Practical Guidance No.8 (Issued - December 2010) Topic: Revenue and Purchases Cut-off on Sale of Goods Introduction 1.

Financial Reporting Standard (FRS) 18 Revenue states that for sale of goods, one of the criteria to recognise revenue is when the entity has transferred to the buyer the significant risks and rewards associated with ownership of the goods (FRS 18, paragraph 14a). There could be instances where companies recognise revenue and purchases based on the date of sales invoices or supplier invoices respectively without taking into consideration the requirements of FRS 18 as mentioned above and this could potentially lead to improper cut-off of revenue and purchases at year-end, resulting in misstatements of the financial statements. Hence, proper revenue and purchases cut-off tests at year-end are critical in addressing the cut-off assertion for sales and purchases. 2. The aim of this Practical Guidance is to provide auditors with some guidance when performing sales and purchases cut-off procedures for companies engaged in local and/or overseas trading sales of goods. Guiding Principle 3. FRS 18 states that revenue from the sale of goods should be recognised when the entity has transferred to the buyer the significant risks and rewards of ownership of the goods (FRS 18, paragraph 14a). 4. FRS 18 also further explains that the assessment of when an entity has transferred the significant risks and rewards of ownership to the buyer requires an examination of the circumstances of the transaction. In most cases, the transfer of the risks and rewards of ownership coincides with the transfer of the legal title or the passing of possession to the buyer. This is the case for most retail sales. In other cases, the transfer of risks and rewards of ownership occurs at a different time from the transfer of legal title or the passing of possession (FRS 18, paragraph 15). Practical Application Sales cut-off procedures 5. Cut-off errors will usually arise when companies recognise revenue based on the date on which the sales invoices are generated rather than the date on which the risks and rewards are transferred to the buyers. In order to perform a robust sales cut-off test, auditors need to understand and consider the specific cut-off error risk of each engagement. Adequate samples in the period during which the risk of cut-off is assessed to be high by the auditors should be selected for testing rather than just taking a fixed number of samples before and after year end.

6. As part of the sales cut-off tests, auditors should also examine the credit notes issued after year-end and determine whether any sales made before year end are returned to the company subsequent to year end. As this may have significant impact on the sales recognised before year end. (a) Local trading sales 7. As part of the audit procedures, auditors will ordinarily select samples to test cut-off before and after year end. 8. For local sales, auditors will need to obtain acknowledged delivery orders or sales invoices issued by the company and check that the dates of acknowledgement by the customers, indicated on the delivery orders or sales invoices, are in the same accounting period in which the sales are recognised. As mentioned in Practical Guidance No. 5 Occurrence of Revenue from Sales of Goods, auditors would also need to be mindful of whether there are any side agreements entered or clauses in the sales agreements or invoices which may impact the appropriate point of revenue recognition. 9. However, there could be situations where the customers do not sign as acknowledgement or indicate the date of receipt of goods on the delivery orders or sales invoices. Such delivery orders and sales invoices may not be considered as appropriate and reliable source documents for the purpose of testing sales cut-off. In the absence of reliable source documents, auditors could try to obtain alternative evidence from other audit procedures performed. For example, the auditors can understand and test the key controls for the inventories cycle to establish the reliability of the Companys stock card records. With reliable stock card records, the sales cutoff can be performed by obtaining the stocks cards of the samples selected and check the dates that the goods are despatched from the warehouse to determine if they should be accounted for before or after the year end. The auditors could also perform a detailed analytical review to identify potential cut-off errors (refer to paragraph 16 below for more details). (b) Overseas trading sales 10. As mentioned in Practical Guidance No. 5 Occurrence of Revenue from Sales of Goods, overseas trading sales would usually require the company to transport the goods to a destination designated by the buyers for them to receive the goods. To alleviate the confusion of the responsibility of buyers and sellers, the incoterms published by The International Chamber of Commerce are commonly used. When the incoterms are used, buyers and sellers would mutually understand the point where risks and rewards of the ownership of goods are transferred, unless both parties have an agreement which specifically determines the point where the transfer of risks and rewards of the ownership would take place. If incoterms are used, the auditor should examine the incoterms when performing the sales cut-off test to determine if the company had recorded and recognised sales in the correct accounting period during the year end audit. This would require the auditors to obtain the relevant shipping documents such as bills of lading or airway bills and check that the dates of the shipping documents are in the same accounting period in which the sales are recognised.

11. There could be instances where goods are directly shipped from the companys suppliers to the customers or where goods are purchased only when there is a sales order (i.e. back-to-back). For these transactions, the auditors should verify the sales/purchases cut-off samples selected to the shipping documents and match with the corresponding purchases/sales to better address the cut-off assertion. Purchases cut-off procedures (a) Local trading purchases 12. For local purchases, the auditors will need to obtain delivery orders of suppliers and check that the dates of receipt of the goods by the company are in the same accounting period in which the purchases are recognised. 13. Similar to sales, if there is no acknowledgement or there is no indication of the date of receipt of goods on the delivery orders, the auditors could try to obtain alternative evidence from other audit procedures performed such as obtaining the stocks cards of the samples selected and checking whether the goods are received before or after the year end after understanding and testing the key controls for the inventories cycle to establish that the stock card records are reliable. (b) Overseas trading purchases 14. For overseas purchases where incoterms are used, similar to overseas trading sales, auditors would need to consider the incoterms to determine the point where the risks and rewards of the ownership are transferred and obtain the relevant shipping documents and check that the dates of the shipping documents are in the same accounting period in which the purchases are recognised. The auditors would also need to be mindful of whether there are any side agreements entered or clauses in the sales agreements or invoices which may impact the appropriate point of recognition of the purchases. 15. When performing cut-off tests for overseas purchases, auditors should be mindful that the company should not recognise purchases based on the dates of the letters of credit or trust receipts with financial institutions. Letters of credit and trust receipts are means of financing the payments and they do not determine when transfer of title takes place. Cut-off errors will result if purchases are recognised based on payment terms rather than incoterms or the side agreements entered or clauses in the purchase agreements or invoices which may impact the appropriate point of recognition of the purchases. Cut-off errors 16. If there are discrepancies in the samples tested for cut-off tests, auditors need to consider the requirements of Clarified SSA 530 Audit Sampling. Specifically, paragraphs 12, 13 and A17 of Clarified SSA 530 requires the auditor to investigate the nature and cause of any deviations or misstatements identified and evaluate their possible effect on the purpose of the audit procedure and on other areas of the audit (paragraph 12). In the extremely rare circumstances

when the auditor considers a misstatement or deviation discovered in a sample to be an anomaly, the auditor shall obtain a high degree of certainty that such misstatement or deviation is not representative of the population. The auditor shall obtain this degree of certainty by performing additional audit procedures to obtain sufficient appropriate audit evidence that the misstatement or deviation does not affect the remainder of the population (paragraph 13). In analyzing the deviations and misstatements identified, the auditor may observe that many have a common feature, for example, type of transaction, location, product line or period of time. In such circumstances, the auditor may decide to identify all items in the population that possess the common feature, and extend audit procedures to those items. In addition, such deviations or misstatements may be intentional, and may indicate the possibility of fraud (paragraph A17). This means that if discrepancies are noted in cut-off tests, the auditors will need to consider whether there is a need to increase the number of samples tested or extend the period covered before arriving at a conclusion on the impact of the discrepancies on the financial statements as a whole. Overall review at the end of the audit 17. Clarified SSA 520 Analytical Procedures, paragraph 6 states that the auditor should design and perform analytical procedures near the end of the audit to assist the auditor when forming an overall conclusion as to whether the financial statements as a whole are consistent with the auditor's understanding of the entity. Such analytical procedures are useful tools if they are robustly performed at the disaggregated level of sales and purchases as they can help the auditors to identify potential cut-off errors. Conclusion 18. Auditors need to bear in mind the importance of assessing when the significant risks and rewards of ownership of the goods are transferred when performing cut-off tests and the requirements of Clarified SSA 530 Audit Sampling when cut-off errors are noted to properly address the cut-off of revenue and purchases at year-end.
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