Listed below are audit situations that may affect the audit of receivables and revenue

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) The Audit of a Construction Company with Long-term Construction Contracts

Audit Significance:
Long-term construction contracts involve complexities related to revenue recognition, contract costs, and estimates of completion. The primary concern is whether the company follows an appropriate revenue recognition method, such as the percentage-of-completion or completed-contract method, per applicable accounting standards (e.g., IFRS 15 or ASC 606). Risks include premature revenue recognition, inaccurate estimation of costs, and the possibility of contract losses not being recorded timely.

Special Audit Procedures:

1. Review Revenue Recognition Policies: Ensure compliance with applicable accounting standards.
2. Examine Contract Agreements: Verify terms, milestones, and payment schedules.
3. Inspect Cost Estimates and Budgeting Process: Assess the reasonableness of estimates used in revenue recognition.
4. Confirm Receivables and Progress Billings: Send confirmation letters to customers for contract-related receivables.
5. Assess Completion Status: Compare project progress reports with actual work done.
6. Analyze Contingencies and Provisions: Review if any expected losses are properly accounted for.

(b) Kidz Toy Manufacturing Co. with a Liberal Return Policy

Audit Significance:
The extended return policy (120 days) raises concerns about revenue recognition, as sales recorded in the last quarter may be overstated due to potential returns. Under IFRS 15 or ASC 606, companies must recognize revenue only when it is probable that sales will not be reversed. The audit should focus on ensuring that revenue is adjusted for estimated returns.

Special Audit Procedures:

1. Analyze Return Trends: Examine historical return rates to estimate expected returns.
2. Review Revenue Recognition Policies: Ensure compliance with revenue recognition rules, particularly regarding variable consideration.
3. Inspect Sales Transactions Near Year-End: Verify if appropriate reserves for returns are created.
4. Examine Credit Notes Issued Post-Year-End: Check if significant returns occurred after year-end.
5. Confirm Sales Cutoff Procedures: Ensure sales and returns are properly recorded in the correct period.