CHAPTER TWO

AUDIT OF THE SALES AND COLLECTION CYCLE: TESTS OF

CONTROLS AND SUBSTANTIVE TESTS OF TRANSACTIONS
Auditors perform both tests of controls and tests of transactions and balances. As a means of
securing assurance from the clients system of control, it is important for the auditors to know
when they should rely extensively on internal controls and when they should not. This chapter
studies assessing control risk and designing tests of controls and substantive tests of
transactions for each of the classes of transactions in the sales and collection cycle. In the
second part of the chapter, discussions on designing of tests of account balances are included.

Before studying the process of assessing control risk and designing tests of controls and
substantive tests of transactions for each class of transactions, it is important to know the sales
and collection cycle classes of transactions and account balances. It is also important to
understand the typical documents and records used in the cycle.
I. ACCOUNTS AND CLASSES OF TRANSACTIONS IN THE SALES
AND COLLECTION CYCLE
The overall objective in the audit of the sales and collection cycle is to evaluate whether the
account balances affected by the cycles are fairly presented in accordance with IFRS.
 ACCOUNTS IN THE SALES AND COLLECTION CYCLE includes- Sales,
A/Receivable, Cash in Bank, Cash Discounts Taken, Allowance for Uncollectible
Accounts, and Bad Debt Expense

 CLASSES OF TRANSACTIONS IN THE SALES AND COLLECTION CYCLE are –

Sales (cash and sales on account), Cash receipts, Sales returns and allowances,
Charge-off of uncollectible accounts and Estimate of bad debt expense.
II. 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.

 There are eight Business Functions for sales and collection cycle. They occur in every
business in the recording of the five classes of transactions.

Below you will find summary discussions of the Classes of Transactions, Accounts, Business
functions, and related Documents and Records for the Sales and Collection Cycle.
1. SALES TRANSACTION
Accounts
 Sales
 Accounts receivable
Business Functions
 Processing customer orders, - Customer places an order using Customer Order
document.
o This is often followed by the issuance of Sales Order.

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  Granting credit- a properly authorized person must approve credit to the customer for
sales on account.
o Minimizes the possibility of bad debts.
o It may be a programmed approval- based on preapproved credit limit
maintained in a customer master file.
 Shipping goods
o A point at which most companies recognize sale.
o A shipping document is prepared.
o The shipping document may be a multicopy bill of lading.
o Update perpetual inventory record.
 Billing customers and recording sales- Billing is a means by which the customer is
informed of the amount due for the goods.
o All shipments should be billed and no shipment should be billed more than
once.
o Billing should consider authorized price, quantity shipped and other terms.
o Done with multicopy sales invoice and simultaneously updating of the sales
transaction file, accounts receivable master file, and the general ledger master
file for sales and accounts receivable.
Documents and Records
 Customer Order- a request for merchandise by a customer.
o It may be received in differing formats.
 Sales Order- used to communicate the description, quantity and related specification of
goods ordered.
o Often used to indicate credit approval and authorization for shipment.
 Shipping Document- a document prepared to initiate shipment of goods.
o Prepared in at lease in three copies – customer, accounts, retained
 Sales invoice-a document indicating the description and quantity of goods sold the
price, freight charges, insurance, terms, and other relevant data.
o Prepared in at least three copies.
 Sales transaction file- a computer generated file that includes all sales transactions
processed by the accounting system for a period.
o It includes all information entered into the system and information for each
transaction- customer name, date, amount, account classifications, sales person,
and commission rate.
o The file may include returns and allowances if separate files are not kept for
those transactions.
o The information in this file is used for a variety of records, listing, or reports-
e.g. sales journal, A/R master file, and transactions for certain account balance
or division.
 Sales journal or listing- a 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.
o It also identifies whether the sale was for cash or credit.
 Accounts receivable master file- a file used to record individual sales, cash receipts,
and sales returns and allowances for each customer and to maintain customer account
balances.

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 o The master file is updated from the sales, sales returns and allowances, and cash
receipts computer transaction files.
o It is also called the A/R subsidiary ledger or subledger
 Accounts Receivable trial balance- a list of the amounts owed by each customer at a
point in time.
o This is prepared directly from the A/R master file.
o It is often an aged trial balance.
 Monthly statements- a document sent by mail or electronically to each customer
indicating the beginning balance of A/R, the amount and due date of each sale, cash
payments received, credit memos issued, and the ending balance due.
2. CASH RECEIPTS TRANSACTION
Accounts
 Cash in bank (debits from cash receipts)
 Accounts receivable
Business Functions
 Processing and recording cash receipts- includes receiving, depositing and recording
cash- currency & checks.
o The possibility of theft is the most important concern (both before and after
recorded).
o All cash receipts must be deposited intact and recorded in the cash receipts
transaction file.
o Remittance advices are important for this purpose.
Documents and Records
 Remittance advice- a document that accompanies the sales invoice mailed to the
customer and can be returned to the seller with the cash payment.
o If no remittance advices are received the person opening the mail should
prepare it.
o Used to permit the immediate deposit of cash & to improve control over custody
of assets.
 Prelisting of cash receipts- a list prepared when cash is received by someone who has
no responsibility for recording sales, A/R, or cash and who has no access to accounting
records.
o It is used for verifying whether cash received was recorded and deposited.
 Cash receipts transaction file- a computer generated file that includes all cash receipts
transactions processed by the accounting system for a period.
o Used to prepare the cash receipts journal and update the A/R and general ledger
master files.
 Cash receipts journal or listing- a report generated from the cash receipts transaction
file that includes all transactions for any time period.

3. SALES RETURNS AND ALLOWANCES TRANSACTION

Accounts
 Sales returns and allowances
 Accounts receivable
Business Functions
 Processing and recording sales returns and allowances

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 o When a customer is dissatisfied with the goods, the seller often accepts the
returned goods or grants a reduction in the charges.
o It is necessary to issue a Receiving Report and return the goods to store.
o Record the transaction promptly and accurately on the Sales and Returns
Journal & A/R master file.
o As an aid for control & to facilitate recording Credit Memos are issued.
Documents and Records
 Credit memo- a document indicating a reduction in the amount due from a customer
because of returned goods and allowances granted.
 Sales returns and allowances journal- a journal used to record sales returns and
allowances.
o Sales journal can be used instead.
4. CHARGE-OFF OF UNCOLLECTIBLE ACCOUNTS TRANSACTION
Accounts
 Accounts receivable
 Allowance for uncollectible accounts
Business Functions
 Charging off uncollectible accounts receivable
o When the company concludes that an amount is no longer collectible, it must be
charged off- e.g. if a customer becomes bankrupt.
o Necessary adjusting entries are made.
Documents and Records
 Uncollectible account authorization form- a document used initially to indicate
authority to write an account receivable off as uncollectible.
 General journal
5. BAD DEBT EXPENSE TRANSACTION
Accounts
 Bad debt expense
 Allowance for uncollectible accounts
Business Functions
 Providing for bad debts
o The provision should be sufficient to allow for the current period sales that the
company will be unable to collect in the future.
o Allowance method is used.
Documents and Records
 General journal
III. METHODOLOGY FOR DESIGNING TESTS OF CONTROLS AND
SUBSTANTIVE TESTS TRANSACTIONS FOR SALES
UNDERSTANDING INTERNAL CONTROLS- SALES
 Typical approach- Auditor prepares an internal control questionnaire, and performs
walk-through tests of sales
ASSESS PLANNED CONTROL RISK- SALES
Information obtained in understanding internal control is used to assess control risk.
There are four essential steps:

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 1. The auditor needs a framework for assessing control risk. The framework for all classes
of transactions is the six transaction-related audit objectives.
2. Identify the key internal controls and weaknesses for sales.
3. Associate the controls and weaknesses identified with the objectives.
4. Assess the control risk for each objective by evaluating the controls and weaknesses for
each objective.
Step four is critical because it affects the auditor’s decisions about both tests of controls and
substantive tests. It is a highly subjective decision.
ADEQUATE SEPARATION OF DUTIES
 Person responsible for inputting sales and cash receipts transaction information into the
computer vs. person having access to cash.
 Credit granting function vs. the sales function (to minimize the sales people tendency to
optimize volume even at the expense of high bad debt write-offs).
 Personnel responsible for doing internal comparisons vs. those entering the original
data. (E.g. comparison of batch control totals with summary reports and comparison of
A/R master file totals with the GL balance should be done by someone independent of
those who input sales & cash receipt transactions).
PROPER AUTHORIZATION
Three key points of authorization
 Credit must be properly authorized before sales takes place,
 Goods should be shipped only after proper authorization, and
 Price, including freight and discount, must be properly approved- to ensure sales is
billed at the price set by co policy
ADEQUATE DOCUMENTS AND RECORDS
 Documents and records used must be adequate.
 Should contain sufficient information.
 Most companies automatically prepare a multi-copy prenumbered sales invoice at the
time the customer places an order. –Useful for minimizing the chance of failure to bill
the customer if all invoices are accounted for periodically.
PRENUMBERED DOCUMENTS
 Use of prenumbered documented prevents both the failure to bill or record sales and the
occurrence of duplicate billings and recordings.
 All should be properly accounted for.
e.g. filing, by a billing clerk, of a copy of all shipping documents in sequential order
after each shipment is billed, with someone else periodically accounting for all numbers
and investigating the reason for any missing documents.
MONTHLY STATEMENTS
 Sent by someone having no responsibility for handling cash or preparing the sales and
A/R records.
 Encourages response from customers if the balance is improperly stated.
 All disagreements about the balance in the account should be directed to the
independent designated official.
INTERNAL VERIFICATION PROCEDURE
 For fulfilling the each of the six transaction related audit objectives, a computer
program or an independent person check the processing and recording of sales. e.g.
accounting for numerical sequence of prenumberd documents,

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  Checking the accuracy of document preparation.
 Reviewing reports for unusual or incorrect items.

i) DESIGN TESTS OF CONTROLS FOR SALES

For each control the auditor plans to rely on to reduce assessed control risk, one or more tests
of controls must be designed to verify its effectiveness.
The nature of the tests of controls is determined from the nature of the control.

ii) DESIGNING SUBSTANTIVE TESTS OF TRANSACTIONS FOR SALES

In designing substantive tests of transactions, some procedures are commonly used on every
audit regardless of the circumstances of tests, where as others are dependent on the adequacy
of the controls and the results of the tests of controls
 The audit procedures are affected by the internal controls and tests of controls for that
objective.
 Materiality and results of the prior year affect the procedures used.
The typical substantive tests of transactions are shown in the table provided above. Below you
will find additional procedures to be performed in relation to the transaction related audit
objectives.

RECORDED SALES EXIST

For this objective, the auditor is concerned with the possibility of three types of misstatements.
 Sales being included in the journals for which no shipment was made,
 Sales recorded more than once, and
 Shipments being made to nonexistent customers and recorded as sales
 Many auditors do substantive tests of transactions for existence objective
depend on where the auditor believes the misstatements are likely to take place.
The test will be done only if they believe that a control weakness exists.
Recorded Sales for which there was No Shipment
 Trace selected entries from the sales journal to make sure that related copies of the
shipping and other supporting documents exist.
 If the possibility of fictitious duplicate copy of a shipping document, trace amounts to
the perpetual inventory records.
 Trace the credit in the A/r master file to its source- if collected or goods returned, there
must originally have been a sale. If credited for bad debt or if the account was still
unpaid, intensive follow-up by examining shipping docs and customer order docs.
Sales Recorded More than Once
 Duplicate sales can be determined by reviewing a numerically sorted list of recorded
sales transactions for duplicate numbers.
 Also test proper cancellation of shipping documents.
Shipment Made to Nonexistent Customers
 Can occur only when the person recording sales is also in a position to authorize
shipments.
 If controls are weak, it is difficult to detect.
EXISTING SALES TRANSACTIONS ARE RECORDED
 Normally, substantive test for completeness is less emphasized.

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 But if controls are inadequate, which is likely if the client does no independent
internal tracing from shipping documents to the sales journal, substantive testes are
necessary.
 Test for unbilled shipments to trace selected shipping documents from a
file in the shipping department to related duplicate sales invoices and the sales
journal.
Direction of Testing
 Tracing from source documents to the journals- a test for omitted
transactions- Completeness Objective…likely starting point could be a shipping doc…a
sample selected and traced to sales invoices and sales journal.
 Tracing from the journals back to source documents- a test for
nonexistent transactions- existence objective….likely starting point could be the journal…
a sample of invoice numbers is selected from the journals and traced to duplicate sales
invoices, shipping docs, and customer orders.
SALES ARE ACCURATELY RECORDED
Accurate recording of sales - shipping the amount of goods ordered, accurate billing for the
amount of goods shipped, and accurately recording the amount billed.

Typical substantive tests include: Recomputing information in the accounting records

 Start with entries in the sales journal to compare the total of selected transactions with
A/R master file entries & duplicate sales invoices.
 Compare prices on the duplicate sales invoices with an approved price list,
 Recompute extensions and footings
 Compare details listed on the invoices with shipping records for description, quantity,
and customer identification

 When sales invoices are automatically calculated and posted by a computer, the
auditor may be able to reduce substantive tests of transactions for the accuracy objective.
 If the auditor determines that the computer is programmed accurately and the
price list master file is authorized and correct, detailed invoice calculations can be reduced
or eliminated. In this case, the focus will be on determining if effective computer controls
exist.
RECORDED SALES ARE PROPERLY CLASSIFIED
 Sales of cash vs. credit sales
 Exclude sales of operating assets such as machinery
 Use of more than one sales classification….. Regular, installment…
SALES ARE RECORDED ON THE CORRECT DATES
 Sales should be billed and recorded as soon after shipment takes place as possible to
prevent the unintentional omission of transactions from the records and to make sure
that sales are recorded in the proper period.
 Compare the date on selected bills of lading or other shipping documents with the date
on the related duplicate sales invoices, the sales journal, and the A/R master file.
SALES TRANSACTIONS ARE PROPERLY INCLUDED IN THE MASTER FILE
AND CORRECTLY SUMMARIZED
 Needed b/se the accuracy of these records affect’s the client’s ability to collect
outstanding receivables.
 The sales journal must be correctly totaled and posted to the GL

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  Perform clerical accuracy tests such as footing the journals and tracing the totals and
details to the GL and the master file to check whether there are misstatements.
 The distinction between posting and summarization and other transaction
related audit objectives is that posting and summarization includes footing journals,
master file records, and ledgers and tracing from one to the other among these three.
 When footing and comparisons are restricted to these three records, the process is
posting and summarization
 In contrast, accuracy involves determining the monetary correctness of transactions
and comparing amounts b/n docs or with journals and master file records.
SALES RETURNS AND ALLOWANCES
The transaction-related audit objectives and the client’s methods of controlling misstatements
are essentially the same for processing credit memos as those described for sales.
But two important differences:
 Materiality, and
 Emphasis on audit objectives- primary emphasis is normally on testing the existence of
recorded transactions as a means of uncovering any diversion of cash from collection of
A/R that has been covered up by a fictitious sales return or allowance.
 Completeness objective is important especially at year-end. Unrecorded SR/A can be
material… overstates net income if unrecognized.
IV. METHODOLOGY FOR DESIGNING TESTS OF CONTROLS AND
SUBSTANTIVE TESTS OF TRANSACTIONS FOR CASH RECEIPTS
The same methodology used for designing tests of controls and substantive tests of transactions
for sales is used for cash receipts.
 Cash receipts tests of controls and substantive tests of transactions audit procedures are
developed around the same framework used for sales.
 Key internal controls for each objective are determined, tests of controls are developed
for each control, and substantive tests of transactions for the monetary misstatements
related to each objective are developed.
 The tests of controls depend on the controls the auditor has identified and the extent
they will be relied on to reduce assessed control risk.
In the Table xx below you will find examples of key controls, common tests of controls, and
common substantive tests of transactions to satisfy each of the transaction-related audit
objectives for cash receipts.

 An essential part of the auditor’s responsibility in auditing cash receipts is identification

of weaknesses in internal control that increase the likelihood of fraud.
DETERMINE WHETHER CASH RECEIVED WAS RECORDED
It is difficult to detect a cash fraud occurred before the cash is recorded in the cash receipt
journal or other cash listing.
 Internal controls designed to satisfy completeness objective are important.
 Trace from prenumbered remittance advices or prelists of cash receipts to the cash
receipt journal and subsidiary A/r records as a substantive tests of the recording of the
actual cash received… effective only if a cash register tape or some other prelisting was
prepared at the time cash was received
PREPARE PROOF OF CASH
 A useful audit procedure to test whether all recorded cash receipts have been deposited
in the bank account.

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  Total cash receipts recorded in the journal vs. actual deposits made during the month…
 Helps to detect recorded cash receipts that haven’t been deposited, unrecorded deposits,
unrecorded loans, bank loan deposited directly into the bank account etc.
 Can not help to detect cash receipts that have not been recorded inn the journals or time
lags in making deposits.
 Performed only when controls are weak.
TEST TO DISCOVER LAPPING OF A/R
Lapping of A/R is the postponement of entries for the collection of receivables to conceal an
existing cash shortage.
 The defalcation is perpetrated by a person who handles cash receipts and then enters
them into the computer system.
 Involves differing recording the cash receipts from one customer and covers the
shortage with receipts of another. This in turn is covered from the receipts of a third
customer few days later.
 Prevention…. Separate duties and mandatory vacation policy for employees who both
handle cash and enter cash receipts into the system.
 Detection… Compare the name, amount, and dates shown on remittance advices with
cash receipts journal entries and related duplicate deposit slips.