Question 4: Refer to SAS No. 31, Evidential Matter. What management assertions did Star violate in its original 1989 financial statements? Explain.
Supplementary Question 1: Explain why industrial knowledge is so important to an audit engagement team. Identify risk factors commonly posed by companies in high-tech industries.
SAS No. 31 refers to the gathering of evidence that an auditor must collect in order to properly audit the financial statement of a client. SAS No. 31 has five general criteria that should be followed to insure that the financial statements fairly state the economic events of the client's business. The five criteria are existence, completeness, valuation, rights and obligations, and presentation and disclosure. Star Technology violated a number of these criteria in their original financial statements in 1989. The engagement partner, Clark Childers of Price Waterhouse, allowed Star Technology to engage in incorrect reporting and did not question or object to the adjustments in the financial statements. However, Paul Argy, a senior audit manager at Price Waterhouse and member of the engagement team, would constantly question the actions of Childers but would eventually become wrapped up in the mess that had been created. These improper techniques lead to Price Waterhouse recalling it initial unqualified audit report for Star Technology in 1989.
Star Technology wanted to go into business with a small company the produced supercomputers named Glen Culler and Associates. Star Technology and Culler wanted to work together on research and development for the production of a better supercomputer. Star Technology agreed to advance Culler $900,000 that was to be paid back in ten years. The funds would be used solely for the purpose to develop a new computer. The agreement also allowed Star Technology to acquire Culler. Star Technology's management booked the $900,000 advance to Culler as a note receivable in their 1989 financial statements. The amount was shown in the other assets section of the balance sheet. Childers did not have any objection to this booking. According the SAS No. 31, this violates the management assertion of presentation and disclosure. The amount of $900,000 was not properly classified in the financial statements. The $900,000 was really a research and development cost that should have been expensed on the income statement of Star Technology for 1989. Star technology also improperly classified a loan agreement with their primary bank. The loan was to be paid in 1989 but Star Technology and Childers believed the obligation to be a long-term liability since the bank granted a five month waiver period to repay the debt. Argy told Childers that he believed that it was not a long term liability. However, Childers disagreed and allowed it to be presented improperly making it a presentation and disclosure violation of a management assertion.
Star Technology produced the ST-100 which was a computer that was state-of-the-art in 1982 but was obsolete by 1989. The short life spans of the computers lead to Star Technology lowering the net book value of the inventory to $2 million dollars. Members of the audit engagement team believed that inventory was still overvalued and needed to be further written down. However, members of Star Technology's management convinced Childers to only slightly lower the net book value of the inventory. Star Technology also convinced Childers that there was $1 million dollars in spare parts that should be included in the inventory account for any repairs for previously sold ST-100 computers. The actions that the management of Star Technology took were violations of valuation according to SAS No. 31. This assertion states that the correct value for items must be reported fairly in the financial statements. The auditor should follow the specific standards of GAAP to measure the true value of the accounts.
Star Technology also had another violation of SAS No. 31 dealing with the valuation of their allowance for bad debt account. At the end of the 1989 year, Star Technology had two large receivables that had been outstanding for more than two years that totaled $1,062,000. Members of the engagement team and Argy believed that the allowance for bad debt account should be increased by $400,000 to correctly show receivables that were assumed to never be collected. However, the management of Star Technology had their lawyers' convince Childers that the account should only be increased by only $65,000. This action violated the management assertion concept of valuation. The audit procedures that were used did not fairly show the value of the account in the financial statements.
The management assertion of existence refers to whether a transaction dealing with assets or liabilities actually occurred and what time period the transactions took place. Star Technology's management had an account in the financial statements know as Assets in Process with a balance of $435,000. This account was supposedly for computer equipment that was placed into service in 1985. The problem with this account was that no documentation of these assets could be found. Star Technology could not even produce physical evidence that the assets had ever existed. Star Technology claimed that the equipment had been integrated into the existing computer system and could not be traced. This clearly violated the management assertion of existence because no tangible evidence could be produced to verify the asset.
Auditors must ensure that the management assertions of SAS No. 31 are being followed to properly capture the economic events of a company. It is also very important for the auditors to have knowledge of the company that they are auditing. The audit engagement team should have a firm understanding of the industry and operation of the company being audited to ensure the best possible audit. When the engagement team has knowledge of the business, they can comprehend the meaning and reasoning behind the entries being made by the company. If an erroneous entry has been made by the company being audited, the auditors with knowledge of the industry will be able to red flag the entry and investigate it further.
The auditing of high-tech industries and companies, such Star Technology, posses certain risk factors for audit engagement teams who want to obtain industry knowledge. One risk factor is the specific and complex knowledge that must be held by an employee of a high-tech company. For example, a developer of computer software has extensive knowledge of computers that has taken many years to master. An auditor may have a difficult time comprehending the complexity of the computer industry which could result in a less accurate audit report. Another risk factor is the extremely short life cycle of the products produced by a high-tech company. In many instances products produced at the beginning of the year by a high-tech company are obsolete by the end of the year. This could lead to a company valuing their inventory incorrectly to compensate for the obsolete products. If the auditors do not have the industry knowledge of the products and their short product life cycle, they may miss the incorrect valuation of the inventory.
