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Partner CA Student Bio Tech Enterprises (BTE)
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.
Apart from Mr. Changes in sales figure is less likely because most of the sales are cash sales with small accounts receivable. the only owner. Therefore.000 = Tk 1.The position of the chief accountant is vacant for last six months. Since 2009 numbers are unaudited. Under substantive approach we are not required to audit the internal control. Chowdhury. I would conclude that internal control is not functioning and control risk is high. it will be difficult to implement any internal control policies or procedures. we must use substantive approach of audit. 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. Therefore. If there is any change in future then we have to revise the materiality. HSBC bank will also be a user of the financial statements. Chowdhury. We have to increase the sample sizes of our audit tests and spend more time in vouching and other tests. the owner. However. There are only two people working in the accounting department. 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. Materiality calculated as ½% of sales will be ½% X Tk 205. Specific Issues • Cash at bank is a material number. is regularly monitoring the accounting department functions. We must consider who would use the financial statements and our audit report before calculating the materiality. we have to reduce the materiality level. Overall conclusion: the audit risk is high. It is not sufficient to have a written internal control manual if the control policies cannot be implemented. We must send a bank confirmation letter to Standard and Chartered to confirm the balance in the bank account on December 31. I suggest that we use 2010 sales as a materiality base for the preliminary planning materiality. Therefore. Therefore. 2010. the monitoring and overseeing in the accounting department is totally absent. 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. we cannot use 2009 net income as a proxy for 2010. Therefore. we must document the reasons why we cannot use the compliance approach. . Therefore. There is no indication that Mr. Materiality In order to reduce the overall audit risk we should try to lower the detection risk as much as possible.025 Audit Approach Since we cannot rely on the internal control (see discussion of control risk above) we cannot use compliance approach of audit. 2010 net income can change significantly if material accounting errors are discovered.
We should review the cash expenses after year end i. We should make sure that management of BTE and HSBC is ready to accept this loss. Research and development cost is an intangible asset. We should enquire the management what is the relation of Turbo Company with BTE. If there are any purchases from or sales to Turbo then we should examine if the prices are close to market price. • • • • . If the amount to adjust is Tk 30. in January and February and try to find out if any of those payments relate to liabilities incurred on or before December 31. The first condition is difficult to test because recoverability involves future sales. We must disclose this scope limitation in our audit report. We can then examine the reasonability of the numbers and evaluate if future sales are enough to recover the costs. we should send confirmation letters to major customers. we have not physically inspected the inventory on December 31. 2010. Alternatively we can check the subsequent collection of cash from the customers in January and February as an alternative procedure. We must ensure that those liabilities have been all accrued at year end. inventory amount of Tk 65. The adjusting entry should be: debit research expenses and credit research and development costs. Instead BTE management is capitalizing the salaries on the balance sheet. existence assertion related to inventory remains untested.000 is very much material. Since we have been appointed as an auditor after the year end of BTE.000 or more then there will be a loss on the income statement instead of profit. Research and development costs on the balance sheet consist mainly of salaries paid to bio tech scientists which the company has not expensed. Therefore.e. 2010. Therefore. If all costs are not recoverable then R&D amount on the balance sheet should be written down. this should also be disclosed in the notes. completeness of accounts payable and accrued liabilities should be particularly examined during our audit. 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. Since BTE is applying for the loan the bias of the management would be to overstate income and assets and understate liabilities. We should ask the management if they have prepared the forecasted cash flow statement that HSBC has asked from them. Chowdhury then the transactions between Turbo and BTE are related party transactions. However. Otherwise. If Turbo company is fully or partially owned by Mr. 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.• Accounts receivable slightly above the materiality we have calculated. Therefore. According to Bangladesh Standard for Audit and ISA 550 all related party transactions should be disclosed in notes to the financial statements.
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. Some customers have complaints about side effects of bio products. If BTE management fails to do either then there will be an undisclosed contingent liability. If there are lawsuits currently going on. We should read the lease agreement in details. If the amount is not estimable then this should be disclosed in the notes to financial statements. Depreciation should also be recorded on the leased asset. 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.• Currently BTE is expensing the lease payments as rent expense of machinery. • . then we should ask about the likelihood of losing the case and the possible amounts of payments for the damage. 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. 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. We should confirm with the external lawyers of BTE if there is any lawsuit against the company on this matter. 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.
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