San Diego Corporation

San Diego Corporation ("San Diego"), a private company, has borrowed

$7,000,000 from a local financial institution. The annual interest rate for the loan

is 6.5%. In accordance with the loan agreement, San Diego provides internal,

company-prepared financial statements to the lender.

Two other local lenders have approached San Diego and have offered to replace

San Diego's existing loan with a new one with new terms. Southern California

Bank has offered to loan San Diego $7,000,000 at 5.5% interest. Under the terms

of the loan, San Diego will be required to engage an independent public

accounting firm to "review" their financial statements prior to providing them to

the Bank. A review is an assurance engagement that provides less assurance on

the financial statements than does an audit.

Southern Regional Bank has also approached San Diego, and has made an offer

to lend San Diego $7,000,000 at a rate of 4.5% interest. Southern Regional will

require that San Diego engage an independent public accounting firm to conduct

an audit of its financial statements.

Interested in the various possibilities, San Diego's CFO approached a public

accounting firm, and learned that a review would likely cost San Diego $45,000,

and an audit would have an estimated cost of about $80,000.

Required:

1. Explain why the interest rates on the various loan offers differ from each

other.

2. Calculate San Diego's costs under the different loan proposals, and

indicate which of the loan proposals that San Diego should accept.

3. Assume that Southern California Bank offer is as described above, but the

cost of the audit has risen to $125,000 due to the costs of implementing new

auditing standards. Which loan offer should San Diego accept?

4. Setting aside your analysis above, and the consideration of interest rates,

are there other reasons that San Diego might desire to have their financialstatements audited?

5.As part of an audit, the CPA firm will gain an understanding of San

Diego's internal business operations and internal control, as well as an

understanding of the industry in which San Diego is situated. Why is this

important to the auditor