Auditing the Revenue Cycle

Sales, Accounts Receivable, and Cash Receipts

Revenue Cycle Overview

The revenue cycle encompasses all business activities related to providing goods and services to customers and collecting payment. It is one of the most significant areas in any audit due to its materiality and susceptibility to fraud. Auditors must thoroughly understand the revenue recognition process and assess controls over sales transactions, accounts receivable, and cash collections.

Revenue Cycle Process Flow

Step 1 Customer
Order
Step 2 Credit
Approval
Step 3 Shipment/
Delivery
Step 4 Billing/
Invoicing
Step 5 Cash
Collection
Step 6 Recording
& Posting

💡 Key Point: Revenue Recognition

Revenue should be recognized when performance obligations are satisfied - typically when goods are shipped or services are rendered, and collection is reasonably assured. The timing of revenue recognition is critical and must comply with ASC 606 (IFRS 15).

Key Risks in Revenue Cycle

  • Fictitious Sales: Recording sales that never occurred to inflate revenue (channel stuffing, side agreements)
  • Premature Revenue Recognition: Recognizing revenue before performance obligations are satisfied
  • Improper Cutoff: Recording sales in the wrong accounting period to manipulate results
  • Overstatement of Accounts Receivable: Failing to write off uncollectible accounts or adequately reserve
  • Inadequate Allowance for Doubtful Accounts: Underestimating bad debt expense to inflate earnings
  • Cash Misappropriation: Theft of cash receipts through lapping, skimming, or other schemes
  • Unauthorized Sales Transactions: Sales made without proper authorization or credit approval
  • Incorrect Pricing or Terms: Billing errors due to wrong prices, discounts, or payment terms
  • Unrecorded Sales Returns: Failing to record returns to overstate revenue and receivables
  • Related Party Transactions: Sales to related parties at non-arm's length terms

💡 Why Revenue is High Risk

Revenue is presumed to be a fraud risk in auditing standards (AU-C 240) due to management's incentive to meet earnings targets and analyst expectations. The subjective nature of revenue recognition and the complexity of some arrangements increase the risk of material misstatement.

Management Assertions for Revenue Cycle

Occurrence / Existence

Revenue: Sales transactions actually occurred and pertain to the entity.

A/R: Accounts receivable actually exist and represent valid claims.

Completeness

Revenue: All sales transactions that should be recorded are recorded.

A/R: All accounts receivable are included in the financial statements.

Accuracy / Valuation

Revenue: Sales are recorded at correct amounts.

A/R: Receivables are stated at net realizable value (gross less allowance).

Cutoff

Revenue: Sales are recorded in the proper accounting period.

A/R: Receivables and cash receipts are recorded in correct period.

Classification

Revenue: Sales transactions are properly classified (e.g., operating vs. non-operating).

A/R: Receivables properly classified as current or non-current.

Rights & Obligations

A/R: The entity has legal right to the receivables.

Cash: The entity has legal ownership of cash received.

Presentation & Disclosure

Revenue and receivables are properly presented in financial statements with adequate disclosure of accounting policies, significant concentrations, and related party transactions.

Substantive Audit Procedures for Revenue

  • Analytical Procedures: Compare revenue to prior periods, budget, and industry trends; analyze gross margin ratios
  • Cutoff Testing: Examine sales transactions before and after year-end to ensure proper period recognition
  • Vouching Sales Transactions: Trace recorded sales to supporting documents (sales orders, shipping documents, customer orders)
  • Review Sales Returns: Analyze returns after year-end that may relate to year-end sales
  • Test Revenue Recognition: Verify that revenue recognition criteria are met per ASC 606
  • Related Party Transactions: Identify and evaluate sales to related parties
  • Journal Entry Testing: Test unusual or non-standard revenue journal entries

Substantive Audit Procedures for Accounts Receivable

  • Confirmation of Receivables: Send positive confirmations to a sample of customers to verify balances
  • Aging Analysis: Review aging of receivables and assess adequacy of allowance for doubtful accounts
  • Test Subsequent Collections: Examine cash receipts after year-end to verify collectibility
  • Evaluate Allowance: Assess management's estimate of uncollectible accounts for reasonableness
  • Recalculate Allowance: Independently calculate allowance based on aging and historical data
  • Review Credit Memos: Examine credit memos issued after year-end
  • Investigate Large/Old Balances: Scrutinize unusual or aged receivables

Substantive Audit Procedures for Cash Receipts

  • Bank Reconciliation: Examine and test bank reconciliations for all cash accounts
  • Bank Confirmation: Confirm cash balances directly with banks
  • Cutoff Bank Statement: Obtain bank statement for period after year-end to verify reconciling items
  • Test Cash Receipts: Trace cash receipts to bank deposits and receivable credits
  • Proof of Cash: Prepare proof of cash for high-risk situations

💡 Tests of Controls

If relying on internal controls, auditors also perform tests of controls such as: testing authorization of sales, examining evidence of credit approval, verifying segregation of duties, testing accuracy of billings, and observing cash handling procedures.

Key Internal Controls Over Revenue Cycle

  • Segregation of Duties: Separate authorization, recording, and custody functions (e.g., person recording sales ≠ person handling cash)
  • Credit Approval: Require independent credit approval before extending credit to customers
  • Prenumbered Documents: Use prenumbered sales orders, invoices, and shipping documents to ensure completeness
  • Matching Documents: Match sales orders, shipping documents, and invoices before recording revenue
  • Authorization of Sales: Require proper authorization for sales transactions, especially unusual terms
  • Independent Reconciliations: Regularly reconcile subsidiary ledgers to general ledger
  • Physical Controls: Restrict access to inventory, shipping areas, and accounting records
  • Monthly Statements: Send monthly statements to customers and investigate discrepancies
  • Aging Reports: Prepare and review aged trial balance of accounts receivable regularly
  • Cash Controls: Deposit cash daily, restrictively endorse checks immediately, use lockbox systems
  • Write-off Approval: Require senior management approval for write-offs of receivables
  • IT Controls: Implement system controls such as edit checks, automated matching, and access controls

💡 Control Environment

Strong controls over revenue also require an appropriate control environment including: tone at the top emphasizing ethical behavior, compensation structures that don't create excessive pressure to meet targets, and clear communication of expectations regarding revenue recognition policies.

⚠️ Red Flags for Revenue Fraud

Unusual sales near period-end, significant sales returns after year-end, sales to new customers with no credit history, side agreements or special terms, revenue from related parties, inability to confirm receivables, significant write-offs, and departure from industry norms.