Reference no: EM13169411

Audit Client Considerations

Lanny Beaudean joined the CPA firm of Cardinal & Coyote LLP in 2008 after working for two years for the IRS in Phoenix, Arizona. The firm is a second-tier CPA firm just below the Big Four in size. Beaudean had passed all four parts of the CPA Exam in Arizona and decided to work for a locally based CPA firm with international clients to gain a broad base of experience that might help him become a CFO at a public company in the future. Beaudean has been advancing rapidly and just became a senior at Cardinal & Coyote.

Yancy Corliss is a new audit partner at Cardinal & Coyote. One day Corliss was summoned to the office of Sharon Rules, the managing partner of the firm. Rules told Corliss that she had been approached by a new client, Jost Furniture International. Jost is a large southwestern chain of home furniture rental catering to young upscale individuals who might live in a city for two years or so and then move on. It recently opened an office in Canada and plans to expand to Europe in the not-too-distant future. Top management at Jost seemed to imply that the firm would get the audit as long as it submitted a reasonable bid.

Rules asked Corliss to do background checks on Jost and make whatever inquiries were necessary to assess the potential business risk of Jost as a future client. Corliss was given three days to do the work and report back to Rules with a recommendation. If the decision is to go ahead, then Cardinal & Coyote would submit a bid and compete with one other CPA firm for the account. The firm believes it will be a lucrative account, especially since the company has been in an expansion mode and will require advice on acquisitions and other advisory services in the future.

Corliss assembled his team to review the background and other information about Jost Furniture. Corliss asked Beaudean to head up the assessment and report back to Corliss in two days. During that time, Beaudean would have two other staff members to help with the assignment. Beaudean was excited about his first opportunity to work on new client assessment.

Beaudean met with Vinnie Gabelli, a transplanted Brooklyn native who had graduated from Arizona State University (ASU) at Phoenix. Gabelli was like a fish out of water in Arizona even though he had spent 16 months in the master's of accounting program at ASU. Gabelli thought a prickly pear was someone who could not make it in Staten Island and moved to Brooklyn for a better life.

Gabelli told Beaudean that he welcomed the opportunity to work with a native of Phoenix and learn about its colorful history. Beaudean also asked Jackie Oloff, a native of Minneapolis, to join the team. Jackie had moved to Phoenix two years ago with her husband, who is a professor of accounting at ASU. The team discussed mutual responsibilities, data sources for the information, key areas of risk, and then they broke up to start their work. At the end of the day, the team reassembled to share information. Here is a brief list of the findings:

• 1.The predecessor firm had helped Jost Furniture with its initial public offering and audited the financial statements of the company for five years. The firm resigned the account in 2007, following the issuance of a modified opinion on the 2006 financial statements. The firm had issued an unqualified opinion with an explanatory paragraph that raised questions about the ability of Jost to continue as a going concern because of persistent operating losses that threatened the company's ability to secure needed financing.
• 2.A second firm audited the financial statements for 2007. That firm also raised going-concern questions and was dismissed by Jost's top management.
• 3.Jost's financial statements for 2008 and 2009 were audited by a third firm that was dismissed after two years.
• 4.The financial statements for 2010 had not been audited and on March 19, 2011, the CEO of Jost Furniture, Jerry Jost, approached Sharon Rules at a community event and asked her to submit a bid for the Jost audit. Jost asked that the bid be submitted by March 23.
• 5.A memorandum to the file prepared by Rules indicated that Jost had admitted to Rules that the company had past problems with various auditors, but Jost assured Rules the going-concern issues had been resolved. He also told Rules that the company's controller had recently quit, the third time in four years there had been a turnover at that position. Jost told Rules the company had two candidates and he wanted her to help with the final decision since the CPA firm would work closely with the controller.
• 6.Beaudean, with the help of Gabelli and Oloff, reviewed the financial statements of Jost Furniture for the past four years during which time going-concern explanatory paragraphs had been issued. They went through a checklist of risk assessment issues for new clients and stopped when they came to the following: Verify the circumstances of any prior auditor dismissal or withdrawal by first asking the client for permission to approach the predecessor auditor(s). All three auditors felt this should be done by Yancy Corliss.

At the meeting at the end of the first day, the auditors discussed the unusual number of auditor changes in a short period of time apparently due to going-concern issues that were raised in the audit reports for the years 2006 through 2009. Beaudean asked Gabelli to contact the two banks where the company does business and check into its payment record. Oloff had a past business relationship with Miles247248Frazer, the attorney for Jost Furniture. Oloff agreed to contact Frazer to determine whether there are any outstanding litigation issues or other legal matters that the firm should know about. They all agreed to get these matters done by the end of the second day and a meeting was set for 5:00 p.m.

Gabelli found out that a $1 million loan payable to Phoenix Second National Bank had been overdue before payment had been made March 15, 2011. The president of the bank told Gabelli that Jost had been in violation of a debt covenant agreement that obligated Jost to maintain a current ratio of 1.5:1 at all times and that the bank was concerned about Jost's ability to continue as a going concern, pointing out that Jost had gone below the ratio twice. The first time Jost had violated the covenant, the bank accepted the explanation of a temporary cash flow problem. The bank granted the company a three-month extension to meet the requirements of the debt covenant. The bank subsequently found out the cash flow problem had been due to the fact Jerry Jost withdrew $500,000 from the Jost cash account at Second National Bank to help put a down payment on a mortgage loan to buy an upscale house in Scottsdale. The second time it occurred, the bank began foreclosure on the loan on January 31, 2011, but by the time the process had been completed, Jost had paid off the entire $1 million balance.

Oloff had no luck with the Frazer, the attorney for Jost. When she called his offices, the secretary always told Oloff that Frazer was on another line and she'd take a message. When Oloff asked to leave a voice-mail message, she was told Frazer did not have voice mail. How about leaving an e-mail message? she asked. No e-mail either. Can I text him, tweet him, or just do it the old-fashioned way and set up an appointment? No, no, no were the answers. Oloff had left five messages for Frazer in the time before the meeting. She had nothing to report except to make an editorial comment about lawyer responsiveness, or lack thereof.

At first, Jost had side-stepped Corliss's request for permission to speak with the predecessor auditor. Jost claimed that there had been a "personality conflict" and Jost was afraid the auditor would speak negatively about the company. Jost did agree after Corliss reminded him it was a required part of the procedures auditors follow in making the client acceptance decision.

At 5:00 p.m. on March 22, the auditors met in the firm's conference room to discuss their findings. After hearing about Gabelli's concerns and Oloff's lack of success with Frazer, Beaudean expressed serious concerns about taking on Jost as a client.

Questions

• 1.Why is it important to do the kind of due diligence testing and risk assessment review conducted by Cardinal & Coyote prior to determining whether to make a bid for the audit of a potential client? What are the potential red flags with respect to the Jost audit? If you were Yancy Corliss, would you go ahead and recommend to Sharon Rules that the firm should submit a bid for the Jost audit? Why or why not?
• 2.Regardless of your answer to question 1, assume Corliss decides to recommend to Rules that the firm should make a bid for the Jost Furniture audit. Beaudean seems surprised and asks what other factors Corliss might have considered in making the decision. Corliss is quite blunt and says: "I am a new partner in the firm. I have to bring in new business. This client is a slam dunk. If we make a reasonably competitive bid, we will get the account."

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  • a. Why do you think there is so much pressure in public accounting to bring in new clients? Is this a good thing or are there potential risks that might go unnoticed or ignored? How might the decision by Corliss present an impediment to making sound audit decisions later on?
  • b. Some CPA firms have started to add indemnification clauses to their engagement letters that state the firm is not responsible for fraud when the client knowingly misrepresented financial information during the course of gathering evidence and testing account balances. Do you think these clauses are ethical? Why or why not?
• 3. Typically, when there is a going-concern issue with a client, the CPA firm issues an unqualified opinion with an explanatory paragraph. Given the limited facts of the case, do you believe this type of opinion is justified? Do you think the firm should consider issuing a qualified opinion or disclaim an opinion? Why or why not? How about withdrawal from the engagement?