Week 10

1 AUDITING Week 10

14.11 Identify factors that ought to be considered in the assessment of inherent and control risks specific to sales and accounts receivable. Pervasive factors include:  Pressure to overstate sales in order to report that announced sales or profitability targets were achieved  Pressure to overstate cash and accounts receivable or understate the allowance for bad debts to hide liquidity or going-concern problems. Other factors include:  A high volume of transactions resulting in numerous opportunities for errors to occur.  The timing of revenue recognition may be contentious.  Classification of factored accounts with recourse.  Cash is susceptible to misappropriation.  Sales adjustment transactions may be used to conceal irregularities such as theft of cash received from customers. Due to the above inherent risk factors, the auditor will need to consider the extent the client’s internal control structure overcomes them. 14.13 Why is the auditor likely to adopt a lower assessed level of control risk approach to the audit of accounts receivable wherever practicable? Why are substantive procedures more likely to be based on the accounts receivable balance than on sales, cash receipts and sales adjustment transactions? 

The principal inherent risk is that of overstatement of sales revenue and accounts receivable balances. In the audit of transaction classes, this relates to the occurrence and measurement assertions for sales transactions and to the completeness assertion for cash receipts and sales adjustments. In most entities, controls relative to these assertions for sales and cash receipts are effective and the auditor is able to adopt a lower assessed level of control risk strategy for these transaction classes.

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In the design of substantive audit procedures, the large volume of sales and cash receipt transactions means that it is normally cost-effective to obtain most of the evidence from the application of substantive procedures to the accounts receivable balance.

14.15 If the auditor does not receive a response after sending a letter to confirm a debtor’s balance, what alternative audit procedures may be performed? The best evidence is the receipt of payment from the customer. The matching of such cash

2 receipts to unpaid invoices at the confirmation date, evidenced by the remittance advice accompanying the cash receipt, establishes the existence and collectability of the accounts. Alternatively, if payments are made by direct credit to the entity’s bank account, there is usually some identifier or corresponding email supporting the receipt and identifying items covered in the payment. Any unpaid balances should be vouched to supporting documentation, preferably a dispatch note signed by the customer acknowledging receipt of the goods, or a written order from the customer. 14.19

Explain what is meant by 'cut-off' and why it is important to auditors in establishing the fairness of financial statements.

'Cut-off' tests are performed on sales and cash receipts as part of the year-end work, to verify the recorded balance at year-end. The sales cut off test, which traces movements a few days on either side of balance date, is designed to ensure that sales and accounts receivable are recorded in the correct accounting period, as is the related inventory. The cash receipts cut off test is designed to ensure cash receipts are recorded in the proper accounting period. 14.22 Tests of controls—sales transactions You have been assigned to perform tests of controls on the sales system at EDB Pty Ltd as part of the 30 June 2011 audit. 13DB is a wholesaler of bathroom supplies such as vanity units, toilets, taps and sinks. During testing, you noted the following errors: Invoice no. 54922 issued on 12 December 2010 was entered twice. The error was discovered when the customer rang to complain about being charged double the agreed amount. Invoice no. 51839 issued on 25 September X10 contained incorrect prices. Three vanity units were charged at $453 each instead of $543, and five sinks were charged at $231 each instead of $321. The error was discovered when the salesperson complained about not receiving the MI commission entitlement for the month. No prices were entered on invoice no. 56329 issued on 24 January 2011, resulting in a zero dollar invoice being issued. The error was discovered when accounts receivable staff queried the zero amount appearing on the accounts receivable ledger. Invoice no. 59328 issued on 18 March 2011 matched the customer's ogler. However, the order was only partially tilled because of a lack of stock in the warehouse, meaning items that were never delivered were included in the invoice. The error was discovered when the customer rang to complain about being overcharged. Invoice no. 61348 issued on 7 May 2011 was sent to the wrong address. Apparently, the invoice had the correct address on it, but a typing error occurred on the envelope. The error was discovered when the customer rang to complain about the overdue notice received, stating the invoice had never been received in the first place. Invoice no. 62875 issued on 29 June 2011 was not processed through the usual channels. The details were correct but certain procedures, such as a formal credit check, were not documented. The invoice was a special order for a large building project and amounted to

3 around ten times the value of EDB's average invoices. The sale was personally handed by one of the directors and the invoice was prepared by his assistant. Treating each of the listed errors independently: a) Describe application controls (both manual and via the computer information system) that would have prevented or detected the error. b) Describe further work you would perform in relation to each of the errors. c) Explain the implications of the errors for your substantive testing of accounts receivable. d) Briefly discuss how you would present these matters in your year-end management letter: Error 1 (a)

The computer should be programmed to check invoice numbers on being entered against invoice numbers already recorded in the sales transactions file and reject duplicate entries with an error message being given to the operator. (b) Use computer audit software to test the sales transactions file for duplicate invoice numbers. (c) Duplication of invoices could result in an overstatement of accounts receivable and sales. Where customers have failed to detect duplicate invoicing prior to payment, they might still subsequently discover the error. This gives rise to a potential obligation to refund the overcharge for which a provision would be needed. (d) I would advise management to introduce a programmed application control such as described in (a) above. I would also advise management to enquire into the possibility that the duplication could be deliberate in order to achieve sales targets. Error 2 (a)

If possible the product price file should be online at the point of entry of sales information. Products would be automatically priced on entry of the product code. If the product price file is not on computer, then invoice pricing should be checked manually before invoices are sent to customers. Only a sample need be checked since knowledge that testing is performed will encourage invoicing clerks to be more careful. (b) If the product price file is online, computer audit software can be used to check invoice prices. If the product price file is not computerised, a random sample of invoices will need to be checked. The sample will need to be drawn from all invoices prepared during the year. (c) Accounts receivable and commissions payable, and the related sales and commissions expense accounts, could be over or understated as a result of pricing errors. Customers who have already paid may retrospectively discover overcharging, requiring a provision to be made to allow for credits to be issued. Where customers who have already paid are discovered to have been undercharged, there is a possible recovery, although this may not be considered desirable. Provision may also be required for over- or underpayment of commissions to sales staff. (d) I would advise management to introduce controls described in (a) above. If errors discovered consistently under-price sales I would advise management to enquire into the possibility of collusion between invoicing clerks and customers.

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Error 3 (a)

The computer should be programmed to reject sales entries unless data is entered into all relevant fields. Alternatively, pricing should be done online by reference to the product price file. Manual scrutiny of invoices as described in error 2 would also reduce the incidence of such errors. (b) Using computer audit software, all zero balance invoices could be identified from the sales transactions file and printed out for scrutiny. (c) Sales and accounts receivable could be understated. (d) I would advise management to introduce controls described in (a) above. I would advise management to enquire into the possibility of collusion between invoicing clerks and customers. Error 4 (a)

Normally invoices are based on dispatch notes. However, since the customer orders are also on file and procedures require for back orders to be carried forward where an order is not completed in a single dispatch, there is a possibility of such errors occurring. Programmed controls should ensure that invoices are based on dispatch note details of goods delivered and not of goods ordered. (b) Computer audit software should be used to match quantities invoiced with quantities recorded on dispatch notes. If dispatch notes are not computerised, the test must be performed manually. (c) Accounts receivable and sales could be overstated. If inventory is based on perpetual records updated at the point of sale, inventory could be understated and cost of sales overstated. (d) I would advise management to introduce the procedures in (a) above. If there is a program error the company could be losing revenue by not recording back orders and subsequently dispatching the goods when they become available. Error 5 (a)

Invoices should be addressed using data held on the accounts receivable master file and mailed in window envelopes. (b) No further audit work would be necessary. Amounts recorded in the accounting records are correct. (c) There may be a possible effect on the provision for bad debts but, since overdue notices are sent out, it is unlikely that customers would be able to avoid payment. (d) I would advise management to introduce controls described in (a) above. I would advise management to enquire into the possibility of collusion between invoicing clerks and customers. Error 6 (a)

In any system, manual override by directors must be permitted to allow for exceptional situations. This is an accepted limitation of control. If the control

5 environment is strong, directors will be aware of the importance of control and will only override the system where alternative and appropriate control procedures are followed. (b) It would be standard audit practice to scrutinise the accounting records for large transactions, especially those occurring shortly before the financial year-end. This transaction should be identified by such a procedure. (c) By its size, nature and timing of its occurrence, this transaction may fall into the category known as 'special purpose transactions' and may be intended to distort the company's financial position. (d) I would probably report this matter directly to the audit committee, if there is one, and recommend a policy relating to the override of normal control procedures so as to reduce the likelihood of such transactions omitting important controls such as, in this case, credit control. ·

Check that the provision had been properly considered and approved by the directors.