Revenue sampling, cut-off and support revenue recognition
You are auditing the revenue of Brightline Software Ltd, a UK company with revenue of £24m for the year ended 31 December 20X5. Revenue comprises £14m of perpetual licence sales and £10m of support and maintenance. Overall materiality is £1.2m and tolerable misstatement is £600k. You select a monetary sample of 60 invoices from a population of 2,400 invoices using audit software. The sample identifies three exceptions: (1) a licence invoice of £240,000 recognised on 20 December, but the delivery and customer acceptance occurred on 8 January 20X6; (2) a support invoice of £180,000 covering 18 months from 1 November 20X5, recognised in full at invoice date; (3) a duplicate invoice of £95,000 for the same licence and customer as another invoice in the population. The finance director says the duplicate is a clerical error and will be credited in 20X6. The sample exceptions total £515,000.
1. Evaluate the sample results. How should you project the misstatement and conclude on the population?
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Nature of the exceptions. The duplicate invoice is an anomaly: it appears to be a one-off clerical error and should be confirmed by tracing the credit note and the customer account. An anomaly should not be projected across the population. The cut-off error and the support revenue error are different: they arise from the revenue recognition policy and are likely to be systematic.
Projection. ISA (UK) 530 requires projection of misstatements identified in a sample, but the method must reflect the sampling design. Simply multiplying £515,000 by 40 gives £20.6m, which is absurd and would not be a fair projection because it mixes an isolated duplicate with systematic errors. Instead, stratify: test licence cut-off separately and support revenue separately, then project each stratum. For the licence population, a £240,000 error in a sample of 60 suggests a potentially material cut-off misstatement. For support, the £180,000 error suggests the policy is wrong for all 18-month invoices.
Conclusion. Tolerable misstatement is £600,000. The known error in the sample is already £515,000 before projection. I would extend testing, quantify the systematic errors, and conclude that the population is likely materially misstated. Management should adjust and correct the policy.
2. What additional procedures would you perform on cut-off and on support revenue recognition?
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Cut-off. Obtain the licence agreements and delivery/acceptance evidence for the December and January invoices. Trace the £240,000 invoice to the delivery note and customer acceptance dated 8 January. Review credit notes and subsequent cash. Test a sample of invoices around 31 December for matching to delivery. Consider whether revenue should be deferred under IFRS 15/FRS 102.
Support revenue. Inspect the contract for the £180,000 invoice. Recalculate the amount relating to 20X5 (two months of 18) and compare with the deferred income account. Test the consistency of the policy across other support invoices. Review the revenue recognition policy and discuss with the finance director.
Fraud and journals. Test manual journal entries posted to revenue, especially around year-end. Review the duplicate invoice for signs of fraud. Obtain written representations on revenue recognition and consider whether the matter should be reported to those charged with governance.
3. If management refuses to adjust the £420,000 of identified errors (excluding the duplicate) and the projected misstatement remains above tolerable, what audit opinion would you issue and why?
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Materiality. The identified errors of £420,000 (excluding the duplicate) are below overall materiality of £1.2m, but the projected misstatement from the systematic cut-off and support errors may exceed £1.2m. If the projected misstatement is above materiality and management refuses to adjust, the financial statements are materially misstated.
Opinion. Under ISA (UK) 705, if the effect is material but not pervasive, I would issue a qualified 'except for' opinion. Revenue is a significant balance but not the whole financial statements, so a qualification is more likely than an adverse opinion. If the misstatement affects many balances and is pervasive, an adverse opinion may be appropriate. I would document the projection, communicate with those charged with governance, and consider the effect on the auditor's report.