You are performing the audit of the JZ Limited (JZ) financial statements for its year ended September 30, 20X2. JZ is a private company that provides computer network repair services to businesses in the Greater Toronto Area (GTA). JZ’s audited financial statements are used mainly by its bank to support an ongoing operating loan arrangement. JZ has four shareholders who are all actively involved in the business. JZ’s accounting policy is to recognize revenue when each repair job is completed. All sales are on account. At their September 30, 20X2, year-end, JZ had completed a large job, but during your audit you have discovered that the company’s accountant did not record this sales revenue until October 10, 20X2, when the company issued the customer an invoice for $145,000. Before correcting this error, JZ’s draft financial statements show sales revenues of $3,200,000 and accounts receivable, net of allowance for bad debts, of $450,000. Required: a. Explain how the accounts in the JZ financial statements will be affected by this error. b. Explain the assertion that has been violated by this error. c. Give one example of an audit procedure that would have discovered this error. d. What is the impact of this error on JZ’s accounts receivable turnover? e. Would you consider this error to be material? Justify your response.
The error of not recording the $145,000 in sales revenue when the job was completed will affect the financial statements as follows:
Sales Revenue: The sales revenue will be understated by $145,000 because this amount was not recorded in the financial year ending September 30, 20X2. As a result, the reported sales revenue of $3,200,000 is too low and should have been $3,345,000.
Accounts Receivable: Accounts receivable will also be understated by $145,000. This amount represents the receivable that should have been recorded once the repair job was completed. The reported accounts receivable of $450,000 is thus understated and should have been $595,000.
Net Income: Since revenue is understated, net income will also be understated. This will impact retained earnings and could potentially impact tax liabilities.
Equity: Understated net income will lead to an understatement of retained earnings, which is part of equity on the balance sheet.
The assertion that has been violated by this error is the "Completeness" assertion. This assertion states that all transactions and events that should have been recorded have been recorded in the financial statements. In this case, the revenue for the completed job was not recorded in the correct accounting period, leading to an understatement of sales revenue and accounts receivable.
An example of an audit procedure that would have discovered this error is:
To determine whether the error is material, the auditor would consider both the quantitative and qualitative aspects.
Quantitative Materiality: The error represents $145,000, which is approximately 4.53% of reported sales revenue ($145,000 / $3,200,000) and 24.44% of reported accounts receivable ($145,000 / $450,000). Generally, an error exceeding 5% of a financial statement line item is often considered material, so the sales impact is close to materiality, but the impact on accounts receivable is highly material.
Qualitative Materiality: Even if the error is slightly below a quantitative threshold, it can still be considered material if it impacts important metrics, such as net income or compliance with loan covenants. Since JZ's financial statements are primarily used by its bank to support an operating loan, an understatement of revenue and accounts receivable could affect the bank’s perception of JZ’s financial health.
Given these considerations, I would consider the error to be material due to its significant impact on accounts receivable and the potential effect on the bank's lending decisions.
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