CPA Exam — AUDAssessing Risk and Developing a Planned ResponseMedium
A client, a software development company, recognizes revenue over time for long-term contracts. The auditor notes that revenue recognition involves significant management estimates regarding the percentage of completion and the total estimated costs. This scenario is most likely to increase the auditor's assessment of:
- ADetection risk for completeness.
- BInherent risk for revenue recognition.
- CControl risk for existence.
- DSampling risk for accuracy.
Show answer & explanationAnswer & explanation
Correct answer: B. Inherent risk for revenue recognition.
Revenue recognition for long-term contracts based on percentage of completion involves significant management judgment and estimates. These estimates are inherently subjective and prone to misstatement, independent of internal controls, thus increasing the inherent risk related to the revenue recognition assertion.
Why the other options are wrong
- A. Detection risk relates to the auditor's procedures; the issue here is the client's accounting complexity.
- C. Control risk relates to internal controls failing; while controls might be weak, the core issue is the inherent subjectivity of the estimates.
- D. Sampling risk is a statistical risk in audit testing; it's not the primary risk arising from complex accounting estimates.
Inherent Risk & Estimates
Inherent risk is often higher for financial statement items that involve significant management judgment, complex calculations, or subjective estimates, as these factors increase the susceptibility to material misstatement.
- Estimates are inherently uncertain.
- Judgment can be subjective.
- Complexity increases chance of error.
Memory trick: Estimates are inherently 'guess-timates' with high risk.