Billy’s Beats, Inc. Case

Billy’s Beats, Inc. Case

The engagement team overseeing the Billy’s Beats, Inc. audit correctly followed the most general standard auditing practices, but did not use sufficient enough auditing evidence and procedures to verify some of management’s more specific financial statement assumptions. They did not, in other words, adequately assess the accuracy of, or reasoning for, estimations regarding the initial and periodic assessment of assets. The problems in these areas primarily relate to the useful lives of the acquired Little Drummer assets, the percentages used to allocate the fair value of that acquisition to asset classes, and the amortization rates initially used and then subsequently changed for RockOut.

The first set of issues we identified deals primarily with the useful lives used by BBI management with regards to the PP&E of Little Drummer. Although the engagement team at least properly documented the conversations they had with both sets of management regarding their different depreciation rates, they did not adequately asses the rational for Little Drummer’s PP&E depreciation periods being much higher than those used by BBI for its own standard assets. To explain this discrepancy, the plant manager of Little Drummer and BBI’s management stated that the useful lives for the acquired entity were used before the acquisition, a statement that the engagement team accepted and analyzed no further.  Even though the engagement team was correct in bringing up this discrepancy in the first place, they should have inspected these numbers more closely due to the fact that auditors generally must have a more thorough understanding of an entity’s historical experience. In doing so, more accurate valuations of management’s estimates would then occur, especially in consideration of deviations from historical patterns (AU sec. 342.09). This approach is certainly necessary in this case since the useful life estimates went from 30 plant years and 15 equipment years to 20 and 10 years, respectively. Additionally, the estimates of useful lives are susceptible to management’s biases due to the fact that they directly affect net income. In consideration of both of these facts, the auditors should also have physically tested the useful lives, instead of simply taking management’s word for it. Furthermore, they should have compared their PP&E’s useful lives to that of the industry average to assess the degree to which their practices deviated from the norm (AU sec. 342.11).

The second major issue relates to the valuation specialist relying on the percentages management provided for the allocation of the $875 million fair value to each asset class of Little Drummer. In this instance, it is evident that since the valuation was prepared for the client and not the auditor, it is less reliable and could possibly be biased in favor of management (AU sec. 336.10). We do not know the exact relationship between the specialist and management, and therefore may not be able to fully rely on his calculations in assessing the fair value of each asset class. Additionally, neither the specialist nor the engagement team examined the allocation percentage estimations that management provided, regardless of whether or not it matched the client spreadsheet. When developing accounting estimates management is responsible for “accumulating relevant, sufficient, and reliable data on which to base the estimate” (AU sec. 342.05). It seems that through comparing BBI’s given percentages of fair value allocation with the client spreadsheet containing the same data, the engagement team is only testing the correctness of the specialist’s calculations, not necessarily the accuracy of the fair value allocation percentages themselves. The engagement team, in essence, did not seek out the rationality behind the source of the allocation percentages. Even though it is up to management to assess the validity of estimated numbers, the auditor is entrusted with the obligation to assess whether or not the estimations are reasonable. Management’s oral or written representations, in this case the spreadsheet listing each asset class, ID, and percentage of total cost, is not a substitute for the procedures necessary to form an opinion (Au sec. 333.02). Although the engagement team was at least sufficient in comparing the two sets of data to begin with, it does not appear any physical inspection of the assets themselves occurred. Therefore, one must question the reliability of comparing the client’s costs with the valuation specialist’s costs.