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. Audit of a Construction Company with Long-Term Contracts
Audit Significance:
Long-term construction contracts often use percentage-of-completion accounting, which involves estimates and judgments about costs to complete and project progress. This creates a higher risk of material misstatement due to the subjectivity and potential for manipulation in revenue recognition. If revenue is recognized prematurely or based on inaccurate estimates, it can materially misstate both revenue and receivables.
Special Audit Procedures:
- Review contract terms: Evaluate the contract’s duration, payment terms, performance obligations, and provisions for penalties or delays.
- Assess percentage-of-completion calculations: Test the accuracy of inputs such as actual costs incurred and estimated total costs to complete.
- Inspect supporting documentation: Verify costs with invoices, labor reports, and subcontractor agreements.
- Perform site visits: Observe construction progress and corroborate management’s estimates with physical evidence.
- Evaluate internal controls: Examine the controls over project budgeting, cost tracking, and revenue recognition.
- Review subsequent events: Inspect post-year-end billing and collections to assess the reasonableness of estimates.
b. Kidz Toy Manufacturing Co. with Liberal Return Policy
Audit Significance:
The liberal return policy significantly impacts revenue recognition, especially at year-end when many sales may still be subject to return. There’s an increased risk of overstating revenue and receivables if returns are not properly estimated and accounted for.
Special Audit Procedures:
- Review the return policy: Understand the terms and how they affect revenue recognition.
- Analyze sales returns history: Use historical data to estimate a reasonable returns reserve.
- Test year-end sales: Examine transactions near year-end for evidence of shipment and customer acceptance.
- Evaluate management’s estimates: Assess assumptions used to calculate the sales returns allowance.
- Subsequent period review: Examine sales returns after year-end to validate management’s estimate.
- Confirm receivables: Send confirmations to customers to verify balances and check for potential returns not yet processed.
Each scenario presents significant audit risks that require tailored procedures to ensure that revenue and receivables are fairly stated in accordance with applicable financial reporting frameworks.
