Question

BACKGROUND Apply audit risk and materiality concepts to address the following circumstances regarding Able & Baker LLP’s audits of the financial statements of Foster Engineering, Inc. 1. Able & Baker LLP auditors are beginning their audit of Foster’s 2017 financial statements. Because of changes in the market and increased competition, Foster changed the terms of its sales at the beginning of 2017. Previously, Foster’s customers had to pay for maintenance of the Foster products at the time such maintenance was performed. Beginning in 2017, Foster included 3 years of maintenance as a part of the sales price. This requires Foster to defer a portion of revenue from sales of the product and recognize it in future periods. Accordingly, Foster’s accounting staff must estimate the amount to defer based on Foster’s future involvement with the products sold. This change resulted in Foster showing the following unaudited results: a lower gross profit margin, but significantly increased sales, which increased Foster’s overall net profit as compared to 2016. Questions: How do each of the changes described above affect the amount of audit evidence the Able & Baker LLP auditors will need to obtain about the occurrence and accuracy of the recorded revenue, as compared to the previous year, and why? 2. Because of its overall good results in 2017, Foster has become recognized as one of the leading private companies in its industry. Because of this and other factors, Foster’s shareholders and board of directors voted in 2018 to have an initial public offering of its common stock and to become a publicly traded company by the middle of 2019. Questions: Does the plan to become a pubic company affect the overall amount of audit evidence the Able & Baker LLP auditors will obtain in its audit of Foster’s 2018 financial statements, as compared to 2017? Why or why not? 3. In past audits, the Able & Baker LLP auditors found few, if any, errors in its substantive audit procedures for the existence of Foster’s accounts receivable. During the 2017 audit, Able & Baker LLP decided to change its audit strategy for the existence of accounts receivable by reducing assessed control risk. In the past, Able & Baker LLP assumed control risk was high. After performing the necessary tests, the auditors concluded that the controls were designed and operated effectively. Additionally, the auditors did not discover any errors in connection with their substantive tests of details of balances. Questions: a. What effects did the change in strategy have on the planned nature and extent of auditing procedures performed regarding the existence of Foster’s accounts receivable as compared to the 2016 audit and why? b. What do the results of the substantive tests of details of balances indicate, how should the auditors respond, and why?

Answer 1

1.The International Standard on Auditing 500 (ISA 500) explains that an auditor in an audit of financial statements should design and perform audit procedures to obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to base the auditor’s opinion whether the financial statements and the books maintainnes reflects true and a fair view and are free feom material misstatements, errors and fraud. Further an auditor in his audit report also states that all the accounting policies as adopted and disclosed by the management in preparation of the financial statement have been applied consistently and diligently. Thus in the given scenario, Able & Baker LLP’s engaged as an auditor of Foster from 2017 shall have to obtain necessary additional audit evidences to provide an opinion on the 'Revenue' reported in the books in accordance with the new accounting policy. Such revenue reported includes therein a portion of deferred maintenance charges levied by the company, which will increase the current period sales and at the same time ahall reduce future profits when exercised. Therefore there is an impact on the financial figures due to change in this accounting policy and hence must be thoroughly audited. Further the effect in terms of financial figures (incrase/decrease in revenue) required to be disclosed by the management in the financial statements due to this change should be accurately checked. The auditor should check on a materiality basis sampling, that all the sales contracts have mentioned therein about the fact that the invoice amount includes 3-year maintenance service charges as stated in their policy. And whether such terms have been authorized by an authorized representative of the management and the customer. Also he should review in each contract that the amount of maintenance charges of every year is stated in monetary terms along with the upper limits and vesting conditions etc. have also been mentioned. And thre is proper internal control system to record the deferred revenue.

2.The plan to become a public company in 2018 shall not affect the amount of audit evidence that Able & Baker LLP auditors will obtain in its audit of financial statements, as compared to 2017. This is because of the fact that the auditee ie. Foster co. shall always remain a separete legal entity whether be private entity or a public entity. The role of auditor in stating an audit opinion is independent and at any ppint of time the auditor exercises his role diligently with full integrity which cannot be questioned. Be there a case, the the auditee turns into public co. resulting in higher volume of transactions then the auditor should review the audit procedures applied and obtain suffcient evidence, which is not applicable in the given case.

3. The auditor shall in designing an audit program and the audit procedures shall assess the level of control risk ,that is, whether the internal control framework designed by the management are efficient and operating effectively in detect and correct any errors,fraud and material misstatement in the books. In the given case, the control risks levels assessed by Able and Bakers' LLP on accepting the audit engagement of Foster co. is stated to be significantly high and therefore the financial figures depicted in teh books are assumed to be highly reliable and accurate. Hence the extent of audit procedures to be applied on the accounts receivable figures to state its accuracy shall be low as compared with those applied by the precious auditors in 2016.

However the auditor should review the nature of error occured disclosed in the past audit reports and design their audit procedures accordingly. Because it is the primary responsibilty of the auditor that he should comprehensively review the past auditors' opinions expressed on the books maintained by his auditee that may help in their audit assignment, but at the same time the auditor are independent in reviewing the financial statements of the auditee and are not necessarily bound by the opinions expressed by the past auditors.