Auditors assess internal controls to determine how well an organization prevents or detects material misstatements in the revenue and collection cycle. Proper internal control activities align with relevant assertions such as occurrence, completeness, cutoff, existence, and valuation.
The following are important internal controls designed to mitigate risks of material misstatement:
Risk: Management may overstate revenue by recording fictitious transactions or inflating sales.
Controls:
Require supporting customer purchase orders for all invoices.
Verify shipping documents (bills of lading) before recording sales.
Review sales account entries to ensure they are backed by legitimate invoices.
Risk: Sales transactions may not be recorded, leading to understated revenue.
Controls:
Use prenumbered invoices and shipping documents to track all transactions.
Review pending orders regularly to identify unbilled shipments.
Perform cutoff tests to ensure transactions are recorded in the correct period.
Risk: Revenue may be recorded in the wrong accounting period.
Controls:
Compare shipping dates to invoice dates.
Examine FOB terms on shipping documents to determine when ownership transfers.
Check for sales returns after year-end that should be deducted from current-period revenue.
Risk: Accounts receivable may be overstated due to fake or premature sales.
Controls:
Match sales orders and shipping documents with recorded accounts receivable.
Use customer confirmations to verify outstanding balances.
Review bad debt write-offs for unusual patterns.
Risk: Uncollectible accounts may not be properly estimated.
Controls:
Perform credit checks before approving sales on account.
Regularly review and update the allowance for doubtful accounts.
Monitor collection history and aging reports for overdue balances.
Auditors evaluate internal controls through:
Walkthroughs – Tracing transactions from start to finish.
Testing segregation of duties – Ensuring different employees handle authorization, recording, and custody.
Dual-direction testing:
Vouching: Select recorded sales and check supporting documentation.
Tracing: Select shipments and verify they are recorded as sales.
By ensuring these internal controls are in place and effective, auditors can reduce the risk of material misstatement in financial statements.