Cutoff Testing in an Audit: Sales and Purchases Cutoff Procedures

Cutoff testing checks that transactions near the balance sheet date are recorded in the right period. It is a simple idea that catches misstatements such as December sales that belong in January, January invoices for December inventory, and returns that quietly reverse year-end revenue.

This guide covers sales and purchases cutoff for a nonissuer audit under GAAS: what to test, how to choose the window and the sample, and what to document.

What cutoff testing addresses

The cutoff assertion is that transactions and events have been recorded in the correct accounting period. Cutoff testing also supports related assertions:

• Occurrence of revenue: a sale recorded before year end actually happened before year end.
• Completeness of liabilities and expenses: goods received before year end are recorded before year end.
• Existence of receivables and completeness of inventory, because sales and receiving cutoff errors flow through both.

See audit assertions for how these fit together. In risk assessment under AU-C 315, revenue cutoff is often assessed as a higher-risk area, particularly where AU-C 240's presumed fraud risk in revenue recognition has not been rebutted.

Know the shipping terms and when control transfers

You cannot test cutoff without knowing when the sale should be recognized. Under ASC 606, revenue is recognized when (or as) the entity satisfies a performance obligation by transferring control of a good or service to the customer. For goods, shipping terms are one indicator of when control transfers, alongside legal title, physical possession, risks and rewards, and acceptance.

Shipping terms are an indicator, not the conclusion. Read the contract terms that actually govern the transaction. For more on the framework, see ASC 606 revenue recognition.

Sales cutoff procedures

Define the window

Pick a number of days before and after year end. The window should reflect transaction volume, the risk assessment and the entity's billing pattern. A business that ships daily might use five business days on each side; one that invoices monthly may need the full last and first month.

Select from the right source

Direction matters:

• To test that recorded sales occurred in the period (occurrence and cutoff), select from sales recorded in the last days before year end and trace to shipping documents dated before year end.
• To test that shipments before year end were recorded (completeness), select from shipping records in the last days before year end and trace to sales recorded before year end.
• To test that shipments after year end were not recorded early, select from shipping records in the first days after year end and confirm the sales were recorded after year end.

Many firms select both from the sales journal and from the shipping log, because each direction addresses a different risk.

Worked example (illustrative)

Year end December 31. Terms FOB shipping point. Window: December 24 to January 7.

Invoice 10492 is a $38,500 overstatement of revenue and receivables at year end, with a related inventory and cost of sales effect. Invoice 10501 is a $21,000 understatement. Each is a factual misstatement; post both to the summary of misstatements under AU-C 450 without netting them until you have considered whether either points to a pattern. An early shipment recorded in December by a salesperson with a year-end target is a different kind of error from a clerical lag, and bears on the fraud risk assessment.

Credit memos and returns after year end

Review credit memos issued after year end, typically through the date of fieldwork or close to the report date. A large credit memo in January against a December sale can mean the original sale should not have been recognized, or that a returns reserve was needed. Look for:

• credits to customers who received unusually large December shipments
• returns of the same goods shipped just before year end
• side letters or extended return rights not reflected in the contract

Other sales cutoff considerations

• Service revenue: test cutoff against time records, completion certificates or milestone evidence rather than shipping documents.
• Deferred revenue: test that cash received in advance before year end was not recognized before performance.
• Unusual year-end activity: compare December sales with prior months and the prior year. A spike in the last week deserves a closer look.

Purchases and receiving cutoff procedures

Purchases cutoff tests that goods and services received before year end are recorded as liabilities and expenses or inventory before year end, and that items received after year end are not.

Procedures

1. Obtain the receiving log for the window around year end.
2. For receipts before year end, trace to the vendor invoice and confirm it was recorded in accounts payable or accrued liabilities at year end.
3. For receipts after year end, confirm the related liability and inventory were not recorded at year end (unless title passed earlier, for example FOB shipping point purchases in transit).
4. Select from purchases recorded in the last days of the year and agree to receiving documents dated before year end.
5. Check that the last receiving report numbers used before the physical inventory count match the inventory and payables records.

Link to the inventory count and unrecorded liabilities

Receiving cutoff overlaps two other areas. At the physical count, record the last receiving and shipping document numbers so you can test that inventory and purchases are consistent. After year end, the search for unrecorded liabilities tests subsequent disbursements and unpaid invoices for completeness. Cross-reference all three so the reviewer can see the cutoff evidence as one picture.

Worked example (illustrative)

Year end December 31. Window December 27 to January 5.

RR-2234 is an unrecorded liability: the goods were received in December and counted in inventory, but the payable was recorded in January. RR-2236 may be correct if the goods were shipped FOB shipping point and in transit at year end; check the terms before calling it an error.

Sample size and selection

Cutoff tests are usually targeted rather than statistical: every transaction in a short window above a threshold, plus a selection below it. If you use sampling, design it under AU-C 530 and document the population, sampling unit and sample size so a reviewer can re-perform the selection.

Factors that justify a wider window or more items:

• a revenue fraud risk that has not been rebutted
• prior-year cutoff errors
• incentives tied to year-end results, such as bonuses or covenants
• manual invoicing or a lag between shipment and billing
• a change in systems or shipping terms during the year

Documentation

Under AU-C 230, a cutoff workpaper should include:

• the objective and assertions addressed
• the shipping and receiving terms relied on
• the window and the reason for it
• the source of each selection (sales journal, shipping log, receiving log) and how completeness of that source was checked
• identifying details for each item: document numbers, dates and amounts
• results, including quantified misstatements and whether they were corrected
• the credit memo review and its result
• a conclusion on cutoff

Common cutoff testing mistakes

• Testing in only one direction. Selecting only from recorded sales misses shipments that were never billed.
• Using invoice dates as shipping evidence. The invoice date is what you are testing, not the evidence.
• Ignoring terms. Treating every shipment as FOB shipping point without reading contracts.
• Skipping credit memos. January returns can undo December sales.
• Window too short for an entity with a billing lag.
• Errors netted without considering what they say about controls or intent.

Frequently asked questions

What is cutoff testing in an audit?

Cutoff testing is a substantive procedure that checks whether transactions near the balance sheet date are recorded in the correct accounting period, usually by comparing recorded dates with shipping, receiving or performance evidence.

How many days before and after year end should cutoff testing cover?

There is no fixed rule. The window depends on transaction volume, billing practices and risk. Practice varies, and the window is widened where there is a billing lag, prior errors or a revenue fraud risk.

What is the difference between sales cutoff and purchases cutoff?

Sales cutoff tests that revenue and receivables are recorded in the period goods or services transfer to customers. Purchases cutoff tests that liabilities and inventory or expenses are recorded in the period goods or services are received.

Why review credit memos after year end?

Credit memos issued after year end can show that year-end sales did not occur, were subject to return rights, or needed a returns reserve. Large credits shortly after year end can be a sign of revenue recorded early.

Is a cutoff error always a misstatement?

A transaction recorded in the wrong period is a misstatement in each period affected. Whether it is material depends on amount and nature, and a pattern of early recording may indicate a control deficiency or fraud risk.

Sources

• AICPA, AU-C Section 315, Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement (assertions about classes of transactions, including cutoff)
• AICPA, AU-C Section 240, Consideration of Fraud in a Financial Statement Audit (presumed risk in revenue recognition)
• FASB ASC 606-10-25-23 through 25-30 (control transfer indicators) and ASC 606-10-55-79 through 55-84 (consignment and bill-and-hold)
• AICPA, AU-C Section 450, Evaluation of Misstatements Identified During the Audit
• AICPA, AU-C Section 530, Audit Sampling, and AU-C Section 230, Audit Documentation

CORAA prepares ready-to-review audit files for US CPA firms; see /us.

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error