 in this presentation we will discuss auditing revenue we're going to be discussing the revenue cycle and the approach of auditing the revenue cycle first thing we want to consider is the revenue recognition principle because obviously when we audit the revenue the timing is going to be one of the major principles that we need to consider first a word from our sponsor well actually these are just items that we picked from the youtube shopping affiliate program but that's actually good for you because these aren't things that were just given to us from some large corporation which we don't even use in exchange for us selling them to you these are things that we actually researched purchase and use ourselves bayer dynamic not sure if i said that right but this is the dt 770 pro 250 ohm studio reference closed back headphones i wear headphones basically every day for a large part of the day they are important to me therefore i've gone through many different kinds of headphones i've had 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have many different courses you can purchase one at a time or have a subscription model giving you access to all the courses courses which are well organized have other resources like excel files and pdf files to download and no commercials with the auditing of revenue we therefore have to understand the accrual principle as it relates to revenue that's the revenue recognition principle now this is going to be a fairly detailed revenue recognition principle because we want to see this step by step as we can apply it to the approach for auditing revenue so revenue recognition principle just in general terms we might just say that we're going to recognize revenue when it has been earned but we want as opposed to when cash is received that's probably what most people would say as a revenue recognition principle but we want to be very specific in this and we want to be able to apply this to different types of businesses as well because we may have some businesses that sell goods inventory we may have other businesses that have services so revenue recognition principle revenue can be defined as inflows or other increases of assets of an entity so we're going to say there's some kind of inflow does it have to be cash did we decide did we define cash here no because another inflow it could be a counts receivable for example going up as we make a sale on account of the entity or settlement of liabilities this is often something that is overlooked it's quite possible that we make a sale and instead of receiving something instead of getting some type of asset a counts receivable or cash we have something that is a liability that's relieved in some case reducing a liability now that's not normal the process that happens usually a counts receivable goes up or cash goes up but it's quite possible that we could have a liability go down and that would still be revenue should be in the definition of an entity from providing goods so goods or inventory providing services so we're having services which would be non inventory related for a service type company or from activities that make up the entities of major operations so when we are considering revenue we're typically considering those major operations so for example if we're in the business of selling some type of inventory and we actually happen to sell some stocks and bonds some of our investments we're not a financial company but we sold stocks and bonds or we earned interest on stocks in the bonds and we had capital gains of some kind or interest income or dividend income this would be another type of income but it's not going to be our principal revenue recognition in the operations of the business so let's go through this one more time revenue can be defined as inflows or other increases in assets of an entity or settlement of liabilities of an entity from providing goods providing services or from activities that make up the entities major operations so what are we going to do in the auditing of the revenue approach within the auditing process we're going to have to understand the business what is it that they do in order to generate revenue we're going to identify the contract with the customers so what's going to be the contract that is involved with the customer with regard to revenue recognition what kind of contract is it is it goods or services that are being given is it goods that are being given or services that are being given or some combination of the two identify the poor performance obligations in the contract so what is the performance that has to be done we need to know that because that's a major component to the revenue recognition principle because that's typically the point in time when the revenue should actually be recognized within the agreement determine the transaction price so what's going to be the transaction price for the contract that's being involved for the major operation of the business allocate the transaction price to the performance obligations in the contract so we're going to allocate that out and then recognize revenue when the entity satisfies performance obligation which of course is in alignment with our revenue recognition principle revenue recognition fraud risks so as we go through this we want to be considering the fraud risks one type of fraud risk is side agreements side agreements are arrangements that are used to alter the terms and conditions of recorded sales so we're going to be altering the terms and that's typically not a good thing to do because it could be deceptive that's where the fraud comes into place so one more time arrangements that are used to alter the terms and conditions of recorded sales in order to entice customers to accept delivery of goods and services then we have channel stuffing which is a marketing practice that suppliers sometimes use to increase sales by incentivizing distributors to buy substantially more inventory than they can promptly sell and of course we can imagine this happening at the end of the year if you were if you could you could imagine a manager at the end of the year saying i need to increase sales to this level because i want to get my bonus and i have to get over this level before the end of the year the cutoff is that 1231 how can sales be increased well maybe we can somehow incentivize our distributors to purchase more before the end of the year in some way and and they're going to purchase more than they otherwise would thereby increasing the sales before the cutoff now in the long term of course it's it's not going to be a good thing because the increase in the sales of the cutoff would be just a timing difference that would indicate that you would think that sales would decrease after the year and it kind of distorts basically the numbers and it could actually decrease the amount of that is is going to be sold because you might have to have some type of incentivization in order to incentivize someone to have the the higher purchases maybe by discounting and or hurt the relationship with uh with the distributors in that in that way by kind of changing the normal terms related party transactions related party transactions transactions that are not considered at arm's length so for example if a company had something like a subsidiary and there was some type of related party transactions the subsidiary being in some way owned or related to the parent company you can imagine sales types transactions that would happen to the related party that could be another way that that a manager or a company might try to manipulate or increase their sales by basically making sales to uh related party at at terms that aren't on arm's lengths meaning they're not like normal market sales because they're at they're at related party uh level and then we have bill and hold sales bill and hold sales sales where the customer agrees to purchase the goods but the seller retains physical possession until the customer requests shipment so this is another thing that you can kind of imagine happening at the end of the year you can say oh well what if there's going to be some type of sale that's going to be agreed upon but the the company is holding on to the inventory they don't actually distribute the inventory until after year end so you can imagine the cutoff date sale happens but the the company is holding on to the inventory not shipping it till after the cutoff date well typically uh the the sales should be recognized when the service is done when the work is done when that relates to inventory goods that's usually at the point in time that they have been shipped or at the point they have been arrived whether it fob shipping or fob uh destination so you can imagine this type of situation invoice goes out accounts receivable bull goes up sales goes up they they say well this they have had purchase that has happened but the inventory hasn't been shipped yet and therefore it's just basically on the books as a sale at that point even though the transaction hasn't taken place revenue recognition process so what's going to be the cycle for revenue recognition if we're selling goods so if we sell inventory we're going to have purchases we're going to purchase the inventory that we're then going to mark up and sell then we're going to have the inventory we're going to be tracking the inventory then of course we'll have cash sale so this is the case if we sell it for cash we would have purchases you can imagine then us holding on to the inventory and then putting possibly into a store at which point we make sales for cash at the store point and that would be our cycle what if we had sales that were going to be made on account we may have then purchases we're then going to have the inventory that we're going to track then we're going to have credit sales so now we have a sale we can imagine basically a credit sale accounts receivable sale we didn't get cash at the point in time of the sale we expect to get cash sometime in the future and then of course that's going to be recording the accounts receivable now being involved now that we have this accrual process accounts receivable and then we're going to have the cash collection on the accounts receivable so most of the time when we think about basically sales on account this is the cycle this is the more complex cycle we would have if we make sales for cash we would have a more simplified cycle looking like this type of transactions related to the revenue process what kind of transactions are we going to be looking at we're going to have these sales of goods or rendering of services for cash or credit so obviously we're going to have the sales that will be taking place these are going to be the transactions that will be testing so when we consider revenue we will be testing these transactions our focus is on revenue but notice this full transaction that will be happening sales of goods or rendering of services which will include revenue possibly cash and we'll talk about the accounts involved shortly receipt of cash from customers in payment for goods or services we also want to test the receipt of cash from customers for the goods and services and then we're going to have the return of goods by customers for credit or cash so this is the other thing that could happen the customer could come back and return the transaction so we basically these are the transactions we're concerned with with regard to revenue recognition what are going to be the accounts then that we will be considering with regard to revenue recognition the revenue process now our main account is of course revenue but as we test revenue we're going to also be testing some of these other type of items to some degree or another given the fact that we have to as we test revenue note that that could be a good thing because as we go through this testing process as we go through these accounts we will be testing other types of accounts as we go which means we could possibly do less testing once we get to those basically accounts and those transactions because we would have already touched on them to some degree as we've been considering the revenue process so then these are going to be the financial statement accounts that will be affected as we consider revenue then we're also going to be considering these type of accounts because they're involved in the transactions the sales transaction will involve accounts receivable if we make sales on accounts therefore to some degree as we test the revenue process we will be testing accounts receivable we'll have sales or revenue because obviously revenue will be involved in the sales transactions allowance for uncollectible accounts this is going to be something that will be involved with accounts receivable as we consider the value of accounts receivable the allowance for doubtful accounts will be part of that net value and then and then the bad debt expense representing those receivables that are not going to be collected that's important with regards to the revenue process because really those bad debt expenses are our sales that didn't really happen it's really kind of a negative sale that happened when someone says they're not going to pay us then the sale never really happened and we have this bad debt expense is really kind of a negative sale in that sense so it's related to the sales transactions cash receipts transactions related to this revenue process we're going to be dealing with cash either with the cash sales or with the receipt from sales on account paying off the accounts receivable so as we test then the sales will also be testing cash so we'll do some testing of cash of course in that process we will be concentrated on cash in and of itself as we as we test cash at that at some point we're testing the bank reconciliation and whatnot but as we test revenue we also look at cash to some degree at least on the deposit side of things and then we have the receivables accounts receivables transaction because it will be going down as we collect cash on account and then we'll have cash discounts as well that we'll have to consider with regards to cash transactions then we have sales returns and allowance transactions so sales return and allowance and this is going include the sales returns and the sales allowances we want to consider these at the same point in time as we consider the revenue process because although these are broken out as separate type of accounts and they act kind of like expenses they're really contra sales accounts what that means if someone came back and said hey i'm giving the inventory back now well the sale never really happened then it's a it's basically a reversal so we don't usually decrease the sales account recall what we do instead is we make these other accounts with our which are kind of like contra sales accounts they're going to be credited they're going to be debit balance accounts that are basically revenue accounts that are debit balance contra revenue accounts and that's going to be the sales returns and allowances and then of course the accounts receivable also involved with the sales returns