AUDIT OF SALES, DEBTORS AND PREPAYMENTSppspeakprofessional.com/seminar6.pdf · 1 | p a g e audit of sales, debtors and prepayments presented by audit and assurance department: peak

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AUDIT OF SALES, DEBTORS AND PREPAYMENTS

PRESENTED BY

AUDIT AND ASSURANCE DEPARTMENT:

PEAK PROFESSIONAL SERVICES

IN HOUSE SEMINAR SERIES NO 6


(CHARTERED ACCOUNTANTS)

NIGERIA

A member of Kreston International | A global network of independent accounting firms

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INTRODUCTION

As part of the year-end audit of a company's financial statements, external

auditors test sales transactions and the internal controls over those

transactions to ensure that the company is not materially misstating its

revenues or accounts receivable.

The sales and collections cycle in a business refers to the set of processes

that begin when a customer makes a request for the purchase of goods or

services and ends when the company receives complete payment for the

purchase.

The overall objective in the audit of sales and collection cycle is to evaluate

whether the account balances affected by the cycle are fairly presented in

accordance with relevant accounting standards.

It should be noted that there are various accounts that are involved in the

sales and collection cycle of a business. The name given to the various types

of accounts in the sale and collection cycle vary from business to business.

For example, the name given to sales in a retail business will be SALES while

in an Insurance business it would be PREMIUM. Though the names differ, it

is important to note that the key concepts and principles are the same.

Debtors and Prepayments form significant part of the assets of most

companies. While sales figure is key to determining the overall result and

performance of a business. It is therefore important that the auditor carries

out appropriate audit procedures to verify the accounts in the financial

statements of a company being audited.

This paper covers the audit of Sales, Debtors and Prepayments. It is hoped

that at the end of the presentation members of staff will be able to identify

the processes involved in any sales cycle and carry out audit procedures to verify the associated balances in the financial statements of our clients.

The topics covered in this paper are as follows:

Definition of terms

Understanding the client’s Revenue System

Internal Controls over the Sales System

Audit of the Revenue/Sales System

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Audit of Cash Sales/ Receipts

Audit of Accounts Receivable/Debtors

Audit of prepayments

Definition of Terms

Revenue

Revenue is defined by the International Accounting Standard (IAS) 18 as

income that arises from the course of ordinary activities of an entity. This

could be referred to by a variety of different names such as Sales, Fees,

Interest, Dividends and Royalties.

It is important to note that sales are generated from the ordinary course of

the business. Incomes generated from the activities that are not part of the

core business of an entity are regarded as gains and not sales. For instance,

sale revenue of a business whose main aim is to sell biscuits is income

generated from selling biscuits. If the business sells one of its factory

machines, income from the transaction would be classified as a gain rather

than sale revenue.

Debtors

Trade debtors also known as account receivables are the value of revenue

invoiced for which money is still owed to the business after the sale is made

or service rendered. In practice, this usually happens when goods are

dispatched or service rendered and invoice issued to the customer.

Debtors are recorded in the balance sheet of the accounts as a current asset

at the time that sales are recorded, but before cash has been received from

the customer. The debtors control account in the balance sheet will be the

net of all invoices to customers (debits) less the receipts from all customers

(credits), and should always be a debit balance.

Prepayments

Prepayments are amounts paid for one period which relates to the next

period. They are sometimes referred to as deferred charges and could be

related to different expense heads such as Prepaid Rent, Prepaid Insurance,

and Prepaid Trade Marks etc.

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Understanding the Entity’s Revenue System

We stated at the beginning of this paper that the sales and collections cycle

in a business refers to the set of processes that begin when a customer

makes a request for the purchase of goods or services and ends when the

company receives complete payment for the purchase.

The process begins with a request by a customer and ends with the

conversion of material or service into accounts receivable and ultimately

cash.

Kindly note that the process is common to all types of business no matter

what they are engaged in. What would be different is the names and degree

of details.

In order to have a good understanding of a company’s sale system, we must

understand that every company has specific functions that are associated

with the sales cycle. It is important that we understand the functions and

the documents that are used for each function whenever we set forth to

perform audit on any company.

In order to facilitate our understanding of the sales system, we present a

summary of the functions in the table below:

BUSINESS

FUNCTION

DOCUMENT

USED

ACCOUNTS

AFFECTED

CLASSES OF

TRANSACTIONS

1 Processing of

customer orders

Customer

Order/ Sales Order

Sales and

Accounts Receivable

Sales

2 Granting Credit Customer

Order/Sales

order

Sales and

Accounts

Receivable

Sales

3 Shipping

Goods/Rendering

Service

Shipping

Documents/

Waybills,

Certificate of completion etc

Sales and

Accounts

Receivable

Sales

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4 Billing Customers

and recording

sales

Sales invoice,

Bills, Sales list

Sales and

Accounts

Receivable

Sales

5 Processing and

recording cash

receipts

Remittance

Advice,

Prelisting of

Cash Receipts

Cash in Bank

and Accounts

Receivable

Cash Receipts

6 Processing and

recording sales

returns and

allowances

Credit Memos,

Sales Returns

Journals and

allowances Journals

Sales Returns

and Allowances

and Accounts

Receivable Accounts

Sales Returns

and Allowances

7 Writing off

uncollectable

accounts receivable

Uncollectible

Accounts

authorization Journal, General

Journal Form

Accounts

Receivable and

Provision for Bad Debt

Account

Write Off of

Uncollectible

Accounts

8 Providing for Bad

Debts

General Journal Bad Debt

Expense and Provision for

Bad Debt

expense

account

Bad Debt

expense accounts

The table is now explained as follows:

When carrying out the audit of a client’s sales cycle, we must understand

and document the activities in the table above. Such understanding will help

us to design the nature of audit test to be performed. It would also help us

to fulfill the requirements in ISA 315 Understanding the entity and its

Environment.

CUSTOMER ORDER

A customer order is a request for goods or service by a customer. This could

take the form of telephone, letter or a printed form. The form can be sent by

post, hand delivered or by internet.

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Sales Order

This is a document that is used for communicating the description, quantity

or related information for goods or and services ordered by a customer.

Sometimes the sales order also includes details relating to credit.

It is important to note that before services are rendered or goods are

shipped to customer, a properly authorized person must approve credit to

the customer for credit sales.

Shipping of Goods/ Rendering of Service

This is the most important function in the sales cycle. It is the point at which

risks and rewards of an asset are transferred to the customer. At this point,

most companies recognize income.

The document for this important stage is known as the shipping document.

It indicates the description of goods, the quantity shipped and other relevant

data. The name given to a shipping document could be waybill, bill of laden

or any other name depending on the nature of business.

Billing Customers

Billing customers is the means by which customer is informed of the amount

of goods shipped or services rendered. The most important aspects of billing

are:

All shipments or services have been billed (Completeness)

No shipment or service has been billed more than once (Occurrence)

Each one is billed for the proper amount (Accuracy)

Billing is normally done by means of a sales invoice. A sales invoice is a

document indicating the description and quantity of goods sold, the price

and other relevant terms.

In a computerized accounting system, it is usually possible to obtain what is

often referred to as a Sales Transaction File. This file includes all information

entered into the system and information for each transaction such as the

customer name, date, amount, account classification etc.

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This file can also be varied to obtain what is known as the Sales Journal. The

Sales Journal is a listing or report which also includes the product line or

division.

NOTE

The transaction functions explained above are necessary for getting the

goods and services into the hands of the customers, correctly billing them

and reflecting the information in the accounting records.

The other four functions are concerned with collection and recording of cash,

sales returns and allowances, write off of uncollectible accounts and

providing for bad debt expense.

PROCESSING AND RECORDING CASH RECEIPTS

Processing and recording cash receipt involve receiving, depositing and

recording cash. Kindly note that cash includes currency, cheques and

electronic funds transfer. The auditor’s concern here is the possibility of theft

and misappropriation of the asset.

Sometimes customers will include a remittance advice when making

payments, such advice helps the seller to keep track of what has been paid

for in order to pass the accounting entries. In the case of electronic funds

transfer or purchase of goods by credit cards, the bank provides information

to the company to prepare the accounting entries.

Most computer system can also generate a cash receipt transaction file that

will indicate the name of the customer and invoice details.

PROCESSING AND RECORDING OF SALES RETURNS AND ALLOWANCES

When a customer is dissatisfied with the goods or services, the seller often

accepts the return of goods and grants a reduction in the charges. The

company prepares a receiving report for returned goods and returns them

for storage. These are recorded in the sales returns transaction file.

Credit memos or credit notes are raised to indicate a reduction in the

amount due from a customer.

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A sales return journal is used to record sales returns and allowances, though

some companies might use the sales journal to also record sales returns.

WRITING OFF UNCOLLECTIBLE RECEIVABLES

When the company has assessed that certain amount is not collectible, it

must be provided for. The process is done by making use of an internal

document known as the uncollectible Account Authorization Form.

PROVIDING FOR BAD DEBTS

When it becomes clear that an amount cannot be collected for example the

customer has become bankrupt, the amount must be written off as bad debt

expenses

EXERCISE

1. Each member of staff is required to take a particular business and

explain their sales process using the 8 sales cycle function above. The

explanation should clearly indicate the document that are used for

each function

2. Explain the difference between bad debt and allowance for bad debt

and tell us how this is treated in the accounts

INTERNAL CONTROL SYSTEM OVER SALES

Internal Control is defined as the process designed and effected by

management to provide reasonable assurance about the entities objectives

with regard to the reliability of financial reporting, effectiveness and

efficiency of operations and compliance with applicable laws and regulations.

From the above, it would be observed that internal controls are designed to

enable the business achieve specific business objectives.

In this section, we shall be looking at what the control objectives of the sales

systems and the control procedures which are put in place to achieve the

objectives.

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REVENUE OR SALES SYSTEM OBJECTIVES

The objectives of any revenue system can be broadly classified into three

categories.

Ordering and granting of credit

Dispatch and invoicing

Accounting

The details of each component are as follows:

ORDERING AND GRANTING OF CREDIT

1. Goods and services are supplied to customers with good credit

standing

2. All Orders are recorded correctly

3. All Orders are met

4. Goods and Services returned by customers are recorded

DISPATCH AND INVOICING

1. All invoices raised relate to goods and services supplied by a business

2. All dispatches and Services are accurately recorded

3. Any Credit notes are only given for valid reason

4. Cut off procedures are correctly applied to recording dispatch of goods

ACCOUNTING

1. All invoices and credit notes are properly recorded in the books of

accounts

2. All receipts from customers are properly recorded

3. All payments are for goods and services which have been supplied

4. All credit notes given have been properly recorded in the books and

records of the business

5. All entries to the receivable ledger are in the correct customer

accounts

6. Potential or actual bad debts are identified

7. Cut off procedures are applied

Based on the objectives mentioned above, an entity’s sales control system

will be designed to achieve the set objectives.

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In addition to the set objectives, the sales control system would be designed

to minimize the possibility of fraud.

ELEMENTS OF CONTROL PROCEDURES

When reviewing the Internal Control Procedures put in place by management

to achieve the sales system objectives, the relevant aspects to examine are:

Organizational Controls

Segregation of duties

Physical Controls

Authorization

Arithmetic and Accounting Controls

The application of the elements to the three objectives is summarized in the

following table.

ORDERING AND GRANTING OF CREDIT

1 Organizational controls There should be written procedures for receiving orders and granting of credits

Authority for approving new credit customers

must be well defined

There should be procedures for checking the

suitability of customers for credit

2 Segregation of duties Different members of staff should be involved

in different aspect of the sales process. For

example, the same staff should not be

involved in dispatching of goods and raising invoices

3 Physical Controls There should be physical control over access

to sales order documents

Sales order forms should be prenumbered

4 Authorization Changes in customer database can only be

made with proper authority

Changes to credit limit must be properly

authorized

5 Arithmetic and accounting Prices are correctly quoted

Discounts are calculated correctly

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Matching of customers orders to dispatch

notes

Accurate computation of VAT

SHIPPING AND INVOICING

1 Organizational controls There should be written procedures for dispatching of goods and invoicing

Authority level for selling prices and

discounts

There should be authority for issuing credit

notes to customers


in different aspect of the sales process. For

example, the same staff should not be

involved in dispatching of goods and raising invoices

3 Physical Controls There should be monitoring of quantity and

condition of goods supplied.

Delivery notes should be prenumbered Sales invoices should be pre numbered

Goods returned notes should be pre

numbered

Goods delivery notes/service performance notes should be signed by customers

There should be pre numbered goods

returned notes

4 Authorization Authorization of selling prices Authorization of discounts

Matching of sales invoices with dispatch

notes

Matching of credit notes with goods returned

notes

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ACCOUNTING

1 Organizational controls There should be written procedures accounting for sales and receivables

There should be written procedures for write

off of bad debts


in posting invoices and maintaining customer

accounts receivable. They should also be

different from those responsible for receiving

cash from customers

3 Physical Controls Sales invoices should be numbered

consecutively

There should be control over unused invoices

There should be control over the computer system used for creating invoices

Restriction of access to unauthorized persons

4 Authorization Authorization to implement credit control

procedures

5 Arithmetic and accounting Checking invoices for prices and calculations

Invoices and credit notes are entered into

accounting records promptly

Sending Statements to customers Production of aged receivable reports and

credit control procedure

Reconciliation of receivable ledger control

accounts with receivable ledger subsidiary account

Cut off checks to ensure that goods

dispatched but not invoiced are dealt with in

the correct period Analytical review procedures

PRACTICAL APPLICATION

Most of the issues raised in the above tables can be ascertained and

documented by administering a standard Internal Control Questionnaire on

the Sales process to a client.

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An example of a typical ICQ on sales is as follows:


INTERNAL CONTROL QUESTIONNAIRE- SALES

CLIENT:

COMPLETED BY: DATE----------------------

REVIEWED BY DATE----------------------

QUESTIONS ANSWERS

GENERAL INFORMATION TECHNOLOGY Y N

N/A REMARKS

1 What software is used to record and manage customer information

2 Is it the same thing as the General Ledger Software

SALES ORDERS/SERVICE REQUEST

1 What record is kept of service request/ Sales Orders 2 Who receives the order

3 Upon receipt of the order is there a verification of the approved buyer

4 If yes, how is this function performed 5 Who is responsible for inputing the order into the system 6 Are customer orders approved before execution 7 If yes, how is performance evidenced? 8 Is there Automatic matching of price by the computer system 9 For non standard billing terms when and how is the billing terms

set up

10 Are customers credit limit checked before orders are performed 11 Does the Company have a Credit Policy 12 is it documented? obtain a copy 13 If yes, how often is the policy subject to review 14 Are new Customers required to submit credit application 15 If yes, is it standardized 16 If so who performs the task 17 How is the performance evidenced 18 Who are those that have access to the order entry system 19 What controls are in place to check unathorised access to the

order entry system

20 What record is kept of orders received but not yet performed 21 How often is the record reviewed 22 Who is responsible for the review

PERFORMANCE OF SERVICE/DISPATCH OF GOODS

1 List the major centres at which Goods/ Services are sold

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2 What records are kept of Goods Sold/ Services rendered to

customers

3 Are these records under numerical control

4 Are these records kept by a person independent of the Sales/ Invoice

Processing

5 Are acknowledgement of the receipts of goods or service

performance obtained from customers

6 How is it evidenced

7 How does the system ensure that all services performed or Goods

sold are covered by the issue of sales Invoice?

8 What records are kept of short deliveries or inadequate performance

of service

9 Are these records under numerical control

CONTROLS OVER CREDIT MEMOS

1 How does the system ensure that Credit Notes are issued for all

returns from customers or claims by customers

2 List other conditions that warrant the issue of Credit Notes 3 Who is authorized to issue credit notes 4 Is this person Independent of the collection function 5 Is this person independent of operations/ Dispatch of Goods 6 What level of approval is required for various Credit Notes 7 Are Credit Memos Pre numbered

8 Is there an Independent Review of the Schedule of Credit Memos

9 If yes by whom 10 How often is this done

CONTROLS OVER BILLING AND INVOICING

1 Does the Company have a billing policy 2 Does the policy specify the period in which a bill must be issued

after task is performed?

3 Who or which department is responsible for raising Invoice 4 Is the person/ department separate from the collection function 5 From what sources of Information are Invoices prepared 6 How many copies of sales Invoices are Prepared 7 How are they distributed 9 Are Invoices/Bills prenumbered 10 Does the Bill/Invoice have contact information 11 How are cancelled, altered and no charge invoices authorized 12 Are Provisional or proforma invoices rendered? 13 If yes, how are they treated for accounting purposes?

14 Is there a procedure for reconciling service request and performance

of service to invoices issued

15 Is there a software for raising Invoices 16 If yes, what is the software 17 Is it Integrated with the General Ledger 18 Is it Integrated with the operational/service delivery and Goods

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issued?

19 Does the billng process involve automatic validation check on price

(per standard tarif or contract terms and quantity (as per stores

records and service request/operational records)

20 Is there an authorized price list/ tariff 21 if yes who is authorized to change it 22 Is there a restriction of access to invoicing software to only

authorized personnel

23 If yes how is it done

GENERAL

1 Do sales to related parties have the same process as third party

sales

2 If no kindly describe the system for processing Intercompany

sales

3 Are Customers given Month end statements 4 If yes who is responsible for this function 5 Does the computer automatically post transactions to account

receivable master file and General Ledger

6 Is the account receivable master file reconcile with the General

Ledger on a Monthly basis?

7 Is there a memorandum Invoice Account? 8 If yes is there a reconcilition of the Invoice listing to the Chart of

accounts

9 Who performs this function 10 How often are Journal entries into the Sales Ledger reviewed? 11 Describe the procedure for authorizing, controlling and recording

sales to Employees, sale of scrap and cash on delivery/cash sales

AUDIT OF THE SALES SYSTEM

The nature and timing of audit procedures will depend on the assessment of

the client’s system which is obtained from an understanding and assessment

of the system.

Typical and practical steps that will be taken would be a combination of the

following:

1. Obtain the client’s sales journal and review for unusual transactions

and amounts

2. Check new accounts and credit limits are properly authorized and

credit procedures are operating

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3. Check that sales invoices are supported by customer orders, and

signed delivery notes or evidence of work performance

4. Check for prices, arithmetic and calculations of invoices

5. Check that invoices are correctly coded with customer codes

6. Test numerical sequences of invoices and enquire into missing

invoices, sales orders, delivery notes and goods returned notes

7. Check goods returned are supported by goods returned notes,

evidence of correspondence with customers and credit note

authorized.

8. Observe whether monthly statements are sent to customers

9. Observe whether accountant compares subsidiary ledger total with

control totals

10. Account for the sequence of dispatch/shipping documents

11. Trace selected dispatch documents to sales journal to be sure

that each one has been included

12. Account for the sequence of sales invoices to the sales journal

13. Trace selected sales invoice numbers from the sales journals to

the accounts receivable ledger

14. Sample selected sales invoices and check supporting documents

for internal verification

15. Test selected invoices with customer order checking for customer

name, product description, quantity, date, contracts and credit

approval

16. Obtain prelisting of cash receipts and trace amounts to the cash

receipt journal testing for names, amounts, dates and internal

verification

17. Trace cash receipt entries to bank statement

18. Trace selected entries from the cash receipt journal to entries in

the customer subsidiary ledger

As stated above, how the above procedures are combined in the audit of

sales will depend on our assessment of the clients system of internal

controls over sales

ANALYTICAL REVIEW

As with most audit exercise, we should carry out relevant analytical

procedures when carrying out the audit of sales.

Prepare summary for present year and previous

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two years to compare –

Sales

Cost of Sales

Gross Profit

G.P. %

Stock at Balance Sheet date

Trade Debtors

2.Explain material fluctuations in above.

3. Explain any significant changes in type of business carried on, method

of operating source of earning, etc.

AUDIT OF CASH REVENUE

In certain types of businesses, a significant proportion of sales is carried

out in cash. For example, shops, supermarkets, bars and restaurants.

In these instances, the auditor must be aware that the activities are

highly susceptible to fraud.

Therefore audit procedures must be designed to verify sales revenue and

to detect fraud.

Some of the steps to be undertaken by the auditor are as follows:

Review the procedures for recording cash revenues e.g cash sheets, tills

etc

Review and test the reconciliation of cash taking to the records above

Review and test bank transactions by ensuring that:

Cash takings are banked intact

Reconciliation and banking of cash receipts are carried out by persons

independent of revenues

Ensure cash takings are banked the same day or the next date by

checking pay in slips

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TESTING FOR LAPPING OF ACCOUNTS RECEIVABLE AND PROOF OF CASH

RECEIPTS

Lapping of account receivable is the postponement of entries for the

collection of receivables to conceal an existing cash shortage. The fraud is

perpetrated by a person who handles cash receipts and then enters them

into the computer system. This fraud can be prevented by separation of

duties and mandatory vacation policy for employees who handle both

cash and entry into the system.

A useful audit procedures for testing whether all recorded cash has been

deposited in the bank is the proof of cash receipts. In this test, the total

cash receipts recorded in the cash receipts journal is compared with the

actual cash deposited in the bank for a given period say one month.

Differences observed should be reconciled and explained.

AUDIT OF SALES RETURNS AND WRITE OFF OF UNCOLLECTIBLE

ACCOUNTS

The audit procedures for sales returns are similar to the procedures

adopted for sales. We should however test recorded transactions to

ensure that theft of cash is not concealed with sales returns. The point

also applies to write off of uncollectible accounts.

The major control for these transactions is proper authorization by a

designated official.

AUDIT OF ACCOUNTS RECEIVABLES (DEBTORS)

Receivables also known as debtors form part of the sales receivable cycle.

It is therefore important to carry out the compliance procedures in the

sales audit as part of the debtors audit procedure. In summary, check to

ensure that the system for receivables has the following features:

Only bona fide sales bring receivables

All such sales are to approved customers

All such sales are recorded

Once recorded, the debts can only be eliminated by receipt of cash

or on the authority of a responsible official

Debts are collected promptly

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Balances are regularly reviewed and aged, a proper system of

follow up exists and if necessary adequate provision for bad debt

exists.

We are required to carry out further audit procedures to verify debtors’

balances at year end on the completion of our compliance review.

See section 13 of our file divider

1. Obtain and check or prepare schedules of all debtors in detail and

summary per Balance Sheet showing

1. Trade Debtors

2. Hire Purchase Debtors

3. Sundry Debtors

4. Staff Accounts

5. Deposits

6. Prepayments

7. Others

2. Circularize major accounts as at or prior to year end and tabulate

results in normal form i.e.

(i) (a) number and value of all debtors

(b) number and value of all confirmations requested

(c) number and value of replies received and agreeing

(d) number and value of replies received and disagreeing

(e) percentage results achieved

(1) Replies Received

(2) Replies Agreeing

(3) Replies Disagreeing

(f) Remittances to date from those not replying

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(ii) Investigated disagreed replies and record reasons.

(iii) Pass requests from customers for information to client.

3. Agree all control accounts with Ledger Balances.

4. Obtain Age analysis of debtors

5. Identify balances to specific invoices.

6. Explain nature of all Sundry Debtors and Deposits.

7. Vouch authority for Staff Loans and ensure being

repaid regularly. Trace sample repayments to payroll

8. Review all accounts to determine if provision necessary

and indicate on schedules all information given to us in

arriving at decision

9. Prepare schedule of movements on Bad Debts –

Provision Accounts and Debts written off.

10. Check and file calculations of major prepayments.

11. Review cut-off procedure for sales with stock audit

by appropriate schedules showing:-

(a) That all sales made within the last two weeks

of the accounting period had been entered in

the stock records before the end of the period.

(b) Goods relating to purchase invoices taken up

in the books and actually been received.

(c) That sales invoices after the year end do not

relate to the preceding year – also purchases.

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CUT OFF PROCEDURES

Cut off is a very important term that has implications for sales, purchases

and inventory. We should read it up and discuss in our next seminar.

AUDIT OF PREPAYMENTS

In the audit of prepayments, the auditor reviews the clients system for

ensuring that all prepayments are recorded

The auditor obtains a schedule from the client or prepares one that includes

the opening figures of the previous year, the current year additions and

write offs and the ending balance of prepayments.

Re-performing the calculations for arithmetic accuracy

Reviewing previous year working papers for evidence that the same

prepayments existed previously

We could also carryout certain analytical procedures such as:

Comparing the ratio of prepaid expense to the total of related expense for

the current and previous year

Compare the actual expense with prior year figure