Exam 3 Study Guide - Ch. 7
Chapter 7 -- The Revenue and Collection Cycle
Allowable detection risk is the maximum amount of detection risk that the auditor can have (or allow) for that combination of account and assertion, and still limit his or her overall level of audit risk to his or her specified level (for example, 5%). Allowable detection risk is calculated from the audit risk model formula (Actual Risk = Inherent Risk * Control Risk * Allowable Detection Risk) Actual detection risk is the likelihood that the auditor would fail to detect a material misstatement if it were to occur (that is, not be prevented by the client's internal controls. AND not be detected or corrected by those controls). Actual detection risk is determined by the nature, timing, and extent of the auditor's substantive tests. Substantive tests: the tests used by the auditor to determine whether the financial statements contain one or more material misstatements The allowable level of detection risk informs the auditor as to the appropriate nature, timing, and extent of his or her substantive audit procedures (substantive tests). If Allowable Detection risk is found to be 95%, then 1-Allowable DR is 5%, which means the auditor only needs to design and carry out substantive tests that have a 5% chance of finding any material misstatement that exists for that assertion for that account.
The existence assertion is more important than the completeness assertion when auditing accounts receivable.
To be recognized, revenues must be (1) realized or realizable, and (2) earned.
Channel stuffing is a deceptive business practice that inflates sales and earnings by forcing more products along a company's distribution channel without actual sales taking place.
Bill and hold: a fraudulent financial reporting activity by which a company recognizes a sale even though it does not ship the merchandise to the customer, but holds it in its own warehouse
Estimation of the allowance for doubtful accounts can be subjective and difficult for the client and the auditor. This is particularly true when the client has changed products, credit policies, or its customer base, causing it to have little experience on which to make estimates. Changing economic conditions also make it difficult to estimate collectability. Therefore, valuation is a high risk assertion and the auditor evaluates the reasonableness of the allowance.
Liabilities for known rights of return, warranties, and other potential obligations are often very difficult to estimate. Companies with new products or technologies have an even higher inherent risk in these areas.
Basic Activities in the Revenue and Collection Cycle (for a typical manufacturing company):
1. Receiving and processing customer orders, including credit approval
a. If a company sells its goods or services for something other than cash, it is important that someone authorize credit sales to ensure that the customer will be able to pay for the goods or services.
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Exam 3 Study Guide - Ch. 7
b. Customer orders, shipping documents, and invoices should be in prenumbered seq