Revenue Cycle

Revenue Cycle

The concept of cycle helps the auditor review both the income and balance sheet accounts related to most transactions of the organization and thus provides a convenient way to organize accounting transactions for audit testing and evaluation. There is no such thing as a typical revenue and collection cycle. Companies can come in all shapes and sizes, and the actual revenue generation process can vary greatly among industries. The basic activities in the revenue and collection cycle for a company;

• Receiving and processing costumer orders, including credit approval
• Delivering goods and services to costumers
• Billing costumers and accounting for accounts receivable
• Collecting and depositing cash received from costumers

The nature of transactions vary with the organization, but the commonalities of the revenue cycle can be used to develop audit programs for most organization. The accuracy of accounting in the revenue cycle is important for management decisions as well as for the preparation of financial statements. The organization’s control environment affects revenue and related transactions more than most accounts. Consideration of fraud in a financial statement audit, states that the auditor should ordinarily presume there is a risk of material misstatement due to fraud relating to revenue recognition. Fraudulent financial statement cases between 1987 and 1997 showed that more than half of frauds involved overstatement of revenues. The following criteria must be meet in applying revenue recognition concept;

• Persuasive evidence of an arrangement exists
• Delivery has occurred or services have been rendered
• The seller’s price to the buyer is fixed or determinable
• Collectability is reasonably assured

There are a number of “red flags” to which the auditor should be alert when evaluating the potential for fraud in the revenue cycle. Auditor may categorized these risks into external factors, internal factors and unusual financial results. Basic analytical procedures can identify unexpected results for revenue, the allowance for doubtful accounts, and accounts receivable. Ratio analysis, trend analysis, and reasonableness tests are three standard analytical procedure types that are often used on revenue cycle accounts. There should be a presumption in every audit that there is the risk of material misstatement due to revenue recognition fraud. Common revenue cycle fraud methods to inflate revenue;

• Early revenue recognition
• Recording consignment sales as final sales
• Fictitious sales
• Failure to record sales return
• Hidden “Side agreements” giving costumers an irrevocable right to return the product.
• Shipment of unfinished product, more product than the costumer ordered, or unfinished product
• Channel stuffing for distributors purchasing more inventory than they can sell in the near term
• Overstatement of receivables, achieved by overstating balances, reporting fictitious balances, or understanding the allowance for uncollectible accounts

Performing Specific procedures to obtain evidence for the revenue cycle; the control objectives in the revenue cycle are that the auditor should determine that design the design of the system and the implemented control procedure ensure that;

• All recorded transactions have occurred
• All of the transactions that took place are recorded
• The transactions have been recorded accurately
• The transactions have been recorded in the correct accounting period.
• The transactions have been recorded in the proper accounts.

Segregation of the functions in a sales transaction, the basic idea underlying segregation of duties is that no employee should be in a position both to perpetrate and conceal errors for fraud in the normal course of their duties. In general, the principal incompatible duties to be segregated are: the custody of assets, the authorization or approval of related transactions affecting those assets, and the recording or reporting of related transactions.

1. Preparation of the sales order; the process usually begins when a customer approaches the company and files a customer purchase order. The sales department receives the document and prepares a sales order that is then sent to the credit department for a credit check. The sales order document should contain elements that provide a basis for determining that all transactions are properly authorized and fully recorded.
2. Check Inventory Stock and consider Back Order; considering the existence stock and back orders
3. Credit approval; Credit approval policies are implemented by organizations to minimize credit losses
4. Shipment; The shipping department confirms the shipment by completing the packing slip and returning it to the billing department.
5. Billing; Invoices are normally prepared when notice that the goods have been shipped. However, some companies find it efficient to prepare invoices in advance as long as records show that there is sufficient inventory on hand.
6. Accounting; When the payment is received from the customer, accounting or treasury records the credit to cash and debits the balance in accounts receivable.

Segregation of the functions in an accounts receivable transaction should exist as (a) Sales, (b) Collection of cash receipts, (c) Uncollectible receivables, (d) Sales returns, and (e) Sales discounts. Incoming mail must be opened by a person who does not have access to the accounts receivable ledger. The receipts should be listed in detail and three copies distributed to departments, respectively; Cashier, Accounts Receivable Department, and Accounting Department.

Standard accounts receivable audit procedures; Aging accounts receivable and Accounts Receivable Confirmation; the auditor is required to consider whether external confirmation procedures are to be performed as substantive audit procedures and is required to use external confirmation procedures for accounts receivable unless;

• The overall account balance immaterial
• The use of confirmations would be ineffective
• The auditor’s assessment of environment risk is low, and that assessment, in conjunction with the evidence provided by other substantive tests, is sufficient to reduce audit risk to an acceptably low level.

Types of confirmation;

The confirmation process begins when the auditor develops the confirmation form and sends it to a third party. In order to determine the type of information to be confirmed, the auditor should understand the substance of transactions the client has with third parties. The auditor also considers whether to use positive or negative confirmations. Positive forms typically request the recipient to indicate whether the information provided is correct. Blank forms (a type of positive confirmation) request that the recipient furnishes certain data. Negative confirmations request a response only if the information on the form is inaccurate.

• Positive confirmation; Positive confirmations are considered to be more persuasive than negative confirmations because they result in either (1) the receipt of a response from the costumer, or (2) the use of alternative procedures.
  • There are large individual accounts
  • There are expected errors or items in dispute
  • When internal control is weak
• Negative confirmation; Negative confirmations are less reliable because the auditor does not know if the intended recipient considered the form or even received it.
  • The combined assessed level of inherent and control risk (RMM) is low
  • A large number of small account balances, transactions, and conditions
  • The auditor is not aware of circumstances or conditions that would cause recipients of negative confirmation requests to disregard such requests.
  • A very low exception rate is expected.
• Confirmation Exceptions; A response that indicates a difference between information requested to be confirmed, or contained in the entity’s records, and information provided by the confirming party. There are two resulting natural exceptions, either timing difference or inappropriate situation.
  • Timing Differences; timing differences occur when there is a delay in the recording of the transaction by the client or their costumer.
  • Misstatements; a confirmation exception would be indicative of misstatement if the exception is due to any of error or frauds

Confirmation issues

• Confirmations received via fax or electronically; the auditor should consider verifying by phone in order to validate confirmations.
• Confirmation Nonresponse
  • Follow-up to nonresponses for positive confirmation; Nonresponses should be followed up with second and event third confirmation requests if necessary. The client may be asked to intervene. When confirmation responses are not received, the auditor should perform alternative procedures such as inspecting supporting documents, or reviewing subsequent cash receipts.
  • Follow-up to nonresponses for negative confirmation; The basic premise underlying negative confirmations is that if no response is received, the auditor may assume that the costumer agrees with the balance and no follow-up procedures are required. This is not always the correct assumption such as due to not understanding the request, lost letter or misaddressing etc.
• Procedures when accounts are confirmed at an interim date; If the internal controls surrounding receivable transactions are strong, and the auditor has chosen to confirm receivables at a date prior to the balance sheet date, additional evidence must be gathered to ensure that no material misstatements have occurred between the confirmation date and year-end (roll-forward period). The procedures used in gathering the additional evidence are often referred to as roll-forward procedures.
• Summarizing confirmation work; the confirmation work should be summarized to show the extent of dollars and items confirmed, the confirmation response rate, the number and dollar amount of exceptions that were not misstatements, and the number and amount of exceptions that were misstatements. Such a summary helps the reviewers quickly grasp the extent and results of this work.

The following audit procedures should help detect the frauds just described

• Perform a thorough review of original source documents including invoices, shipping, documents, costumer purchase orders, cash receipts, and written correspondence between the client and the costumer.
• Analyze and review credit memos and other accounts receivable adjustments for the period subsequent to the balance sheet date.
• Confirm with costumers the terms of sales agreements, including the absence of right return and terms that might preclude immediate revenue recognition
• Analyze all large or unusual sales made near year-end. Vouch to original source documents. Confirm terms of the transaction directly with the costumer.
• Scan the general ledger, accounts receivable subsidiary ledger, and sales journal for unusual activity.
• Perform analytical reviews of credit memo and write-off activity by comparing to prior periods. Look for unusual trends or patterns such as large numbers of credit memos pertaining to one costumer or salesperson, or those processed shortly after the close of the accounting period.
• Analyze recoveries of written-off accounts.