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 :
Audit Significance and Special Audit Procedures for Receivables and Revenue
a. Audit of a Construction Company with Long-term Contracts
Audit Significance:
The audit of a construction company with long-term contracts presents significant challenges due to the complexity of revenue recognition. These contracts often involve estimates of costs, progress measurements, and recognition of revenue over time. The primary concern is whether revenue is recognized in accordance with applicable accounting standards (e.g., IFRS 15 or ASC 606). There is also a risk of revenue manipulation, as management may recognize revenue prematurely to meet financial targets.
Special Audit Procedures:
- Review of Contracts – Obtain and examine contracts to understand terms related to revenue recognition, billing, and completion milestones.
- Examine Cost Estimates – Assess the reasonableness of cost estimates, including labor, materials, and overhead. Compare prior period estimates to actual results to identify inconsistencies.
- Verify Percentage of Completion – If revenue is recognized over time, test the percentage of completion using actual costs incurred versus estimated total costs.
- Substantive Analytical Procedures – Compare revenue trends, margins, and progress billings to prior years and industry standards.
- Confirm Receivables and Work-in-Progress – Send confirmations to customers to verify outstanding receivables and check the physical progress of projects.
b. Audit of Kidz Toy Manufacturing Co. with a Liberal Return Policy
Audit Significance:
The company’s liberal return policy increases the risk of revenue overstatement. Since customers can return products within 120 days, some revenue recognized in the last quarter may be reversed in the following period. Proper estimation and recording of sales returns and allowances are crucial for accurate financial reporting.
Special Audit Procedures:
- Evaluate Return Policies and Past Trends – Analyze historical return rates and compare them with current sales trends.
- Review Subsequent Returns – Examine sales returns recorded after year-end to ensure proper cut-off and recognition of allowances.
- Test Management Estimates – Assess the reasonableness of the sales return provision by checking the assumptions used in its calculation.
- Examine Customer Complaints – Review customer feedback and return reasons to identify potential misstatements in revenue.
- Substantive Testing of Sales Transactions – Select a sample of year-end sales and verify if they meet the revenue recognition criteria, considering the likelihood of returns.
By performing these procedures, auditors can ensure revenue and receivables are not overstated, providing a fair presentation of the financial statements.