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 Situation Analysis
1. The audit of a construction company that enters into long-term construction contracts.
Audit Significance:
- Long-term construction contracts often span multiple periods and involve significant judgment in terms of recognizing revenue and expenses. This can affect the timing and amounts of revenue recognized.
- The audit is critical for ensuring that the construction company follows the percentage-of-completion method or completed-contract method correctly, in accordance with accounting standards (e.g., IFRS or GAAP).
- Proper recognition of revenue over time, along with the associated costs, is key to ensuring the financial statements are not misstated.
Special Audit Procedures:
- Revenue Recognition: Review the methods used to recognize revenue for the contracts, ensuring compliance with the appropriate accounting framework.
- Examine Contracts: Obtain and analyze the terms of the construction contracts to verify that revenue recognition is aligned with contract milestones and actual progress.
- Estimate Review: Assess the appropriateness of cost estimates for the contracts, including reviewing the cost-to-complete for the ongoing projects.
- Inspection of Progress Reports: Evaluate and verify the internal project management reports, inspecting progress reports to determine if they reflect actual project completion percentages.
- Testing of Estimates: Given the significant judgment involved, audit procedures should include testing the basis for estimates (e.g., labor costs, materials, etc.) and verifying their accuracy.
2. Kidz Toy Manufacturing Co. introduced a number of new products in the last quarter of the year with a liberal return policy.
Audit Significance:
- The liberal return policy introduces uncertainty regarding the actual revenue the company can recognize. There’s a risk that the company may overstate revenue if returns are higher than expected.
- It is important to assess the proper recognition of revenue, especially when dealing with the timing of sales and the potential for future returns.
Special Audit Procedures:
- Review Return Policy: Examine the details of the return policy, including how the company estimates future returns and accounts for them in the financial statements.
- Testing of Sales and Returns: Perform cut-off tests around year-end to ensure sales are recognized in the correct period and that the estimated returns are accurately accounted for.
- Revenue Recognition: Ensure that revenue is only recognized to the extent that it is likely to be realized, with the return policy considered when assessing this likelihood.
- Historical Data Analysis: Analyze past return data to assess the reasonableness of management’s estimates for returns, and confirm that these estimates align with historical trends.
- Provision for Returns: Audit the adequacy of the provision for returns included in the financial statements and verify it against actual returns data.
Image Representation:
Here is the infographic summarizing the two audit situations and their associated audit procedures. It provides a clear overview of the key points for both the construction company and the toy manufacturing company.