Chapter 14: Audit of the Sales and Collection Cycle:

Tests of Controls and Substantive Tests of Transactions

 Concept Checks
P. 462
1. a. The customer order is a request from the customer indicating the
quantity and the description of the merchandise ordered.
b. A sales invoice is a document indicating the description and
quantity of goods sold, the price including freight, insurance,
terms, and other relevant data. It is the method of indicating to the
customer the amount owed for the sale and the due date of the
payments. The original is sent to the customer and an electronic
copy is retained. The sales invoice is the document for recording
sales in the accounting records.
c. A prelisting of cash receipts is a list prepared when cash is
received by someone who has no responsibility for recording
sales, accounts receivable, or cash and who has no access to
accounting records. It is used to verify whether cash received was
recorded and deposited at the correct amounts and on a timely
basis.
d. The monthly statement to customers is the document prepared
monthly and sent to each customer indicating the beginning balance
of that customer’s accounts receivable, the amount and date of
each sale, cash payments received, credit memos issued, and
the ending balance due. It is, in essence, a copy of the customer’s
portion of the accounts receivable master file.
2. A shipping document is prepared at the time of shipment indicating
the quantity and description of goods ordered. It is used to generate
an invoice to the customer. Assuring that all shipments are recorded
and billed is important to addressing the completeness assertion, as
well as the accuracy of the quantities billed.
P. 473
1. The following are the three main authorizations in the sales cycle:
1. Credit is authorized before a sale takes place.
Credit approval is critical to ensure that goods are only
shipped to customers who can pay for the goods.
2. Goods are shipped only after proper authorization.
This authorization is to verify that goods are only shipped to
valid customers who can pay.
3. Prices, including payment terms, freight, and discounts, are
properly authorized.
Prices are authorized to ensure that customers are charged
the appropriate price consistent with company policy.
2. The following are the transaction-related audit objectives for sales and
examples of internal controls that can reduce the likelihood of
misstatements.

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 TRANSACTION-RELATED
AUDIT OBJECTIVE KEY INTERNAL CONTROLS
1. Recorded sales are for  Recording of sales is supported by authorized
shipments made shipping documents and approved customer
to existing customers orders.
(occurrence).  Credit is authorized before shipment takes
place.
 Sales invoices are prenumbered and properly
accounted for.
 Only customer numbers existing in the
computer data files are accepted when they
are entered.
 Monthly statements are sent to customers;
complaints receive independent follow-up.
2. Existing sales  Shipping documents are prenumbered and
transactions are recorded accounted for.
(completeness).  Sales invoices are prenumbered and
accounted for.
3. Recorded sales are for  Determination of prices, terms, freight, and
goods shipped and are discounts is properly authorized.
correctly billed and  Internal verification of invoice preparation.
recorded (accuracy).  Approved unit selling prices are entered into
the computer and used for sales.
 Batch totals are compared with computer
summary reports.

4. Sales transactions are  Regular monthly statements sent to

properly included in the customers.
accounts receivable master  Internal verification of accounts receivable
file and are correctly master file contents.
summarized (posting and  Comparison of accounts receivable master file
summarization). or trial balance with general ledger balance.
5. Sales transactions are  Use of adequate chart of accounts.
properly classified  Internal review and verification of the account
(classification). classifications.
6. Sales are recorded on the  Procedures requiring billing and recording of
correct dates (timing). sales daily as close to the time of occurrence
as possible.
 Internal verification of timely recording of
transactions.

7. Sales transactions are  Sales per the general ledger are compared to
properly aggregated, and aggregated sales per the financial statements.
disclosures are relevant  Footnote disclosures are reviewed for
and understandable relevance and understandability.
(presentation).

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P. 480
1. Auditors are generally more concerned with the completeness of cash
receipts as cash is a target for theft or defalcation. The occurrence of
cash can be readily verified using bank statements and other
evidence.
2. The theft of cash receipts from customer payments on account is
easily identified by sending customers monthly statements unless the
theft is covered by some other means. One way to hide the theft of
cash receipts is to write-off the customer’s receivable.

Proper credit approval for sales helps minimize the amount of bad debts and
the collection effort for accounts receivable by requiring that each sale be
evaluated for collection potential. Adequate controls in the credit function
enable the auditor to place more reliance on the client’s estimate of
uncollectible accounts. Without these controls, the auditor would have to
make his or her own credit checks on the customers to be convinced that the
allowance for uncollectible accounts is reasonable.

Tests of controls:
1. On a sample of sales invoices, examine proper authorization and
indication of internal verification of sales amounts.
2. Examine approved computer file that reflects the master file
contents containing unit selling prices.
3. Examine file of batch control totals for initials of data control clerk
who reconciled those totals; compare totals to summary reports.

Substantive tests of transactions:

1. Recompute information on sales invoices.
2. Trace entries in sales journal to related sales invoices.
3. Trace detail on sales invoices to shipping documents, approved
price lists, and customers’ orders.

The most important duties that should be segregated in the sales and collection
cycle are:

1. Receiving and approving orders for credit sales

2. Shipping goods
3. Billing customers and recording sales
4. Maintaining inventory records
5. Maintaining general accounting records
6. Maintaining detailed accounts receivable records
7. Processing cash receipts
8. Granting credit and pursuing unpaid accounts

Segregation of duties should be used extensively in the sales and

collection cycle for two reasons. First, cash receipts are subject to easy
manipulation. Second, the large number and nature of transactions within the

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cycle make the procedure of cross-checking, where one employee’s duties
automatically serve to verify the accuracy of another is, highly desirable.
If asset-handling activities (shipping goods and processing cash
receipts) are combined with accountability activities (maintaining inventory,
accounts receivable, and general accounting records), a serious deficiency
with respect to safeguarding those assets exists. It would be easy for an
employee, by either omitting or adding an entry, to use the company’s assets
for his or her own purpose. If credit granting and sales functions are combined,
there may be a tendency of sales staff to optimize volume even at the expense
of high bad debt write-offs.

The purpose of footing and cross footing the sales journal and tracing the
totals to the general ledger is to determine that sales transactions are properly
included in the accounts receivable master file and are correctly
summarized. The auditor will make a sample selection from the sales journal to
perform tests of controls and substantive tests of transactions, so he or she
must determine that the general ledger agrees with the sales journal.

Cash is the most liquid asset that a company owns and thus it is the most likely
target of misappropriation. The emphasis the auditor places on the possibility
of misappropriation of cash is not inconsistent with his or her responsibility,
which is to determine the fairness of the presentation of the financial
statements. If material fraud has occurred, and it is not fully disclosed in the
financial statements, those statements are not fairly presented.
Proof of cash receipts is a procedure to test whether all recorded cash
receipts have been deposited in the bank account. In this test, the total cash
receipts recorded in the cash receipts journal for a period, such as a month, are
reconciled to the actual deposits made to the bank during the same time. The
procedure is not useful to discover cash receipts that have not been recorded in
the journals or time lags in making deposits, but it is useful to discover
recorded cash receipts that have not been deposited, unrecorded deposits,
unrecorded loans, bank loans deposited directly into the bank account, and
similar misstatements.

Lapping is the postponement of entries for the collection of receivables to

conceal an existing cash shortage. The fraud is perpetrated by someone who
records cash in the cash receipts journal and then enters them into the
computer system. The person defers recording the cash receipts from one
customer and covers the shortage with receipts from another customer. These
in turn are covered by the receipts from a third customer a few days later. The
employee must either continue to cover the shortage through lapping, replace
the stolen money, or find another way to conceal the shortage.
This fraud can be detected by comparing the name, amount, and dates
shown on remittance advices to cash receipts journal entries and related duplicate
deposit slips. Since the procedure is relatively time-consuming, auditors
ordinarily perform the procedure only where there is a specific concern with
fraud because of internal control deficiencies discovered.

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 Review Questions
14-4 (Objective 14-2) BestSellers.com sells fiction and nonfiction books and e-
books to customers through the company’s website. Customers place orders for
books via the website by providing their name, address, credit card number, and
expiration date. What internal controls could BestSellers.com implement to
ensure that shipments of books occur only for customers who can pay for those
books? At what point will BestSellers.com be able to record the sale as revenue?

14-9 (Objective 14-3) Accounting standards require that companies provide

footnote disclosures that enable a reader to understand the nature, timing,
amount, and uncertainty surrounding revenue and cash flows arising from
contracts with customers. Provide an example of an internal control that the client
can use to address this requirement and an example of a test of control the
auditor can perform to test the operating effectiveness of the control.

14-13 (Objective 14-5) List several audit procedures that the auditor can use to
determine whether all cash received was recorded.

14-19 (Objective 14-7) Diane Smith, CPA, performed tests of controls and
substantive tests of transactions for sales for the month of March in an audit of
the financial statements for the year ended December 31, 2019. Based on the
excellent results of both the tests of controls and the substantive tests of
transactions, she decided to significantly reduce her substantive tests of details
of balances at year end. Evaluate this decision.

Multiple Choice Questions from CPA Examinations

14-20 (Objectives 14-3, 14-5) The following questions deal with internal controls in the
sales and collection cycle. Choose the best response.

a. Which of the following controls would be most effective in

detecting a failure to record cash received from customers paying
on their accounts?
1. A person in accounting reconciles the bank deposit to the
cash receipts journal.
2. Transactions recorded in the cash receipts journal are
posted on a real-time basis to the accounts receivable
master file.
3. Monthly statements are sent to customers and any
discrepancies are resolved by someone independent of
cash handling and accounting.
4. Deposits of cash received are made daily.
b. The accounting system will not post a sales transaction to the sales
journal without a valid bill of lading number. This control is most
relevant to which transaction-related objective for sales?

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 1. Accuracy
2. Occurrence
3. Completeness
4. Posting and summarization
c. The accounting system automatically obtains the unit price based
on scans of bar codes for merchandise sold. This control is most
relevant to which transaction-related objective for sales?
1. Posting and Summarization
2. Occurrence
3. Completeness
4. Accuracy
2. 14-21 (Objectives 14-3, 14-6) For each of the following types of
misstatements (parts a. through c.), select the control that should have
prevented the misstatement:
a. Which of the following controls most likely will be effective in
offsetting the tendency of sales personnel to maximize sales
volume at the expense of high bad-debt write-offs?
1. Employees responsible for authorizing sales and bad-
debt write-offs are denied access to cash.
2. Employees involved in the credit-granting function are
separated from the sales function.
3. Shipping documents and sales invoices are matched by
an employee who does not have the authority to write off
bad debts.
4. Subsidiary accounts receivable records are reconciled to
the control account by an employee independent of the
authorization of credit.
b. A sales invoice for $5,200 was computed correctly but, by mistake,
was entered as $2,500 to the sales journal and posted to the
accounts receivable master file. The customer remitted only
$2,500, the amount on his monthly statement.
1. Prelistings and predetermined totals are used to control
postings.
2. The customers’ monthly statements are verified and
mailed by a responsible person other than the
bookkeeper who prepared them.
3. Sales invoice numbers, prices, discounts, extensions, and
footings are independently checked.
4. Unauthorized remittance deductions made by customers
or other matters in dispute are investigated promptly by a
person independent of the accounts receivable function.
c. Shipments occurring in December 2019 did not get recorded until
the first few days of January 2020.
1. The system automatically assigns bill of lading numbers
and ensures no duplicates are issued.
2. As goods leave the shipping dock, the system generates a
bill of lading and associated sales invoice, which is
automatically recorded in the sales journal.

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 3. The accounting system requires entry of a valid bill of
lading number provided by the shipping department
before a sales transaction is accepted for entry.
4. The system prevents the creation of a bill of lading
without a customer order dated prior to the shipping date.
3. 14-22 (Objectives 14-2, 14-3) The following questions deal with audit
evidence for the sales and collection cycle. Choose the best response.
a. To determine whether internal control relative to the revenue cycle
of a wholesaling entity is operating effectively in minimizing the
failure to prepare sales invoices, an auditor would most likely
select a sample of transactions from the population represented by
the
1. sales order file.
2. customer order file.
3. shipping document file.
4. sales invoice file.
b. An auditor is performing substantive tests of transactions for sales.
One step is to trace a sample of debit entries from the accounts
receivable master file back to the supporting duplicate sales
invoices. What will the auditor intend to establish by this step?
1. Sales invoices represent existing sales.
2. All sales have been recorded.
3. All sales invoices have been correctly posted to customer
accounts.
4. Debit entries in the accounts receivable master file are
correctly supported by sales invoices.
c. Which audit procedure is most effective in testing credit sales for
overstatement?
1. Trace a sample of postings from the sales journal to the
sales account in the general ledger.
2. Vouch a sample of recorded sales from the sales journal
to shipping documents.
3. Prepare an aging of accounts receivable.
4. Trace a sample of initial sales orders to sales recorded in
the sales journal.
4. 14-23 (Objectives 14-2, 14-3) The following questions deal with internal control
and audit evidence in the sales and collection cycle. Choose the best response.
a. Tracing shipping documents to sales invoices provides evidence that
1. sales billed to customers were actually shipped.
2. all goods ordered by customers were shipped.
3. shipments to customers were recorded as sales.
4. shipments to customers were properly invoiced.
b. Which of the following procedures most likely represents an internal
control designed to reduce the risk of errors in the billing process?
1. Comparing control totals for shipping documents with
corresponding totals for sales invoices.
2. Matching receiving documents with approved sales orders before
invoice preparation.

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 3. Reconciling the control totals for sales invoices with the accounts
receivable subsidiary ledger.
4. Requiring customers that purchase on account to be approved by
the credit department.
c. An auditor wishes to test the completeness assertion for sales. Which of
the following audit tests would most likely accomplish this objective?
1. Select a sample of shipments occurring during the year and trace
each one to inclusion in the sales journal.
2. Compare accounts receivable turnover (net credit sales/average
gross receivables) in the current year to that achieved in the prior
year.
3. Use common size analysis to compare recorded sales to sales
recorded by other companies in the same industry.
4. Select large individual sales recorded during the year and review
supporting documentation.

 Discussion Questions and Problems

14-26 (Objectives 14-3, 14-4, 14-5) The following are commonly performed tests of
controls and substantive tests of transactions audit procedures in the sales and collection
cycle:

1- Review the prelisting of cash receipts to determine whether cash is prelisted daily.
2- Reconcile the recorded cash receipts on the prelisting with the cash receipts
journal and the bank statement for a one-month period.
3- Account for a sequence of shipping documents and examine each one to make
sure that a related sales invoice exists.
4- Account for a sequence of sales invoices and examine each one to make sure that
a related shipping document exists.
5- Compare the quantity and description of items on shipping documents with the
related sales invoices.
6- Trace recorded sales in the sales journal to the related accounts receivable master
file and compare the customer’s name, date, and amount for each one.
7- Examine sales returns for approval by an authorized official.

a- Identify whether each audit procedure is a test of control or a substantive test of

transactions.
b- State which of the seven transaction-related audit objectives each of the audit
procedures fulfills.
c- Identify the type of evidence used for each audit procedure, such as inspection
and observation.

14-27 (Objectives 14-3, 14-4) The following is a list of possible errors or fraud (1
through 8) involving sales and controls (a. through k.) that may prevent or detect
the errors or fraud:

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Possible Errors or Fraud
1. Invoices are sent for shipped goods, and are recorded in the
sales journal, but are not posted to any customer accounts.
2. Invoices for goods sold are posted to incorrect customer
accounts.
3. Invalid transactions granting credit for sales returns are recorded.
4. Goods are removed from inventory for unauthorized orders.
5. Credit sales are made to customers with unsatisfactory credit
ratings.
6. Invoices are sent to co-participants in a fraudulent scheme, and
sales are recorded for fictitious transactions.
7. Goods shipped to customers do not agree with goods ordered by
customers.
8. Invoices are sent for shipped goods but are not recorded in the
sales journal.

Internal Controls
a. Customer orders are compared with an approved customer list.
b. Sales orders are prepared for each customer order.
c. Shipping clerks compare goods received from warehouse with
details on shipping documents.
d. Prenumbered credit memos are used for granting credit for
goods returned.
e. Goods returned for credit are approved by the supervisor of the
sales department.
f. Approved sales orders are required for goods to be released
from the warehouse.
g. Monthly statements are mailed to customers with outstanding
balances.
h. Shipping clerks compare goods received from warehouse with
approved sales orders.
i. Sales invoices are compared with shipping documents and
approved customer orders before invoices are mailed.
j. Control amounts posted to the accounts receivable ledger are
compared with the control totals of invoices.
k. Daily sales summaries are compared with control total of
invoices.

Required
For each error or fraud, select one internal control that, if properly designed and
implemented, most likely would be effective in preventing or detecting the errors
and fraud. Each response in the list of controls may be used once, more than
once, or not at all.

14-30 (Objectives 14-3, 14-5) The following are common audit procedures for
tests of sales and cash receipts:

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 1- Examine the sales journal for related-party transactions, notes
receivable, and other unusual items.
2- Select a sample of customer orders and trace the document to
related shipping documents, sales invoices, and the accounts
receivable master file for comparison of name, date, and amount.
3- Examine sales invoices for an indication that unit selling prices
were compared to the approved price list.
4- Examine sales invoices to determine whether the account
classification for sales has been included in the electronic record.
5- Compare the quantity and description of items on sales invoices
with related shipping documents.
6- Perform a proof of cash receipts.
7- Examine financial statement footnotes for appropriate disclosure of
sales to related parties.
8- Examine a sample of remittance advices for approval of cash
discounts.
9- Trace recorded cash receipts in the accounts receivable master file
to the cash receipts journal and compare the customer’s name,
date, and amount of each one.

a-Identify whether each audit procedure is a test of control or a substantive test

of transactions.

b-State which transaction-related audit objective(s) each of the audit procedures

fulfills.

c-For each test of control in part a., state a substantive test that could be used to
determine whether there was a monetary misstatement.

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