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
(a) Audit of a Construction Company with Long-Term Contracts
Audit Significance:
The main audit concern in a construction company with long-term contracts is the revenue recognition method applied. Revenue recognition in construction contracts often follows the percentage-of-completion method (POC) or the completed-contract method under accounting standards like IFRS 15 and ASC 606. Misstated revenue can result from errors in estimating project costs, recognizing revenue prematurely, or improper allocation of contract costs.
Special Audit Procedures:
- Review of Contracts: Examine terms related to pricing, penalties, progress payments, and completion milestones.
- Examine Revenue Recognition Method: Verify whether revenue is recognized according to POC (by verifying work completion percentages) or completed-contract method.
- Testing Estimates of Costs and Progress: Assess management’s assumptions in estimating contract costs and completion status by reviewing engineering reports and site visit inspections.
- Examine Change Orders: Review contract modifications and verify whether additional revenue is properly recorded.
- Confirm Receivables and Retentions: Send confirmation letters to clients regarding outstanding receivables and retentions to validate balances.
- Cutoff Testing: Ensure that revenue is recorded in the correct period by reviewing contract milestones and progress billings.
(b) Audit of Kidz Toy Manufacturing Co. with a Liberal Return Policy
Audit Significance:
The major audit risk for Kidz Toy Manufacturing is revenue overstatement due to high product returns, especially since customers have 120 days to return products. If returns are not properly estimated, revenue may be materially misstated. The company must recognize a sales return reserve to reflect potential returns.
Special Audit Procedures:
- Review Return Policy & Historical Return Data: Assess past return trends to evaluate the adequacy of sales return reserves.
- Revenue Cutoff Testing: Examine sales transactions near year-end to ensure revenue recognition aligns with return risks.
- Analyze Subsequent Returns: Check post-year-end returns to assess if management’s estimated return reserve is reasonable.
- Evaluate Accrual for Sales Returns: Verify the reserve for sales returns using statistical methods, considering industry trends and prior years’ data.
- Review Customer Complaints and Product Defects: High return rates may indicate product quality issues, affecting revenue projections.
By conducting these procedures, auditors can ensure that revenue and receivables are not overstated and comply with accounting standards.
Here is an image representation related to the auditing of revenue and receivables.
