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Chapter 14

Audit of the Sales and Collection Cycle:Tests of Controls and Substantive

Tests of Transactions

Review Questions

14-1 a. The bill of lading is a document prepared at the time of shipment ofgoods to a customer indicating the description of the merchandise,the quantity shipped, and other relevant data. Formally, it is awritten contract of the shipment and receipt of goods between theseller and carrier. It is also used as a signal to bill the client. Theoriginal is sent to the customer and one or more copies areretained.

b. A sales invoice is a document indicating the description andquantity of goods sold, the price including freight, insurance, terms,and other relevant data. It is the method of indicating to thecustomer the amount owed for the sale and the due date of thepayments. The original is sent to the customer and one or morecopies are retained. The sales invoice is the document forrecording sales in the accounting records.

c. The credit memo is a document indicating a reduction in theamount due from a customer because of returned goods or anallowance granted. It often takes the same general form as a salesinvoice, but it reduces the customer's accounts receivablebalance rather than increasing it.

d. The remittance advice is a document that accompanies the salesinvoice mailed to the customer and can be returned to the sellerwith the payment. It is used to indicate the customer name, salesinvoice number, and the amount of the invoice when the payment isreceived. A remittance advice is used to permit the immediatedeposit of cash receipts as a means of improving control over thecustody of assets.

e. The monthly statement to customers is the document preparedmonthly and sent to each customer indicating the beginningbalance of that customer's accounts receivable, the amount anddate of each sale, cash payments received, credit memos issued,and the ending balance due. It is, in essence, a copy of thecustomer's portion of the accounts receivable master file.

14-2 roper credit approval for sales helps minimi!e the amount of bad debtsand the collection effort for accounts receivable by requiring that each sale beevaluated for collection potential.

Adequate controls in the credit function enable the auditor to place morereliance on the client's estimate of uncollectible accounts. "ithout these controls,the auditor would have to make his or her own credit checks on the customers in

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14- The sales ournal contains the record of each sales transaction thatincludes the customer name, date, amount, and the account classification foreach transaction. The sales ournal generally represents the record of eachindividual transaction. Typically, the sales ournal accumulates transactions for aperiod of time, which is often monthly. Transactions recorded in the sales ournalare then posted to the general ledger, and if the transaction is for sales on

account the accounts receivable master file is updated for each transaction.The accounts receivable master file is used to record individual sales,

cash receipts, and sales returns and allowances for each customer and tomaintain customer account balances. The master file is updated using data fromthe sales ournal, sales return ournal, cash receipts ournal. The total in theaccounts receivable master file equals the total in the accounts receivable generalledger account.

14-4 (est)ellers.com could integrate its online ordering system with itsinventory system so that a book shipment is made only after the customer*scredit card company approves the customer*s purchase. (ecause credit card

issuers often transfer funds electronically almost immediately after a sale,(est)ellers.com could also set up their system to ship books only after paymenthas been received by the credit card issuer. Finally, (est)ellers.com couldarrange with an online credit service bureau to run credit checks on customerspurchasing over a preset minimum amount. Although (est)ellers.com sells itsgoods through the Internet, the company should still record sales revenuewhen the books are shipped to customers.

14-!

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#. +ecorded sales are forshipments actually madeto eisting customers-occurrence.

+ecording of sales is supported by authori!edshipping documents and approved customerorders.

/redit is authori!ed before shipment takesplace.

)ales invoices are prenumbered and properlyaccounted for.

0nly customer numbers eisting in thecomputer data files are accepted when theyare entered.

1onthly statements are sent to customers2complaints receive independent follow%up.

&. 3isting salestransactions are recorded-completeness.

)hipping documents are prenumbered andaccounted for.

)ales invoices are prenumbered andaccounted for.

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14-! .continued/

TRA"SACT#$"-R%&AT%'A('#T $)*%CT#+% ,% #"T%R"A& C$"TR$&S

4. +ecorded sales are for the

amount of goods shippedand are correctly billed andrecorded -accuracy.

5etermination of prices, terms, freight, and

discounts is properly authori!ed. Internal verification of invoice preparation. Approved unit selling prices are entered into

the computer and used for sales. (atch totals are compared with computer

summary reports.

$. )ales transactions areproperly included in theaccounts receivable masterfile and are correctlysummari!ed -posting andsummari!ation.

+egular monthly statements sent to customers. Internal verification of accounts receivable

master file contents. /omparison of accounts receivable master file

or trial balance with general ledger balance.

6. )ales transactions areproperly classified-classification.

7se of adequate chart of accounts. Internal review and verification of the account

classifications.

8. )ales are recorded on thecorrect dates -timing.

rocedures requiring billing and recording ofsales on a daily basis as close to the time ofoccurrence as possible.

Internal verification of timely recording oftransactions.

14-0

Tests of controls:

#. 0n a sample of sales invoices, eamine proper authori!ation andindication of internal verification of sales amounts.

&. 3amine approved computer printout of unit selling prices.4. 3amine file of batch totals for initials of data control clerk2 compare

totals to summary reports.

Substantive tests of transactions:

#. +ecompute information on sales invoices.&. Trace entries in sales ournal to related sales invoices.4. Trace detail on sales invoices to shipping documents, approved

price lists, and customers' orders.

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14- The most important duties that should be segregated in the sales andcollection cycle are9

#. +eceiving orders for sales&. )hipping goods4. (illing customers and recording sales

$. 1aintaining inventory records6. 1aintaining general accounting records8. 1aintaining detailed accounts receivable records:. rocessing cash receipts;.

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14-3 #. /redit is authori!ed before a sale takes place.

Test9 Analy!e the allowance for uncollectible accounts and write%offs of accounts receivable during the period to determinethe effectiveness of the credit approval system.

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14-1

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#. +ecorded cash receipts are for

funds actually received by thecompany -occurrence.

)eparation of duties between

handling cash and record keeping. Independent reconciliation of bank

accounts.

&. /ash received is recorded in thecash receipts ournal-completeness.

)eparation of duties betweenhandling cash and record keeping.

7se of remittance advices or aprelisting of cash.

Immediate endorsement of incomingchecks.

Internal verification of the recordingof cash receipts.

+egular monthly statements to

customers.

4. /ash receipts are deposited andrecorded at the amounts received-accuracy.

)ame as & above. Approval of cash discounts. +egular reconciliation of bank

accounts. (atch totals are compared with

computer summary reports.

$. /ash receipts are properly includedin the accounts receivable masterfile and are correctly summari!ed

-posting and summari!ation.

+egular monthly statements tocustomers.

Internal verification of accounts

receivable master file contents. /omparison of accounts receivablemaster file or trial balance totals withgeneral ledger balance.

6. /ash receipts transactions areproperly classified -classification.

7se of adequate chart of accounts. Internal review and verification.

8. /ash receipts are recorded on thecorrect dates -timing.

rocedure requiring recording ofcash receipts on a daily basis.

Internal verification.

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14-14 Audit procedures that the auditor can use to determine whether all cashreceipts were recorded are9

5iscussion with personnel and observation of the separation ofduties between handling cash and record keeping.

Account for numerical sequence of remittance advices or eamine

prelisting of cash receipts. 0bserve immediate endorsement of incoming checks. 3amine indication of internal verification of the recording of cash

receipts. 0bserve whether monthly statements are sent to customers. Trace from remittance advices or prelisting to cash receipts ournal.

14-1! roof of cash receipts is a procedure to test whether all recorded cashreceipts have been deposited in the bank account. In this test, the total cashreceipts recorded in the cash receipts ournal for a period of time, such as amonth, are reconciled to the actual deposits made to the bank during the same

time period. The procedure is not useful to discover cash receipts that have notbeen recorded in the ournals or time lags in making deposits, but it is useful todiscover recorded cash receipts that have not been deposited, unrecordeddeposits, unrecorded loans, bank loans deposited directly into the bank account,and similar misstatements.

14-10 =apping is the postponement of entries for the collection of receivablesto conceal an eisting cash shortage. The fraud is perpetrated by someone whorecords cash in the cash receipts ournal and then enters them into the computersystem. The person defers recording the cash receipts from one customer andcovers the shortage with receipts from another customer. These in turn are

covered by the receipts from a third customer a few days later. The employeemust either continue to cover the shortage through lapping, replace the stolenmoney, or find another way to conceal the shortage.

This fraud can be detected by comparing the name, amount and datesshown on remittance advices to cash receipts ournal entries and relatedduplicate deposit slips. )ince the procedure is relatively time%consuming, auditorsordinarily perform the procedure only where there is a specific concern with fraudbecause of internal control deficiencies discovered.

14-1 The audit procedures most likely to be used to verify accounts receivablecharged off as uncollectible and the purpose of each procedure are as follows9

3amine approvals by the appropriate persons of individualaccounts charged off. The purpose is to determine that charge%offsare approved.

3amine correspondence in client's files that indicates theuncollectibility of the accounts for a selected number of write%offs.The purpose is to determine that the account appears to beuncollectible.

3amine 5un and (radstreet credit records as an indication of the

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uncollectibility of an account. The purpose is the same as theprevious procedure.

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14-1 .continued/

/onsider the reason for the charge%off compared to the companypolicy for writing off uncollectible accounts. The purpose is todetermine whether or not company policy is being followed.

14-1 The primary obective of the tests of controls and substantive tests oftransactions for sales and cash receipts is to determine whether or not theauditor may rely on internal controls to produce accurate information. If it isdetermined through tests of controls and substantive tests of transactions thatthe system provides reliable information as to accounts receivable balances, theauditor may reduce the sample si!e for the confirmation of accounts receivableand adust the type of confirmation and timing of the tests. If the system is notconsidered effective because of deficiencies in internal control, the sample si!emust be increased, positive confirmations will probably be necessary, and theconfirmations will most likely be as of the balance sheet date.

14-13 It is often acceptable to perform tests of controls and substantive tests of

transactions at an interim date. The auditor may decide it is necessary to test theuntested period at year%end. It is acceptable to perform tests of controls andsubstantive tests of transactions for sales and cash receipts at an interim dateand not perform additional tests of the system at year%end under the followingcircumstances9

The auditor believes that internal controls are effective. The auditor does not anticipate significant changes in the internal

controls during the remaining period. The transactions normally occurring between the completion of the

tests of controls and substantive tests of transactions and the end

of the year are similar to the transactions prior to the test date. The remaining period is not too long.

14-2

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'iscussion Questions and 8roble7s

14-24 #. a. +ecorded sales are for the amount of goods ordered and arecorrectly billed and recorded. -Accuracy

b. 3amine indication of internal verification on salesdocuments.

c. Incorrect prices may be charged, the customer may be billedfor the wrong quantity, or the total amount may be computedincorrectly.

d.+ecompute information on the sales invoices. Trace details onsales invoices to shipping records, price lists, and customers'orders.

&. a. +ecorded sales and credit transactions are for shipmentsactually made and eisting sales transactions are recorded.-0ccurrence and /ompleteness

b. Account for the numerical sequences of sales orders,invoices, and credit memoranda.

c. )hipments or returns are not recorded. 0rders fromcustomers are misplaced and not filled.

d. 3amine correspondence concerning credit memoranda toassure that they were properly issued. Trace sample ofshipping documents to related sales invoices and entries intothe sales ournal and accounts receivable master file./onfirm accounts receivable.

4. a. 3isting transactions are recorded2 recorded transactionseist. -/ompleteness and 0ccurrence

b. The auditor should observe the employees and discuss theprocedures with personnel.

c. )ales could be made and not recorded, with the employeekeeping the proceeds of the sale.

d. Trace selected shipping documents to related duplicatesales invoices, the sales ournal, and accounts receivablemaster file.

$. a. 3isting transactions are recorded. -/ompletenessb. 0nline shipping documents are prenumbered and accounted

for weekly.c. 0nline sales could be made but not recorded.d. )elect a sample of online shipments -using the prenumbered

online shipping documents, and trace to a sales invoice,sales ournal or listing, and the accounts receivable masterfile.

6. a. 3isting transactions are recorded. -/ompletenessb. The auditor should observe the activities of those employees

and discuss the procedures with personnel.c. These unusual sales could be made but not recorded and

the proceeds kept from the company.

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d. 3amine sales documents for these sales and trace theentries into the cash receipts ournal.

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14-24 .continued/

8. a. 3isting transactions are recorded and recorded salesare for the amount of goods ordered and are correctlybilled. -/ompleteness and Accuracy

b. The auditor should observe the activities of employees and

discuss the procedures with personnel.c. A receivable might intentionally not be recorded, allowing the

cash to be kept from the company.d. Trace from the shipping records to the sales invoice, to the

accounts receivable master file, and to the cash receiptsournal.

:. a. )ales and cash receipts transactions are properly included inthe accounts receivable master file and are correctlysummari!ed. -osting and summari!ation

b. 0bservation of procedures and eamination of indication of

internal verification.c. 7nintentional errors could be posted in the control accounts

and left undetected for long periods of time.d. erform tests of clerical accuracyfoot ournals and trace

postings from ournal to general ledger and accountsreceivable master file.

;. a. 3isting cash receipts transactions are recorded.-/ompleteness

b. 0bservation and discussion of procedures with employees.c. /ash could be received, not recorded, and kept from the

company by an employee or lost prior to deposit.d. Trace receipts recorded on a list such as from a prelisting of

cash to the books of original entry. /onfirm accountsreceivable.

>. a. Transactions are recorded on the correct dates. -Timingb. /ompare date per books to the date that the deposit

appears on the bank statement.c. /ash receipts might be recorded in the wrong accounting

period, lost, or stolen.d. Trace cash recorded on a list, such as a prelisting of cash, to

the cash receipts ournal and to the bank statement.

14-2! #. a. Test of controlb. 3isting sales transactions are recorded. -/ompletenessc. 5ocumentation

&. a. Test of controlb. +ecorded sales are for shipments actually made to eisting

customers. -0ccurrence

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c. 5ocumentation

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14-2! .continued/

4. a. )ubstantive test of transactionsb. +ecorded sales are for the amount of goods shipped.

-Accuracyc. 5ocumentation

$. a. )ubstantive test of transactionsb. )ales transactions are properly included in the accounts

receivable master file and are correctly summari!ed.-osting and summari!ation

c. +eperformance

6. a. Test of controlb. +ecorded sales returns are for returns from eisting

customers. -0ccurrencec. 5ocumentation

8. a. Test of controlb. -# /ash received is recorded in the cash receipts

ournal. -/ompleteness-& /ash receipts are recorded on the correct dates.

-Timingc. 0bservation or documentation

:. a. )ubstantive test of transactionsb. -# +ecorded receipts are for funds actually

received by the company. -0ccurrence

-& /ash received is recorded in the cash receiptsournal. -/ompleteness

-4 /ash receipts are deposited at the amount received.-Accuracy

-$ /ash receipts are recorded on the correct dates.-Timing

c. 5ocumentation

14-20 a. Objective 1 A given sale is recorded more than once, or a saleis recorded for which a shipment was not made.

Objective 2 A shipment took place for which no sale was

recorded.Objective 3 A sales ournal was incorrectly footed, or a sales

transaction was posted to the incorrect customeraccount.

b. The first obective deals with overstatement of sales resulting fromrecording sales for which no shipment had occurred. The secondobective concerns understatement of sales. It results from ashipment that has not been recorded.

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c. rocedures &, 4, and $ are tests of controls. rocedures #, 6, and 8are substantive tests of transactions.

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14-20 .continued/

d.

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& A shipping document isattached to each duplicatesales invoice.

To prevent billing to acustomer or recording asale for which no shipmenthas been made.

4 An independent persontraces from the sales ournalto the accounts receivablemaster file. A tick mark isshown in the margin of thesales ournal after atransaction is traced.

reventing misstatementsin failure to post to theaccounts receivable masterfile, posting to the wrongcustomer, at the wrongamount, or at the wrongdate.

$ At the time of billing, theduplicate sales invoicenumber is written on thebottom left%hand corner ofeach shipping document.eriodically, the entiresequence of shipping

documents is accounted forand each is eamined tomake certain there is aninvoice number, whichindicates that a givenshipment has been billed.

The failure to bill customersfor shipments actuallymade.

14-2 a. -$ b. -& c. -4

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14-2

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1< ) T of T Accuracy ot applicable

2< ) T of T osting andsummari!ation

ot applicable

< T of / Accuracy /ompare unit selling prices onduplicate sales invoices to theapproved price list.

4< T of / /lassification 3amine a sample of salestransactions to determine if

each one is correctly classifiedin the sales ournal.

!< ) T of T /lassification ot applicable

0< ) T of T /ompleteness

Accuracy

Timing

osting andsummari!ation

ot applicable

< ) T of T 0ccurrence/ompleteness

Accuracy

Timing

ot applicable

< T of / Accuracy +ecalculate the cashdiscounts for a sample ofremittances and determinewhether each one wasconsistent with companypolicy.

3< T of / /ompleteness Trace from a sample ofremittance advices to the cashreceipts ournal to determine ifthe related cash is recorded.

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14-23

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#. Invoices for goods sold are postedto incorrect customer accounts.

c. 1onthly statements are mailed toall customers with outstanding

balances.

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14- a.

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#. Financial secretary eercises toomuch control over collections.

To etent possible, financialsecretary's responsibilities should

be confined to record keeping.

&. Finance committee is noteercising its assignedresponsibility for collection.

Finance committee should assumea more active supervisory role.

4. The finance committee isresponsible for the auditingfunction and administration of thecash function. 1oreover, thefinance committee has notperformed the auditing functions.

An audit committee should beappointed to perform periodicauditing procedures or engageoutside auditors.

$. The head usher has sole access tocash during the period of the count.0ne person should not be leftalone with the cash until theamount has been recorded orcontrol established in some otherway.

The number of counters should beincreased to at least two, and cashshould remain under ointsurveillance until counted andrecorded so that any discrepancieswill be brought to attention.

6. The collection is vulnerable torobbery while it is being countedand from the church safe prior to itsdeposit in the bank.

The collection should be depositedin the bank's night depositoryimmediately after the count.hysical safeguards, such aslocking and bolting the door duringthe period of the count, should beinstituted. Bulnerability to robberywill also be reduced by increasingthe number of counters.

8. The head usher's count lacksusefulness from a controlstandpoint because he surrenderscustody of both the cash and the

record of the count.

The financial secretary shouldreceive a copy of the collectionreport for posting to the financialrecords. The head usher should

maintain a copy of the report foruse by the audit committee.

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14- .continued/

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:. /ontributions are not depositedintact. There is no assurance that

amounts withheld by the financialsecretary for ependitures will beproperly accounted for.

/ontributions should be depositedintact. If it is considered necessary

for the financial secretary to makecash ependitures, he should beprovided with a petty cash fund. Thefund should be replenished by acheck based upon a properlyapproved reimbursement requestand satisfactory support.

;. 1embers are asked to drawchecks to Ccash,C thus making thechecks completely negotiable and

vulnerable to misappropriation.

1embers should be asked to makechecks payable to the church. At thetime of the count, ushers should

stamp the church's restrictiveendorsement -For 5eposit 0nly onthe back of the check.

>. o mention is made of bonding. Dey employees and membersinvolved in receiving and disbursingcash should be bonded.

#@. "ritten instructions for handlingcash collections apparently havenot been prepared.

3specially because much of thework involved in cash collections isperformed by unpaid, untrainedchurch members, often on a short%

term basis, detailed writteninstructions should be prepared.

##. The envelope system has not beenencouraged. /ontrol features that itcould provide have been ignored.

The envelope system should beencouraged. 7shers should indicateon the outside of each envelope theamount contributed. 3nvelopecontributions should be reportedseparately and supported by theempty collection envelopes.renumbered envelopes will permitready identification of the donor byauthori!ed persons without generalloss of confidentiality.

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14-1

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#nte>rated Case Application

14-4 a., b., c., and d.8#""AC&% 5A"(6ACT(R#"?8art #+

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a