Question

All Tunes Satellite Radio (ATS) provides a subscription service to satellite radio channels. Customers can pay for a subscription on a monthly basis, or pay for a year in advance and receive a 15% discount. Approximately 53% of customers pay in advance. When ATS receives payment in advance, a deferred revenue account (Unearned Revenue) is credited. At the end of each month as the satellite radio service is provided to customers, ATS makes an adjusting entry to recognize subscription revenue. The audit team is planning a reliance on controls strategy to obtain evidence of revenue recognition for ATS. The team will be testing internal controls over the recognition of subscription revenue during interim.

Explain the type of audit strategy planned by the audit team for gathering evidence about revenue recognition.

Suppose during the interim testing of internal controls the team discovers a significant number of instances in which subscription revenue received in advance is recognized immediately as revenue. Analyze how the audit strategy will be impacted.

Answer 1

Answer:

a.

The initial audit plan is to obtain evidence of revenue recognition by relying on internal controls. This type of audit strategy is based on an initial assessment of control risk as low. When control risk is low, auditors will test the operating effectiveness of internal controls (i.e. company’s policies and procedures on revenue recognition), and rely less on substantive detail testing of account balances.

b.

If during testing of controls auditors detect deviations from controls that they were not expecting, they will make specific inquiries and will determine whether the potential risks of misstatement need to be addressed using substantive procedures. In the case of ATS, significant deviations from controls occurred in which revenue was incorrectly recognized immediately upon customer payment in advance. Therefore, the controls on revenue recognition are not operating effectively. The controls will have to be reassessed as ineffective and less reliable. In response to the reassessed level of control risk, the auditors should change the audit approach to a predominantly substantive approach.

The initially planned audit strategy of reliance on controls is no longer appropriate because the predominantly substantive approach will be more efficient and effective in obtaining sufficient appropriate audit evidence.