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:
a. Construction Company with Long-Term Contracts
Audit Significance:
Revenue recognition is a critical area for construction companies with long-term contracts, often subject to percentage-of-completion or cost-to-cost methods under AASB 15 (IFRS 15). These methods require significant estimates and judgments, especially in estimating total contract costs, stage of completion, and collectability. As a result, the risk of material misstatement due to error or fraud in revenue recognition is high.
Special Audit Procedures:
- Review and evaluate accounting policies related to revenue recognition for compliance with AASB 15.
- Inspect contracts to understand the performance obligations and terms.
- Test estimates used to determine the percentage of completion (e.g., estimated costs to complete, contract modifications).
- Perform cut-off testing to ensure revenues and costs are recognized in the correct period.
- Assess management’s judgment regarding expected losses or contract overruns.
- Review subsequent events for changes in estimates or contract disputes.
- Confirm receivables and unbilled revenue with customers, especially for contracts in progress.
b. Kidz Toy Manufacturing Co. with Liberal Return Policy
Audit Significance:
The liberal return policy introduces complexity and uncertainty in revenue recognition. Sales returns can materially affect reported revenues and receivables, particularly if many sales occur near year-end. There is a high risk of overstated revenue and receivables if return allowances are not accurately estimated.
Special Audit Procedures:
- Evaluate the return policy and its consistent application.
- Review sales transactions near year-end to assess whether revenue recognition criteria are met.
- Analyze historical return patterns to test the adequacy of the sales return provision.
- Inspect subsequent return data after year-end to validate management’s estimate.
- Perform analytical procedures to identify unusual spikes in sales or credits.
- Inquire with management about new product performance and expected return rates.
- Test journal entries for manual adjustments related to sales and returns.
These audit procedures help ensure that revenue and receivables are not materially misstated, thus maintaining the integrity of the financial statements.Here is the correct and comprehensive analysis of the two audit situations related to receivables and revenue, along with their audit significance and special audit procedures:
a. Construction Company with Long-Term Contracts
Audit Significance:
Revenue recognition is a critical area for construction companies with long-term contracts, often subject to percentage-of-completion or cost-to-cost methods under AASB 15 (IFRS 15). These methods require significant estimates and judgments, especially in estimating total contract costs, stage of completion, and collectability. As a result, the risk of material misstatement due to error or fraud in revenue recognition is high.
Special Audit Procedures:
- Review and evaluate accounting policies related to revenue recognition for compliance with AASB 15.
- Inspect contracts to understand the performance obligations and terms.
- Test estimates used to determine the percentage of completion (e.g., estimated costs to complete, contract modifications).
- Perform cut-off testing to ensure revenues and costs are recognized in the correct period.
- Assess management’s judgment regarding expected losses or contract overruns.
- Review subsequent events for changes in estimates or contract disputes.
- Confirm receivables and unbilled revenue with customers, especially for contracts in progress.
b. Kidz Toy Manufacturing Co. with Liberal Return Policy
Audit Significance:
The liberal return policy introduces complexity and uncertainty in revenue recognition. Sales returns can materially affect reported revenues and receivables, particularly if many sales occur near year-end. There is a high risk of overstated revenue and receivables if return allowances are not accurately estimated.
Special Audit Procedures:
- Evaluate the return policy and its consistent application.
- Review sales transactions near year-end to assess whether revenue recognition criteria are met.
- Analyze historical return patterns to test the adequacy of the sales return provision.
- Inspect subsequent return data after year-end to validate management’s estimate.
- Perform analytical procedures to identify unusual spikes in sales or credits.
- Inquire with management about new product performance and expected return rates.
- Test journal entries for manual adjustments related to sales and returns.
These audit procedures help ensure that revenue and receivables are not materially misstated, thus maintaining the integrity of the financial statements.
