to the details of balances in general ledger accounts. For example, confirming the balance of accounts in the accounts receivable subsidiary ledger with individual customers. These tests have the objective of establishing the monetary correctness of the accounts they relate to. (b) Analytical Review Procedures – involved study and comparison of relationships among accounting data and related information. They identify unusual fluctuations for investigation and focus on the rationale of relationship. They are substantive tests that may achieve specific audit objectives if the evidential matter is considered persuasive by the auditor. A concrete example of this is horizontal analysis and ratio analysis of financial statements. What is the nature of the Revenue and Collection Cycle? It consists of the activities relating to the exchange of goods and services with customers and the collection of the revenue in cash. Specific activities in the revenue and collection cycle may include the following:        Receiving a customer's order Approving credit for a sale Determining whether goods are available for shipment S hipping the goods Billing the customers Collecting cash Recognizing effect of this process on other related accounts For a trading concern, the classes of transactions in the revenue and collection cycle involve. A. Sales (cash and credit); B. Sales adjustments (discounts, returns and allowances and uncollectible accounts provision and write-offs); and C. Cash receipts (collections on accounts and cash sales). What are the documents commonly used in the revenue and collection cycle and their and their audit significance? Documents Audit Significance A written purchase order from a Customer’s Purchase Order provides evidence thatsenta to A request for merchandise by a customer. It may be received by telephone, customer letter, a printed form that has been customer actually ordered the goods. prospective and existing customers, through salespeople, or in other ways. Purchase order numbers are generally recorded on sales invoices so that an auditor can determine the purchase order to which an invoice relates. Sellers generally maintain a file of each customer's purchase orders. Sales order A prenumbered document for recording the description, quantity, and related information for goods ordered by a customer. This is frequently used to show credit approval and authorization for shipment. A sales order contains the seller's understanding of the sales terms. A seller should account for the numerical sequence to help ensure that shipments are made for sales orders and that all sales are billed. Shipping document or Bill of lading A prenumbered document prepared to initiate shipment of the goods, indicating the description of the merchandise, the quantity shipped, and other relevant data. The signature of the carrier or the customer on the shipping document provides externally created evidence that goods have been shipped. Sellers should account for the numerical sequence to help ensure that all shipments are recorded as sales. A sales invoice indicates credit terms, Sales invoice A prenumbered document indicating the description and quantity of goods shipping terms, and price charged for merchandise. Sellers should account for sold, the price including freight, insurance, terms, and other relevant data. the numerical sequence to help ensure that all sales are recorded. Credit memo A prenumbered document indicating a reduction in the amount due from a customer because of returned goods or an allowance granted. It often takes the same general form as a sales invoice, but it supports reductions in accounts receivable rather than increases. A credit memo provides evidence that a seller has reduced the amount previously billed to a customer. Sellers should account for the numerical sequence to help ensure that all credit memos are recorded. Remittance advice A document that a customer attaches to a check in payment of an invoice. The document may be a turnaround document, a part of a check, or a statement identifying the invoices being paid. Remittance advices facilitate recording cash receipts. If a customer does not return a remittance advice, the employee opening the mail generally prepares one. A remittance advice usually indicates the date and amount of payment and the invoices paid. Sellers generally file remittance advices by date. Monthly statement A document sent to each customer indicating the beginning balance of accounts receivable, the amount and date of each sale, cash payments received, credit memos issued, and ending balance due. A statement mailed to a customer reporting a beginning balance and transactions that occurred during the period. If the statement is inaccurate, many customers would contact the seller. How about the relevant accounting records in the revenue and collection cycle? Sales journal A journal for recording sales transactions. A detailed sales journal includes each sales transaction. It usually indicates gross sales for different classifications, such as product lines, the entry to accounts receivable, and miscellaneous debits and credits. The sales journal can also include sales returns and allowances transactions. Sales returns and allowances journal A journal similar to the sales journal except the merchandisers use it to record returns of merchandise or adjustments to invoice prices. Cash receipts journal A journal for recording cash receipts from collections, cash sales, and all other cash receipts. General journal A journal in which are recorded all transactions for which a special journal has not-been created. Sales and collections cycle transactions frequently recorded in the general journal include entries to estimate uncollectible accounts expense and entries to write off accounts identified as uncollectible. Accounts receivable masterfile / subsidiary ledger A file for recording individual sales, cash receipts, and sales returns allowances for each customer and maintaining customer account balances. Accounts receivable trial balance A listing of the amount owed by each customer at a point in time. This is prepared directly from the accounts receivable master file. Ok, guys! After you familiarized yourself on the nature of, and relevant documents and accounting records in the revenue and collection cycle, including your objectives as auditor, you are now ready to audit the major classes of transactions in the revenue and collection cycle, namely: A. Sales Transactions; B. Sales Adjustments Transactions; and C. Cash Receipts Transactions. First, let’s obtain an understanding of the internal controls over SALES TRANSACTIONS!!! Typically, the sales transaction involved the following business activities. a. Accepting sales order b. Approving credit c. Filling sales order d. Shipping sales order e. Billing customers Second, let’s obtain an understanding of the internal controls over SALES ADJUSTMENTS TRANSACTIONS!!! Adjustment to sales may include: a) Granting cash discounts; b) Granting sales allowances or reduction in price; c) Returns of merchandise; Third, let’s obtain an understanding of the internal controls over CASH RECEIPTS TRANSACTIONS!!! There are variety of sources of cash receipts. Cash receipts may result from revenue transactions, short and long-term borrowing, issuance of share capital, and sale of marketable securities, long-term investments and other assets. The scope of this chapter is limited to cash receipts from sales transactions which include cash sales and collections from trade customers on credit sales. Other sources of cash receipts are discussed in the investing and financing cycles. Executing cash receipts transactions generally involve: After obtaining an understanding of the internal controls, we now EVALUATE a. Sales transactions; b. Sales adjustments transactions; and c. Cash receipts transactions Guys remember that this point of the audit process – EVALUATE RISK ASSESSMENT phase to identify potential risks of materia statements. One of the risk assessment procedures being conducted by the auditor to eval class of transactions is WALKTHROUGH. Walk-through simply means to sit with accounts staff and understand and view flow of transaction through systems from start till end, to understand how system process a transaction, it gives understanding about in control system, it is starting point of test of control, we cannot c tests, it can give some evidence but then we have to perform enhanced test on controls to conclude about test controls. A walk through is a procedure in which an auditor traces a transaction from its init information systems to the point when it is reflected in the financial reports. The auditor should perform one walk through, at a minimum, for each major class of transactions. A walk-through provides evidence to confirm that the auditor understands 1. the process flow of transactions, 2. the design of identified controls for internal control components, including those related to preventing and detecting fraud, and 3. whether all points in the process have been identified at statement assertion could occur. Walk through also provide evidence to evaluate the effectiveness of the controls’ design and confirm that the controls have been placed in operation. When performing a walk-through, the auditor should: 1. Be sure that the walk-through encompasses the comp processing and reporting) for each significant process identified, including controls intended to address fraud risk. 2. Ask the entity’s personnel, at each of key stage in the process, about their und company’s prescribed procedures require. 3. Determine whether processing procedures are performed as expected on a timely exceptions to prescribed procedures and controls. 4. Evaluate the quality of evidence provided and perform procedures that produce a level of evidence consistent with the auditor’s objectives. The auditor should follow the whole process, using the technology that company staff use, asking questions of different perso asking follow- up questions to identify any abuse of controls or fraud indicators. Once a walk-through is performed, the auditor may car significant changes make preparation of new documentation more efficient. If such significant changes occur in the process flow of transactions or supporting computer applications, the auditor shoul changes and the effect on related accounts. The auditor should d transactions that were processed both before and after the change. A. Evaluate the Internal Control under SALES TRANSACTIONS The following procedures may be performed when obtaining information concerning specific controls over sales transactions. a. Inquiry; b. Observation; and c. Review of documentation. The following figure shows a questionnaire for sales transactions. The questions relate to control procedures that the auditor considers to be necessary for effective control over sales. A “Yes” answer to the question indicates that the client has good control; a “No” response suggests a possible weakness in internal control over sales. In addition to answers to questionnaires, the information gathered by the auditor may be documented in flowcharts and narrative memoranda. A concern about these transactions may be recorded to cover a material misappropriation of cash receipts. Auditors generally pay little attention to these adjustments unless they are a material amount or individual adjustments are large. C. Evaluate the Internal Control under CASH TRANSACTIONS RECEIPTS The following internal control questionnaire which can be used in evaluating internal control over cash 1. Test of controls over: a. Sales Transactions; b. Sales Adjustments Transactions; and c. Cash Receipts Transactions. 2. Substantive Tests over: a. Sales Transactions; b. Sales Adjustments Transactions; and c. Cash Receipts Transactions.