Monterrey Corporation has an existing loan in the amount of $7 million with an annual interest rate of 6.5%. The company provides an internal company-prepared financial statement to the bank under the loan agreement. Two competing banks have offered to replace Monterrey Corporation’s existing loan agreement with a new one. Southwest National Bank has offered to loan Monterrey $7 million at a rate of 5.5% but requires Monterrey to provide financial statements that have been reviewed by a CPA firm. First City Bank has offered to loan Monterrey $7 million at a rate of 4.5% but requires Monterrey to provide financial statements that have been audited by a CPA firm. Monterrey Corporation’s controller approached a CPA firm and was given an estimated cost of $45,000 to perform a review and $80,000 to perform an audit. 

Required:

a. Explain why the interest rate for the loan that requires a review report is lower than that for the loan that does not require a review. Explain why the interest rate for the loan that requires an audit report is lower than the interest rate for the other two loans. 

b. Calculate Monterrey Corporation’s annual costs under each loan agreement, including interest and costs for the CPA firm’s services. Indicate whether Monterrey should keep its existing loan, accept the offer from Southwest National Bank, or accept the offer from First City Bank. 

c. Assume that Southwest National Bank has offered the loan at a rate of 5.5% with a review, and the cost of the audit has increased to $125,000 due to new auditing standards requirements. Indicate whether Monterrey should keep its existing loan, accept the offer from Southwest National Bank, or accept the offer from First City Bank. 

d. Discuss why Monterrey may desire to have an audit, ignoring the potential reduction in interest costs. 

e. Explain how a strategic understanding of the client’s business may increase the value of the audit service.