CHAPTER TWO

AUDIT OF SALES AND COLLECTION

CYCLE
 2. 1 Overview of the cycle

• The over all objective in the audit of the sales and collection cycle

is to evaluate whether the account balances affected by the cycle

are fairly presented in accordance with accounting standards.

• The nature of the accounts in the sales and collection cycle may

vary, of course, depending on the industry and client involved.

• There are differences in the nature and account titles for a service

industry, a retail company, and an insurance company, but the key

concepts remain the same.

• To provide a frame of reference for understanding the material in

this chapter,

• let’s assume we’re dealing with a wholesale merchandising

company.
1. Sales (cash and sales on account )
2. Cash receipts
3. Sales returns and allowances
4. Write- off of uncollectible accounts
5. Estimate of bad debt expense
• With the exception of cash sales, every
transaction and amount is ultimately
included in one of two balance sheet
accounts, accounts receivable or
allowance for uncollectible accounts.
• For simplicity, we assume that the same
internal controls exist for both cash and
credit sales.
 2.1.1. Business Functions in the Cycle and Related
Documents and Records

• The sales and collection cycle involves the decisions

and processes necessary for the transfer of the
ownership of goods and services to customers after
they are made available for sale.
• It begins with a request by a customer and ends with
the conversion of material or service into an account
receivable, and ultimately into cash.
• 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.
 2.2 Key Internal Control

• The auditor, in evaluating the internal control

system, is concerned to determine the extent
to which the common characteristics of
control are present within the system.
• Because the specific placement of
responsibility, compliance and qualified
personnel characteristics all apply in the
same way to all subsystems, we shall
concentrate our attention on the others as
they relate specifically to the revenue system.
• Receivable is a general term that may refer to
many types of receivables whose origin and
nature may be different.
• Receivables include amounts due from
customers, employees, and affiliates on open
accounts, notes, and loans and accrued interest
on such balances.
• The internal controls with regard to accounts
receivable include the following:
a) Appropriate segregation of responsibilities

1. Persons handling cash receipts do not have access to

the accounts receivable records.
2. The billing function should be separated from the
handling of cash receipts.
3. Any special discount concessions to customers
should be approved by a responsible supervisor.
4. The credit function should be separated from the
handling of cash receipts and the record keeping
function.
5. The A/R ledger clerk recording sales and cash
collections should be someone other than the general
bookkeeper.
6. Persons having the authority to originate non-cash
credits to receivables should not have access to cash.
b) Documentation approvals and records
7. Sales invoices should be sequentially numbered and
procedures should be established to account for the
use of the invoice forms.
8. Credit memos should also be sequentially numbered
and controlled in the same manner as are sales
invoices.
3. Sequentially numbered remittance advice
forms should be prepared when cash is
received by the company. Formal
procedures should be established for
carrying out the billing function.
4. A/R records should indicate both control
account and a subsidiary ledger.
5. Formal procedures should be established
for authorizing and approving the
acceptance of notes receivable.
c) Safeguarding Assets and records
1. All cash receipts should be deposited
intact daily.
2. Appropriately protected storage facilities
for undeposited cash receipts.
3. The accounts receivable records should
be stored in a safe or vault designed to
protect those records from damage or
alteration when they are not being used.
2.3. SOURCES AND NATURE OF
RECEIVABLE
• The sales and collection cycle including the
receiving of orders from customers are
delivery and billing of merchandise to
customers, and the recording and collection
of receivables.
• Receivables from customers include both
accounts receivable and various types of
notes receivable.
 3.4. FINANCIAL REPORTING
STANDARDS
• Financial reporting standards for
receivables require:
 separation of trade from non – trade
receivables.
 assurance of ownership disclosure.
 assurance of collectability of
receivables.
 2.5. AUDIT OBJECTIVES
• The audit objectives for the receivables
and sales relate to obtain to sufficient
competent evidence about each significant
financial statement assertion that pertains
receivables and sales transactions and
balances.
• To achieve each of these specific audit
objectives, the auditors employ various
parts of the audit planning and audit
testing methodology.
The auditors’ objectives in the examination of receivables and sales are:

1.To consider internal control over receivables and

sales transactions.
2.To determine the existence of receivables, the
clients ownership of these assets, and the
occurrence of sales transactions.
3.To establish the completeness of receivables and
sales transactions.
4.To establish the clerical accuracy of records and
supporting schedules of receivables and sales.
5.To determine that the valuation of receivables is at
appropriate net realizable values.
6.To determine that the statement presentation of
receivables and sales is adequate.
 Assertion Transaction class Account balance
Category Audit objective Audit objective
Recorded sales transactions represent Accounts receivable include all
Category goods shipped during the period. amounts owed by the customers
Existence or Recorded cash receipts transactions exists at the balance sheet date.
Occurrence represent cash received during the
period.

All sales, cash receipts sales Accounts receivable include all

Completeness adjustments that occurred during the claims on customers at the
period have been recorded. balance sheet date.

The entity has rights to the receivables Accounts receivable at the

Rights and and cash resulting from sales balance sheet date represents
Obligations transactions. legal claims of the entity.

Valuation All sales, cash receipts and sales Accounts receivable represent
adjustments transactions are correctly gross claims, On customers at
journalized, summarized, and posted. the balance sheet date. The
allowance for uncollectible
accounts represent a reasonable
estimate.

Presentation ad The details of sales, cash receipts and Accounts receivables are
2.6. INTERNAL CONTROL OF SALES AND RECEIVABLES

• The objectives of internal controls over

receivables are to ensure:
a. All goods dispatched/Shipped are invoiced.

b. Invoicing is at correct price and discount.

c. Goods are only dispatched on credit to approved

customers.
d. Invoices are recorded and related to subsequent
cash receipts.
e. Receivables are controlled and bad debts
pursued.
f. Credit notes approved.
 In addition the internal control over
receivables should be such that the
possibility of any falsification of the
receivables accounts is eliminated.

 An important part of the controls

would be to ensure that the cashier
does not have access to the sales
ledger, and the sales ledger clerk does
not have access to cash received.
• Control procedures, over sales and
receivables include the following.
a.Orders.
- The orders should be checked against
the customer’s account.
- All orders received should be recorded
on pre- numbered sales order
documents.
- All orders should be authorized before
goods are dispatched.
b. Dispatch.

- Dispatch notes should be pre-numbered and

a register kept of them to relate to sales
invoices and orders.
- Goods dispatch notes should be authorized
as goods leave.
c. Invoicing

- Sales invoices should be authorized by a responsible

official.
- Sales invoices should be checked for prices and
calculations by a person other than the one
preparing the invoice.
- All invoices should be pre-numbered consecutively.

- Copies of cancelled invoices should be

retained/booked.
c. Receivables.
- A receivable ledger control account should be
prepared and checked to individual sales ledger
balances.
- Receivables ledger personnel should be
independent of dispatch and cash receipt
functions.
- Statements should be sent regularly to customers.
e. Bad debts.
- The authority to write off a bad debt should be
given in writing and adjustments made to the
accounts receivable ledger.
- The use of court action or write-off of a bad
debt should be authorized by an official
independent of the cash receipts function.
The following audit procedures are typical
of the work done in the verification of
notes, accounts receivable, and sales
transaction.
A.Consider internal control for
receivables and sales.
Obtain an understanding of internal
control for receivables and sales.
• The auditors’ consideration of internal
controls over receivables and sales may
begin with the preparation of a written
narrative or flow chart and the
completion of an internal control
questionnaire.
As the auditors’ confirm their understanding of the sales
and collection cycle, they will observe whether there is
appropriate segregation of duties, and enquire as to who
performed various functions throughout the year.
Assess control risk and design additional tests of
controls for receivables and sales. After obtaining an
understanding of the client’s internal control for
receivables and sales transactions, the auditors perform
their initial assessment of control risk for the variant
financial statement assertions.
Perform additional tests and
controls: Tests directed towards the
effectiveness of control help to
evaluate the client’s internal
control, and determine the extent to
which the auditors are justified in
reducing their assessed levels of
control risk for the assertion about
the receivables and sales accounts.
The following are examples of additional
tests:
1.Examine significant aspects of a
sample of sales transactions.
2.Compare a sample of shipping
documents to related sales invoices.
3.Review the use and authorization of
credit memoranda.
4.Reconcile selected cash register tapes
and sales invoices with sales journals.
Reassess control risk and design
substantial tests. When auditors have
completed the procedures described
in the preceding sections, they should
assess the extent of control risk
for each financial statement
assertions regarding receivables and
sales transactions. The assessment
will determine the nature, extent, and
timing of auditors’ substantive tests
B. Substantive tests

1. Obtain an aged trail balance of trade accounts receivable and

analyses of other accounts receivable and reconcile to ledgers.
When trial balances or analyses of accounts receivable are
furnished to the auditors by the client’s employees, some
independent verification of the listings is essential.

2. Obtain analyses of notes receivable and related interest.

3. Inspect notes on hand and confirm those not on hand with

holders.

4. Confirm receivables with debtors.

5. Receive the year-end cutoff/limit of sales transactions.

6. Perform analytical procedures for accounts
receivable, sales, notes receivable, and
interest revenue.
7. Verify interest earned on notes and accrued
interest receivable.
8. Evaluate the propriety/correctness of the
client’s accounting for receivables and sales
9. Determine adequacy of allowance for
uncollectible accounts.
10. Ascertain whether any receivables have
been pledged.
11. Investigate fully any notes or accounts
receivable from related parties.
12. Evaluate financial statement
presentation and disclosure.
 END OF
CHAPTER 2
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