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1 Thomson Learning 10 Substantive Tests in the Revenue/Receipt Cycle:Sales, Receivables, Cash,and Management Discretionin Revenue Recognitionchapterchapter365major topics discussed in this chapter arethe: Relationship between financial statement assertions and audit procedures within the revenue/receipt cycle. Relationship among audit risk, client strategies, and the nature, timing, and extent of substantive tests. Substantive tests applicable to assertions about sales, accounts receivable, and cash balances. Application of audit sampling in substantive tests of accounts receivable. Computer-assisted audit techniques applicable to accounts receivable. Application of audit judgment to questions of earnings manipulationand revenue on the assessed levels of control and inherent risk for assertions within therevenue/receipt cycle, an auditor determines acceptable levels of detection riskand then designs substantive tests for the major financial statement accountsprocessed by the cycle: sales, accounts receivable, and cash.

2 This chapter focuseson substantive tests of details for these accounts. The chapter begins by dis-cussing how each of the financial statement assertions introduced in chapter 4 existence or occurrence, completeness, rights and obligations, valuation or allo-cation, and presentation and disclosure is tested for audits of sales, accounts re-ceivable, and cash, and how audit risk and client strategies bear on the nature,timing, and extent of an auditor s substantive tests. In turn, the chapter relates theassertions to substantive tests for these accounts and then describes and illus-trates each test. Thereafter, the chapter illustrates how audit sampling, introducedin chapter 8, can be used in substantive tests of receivables balances, and by Thomson Learning 366 Part 2 Methoddiscussing computer-assisted audit procedures applicable to the revenue/receiptcycle.

3 The chapter concludes by explaining common means to overstate revenueby addressing audit , legal, and ethical questions that arise when the timing of rev-enue recognition is subject to management s explained in chapter 4, much of an auditor s work during a financial state-ment audit consists of obtaining and evaluating evidence about the assertionsembodied within an entity s financial statements. For example, management as-serts that recorded receivables and cash balances: Exist, Include all transactions that should be presented, Represent rights of the entity, Are valued appropriately, and Are presented and disclosed properly within the financial financial statement assertion translates to an audit objective for which audi-tors design procedures to obtain evidence.

4 For example, management s assertionthat cash and receivables exist creates a corresponding audit objective to deter-mine whether each asset actually does exist, and auditors generally use confir-mation procedures to test their existence. Hence, financial statement assertionsare synonymous with audit objectives. But, specifically, what procedures do prac-ticing auditors commonly use to address which financial statement assertions?The following relates each financial statement assertion to audit procedures thatpractitioners commonly use to audit revenue/receipt cycle accounts. The asser-tions and procedures are summarized in Figure or OccurrenceWithin the revenue/receipt cycle, the existence or occurrence assertion addresseswhether all recorded sales, receivables, and cash balances actually exist andwhether all recorded transactions actually occurred.

5 Existence is normally testedby physical observation or confirmation with outside parties. In practice, the ex-istence of receivables is often tested by confirming balances with debtors (cus-tomers). The existence of cash on deposit is tested by confirming bank balanceswith banks, and the existence of cash on hand can be observed physically andcounted. In addition, auditors use cutoff testing to determine whether recordedsales transactions and related receivables and cash transactions are recorded inthe proper completeness assertion addresses whether all receivables, sales, and cashtransactions that should be presented in the financial statements actually are presented.

6 Generally, completeness is tested by examining documentation and by applying analytical procedures, such as making comparisons among relatedaccounts. For sales and receivables, completeness is tested by performing analyt-ical procedures, which helps determine whether recorded receivables and salesbalances are reasonable at the balance sheet date, and by testing cutoff, which de-termines whether transactions are recorded in the proper accounting period. financial statement assertions, objectives, and audit proceduresThomson Learning Auditors typically test completeness for cash balances by examining cutoff bankstatements to assure that all receipts and disbursements are recorded in theproper period, and by examining bank reconciliations (or proofs of cash) andrecords of intercompany and interbank and ObligationsWithin the revenue/receipt cycle, the rights and obligations assertion addresseswhether an entity has property rights for example, claims against thirdparties for recorded receivables and cash balances.

7 That is, does the companyhave legally binding claims against customers for receivables balances andagainst commercial banks and other depositories for recorded cash balances?Generally, an auditor tests rights by examining documentation and through con-firmations and inquiries. Rights to receivables are typically tested by confirmingbalances with debtors and by reviewing the collectibility of confirmed and un-confirmed customer balances. In turn, rights to cash are tested primarily by con-firming balances and deposit terms ( , demand deposits and compensatingbalances) with 10 Substantive Tests in the Revenue/Receipt Cycle367 audit ProceduresAssertionsSalesReceivablesCash Balances Existence or Test withConfirm analyticalPerform analyticalTest bankTest orproofs of cash.

8 Examine inter- company and interbank and Confirm withConfirm withobligationsdebtors. or Perform analyticalConfirm withConfirm collectibility. Verify mathematicalVerify accuracy ofaccuracy of recordedaged trial and Compare statement Compare statementCompare statementdisclosure presentation andpresentation andpresentation anddisclosures withdisclosures with disclosures with those required those required bythose required byby 10-1:Relating Financial Statement Assertions and audit Procedures: Sales, Receivables, and Cash Balances Thomson Learning Valuation or AllocationThe valuation assertion addresses whether receivables, sales, and cash balancesare reported in the financial statements at appropriate amounts.

9 That is, are theyvalued in accordance with generally accepted accounting principles (GAAP)? Ingeneral, auditors test valuation by examining documentation, confirming, ob-serving, performing mechanical tests, and making inquiries. More specifically, thecarrying value of receivables is tested by confirming balances with debtors andreviewing collectibility both of which also address rights and obligations andby verifying the accuracy of management s aged trial balance. Recorded valuesfor cash are tested by confirming balances with banks, by verifying the mathe-matical accuracy of recorded cash balances, and by examining the details withincutoff bank and DisclosureThe presentation and disclosure assertion addresses whether recorded transac-tions and balances are properly classified, described, and disclosed in the finan-cial statements.

10 Generally, auditors address this assertion by comparing anentity s financial statement presentation and disclosures with those required byGAAP. Presentation and disclosure guidelines, such as the AICPA s annually up-dated Accounting and audit Manual, are often used by practicing auditors to ad-dress this explained in chapter 5, an auditor completes interim audit work by draftingpreliminary year-end audit programs that is, by planning substantive audit pro-cedures, the nature, timing, and extentof which are based on: Detection risk (DR), the likelihood that error could occur and not be detectedby audit procedures, which is based in turn on the auditor s interim assess-ments of two other risks: Control risk (CR), the likelihood that material error could occur and not bedetected by internal control, and Inherent risk (IR), the susceptibility of an account balance to material errorfor which there is no related internal chapter 5 much was made of the role of client strategies and balanced score-cards in the assessment of audit risk.