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 :
Situation a: The Audit of a Construction Company with Long-Term Construction Contracts
Audit Significance:
The audit of a construction company that enters into long-term construction contracts is significant due to the complexities of revenue recognition and the potential for misstatements. Revenue for long-term contracts is often recognized over time as the project progresses, using methods such as the percentage-of-completion or completed-contract method. This requires estimates related to the costs incurred, progress of the work, and projected costs to complete the project.
Special Audit Procedures:
- Review of Contract Terms: The auditor must evaluate the terms and conditions of long-term contracts to understand the performance obligations and ensure they align with revenue recognition policies.
- Verification of Costs: Auditors must verify the costs incurred on each project, including labor, materials, overhead, and subcontractor costs. This includes inspecting invoices and contracts to ensure accuracy.
- Testing Percentage-of-Completion: If using the percentage-of-completion method, auditors should review the methodology and the assumptions used to calculate the percentage of completion. The auditor should assess whether the estimates of total project costs and revenues are reasonable.
- Confirmations and Independent Estimations: Independent confirmations from subcontractors, suppliers, and other stakeholders can be used to verify costs and progress on projects.
- Assessment of the Company’s Internal Controls: Due to the complexity of long-term contracts, evaluating the company’s internal controls around revenue recognition and cost allocation is crucial.
Situation b: Kidz Toy Manufacturing Co. with a Liberal Return Policy
Audit Significance:
The introduction of new products and a liberal return policy significantly affects the recognition of revenue. According to accounting standards like IFRS and GAAP, revenue should not be recognized until it is probable that the returns can be estimated reliably. A generous return policy increases the risk that revenue may be prematurely recognized or overstated.
Special Audit Procedures:
- Review of Return Policy and Historical Trends: The auditor should examine the company’s return policy and analyze historical return rates to assess the reliability of estimating returns.
- Estimation of Returns: The auditor needs to ensure that the company has made an appropriate provision for expected returns. This involves reviewing the company’s historical return data and assessing whether the estimated returns are reasonable based on the nature of the products and the market.
- Subsequent Sales Returns: Auditors may review post-year-end sales returns to verify the accuracy of the return provision made at year-end. A large number of returns after year-end could indicate that revenue recognized prior to year-end may need to be adjusted.
- Confirmation of Sales and Revenue Recognition: Verifying sales contracts and delivery documentation is essential to ensure that revenue was recognized in the correct period. Special attention should be paid to ensure that revenue is not recognized before it is earned.
Visual Representation:
Here’s a breakdown of both situations using a diagram, illustrating the key audit steps for each scenario.
The flowchart above illustrates the audit procedures for both situations. On the left, we have the steps for auditing a construction company with long-term contracts, and on the right, we have the procedures for auditing Kidz Toy Manufacturing with a liberal return policy. Each section outlines the key audit steps relevant to the specific situation.