You are performing the audit of the Pirouette Systems Inc. (PSI) financial statements for its year ended November 30, 20X0. PSI is a private company that sells and installs computer networks for businesses in the Toronto area. PSI’s has four shareholders who are all actively involved in the business. PSI’s audited financial statements are used mainly by its bank, which has made a large operating loan. The bank requires PSI to maintain a current ratio of at least 1.2 to 1, based on its year-end financial statements; otherwise the bank can require PSI to repay the loan in full immediately.
PSI’s accounting policy for recognizing revenue is to recognize 50% of the sales contract amount when the customer signs a sales contract and the balance when the network installation is complete. All sales are on account. During 20X0, PSI hired a new sales manager who has focused on making sales to larger companies. On November 30, 20X0, the sales manager reported to the PSI’s accountant that $250,000 should be recorded as sales revenue. This amount is 50% of the revenue on a large sale to a new customer. This is the largest single sale in PSI’s history. In January 20X1, while doing the audit you have discovered that the sales manager had been premature in reporting this contract as a sale, since the customer did not actually give the final approval of the contract purchase of the network until December 15, 20X0.
Before correcting this error, PSI’s draft financial statements show the following:
Net income before taxes of $6,200,000 Accounts receivable, net of allowance for bad debts, of $850,000, Total current assets of $1,100,000 and Total current liabilities of $860,000
a. Explain how the accounts in the PSI financial statements will be affected by this error. In your explanation identify the assertion(s) violated by this error.
b. Calculate the impact of this error on PSI’s current ratio
c. Would you consider this error material? Justify your response.