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:
Certainly! Here’s a detailed explanation for each audit situation related to receivables and revenue, including audit significance and special audit procedures.
a. Audit of a Construction Company with Long-term Construction Contracts
Audit Significance:
Long-term construction contracts pose significant challenges to auditors because revenue recognition is complex and often based on the percentage-of-completion method. This requires accurate measurement of progress, costs incurred, and estimated costs to complete. Misstatements in revenue or receivables are common risks due to the estimates involved and management judgment, which can affect the timing and amount of revenue recognized. There is also a risk of overstatement of receivables and revenue if costs are understated or progress is overstated.
Special Audit Procedures:
- Review Contract Terms: Examine the contract terms to understand payment schedules, performance obligations, and how revenue is recognized.
- Test Percentage-of-Completion Calculations: Verify the methods used to calculate the percentage of completion, including physical progress or cost-to-cost methods.
- Analyze Costs Incurred and Estimated Costs to Complete: Review job cost ledgers, invoices, and other documentation to validate costs incurred to date. Assess reasonableness of estimated costs to complete by comparing with historical data or industry benchmarks.
- Inspect Supporting Documentation: Confirm subcontractor agreements, change orders, and correspondence to identify any contract modifications affecting revenue recognition.
- Review Receivables Aging and Confirmations: Confirm outstanding receivables with clients, and analyze aging reports to assess collectibility.
- Evaluate Management’s Assumptions: Assess the reasonableness of key management assumptions and estimates, including potential losses or claims.
b. Kidz Toy Manufacturing Co. with New Products and Liberal Return Policy (120 days)
Audit Significance:
A liberal return policy extending 120 days after purchase increases the risk of revenue overstatement and receivables that are not collectible. Revenue may have to be deferred until the return period lapses or provisions must be made for expected returns. New products further complicate matters, as historical return data may not exist to estimate return rates accurately. This raises risks in revenue recognition, receivables valuation, and adequacy of allowances for returns.
Special Audit Procedures:
- Review Return Policy: Understand the terms and how the company accounts for returns and revenue recognition under such policies.
- Evaluate Revenue Recognition Policy: Ensure revenue is recognized only when the right of return is remote or a provision for expected returns is made.
- Test the Allowance for Sales Returns: Assess the methodology used to estimate returns, considering new product introduction. This may involve analyzing historical return rates for similar products, or industry data.
- Inspect Subsequent Returns: Review returns after the year-end to validate the reasonableness of provisions.
- Confirm Receivables and Review Aging: Confirm receivables and analyze aging reports to identify slow-paying or disputed accounts.
- Test Cut-off Procedures: Verify sales transactions near year-end to ensure revenue is recorded in the correct period and that return rights are properly accounted for.
Summary
In both cases, revenue recognition and receivables valuation require heightened audit attention due to complexity and judgment involved. For the construction company, the focus is on percentage-of-completion and cost estimates, while for Kidz Toy, the key risks are related to returns and new product uncertainties. Auditors must tailor procedures to the specific risks to obtain sufficient evidence for a fair audit opinion.
If you want, I can provide a similarly detailed explanation for any other audit scenarios or questions!