Listed below are audit situations that may affect the audit of receivables and revenue.
a. The audit of a construction company that enters into long-term construction contracts.
b. Kidz Toy Manufacturing Co. introduced a number of new products in the last quarter of the year. The company has a liberal return policy allowing retail customers to return products within 120 days of purchase.
For each circumstance, provide an indication of its audit significance and any special audit procedures that would result.
The correct answer and explanation is :
Answer:
1. The audit of a construction company that enters into long-term construction contracts:
Audit Significance:
The audit of long-term construction contracts is complex due to the long duration and the recognition of revenue over time, based on the percentage of completion method or the completed contract method. This complexity stems from the inherent subjectivity involved in estimating costs to complete, revenue recognition, and potential changes to contract terms (e.g., claims or change orders).
Special Audit Procedures:
- Review of Contracts: The auditor must obtain and thoroughly review the terms of each construction contract to determine how revenue should be recognized (e.g., percentage of completion or completed contract method).
- Percentage of Completion Method: For contracts recognized under the percentage of completion method, the auditor will need to verify the calculations of the percentage of completion based on reliable evidence such as costs incurred to date compared to total estimated costs.
- Examine Estimates of Costs to Complete: The auditor should review management’s estimates of future costs to complete the contract and assess their reasonableness by comparing them to historical experience and third-party data.
- Revenue Recognition Testing: Audit tests should be performed to ensure that revenue is appropriately recognized, including checking that the related costs are accurately matched with the recognized revenue.
- Review of Change Orders and Claims: Since construction contracts often involve change orders, claims, or disputes, auditors should ensure that any changes in contract scope or price are properly documented and reflected in the financial statements.
2. Kidz Toy Manufacturing Co. introduced a number of new products in the last quarter of the year. The company has a liberal return policy allowing retail customers to return products within 120 days of purchase:
Audit Significance:
The introduction of new products and a liberal return policy significantly impacts revenue recognition. The auditor must consider the possibility of returns that may reduce the recorded revenue, requiring adjustments to both revenue and related provisions for returns.
Special Audit Procedures:
- Assess Return Policy and Revenue Recognition: The auditor needs to assess the company’s policy on returns and whether the revenue recognized is appropriately adjusted for estimated returns. The auditor should ensure that the company complies with the revenue recognition standards (e.g., ASC 606 or IFRS 15) for recognizing revenue only when the transfer of control has occurred and it is probable that a return will not occur.
- Examine Historical Return Data: The auditor should analyze past return trends, including rates of returns and reasons for returns, to assess the adequacy of provisions for returns. A high return rate for new products may indicate that the recorded revenue needs to be adjusted.
- Verify Provisions for Returns: The auditor should verify the adequacy of the provision for returns by testing the calculation based on actual return experience or expected return rates. This includes reviewing management’s assumptions and the accuracy of return estimates.
- Physical Observation of Inventory: Since the return policy allows returns up to 120 days, auditors may need to observe the inventory to verify that the returned goods are being properly accounted for and adjusted in the financial records.
Explanation:
For both circumstances, auditors need to consider the risks and complexities involved in revenue recognition. In long-term construction contracts, auditors must focus on ensuring that revenue and costs are recognized correctly over the course of the contract, while for the toy company, auditors need to adjust for potential product returns, which affect both revenue and provisions for future returns.
Both situations require a careful examination of estimates, terms, and historical trends to ensure that financial statements accurately reflect the company’s financial position.