10

Review Qustions 10-1 10-1

Acco Accoun unti ting ng stan standa dard rdss dete determ rmin inee when when to reco recogn gniz izee reve revenu nue. e. Disc Discus usss when when revenue should be recognized.

Answer :

As a general rule revenue is recognized when the earnings process is complete.International Accounting Standard (IAS) 18  Revenue states that revenue is recognised when it is probable that that future future econom economic ic benefit benefitss will will flow flow to the entity entity and these these benefit benefitss can be measure measured d reliably. or e!ample" revenues from the sale of goods are recognised once delivery deliver y has ta#en  place" the ris# has been transferred" and the entity has established a receivable due by customer. IAS 18 provides the following criteria for revenue recognition$ •

•

• •

•

%he entity has transferred to the buyer the significant ris#s and rewards of ownership of  the goods. %he %he entity entity retains retains neithe neitherr contin continuin uing g manage managerial rial involv involveme ement nt to the degree degree usually usually associated with ownership nor effective control over the goods sold. %he amount of revenue can be measured reliably. It is probable that the economic benefits associated with the transaction will flow to the entity. %he costs incurred or to be incurred in respect of the transaction can be measure reliably.

10-2 10-2

Descr Describe ibe the the credit credit functio function nss duties duties for monit monitori oring ng custo customer mer !a"me !a"ments nts and and handling bad debts.

Answer :

%he credit authorization function has the responsibility for monitoring customer payments. An aged trial balance of accounts receivable should be prepared and reviewed by the credit authorization function. &ayment should be re'uested from customers who are delin'uent in ma#ing ma#ing paymen payments ts for goods goods or service services. s. %he %he credit credit functi function on is usually usually responsib responsible le for   preparing a report of customer accounts that may re'uire writeoff as bad debts. owever" the final approval for writing off an account should come from an officer of the company who is not responsible for credit or collections. 10-#

when a client client does does not not ade$uat ade$uatel" el" segr segrega egate te duties duties%% the !ossibilit !ossibilit" " of cash cash being being stolen before it is recorded recorded is increased. &f the auditor sus!ects sus!ects that this t"!e of defalcat defalcation ion is !ossible% !ossible% what t"!e of audit !rocedu !rocedures res can he or she use to test this !ossibilit"'

Answer :

10-( 10-(

the audit auditor or needs needs to underst understand and how how selected selected inher inheren entt ris) facto factors rs affec affectt the transact transactions ions !rocess !rocessed ed b" the revenue revenue !rocess. !rocess. Discuss Discuss the !otentia !otentiall effect that that

industr"-related factors and misstatement detected in !rior !eriods haveon the inherent ris) assessment for the revenue !rocess. Answer :

Industryrelated factors such as the profitability and health of the industry in which the entity operates" the level of competition within the industry" and the industry*s rate of technological change affect the potential for misstatements in the revenue process. %he level of  governmental regulation (e.g. by a medicine control agency) within the industry may also affect sales activity. inally" most countries have consumer protection legislation that may affect product warranties" returns" financing and product liability. Such industryrelated factors directly impact the auditor*s inherent ris# assessment for the authorization and valuation auditob+ectives. %he presence of misstatements in previous audits is a good indicator that misstatements are li#ely to be present during the current audit. If misstatements were present in previous audits" the auditor should assess inherent ris# to be high.

10-*

in understanding the accouting s"stems in the revenue !rocess% the auditor t"!icall" !erforms a wal)-through to gain )nowledge of the s"stem. +hat )nowledge should the auditor tr" to obtain about the accounting s"stem'

Answer :

%he auditor needs to obtain the following #nowledge for each ma+or class of transactions in the revenue process when performing a wal#through$ ow sales" cash receipts" and sales returns and allowances transactions are initiated. • %he accounting records" supporting documents and accounts that are involved in •  processing sales" cash receipts" and sales returns and allowances transactions. %he flow of each type of transaction from initiation to inclusion in the financial • statements" including computer processing of the data. %he process used to prepare estimates for accounts such as the allowance for  • uncollectible accounts and sales returns.

10-,

what are the two maor controls for sales return and allowances transactions'

Answer :

%wo important controls for processing of credit memoranda for sales returns and allowances transactions are$ (1) each credit memorandum should be approved by someone other than the individual who initiated it and (,) a credit for returned goods should be supportedby a receiving document indicating that the goods have been returned. 1-

list four anal"tical !rocedures that can be used to test revenue-related accounts. +hat !otential misstatement are indicated b" each of these anal"tical !rocedures'

Answer :

ubstantive Anal"tical /rocedure

/ossible isstatement Detected

Revenue :

/omparison of gross profit percentage by product nrecorded (understated) revenue ictitious (overs line with previous years* and0or industry data. revenue /hanges in pricing policies &roductpr  /omparison of reported revenue to budgeted  problems revenue. Accounts Receivable% Allowance for ncollectible Accounts% and ad-Debt 34!ense: /omparison of receivables turnover and days nder or overstatement of allowance for uncolle outstanding in accounts receivable to previous years* accounts and baddebt e!pense and0or industry data. /omparison of aging categories on aged trial balance of accounts receivable to previous years. /omparison of baddebt e!pense as a percentage of  revenue to previous years* and0or industry data. /omparison of the allowance for uncollectible accounts as a percentage of accounts receivable or  credit sales to previous years* and0or industry data. 2!amination of large customer accounts individually and comparison to previous year. ales Returns and Allowances% and ales 5ommissions:

/omparison of sales returns as a percentage of revenue to previous years* and0or industry data. /omparison of sales discounts as a percentage of  revenue to previous years* and0or industry data. 2stimation of sales commissions e!pense by multiplication of net revenue by the average commission rate and comparison to recorded sales commission e!pense.

10-6

nder or overstatement of sales returns. nder or overstatement of sales discounts. nder or overstatement of sales commission e!pense and related accrual.

Describe how the auditor verifies the accurac" of aged trial balance.

Answer :

%he auditor verifies the accuracy of the aged trial balance using the following steps. irst" a copy of the aged trial balance of accounts receivable is obtained from the client and thetotal  balance is compared to the accounts receivable general ledger balance. Second" a sample of  customer accounts selected for proper inclusion in the aged trial balance. or eachselected customer account" the auditor traces the customer*s balance bac# to the subsidiaryledger  detail and verifies the total amount and the amounts included in each column for properaging. %hese two steps mainly describe a manual approach to testing accuracy. A secondapproach would involve the use of computerassisted audit techni'ues. If the general controlsover I% are ade'uate" the auditor can use a generalized audit software pac#age to perform thesteps described in the first approach to e!amine the accuracy of the aged trial balancegenerated by the client*s accounting system. 10-7

list and discuss the three factors mentioned in the cha!ter that ma" affect the reliabilit" of confirmations of account receivable.

Answer :

%hree factors that affect the reliability of accounts receivable confirmations are$ %he type of confirmation re'uest. • &rior e!perience on the client or similar engagements. • %he intended respondent. • %he types of confirmations include positive and negative confirmations. 3enerally" positive confirmations are considered more reliable because the recipient is re'uired to respond to the auditor regardless of whether a misstatement e!ists or not. &rior e!perience with the client in terms of confirmation response rates" misstatements identified" and the accuracy of returned confirmations should be considered when assessing the reliability of accounts receivable confirmations. or e!ample" if response rates were low in prior audits" the auditor might consider obtaining evidence using alternative procedures. inally" the intended respondents to accounts receivable confirmations may vary from individuals with little accounting #nowledge to highly 'ualified accounting personnel in large companies. %he auditor should consider the respondent*s competence" #nowledge" ability and ob+ectivity when assessing the reliability of confirmation re'uests. 10-10 Distinguish between !ositive and negative confirmations. nder what circumstances would !ositive confirmations be more a!!ro!riate than negative confirmations' Answer :

A positive accounts receivable confirmation re'uests that the customer indicate whether or  not it is in agreement with the amount due to the client stated in the confirmation. %hus" a response is re'uired regardless of whether the customer believes that the amount is correct orincorrect. A negative confirmation re'uests that the customer respond only when it disagreeswith the amount due to the client.&ositive confirmations are generally used when an account contains large individual balances orif errors are anticipated because control ris# was  +udged to be high. 4egative confirmationre'uests are used when there are a large number of  accounts with small balances" control ris#is assessed to be low" and the auditor believes that the customers will devote ade'uate attention to the confirmation.

10-11 &dentif" three other t"!es of receivables the auditor should e4amine. +hat audit !rocedures would t"!icall" be used to audit other receivables' Answer :

5ther types of receivables that the auditor should e!amine include$ 6eceivables from officers and employees. • 6eceivables from related parties. •  4otes receivable. • %he auditor would confirm and evaluate each type of receivable for collectibility. %he transactions that result in receivables from related parties are e!amined to determine if they were at 7arm*s length.* 4otes receivable would also be confirmed and e!amined for  repayment terms and whether interest income has been properly recognized.

/roblems 10-12 8or each of the following situation indicate how and9or when the client should recognize the revenue. ustif" "our decision. 

1. our client" thompson telecom" maintains an inventory of telecommunications e'uipment. 9ayone %elephone /ompany placed an order for 1- new transformers valued at : million and thomson delivered them +ust prior to ;1 december. %hompson*s normal business practise for this class of customer is to enter into a written sales agreement that re'uires the signatures of all the authorized representatives of thompson and its customer before the contract is binding. owever" bayone has not signed the sales agreement because it is awaiting the re'uisite approval by the legal department. 9ayone*s purchasing department has orally agreed to the contract and the purchasing manager has assured you that the contract will be approved the first wee# of ne!t year.



,. 9est products is a retailer of appliances that offer
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;. >ave*s >iscount stores is a discount retailer who generates revenue from the sale of membership fees it charges customers to shop at its stores. %he membership arrangement re'uires the customer to pay the entire membership fee ( usually ?8 ) at the beginning of the arrangement. owever" the customer can unilaterally cancel the membership arrangement and the receive a refund of the unused portion. >ave*s estimates that ;: per cent of the customer will cancel their  membership before the end of the contract.

Answer :



1. IAS 18 states that revenue is recognized when the entity has transferred to the buyer  the significant ris#s and rewards of ownership of the goods. %he assessment of when an entity has transferred the significant ris#s and rewards of ownership to the buyer re'uires an e!amination of the circumstances of the transaction. In %hompson*s business practice of re'uiring a written sales agreement for this class of customer" persuasive evidence of  an arrangement would re'uire properly authorized personnel of the customer have e!ecuted final agreement. 9ayonne*s e!ecution of the sales agreement after the end of  the 'uarter causes the transaction to be considered a transaction of the subse'uent period  by accounting standards such as IAS 18.



,. &rovided that other criteria for revenue recognition are met" 9est &roducts should recognize revenue from sales of its layaway program upon delivery of the merchandise to the customer. ntil then" the amount of cash received should be recognized as a liability. 9ecause 9est &roducts retains the ris# of ownership of the merchandise" receives only a deposit from the customer" and does not have an enforceable right to the remainder of the purchase price" accounting standards such as IAS 18 would not allow recognition of the revenue.



It would not be appropriate for >ave*s to recognize the membership fees as revenue upon  billing or receipt of initial fee with a corresponding accrual of estimated costs to provide the membership services. %his conclusion is based on >ave*s remaining and unfulfilled contractual obligation to perform services throughout the remaining period. %herefore" the earnings process" irrespective of whether a cancellation clause e!ists" is not complete. Additionally" the ability of the member to receive full refund of the membership fee up to the last day of the membership term raises uncertainty as to whether the fee is fi!ed or  determinable at any point before the end of the term.

10-1; ou are engaged to audit the ferric# corporation for the year ended ;1 december ,--@. only merchandise shipped by the ferric# corporation to customers up to and including ;- december ,--@ has been eliminated from inventory. %he inventory as determined by physical inventory count has been recorded on the boo#s by the company 7s controller. 4o perpetual inventory records are maintained. All sales are made in an 59shipping point basis. ou are to assume that all purchase invoices have been correctly recorded. %he following lists of sales invoices are entered in the sales +ournal for the months of december ,--@ and +anuary ,-1-" respectively.
ales invoice ales &nvoice Amount Date

5ost of erchandise old

Date hi!!ed

>ec ,--@ A

;---

,1 >ec

,---

;1 >ec

9 /

,--1---

;1 >ec ,@ >ec

8---

1; >ec ;- >ec

> 2 Ban ,-1 3

?--1----

;1 >ec ;- >ec

,?-:--

@ Ban ,@ >ecC

--?---

;1 >ec , Ban

?--,;--

;- >ec , Ban

; Ban

::--

;1 >ec.

 8--C Shipped to consignee  Required:

ou are to ensure that there is proper cutoff of sales and inventory. If an item is not properly recorded" prepare the necessary ad+usting entries. Answer : A. ince the goods were shi!!ed on #1 December% the" were included in the !h"sical inventor" at the end of the fiscal "ear. ince the sale should be recognized in the current fiscal "ear% the following adustment is necessar": 5ost of merchandise sold

2%000

&nventor"

2%000

. =his sale is !ro!erl" recorded as a current-fiscal-"ear sale. >owever% the auditor should in$uire as to wh" there was such a dela" in !rocessing the sales invoice. 5. =he sale is !ro!erl" recorded in the current "ear. D. ince the goods were not shi!!ed until 7 anuari% the" would have been included in the !h"sical inventor". >owever% the sale was recorded as a current-fiscal-"ear sale. =herefore% the sale should be reversed since title has not !assed to the customer. =he following adusting entr" should be made: ales

(%000

Accounts receivable

(%000

3. ince this transaction is a shi!ment of merchandise to a consignee% no sale should be recognized. ince the goods were not on hand on #0 December% the following entr" is necessar": ales

10%000

&nventor"

*%,00

Accounts receivable

10%000

5ost of merchandise sold

*%,00

8. =his sale should be recorded in the current fiscal "ear. ince the merchandise was shi!!ed on #0 December%it was not included in the !h"sical inventor". =hus the following adusting entr" is necessar": Accounts receivable

,%000

ales

,%000

?. =his transaction is correctl" recorded as a sale in the ne4t !eriod. >. ince the merchandise was shi!!ed on #1 December% it should be recorded as a sale in the current fiscal "ear. &t was also included in the !h"sical inventor" because it was on hand on that date. =hus the following adusting entr" is necessar": Accounts receivable

6%000

5ost of merchandise sold

*%*00

ales

6%000

&nventor"

*%*00