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

(a) Engagement risk represents the overall risk associated with an audit engagement. It also include the possibility of financial loss to audit firm's reputation by a particular client.

Professional Skepticism is an attitude of an auditor that includes a questioning mind, being alert to a conditions which may indicate possible misstatement due to fraud and error and critical assessment of audit evidence.

In the above given scenario, the changes at this company are very huge, it appears that there can be some irregularities or fraud. Thus engagement risk, professional skepticism and assessment of fraud risk are important in this scenario.

(b) Current ratio = Current assets/current liabilities

Year 1

$107420/$3240 = 33.15

Year 2

$1727620/$1776500 = 0.97

The current ratio changed too much from Year 1 to Year 2. In year 1, current assets are 331% over current liabilities whereas in Year 2 current assets can only cover 97% of the current liabilities. These changes are very dramatic and are inconsistent with the CEO's claim that sales and gross profit has increased that much.

(c) Questions that auditor should ask Ryan before making the decision about accepting the audit:

1. What does the other current assets and other current liabilities include?

2. What are the credit policies of the company as the accounts receiveable increased so much?

3. Is the company having problem with collection of accounts receivable?

4. Why the company need significant other current assets and other current liabilities?