Michael, CPA and a senior auditor, is currently auditing XYZ company, which designs and manufactures devices used for detecting and analyzing sources of radiation, and sells its products mostly to universities, governments, and other private businesses. The founder of the company also acts as the company's chief executive officer (CEO) and also chair of the board of directors (COB). The company's year-end results showing net income of $7,500, total sales of $1,000,000, total assets of $1,500,000, and total liabilities of $1,200,000. This is the first year that XYZ has an audit.

Required

Comment on the appropriateness of the following decisions/scenarios during the audit of XYZ.

Planning materiality for the audit was assessed to be 10% of sales, or $100,000. Michael believes this assessment to be appropriate because he has great confidence in the integrity of the CEO and considers the risk of material misstatements in this audit to be low. Because net income this year was well below the normal level, he chooses the basis for materiality assessment to be a percentage of sales.

The client's CEO plans to make a public offering of shares when market conditions are favorable. Because the company is not large and has few employees, Michael decides to ignore the company's internal controls and rely solely on substantive tests of transactions and details in this first audit engagement. Michael believes that this approach will allow him to perform an audit at minimum cost, and hence charge a minimum audit fee. In later years, as the client's systems become better developed, Michael plans to modify his audit approach to incorporate some reliance on the client's internal controls, and thereby reduce his level of substantive testing. Before beginning the audit, Michael discusses this audit plan with the CEO, who fully agrees that this is the most efficient way to proceed, given the circumstances.

Michael is informed by the client that he will not be allowed to confirm any accounts receivable balances this year because several customers have complained to the company about being bothered by these confirmation requests. Michael agrees to this restriction, and instead examines sales invoice copies in support of a large percentage of the open customer accounts at year end. Finding no exceptions, Michael concludes that he has obtained reasonable assurance that the receivables are not materially misstated.

Through correspondence with the client's lawyers, Michael confirms that a lawsuit that has been in progress for some time still remains in the courts. Specifically, the client is being sued by a competitor for patent infringement. The company's financial statements include a footnote describing the lawsuit, including the amount of damages claimed by the competitor, along with a statement by management that says: "We and the company's lawyers are convinced that this lawsuit is without merit, and we intend to vigorously defend the company's interests in this matter." After examining all the relevant legal documents and carefully considering the matter, Michael concludes that the company will very likely lose the lawsuit and be liable for damages of about $1,000,000 - a very material amount. However, because management is responsible for developing the accounting estimates and related disclosures included in the financial statements, Michael takes no other action and issues an unqualified opinion on the financial statements for the current year.

Michael told a junior auditor in the engagement team that most of the elements of a control environment - such as integrity and ethical values, management philosophy and operating style, human resources policies and procedures - were so vague that it was almost impossible to audit them. Michael said: "Don't waste too much time worrying about it. Rather, just sit down with the company's chief accountant for an afternoon and chat about the things on our checklist. If he tells you that everything is fine, then write a memo for the files and go on to the more serious matters -studying the company's transaction streams, like revenues and cash disbursements, and how these are processed."