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:
The audit of a construction company that enters into long-term construction contracts is highly significant due to the complexity and unique nature of recognizing revenue and costs over time. For long-term contracts, revenue is typically recognized using the percentage-of-completion method, which requires careful estimation of the total contract cost, progress toward completion, and any potential changes in the contract terms. This introduces risks related to the accuracy and reliability of the company’s estimates and assumptions.
Special Audit Procedures:
- Review of Contracts: The auditor must thoroughly review the terms of the construction contracts, including progress billing schedules, payment terms, milestones, and clauses related to penalties, bonuses, and contract modifications.
- Verification of Percentage of Completion: The auditor should verify the percentage of completion by examining the progress reports, subcontractor invoices, and cost data related to the construction project. The auditor may also perform physical inspections of the job site to assess the accuracy of the reported progress.
- Evaluation of Revenue Recognition: Special attention must be given to ensuring that the revenue recognition method (e.g., percentage of completion) is applied correctly and consistently. The auditor must assess whether estimates for total contract costs and revenues are reasonable and based on reliable data.
- Assessment of Contingencies: The auditor must evaluate the impact of contingencies, such as change orders or claims, and determine if these are appropriately disclosed or accounted for in the financial statements.
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:
The introduction of new products and a liberal return policy introduces significant audit risks. The main concern is the potential for revenue to be overstated, as sales may have been recorded for products that are likely to be returned. The liberal return policy requires the auditor to assess whether the revenue recognized is accurate and whether provisions for returns are appropriately established.
Special Audit Procedures:
- Review of Return Policy: The auditor must review the company’s return policy and its impact on revenue recognition. This involves understanding the likelihood of returns and assessing whether the company is accurately estimating returns at the end of the period.
- Testing of Revenue Recognition: The auditor should test a sample of sales transactions made during the period to verify if they were recorded in accordance with the company’s revenue recognition policy. Special attention should be given to sales made in the last quarter, considering the long return period.
- Estimation of Returns: The auditor should assess the reasonableness of the company’s provision for returns. This can involve comparing historical return patterns, reviewing return rates for similar products, and evaluating whether the provision for returns is in line with industry standards and company experience.
- Cut-off Testing: The auditor must ensure that revenue from sales near year-end has been recorded in the correct period, given the potential for returns after the year-end cutoff.
Here’s an image that summarizes these two audit situations.
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| Situation | Audit Procedures |
+---------------------------------------------------------------+
| Construction Contracts (Long-term) | 1. Review of Contracts |
| - Complexity of revenue recognition (percentage-of-completion) | 2. Verification of Completion Progress |
| - Estimation of contract costs and progress | 3. Evaluation of Revenue Recognition |
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| New Products and Liberal Return Policy | 1. Review of Return Policy |
| - Risk of overstated revenue from potential returns | 2. Testing of Revenue Recognition |
| - Estimation of returns and provision adjustments | 3. Estimation of Returns |
| - Year-end cut-off considerations | 4. Cut-off Testing |
+---------------------------------------------------------------+