To: Partner

From: CA Student
Re: Bio Tech Enterprises (BTE)

Overview

Bio Tech Enterprises (BTE) is a prospective new client for us. Before accepting the
client we must consider possible engagement risks. Since BTE has applied for a bank
loan the management can have a bias to show high income and more assets on its
financial statements so that loan can be sanctioned easily. BTE had net loss in 2007 and
2008. It only started generating income in 2009. Therefore, we should be careful about
the bias during our audit.

Lisa has prepared the financial statements. It is questionable to what extent she is
knowledgeable about accounting. This is important because HSBC might insist that
Bangladesh financial reporting standard (BFRS) be followed. Since Lisa is only a book
keeper she might not have higher accounting skill. Therefore, chance of misstatements in
the statements is high. We should enquire if she has also prepared the cash flow
statement because that is also a part of financial statements.

Client acceptance

We must look at the factors which can affect the engagement risk if we accept this client.
The most critical issue here is the industry risk. The bio technology industry is new in
Bangladesh. If the business fails then we should consider how it can affect our
reputation, especially in the eye of the lender i.e. bank. Further, bio technology industry
is heavily research based. The capitalized research cost is an intangible asset. The real
value of this asset depends on the future recoverability of the costs through future sales.
This increases the engagement risk.

Audit Risk

The inherent risk is particularly high with research and development costs on the balance
sheet because the valuation of this asset is dependent on future recoverability of the
research costs. Since the future cannot be forecasted very precisely the valuation
assertion is difficult to audit. Research and development cost consists of 47% of the total
assets on the balance sheet. The inherent risk associated with cash at bank and accounts
receivable is low because the exact amounts can be known by confirming the balances
with third parties. Inherent risk associated with inventory would be moderate because
although we can verify the costs of the bio tech products, doing a test of lower of cost and
market will be difficult since only a few companies are in bio tech business and they have
monopoly over the market price. I would conclude that the overall inherent risk is
moderate.
The position of the chief accountant is vacant for last six months. Therefore, the
monitoring and overseeing in the accounting department is totally absent. There are only
two people working in the accounting department. Therefore, it will be difficult to
implement any internal control policies or procedures. It is not sufficient to have a
written internal control manual if the control policies cannot be implemented. There is
no indication that Mr. Chowdhury, the owner, is regularly monitoring the accounting
department functions. Therefore, I would conclude that internal control is not
functioning and control risk is high. Overall conclusion: the audit risk is high.

Materiality

In order to reduce the overall audit risk we should try to lower the detection risk as much
as possible. We have to increase the sample sizes of our audit tests and spend more time
in vouching and other tests. Therefore, we have to reduce the materiality level.

We must consider who would use the financial statements and our audit report before
calculating the materiality. Apart from Mr. Chowdhury, the only owner, HSBC bank will
also be a user of the financial statements. HSBC will be interested in the performance of
BTE because the repayment of the HSBC loan will depend on whether BTE can generate
sufficient sales and income. Since 2009 numbers are unaudited, we cannot use 2009 net
income as a proxy for 2010. 2010 net income can change significantly if material
accounting errors are discovered. Therefore, I suggest that we use 2010 sales as a
materiality base for the preliminary planning materiality. Changes in sales figure is less
likely because most of the sales are cash sales with small accounts receivable. If there is
any change in future then we have to revise the materiality. Materiality calculated as ½%
of sales will be ½% X Tk 205,000 = Tk 1,025

Audit Approach

Since we cannot rely on the internal control (see discussion of control risk above) we
cannot use compliance approach of audit. Therefore, we must use substantive approach
of audit. Under substantive approach we are not required to audit the internal control.
However, we must document the reasons why we cannot use the compliance approach.

Specific Issues

• Cash at bank is a material number. We must send a bank confirmation letter to

Standard and Chartered to confirm the balance in the bank account on December
31, 2010. If there is a difference between the amount as per bank and the amount
as per Bio Tech then we should ask Lisa to provide the bank reconciliation
prepared by her. We have to trace the outstanding cheques and outstanding
deposits from bank reconciliation to January 2011 bank statement to test the
correctness of the bank reconciliation.
• Accounts receivable slightly above the materiality we have calculated. Therefore,
we should send confirmation letters to major customers. Alternatively we can
check the subsequent collection of cash from the customers in January and
February as an alternative procedure.

• Since we have been appointed as an auditor after the year end of BTE, we have
not physically inspected the inventory on December 31, 2010. However,
inventory amount of Tk 65,000 is very much material. Therefore, existence
assertion related to inventory remains untested. We must disclose this scope
limitation in our audit report.

• Research and development costs on the balance sheet consist mainly of salaries
paid to bio tech scientists which the company has not expensed. Instead BTE
management is capitalizing the salaries on the balance sheet. Research and
development cost is an intangible asset. According to International Accounting
Standard (IAS 38) intangible assets can be recorded only if both of the following
are met: 1) cost can be recovered from future sales and 2) cost can be reliably
measured. We can test the second condition by examining the documents
supporting the salaries paid to scientists and agreeing the amounts paid to the
amounts debited in R&D account. The first condition is difficult to test because
recoverability involves future sales. We should ask the management if they have
prepared the forecasted cash flow statement that HSBC has asked from them. We
can then examine the reasonability of the numbers and evaluate if future sales are
enough to recover the costs. If all costs are not recoverable then R&D amount on
the balance sheet should be written down. The adjusting entry should be: debit
research expenses and credit research and development costs. If the amount to
adjust is Tk 30,000 or more then there will be a loss on the income statement
instead of profit. We should make sure that management of BTE and HSBC is
ready to accept this loss.

• Since BTE is applying for the loan the bias of the management would be to
overstate income and assets and understate liabilities. Therefore, completeness of
accounts payable and accrued liabilities should be particularly examined during
our audit. We should review the cash expenses after year end i.e. in January and
February and try to find out if any of those payments relate to liabilities incurred
on or before December 31, 2010. We must ensure that those liabilities have been
all accrued at year end.

• We should enquire the management what is the relation of Turbo Company with
BTE. If Turbo company is fully or partially owned by Mr. Chowdhury then the
transactions between Turbo and BTE are related party transactions. According to
Bangladesh Standard for Audit and ISA 550 all related party transactions should
be disclosed in notes to the financial statements. If there are any purchases from
or sales to Turbo then we should examine if the prices are close to market price.
Otherwise, this should also be disclosed in the notes.
• Currently BTE is expensing the lease payments as rent expense of machinery.
We should read the lease agreement in details. If there is a bargain purchase
option at the end of the lease agreement or the lease term is 75% or more of the
economic life or the present value of all lease payments is 90% or more than the
market price of the machine, then this should be a capital lease. Accordingly we
should tell BTE management to set up a leased asset and a lease obligation on the
balance sheet. Depreciation should also be recorded on the leased asset. If the
management refuses to do it then this will be a violation of accounting standard
[IAS 17] and we have to qualify the audit report. If this is not a capital lease then
we should ensure that lease payments are being expensed on a straight line basis
over the lease period.

• Some customers have complaints about side effects of bio products. We should
confirm with the external lawyers of BTE if there is any lawsuit against the
company on this matter. If there are lawsuits currently going on, then we should
ask about the likelihood of losing the case and the possible amounts of payments
for the damage. If the likelihood is high and the amount to be paid can be
estimated then we should tell BTE management to accrue the liability on the
balance sheet. If the amount is not estimable then this should be disclosed in the
notes to financial statements. If BTE management fails to do either then there
will be an undisclosed contingent liability.