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 for Receivables and Revenue

a. The Audit of a Construction Company with Long-Term Contracts

Audit Significance:
Construction companies often use percentage-of-completion accounting for long-term contracts. This introduces risks related to revenue recognition, including premature recognition, incorrect cost estimation, and potential contract losses. The auditor must ensure compliance with applicable accounting standards such as IFRS 15 or ASC 606.

Special Audit Procedures:

1. Contract Review: Examine long-term contracts to ensure proper revenue recognition policies are applied.
2. Estimation Verification: Assess management’s estimates for project completion, cost allocation, and anticipated losses.
3. Revenue Cutoff Tests: Verify revenue is recognized in the correct accounting period.
4. Confirmations with Customers: Obtain direct confirmations from customers regarding contract progress and payments.
5. Site Visits: Inspect physical progress and compare with accounting records.
6. Analytical Procedures: Compare current period revenue with prior periods for unusual fluctuations.

b. Kidz Toy Manufacturing Co.’s New Product Introductions and Return Policy

Audit Significance:
A liberal return policy (120 days) creates risks related to revenue recognition and the completeness of return reserves. There is a risk that revenue is overstated if sales returns are not properly accounted for.

Special Audit Procedures:

1. Review of Return Policy: Ensure return allowances are reasonable and in line with past trends.
2. Cutoff Testing: Examine year-end sales and returns to verify proper revenue recognition.
3. Subsequent Return Analysis: Inspect post-year-end returns to determine if sufficient reserves were recorded.
4. Customer Confirmation: Confirm balances with major retailers to verify revenue and expected returns.
5. Recalculation of Sales Allowances: Validate management’s return reserve estimates based on historical return rates.

Both scenarios require auditors to apply professional skepticism and analytical procedures to ensure accurate financial reporting.

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