Audit Risk, Covenant Pressure and a Request to Work Around a Return

Significant risks

1. Revenue recognition - cut-off and returns. The $420,000 shipment on December 30 is material relative to performance materiality of $180,000 and close to overall materiality of $250,000. FOB shipping point supports recognition, but the 60-day right of return and 8% historical return rate create a refund liability and a variable consideration estimate. Risk: revenue and receivables overstated, and returns liability understated. Assertions: occurrence, cut-off, accuracy, valuation.
2. Inventory valuation. Turnover fell from 4.2 to 3.1, and slow-moving SKUs have not sold in nine months. Inventory of $3.2 million is 1.28 times overall materiality. Risk: inventory is not carried at the lower of cost and net realizable value. Assertion: valuation.
3. Management override and fraud risk. The CEO approves all journal entries above $50,000, rarely takes vacation, and the CFO is new. The CFO has proposed a $180,000 capitalization of routine repairs and asked the auditor to work around the returned sale. These are fraud risk factors. Assertions: existence/occurrence, valuation, presentation.
4. Covenant and going concern. The draft current ratio is 1.48 against a 1.50 covenant. A small adjustment, such as reversing the $180,000 capitalization or recording the sales return, could cause a breach. Risk: the loan may become payable on demand, raising going concern and classification risk.

Returned sale procedures

• Inspect the December 30 shipping document, bill of lading, and sales contract to confirm FOB shipping point and whether control transferred.
• Obtain the customer's return history and the terms of the 60-day right of return; calculate the expected return liability using the 8% rate and consider whether the rate is representative.
• Review subsequent returns through the audit report date and compare to the estimate.
• Test the sales cutoff around December 31, including the next few days' shipments, to see whether any revenue was recorded in the wrong period.
• Confirm the balance with the customer and inquire about side agreements, price concessions, or extended payment terms.
• Recalculate the refund liability and any asset for the right to recover returned goods, and check the presentation.

Inventory obsolescence procedures

• Obtain the inventory aging and compare to sales forecasts and post-year-end sales.
• Test a sample of slow-moving SKUs to recent selling prices, less costs to complete and sell, to assess net realizable value.
• Inquire of sales and production about discontinued products and customer changes.
• Observe the physical inventory count for damaged or obsolete items.
• Recompute the turnover ratio and investigate the decline from 4.2 to 3.1.
• Evaluate management's write-down and challenge assumptions.

The $180,000 repair capitalization

Routine repairs maintain an asset's normal operating condition and do not meet the IAS 16 recognition criteria for property, plant and equipment. The $180,000 should be expensed. Although it is below overall materiality of $250,000, it is at performance materiality of $180,000 and is not clearly trivial. Qualitative factors make it material: it increases profit and assets, affects the current ratio and debt-to-equity covenant, and is proposed by a new CFO under covenant pressure. It should be accumulated with other misstatements and communicated to those charged with governance.

The CFO's request

An auditor cannot work around a returned sale or design procedures to reach a predetermined conclusion. The auditor must obtain sufficient appropriate evidence, apply professional skepticism, and insist on IFRS-compliant accounting. If management refuses to adjust a material misstatement, the auditor should communicate with the board or audit committee, consider the effect on the audit opinion, and evaluate whether withdrawal is appropriate under ethical standards. The auditor should also consider whether the CEO's control over journal entries and the covenant pressure indicate a fraud risk, and document the response. Confidentiality does not permit the auditor to mislead the bank; the auditor should not communicate directly with the bank without client consent unless required by law or professional standards.