Keune and Keune, CPAs, a regional audit firm with most of its activities located in one state, just accepted a new privately held company as an audit client. The company is considered a plum because it is one of the largest companies in that region of the state. It is well known in the home building business and its owner, Paul Maynard, sponsors race cars in both the Indy League and NASCAR with the company's logo and name on the cars. Because the company is well known, the audit partners concentrated on scoping and pricing the engagement. The auditors are well aware of the previous auditors, but given the reputation of the company, they did not feel a need to contact the predecessor auditors because it was a routine "bid for audit" and the current auditors were also bidding. Because it was routine, the auditors did not feel it necessary to write an engagement letter.

After beginning the audit, the auditors find out the following:

• The audit committee was not involved in the decision to change auditors, and only two of the three audit committee members are outside directors.

• The company engages in significant related-party transactions to minimize its tax liability. Although not illegal, the transactions do not meet the substance criteria required by the IRS.

Company management is adamant that it will not change unless the IRS requires it to change.

• There are a significant number of related-party transactions with the owner, and no valid business reason or economic benefit to the company is associated with these transactions.

• The decision to invest $15 million in sponsoring race cars was not approved by the board, but came at the dictate of the company CEO, Paul Maynard, who has a passion for racing.

• The board consists of mostly family members, with only two members who might be considered outside directors.

• The company wants to file to obtain public debt but has not done so yet. However, it does not feel that Sarbanes-Oxley 404 is effective and has told the auditors that they need to rely on their existing tests of account balances and controls in order to issue the required report on internal control over financial reporting.

• There is a very casual attitude toward accounting. The CFO states: "Most accounts are estimates, and my estimate is as good as anybody else's." Thus, there is no need to spend a great deal of time on those accounts.

Required

a. What are the important deficiencies in the auditor's process of accepting the audit client? What should have been done prior to accepting the client?

b. Many of the issues identified above reflect negatively on the integrity of management.

1. What choices does the auditor have regarding continuing the audit or resigning from the audit? What choice do you recommend and why? If the auditor resigns from the audit, to whom must the reasons for the resignation be communicated?

2. How would an engagement letter have been useful to the audit firm in this engagement? Will an engagement letter normally cover the types of issues that were subsequently identified by the auditor? How would an engagement letter assist the auditor should the auditor decide to resign?

3. How would the audit be expanded given the findings stated above? How will professional skepticism impact the planning of the audit? Be specific in your answer.

4. If the auditor has to significantly expand the audit because of the problems identified above, and the auditor had bid the audit for a fixed fee for the first three years, is it permissible to

(a) Raise the audit rates or

(b) Resign? Explain your answer.

c. Is it ethically appropriate for the audit firm to resign from this client at this point? Is it obligated to continue providing services to this client? In structuring your answer, consider the ethical decision-making framework that was introduced in Chapter 3 and recall that it consists of the following steps:

(1) Identify the ethical issue(s);

(2) Determine who are the affected parties and identify their rights;

(3) Determine the most important rights;

(4) Develop alternative courses of action;

(5) Determine the likely consequences of each proposed course of action;

(6) Assess the possible consequences, including an estimation of the greatest good for the greatest number;

(7) Determine whether the rights framework would cause any course of action to be eliminated; and

(8) Decide on the appropriate course of action.