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Billy’s Beats Case

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Billy’s Beats Inc (Bill’ys) is an SEC registrant manufacturer of musical intraments. Billy’s has recently acquired one company, Little Drummer Boy Inc (Little Drummer), and wholly owns RockOut Inc. Both Little Drummer and RockOut are manufacturers of musical intstraments, making guitars, and drums respectively.

Billy’s acquisition of Little Drummer took place in 201X for an outlay of $575 million in cash; an external valuation specialist assessed the fair values of significant acquired assets at $865 million (PP&E), and $145 million (other assets). Billy’s used the previously determined useful lives for PP&E (determined by Little Drummer’s management) of 30 years for plant, and 20 years for equipment respectively. These calculations differ from those used by Billy’s, which come in at 20 years for plant, and 10 years for equipment. In addition, customer lists acquired in the purchase were determined to have a useful life of 15 years.

RockOut (Billy’s subsidiary), has grown substantially through acquisitions of five guitar companies in 201X, eight in 201Y, and four in 200Z. Consequently, RockOut has accumulated a customer’s list that has an approximate reported value of $90 million, which accounts for 15 percent of total assets, and 60 percent of total intangible assets. RockOut uses straight-line amortization for these lists over a 25-year useful life (calculated by management), but during 201X, RockOut management has decided to modify the useful life of newly acquired customer lists at a useful life of 15 years. This decision has resulted in a total amortization expense for 12/31/2011 of $3 million.

The substantive tests used by the audit team are designed to detect whether any material misstatements in accounting transactions have occurred in regard to completeness, validity, and accuracy of the financial statements that pertain to a specific entity. The following paragraphs will assess whether the audit team “performed adequate and appropriate audit procedures considering management’s assumptions.”(deloitte.com).

Little Drummer Boy Inc
In regards to the tests performed by the engagement team as it pertains to Little Drummer, there are many holes in the tests completed on accounts relating to plant and equipment (long term asset accounts, depreciation, accumulated depreciation).

The audit team simply asked management of Billy’s why the number of years assigned to plant and equipment differed from assets already owned by Billy’s, and those acquired from Little Drummer. The response the engagement team received from management was; “useful lives of the acquired assets were amounts used by Little Drummer before the acquisition date.” Further more, the external valuation specialist allocated plant fair value of $865 million to each asset class based upon the percentage of the seller’s (Little Drummer) original cost; Little Drummer’s management provided these percentages, which were relied upon. The engagement team then examined spreadsheets relating to their total costs calculated and a management prepared sheet listing each asset class, ID, and percentage of total cost.; no errors were noted. This leads me to believe that no other substantive procedures to detect material misstatements were performed as it pertains to the aforementioned accounts of P&E, depreciation, and accumulated depreciation.

With regards to the spreadsheets completed by Little Drummer’s management, the engagement team failed to “obtain appropriate audit evidence that is sufficient to support the opinion expressed” (AS 12) (pcaobus.org). The information provided to the team should have been accepted with a level of professional skepticism as to its relevance and reliability due to the fact that it was generated using internally calculated percentages (evidence not obtained from a knowledgeable independent source) (AS 15). The team failed to test the plant and equipment accounts and the related payable accounts to determine whether the PP&E were indeed recorded at the proper fair values in the ending financial statements. They also failed to assess the quality of the spreadsheet calculations, although no errors were detected, re-performance tests should have been conducted; if any discrepancies were to be discovered, additional tests need to be performed.

With regards to the differentiating useful lives, the engagement team failed to assess whether the management determined useful lives of plant and equipment were in line with other manufactures in the industry; relying on a discussion with management is not sufficient evidence for the engagement. According to AS 12, the engagement team is to “obtain an understanding of the company and its environment.” If the team failed to prepare adequately (in order to perform an accurate inspection of tangible assets) for the engagement, an outside specialist should have been contracted to determine the condition of the plant and equipment in order to evaluate management’s assertions on useful life. Finally, the audit team needs to look at past data pertaining to useful life calculations to determine if there were any significant departures in estimates; this is due to the sudden change in useful life estimates made this year. If any discrepancies are discovered, additional tests should be performed.

RockOut Inc
In regards to the tests performed by the engagement team as it pertains to RockOut’s changes of economic lives of their customer lists, a memorandum explaining the rationale behind the changes is not sufficient audit evidence for the engagement. On the acquisition of 17 various companies over the years of 201X-200Z, the engagement team fail to determine if the goodwill accounts relating to each acquisition, and relating payable accounts (if transaction wasn’t purely cash based) were properly recorded at fair values. Due to a change in economic lives for customer lists, the financial statements must reflect the departure from previously generated calculations. In addition, since a change was made to economic life estimates, the financial statements also must include disclosure of said change. The engagement team failed to determine if there were material misstatements within the financial statements, and if proper disclosure of information was present. According to AU 540, the engagement team must develop an understanding as to how management developed their estimations; a memorandum is not sufficient to fulfill this requirement. The engagement team needs to test the process through which management developed their assumptions and verify these findings with information found on the Balance Sheet.

The engagement team failed to perform substantive audit procedures that were both appropriate and adequate in consideration to assumptions made by management of Little Drummer Inc, and RockOut Inc. Conversations, and memorandums are not sufficient in order to determine whether material misstatements have occurred with accounting transactions as is relates to the completeness, validity, and accuracy of financial statements.

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