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. The audit of a construction company that enters into long-term construction contracts.
Audit Significance:
Revenue recognition for long-term construction contracts often involves the percentage-of-completion method, which is complex and subject to significant judgment. This poses a risk of revenue overstatement, especially if estimates related to costs to complete or project progress are manipulated.
Special Audit Procedures:
- Review and test the company’s revenue recognition policy for compliance with relevant accounting standards (e.g., IFRS 15 or ASC 606).
- Examine contract terms to determine proper accounting treatment.
- Test project budgets and cost estimates for reasonableness.
- Review change orders, claims, and disputes that may affect costs or revenue.
- Confirm with clients the status of contracts and any approved progress billings.
- Perform cut-off tests at year-end to ensure appropriate revenue recognition.
- Inspect documentation supporting estimated percentage of completion, such as engineers’ reports or project progress certifications.
Explanation:
Construction contracts often span multiple periods, and recognizing revenue before project completion requires careful estimation of project stage and costs. Misjudgment or manipulation can materially misstate revenue and receivables. Thus, auditors must place significant emphasis on evaluating management’s estimates and verifying that revenue is not prematurely or inappropriately recognized.
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.
Audit Significance:
There is a risk of revenue overstatement and misstated accounts receivable due to the high probability of returns. Sales occurring late in the year under a liberal return policy may not meet the criteria for revenue recognition.
Special Audit Procedures:
- Review return policies and ensure they are consistently applied.
- Analyze sales returns subsequent to year-end for trends.
- Inspect credit memos and return authorizations issued after year-end.
- Assess the adequacy of the sales return allowance by comparing historical return rates.
- Test sales cut-off to ensure that only valid sales are recorded in the current period.
- Review customer contracts and promotional materials to understand return terms.
Explanation:
Under accounting standards, revenue should only be recognized when it is earned and realizable. With a generous return policy, especially for newly introduced products, the risk increases that products will be returned post year-end. If returns are probable, revenue should be reduced, or deferred until the return period lapses. Therefore, the auditor must assess the adequacy of return provisions and ensure that sales figures are not overstated.