An auditor is performing substantive analytical procedures on a client's revenue accounts. The client produces custom-engineered industrial machinery, and revenue recognition is based on the percentage-of-completion method for long-term contracts. Which of the following analytical procedures would be MOST effective in detecting potential overstatement of revenue?
- AAnalyzing trends in shipping costs as a percentage of revenue and comparing to prior periods.
- BComparing actual costs incurred to estimated total costs for a sample of contracts and investigating contracts with high cost overruns.
- CCalculating the gross profit percentage and comparing it to industry benchmarks and prior periods.
- DComparing current year total revenue to prior year total revenue and investigating significant fluctuations.
Show answer & explanationAnswer & explanation
Correct answer: B. Comparing actual costs incurred to estimated total costs for a sample of contracts and investigating contracts with high cost overruns.
Under the percentage-of-completion method, revenue is recognized based on the proportion of costs incurred to total estimated costs. If actual costs exceed estimated costs (cost overruns), it suggests that the original total cost estimate was too low. A lower estimated total cost would lead to a higher percentage of completion and thus an overstatement of revenue recognized to date. Comparing actual to estimated costs directly addresses this critical component of revenue recognition for such contracts.
Why the other options are wrong
- A. Shipping costs are less directly related to the *recognition* of revenue under percentage-of-completion than the cost estimates themselves.
- C. Gross profit percentage is a good indicator, but *why* it fluctuates for percentage-of-completion contracts is often tied to cost estimates. Option D is more direct in identifying the root cause of potential overstatement.
- D. While a general analytical procedure, comparing total revenue might not specifically pinpoint overstatement due to issues with percentage-of-completion calculations without further breakdown.
Revenue Recognition for Long-Term Contracts (Percentage-of-Completion)
Under the percentage-of-completion method, revenue and profit are recognized as work progresses based on the proportion of costs incurred to total estimated costs. Auditors must carefully assess management's cost estimates due to the risk of revenue overstatement.
- Revenue recognized based on progress towards completion.
- Progress is often measured by costs incurred / total estimated costs.
- Risk of overstatement if total estimated costs are understated.
- Auditors test the reasonableness of cost estimates.
Memory trick: Overstatement in construction revenue often hides in the 'ESTIMATES'.