classes of transactions in the sales and collection cycle.

Under “Business Functions,”

observe that the first four processes are for recording sales, while every other class of

transactions includes only one business function. In this section, we’ll explain each of

the eight business functions in the context of a wholesale merchandising company

and describe typical documents and records for each function, which appear in the

fourth column of Table 13-1. Before auditors can assess control risk and design tests

of controls and substantive tests of transactions, they need to understand the business

functions and documents and records in a business.

Processing Customer Orders

A customer’s request for goods initiates the entire cycle. Legally, it is an offer to buy

goods under specified terms. The receipt of a customer order often results in the immediate creation of
a sales order.

Customer Order A customer order is a request for merchandise by a customer. It may be received by
telephone, letter, a printed form that has been sent to prospective and existing customers, through
salespeople, electronic submission of the customer order through the Internet, or other network linkage
between the supplier and the 1customet.

Sales Order A sales order is a document for communicating the description, quantity, and related
information for goods ordered by a customer. This is often used to indicate credit approval and
authorization for shipment.1

2. Granting Credit

Before goods are shipped, a properly authorized person must approve credit to the customer for sales
on account. Weak practices in credit approval often result in excessive bad debts and accounts
receivable that may be uncollectible. An indication of credit approval on the sales order often serves as
the approval to ship the goods. In many companies, the computer automatically approves a credit sale
based on preapproved credit limits maintained in a customer master file. The computer allows the sale
to proceed only when the proposed sales order total plus the existing customer balance is less than the
credit limit in the master file.

3. Shipping Goods

Shipping Goods This critical function is the first point in the cycle at which the company transfers
ownership of assets. Accounting standards state that revenue should be recognized when a
performance obligation is satisfied by transferring goods or services to a customer. For most companies,
a sale is recognized when goods are shipped (or when services are provided). A shipping document is
prepared at the time of shipment, which can be done automatically by computer, based on sales order
information. The shipping document, which is often a bill of lading, is essential to the proper billing of
shipments to customers. Companies that maintain perpetual inventory records also update them based
on shipping records. Shipping Document A shipping document is prepared to initiate shipment of the
goods, indicating the description of the merchandise, the quantity shipped, and other relevant data. The
company provides a copy to the customer and retains a copy. The shipping document serves as a signal
to bill the customer and is generally in electronic form but may also be in paper form.

One type of shipping document is a bill of lading, which is a written contract between the carrier and the
seller of the receipt and shipment of goods. Often, bills of lading include only the number of boxes or
pounds shipped, rather than complete details of quantity and description. (For the purpose of this
textbook chapter, however, we will assume that complete details are included on bills of lading.)

The bill of lading is often transmitted electronically, once goods have been shipped, and automatically
generates the related sales invoice as well as the entry in the sales journal. Many companies use bar
codes and handheld computers to record removal of inventory from the warehouse.2 This information is
used to update the perpetual2inventory records.2

4. Billing customers and Recording sales

Because billing customers is the means by which the customer is informed of the amount due for the
goods, it must be done correctly and on a timely basis. The most important aspects of billing are as
follows:

• All shipments made have been billed (completeness)

• No shipment has been billed more than once (occurrence)

• Each one is billed for the proper amount (accuracy)

Billing the proper amount is dependent on charging the customer for the quantity shipped at the
authorized price, which includes consideration for freight charges, insurance, and terms of payment.

In most systems, billing of the customer includes preparation of a sales invoice and real-time updating of
the sales transactions file, accounts receivable master file, and general ledger master file for sales and
accounts receivable. The accounting system uses this information to generate the sales journal and,
along with cash receipts and miscellaneous credits, to prepare the accounts receivable trial balance.
Sales Invoice A sales invoice is an electronic record or a document indicating the description and
quantity of goods sold, the price, freight charges, insurance, terms, and other relevant data. The sales
invoice is the method of indicating to the customer the amount of a sale and the payment due date.
Companies retain an electronic copy and send a copy to the customer. Typically, the computer
automatically prepares the sales invoice after the customer number, quantity, destination of goods
shipped, and sales terms are entered. The computer calculates the invoice extensions and total sales
amount using the information entered, along with prices in the inventory master file.

Sales Transaction File This is a computer-generated file that includes all sales transactions processed by
the accounting system for a period, which could be a day, week, or month. It includes all information
entered into the system and information for each

transaction, such as customer name, date, amount, account classification or classifications, salesperson,
and commission rate. The file can also include returns and allowances, or there can be a separate file for
those transactions.3

The information in the sales transaction file is used for a variety of records, listings, or reports,
depending on the company’s needs. These may include a sales journal, accounts receivable master file,
and transactions for a certain account balance or division.

Sales Journal or Listing This is a listing or report generated from the sales transaction file that typically
includes the customer name, date, amount, and account classification or classifications for each
transaction, such as division or product line. It also identifies whether the sale was for cash or accounts
receivable. The journal or listing is usually for a month but can cover any period of time. Typically, the
journal or listing includes totals of every account number for the time period. The same transactions
included in the journal or listing are also posted simultaneously to the general ledger and, if they are on
account, to the accounts receivable master file. The journal or listing can also include returns and
allowances or there can be a separate journal or listing of those transactions.

Accounts Receivable Master File This is a computer file used to record individual

sales, cash receipts, and sales returns and allowances for each customer and to maintain customer
account balances. In this book, we use the term accounts receivable master file, but it is sometimes
called the accounts receivable subsidiary ledger or subledger.

The master file is updated from the sales, sales returns and allowances, and cash

receipts computer transaction files. The accounts receivable master file shows, by

customer, the beginning balance in accounts receivable, each sales transaction, sales

returns and allowances, cash receipts, and the ending balance. The total of the individual account
balances in the master file equals the total balance of accounts receivable in the general ledger.

Accounts Receivable Trial Balance This list or report shows the amount receivable

from each customer at a point in time. It is prepared directly from the accounts receivable master file
and is usually an aged trial balance that includes the total balance outstanding and the number of days
the receivable has been outstanding, grouped by category of days (such as less than 30 days, 31 to 60
days, and so on).
Monthly Statement This is a document sent by mail or electronically to each customer, indicating the
beginning balance of their accounts receivable, the amount

and date of each sale, payments received, credit memos issued, and the ending balance due. It is, in
essence, a copy of the customer’s portion of the account receivable master file.

5. Processing and Recording Cash Receipts

The four sales transaction functions are necessary for getting the goods into the hands

of customers, correctly billing them, and reflecting the information in the accounting records. The
remaining four functions involve the collection and recording of cash,

sales returns and allowances, write-off of uncollectible accounts, and providing for

bad debt expense.

Processing and recording cash receipts includes receiving, depositing, and recording cash. Cash includes
currency, checks, and electronic funds transfers. The most important concern is the possibility of theft.
Theft can occur before receipts are entered in the records or later. It is important that all cash receipts
are deposited in the bank at the proper amount on a timely basis and recorded in the cash receipts
transaction file.

This file is used to prepare the cash receipts journal and update the accounts receivable and general
ledger master files.

Remittance Advice A remittance advice is a document mailed to the customer and

typically returned to the seller with the customer’s payment. It indicates the customer name, the sales
invoice number, and the amount of the invoice. A remittance advice

is used as a record of the payment received to permit the immediate deposit of checks

received and to improve control over the custody of assets. If the customer fails to 4include the
remittance advice with the payment, it is common for the person opening

the mail to prepare one at that time.

Prelisting of Cash Receipts This 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.

maintained by the bank. The bank is responsible for opening all receipts, maintaining records of all
customer payments received at the lockbox address, and depositing receipts into the company’s bank
account on a timely basis. In other cases, receipts are submitted electronically from a customer’s bank
account to a company bank account through the use of electronic funds transfer (EFT). When customers
purchase goods

by credit card, the issuer of the credit card uses EFT to transfer funds into the company’s bank account.
For both lockbox systems and EFT transactions, the bank provides information to the company to
prepare the cash receipt entries in the accounting records.

Cash Receipts Transaction File This is a computer-generated file that includes all cash receipts
transactions processed by the accounting system for a period such as

a day, week, or month. It includes the same type of information as the sales transaction file.

Cash Receipts Journal or Listing This listing or report is generated from the cash receipts transaction file
and includes all transactions for a time period. The same transactions, including all relevant information,
are included in the accounts receivable master file and general ledger.

6. Processing and Recording Sales Returns and Allowances

When a customer is dissatisfied with the goods, the seller often accepts the return

of the goods or grants a reduction in the charges. The company prepares a receiving report for returned
goods and returns them to storage. Returns and allowances are recorded in the sales returns and
allowances transaction file, as well as the accounts

receivable master file. Credit memos are issued for returns and allowances to aid in

maintaining control and to facilitate record keeping.

Credit Memo A credit memo indicates a reduction in the amount due from a customer because of
returned goods or an allowance. It often takes the same general

form as a sales invoice, but it supports reductions in accounts receivable rather than increases.

Sales Returns and Allowances Journal This is the journal used to record sales returns and allowances. It
performs the same function as the sales journal. Many companies record these transactions in the sales
journal rather than in a separate journal.
7. Accounting for uncollectible account Receivable

Writing Off Uncollectible Accounts Receivable

Regardless of the diligence of credit departments, some customers do not pay their bills. After
concluding that an amount cannot be collected, the company must write it off. Typically, this occurs
after a customer files for bankruptcy or the account is turned over to a collection agency. Proper
accounting requires an adjustment for these uncollectible accounts.

Uncollectible Account Authorization Form This is a document used internally to indicate authority to
write an account receivable off as uncollectible.

8. Providing for Bad Debts

Because companies cannot expect to collect on 100 percent of their sales, accounting principles require
them to record bad debt expense for the amount they do not expect to collect. Most companies record
this transaction at the end of each month or quarter.6