456 Chapter Eleven

Appendix 11B

Illustrative Audit Case: Keystone Computers & Networks, Inc.

Part III: Substantive TestsAccounts Receivable and Revenue
This part of the audit case illustrates the manner in which the auditors design substantive tests of balances. The substantive tests are illustrated for two accountsreceivables and revenue. This aspect of the audit is illustrated with the following audit documentation: ABCs risk assessment working paper that combines the auditors assessments of inherent and control risks into an overall risk of material misstatement for the assertions. The substantive audit program of accounts receivable and revenue. The audit sampling plan for the conrmation of accounts receivable. Adams, Barnes & Cos. assessment of control risk is described in Part II of the audit case on pages 441 through 454. To refresh your knowledge of the case, review that part as well as Part I on pages 213 through 220 of Chapter 6.

Risk AssessmentRevenue Cycle

Client: Keystone Computers & Networks, Inc. Financial Statement Date: 12/31/X5

RA-8 WL 11/24/X5

Assertion
Existence of receivables and occurrence of revenue transactions Completeness of receivables and revenue Rights to receivables Valuation of receivables Presentation and disclosure

Inherent Risk

Control Risk

Overall Risk of Material Misstatement

Fraud risk Moderate High Fraud risk Moderate

Moderate Low Moderate Moderate Maximum

High Low Moderate/High High Moderate

Fraud Risks: Description: Management may be motivated to overstate revenue and receivables to improve nancial results due to impending sale of

business.
Controls: Because Keystone is a nonpublic company without an independent board or audit committee, there are no signicant internal

controls to prevent management from overstating results. Audit Response: The nature, timing, and extent of audit procedures will be modied as described below: a. Accounts receivable will be conrmed at year-end using a 5 percent risk of incorrect acceptance. b. A review of the monthly sales reports by salesperson will be performed to identify any unusual individual sales or sales volume. c. Credit les of customers with large receivables (over $25,000) will be reviewed for indications of ctitious customers.

Accounts Receivable, Notes Receivable, and Revenue 457

Audit ProgramSubstantive TestsAccounts Receivable and Revenues

B-6 WL 11/13/X5

Client: Keystone Computers & Networks, Inc. Financial Statement Date: 12/31/X5 Performed by Procedure Sales Transactions
1. Obtain an aged trial balance of accounts receivable as of 12/31/X5. 2. Select a sample of customers accounts at 12/31/X5 for positive conrmation using probability-proportional-to-size sampling based on the following parameters: a. Risk of incorrect acceptance of 5%. b. Tolerable misstatement of $35,000. c. Expected misstatement of $10,000. 3. Use generalized audit software to: a. Foot the master le of accounts receivable at 12/31/X5. b. Test the client-prepared aging of accounts receivable. c. Select the specic accounts for conrmation. 4. Mail accounts receivable conrmation requests. 5. Send second requests for all unanswered conrmation requests. 6. For conrmation requests to which no reply is received perform the following alternative procedures: a. Test items subsequently paid to remittance advices which identify the specic invoices paid. If necessary, reconcile the amounts paid to sales invoices and delivery receipts. b. For items not paid, inspect the invoices and delivery receipts for the sales transactions making up the account balance. 7. Resolve exceptions noted on conrmation requests. 8. Review credit les for customers with accounts receivable above $25,000 at 12/31/X5. Investigate any indications of ctitious accounts. 9. Summarize the results of the conrmation procedures.

Initials MP

Date 1/6/X6

MP MP MP MP MP MP

1/7/X6 2/12/X6 1/7/X6 1/7/X6 1/8/X6 1/25/X6

MP MP MP MP MP

2/16/X6 2/16/X6 2/16/X6 2/16/X6 2/16/X6

(continued)

458 Chapter Eleven

Audit ProgramSubstantive TestsAccounts Receivable and Revenues

(Concluded) Client: Keystone Computers & Networks, Inc. Financial Statement Date: 12/31/X5

B-6 WL 11/13/X5

Performed by Procedure
10. Review the adequacy of the allowance for uncollectible accounts by performing the following procedures: a. Review the aged trial balance of accounts receivable with the president. b. Review conrmation exceptions for indications of disputed amounts. c. Analyze and review trends in the following relationships: (1) Accounts receivable to net sales. (2) Allowance for bad debts to accounts receivable. (3) Bad debt expense to net sales. 11. At year-end, review the le of sales invoices that are waiting to be matched with delivery receipts for any sales transactions that were not executed and, therefore, should be recorded in the subsequent period. 12. For all sales recorded in the last week of the year inspect the related delivery receipt to determine that the sale occurred before 12/31/X5. 13. Review credit memoranda for sales returns and allowances through the last day of eldwork to determine if an adjustment is needed to record the items as of year-end. 14. Perform analytical procedures for sales and accounts receivable including comparison of the following to prior years and/or industry data: a. Gross prot percentage by month. b. Sales by month by salesperson. c. Accounts receivable turnover. d. Advertising expense as a percentage of sales. e. Net receivables as a percentage of total current assets. 15. Ascertain whether any accounts have been assigned, pledged, or discounted by review of agreements and conrmation with banks. 16. Ascertain by inquiry whether any accounts are owed by employees or related parties such as ofcers, directors, or shareholders, and: a. Obtain an understanding of the business purpose for the transactions that resulted in the balances. b. Ascertain the amounts involved. c. Conrm the balances.

Initials

Date

WL WL WL WL WL

2/13/X6 2/13/X6 2/15/X6 2/15/X6 2/15/X6

MP MP

12/31/X5 2/12/X6

MP WL WL WL WL WL WL WL

2/16/X6 2/12/X6 2/12/X6 2/16/X6 2/16/X6 2/16/X6 2/16/X6 2/13/X6

WL WL WL

2/16/X6 2/16/X6 1/25/X6

Accounts Receivable, Notes Receivable, and Revenue 459

Keystone Computers & Networks, Inc. Audit Sample Plan for Conrmation of Accounts Receivable 12/31/X5

B-9 WL 1/7/X6

Objective: Establish the existence and gross valuation of accounts receivable and occurrence and accuracy of sales by

conrmation. Population: The trial balance of 433 accounts receivable at 12/31/X5, with a total book value of $1,023,545. Denition of Misstatement: Any amount that is determined not to be a valid account receivable. Sampling Technique: Probability-proportional-to-size.
Sampling Parameters: 1. Tolerable misstatement:

Total materiality as indicated in the audit plan Less: Estimate of undetected misstatement (50% of overall materiality) Tolerable misstatement for this test
2. Risk of incorrect acceptance:

$70,000 35,000 $35,000

Because we have assessed the risk of material misstatement as high, the risk of incorrect acceptance will be set at 5 percent.
3. Expected misstatement:

Based on prior-year audits, the expected misstatement for the account is $10,000.
Calculation of Sample Size and Sampling Interval:

Sample size

Book value of population Reliability factor Tolerable misstatement (Expected misstatement Expansion factor) $1,023,545 3.00 $35,000 ($10,000 1.6) $1,023,545 Book value of population $6,300 (rounded) Sample size 162

162 Sampling interval

Actual sample size was only 94 because a number of accounts were more than twice the sampling interval.

460

KEYSTONE COMPUTERS & NETWORKS

Monthly Sales Report For the Three Years Ended 12/31/X5

B-11 WL 1/9/X6

Sales of Computers 20X4

$ 701,000 744,000 762,000 733,000 731,000 765,000 702,000 754,000 802,000 764,000 774,000 812,000 $9,044,000 $10,157,000 $832,000 $996,000 $ 784,000 862,000 907,000 762,000 806,000 894,000 796,000 856,000 932,000 758,000 849,000 951,000 $ 63,000 72,000 67,000 66,000 68,000 66,000 73,000 69,000 68,000 75,000 73,000 72,000 $ 75,000 75,000 82,000 81,000 79,000 84,000 79,000 87,000 84,000 87,000 91,000 92,000

Consulting Revenue 20X5 20X3 20X4

$

Service Revenue 20X5

86,000 90,000 102,000 92,000 95,000 111,000 96,000 102,000 116,000 105,000 113,000 127,000 $1,235,000

20X3

20X3
$ 12,000 13,000 13,000 12,000 14,000 13,000 14,000 13,000 13,000 15,000 14,000 14,000 $160,000

20X4
$ 14,000 16,000 15,000 16,000 15,000 17,000 16,000 15,000 16,000 16,000 16,000 15,000 $187,000

20X5
$ 15,000 17,000 17,000 19,000 17,000 18,000 18,000 17,000 19,000 18,000 18,000 18,000 $211,000

January February March April May June July August September October November December

$ 587,000 590,000 643,000 656,000 668,000 657,000 681,000 679,000 675,000 701,000 734,000 737,000

Total

$8,008,000

Note: Amounts were generated by ACL program from Keystones general ledger.

Accounts Receivable, Notes Receivable, and Revenue 461

Appendix 11B Problems

Required:

11B1.

In Part II (Appendix 11A) of the audit case, the audit staff of Adams, Barnes & Co. identied the following two internal control weaknesses: a. Sales invoices are prepared and mailed prior to delivery of goods. b. Accounts receivable are not written off on a regular basis. Review the audit program on pages 457 through 458 and identify the substantive audit procedures that were designed specically to address the misstatements that are made more probable due to these weaknesses. Assume that you have been assigned to the audit of Keystone after audit planning has occurred. Review the planning information on pages 213 through 220 and the audit program for the accounts receivable and revenue (B-6 on pages 457458). The manager on the engagement has given you the task of reviewing the monthly revenue report on page 460 (B-11). a. Based on your review of the report, describe any unusual relationships that might indicate a risk of misstatement of revenues based on your knowledge of the company derived from a review of the information on pages 213 through 220. b. Identify any procedures on the audit program for receivables and revenue that might address the risk(s) identied in (a). c. Design two other procedures that would address the risk(s) identied in (a).

11B2.

11B3.

Keystone Computers & Networks, Inc. (KCN), has 433 accounts receivable, with a total book value of $1,023,545. From that population, Adams, Barnes & Co. (ABC), CPAs, selected a sample of 94 accounts for conrmation for the year ended December 31, 20X5, as illustrated by the working paper on page 459. First and second conrmation requests resulted in replies for all but 10 of those accounts. ABC performed alternative procedures on those 10 accounts and noted no exceptions. Of the 84 replies, 5 had exceptions as described below (with ABC follow-up): 1. The balance of $1,200 is incorrect because we paid that amount in full on December 31, 20X5. Follow-up: An analysis of the cash receipts journal revealed that the check had been received in the mail on January 9, 20X6. 2. Of the balance of $30,000, $330 is incorrect because on December 19 we returned a printer to Keystone when we found that we didnt need it. We ordered it in the middle of November when we had anticipated a need for it. When we received the printer we realized it was unnecessary and returned it unopened. Follow-up: An analysis of the transaction revealed that it was received by Keystone on December 31, 20X5, and that the adjustment to the account had been processed on January 2, 20X6. 3. The balance of $300 is correct, and we paid it on January 5, 19X6. Follow-up: An analysis of the cash receipts journal revealed that the check had been received on January 10, 20X6. 4. Of the balance of $13,000, $1,000 is incorrect because it represents goods that we didnt receive until January 5, 20X6. Follow-up: Inspection of shipping records reveals that the item was shipped on January 3, 20X6. 5. Of the accounts $1,800 balance, we paid $1,746 and the $54 (3 percent of the total) remains unpaid because the Keystone salesperson told us that she would be able to obtain a special discount beyond the normal. Follow-up: While inspection of the sales agreement indicated no such discount arrangement, discussions with Loren Steele (controller) and Sam Best (president) indicated that the salesperson had inappropriately granted such a discount to the client. On January 15 of 20X6 they processed the discount and credited the account for $54. a. For each of the ve exceptions, determine the accounts proper audited value. b. Use the probability-proportional-to-size method with your analysis from part (a) to evaluate your samples results. The risk of incorrect acceptance is 5 percent.

Required: