Specialties Papers Inc. (SPI) makes a unique type of paper that is used in specialized biohazard cleanup operations. Since customers cannot predict when they will need large supplies of the paper, they typically purchase a quantity of paper and ask SPI to hold it in its warehouse until they order it to be delivered. Kelly is auditing the revenues of SPI for the first time and notices a number of sales classified as bill and hold. She consults with more-senior auditors in her firm and learns that while bill-and-hold sales transactions are not necessarily a GAAP violation when customers have actually requested this arrangement, they have often been associated with financial fraud and should be investigated. It is the substance rather than the form of the transaction that is important. Kelly realizes she needs to do some GAAP research to get up to speed on this accounting issue. She learns that according to IAS 18, Revenue, the following conditions should be met for revenue recognition to be appropriate, including for any bill-and-hold sales arrangements:

(14) Revenue from the sale of goods shall be recognized when all the following conditions have been satisfied:

(a) The entity has transferred to the buyer the significant risks and rewards of ownership of the goods;

(b) The entity retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold;

(c) The amount of revenue can be measured reliably;

(d) It is probable that the economic benefits associated with the transaction will flow to the entity; and (e) the costs incurred or to be incurred in respect of the transaction can be measured reliably.

(15) The assessment of when an entity has transferred the significant risks and rewards of ownership to the buyer requires an examination of the circumstances of the transaction. 

In most cases, the transfer of the risks and rewards of ownership coincides with the transfer of the legal title or the passing of possession to the buyer. This is the case for most retail sales.

(16) If the entity retains significant risks of ownership, the transaction is not a sale and revenue is not recognized.

Kelly also learns from some auditing research that a special positive confirmation letter is often used for possibly inappropriate bill-and-hold transactions. An example of this confirmation is illustrated in Exhibit DC 11-13.

Required:

a. Discuss how the issues Kelly is addressing in the SPI audit illustrate that auditors must have a good understanding of the auditee, its business, and its products in order to identify the warning signs of revenue recognition misstatements and fraud.

b. Discuss the nature of the special bill-and-hold confirmation, and what evidence it will provide (i.e., is it an example of a confirmation request to verify the contractual substance of a sales transaction from the customer’s point of view?).