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:
Here is a detailed explanation of each audit situation regarding receivables and revenue:
(a) Audit of a Construction Company with Long-Term Contracts
Audit Significance:
Long-term construction contracts are typically accounted for using either the percentage-of-completion method or the completed-contract method, which can have significant implications for revenue recognition. Under the percentage-of-completion method, revenue is recognized over time based on progress towards completion. This introduces subjectivity and judgment into the revenue recognition process, increasing inherent risk.
Key risks include overstatement of revenue and receivables, manipulation of contract costs or progress estimations, and inappropriate application of revenue recognition criteria.
Special Audit Procedures:
- Evaluate the method of revenue recognition (percentage-of-completion or completed-contract) and ensure it complies with applicable accounting standards (e.g., IFRS 15 or ASC 606).
- Review contracts to identify performance obligations, contract modifications, and transaction prices.
- Test cost estimates and actual costs incurred for reasonableness and consistency.
- Inspect progress reports and certifications from engineers or third-party inspectors to validate reported stage of completion.
- Perform cut-off testing at year-end to ensure revenues and costs are recorded in the proper period.
- Confirm balances of accounts receivable and construction-in-progress with customers.
- Assess management’s estimation process for losses on contracts and evaluate provisions.
(b) Kidz Toy Manufacturing Co. with New Products and Liberal Return Policy
Audit Significance:
The introduction of new products near year-end, combined with a 120-day liberal return policy, raises concerns about the timing and accuracy of revenue recognition. There is a high risk that revenue may be overstated if returns are not properly estimated and recorded. This situation affects both net sales and accounts receivable valuation.
Special Audit Procedures:
- Review sales transactions in the last quarter to assess the volume of new product sales and determine if they are genuine and meet the revenue recognition criteria.
- Evaluate the company’s return history to assess the adequacy of the sales return reserve.
- Inspect return policy disclosures and ensure they are consistent with the actual practice.
- Test subsequent returns (after year-end) to validate the estimated returns liability.
- Perform analytical procedures comparing current and prior year return rates.
- Confirm receivable balances with major customers, focusing on disputes or return issues.
- Assess controls over sales and returns to determine the reliability of internal systems.
In both cases, auditors must apply professional skepticism and tailor audit procedures to address the unique risks posed by revenue recognition and receivable valuation
.