Management of Billy’s made several assumptions towards its newly acquired company, Little Drummer Boy. Management finally adopted the assumptions that the fair value of significant assets acquired was $865 million and that of other assets was $145 million. At the same time of the acquisition, management also decided that useful lives of the acquired plant and equipment were 30 years and 15 years, respectively, which were different from the 20 years and 10 years useful lives for the previously owned plant and equipment. Furthermore, management determined a useful live of 15 years for the acquired customer list. Regarding the $865 million assumption, auditors only adopted the procedure to compare the percentage used to calculate the fair market value to a client prepared spreadsheet. Regarding the useful lives of the plant and equipment, first, auditors inquired the management of Billy’s. Then, auditors made a discussion with the manager of Litter Drummer about the useful lives it previously assigned to the plant and equipment.
Auditors only focused on the valuation and allocation assertion towards its assumptions. However, the above procedures taken by auditors were not adequate to determine the appropriateness of the management’s estimates. First, Billy’s was a new client to the audit teams, which meant the engagement team should take some actions to obtain some understandings towards the new client. The engagement team should contact the predecessor auditors to obtain knowledge of Billy’s. If the engagement team failed to gather enough information about the client, the control risk of Billy’s should be automatically set at maximum. In this situation, the engagement team would choose to use substantive tests of details at year-end to test controls. Large sample size would be adopted as well. However, in the case, auditors did not get contact with the predecessor auditors.
The only audit evidence the engagement team gathered was the inquiries of the management either from Billy’s or from Little Drummer. All of those inquires would be included in the written representation as the audit evidence. As indicated by PCAOB, the written representation cannot be a substitute for substantive procedures. Thus, auditors did not perform adequate procedures to test the management’s estimates. What’s more, inquires were heavily relied on the management’s integrity. Auditors ignored the professional skepticism. Finally, the 30 years and 15 years useful lives, which were adopted previously by Little Drummer, were not appropriately audited. Since the engagement team did not contact the predecessor auditors, the team did not get any audit documents from predecessor auditors regarding the assumptions of 30 years and 15 years. There was no evidence to show the reasonableness of these two assumptions. For Little Drummer, auditors should focus on testing the fair market value of the assets acquired and the depreciation-related items. Audit of the presentation and disclosures were required. Substantive procedures were also required.
The engagement team could use physical inspection to determine the existence and the actual condition of the property, plant, and equipment acquired. The title documents of the significant assets should be obtained to determine the rights and obligations of Billy’s. Regarding the valuation and allocation assertion, the reasonableness of $865 million and $145 million should be carefully evaluated. The fair market value of the significant assets was calculated based on the second level of input. Auditors should perform the substantive procedures starting from examining the availability of the level one input. The percentage of each asset should be re-evaluated. Auditors could obtain the knowledge about the specific industry’s economic and regulatory environment similar to Litter Drummer. Auditors may inquire the industry specialist regarding the market information, past experience with similar companies, data used in calculating the assumptions, and the similar experience in allocating the cost.
Auditors could choose to check the background of the valuation specialist that Billy’s used. If the valuation specialist was deemed independent, auditors could use the assumptions made by him. If possible, auditors should re-perform the computations. Then, auditors could trace the data they generated to the $865 million, $145 million, and the cost allocation amounts. Any bias or misapplication must be communicated to the management and documented. Furthermore, auditors should pay attention to any goodwill impairment. By testing the significant assets values, auditors could find out whether goodwill impairment existed or not. If this happened, auditors should communicate with the management about any improper recording and losses. The related data and methods regarding the assumptions should be disclosed in detail.
Auditors must carry out other procedures to ensure the occurrence and rights and obligations, completeness, classification and understandability, and accuracy and valuation regarding the presentation and disclosure were all tested. For useful lives used by Billy’s and Little Drummer, auditors should contact the predecessor auditors to get the previous-year audit documentations. Auditors could trace exiting items to the previous-year to ensure the consistency. Auditors should inquire industry specialists or search for the industry standards to find out the standard useful lives of the specific asset to develop auditors’ own estimates.
The different useful lives of Billy’s and Little Drummer should be carefully examined. Auditors then compared the own estimates with the management’s assumption. Any discrepancy should be noted in the audit working paper. Auditors should also perform the recalculation of the depreciation expense balance to test the valuation and allocation assertion. The depreciation methods and the related estimates should be disclosed in detail. RockOut:
The management of RockOut made estimates of 25 years and 15 years of useful lives of the customer lists acquired. Auditors only made inquiries towards the assumptions and the reason why the management decided to change the useful lives. Auditors only focused on the valuation and allocation assertion. The above procedure taken by auditors was not adequate to determine the appropriateness of the management’s estimates. Auditors did not contact the predecessor auditors of RockOut to obtain any audit documentations about the company. The only evidence was the memo prepared by the management, which was heavily relied on management’s integrity. Auditors lacked professional skepticism to evaluate whether it was reasonable or not. The memo could be included in the written representation as audit evidence.
However, it could not substitute substantive procedures to test the assertions of the related balance. First, auditors should evaluate assets acquired by RockOut. For tangible assets, auditors used the same substantive procedures as described above in Little Drummer section. For the intangible assets, auditors should inspect the related documents to ensure that the title was transferred to RockOut. Auditors should review the acquisition documents for proper calculation of the goodwill. Auditors should design procedures to test goodwill impairment. Regarding the customer lists, auditors could consult the appraiser in the related industry to get independent third party data. Then, auditors made own assumption towards the useful lives. Auditors then compared the own assumption with management’s assumption to find out any bias. Auditors could also consult with the specialist regarding the change in useful lives. If auditors found the change was reasonable, the detailed explanations should be disclosed in the footnotes.
Auditors should perform substantive procedures regarding the related disclosures. If the change was deemed unreasonable, auditors should communicate with the management to change its calculations and identify any misstatements. After evaluating the reasonableness of the management’s assumption, auditors should inquire management about the amortization method and useful lives of customer lists. Auditors re-performed the recalculation towards the amortization expense. Auditors compared the calculated amortization expense with the company’s balance. The amortization methods and any related estimates should be disclosed in detail.
Louwer, Ramsay, Sinason, Strawser, & Thibodeau. (n.d.). Auditing & Assurance Services(6th ed., p. 336). New York: McGraw-Hill Education.