to determine the causes of the
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Type of
Failure
Possible Misstatement
Assertion
Effect on substantive
tests
checked
Customers may not have had
a chance to get pricing
end rather than at an
interim date.
a. No evidence
that price and
quantity
Sales and accounts
receivable may be over or
understated at year-end.
Valuation
(Gross)
Extend confirmation and
subsequent collection
work. Confirm as of year-
adequate.
obtain credit reports on
customers with large
overdue balances, review
customer correspondence
files.
c. Recording
sales before
shipped
d. Recording
Just the opposite of c. above.
Completeness
Concentrate sales cutoff
Sales, accounts receivable
and possibly cost of sales
would be overstated.
Existence /
Occurrence
Extend confirmations as of
year-end, concentrate sales
cutoff testing on sales
misstated.
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Type of
Failure
Possible Misstatement
Assertion
Effect on substantive
tests
f. Lack of
customer
order.
Sales and accounts
receivable overstated. Even
though shipped, if customer
did not order the items, this
Existence /
Occurrence
Expand confirmations of
receivable as of yearend.
Verify existence of
customer by looking them
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Controls the auditor might examine to determine that “all transactions are recorded correctly, and
in the correct time period” might include:
• use and reconciliation of pre-numbered documents
• signed authorization of transaction before recorded
• supervisory review of transactions before recording
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The deficiencies included a failure to perform adequate substantive analytical audit procedures to
test revenue and a failure to perform sufficient procedures “to test the allowance for doubtful
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Expectations for substantive analytical procedures will be more precise than those considered
during planning analytical procedures. An increase in precision can be obtained by using more
disaggregated data. The appropriate level of disaggregation will be influenced by the nature of
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For unusual or complex sales transactions, it is advisable to confirm receivables with customer
personnel most familiar with unusual sales agreements and ask about any side agreements that
could affect revenue recognition. Accounts payable personnel would not be aware of these
details.
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a.
Management Assertions and Substantive Procedures in the Revenue Cycle
Management Assertion
Existence / occurrence: Recorded sales
and accounts receivable are valid.
Completeness: All sales are recorded.
Rights and obligations—The accounts
receivable are owned by the organization
(for example, none have been sold).
Presentation and disclosure: Credit
balance and related-party accounts
b.
1. Determine that all goods that were shipped were billed in the proper time period. In addition,
the auditor will normally test for the effectiveness of control procedures, such as proper credit
2. Determine that only authorized prices changes are made to the computerized price list thus
3. Determine that invoiced amounts are correctly computed. Valuation.
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4. Determine that credit is authorized in accordance with company policy. In addition, when
reviewing the credit policy, the auditor can make a determination as to the sufficiency of the
5. Determine that all goods that were shipped were billed. Completeness.
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An aged trial balance lists each customer’s balance with columns to show the age of the unpaid
invoices.
The aged trial balance can be used to select customer balances for confirmation; to identify any
amounts due from officers, employees, or other related parties or any non-trade receivables that
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Positive confirmations are correspondence (paper or electronic) sent to a sample of customers
asking them to sign and return the letters directly to the auditor whether or not they agree with
the indicated balance. Negative confirmations request the customer to respond directly to the
auditor only if they disagree with the indicated balance.
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9-64
a. The auditor should send a second request. If that fails, trace subsequent collections into the
records and the checking account; vouch the unpaid invoices to supporting documents, such as
customer’s order, shipping document, and sales invoice. If the balance is individually significant,
the auditor may call the customer or have the client call, to urge the customer to respond to the
confirmation.
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Substantive procedures are adjusted when specific fraud risk factors are present. Potential fraud
risk factors in the revenue cycle include:
• Excessive credit memos or other credit adjustments to accounts receivable after the end of
the fiscal year
• Customer complaints and discrepancies in accounts receivable confirmations (e.g.,
disputes over terms, prices, or amounts)
• Unusual entries to the accounts receivable subsidiary ledger or sales journal
The following fraud-related audit procedures can be used to respond to these fraud risk factors:
• Perform a thorough review of original source documents including invoices, shipping
documents, customer purchase orders, cash receipts, and written correspondence between the
9-66
A false confirmation is one in which the respondent (in this case, the client’s customer) responds
inaccurately to the audit firm with respect to the information on the confirmation. False
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a. Customers may not be inclined to report understatement errors when returning the
confirmation.
b. A confirmation exception is a statement made by a customer on the confirmation response
indicating a disagreement with the stated balance. The auditor needs to be sure that the cause of
any exception is properly identified as either a client misstatement or a timing difference.
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9-68
a. Neither auditor is incorrect. Both approaches are necessary to determine that all recorded
sales are valid and that all shipments have been properly invoiced. The combination of the two
procedures should give the auditor strong confidence that sales are properly stated if the
c. A dual purpose test is one that is effective in addressing two objectives:
1. controls are operating effectively; and
2. the transactions are recorded correctly, in the proper time period, and so forth.
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To test gross apartment rents, Finney would –
• Physically examine the rental property or review architectural blueprints to ascertain the
total number of rental units.
• Compare the total number of validated rental units with the total number of rent charges
on the schedule of gross apartment rents (Schedule A).
To substantiate the validity of the vacancies, Finney would –
• Physically examine the apartments that were vacant during the month.
To substantiate the validity of unpaid January rents, Finney would –
• Trace unpaid rents from individual tenant apartment ledger cards to Schedule C.
9-31
• Examine the collection file for evidence of collection attempts.
• Request written confirmations from tenants with accounts in January arrears.
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The auditor can use membership records and the fee structure to estimate what membership fee
revenue should be (i.e., perform substantive analytical procedures). The number of members by
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Customer
Conclusion/procedure
a. Meehan Marine Sales, Inc.
2
b. West Coast Ski Center, Inc.
2
c. Fish & Ski World, Inc.
4
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Stanley would test the aging of accounts receivable and then:
• Mail positive accounts receivable confirmation requests directly to all customers with old
balances.
• Investigate all exceptions noted on confirmations.
• Obtain authenticated deposit slips directly from the bank and compare the detail with the
cash receipts journal.
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9-73
Generalized audit software could be used in the following ways:
• Foot the unpaid invoice file to be sure it agrees with the general ledger accounts
receivable balance.
• Select and print confirmation requests. Information from both files will be needed –
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a. The key point to recognize is that there is a pattern of errors in the confirmation non-
responses. There are cases of extended credit terms where goods were not returned, where credit
is to be issued but the goods have not been returned, there is a related party transaction, and there
are some new customers that simply have not responded. The nature of the non-confirmations
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• Examine all documentation on Yunkel Company regarding extended credit terms.
Examine underlying documentation as to how the extended terms were given. Consider
confirming the extended terms (as opposed to account balance) with the controller of
Yunkel.
• Examine all terms of the related party transaction with Beaver Dam. Examine other
transactions with the same company to determine the extent of disclosure needed to fairly
present the financial statements.
• Examine documentation for all transactions labeled as `special terms’, such as those with
Hi-Tech Companies. For these companies, as well as others not responding, verify the
existence of the company through examination of Dun & Bradstreet reports on the
company, or through business directories. Confirm the special terms of the sale with the
b. Assuming that many of the above items could not be cleared to the auditor’s satisfaction,
there would be concern that more items with similar problems exist in the population. The
auditor would first classify all uncleared items as misstatements and would then project the
total to the population as a whole to determine if the projected errors and upper error limit
were material to the financial statements. Assuming the amount would be material, the
auditor would perform the following procedures:
• Identify all companies that have received extended credit. This could be done by (a)
inquiry of company personnel, (b) review of large dollar accounts still outstanding, or
9-34
extending the credit, and sales invoice. Confirm the terms of the extended credit with
the companies identified. For each company selected, review the credit file, outside
credit evaluations, and recent correspondence with the customer to determine the
probability of collection. Develop an estimate (or a range of estimate) of uncollectible
accounts.
• Expand the audit work for all accounts past due. Consider expanding the
confirmation work through another statistical sample. Perform alternative procedures
on all companies that do not respond to the confirmation request.
• Prepare a list of all questionable transactions. Document the nature of the question,
the parties involved, etc. to determine if there is a pattern of misstatement. Based on
the pattern, identify all other account balances fitting that pattern. Schedule the open
account balances fitting that pattern and examine underlying documentation to
• Physically examine all items that have been marked as ’billed, but held pending
customer orders’ to determine that the goods had been physically separated, are in
shipping condition, and are not obsolete. Confirm the terms with the purchaser.
Obtain an opinion from legal counsel on the validity of the sales contract. Gather
additional information to determine the likelihood of default by the customer.
Consider the likelihood of default in determining whether or not a sale should have
been recorded.
Fraud Focus: Contemporary and Historical Cases
9-75
a. Revenue is an inherently risky account as the transactions making up the account can be
quite complex and subject to client judgment. In the case of Zynga, the company is recognizing
revenue for the sale of virtual products and there is not generally accepted accounting guidance
on how to account for such revenue. Further, while Zynga’s auditors have identified what seem
to be reasonable approaches to recording the revenue, each option requires significant
management judgment, which is prone to bias. Thus, a significant inherent risk at Zynga is the
timing of revenue recognition.
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a. The auditor is always concerned with whether side agreements exist as such side agreements
would make it improper for Tvia to recognize revenue on a sale. The difficulty for the auditors in
this case is that Silva concealed the side agreements from Tvia’s CEO, its CFO, and the
Company’s auditors. However, when there is a heightened risk of misstatement auditors might
decide to send sales confirmation requests that ask about the details and terms of the sale.
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9-77
a. Fraud risk factors include:
• weak internal controls over material revenue cycle accounts
• the fact that the company initially recorded revenue in 2004 that should not have been
Even though this case was not formally considered “fraud”, these kinds of fraud risk factors will
cause the auditor to exercise greater professional skepticism and conduct more substantive audit
effort as a result.
b. A variety of possible ideas might be generated by students:
• differences in common practices regarding the writing and enforcing of contracts
c. First, consider that the prior problem indicates that weaknesses existed in the past, which
heightens risk. However, the fact that the problems were disclosed and a remediation plan was
put in place somewhat mitigates that risk. So, the extent to which the remediation plan was
actually implemented would have been important in determining the audit plan for 2005. So, the
d. Regarding potential analytics, the following may be helpful:
• comparing quarter-to-quarter changes in sales during the current year, and comparing
those to prior years and industry averages
• comparing revenue, deferred revenue, and cost of sales figures for reasonableness in
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e. Potential substantive tests include:
• analyzing the timing of contracts, with particular emphasis on fourth quarter contracts (or
end of other quarter contracts)
9-78
a. Putnam’s critical mistake was in not being forceful and proactive the very first time the
problems were encountered. Once he had “caved” to HBOC once, it would have been difficult to
convincingly threaten HBOC in the future. Plus, once Putnam allowed the inappropriate
accounting and issued the first incorrect audit review opinion, HBOC could use that against
Putnam, convincing him that he would also “lose” upon discovery of the problems.
c. The main element of corporate governance that failed was the audit committee. They
displayed a lack of knowledge of the risks in the software industry at the time. They should have
been more proactive in understanding the types of transactions that the company was engaged in,
and the common risks associated with those transactions. They should not have relied so
extensively on the unsubstantiated representations of Putnam.
d. Putnam and the engagement team did not follow up on unreturned confirmations and the very
low response rate should have caused concern. In addition, the dramatic decline in the number of
confirmations sent from 1996 to 1997 without justification is problematic and indicates a lack of
9-38
Gilbertson. Yet, if any situation were to bring Putnam to disclose the problems, this would have
Step 1. Structure the problem. Putnam knew that McKesson would rely on the misstated
Step 2. Assess the consequences. The potential consequences were that (a) McKesson
would acquire HBOC, HBOC’s financial position would improve enough that the fraud would be
Step 3. Assess the risk and uncertainties. The risk associated with possibility (a) is that this
outcome is a relatively low probability event (in hindsight), although at the time Putnam may
Step 4. Evaluate information/audit evidence gathering activities. Possibilities (a) and (b)
require no additional actions on the part of Putnam, so we will focus on Possibility (c) for the
rest of the solution. Assuming that Putnam decided to pursue this possibility, how could he do an
“about face” and finally reveal the problems to, for example, the audit committee? One
Step 5. Conduct sensitivity analyses. This step is not particularly relevant for the decision at
hand. If Putnam chose the course of action to finally reveal what he knew, there would be little
Step 6. Gather information/audit evidence. If Putnam had chosen to increase testing via
the confirmation process, he could have instructed the team to gather significant audit evidence
Step 7. Made decision about audit problem. It is clear from the actual outcome what
Putnam actually decided to do, i.e., nothing and hope for the best. If Putnam had revealed what
he knew to the audit committee and McKesson during Fall 1998, McKesson would probably not
have engaged in the acquisition. Perhaps HBOC could have fixed their accounting problems
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It is apparent from the case that the audit manager for some reason was unwilling to challenge
Putnam or his views. The publicly disclosed documents do not enable an understanding of the
personal characteristics of Putnam or the engagement manager, so it is difficult to draw
inferences about the personal dynamic that existed between the two auditors. However, Ira
(1) Identify the ethical issue. The issue is that the manager knows that HBOC is
misrepresenting its financial results to shareholders, and by very significant amounts. Still, if the
(2) Determine who are the affected parties and identify their rights. Affected parties include
shareholders (right to receive accurate investment information), the audit committee and board of