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SULTHAN HAKIM/ 145020308121003

International Undergraduate Program in Accounting of Brawijaya University

Course: Auditing Laboratory

AUDITING CASES: 5. TOC: THE REVENUE AND CASH RECEIPTS CYCLE

1. SAS 31, "Evidential Matter," states that: "The measure of the validity of [evidential
matter] for audit purposes lies in the judgment of the auditor...." (paragraph 02) Thus,
the quality of oral evidence is an evaluation made by the auditor that would be
influenced by a number of factors: the perception of management's integrity, the rank
of the individual providing the information, the ability to corroborate the evidence
by other sources, and the purpose for which evidence is being gathered. However, in
all cases, statements made by the employees of a client are only circumstantial
evidence. In a comparison with other forms of evidence (such as observing physical
existence and receiving confirmations directly from third parties), it provides less
assurance.
In this case, Mitchell is attempting to gather additional evidence concerning
Lakeside's systems, especially the design and operating efficiency of control
procedures and policies. Oral evidence serves an important role in such testing but
still has to be complemented by other testing: a review of completed internal
documents, flowcharts, organizational charts, job descriptions, systems manuals, etc.
Conversely, oral information provides less evidence in the substantive testing of
account balances. Whereas company employees should be able to furnish relevant
information as to the functioning of control procedures within the various accounting
systems, the auditor must rely almost exclusively on other types of testing to
determine the fair presentation of the client's financial statements.
2. Accounts receivable generate a constant flow of cash into a company, offering a
temptation to any employee who might be inclined to steal. Over the years, ingenious
individuals have devised a multitude of plans for diverting this monetary inflow to
themselves. Some of the more common schemes include the following:
- Money that comes to the company from a customer is stolen by an employee with
the balance then being written off the records as an uncollectible account. This
diversion of funds is especially likely when an old account is collected, one that
can be removed from the books without arousing suspicion.
- Lapping can occur. One or more accounts receivable are collected by the
company but the money is stolen by an employee. However, since the collection
is not recorded, another invoice will eventually be sent to these customers who
would then alert the company to the earlier payment. To prevent the processing
of this second bill, subsequent cash collections from other customers are applied
to the balances of the original customers. This series of events can be repeated
indefinitely. Money is stolen on a daily or weekly basis to cover each previous
theft.
- A customer can pay the total amount of an invoice. An employee removes cash
equal to the 2% discount that is allowed when payment is made within ten days.
If the company does not have a specific policy for rebilling a customer for
incorrect discounts, the difference may simply be recorded as a discount that has
been taken.
3. A company's net income can always be inflated by creating fictitious credit sales. For
example, an invoice is prepared for a fake customer with the amount being recorded
as an increase in both accounts receivable and sales. In the Lakeside audit, the client
company wants to grow. Bank loans or new equity investments may be needed for
this purpose. Increased income would make this type of financing easier (and,
perhaps, cheaper) to negotiate. False sales might also be created for a different
reason: the regional sales representatives are paid a commission based on sales. Thus,
to inflate their own income, they might attempt to falsify sales records.
4. In talking with client personnel, an auditor must be constantly alert for any indication
of potential problems. "Red flags" are often encountered in these discussions that
need to be investigated to ensure that material misstatements do not exist. During
Mitchell's conversation with Miller, a number of comments are made that should
concern the auditors:
- Access to the accounts receivable subsidiary ledger is available to all employees
within the company. Therefore, the possibility exists that an individual could
make an adjustment to a balance without Miller noticing. The receivable of a
friend or relative, for example, could be reduced.
- Aging of the receivables is performed only once a year. Although Miller claims
that he can monitor the age of individual accounts, the company needs to be aware
of changes that occur over time. For example, the increase in the age of the
receivables during the current period seems to have gone unnoticed.
Consequently, the company's assets are tied up for a longer period of time and
the chance of accounts becoming uncollectible increases. The company needs to
be in a position to take corrective action as soon as this type of problem begins to
occur.
- Miller controls the accounts receivable subsidiary ledger with virtually no
company oversight or control. For example, no reconciliation with the general
ledger is made except for the auditor's testing once a year. Errors and evidence of
irregularities could exist and not be discovered for months.
- Complaints about billings are handled by Miller rather than by someone
independent of the system. The handling of complaints is an important method of
control especially in an accounts receivable system, since regular interaction with
outside customers occurs. This control mechanism is neutralized, however, if
Miller is assigned to look into and resolve the problems.
- No formal system exists for setting credit limits and granting credit. Rogers
appears to handle this aspect of the company based almost on intuition. Thus,
potentially excellent customers may have their credit limited while risky
customers are given excessive credit. A formalized system needs to be developed
with some oversight included.
- Credit is based solely on reports that are filed by the sales representatives. These
individuals have a direct interest in getting additional sales since they are paid on
commission. Thus, they have reason to want each report to sound as if the
customer is worthy of credit. Additional independent information should be
accumulated to help the company decide on the granting of credit.
- The credit files are never updated. Therefore, the company learns that a customer
is no longer a good credit risk only by incurring a loss, the writing off of a balance
as a bad debt. Therefore, customers in financial difficulties can run up large debts
that will never be paid. The company needs to establish a periodic review of credit
information to ensure that each customer is still worthy of credit. The age of the
accounts receivable is up significantly from the previous year without any good
explanation. Miller blames the change on Christmas, but the effects of that
holiday would have also been encountered in the preceding year. The possibility
exists that bad accounts or false accounts are now included within the receivable
balance.
- Miller indicates that the company might have previously been holding accounts
rather than writing them off as bad on a timely basis. The auditor must be
concerned that this practice is still being followed. Companies will often attempt
to manipulate net income by varying the point at which accounts are determined
to be bad.
- No justification seems to exist for using 0.7% of net sales as the estimation of bad
accounts. The auditor cannot corroborate a number that appears to have been
selected at random. A new attempt must be made to derive an estimation that is a
reasonable representation of the company's uncollectible accounts.
- The company waits until an account is 15 days old before a second invoice is
mailed. This delay is, perhaps, one of the reasons that the age of the accounts has
increased. Many customers may be waiting for the pressure of the second bill
before making payment.
- Miller writes off accounts as uncollectible with no apparent company control.
Since bad accounts may indicate errors or irregularities, they should always be
reviewed and approved by some independent party within the organization.
- Miller produces and mails the final invoice for overdue accounts. Since Miller
has a great many responsibilities in this system, this last billing should be made
by some other individual. Therefore, if the account has been paid (and stolen or
incorrectly recorded), the information comes back to this independent person.
- Prices and extensions of invoices are sometimes checked after the invoice has
been mailed to the customers. This system is obviously inefficient. Payments may
be made incorrectly, and customers can become aggravated by later adjustments
being made.
5. First, because of weaknesses found during the preliminary evaluation of the internal
control, control risk may be assessed at the maximum level. Since maximum control
risk is being assumed, the auditor has no reason to test the operating efficiency of the
control procedures.

Second, although potential strengths may be identified by the preliminary evaluation


of internal control, the auditors may still opt to assess control risk at the maximum
level. This decision would be justified if additional substantive tests appear to be
easier and cheaper to perform than the testing of the operating efficiency of specific
control policies and procedures. Thus, once again, the testing of the control
procedures becomes unnecessary.

In the new Sarbanes-Oxley environment, testing cannot be omitted for public


companies.
6. Inherent risk is the susceptibility of an account balance or class of transactions to a
material misstatement. A number of factors affect this assessment: the quantity
and size of transactions occurring over time, the past history of the company in this
area, the likelihood of theft, the necessity of performing complicated calculations in
order to generate reported figures, problems inherent to a particular industry, the need
for making estimations, the results of analytical procedures, and the possibility of
obsolescence. For example, in the Lakeside audit, inventory would be an account that
would probably have a high inherent risk. The company has numerous transactions
in both buying and selling inventory. Computations of discounts and freight charges
could be difficult, as would be the application of a cost flow assumption. The
possibility of theft, breakage, returns, and obsolescence of inventory would all be
high and require periodic estimations.

The auditor's assessments of both inherent risk and control risk have a significant
impact on detection risk and, therefore, substantive testing procedures. If the inherent
risk and control risk are both determined to be low, detection risk need not be kept
low. Thus, less substantive testing (both in quantity and quality) is needed.
Conversely, if the inherent risk and the control risk are judged to be high, the auditor
must reduce detection risk. As discussed above, this risk can be brought down to an
acceptable level by such means as performing additional substantive testing, using
more experienced staff personnel, carrying out procedures closer to the balance sheet
date, or relying on more effective testing procedures.

7. In positive confirmations, debtors are asked to respond in all cases whether or not
they are in agreement with the information given. When using the negative form of
request, debtors are asked to respond only if they disagree with the information.

Since positive confirmations require a response in every case, they provide better
evidence than do negative confirmations. Hence, positive confirmations are more
appropriate when the internal control is weak, accounts are large or old, or related
parties are involved. Increased audit evidence is needed in each of these cases.
Negative confirmations are not as costly and are most often used when less evidence
is required.

8. The selection of a specific account for confirmation is an indication that the auditor
desires additional evidence or assurance about that particular balance. A number of
situations exist that would suggest the need for confirmation of a specific account:
a. The balance appears to be with a related party
b. The account is quite large in relation to other accounts receivable;

c. The account is far overdue, indicating a possible bad debt to be written off or that
payment has not been properly recorded;

d. The activity within the account has been unusual. For example, later invoices
were paid while earlier charges were ignored.

9. The debit entries made to Lakeside's Accounts Receivable control account produce
an audit trail made up of the following documents or records
- Sales Journal - indicates the original journal entry recorded for each sales
transaction. An auditor matches the debits in the general ledger account to these
journal entries to ascertain that no posting errors have been made.
- Sales Invoice - serves within the Lakeside system as both an invoice indicating
the amount billed to the customer and a sales order. The auditor can use the
various copies of the sales invoice to verify that:
credit was approved for the sale,
quantities and types of items billed agree with the quantities and types of
items shipped to the customer,
prices included on the invoice are appropriate,
that the bill is mathematically correct.

- Bill of Lading - records the quantity and description of the items being shipped.
The auditor compares it with the sales invoice to make certain that the items
ordered and billed are in agreement with the items that were shipped.
- Accounts Receivable Subsidiary Ledger - indicates the receivable balance from
each individual customer. An auditor compares individual entries made to this
subsidiary ledger with entries in the control account in the general ledger.
Indicates proper functioning of system.
- Inventory Price List - used to price sales invoices. An auditor can use this listing
to verify correct pricing of the sales invoices.

- Inventory Sales Journal - records inventory sales as a basis for perpetual


inventory. An auditor verifies that the items recorded as being sold agree with the
sales invoice. Although this verification relates to the inventory system rather
than to receivables
Although the following documents are not part of the audit trail leading to the
recording of the Accounts Receivable debits, they are certainly relevant to any
testing made in connection with the fair presentation of those debits:

Invoice Slips, Cash Remittance Lists, Validated Bank Deposit Slips - some or all
of these documents can be used by the auditor to verify the actual amount of cash
received. The question of collectibility is best answered by actual collection of
the receivable. Thus, the auditor will compare the debit entries in the receivable
account to the subsequent cash collections.

This question also asks about the reliability of the evidence gathered from this
audit trail. Lakeside's audit trail is composed entirely of internally generated
documents. For example, even the original customer order is taken by telephone
and recorded by Lakeside employees. Thus, the reliability of the documents that
comprise this trail such as bills of lading or sales invoices would be closely tied
to the auditor's evaluation of internal control. If controls are perceived as strong,
the reliability of these documents is much higher than if controls are weak.
Because the audit trail is composed solely of Lakeside documents, the student
should be aware that testing this trail provides the auditor with only a portion of
the necessary evidence. Collection of the accounts receivable, for example, and
auditor confirmations would also provide evidence as to the fair presentation of
the accounts receivable.

10. Miller is uncertain how the 0.7% figure was determined. He says that the previous
auditors determined this figure several years ago, and that the company has always
used this figure. Obviously, this is not a reasonable method for estimating bad debts.
The figure should be evaluated by Lakeside's management at least annually for its
reasonableness. This evaluation should include a review of the history of
uncollectible accounts, the current credit policy, and the current aging of accounts
receivable.
11. Mitchell probably should not recommend that Accounts Receivable be confirmed as
of an interim date (November). The internal control for the revenues and cash
receipts cycle appear to be poor and cannot be relied upon to provide reliable
financial information for the month of December; thus, Accounts Receivable should
be confirmed at yearend.
12. Consistent with our answer in #11 above, Miller has not designed an effective system.
It is not unusual for a company to grow and what worked before can no longer be
relied on to handle the increased volume. Miller seems to exhibit a lax attitude in
several of his answers and therefore, since he is responsible for the system, we must
conclude that he has not made good decisions.
Question

1. Comments - The subsidiary ledger is reconciled annually by the independent auditors.

Significance - During the year virtually no control is maintained over Miller's handling
of the subsidiary ledger. The possibility that errors or irregularities will be discovered
on a timely basis becomes remote if not impossible. In addition, Miller has the
opportunity for manipulating the records to cover thefts and other defalcations.

Suggestions - On a periodic basis, a member of the administrative staff should verify that
the subsidiary ledger for accounts receivable agrees with the general ledger control
account.

2. Comments - The criteria for writing off accounts are nebulous and seemingly based
solely on the judgment of Miller.

Significance - For the auditor, a problem exists as to the consistency of removing bad
debts from one year to the next. Once again, no control appears to exist over Miller's
judgment.

Suggestion - Establish a formal system for writing off bad accounts. This system need
be no more than a list of steps to be taken prior to the decision to remove an account.
Company needs to ensure a review of these accounts.

3. Comments - No independent party authorizes the write-off of bad accounts.

Significance - The removal of bad accounts can be used to cover cash thefts. Also, write-
offs may be approved without sufficient attempts being made at collecting the receivables.

Suggestion - Once a system has been established for the write-off procedure (see
Question 2), an independent employee should be required to review every account prior
to removal to make certain that all proper steps have been followed.

4. Comments - Follow-up of bad debts is not addressed in the case; Mitchell does not ask
this specific question.

Significance - If no follow-up is made, the company reduces the possibility of making


any future collection. Additionally, attempting to collect an old account receivable is a
control mechanism to ascertain that the balance has not actually been paid and the money
stolen or the collection recorded incorrectly. Finally, if no follow-up is carried out, the
opportunity exists for employees to steal the money if it should be received at a later
date.

Suggestion - The receivable can be turned over to an outside collection agency or, as an
alternative, a member of Lakeside's staff can be assigned to look into the bad accounts
periodically.

5. Comments - No reevaluation of the method for estimating bad accounts has been
made by the client company.

Significance - No proof exists that the bad debt expense and the allowance for
doubtful accounts is fairly presented.

Suggestion - Client should schedule recent bad accounts to arrive at a new estimation of
the bad debt percentage.
6. Comments - The first three invoices are mailed by the sales division; any further billing
is made by Miller, who is in charge of the subsidiary ledger.

Significance - By having Miller send the last invoices, the opportunity for manipulation
is increased. In a small company such as Lakeside, this situation is not unusual, but it
should be accompanied by additional control and reconciliation features.

Suggestion - Control can be established by allowing Miller to continue the billing, but
with the addition of the control procedures suggested in several of the other questions.

7. Comments - The responsibility for looking into complaints is vested in Miller.

Significance - Again, all of the responsibilities are in the hands of one person with no
independent control being applied. This lack of control reduces the possibility that errors
will be discovered. Basically, an opportunity to establish control over Miller's work is
being missed.

Suggestion - Lakeside should have complaints sent to an employee who can then discuss
the matter with both Miller and the customer to make certain that the issue is properly
resolved.

8. Comments - According to the client, no formal change in the policy of granting credit
has been made. However, the increases in the size of the receivables, the increase in the
average age of the balances, and the apparent write-off of additional uncollectible
accounts indicate the possibility that some, perhaps informal, modification has occurred.
Because the credit policy has never been formally established, the auditor may have
trouble distinguishing an actual change.

Significance - Any shift in credit policy requires auditor attention as to the effect on the
allowance account and bad debt expense. Abernethy and Chapman may want to review
the new customer accounts opened during the current year for any indication of a change
in credit policy. This issue may be especially significant in the Lakeside audit since credit
reports are filed by the sales representatives who are paid on commission, thus benefiting
from an increase in sales.

Suggestions - Lakeside should adopt a policy to guide Rogers in his credit decisions.
In addition, outside verification of credit ratings on a periodic basis would help reduce
the risk of high bad debt losses.

9. Comments - No indication is given in the case as to whether sales invoices are verified
after the shipment to ascertain appropriate credit approval. The system is designed so
that credit approval is necessary before the sale is made, but no control mechanism is
identified to assure that the system is working properly.

Significance - To the auditor, the possibility of a sale being made without credit approval
casts further doubts on the reliability of the system of controls. As a part of the tests of
controls, the auditor will want to review a sample of sales invoices for proper credit
approval.

Suggestions - At the point in the accounting system at which the extensions and prices
are verified, the presence of credit approval should also be checked.

10. Comments - Credit files contain only the sales representative's credit reports and do not
appear to be reviewed periodically.

Significance - As indicated above, the credit granting policy is informal and based almost
solely on Rogers' judgment. Thus, the efficiency of the system is unknown, and review
of the system by the auditor is quite difficult.

Suggestions - As a part of the design of a comprehensive credit system, Lakeside should


determine the desired contents of a credit file including items such as outside credit
reports, financial statements, correspondence, etc. Periodically, these files need to be
reviewed by an independent Lakeside employee to verify that all information is complete
and up-to-date. Each customer's file is also reevaluated at regular time intervals to judge
whether credit should continue to be offered.

11. Comments - Verification of goods and prices is made by Lakeside employees. Miller
implies that his checking of prices and extensions is not made on a timely basis. In
addition, this verification is another responsibility pertaining to accounts receivable
concentrated in Miller's hands.

Significance - Verifying extensions and prices after the invoice has been sent to the
customer is not a logical approach. Also, having Miller perform this task adds nothing to
the efficiency of the organization.

Suggestion - All verifications should be made prior to mailing the invoice, ideally by a
different employee.

12. The answers to Question (11), above, appear to pertain equally as well to this question.

13. Comments - Cash discounts are verified by the sales division.


Significance - System appears adequate. Financial information should be fairly
presented.

Suggestions None

14. Comments - Using prenumbered sales invoices and bills of lading along with the periodic
verification of all numbers is essential in assuring that all sales are recorded. In an earlier
case, the use of prenumbered forms is mentioned. Miller suggests that the presence of all
forms is tested periodically, but the auditor should specifically ask about that procedure.

Significance - If the possibility exists that the company can make sales without recording
them, the auditor's ability to gain assurance as to completeness assertion may be severely
hampered.

Suggestions - Since the documents are already prenumbered, the auditor needs to make
certain that Lakeside has a policy for periodically verifying the presence of all forms.