CH-11 The Revenue, Receivables and Receipts Process – Auditing: An International Approach : Book Guide

CHAPTER 11 The Revenue, Receivables and Receipts Process SOLUTIONS FOR REVIEW CHECKPOINTS 11-1 The basic sequence of activities and accounting in a revenue, receivables and receipts process is: 1. Receiving and processing customer orders. Entering data in an order system and obtaining a credit check. 2. Delivering goods and services to customers. Authorizing release from storekeeping to shipping to customer. Entering shipping information in the accounting system. 3. Billing customers, producing sales invoices. Accounting for customer trade accounts receivable. 4. Collecting cash and depositing it in the bank. Accounting for cash receipts. 5. Reconciling bank statements. 11-2 Risk of material misstatement for revenues include: ⸀ Risks related to the existence and ownership assertions of revenues can arise from aggressive revenue recognition policies, perhaps because of management incentives or pressure to meet performance targets. ⸀ Ownership risks may exist where managers have the ability to transfer funds between related entities under their control. ⸀ Complex sales arrangements that involve multiple deliverables with differing rights of return by customers, or complex revenue recognition situation such as long-term contracts, may also increase the existence and ownership risks, if revenue is recognized too soon. ⸀ Completeness risks relate to recordkeeping and custodial controls over cash receipts; these must ensure that all revenues the business earns are received by the company and recorded in full. Fraudulent misappropriation of cash by employees is a key completeness risk in the revenue process. ⸀ Valuation and ownership risks can exist when substantial revenues are generated in foreign countries. ⸀ Presentation and disclosure risks include revenue recognition policy explanations, reporting significant revenue categories separately, accruals of complex revenue streams such as royalties or long-term contracts, reporting the extent of barter transactions (e.g., in ecommerce), or disclosing contractual commitments to sell inventory at fixed prices. 11-3 When documents such as sales orders, shipping documents, and sales invoices are prenumbered, someone can later account for the numerical sequence and determine whether any transactions have failed to be recorded. (Completeness control objective.) 11-4 Access to computer programs should be controlled so only authorized persons can enter or change transaction data. Access to master data files is important because changes in them affect automatic computer controls, such as credit checking and accurate inventory pricing. 11-5 If the functions of authorizing inventory transfers and recording accounts receivable are done by the same employee, this person has the opportunity to improperly transfer inventory to themselves or someone else fraudulently and cover up the transfer by not recording the account receivable. 11-6 It might be easier just to send the cash to the accounts receivable accountants, but (1) that would delay the bank deposit and the company would lose interest income, and (2) a dishonest accountant could steal cash while still giving the customer credit (to forestall complaints). The accountant could cover the theft by making false debit entries to such accounts as allowance for doubt accounts (account write-offs) or discounts and allowances expense. 11-7 Auditors could examine these files for evidence of: Unrecorded sales -- pending order master file, Inadequate credit checks -- credit data/check files Incorrect product unit prices -- price list master file 11-8 With a sample of customer accounts receivable (1) Find the support for debit entries in the sales journal file. Expect to find evidence (copy) of a sales invoice, shipping document, and customer order. The sales invoice showing recording on the shipping date. This provide evidence that the accounts receivable balance exists, i.e., it is not overstated. (2) Find the support for credit entries in the cash receipts journal file. Expect to find a remittance advice (entry on list), which corresponds to detail on a deposit slip, on a deposit actually in a bank statement for the day posted in the customers' accounts. This provides evidence related to the existence assertions as it establishes that the cash receipt really occurred. The cash receipt reduced the accounts receivable balance, so if they were reduced by non-existent cash receipts it would be understated. So this provided evidence that the account receivable balance is complete, i.e., not understated. 11-9 The account balances in a revenue, receivables and receipts process include: Cash in bank Accounts receivable Allowance for doubtful accounts Bad debt expense Sales revenue Sales returns, allowances, discounts 11-10 These specific control policies and procedures (in addition to separation of duties and responsibilities) should be in place and operating in a control structure governing revenue recognition and cash accounting: (1) no sales order should be entered without a customer order (2) a credit-check code or manual signature should be recorded by an authorized means (3) access to inventory and the shipping area should be restricted to authorized persons (4) access to billing terminals and blank invoice forms should be restricted to authorized personnel (5) accountants should be under orders to record sales and accounts receivable only when all the supporting documentation of shipment is in order, and care should be taken to record sales and receivables as of the date goods and services were shipped, and cash receipts on the date the payments are received (6) customer invoices should be compared with bills of lading and customer orders to determine that the customer is sent the goods ordered at the proper location for the proper prices and that the quantity being billed is the same as the quantity shipped (7) pending order files should be reviewed timely to avoid failure to bill and record shipments (8) bank statements should be reconciled in detail monthly. 11-11 In a "walk through" of a sales transaction, auditors take a single example of a sales transaction and trace it from the initial customer order through credit approval, billing, and delivery of goods, to the entry in the sales journal and subsidiary accounts receivable records, then its subsequent collection and cash deposit. Sample documents are collected and employees in each department are questioned about their specific duties. The information gained from documents and employee; can be compared to answers obtained on an internal control questionnaire. The purpose of the "walk through" is to obtain an understanding of the transaction flow, the control procedures, and the populations of documents that may be utilized in test of controls auditing. 11-12 The two important characteristics of a control test are (1) identification of the data population from which a sample of items will be selected for audit, and (2) an expression of the action that will be taken to produce relevant evidence. In general, the actions used to perform control tests are vouching, tracing, observing, scanning, and recalculating. 11-13 Dual direction test of controls sampling refers to sampling procedures that test file contents in two "directions" -- the validity direction and the completeness direction. The validity direction is a sample from the account balance (e.g., sales revenue) vouched to supporting documents (e.g., sales and shipping documents) for evidence of validity. The completeness direction is a sample from the population that represents all sales (e.g. shipping document files, or withdrawals from perpetual inventory file) traced to the accounting records (e.g., sales journal or sales account) for evidence that no transactions (e.g., shipments, sales) were omitted. The goals of dual-direction testing relate to the first two objectives of internal control, validity and completeness: (1) Validity: all recorded sales revenues (accounts receivable) are valid and documented and (2) Completeness: all valid sales transactions (accounts receivable) that should have been recorded are recorded and none omitted. One direction is to ensure that all recorded debits to accounts receivable represent valid sales on account that actually occurred--the relevant population for sampling to achieve this goal is taken from recorded receivable debits which should be vouched to supporting documents, such as sales invoices. Likewise, a sample of recorded credits to accounts receivable should be vouched to cash receipts documents such as remittance advices and deposits. The other direction is to ensure that all credit sales and cash receipts that occurred were recorded in the receivable records. The relevant populations for sampling to achieve this goal are: (1) evidence of credit sales such as shipping documents, then trace these to the receivable accounts, and (2) evidence of cash receipts such as remittance advices, then trace these to the receivable accounts. 11-14 It is important to place emphasis on the existence and ownership/rights assertions because auditors have often been accused of giving clean, unmodified opinion audit reports on financial statements that overstated assets and revenues and understated expenses. For example, credit sales recorded too early (fictitious sales?) result in overstated accounts receivable and overstated sales revenue; failure to amortize prepaid expense results in understated expenses and overstated prepaid expenses (current assets). 11-15 These procedures are usually the most useful for auditing the existence and ownership/rights assertions: Recalculation. Expired prepaid expenses are recalculated, using auditors' vouching of basic documents, such as loan agreements (prepaid interest), rent contracts (prepaid rent), and insurance policies (prepaid insurance). Goodwill and deferred expenses are recalculated using original acquisition and payment document information and term (useful life) estimates. A bank reconciliation is a special kind of calculation, and the company's reconciliation can be audited. Inspection of Physical Assets. Inventories and fixed assets can be inspected and counted. Titles to autos, land, and buildings can be vouched, sometimes using public records in the county clerk's office. Petty cash and undeposited receipts can be observed and counted. Securities held as investments can be inspected if held on the company's premises. Confirmation. Letters of confirmation can be sent to banks and customers, asking for a report of the balances owed the company. Likewise, if securities held as investments are in the custody of banks or brokerage houses, the custodians can be asked to report the names, numbers, and quantity of the securities held for the company. In some cases, inventories held in public warehouses or out on consignment can be confirmed with the other party. Enquiry. Inquiries to management usually do not provide very convincing evidence about existence and ownership. However, inquiries should always be made about the company's agreements to maintain compensating cash balances (may not be classifiable as "cash" among the current assets), about pledge or sale with recourse of accounts receivable in connection with financings, and about pledge of other assets as collateral for loans. Inspection of Documents -Vouching. Evidence of ownership can be obtained by studying the title documents for assets. Examination of loan documents may yield evidence of the need to disclose assets pledged as loan collateral. Inspection of Documents - Scanning. Assets are supposed to have debit balances. A computer can be used to scan large files of accounts receivable, inventory, and fixed assets for uncharacteristic credit balances. The names of debtors can be scanned for officers, directors, and related parties, amounts for which need to be reported separately or disclosed in the financial statements. Analysis. Comparisons of asset and revenue balances with recent history might help detect overstatements. Relationships such as receivables turnover, gross margin ratio and sales/asset ratios can be compared to historical data and industry statistics for evidence of overall reasonableness. Account interrelationships also can be used in analytical review. For example, sales returns and allowances and sales commissions generally vary directly with dollar sales volume, bad debt expense usually varies directly with credit sales volume, and freight expense varies with the physical sales volume. Accounts receivable write-offs should be compared with earlier estimate of doubtful accounts. 11-16 The following information is requested in a bank confirmation: For Deposit Accounts: Account name Account number Interest rate Balance as of the confirmation date For Direct Liabilities: Account number or description Balance due Date due, repayment terms Interest rate Date through which interest is paid Description of collateral 11-17 A "positive" confirmation is a request for a response from an independent party who the auditor has reason to expect is able to reply. The positive type of confirmation would be used when the auditor requires highly reliable evidence about the existence and valuation of the accounts receivable balance. A "negative" confirmation is a request for a response from the independent party only if the information is disputed. Thus the evidence it provides is much less reliable than that provided by positive confirmations. Negative confirmations should also be sent only if the recipient can be expected to detect error and reply accordingly. 11-18 The response rate for positive confirmations is the proportion of the number of confirmations returned (to the auditor) to the number mailed. The detection rate is the proportion of exceptions reported to the auditors in the responses to the confirmations to the actual number of errors in the accounts that were confirmed (in research studies regarding confirmations). 11-19 Justifications for the decision not to use confirmations for trade accounts receivable in a particular audit include: (1) receivables are not material, (2) confirmations would be ineffective, based on prior years' experience or knowledge that responses could be unreliable, and (3) analytical procedures and other substantive test of details procedures provide sufficient, competent evidence. 11-20 Special care in examining sources of accounts receivable confirmation responses: Auditors need to control the confirmations, including the addresses to which they are sent. Frauds have occurred where confirmations were mailed to company accomplices, who provided false responses. The auditors should carefully consider features of the reply such as postmarks, FAX responses, letterhead, electronic mail address, telephone, or other characteristics that may give clues to indicate false responses. Auditors should follow up electronic and telephone responses to determine their origin (for example, returning the telephone call to a known number, looking up telephone numbers to determine addresses, doing a Google or other internet-based search, or using a business directory to determine the location of a respondent). 11-21 The cutoff bank statement is a bank statement sent by the bank directly to the auditor, and it covers a period following the reconciliation date. The next regular monthly statement could also be used for this purpose. The basic use of the statement by the auditor is to determine whether outstanding cheques were actually mailed before the reconciliation date and outstanding deposits in transit were actually received in a timely manner by the bank. 11.22 The term "lapping" refers to an employee's stealing the cash receipts of a company and then covering the amount with a following day's payment received for another customer's account. A "lapping" operation is possible when a single employee has access to both cash and accounts receivable records. The auditor is alerted to the possibility of a "lapping" operation when there is not a proper separation of duties. Surprise confirmation is the primary means which an auditor can use to uncover such activity. Also, details of deposit slips and cash remittance reports can be compared to detect discrepancies. 11-23 Cheque kiting is the practice of building up apparent balances in one or more bank accounts based on uncollected (float) cheques drawn against similar accounts in other banks. Kiting involves depositing money from one bank account to another, using a hot cheque. Kiting is the deliberate floating of funds between two or more bank accounts. By this method, a bank customer utilizes the time required for cheques to clear to obtain an unauthorized loan without any interest charge. Auditors can detect signs of kiting by observing in the bank statements: - Frequent deposits and cheques in same amounts - Frequent deposits and cheques in round amounts - Frequent deposits with cheques written on the same (other) banks - Short time lag between deposits and withdrawals - Frequent ATM account balance inquiries - Many large deposits made on Thursday or Friday to take advantage of the weekend - Large periodic balances in individual accounts with no apparent business explanation - Low average balance compared to high level of deposits - Many cheques made payable to other banks - Bank willingness to pay against uncollected funds - "Cash" withdrawals with deposit cheques drawn on another bank - Cheques drawn on foreign banks with lax banking laws and regulations If these cash transfers are recorded in the books, a company will show the negative balances that result from cheques drawn on insufficient funds. However, perpetrators may try to hide the kiting by not recording the deposits and cheques. Such maneuvers may be detectable in a bank reconciliation audit. A schedule of interbank transfers can be constructed from the canceled cheques and cleared deposits in the bank statements. This schedule shows each cheque amount, the name of the paying bank (with the book recording date and the cheque clearing date), the name of the receiving bank (with the book deposit date and the bank clearing date). The purpose of this schedule is to see that both sides of the transfer transaction are recorded in the same period (and in the proper period). 11-24 In Audit case 11.1 if someone other than the assistant controller had reconciled the bank statement and compared the details of bank deposit slips to cash remittance reports, the discrepancies could have been noted and followed up. The discrepancies were that customers and amounts on the two did not match. 11-25 To prevent the cash receipts journal and recorded cash sales from reflecting more than the amount shown on the daily deposit slip, the internal control system should provide that receipts be recorded daily and intact. A careful bank reconciliation by an independent person could detect such errors. 11-26 Auditors might have obtained the following information: Enquiries: Personnel admitting the practices of backdating shipping documents in a "bill and hold" tactic, or personnel describing the 60-day wait for a special journal entry to record customer discounts taken. Control test: The sample of customer payment cash receipts would have shown no discount calculations and authorizations, leading to enquiries about the manner and timing of recording the discounts. Observation: When observing the physical inventory-taking, special notice should be taken of any goods on the premises but excluded from the inventory. These are often signs of sales recorded too early. Confirmations of accounts receivable: Customers who had not yet been given credit for their discounts can be expected to take exception to a balance too large. 11-27 The auditors would have known about the normal Friday closing of the books for weekly management reports, and they could have been alerted to the possibility that the accounting employees overlooked the once-a-year occurrence of the year end date during the week. SOLUTIONS FOR EXERCISES AND PROBLEMS EP11-1 Cash Receipts: Control Objectives and Examples General Specific Validity 1. If the remittance advice is not returned, the person opening the mail should prepare one so that each cheque received is represented by a remittance advice. Completeness 2. All cash receipts should be listed from remittance advices. Deposits prepared by a person separate from the one who opens the mail. Subsidiary customer accounts posted from remittance advices. General ledger control account posted from cash receipts journal. Bank statement reconciled independent of other functions. Control account reconciled to subsidiary ledger monthly. Authorization 3. (Authorization is usually not a problem for cash receipts on accounts receivable.) Cash receipts from other than merchandise sales authorized on unique remittance advice forms. Accuracy 4. Daily remittance list compared to duplicate deposit slip received from bank by person independent of either function. Classification 5. Cash receipts entered properly in cash receipts journal as to the origin of the receipts. Separate deposits made for nonmerchandise sales cash receipts. Accounting 6. Monthly reconciliation of control account to customers' individual accounts and bank statement reconciled promptly. Proper period 7. Daily deposit of all cash receipts. Cash receipts recorded as period of date of receipt. Accounts posted as of date cash received. EP11-2 Bank Reconciliation CASH Basic audit procedures that should be performed in gathering evidence in support of each of the items (a) through (f) of the CYNTHIA COMPANY bank reconciliation are as follows: a) Balance per bank * Confirmation by direct written communication with bank (see Standard Bank Confirmation). * Obtain and inspect a January cutoff bank statement obtained directly from the bank (examine opening balance). b) Deposit in transit * Verify that the deposit was listed in the January cutoff bank statement on a timely basis. * Trace to the cash receipts journal. * Inspect the auditee's copy of the deposit slip for the date of the deposit. c) Outstanding cheques * Examine cheques accompanying the January cutoff bank statement and trace all 20x0, or prior, cheques to the outstanding cheque list. * Trace outstanding cheques to the cash disbursements journal. * Examine all supporting documents for those outstanding cheques that were not returned with the cutoff bank statement. * Ascertain why cheque number 837 has been outstanding for so long. d) NSF cheque return * Follow up on the ultimate disposition of the NSF cheques. * Examine all supporting documents. e) Note collected * Examine the bank credit memo. * Trace to accounting records. f) Balance per books * Foot the bank reconciliation to this total and compare with the general ledger balance. EP11-3 Sales cutoff and cutoff bank statements a) The PA's test of the sales cutoff at June 30 should include the following steps: 1. Determine what Houston's cutoff policy is, review the policy for reasonableness, and compare it to the prior year for consistency. 2. Select a sample of sales invoices (including the last serial invoice number) from those recorded in the last few days of June and the first few days of July. 3. Trace these sales invoices to shipping documents and determine that sales have been recorded in the proper period in accordance with company cutoff policy. 4. Determine that the cost of goods sold has been recorded in the period of sale. 5. Select a sample of shipping documents for the same period and trace these to the sales invoice. Determine that the sale and the cost of goods sold have been recorded in the proper period. 6. Review the cutoff for sales returns and allowances, determine that it has been based upon a consistent policy and that there have not been abnormal sales returns and allowances in July; this might indicate either an overstatement of sales during the audit period or the need for a valuation account at June 30 to provide for future returns and allowances. b) 1. The PA will use the July 10 cutoff bank statement in his review of the June 30 bank reconciliation to determine whether: a) The opening balance on the cutoff bank statement agrees with the "balance per bank" on the June 30 reconciliation. b) The June 30 bank reconciliation includes those cancelled cheques that were returned with the cutoff bank statement and are dated or bear bank endorsements prior to July 1. c) Deposits in transit cleared within a reasonable time. d) Interbank transfers have been considered properly in determining the June 30 adjusted bank balance. e) Other reconciling items which had not cleared the bank at June 30 (such as bank errors) clear during the cutoff period. 2. The PA may obtain other audit information by: a) Investigating unusual entries on the cutoff bank statement. b) Examining cancelled cheques, particularly noting unusual payees or endorsements. c) Reviewing other documentation supporting the cutoff bank statement. EP11-4 Alternate accounts receivable procedures The auditor can consider alternative confirmation methods to test the accounts receivable balance, such as confirming individual invoices in the balance. Auditing procedures other than confirmation which may be used to verify an account receivable include: 1. Examination of evidence of subsequent payment of the account including: a) The customer's remittance advice accompanied by the payment. b) The cheque sent in by the customer. c) An authenticated bank deposit ticket listing a deposited cheque for the outstanding account. d) An entry in the cash receipts book. e) A credit posted to the customer's account. 2. Examination of other evidence including: a) Shipping department's notice of shipment, accompanied possibly by a receipted copy of the bill of lading, the customer's purchase order, sales invoices, and any correspondence referring to the shipment of the goods. b) Entries removing the goods from inventory. c) Time records and work orders, if appropriate. 3. External inquiries as to the existence and credit rating of the debtor. 4. Discussion of the account with the auditee's credit manager, examination of credit department records, and records of merchandise returned, and such other investigation as may lead to better understanding of the nature of the account and its collectibility. EP11-5 Accounts receivable audit procedures a) The type of audit procedure is inspection of documents - vouching. The type of evidence created by testing in the this direction is support for the existence of the related account receivable balance at the year end. b) Knowledge of accounting system components, such as the names of books and records use to record cash receipts can be applied to answer this part. The auditor would need to examine the cash receipts journal and post-year-end bank statements and deposit records to verify cash received after year end. EP11-6 Accounts receivable audit procedures a) The importance and reliability of the audit evidence obtained from confirming zero balances needs to be considered against the cost of the procedure. The evidence will be relevant to the completeness of accounts receivable, which often may not be assessed as a high risk assertion for asset accounts such as accounts receivable. b) Confirmation of zero accounts receivable balances would be considered a necessary procedure if the auditor assessed the risk of completeness of accounts receivable assertion to have a high risk of misstatement. The key control weakness would be a lack of effective controls to prevent or detect omitting to record sales. Specific controls procedures to address this risk include using prenumbered shipping documents and verifying continuity, matching procedures for customer orders and bills of lading to invoices, proper segregation of shipping from sales recording, management review of open customer orders. Often companies will have strong controls of this kind in place to prevent failing to invoice valid sales as this is critical to the success of the business, so it is frequently not considered a high risk assertion. Thus the benefit of confirming zero balance accounts receivable often does not exceed the cost. EP11-7 Continuity schedule for allowance for doubtful accounts a) Complete the following continuity schedule indicating how the movements in the allowance for doubtful accounts tie into other amounts in the financial statements Audited amount Financial statement where amount is reported Opening balance of allowance for doubtful accounts Netted off Accounts Receivable, previous year balance, to give A/R at ‘net realizable value’ Add: New bad debts estimate recognized in the year Deduct: Account balances written off as uncollectible Ending balance of allowance for doubtful accounts Netted off Accounts Receivable, current year balance, to give A/R at ‘net realizable value’ b) Audit program for allowance for doubtful accounts: Audit procedures (Assertions addressed) 1. Enquire about and document management’s method of estimation uncollectible accounts. Obtain management’s current analysis and calculation supporting the amount reported in the draft financial statements. Agree management’s amounts to source records and recalculate the estimate to ensure no errors were made by management. Assess the extent to which the auditee’s Allowance provides for the possibility the invoices in each category will turn out to be uncollectible. (Existence, completeness, valuation) 2. Obtain the aged A/R trial balance. Agree the totals to the financial statement A/R balance and working papers for audit testing/confirmation of A/R (Ownership) 3. Scan the aged A/R trial balance for large old items. Ensure all large and high risk items have been audited in the A/R testing. Make specific enquiries of management for all large balances that are more than 90 days overdue (assuming the auditee’s credit terms are a lot less than 90 days). (Existence, completeness, valuation) 4. Develop an independent audit estimate of the Allowance using the following analytical procedures: Analyze the totals in each age category (e.g., current, 30, 60, 90+days) and the percentages that each aging category makes up of the total. Compare the aging totals and percentages to prior year’s amounts. Review the history of account write-offs and collections of overdue accounts. (Existence, completeness, valuation) Perform a continuity analysis that ties the Allowance, the Bad debt expense for the year, and the write-offs into the financial statements Accounts Receivable balances (Presentation) 5. Compare the auditee’s estimate to the audit estimate and resolve any differences. (Existence, completeness, valuation) EP11-8 Cutoff Bank Statement a) The cutoff bank statement is a statement from the auditee’s bank for the period (often one month) immmediately after the period end being audited. It should be obtained directly by the auditor, or if this is not feasible the auditor should have no reason to suspect the one being provided by the client has been altered in any way (if there are suspicions a new bank confirmation should be requested as of the cutoff date to ensure the cutoff bank statement is valid). A bank cutoff statement is used to verify timing difference items in the bank reconciliation audit. Deposits in transit should appear immediately after the period end, and outstanding cheques should also clear in the subsequent period. Sometimes cheques may remain outstanding for longer if the payee doesn’t cash them on a timely basis - in this case supporting documents for those outstanding cheques that were not returned with the cutoff bank statement should be examined to ensure they are valid add-backs to the cash balance. The cutoff bank statement information can also indicate important cash flows out that may indicate unrecorded liabilities at period end, or cash flows in that may indicate unrecorded receivables. Unusual or large cash flows would all be investigated by management enquiry and other procedures as necessary to identify any subsequent events that could affect the financial statements or require disclosure. b) The auditor could also make use of the online access to Velma’s bank accounts. The auditor would enter the company’s access account code to ensure the appropriate account is being accessed. The auditor could then allow the authorized company employee to enter the secret password while the auditor looks away. The auditor could then have full access to the actual bank records online, and effectively control the information from any alteration by the auditee’s personnel since they know the proper account has been brought up online. SOLUTIONS FOR DISCUSSION CASES DC11-1 Internal control questionnaire for book buy-back business cash fund University Books, Incorporated REVOLVING CASH FUND INTERNAL CONTROL QUESTIONNAIRE Question Yes No Is responsibility for the fund vested in one person? Is physical access to the fund denied to all others? Is the custodian independent of other employees who handle cash? Is the custodian bonded? Is the custodian denied access to other cash funds? Are receipts unalterable? Are receipts prenumbered? Is the integrity of the prenumbered sequence periodically accounted for? Does the seller sign receipts? Are receipts attached to reimbursement vouchers? Are vouchers that are submitted for reimbursement approved by someone other than the custodian? Are reimbursement vouchers and attachments (receipts) cancelled after reimbursement? Is the fund used exclusively for the acquisition of books? Is the fund periodically counted and reconciled by someone other than the custodian? Is the fund maintained on an imprest basis? Is the size of the fund appropriate for the purpose intended? DC11-2 Test of controls for cash receipts 9.52 Other Audit Procedures Reason for Other Audit Procedures 1. Source of debit entries in general ledger cash account, other than from cash receipts journal, should be investigated and supporting documents examined. 1. Since the auditor, using standard procedures, only examined the cash receipts journal, he must investigate the validity of all other sources of cash receipts which are not recorded in these journals. 2. A surprise examination of cash receipts should be performed. Prior to the accounts receivable clerk obtaining the cash receipts, the auditor should make a list of them without the clerk's knowledge. The undeposited mail receipts should then be controlled after completion of their preparation for deposit and postings have been made to the subsidiary accounts receivable ledger. The deposit slip should be compared to the remittances for accuracy and totaled. Individual items on the deposit slip should be compared to postings to the subsidiary accounts receivable ledger. The 2. Since there are no initial controls over cash receipts established prior to the time the accounts receivable clerk obtains the cash, a surprise examination is the only method of determining if cash receipts are being recorded and deposited properly. auditor should then supervise the mailing of the deposit to the bank. The auditor should ask Gutzler to ask the bank to send the statement containing this deposit directly to the auditor. 3. Postings from the deposit slips should be traced to the subsidiary accounts receivable ledger. Also, entries in the subsidiary accounts ledger should be traced to deposit slip. 3. Since there is no separation of duties between cash receipts and accounts receivable, the accounts receivable clerk may have been careless in performing her posting duties. This procedure may also disclose whether the accounts receivable clerk may have been lapping the accounts. 4. Review the subsidiary accounts receivable ledger and confirm accounts that have abnormal transaction activity such as consistently late payments. 4. See No. 3 above. 5. If Gutzler allows customers to take discounts, the amount of such discounts and the discount period should be checked. 5. Since there is no separation of duties between cash receipts and accounts receivable, the account receivable clerk may have appropriated discounts which could have been but were not taken or may have been careless in checking the appropriateness of discounts taken. 6. Dates and amounts of daily deposits per bank statement should be compared with entries in the cash receipts journal. 6. Since there are no initial controls over cash receipts established prior to the time the accounts receivable clerk obtains the cash, she may have become careless about prompt deposit of the daily receipts. 7. A proof-of-cash working paper should be prepared which reconciles total cash receipts with credits per bank statement. 7. Since internal control over cash receipts is weak, the auditor should perform this overall check to help substantiate that he has investigated all material items during his detail tests. 8. For those periods for which the above audit procedures were not performed and for a period after the balance sheet date, scan the cash receipts journal and bank statements for unusual items. 8. Since internal control over cash receipts is weak, the auditor should perform this review to help substantiate that he has investigated all material items not covered during his other tests. DC11-3 Cash receipts weaknesses and recommendations Memorandum TO: Board of Directors, The Pottstown Art League FROM: (Student's name) DATE: SUBJECT: Control weaknesses related to Cash Admission Fees You requested a report which identifies the weaknesses in the existing system of cash admission fees and my recommendations. Below are the weaknesses that exist and my recommendations for procedures that overcome these weaknesses. I will be pleased to discuss these at the next board meeting and offer further explanations that may be necessary. Weakness: There is no segregation of duties between persons responsible for collecting admission fees and persons responsible for authorizing admission. Recommendation: One clerk (hereafter referred to as the collection clerk) should collect admission fees and issue prenumbered tickets. The other clerk (hereafter referred to as the admission clerk) should authorize admission upon receipt of the ticket or proof of membership. Weakness: An independent count of paying patrons is not made. Recommendation: The admission clerk should retain a portion of the prenumbered admission ticket (admission ticket stub). Weakness: There is no proof of accuracy of amounts collected by the clerks. Recommendation: Admission ticket stubs should be reconciled with cash collected by the treasurer daily. Weakness: Cash receipts records are not promptly prepared. Recommendation: The cash collections should be recorded by the collection clerk daily on a permanent record that will serve as the first record of accountability. Weakness: Cash receipts are not promptly deposited. Cash should not be left undeposited for a week. Recommendation: Cash should be deposited at least once each day. Weakness: There is no proof of accuracy of amounts deposited. Recommendation: Authenticated deposit slips should be compared with daily cash collection records. Discrepancies should be promptly investigated and resolved. In addition, the treasurer should establish a policy that includes an analytical review of cash collections. Weakness: There is no record of the internal accountability of cash. Recommendation: The treasurer should issue a signed receipt of all proceeds received from the collection clerk. These receipts should be maintained and should be periodically checked against cash collection and deposit records. DC11-4 Control Weakness: Shipping and billing Weaknesses Recommendations Lack of segregation of duties The billing clerk both enters sales data and checks the output. There is a risk that errors will not be detected when a person is checking his or her own work. There is an opportunity for shipper and billing clerk to cover up unauthorized shipments since no one but the billing clerk checks that valid invoices are issued for every shipment. Deficient documentation Need documentation of flowcharts, program changes, systems software, testing. Lack of control totals Error-checking validations need control totals for effective operation. No computer price list For manual entry process, clerk should not need to enter the sales price. It should be in a database. Numerical sequence The computer should be used to check numerical sequence. Control total The billing clerk's control total of sales should be used to compare to total sales processed by the computer. Customer accounts The computer system should be used to maintain customer accounts instead of using a manual open invoice file. b) Shipping clerks could enter the date, customer identification, shipment quantities, and product identification numbers in a terminal. Then the computer system could automatically produce a sales invoice. Controls include: Autoclock date checking Self-checking customer identification numbers Self-checking product identification numbers Terminal batch hash total of customer ID numbers Automatic numbering of sales invoices Authorized price list in database Control total comparison of hash ID numbers in run-to-run totals DC11-5 Bank reconciliation - cash shortage a) Cash balance, per books November 30 $18,901.62 Add: Credit by bank 100.00 Adjusted cash balance (on hand and in bank) $19,001.62 Less adjusted bank balance: Bank balance, November 30$15,550.00 Less outstanding cheques, 6500 $116.25 7126 150.00 7815 253.25 8621 190.71 8623 206.80 8632 145.28 1,062.29 14,487.71 Cash which should be on hand for deposit $ 4,513.91 Cash deposit reported 3,794.41 Amount of theft $ 719.50 The minimum amount of the theft is $719.50 if the cash reported as "undeposited receipts" ($3,794.41) was actually on hand, represented November receipts, and was deposited intact in December. If the $3,794.41 was not available to deposit or represented December receipts, the maximum loss could be $4,513.91 (719.50 + 3,794.41) for November. Such a shortage (minimum or maximum) for November and the attempt to conceal the shortage would alert the auditors to examine the bank reconciliations throughout the year for other concealed shortages. b) He attempted to conceal his theft by: 1. Not listing all outstanding cheques. 2. Miscalculating the outstanding cheques shown on the reconciliation. 3. Subtracting an item from the bank balance that should be added to book balance. c) 1. No one other than the cashier is responsible for tracing cash receipts to the deposits in the bank. 2. The cashier is also responsible for preparing the bank reconciliation. d) The following auditing procedures on December 5 would uncover the theft if the October 31 reconciliation is known to be correct: 1. Compare cheques returned since October 31 with cheques outstanding at that time and with cheque register for November in order to ascertain outstanding cheques. 2. Trace cash on hand at October 31 as well as receipts during November to deposits in bank, ascertaining undeposited cash at November 30. 3. Count cash on hand on December 5, and by adding deposits since November 30 and subtracting receipts since November 30 to develop cash on hand at November 30. 4. Compare adjusted cash on hand developed in count (Step 3) with undeposited cash ascertained in tracing (Step 2). DC11-6 Receivables audit procedures The procedure followed appears to be appropriate except that the examination of detail transactions for three months might be considered to be excessive in view of the exceptionally good internal control. A lighter test of such transactions, designed to test the effectiveness of the control procedures, might be devised. The procedures followed should be supplemented by the following: 1. Review the company's method of sales cutoff at year-end and test billings and shipments (including returns) for an adequate period before and after year-end to establish that cut-off procedures have been adhered to. 2. Examine collections in early part of subsequent period to determine if a substantial portion of the receivables has been collected. 3. Examine agreements entered into with the distributors. If price protection clauses are included, review the current price position and distributor inventory positions to determine whether a reserve for such protection is needed. 4. When a company deals with a limited number of customers, it is dependent upon the continued solvency of all such customers. 5. Obtain a representation letter from appropriate company officials covering the receivables. DC11-7 Rent revenue To audit the schedule of Rent Reconciliation prepared by the controller of CLAYTON REALTY CORPORATION, you would perform the following procedures for those items marked by an asterisk: To substantiate the validity of gross apartment rents, you would-- * Physically examine the rental property or review architectural blueprints to ascertain the total number of rental units. * Compare the total number of validated rental units with the total number of rent charges on the schedule of gross apartment rents (Schedule A). * For occupied units, vouch the individual apartment rental charges per lease agreements to the individual rental charges on Schedule A. * For unoccupied (vacant) units, ascertain the reasonableness of the scheduled rent (by reference to the last rent paid, by reference to comparable rent charges for similar units, etc.). * Foot the gross apartment rent schedule (Schedule A) and compare the total with the figure indicated on the rent reconciliation. To substantiate the validity of the vacancies, you would-- * Physically examine the apartments that were vacant during the month. * Compare the rental charge (validated in the gross apartment rents procedures above) for each vacant apartment with the schedule of vacancies (Schedule B) * Foot the schedule of vacancies (Schedule B) and compare the total with the total indicated on the rent reconciliation. To substantiate the validity of unpaid January rents, you would-- * Trace unpaid rents from individual tenant apartment ledger cards to Schedule C. * Foot the unpaid rents schedule (Schedule C) and compare the total with the amount shown on the rent reconciliation. * Examine the collection file for evidence of collection attempts. * Request written confirmations from tenants with accounts in January arrears. To substantiate the validity of the prepaid rent collected, you would -- * Trace the receipt to the individual tenant apartment ledger card. * Compare the amount collected with the lease terms. To substantiate the validity of the cash collected, you would -- * Foot the auditee-prepared rent reconciliation. * Reconcile the cash receipts per the rent reconciliation with the books and records. * Confirm and reconcile the special bank account balance. DC11-8 Business risk, audit evidence, sales detail The case presents a situation where the company management has incentives to meet certain financial statement targets and this may motivate them to take actions or make accounting choices that have an impact on their financial statements. The auditor is looking for objective evidence to support the financial statement numbers that management has prepared. Points that can be discussed include the following. a) Harrier’s business risks include the risk that sales will not be adequate to cover fixed costs of production capacity, that competitors will be able to make better/cheaper machines, that financing will not be available to permit the long lead time needed to produce the machines, etc. Once sales are made there are risks that the costs of making the machines will exceed the sales revenues that the machines will not work properly in the customers’ factories that warranty costs will eat up profits, etc. The risks of financial statement misstatement that Rosella should consider arise mainly from various important issues that depend on financial statement numbers. First, if the debt covenants are not met this can impose constraints on the business, limit its operating choices, reduce management compensation/bonuses and make it more difficult to raise additional debt financing in future. When the business is not doing well, the debt covenant constraints will create an incentive for Harrier’s management to make aggressive choices in preparing their financial statement so they can ‘make the numbers’. b) Rosella is applying knowledge of the business operation to perform analysis procedures. In particular, the knowledge of the business indicates certain operating factors that determine what results are reasonable and attainable (maximums). She is also trying to support the sales figure by analyzing monthly data trends, and making comparisons to prior periods and to related amounts such as gross profit and engineers’ travel expenses. These procedures can provide evidence about validity and completeness of sales. c) The findings suggest that the company has experienced a large increase in orders and is attempting to meet these orders with its current production capacity. Alternately, given the debt covenants and bonuses, management may be trying to push next year’s sales out the door before they are finished so they can recognize revenue in the current year to avoid missing key targets. This can distort gross profit since not all costs have been incurred at the time of shipment, and since the costs (such as engineers travelling to customer sites and shipping components that would normally be installed at Harrier’s factory before shipping) are not a usual part of production there may be no procedures in place to identify and accrue for them. Various conclusions are possible depending on the interpretation of the case facts, any assumptions made and how this is all analyzed. One possible conclusion might be that, to be consistent with Harrier’s usual revenue recognition policy, the December sales of machines that required significant further work at the auditee’s factory should not be recognized until a reasonable estimate of costs to complete is known, which does not occur till the following year. Alternately, if the sales are recognized an estimate of the unusual extra costs of completing them after year end should be accrued. Either option would reduce the current year profit, and thus have implications for meeting debt covenants and management bonuses. d) With this recognition policy it is possible that the facts support revenue recognition. It appears machines were loaded and titled transferred to customer before year end. In any case, this can be verified with examination of relevant documents and confirmation of customer receivables. The possibility of current income being overstated still exists, but this may be due to a problem of completeness of liabilities (i.e., ‘warranty’ costs of getting the machines working at the customers’ premises) rather than validity of sales. Other valid points can be discussed. DC11-9 Negative confirmations The case requires one to consider risks in a stock brokerage business and evaluate the appropriateness of negative confirmations as audit evidence. A possible approach to the analysis is as follows. a) The main inherent risk is failing to record a customer stock transaction correctly, or omitting recording it. This would result in invalid or incomplete information in the customer’s account. Given that marketable securities are involved, there is also a fairly high risk of fraud by misappropriation of customer funds or investments. Regulatory non-compliance is another consideration. Given the types of inherent risks to be controlled, strong controls are required over authorization/ownership, completeness and validity of customer trades and account balances. There is also the risk that customers will provide incorrect information and the need to keep records of customer telephone orders and instructions, issue confirmations, and verify customer account details regularly. The external audit in this situation can complement internal controls by providing a further check on validity, completeness and authorization/ownership. b) Negative confirmations are relatively inexpensive and a large percentage of the customer population can be queried. While a weakness is the low response rate, and the inability to know if non-responses would have indicated errors, they do get at the key concern that customer assets have been misappropriated by the stock brokerage firm since customers are more likely to respond when their accounts are incomplete. DC11-10 Substantive testing for sales Procedures that would be appropriate include: a. 1. Select a sample of sales from the sales journal and vouch to the sales invoice and then to the shipping document. Any credit sale not shipped is not a valid sale. 2. Trace cash sale invoices to cash receipts journal or bank deposit. Any sale recorded as a cash sale but not paid for would likely not be a valid sale. b. 1. Select a sample of shipping invoices and trace to sales invoice and then to sales journal, to find any sales shipped but not recorded in the sales journal. 2. Trace cash deposits for last week before year end to sales journal to find unrecorded sales. (Source: CGA-Canada AU1 Examination, June 2011) DC11-11 Test of Controls The auditors should perform dual-direction sampling to test the processing of cash receipts. Validity direction: Select a sample of receivables from the computer file, and vouch: 1. charges to the appraisal record, recalculate the amount using the authorized tax rate and 2. payments, if any, to the cash receipts journal and bank deposits. (Note that this procedure would not reveal any exceptions because Shelstad had altered the records to cover up the fraud.) Completeness direction: Select a sample of properties from the appraisal rolls, and determine that tax notices had been sent and tax receivables(charges) recorded in the computer file. Select a sample of cash receipts reports, vouch them to bank deposits of the same amount and date, and trace the payments forward to credits to taxpayers’ accounts. Select a sample of bank deposits, and trace them to cash receipts reports of the same amount and date. In one of these latter two samples, compare the details on bank deposits to the details on the cash receipts reports to determine whether the same taxpayers appear on both documents. (These procedures should reveal the exceptions of counter cash receipts not appearing in the receivables records or bank deposits. This suggests the auditors who did the work in April were not thorough in performing these procedures, or had been persuaded by Shelstad to do testing that missed the stolen payments.) Audit of Balance Confirm a sample of unpaid tax balances with taxpayers. Response rates may not be high, and follow-up procedures determining the ownership (property title files) may need to be performed, and new confirmations may need to be sent. Information that could have been obtained from confirmations directed to the real population of delinquent accounts receivable (i.e., including the ones that had been stolen by Shelstad) - The confirmation sample would likely include taxpayers who had actually paid their taxes, and their response would have contained exceptions, complaints, and people who could produce their counter receipts to prove they had paid. These results likely would reveal the embezzlement. The auditors who did the audit in April appear to have relied too much on Shelstad’s recommendations of which records to use to select their sample - showing the importance of auditor skepticism and why management enquires do not provide sufficient evidence that no misstatements or fraud have occurred.) Determine that proper disclosure is made of the total of delinquent taxes and the total of delinquencies turned over to the region’s legal counsel for collection proceedings. The main procedures that will detect the fraud is confirmation of taxpayers who had paid but Shelstad stole their payments and did not credit their account, and the tracing from the cash receipts book to the accounts receivable credit transactions and the bank deposit records. This should allow the auditors to determine the correct amount of receivables (actual delinquent taxes) that should be reported. More thorough external auditors should be able to detect Shelstad’s scheme. Also, the new managers of the Regional tax district should be able to discover the fraud on taking over the tax assessment-collection office. They would not be influenced by Shelstad since he had resigned, and will question the discrepancy between the delinquent taxes in the audited amount reported and the lower amount turned over to the Region for collection. Also, since the computer file was not usable, to collect the overdue taxes they would have to use the printed book of tax notices, where paid accounts had been marked “paid” (Shelstad had not marked the stolen ones “paid” so the printed book would agree with the computer file.) When they start sending tax due notices to the taxpayers showing with “unpaid” balances, and those taxpayers begin to show up bringing their counter receipts, and loud complaints, the scheme would become evident. DC11-12 The response requires a memo to the audit file, for the engagment partner to review. The memo should discuss planning considerations for the audit of the consolidated financial statements, the risk assessments and materiality decisions for the overall audit strategy. The response also should focus on the specific risks for revenues and the related accounting issues that the auditor will need to verify to assess whether GAAP are being complied with. The student’s response should demonstrate the following competencies: – Analyzes, evaluates and advises on assurance needs – Evaluates the implications of key risks and business issues for the assignments – Determines which rules, standards or policies to apply to the subject matter being evaluated CAS Guidance: In applying CASs , note the need to assess whether the financial statement framework chosen by the client (current Canadian GAAP) that will be applied in the preparation of the financial statements is acceptable; in other words, whether the preconditions for performing an audit are met by the client (CAS 210) and if the audit fits within general purpose financial statements or specific purpose financial statements (CAS 200).) – Develops guidelines to set the extent of assurance work, based on the scope and expectations of the assignment – Designs appropriate procedures based on the assignment’s scope, risk and materiality guidelines An example memo follows: Memo to: File Subject: Planning the 2010 engagements for BSL company In the past, we have audited the Brennan and Sons Ltd. (BSL) financial statements. For the current year, we will be performing an audit of the consolidated statements for the BSL group of companies. BSL has not requested a report from us for its unconsolidated financial statements. We will need individual engagement letters, management representation letters, and independence letters for all of the legal entities we have been asked to work on. In addition to the engagement considerations for BSL and its subsidiaries, we will need to discuss new accounting policies for the consolidated group, since there have been significant changes in the operations of BSL over the past year. Though the adoption of the CICA Accounting Standards for Private Entities, ASPE is not yet required (at the period this audit simulation is set) - it would be advisable for BSL to early adopt it at the same time it is getting its financial statements audited, so the following is based on ASPE being the applicable financial reporting framework for auditing purposes, with references to the prior Canadian GAAP when they are useful. Risks Engagement Risk Factors — The Entity and its Environment We will be auditing a set of consolidated financial statements for the first time for this client. Since it will be the first time the client will perform a consolidation, the consolidated financial statements may contain errors as a result of the client’s inexperience. We will have to carefully scrutinize the statements to ensure the consolidation has been done correctly. There are two new subsidiaries for which all the intercompany transactions and intercompany balances have to be eliminated. Additional scrutiny to identify the related party transactions will be required. In addition, the treatment of the noncontrolling interest will have to be verified. This is the first time BSL has had to account for outside ownership, so there could be errors here as well. Regarding the newly formed companies: Brennan Transport Ltd. (Transport) and Brennan Fuel Tank Installations Inc. (Tanks): While we are fairly familiar with the nature of the business of Transport, since BSL used to perform these operations, we will need to make sure there have been no significant changes to the business. Tanks, however, is a completely new company and new business area, and it involves new outside ownership: 25% is owned by Sean Piper, whom we have never dealt with before. We will need to gain an understanding of the industry, the business, and management. The nature of the business — fuel tank installation and maintenance — creates an environmental risk, which needs to be considered as part of the engagement planning. BSL has a new mortgage in place related to the new land and building, and it is substantially more than the old mortgage amount. The bank is most likely using the consolidated financial statements to assess the financial stability of BSL as a whole. This adds additional risk to our audit engagement. We will need to get a copy of the new banking agreement to ensure all conditions and covenants are met, to gain an understanding of the pledge arranged for the assets, and to obtain details that will allow us to properly disclose the nature of the debt in the notes to the consolidated financial statements. We should also obtain copies of the vendor contracts related to the sale and subsequent purchase of land and building as a way of validating the proceeds, etc. (Note: In their responses students should comment on specific new risk factors affecting the current year, using simulation facts to support the comments and concluding appropriately regarding the level of engagement risk. If they do not use case facts to support their risk assessments, it will make for a difficult time providing any depth of analysis.) Materiality The audit engagement will need its own level of overall materiality (see CAS 320 and AuG-41). The common range for private companies is 5% to 10% of net income. Although BSL’s net income this year is much higher than it was last year, this is mostly due to the gain on sale of the land and building. This is a non-recurring event and it is not appropriate to increase materiality on that basis. I suggest using a materiality that is based on income before other income, which is much lower for the consolidated company. The range would be between $28,350 and $57,000 ((income before other income of $473,000 for BSL + $44,000 for Transport + $50,000 for Tanks = $567,000) @ 5% to 10%), noting that none of the intercompany transactions have been eliminated yet. This range is significantly less than last year’s materiality of $70,000 ($1.1 million °— 5% to 10% = $55,000 to $110,000). The audited consolidated statements will be used by both management and the bank. Since the mortgage amount is much larger than the previous year, the bank will likely be relying quite heavily on the financial statements to assess the financial strength of BSL and its subsidiaries. For this reason, materiality should be set at the lower end of the established range; that is, at 5% of net income before income taxes — perhaps $25,000. As a result, there may be an issue with the audit of opening balances because BSL was audited to a higher materiality level ($70,000 per the audit file) for the 2009 year-end. Work will have to be done on the opening balances using the new materiality level, to ensure they are not materially misstated. Based on the nature of the opening balances, it should be possible to do so. (Note: Students should attempt a discussion and calculation of materiality for the audit engagement. However, their analyses should consider the significance of the current debt load. In addition, they should recognize that materiality should be lower this year. Their calculations may instead result in a higher materiality than the previous year (if their calculations did not remove the nonrecurring gains on the sale of equipment and property from net income). It is important to step back and assess the results of their quantitative analysis in light of their qualitative comments to ensure that the conclusions are consistent.) (CAS Guidance: Guidance under CAS 315 and 320: Students should discuss setting a planning materiality for the financial statements as a whole and possibly setting different materiality levels for particular classes of transactions or account balances, like the intercompany transactions. Students may also mention performance materiality and may comment on the fact that it may change once the audit begins. The actual calculation discussions would be similar based on the following: CAS 320 A4 — Examples of benchmarks that may be appropriate, depending on the circumstances of the entity, include categories of reported income such as profit before tax, total revenue, gross profit and total expenses, total equity or net asset value. Profit before tax from continuing operations is often used for profit-oriented entities. When profit before tax from continuing operations is volatile, other benchmarks may be more appropriate, such as gross profit or total revenues. CAS 320 A7 — Determining a percentage to be applied to a chosen benchmark involves the exercise of professional judgment. There is a relationship between the percentage and the chosen benchmark, such that a percentage applied to profit before tax from continuing operations will normally be higher than a percentage applied to total revenue. For example, the auditor may consider five percent of profit before tax from continuing operations to be appropriate for a profit-oriented entity in a manufacturing industry, while the auditor may consider one percent of total revenue or total expenses to be appropriate for a not-for-profit entity. Higher or lower percentages, however, may be deemed appropriate in the circumstances.) Specific Risk Areas and Suggested Approach Accounting Considerations to Consider when Planning the Engagements Given the changes at BSL during the year, new accounting treatments will be applied. It appears that Jack has incorrectly handled some of the new situations from an accounting perspective. Because the changes typically affect more than one of the companies, they have been discussed from a transactional level rather than an entity level. Fuel Tank Installation Sales [Note that the following discussion presents a detailed analysis of the accounting for revenue in this audit situation, so this analysis may be considered as an additional advanced element of the repsonse, as it goes beyond simply identifying the problem, i.e., that the auditors will need to ensure the revenue accounting is in accordance with the applicable financial reporting framework] Revenue — Multiple deliverables The revenue generated from selling the installation and maintenance package possibly has three distinct streams of revenue: the revenue related to the fuel tank sale, the delivery and installation service of the fuel tank at the client’s site, and the five-year ongoing maintenance contract for the fuel tank. The total revenue that will be derived from the sale of the entire fuel tank package is $40,000. Assuming that ASPE is the financial reporting framework to be used, the recommendations of section 3400 are relevant to revenue recognition. It may also be noted that BSL has different sources of revenues, and further guidance on this situation can be obtained from EICs (not part of ASPE but can be considered if relevant and useful for ensuring fair presentation). According to EIC-142 Revenue Arrangements with Multiple Deliverables, “If there is objective and reliable evidence of fair value for all units of accounting in an arrangement, the arrangement consideration should be allocated to the separate units of accounting based on their relative fair values.” In this case, we would need to determine if the tank itself, the delivery and installation costs, and the maintenance package represent separate units of accounting. According to EIC-142, the items are considered as separate units of accounting if 1. The item has value to the customer on a stand-alone basis; 2. There is objective and reliable evidence of the fair value of the item; and 3. The items include arrangements with respect to general rights of return (if applicable). ***[Note: EIC-175 (effective January 1, 2011) can be e considered. This EIC also addresses whether an arrangement involving multiple deliverables contains more than one unit of accounting and is slightly different. Under EIC-175, in an arrangement with multiple deliverables, the delivered item (or items) should be considered a separate unit of accounting if both the following criteria are met: (a) The delivered item has value to the customer on a stand-alone basis. That item has value on a stand-alone basis if it is sold separately by any vendor or the customer could resell the delivered item on a stand-alone basis. In the context of a customer's ability to resell the delivered item, this criterion does not require the existence of an observable market for that deliverable. (b) If the arrangement includes a general right of return relative to the delivered item, delivery or performance of the undelivered item is considered probable and substantially in the control of the vendor.]*** EIC-142 states: “Contractually stated prices for individual products and/or services in an arrangement with multiple deliverables should not be presumed to be representative of fair value. The best evidence of fair value is the price of a deliverable when it is regularly sold on a stand-alone basis.” ***[Note: EIC-175 contemplates a different method of calculation. EIC-175 states: “Arrangement consideration should be allocated at the inception of the arrangement to all deliverables based on their relative selling price (the relative selling price method), except as specified in the next two paragraphs. When applying the relative selling price method, the selling price for each deliverable should be determined using vendor-specific objective evidence of selling price, if it exists, otherwise third-party evidence of selling price (as discussed in the first paragraph under "Selling price" of this section).” In this particular case students were not given the price of the installation, only of the tank. They would need to come up with the value for each deliverable to meet requirements of EIC-175. Students need to identify that they do not have all the information necessary if they were in the context of EIC- 175.]*** Fair value of delivery and installation Based on the information provided by Jack, Tanks doesn’t sell the tank without installing it. However, other vendors sell the installation separately from the tank, for the same tanks. Therefore, a fair value can be established for the delivery and installation component. Fair value of maintenance contract The value of the maintenance package can be calculated as follows: 5 years at $5,000 per year (fair market value), which totals $25,000. Therefore, if the total revenue generated from the sale of one tank is $40,000, $15,000 should be allocated to the sale and installation of the unit and $25,000 should be allocated to the maintenance package. The maintenance contract therefore appears to meet the criteria to be considered a separate unit of accounting and should be accounted for as such. The value allocated to the maintenance package should be accounted for as deferred revenue. The amounts will be brought into income as the maintenance services are rendered over time (EIC-143). ASPE This response is assuming BSL would be choosing to early adopt the provisions under ASPE. The revenue recognition standards remain the same under ASPE as under the previous Canadian GAAP. However, the EICs noted above have been merged into Section 3400. Breaking the sales contract into components and deferring maintenance are discussed in paragraph 11 (replacing EIC-142 and EIC-143). 3400.11 The recognition criteria in this Section are usually applied separately to each transaction. However, in certain circumstances, it is necessary to apply the recognition criteria to the separately identifiable components of a single transaction in order to reflect the substance of the transaction. A single sales transaction may involve the delivery or performance of multiple products, services, or rights to use assets, and performance may occur at different points in time or over different periods of time. In some cases, the arrangements include initial installation, initiation, or activation services and involve consideration in the form or a fixed fee or a fixed fee coupled with a continuing payment stream. For example, when the selling price of a product includes an identifiable amount for subsequent servicing, that amount is deferred and recognized as revenue over the period during which the service is performed. Conversely, the recognition criteria are applied to two or more transactions together when they are linked in such a way that the commercial effect cannot be understood without reference to the series of transactions as a whole. For example, an entity may sell goods and, at the same time, enter into a separate agreement to repurchase the goods at a later date, thus negating the substantive effect of the transaction. In such a case, the two transactions are dealt with together. Revenue-Recognition — Delivery and Installation Delays We also need to consider the fact that delivery and installation are delayed and only happen two to three weeks after the agreement is signed. Prior to ASPE EIC-141 — Revenue recognition says performance should be regarded as having been achieved when all of the following criteria are met: a) persuasive evidence of an arrangement exists; b) delivery has occurred or services have been rendered; and c) the seller’s price to the buyer is fixed or determinable. In this case, there is a signed agreement, but delivery and installation are delayed (two to three weeks later), so Tanks cannot recognize the revenue at the point of signing the contract. It must wait until terms of the contract are fulfilled — in other words, the point of customer acceptance, which in this case is when the tank is installed and working — to recognize the revenue. ASPE Under ASPE, the provisions related to the timing of delivery are discussed in paragraph 9 of Section 3400. .09 Generally, delivery is not considered to have occurred unless the product has been delivered to the customer's place of business or another site specified by the customer. Some of the aspects of the revenue arrangement an entity would consider in determining if delivery has occurred or services have been rendered are as follows: (a) bill and hold arrangements; (b) customer acceptance of product; (c) layaway sales arrangements; (d) non-refundable fee arrangements; and (e) licensing and similar fee arrangements. (Students may conclude that revenue could not be recognized when the sales agreements are signed; however, their discussions as to why that recognition would not be appropriate should not be limited to commenting that performance had not yet been achieved. More thorough discussions should apply simulation facts regarding the delay between signing and delivery and installation.) (Source: CICA - Uniform Final Evaluation Report - 2010, adapted) Solution Manual for Auditing: An International Approach Wally J. Smieliauskas, Kathiryn Kate Bewley 9780071051415