You are an assistant auditor with Zaird & Associates, CPAs. Universal Air (UA), your fifth audit client in your eight months with Zaird, is a national airline based in your hometown. UA has continued to grow while remaining healthy financially over the eight years of its existence. Indeed, as you start the audit, you notice that (unaudited) sales are up 30 percent this year (20X1), with earnings up 40 percent. Your firm, Zaird & Associates, has been UA’s only auditor.
During the audit you noticed that UA records sales when tickets are sold—debit receivable (or cash), credit sales. In performing substantive procedures relating to receivables, you also found that some of the “sales” are for 20X2 flights—generally in January and early February. You brought up this matter to your in-charge senior and she indicated that she also wondered about this last year when she worked on the audit. She suggested that she concluded that this isn’t likely to be a problem for at least three reasons (any one of which would be sufficient to allow the current method):
1. The company has been using this approach since its inception eight years ago. Thus, any overstatement of this year’s sales at year-end is likely to be “averaged out” by an under-statement at the beginning of the year, since the company followed the same policy last year (and the years before).
2. Valid reasons exist for including the sales when “booked.” The small airline’s earnings process is probably best considered about complete when the sale is made because this is the toughest part of the revenue generation process. The planes are scheduled to fly for the first six months of next year, and will fly, regardless of whether these relatively few passengers who paid before year-end for next year’s flights are on them; there are virtually no variable costs incurred for these passengers, except for a few very small bags of peanuts and a few cans of soda.
3. Imagine what a nightmare it would be to have to record an entry when a passenger buys a ticket, and then another one when the flight occurs.
She says she is willing to discuss this with you if you disagree, but at this point she thinks it isn’t a problem.
a. Discuss whether you agree or disagree with each of her reasons.
Now assume that you potentially agree with her first justification. You think that maybe a journal entry could be made at year-end to estimate the liability for next-year flights. Yet this wouldn’t be necessary if everything does “average out” and any year-end liability is immaterial.
b. Given this situation, would you expect the procedure to “average out” over the year?
c. How might one determine whether it does “average out” over the year?