Revenue Recognition and the Need for Professional Skepticism

IWA 7: Revenue Recognition and the need for professional skepticism

This case study is mainly about GAAP revenue recognition. I, as a staff auditor, concern

about two sale transactions while auditing the revenue account of Longeta Corporation. The first

one is $7 million transaction between Longeta and Magicon. Longeta recorded $5.8 million as

current revenue and $1.2 million as deferred revenue for its transaction with Magicon, an

intermediary that could resell Longeta products to the government purchasers such as U.S Air

Force. The second one is $25 million transaction between Longeta and Newstone Software, a

company that was incorporated by two former Longeta senior sales personnel.

First of all, the fact that these two major transactions happened right before the fiscal

year-end raises a concern of whether these transactions are valid, or they were part of the

management’s earning manipulation scheme. Per AU 316.54, revenue recognition is considered

as one of the most sensitive area according to GAAP, and the auditor should treat it as high fraud

risk in all audit.

Per ASC 606-10-25, an entity shall account for a contract with a customer when all five

of the following categories are met: 1.Both parties to the contract have approved the contract and

committed to perform their respective obligations 2. The entity can identify each party’s rights in

regard to the goods and services being to be transferred 3. The entity can identify the payment

term 4. The contract has commercial substance 5. The amount of payment for goods and services

are reasonably collectible.

In the first case, Longeta’s recording of the sale transaction violated GAAP revenue

recognition, and revenue from this transaction should not be recognized. The letter from

Longeta’s vice president of sales clearly listed all the terms and conditions for the transaction

between Longeta and Magicon. It also stated that both party would