Chapter 14

Audit of the Sales and

Collection Cycle
Key objectives:
1.
2.
3.
4.
5.
6.
1.

Identify the accounts and classes of transactions in the sales and collection cycle.
Describe the business functions and related documents and records in the sales and
collection cycle.
Understand internal control and design appropriate tests of controls and substantive tests of
transactions for sales.
Understanding the accounting and controls for sales returns and allowances.
Understand internal control and design appropriate tests of controls and substantive tests of
transactions for cash receipts.
Understanding the accounting and controls for write-offs of uncollectible accounts.
Introduction to Transactions (Figure 14-1, p. 442 of text)
The accounting for these transactions should be familiar.
Sales and cash receipts are examined simultaneously because
they are interrelated, and both affect accounts receivables.
(Tests applied to each balance/transaction in parentheses.)
Accounts receivable
Beginning
Cash receipts
balance (PY)
(TOT)
Sales on
account (TOT)
Ending
balance (TODB)

Sales returns
and allowances
Bad debt
charge-of

Sales returns and bad debts are non-cash credits to

accounts receivable (TOT and TODB). Both activities
and ending balanced are tested using analytical
procedures.

2.

Documents in the cycle - The attached chart (p. 106-107)

can be used to familiarize you with the documents in the cycle
when studying Table 14-2 and Table 14-3 in the text. We are
especially interested in controls associated with each
document.

105

Documents in Sales Cycle

Document

Controls (objective)

Customer
order

Comments
Process is initiated with the customer
order. The customer order is not
primary for the existence assertion
(shipping document is). Order could
be received by mail, phone, over the
internet, or through EDI.

Sales order

Credit approval and

authorization of
shipment (occurrence).

Sales orders should receive approval

prior to shipment, including
authorization of credit (specific or
general). Credit should be authorized
by someone independent of sales
(often done automatically by
computer). (1) Credit approval process
afects extent of net realizable value
tests (test of allowance for doubtful
accounts).

Shipping
document
(bill of lading)

Checking of quantities
(accuracy).
Account for sequence
(completeness).

Shipper is primary evidence of

occurrence, because all recorded
sales should be supported by a
shipper.
Account for numerical sequence to
ensure completeness (all shippers
should result in a sales invoice).

Sales invoice

Matched with shipper

(occurrence).
Prices, quantities and
extensions checked
(accuracy).
Account for sequence
(completeness).

The sales invoice is the main

document for the recording of sales.
Accounting for the sequence of sales
invoices in the sales journal also
assures completeness by determining
that all sales were recorded. (2)

Sales journal

Footings and postings

checked (posting and
summarization).
Posted as soon as
possible after goods are
shipped (timeliness).

Sales invoices are recorded in the

sales journal. Posted to the G/L,
usually monthly. With computerized
system, individual entries should also
be posted automatically to the A/R
subledger.

Credit Memo

Proper approval
(occurrence).
Receiving report for
returned goods
(occurrence).

Source document for returns and

allowances. Returns should be
supported by a receiving report; other
allowances should be properly
authorized. Testing depends upon
materiality of amounts.

106

(1) Audit software such as ACL can test for shipments exceeding credit limits.
Note that the credit limit must be approved by someone independent of
sales.
(2) Duplicates and gaps in shipping documents and sales invoices can be
checked using audit software.

107

Documents in Cash Receipts Cycle

Document

Controls (objective)

Cash receipt
prelist

Prepared by someone
independent of accounts
receivable, often an
administrative assistant
or someone with no
accounting duties
(completeness).

Comments
Beginning of cash receipts cycle, and
point where cash enters business.
Establishes record of cash received
to prevent theft. Checks should also
be restrictively endorsed at this
point.
This assumes payment by mail,
usually in the form of a check.
Checks can also be sent directly to a
lockbox, or wire transferred. Diferent
controls are necessary for firms that
receive payments in cash.

Remittance
advice

Document that
accompanies payment by
check - often the lower
portion of the check
(completeness and
accuracy).

Additional evidence of amount of

cash received. When no remittance
advice is received, it is customary for
the person who prelists cash to
prepare one.

The remittance advice is

also important evidence
of the occurrence of a
cash receipt because the
other evidence (the
check) is deposited.
The actual cash receipts
should be deposited usually on a daily basis
(timeliness)
Cash receipts
journal

Posting and
summarization checked
(P&S).
CR recorded at time of
receipt (timeliness)

The cash receipts journal is used to

record individual cash receipts.
Individual cash receipts are
automatically posted by computer to
individual customer A/R.

Accounts
receivable
subledger

Reconciled to the
general ledger by
someone independent of
sales and cash receipts
(posting and
summarization, as well
as other objectives)

The accounts receivable subledger is

important because it is the interface
between the sales and cash receipts
cycle. The reconciliation of the
subledger to the general ledger is an
important control.

108

Document
Bad debt
charge-of

Controls (objective)
Should be authorized
(occurrence)

Comments
Company should have proper
procedures to charge-of accounts.
Should be authorized by someone
independent of authorization of
credit and recording of sales.

Note: it also critical that the bank reconciliation be performed by an

independent person.

109

3.

Approach to Cycle (Walk through Table 14-2)

a.
b.

4.

c.

Identify controls (if any) for each objective.

Design tests of controls (assuming cost-effectiveness)
for key controls. (Designing the TOC is easy, once the
control has been identified).
Design appropriate substantive tests of transactions.

d.

Tests should be sufficient to meet each objective.

Miscellaneous Focuses
a.

Three authorizations are very important for the valuation

and existence objectives:

b.

Prenumbered documents (especially shippers) for

completeness.

c.

Monthly statements - Independently mailed statements

will help detect misstatements, especially overstatements
and mispostings, such as:

5.

Credit
Shipment of goods
Pricing

Sale or cash receipt posted to incorrect account

Cash receipt not credited to account

Direction of Tests
A frequent CPA exam question is the objective of a test, or what
can be inferred from a specific test (see problem 14-27). The
main concern with the direction of tests is usually whether it can
be used to infer existence or completeness.
From a journal to source document (concerned with
recorded amounts) = Occurrence
From a source document to journal (concerned with
unrecorded amounts) = Completeness

Another way to view this issue is:

Occurrence - Concerned with overstatements.
Completeness - Concerned with understatements.

Hence, auditors are usually more concerned with existence for

accounts receivable, and completeness for accounts payable.

110

It may help to view the cycle as a sequence of steps

and documents.

Direction of Tests for Sales

Customer
Order

Complete
ness Start

Shipping
Document

Duplicate
Sales
Invoice

Occurren
ce Start

Sales
Journal

Posting and
Summarization

General
Ledger

A/R Master
File

Selecting a sample for tests: (Described further in Chapter 15 - see

problem 15-27 (a,b))
1.

Sampling from the sales journal (sales invoices) can be used to

satisfy any objective, except completeness (a sample drawn from
sales invoices can't be used to test completeness, because they are
already recorded).

2.

Sampling from shippers can be used to satisfy any objective,

except occurrence (since the shipper establishes existence, it can't
be used as the sample to test for existence).
Therefore, a sample selected from either shippers or sales invoices
could be used for a pricing test, etc.)

111

3.

Sampling from sales invoices is essentially the same as

sampling from the sales journal, as they should be identical.
The auditor may account for a sequence of sales invoices as a
completeness test.

Accounting for a sequence of sales

invoices in sales journal
Trace sales invoices to shippers (or examine
sequence of invoices noting shippers)

Completeness
Occurrence

Multiple Choice 14-27 (a)

To minimize failures to post invoices to the AR subledger, the auditor
would select a sample from:
1.
2.
3.
4.

Customer order file.

Bill of lading file.
Customer AR master file.
Sales invoice file.

Multiple Choice 14-23 (a)

An auditor is performing STOT for sales. Tracing debit entries in the AR
master file back to sales invoices establishes:
1.
2.
3.
4.

Sales invoices represent existing sales.

All sales have been recorded.
Sales invoices have been properly posted to customer accounts.
Debit entries in the AR master file are supported by sales invoices.

6.

Substantive tests of transactions - Although we have discussed

TOC more that STOT, they are very important in the audit. The table
on page 113 of the notes indicates some specific STOT for sales.
The primary focus is on occurrence.

Usual test is to trace sales to shipping documents.

In some circumstances, the auditor may also trace the sale to
reductions in inventory records or subsequent cash receipts as
further verification of the validity of the sale.

112

Multiple Choice 14-23 (b)

To verify that all sales transactions have been recorded, STOT should be
performed on a sample drawn from:
1.
2.
3.
4.

Entries in the sales journal.

Billing clerk's file of sales orders.
Duplicate sales invoices for which sequence has been accounted.
Shipping clerk's file of bills of lading.

Multiple Choice 14-22 (c)

A sales invoice for $5200 was correctly computed, but key entered as
$2500 in the journal and AR master file. The customer remitted $2500, the
amount on the monthly statement. This error would most likely be
detected by:
1.
2.
3.
4.

Prelistings and control totals are used to control postings.

Invoice extensions are independently checked.
Customer statements are verified and mailed by someone other than
the bookkeeper.
Unauthorized deductions are investigated

7.

Sales returns and allowances

a.

Recording - theoretically should be matched with sale. In

practice returns and allowances are recorded as they occur.
This does not present a problem, if there are no significant
returns after year-end.
Why might there be excessive returns shortly after year-end?
(Discussion)

b.

Authorization - Returned goods should be sent to the

receiving department, and a receiving report prepared. Other
allowances should be specifically authorized.

c.

Objectives

Transactions - focus is on the occurrence of returns and

allowances since they can be used to hide theft of cash.
Balances - In the year-end tests of accounts receivable,
the focus is on completeness, since the failure to record
returns overstates accounts receivable.

The significance of sales returns and allowances determines the

extent to which they are tested.
Multiple Choice 14-22 (a)
113

A company received a large sales return in the last month of the year, but
the credit memo wasn't prepared until after the auditors completed field
work. The returned goods were included in inventory. This error would
most likely be detected by:
1.
2.
3.
4.

Aged AR trial balance is prepared.

Credit memos are prepared and accounted for.
Reconciliation of the AR trial balance and general ledger is
performed.
Receiving reports are prepared and accounted for.

8.

Cash receipts cycle

The same methodology can be applied to studying the cash receipts
cycle. Cash receipt cycle is easier because it involves fewer
documents. Some key points:
a.

Critical audit point - when cash first enters organization.

Mail should be opened, cash prelisted, and restrictively
endorsed by someone independent of receivable functions.

Prelist should be compared to deposits

A bank lockbox can be used to eliminate the need for company

employees to handle mail receipts - checks are sent directly to
the bank. This prevents employee theft of checks, but is not
cost-effective for many companies.
Therefore, to ensure completeness of cash receipts:

b.

Lockbox is first-best choice (ignoring cost)

Independent prelist if lockbox not feasible

Over-the-counter cash - For organizations which receive

revenue in the form of cash, it must be reconciled to cash
register tapes or other records supporting sales.
Best way to hide theft of cash receipts is to not record the
sale!

c.

Bank accounts and A/R subledger independently reconciled.

d.

Review for large non-cash credits, such as returns and

allowances, and bad debt writeoffs (why?)

114

Sales Cycle
Illustrative Substantive Tests of Transactions

Objective

Procedure

Comment

Recorded sales exist

(occurrence)

Trace from sales journal

or invoice to shipper.

Almost always done,

even if controls are
efective.

Existing sales are

recorded
(completeness)

Trace from shippers to

recorded sales (invoice
or journal)

Probably not
necessary if tested
controls.

Sales are recorded at

proper amounts
(accuracy)

Recompute quantities
and extensions
(reperformance).
Agree price to price list.

Normally done. Can

reduce sample size if
controls exist.

Sales are properly

classified

Check documents
supporting sale for
proper account
distribution in sales
journal.

Not normally an
important issue.

Sales are timely

recorded

Compare dates on
shipper with sales
invoice and entry in
sales journal

Really a test of control.

Sales are
summarized

Foot sales journal and

trace to entry in
general ledger.

Generally always
done.

Test reconciliation of
A/R subledger to
general ledger.

Discussion Case Howard Street Jewelers

Homework Problems
14-26 (c,d,e)
Sales Tests of Transactions (Collected)
Sample Multiple Choice (Text)
115

14-21
14-22
14-23
14-27

(a),
(a),
(a),
(a),

(b),
(b),
(b),
(b),

(c)
(c)
(c)
(c)

116

Problem 14-26
a.
Objective 1 A given sale is recorded more than once, or a sale is
recorded for which a shipment was not made.
Objective 2 A shipment took place for which no sale was recorded.
Objective 3 A sales journal was incorrectly footed, or a sales
transaction was posted to the incorrect customer
account.
b.
The first objective deals with overstatement of sales resulting from
recording sales for which no shipment had occurred. The second
objective concerns understatement of sales. It results from a
shipment that has not been recorded.
c.
Procedures 2, 3, and 4 are tests of controls. Procedures 1, 5, and 6
are substantive tests of transactions.
d.
(1)
OCCURRENCE

(2)
COMPLETENESS

(3)
POSTING AND
SUMMARIZATION

SUBSTANTIVE
TEST OF TRANS

Procedure
6

Procedure
1

Procedure
5

TEST OF
CONTROL

Procedure
2

Procedure
4

Procedure
3

e.
PROCEDUR
E

CONTROL BEING TESTED

NATURE OF MISSTATEMENT
TRYING TO PREVENT

A shipping document is
attached to each duplicate
sales invoice.

To prevent billing to a
customer or recording a sale
for which no shipment has
been made.

An independent person traces

from the sales journal to the
accounts receivable master
file. A tick mark is shown in
the margin of the sales journal
after a transaction is traced.

Preventing misstatements in
failure to post to the
accounts receivable master
file, posting to the wrong
customer, at the wrong
amount, or at the wrong
date.

At the time of billing, the

duplicate sales invoice number
is written on the bottom lefthand corner of each shipping
document. Periodically, the

The failure to bill customers

for shipments actually
made.

entire sequence of shipping

documents is accounted for
and each is examined to make
certain there is an invoice
number, which indicates that a
given shipment has been
billed.
Sales Test of Transactions Problem - Fall 2009

Name: _________________________________

Procedure
1.

Account for sequence of

shippers noting invoice is
attached

2.

Account for sequence of

sales invoices noting shipper
is attached

3.

Compare quantity and

description on shipper with
sales invoice

4.

Trace from sales journal to

master file

5.

Examine sales return for

approval

6.

Trace for prelisting of cash to

cash receipts journal.

7.

Examine sales order for

evidence of credit
authorization.

Type of test
Test of control

Transaction
objective
Completeness