FAR EASTERN UNIVERSITY
INSTITUTE OF ACCOUNTS BUSINESS AND FINANCE
ACT1202 – Auditing and Assurance Principles
Case Study No. 1 Answer Sheet
Name: Kristine Lirose O. Bordeos Section: 5
Student No.: 2018035401 Grade:
Requirements:
1. What are the procedures that an auditor performs before accepting a client or continuing an engagement?
Before a new client or a recurring engagement is accepted, appropriate information is gathered and
evaluated as a basis for deciding whether to accept a new client or retain an existing client.
a. Considering client’s integrity – the integrity and reputation of the prospective client’s management and
governance body should be scrutinized through inquiries of knowledgeable parties from various sources,
both internal and external.
- Review of clients documents
- Inquiries with third parties
- Communicate with predecessor auditor
- Consider other circumstances
b. Competence to perform audit engagement and availability of time and resources – a CPA should not
accept an engagement, which he/she is not competent to carry out (unless experts are available to address
the need for additional competence).
c. Compliance with ethical requirements – the auditor should accept an engagement for an audit of financial
statements only when the auditor concludes that the financial reporting framework adopted by
management is acceptable or when law or regulation requires it.
2. Using the company’s financial information, calculate relevant ratios to obtain a better understanding of the
prospective client and to determine how the company is doing financially. Compare the company’s ratio to the
industry ratios and identify any significant differences.
Financial ratios Industry Ratios Company’s Ratios
2020 2019 2020 2019
ROE (Profit/Equity) 20.0% 18.0% 14.59% 13.74
ROA (Profit/Total Assets) 15.0% 16.0% 9.95% 11.09%
Receivable turnover 4.3 5.2 1.44 1.97
(Sales/Average
receivable)
Average collection period 83.72 69.23 250 182.74
(360/Receivable
turnover)
Debt ratio 0.3 0.25 0.32 0.19
(Liabilities/Assets
Current ratio (Current 1.15 2.11 2.09 4.37
assets/current liabilities)
Profit margin 10.60% 12.40% 6.65% 11.73%
(Profit/Sales)
Figure 1
The results in the computation using relevant ratios to compare the ratios between the industry and the
company, Central Energy Corporation.
FAR EASTERN UNIVERSITY
INSTITUTE OF ACCOUNTS BUSINESS AND FINANCE
ACT1202 – Auditing and Assurance Principles
Case Study No. 1 Answer Sheet
Financial ratios Industry Ratios
Company’s Ratios
2020 2020 Differences for 2019 2019 Differences for
Industry Company 2020 Industry Company 2019
ROE (Profit/Equity) 20.0% 14.59% 5.41% 18.0% 13.74 4.26%
ROA (Profit/Total 15.0% 9.95% 5.05% 16.0% 11.09% 4.91%
Assets)
Receivable turnover 4.3 1.44 2.86% 5.2 1.97 3.23%
(Sales/Average
receivable)
Average collection 83.72 250 (166.28%) 69.23 182.74 (113.51%)
period
(360/Receivable
turnover)
Debt ratio 0.3 0.32 (0.02%) 0.25 0.19 0.06%
(Liabilities/Assets
Current ratio 1.15 2.09 (0.94%) 2.11 4.37 (2.26%)
(Current
assets/current
liabilities)
Profit margin 10.60% 6.65% 3.95% 12.40% 11.73% 0.67%
(Profit/Sales)
Figure 2
Differences of the ratios for the years 2019 and 2020 between the Industry and the Company.
a. Return on equity ratio = net income/shareholder’s equity
The return on equity of company’s ratio that has 9.95 percent and 11.09 percent are generally considered
not good compared to the industry ratio that is relatively higher. It means that the company experienced a
downturn in its net profit.
b. Return on assets ratio = profit/total assets
The ROA of the company is a decline compared to the industry, which means that the organization can
leave a high and dry and over-invested in assets it, cannot sell to pay its bills. While in the industry, can see
a quick indication that it is continuing to earn an increasing profit.
c. Receivable turnover = sales/average receivables
The ratios in the industry shows how well the industry uses and manages the credit it extends to customers,
and how quickly that short-term debt is collected or is paid. However, compared to the company’s ratios
indicates a low receivables turnover that might be due to a company having poor collection process, bad
credit policies, or customers that are not financially viable or creditworthy.
d. Average collection period = 360/receivable turnover
The ratios for the industry indicates the efficiency of the collection process and showing it has shorter and
lower cash cycle that can impact the profitability compared to the company’s ratio which are longer cash
cycle.
FAR EASTERN UNIVERSITY
INSTITUTE OF ACCOUNTS BUSINESS AND FINANCE
ACT1202 – Auditing and Assurance Principles
Case Study No. 1 Answer Sheet
e. Debt-to-equity ratio = total liabilities/shareholder’s equity
In the industry’s ratio, it indicates a lower amount a lower amount of financing by debt via lenders, versus
funding through equity via shareholders while the company’s ratio indicates that the company is getting
more of its financing by borrowing money, which subjects the company to potential risk if debt levels are
too high.
f. Current ratio = current assets/current liabilities
The two current ratios show that they are comparatively low based on the industry but it is generally
acceptable. It means that the company might have difficulty in meeting their obligations and may not be
able to take advantage of opportunities that require cash.
g. Net profit margin = net profit/net sales
The net profit margin ratios of the industry are high if it will compare to the company. It means that they
have money left over to spend on other operations, such as research and development on marketing. While
the company is drastically low that a rough in doing its operational activities.
3. What other information should be considered before accepting CEC as a client? How important are these issues
to the client acceptance decisions and why?
Before accepting CEC as a client, several issues must be considered and I believe they are significant
information that may ponder in deciding whether to accept or reject the engagement with the client. In
addition, the main reason for this phase is that CPAs/ auditors want to avoid associating with clients whose
management lacks integrity.
a. General Considerations. The company was only a small base company for the customer but they are
accepting huge contract or major contracts that really affects their revenue. It causes them to incur losses
when the contracts with their clients ended or completed and when a project drags along or an unforeseen
event. It also raise a question that the company is going concern with limited available resources in
operation.
b. Management Integrity. A check on the background of CEC’s management revealed that several years ago,
they had a previous case filed by the Bureau of Internal Revenue (BIR), which made them to pay millions of
taxes, surcharges, and penalties because of over declaring expenses to lower the profitable taxes. As well
as, the CEC’s chief officer was into illegal drugs when at work. That made auditors start to question the
upper management’s integrity.
c. Management Internal Control Consciousness. After having communication with the predecessor auditor, I
found that they have expressed unqualified or unmodified opinion, after their CFO approved the
adjustments they made. Knowing the fact and such circumstances, it was not necessary and not applicable
to the financial reporting framework. The auditors may accused that they have fraud in the company.
d. Management Commitment to GAAP. During the review, I, as the junior manager, found my firm and myself
as part of my client’s activities. Since, my own firm invests equity of at least 1% of capitalization and as well,
my nephew does his internship with the company or client. It means that my firm and I might not be as an
independent in mind and in appearance if we accept the audit engagement with the company.
e. Reluctance to provide reference. When I approached Mr. Ty, the CFO of the company, to request
permission to speak with previous auditor, he seemed hesitant to discuss much about the prior audit firm. If
they are reluctant to disclose information now, how will they be once a client?
FAR EASTERN UNIVERSITY
INSTITUTE OF ACCOUNTS BUSINESS AND FINANCE
ACT1202 – Auditing and Assurance Principles
Case Study No. 1 Answer Sheet
These presented issues are relatively and objectively important to know by the auditor itself before accepting an
audit engagement with the client. Frankly, the negative actions of clients may bounce on auditors, damaging the
reputation; preventing this means carefully scrutinizing clients and their activities at every stage of an
engagement. In other words, it is a defense of professional liability claims.
4. The prospective client also indicated its interest in obtaining tax services from the firm. What are the pros and
cons of providing this service to the company?
Pros:
The auditor who also provided tax services from the firm may result to knowledge spillover.
It (tax services) can outweigh potential threats to auditor independence.
It is easy to avoid unnecessary costs in charges of the services.
Cons:
They create conflict of interest – for example, if the auditor will made tax strategy outcomes in
sanctions against the company or some other legal liability.
Auditor independence, integrity, or objectivity may be impaired
Auditor may expose to certain risks – including financial reporting restatement risk and reputation
risk.
It may be critical to audit committee to ensure compliance with SEC and applicable framework.
(Regulatory dilemma)
5. It was noted that a partner of the firm has an investment in a fund that has an equity to the potential client.
Would this situation constitute a violation of independence in accordance to Code of Ethics for Professional
Accountants in the Philippines?
No, this situation is not constitute a violate of independence according to the AICPA code of professional
conduct because the rule 101 says that a member in public practice shall be independent in the performance of
professional services as required by standards promulgated by bodies designated by the council. This rule
applies to the covered members as well. Particularly, the equity investment in a fund of the firm is less than 1%
of the company’s entire capitalization so it is immaterial. Independence is not compromised with respect to the
audit client if the respective interests of the firm, the network firm, or member of the assurance team, and the
audit client, or director, officer, or controlling owner thereof are both immaterial and the audit client exercise
significant influence over the entity. If an interest is material, to either the firm, the network firm or the audit
client, and the audit client can exercise significant influence over the entity, no safeguards are available to
reduce the threat to an acceptable level and the firm, the network firm, should either dispose of the interest or
decline the audit engagement.
6. Prepare a memo to the partner making a recommendation as to whether the firm should or should not accept
Central Energy Corporation, as an audit client. Justify your position in light of the information in the case.
Memo for Recommendation:
Ritz & Co., CPAs
Audit and consulting
Date: September 09, 2020
FAR EASTERN UNIVERSITY
INSTITUTE OF ACCOUNTS BUSINESS AND FINANCE
ACT1202 – Auditing and Assurance Principles
Case Study No. 1 Answer Sheet
Subject: Accept Central Energy Corporation as Audit Client
To: The Partner
Central Energy Corporation is requesting assistance and advice with their auditing the financial
statements and tax services, an opinion on its December 31, 2020 should issue by the audit committee. It is
recommended to accept Central Energy Corporation as audit client as our organization even the client is new to
the auditing firm. This will help Ritz & Co., CPAs to look into new market opportunity and gain a competitive
advantage.
Thanks.
Junior Auditor,
Ritz & Co., CPAs
Consideration of reasons for acceptance:
It would give entry to new market.
There will be market expansion for Ritz & Co., CPAs in terms of audit clients.
Company will be having financial support to expand.
Consideration of reasons against acceptance:
It may dilute company’s control over its core audit.
Company has to prepare strong strategy and look after that it does not damage its image and goodwill.
7. Prepare a separate memo to the partner briefly listing and discussing three to five most important issues or risk
areas that will likely affect how the audit is conducted if the prospective client is accepted and how the firm can
address such issues.
Memo for Important factor and risk areas:
Ritz & Co., CPAs
Audit and consulting
Date: September 09, 2020
Subject: Important factor and risk areas for conducting the audit
To: The Partner
Major risk area is complexity in Central Energy Corporation’s revenue recognition policy and the liquidity
of the management and the tendency of the management to adjust belligerently accrual of the year-end in
order to encounter creditor’s requirement. Looking at the past record of CEC with its previous audit service
provider relation it revealed that he had issued an opinion unfairly and unnecessary. In addition, looking at the
client background check, they have a previous case regarding their deliberate over declaration of expenses and
it revealed that the chief officer was into drugs.
FAR EASTERN UNIVERSITY
INSTITUTE OF ACCOUNTS BUSINESS AND FINANCE
ACT1202 – Auditing and Assurance Principles
Case Study No. 1 Answer Sheet
Thanks.
Junior Auditor,
Ritz & Co., CPAs
Certain significant implications are as below:
Accounts receivable turnover, while good, is declining. This proposes that the auditors may want to pay
exceptional attention to the valuation of receivables.
As a result of Ritz & Co., CPAs current implementation, certain audit trails have not been effectively
sustained. The auditors will need to govern how to gain comfort on the items for which traditional audit
trails were not preserved.
Internal controls seem to be missing. Thus, the auditors will likely have to rely greatly on applicable
procedures. This will in turn have implications for the cost of the audit and staffing budgets.
