2. Fraud Risk Related to the Revenue Cycle

There should be a presumption in every audit that there is the risk of material misstatement due to revenue recognition fraud. Common revenue cycle frauds include:

• Early revenue recognition.

• Holding the books open past the close of the accounting period.

• Fictitious sales.

• Failure to record sales returns.

• Side agreements used to alter sales terms and conditions to induce customers to accept goods and services they otherwise do not need.

• Channel stuffing achieved by convincing distributors to purchase more inventory than they can sell in the near term.

• Overstatement of receivables, achieved by overstating balances, reporting fictitious balances, or understating the allowance for uncollectible accounts.

3. Internal Controls Related to the Revenue Cycle

3.1. Sales

Under strong internal control, segregation of the functions in a sales transaction should exist as follows:

1. Preparation of the Sales Order

2. Credit Approval

3. Shipment

4. Billing

5. Accounting

3.2. Accounts Receivable

Under strong internal control, segregation of the functions in an accounts receivable transaction should exist as follows:

1. Sales

2. Collection of Cash Receipts

3. Uncollectible Receivables

4. Sales Returns

5. Sales Discounts

3.3. Cash Receipts

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 the following personnel:

1. Cashier

2. Accounts Receivable Department

3. Accounting Department

4. Performing Specific Procedures to Obtain Evidence: The Revenue Cycle

4.1. Auditing Sales Transactions

The following tests of details may also be performed as tests of controls or dual-purpose tests. The cutoff procedure is performed most often as a substantive procedure.

• Completeness

• Cutoff

• Valuation, Allocation, and Accuracy

• Existence and Occurrence

• Understandability of Presentation and Classification

4.2. Auditing Accounts Receivable

• Completeness

• Valuation, Allocation, and Accuracy

• Existence and Occurrence

• Rights and Obligations

4.3. Accounts Receivable Confirmations

The auditor should review the accounts receivable schedule for accuracy and collectibility. Confirmation of accounts receivable is a required generally accepted auditing procedure unless: (i) receivables are immaterial; (ii) confirmation would be ineffective; or (iii) inherent and control risks are very low and evidence provided by other procedures is sufficient to reduce audit risk to an acceptably low level. If confirmations are not sent, the auditor must document how omission of this procedure was alternatively tested.