Question

You are considering an audit engagement with a new, privately held entrepreneurial company (Moxy, Inc.) headed by Ryan Morris, a charming CEO. The company specializes in chemical lawn treatments. Ryan indicates that his business has really taken off, and he shows you last year’s financial statements, which show a sales growth increase from $1,200,000 to $4,500,000 and gross profit growth from $575,000 to $2,800,000 in just one year. He has had to finance this growth with an $850,000 short-term promissory note, but would like to go public and attract investors. He also gives you the following limited information from his balance sheet:

	Year 1	Year 2
Assets
Current assets:
Cash	$ 30,100	$ 88,120
Accounts receivable	—	697,500
Other	77,320	942,000
Total current assets	$107,420	$1,727,620
Liabilities
Current liabilities:
Notes payable	$    —	$ 780,500
Taxes payable	—	29,000
Other	3,240	967,000
Total current liabilities	$3,240	$1,776,500

Required:

(a) Discuss why engagement risk, professional skepticism, and assessment of fraud risk are important in this scenario.

(b) Calculate the current ratios for year one and year two. What concerns do these calculations raise?

(c) Present at least three questions you would like to ask Ryan about the information provided, before making your decision about accepting the client.

Answer 1

Part a:

In this scenario the growth of Moxy Inc. within a period of one year is extra-ordinary to say the least. The increase in sales from mere $1,200,000 in year 1 to $4,500,000 in year 2 is though not impossible for a company to achieve but certainly very difficult for any company to achieve within a year. Similarly the growth of gross profit from $575,000 to $2,800,000 within a matter of one year is also quite extra ordinary to say the least. Thus, engagement risk, professional risk and assessment of fraud risk are important in this scenario to ensure that the financial statements have been prepared correctly and reflect the financial position and performance of the company correctly.

Part b:

Current ratio (Total current assets / Total current liabilities)	Year 1	Year 2
(A)Total current assets	107,420.00	1,727,620.00
(B)Total current liabilities	3,240.00	1,776,500.00
Current ratio (A/B)	33.15	0.97

As can be seen that though the company has performed exceptionally in year 2 however, the current ratio has deteriorated significantly. From current ratio of 33.15: 1 in year 1 to 0.97: 1 in year 2 raise concern about the ability of the company to pay its current liabilities by using its current assets only.

Part c:

The following three questions shall be asked:

1. Whether the financial statements have been prepared in accordance with the acceptable accounting principles as per the Generally Accepted Accounting Policies in the country?
2. The internal controls that the company has instituted within the entity to ensure there is no fraud in financial reporting and whether these controls have operated efficiently throughout the entire year?    
3. The management has all the supporting documents and information and these shall be made available to the auditors as and when asked by them.