Question

Sunrise Solar Inc. (SSI) is a medium-size company that is developing solar energy systems for private residences and small businesses. It is privately owned, with the majority of the shares held by the company's president, Shu Mingfei. Started up two years ago, to date, it is mostly involved in research and development, but this year it completed its first customer sales and installation. Shu has engaged your firm to do the current year's audit because she plans to obtain $20 million in debt financing from outside investors to allow further commercilization of the SSI systems. You are now reviewing SSI's preliminary general ledger trial balance in order to begin preparing the audit planning.

The following is a summary of the accounts that appear in this trial balance as at year end:

Account Balance Dr/Cr

Cash $101,209

Accounts receivable 85,019

Allowance for bad debts (15,000)

Inventory, finished goods 900,550

Inventory, work-in-process 44,666

Inventory, raw material 67,890

Deferred development costs 34,445

Property, Plant, and Equipment 3,700,990

Accumulated amortization, PPE (901,108)

Patents, at cost 1,010,000

Accounts Payable (198,009)

Warranty provision (30,000)

Shareholder loan, non-interest bearing   (11,000,000)

Share capital, common shares (1,000)

Retained earnings 1,364,767

Revenue   (812,202)

Cost of goods sold 666,502

General & Administration expenses 1,002,500

Research & Development expenses 3,990,000

Other Expenses 89,990

a. Identify three factors that your firm should consider before agreeing to conduct the audit.

b. What economic and industry risks are affecting this business? How would these risks affect the company's financial statements and your overall audit strategy?

c. discuss users, qualitative characteristics, apply a range of at least three quantitative calculations and make a recommendation for planning materiality consistent with your qualitative discussion and key users.

  

Answer 1

Answer:

a)                  Factors to consider before accepting the audit engagement include:

·         Is the PA firm independent?

·         Does the PA firm have the expertise to conduct the audit?

·         Will the auditee be able to pay the audit fee?

·         Is the auditee a going concern?

·         Is management highly questionable?

·         Do they need an audit?

·         Is the risk arising from known users of the financial statements reasonably determinable and acceptable?

b)                  Risk assessment procedures include the following activities.

Identify users of financial statements –owner/major shareholder who has asked for audit for first time this year, and potential lenders she will likely give the audited financial statements to, and who likely will use the f/s to evaluate the risk of the company not paying back its loan and interest.

Other qualitative factors could be relevant, like contracts or covenants based on f/s balances, transaction volumes, pledges of assets as collateral, etc.

c)                  For quantitative assessment, apply appropriate benchmarks, e.g. 5-10% normal income, 0.5 - 1% revenues or assets,

Here there is no ‘Normal income’ as it is a new, start-up company.

Other bases suggested can be considered, such as:

Assets: $25000 to 50000

Revenues: $4000 to 8000

Then also consider qualitative factors, to generate reasonable range.

Assets is probably most appropriate since the start up stage also means revenues are not good performance indicators yet, and user decisions not likely to depend on revenue information.

As the auditor, you must select one amount from the range to provide a materiality level for planning the audit. Your choice needs to be justified based on qualitative factors. For example, in this case it would be appropriate and prudent go to the lower end of asset-based range, $25,000, since it is a first time audit, users are known to be relying at least partly on financial statements for important financial decisions, but the best information in the financial statements at this stage of the business’s life is the asset values.

Materiality is the most important judgment and is made early in the audit because the auditor’s assessment of risk of material misstatement requires a preliminary benchmark of what it ‘material’ - this then affects every other planning decision.