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:
Here is the correct answer and a 300-word explanation for each audit situation:
a. Long-Term Construction Contracts (Construction Company)
Audit Significance:
This situation is significant due to the complexity and subjectivity involved in recognizing revenue under long-term construction contracts. These contracts typically fall under percentage-of-completion accounting (or cost-to-cost method under IFRS and ASC 606), which involves significant estimates and judgments about costs, progress, and profitability. Errors or intentional manipulation in estimating these can lead to material misstatements in revenue and receivables.
Special Audit Procedures:
- Review contract terms to understand performance obligations and billing arrangements.
- Evaluate the appropriateness and consistency of the percentage-of-completion method applied.
- Test the reliability and support for estimated costs to complete contracts.
- Inspect progress billing and compare them to work completed.
- Examine change orders and claims for proper inclusion or exclusion.
- Inquire about any disputes or contingencies that may affect revenue recognition.
Explanation:
Auditors must carefully assess how revenue is recognized and whether the financial statements accurately reflect the economic reality of the contracts. Since estimates are involved, there is a risk of management bias. Auditors should also consider subsequent events (e.g., losses, contract modifications) that might affect current period recognition.
b. Liberal Return Policy (Kidz Toy Manufacturing Co.)
Audit Significance:
The introduction of new products and a liberal return policy increases audit risk due to uncertainty surrounding sales returns. Sales recorded in the final quarter may be overstated if appropriate return reserves are not established. This directly affects both revenue and accounts receivable.
Special Audit Procedures:
- Review the return policy and assess its reasonableness.
- Analyze historical return rates and apply them to current sales for estimating a returns allowance.
- Test sales transactions near year-end to determine if they are properly recorded and not subject to return.
- Review subsequent returns after year-end to evaluate the adequacy of the estimated return reserve.
- Evaluate disclosures related to the return policy and estimates.
Explanation:
Auditors need to ensure revenue recognition criteria are met, especially considering the high likelihood of returns. Estimating future returns is inherently subjective, and poor estimation can materially misstate revenue. Cutoff testing and post-year-end review are key to ensuring proper matching and recognition.
