subject: Auditing and Assurance Principles

After completing and discussing this case you should be able to

Understand the types of information relevant to evaluating a prospective audit client

List some of the steps an auditor should take in deciding whether to accept a prospective client

Identify and evaluate factors important to the client acceptance decision

Understand the process of making and justifying a recommendation client acceptance

Ritz & Co., CPAs is a professional services firm located in Makati City that offers broad range of services to its clients including audit and assurance, tax services, and advisory and consulting. The firm has also recently established offices in Davao, Cebu, and Clark in Pampanga. The firm has also over 800 professionals employed in its various offices.

You are a junior manager in the firm who was recently transferred to the newly established office of the firm in Clark, Pampanga owing to the fact that you grew and studied in a prestigious university in Pampanga. One of the assignments given to you is to assist the partner in Clark to establish a client base there as part of your firms expansion strategy. The partner has attended several events already in the area and scored a number of lead clients in the process. One of these potential clients is Central Energy Corporation (CEC) located in the special economic zone in Clark, Pampanga. According to the partner, CEC recently cut its ties with its previous auditor and is now scrambling to find a new auditor to have its financials audited since the company expects to take a huge loan from a leading financial institution and also to keep its accreditation with a government agency. The companys financial year-end is December 31 and it is now mid- January, so your team needs to expedite the client acceptance decision to allow for proper planning and execution of the engagement.

Furthermore, the firm management in Makati is also pushing your team to accept the engagement since the prospective clients industry is quite new to the firm. Most of the firms clients are in the manufacturing and financial services industries and although the firm has a number of clients also in the energy sector, the firm has none on the specific type of industry of Central Energy Corporation which is the renewable energy sector. Thus, the firm management feels that this is an excellent opportunity to enter this type of market due in part of the new offices location near an industrial hub. However, the Clark partner wants to carefully consider the risks that this client and new market will bring to the firm in general. That is why he is asking you to make a thorough research about the client and the industry to determine whether you should ultimately accept this client for the upcoming audit.

Background:

Central Energy Corporation is engaged in project operations and management services related to alternative energy and sustainable energy operations including those involved in hydroelectric power, wind power, solar power generation, and the manufacture, distribution, and sale of alternative fuels. The securities of the company are not yet listed in any securities market, but the company is planning to acquire a long-term loan to finance some of its on- going projects in the different part of the country. You have been assigned to obtain information as part of your teams preliminary engagement activities and make a recommendation on whether your firm should accept or reject the company as a client.

The audit committee of the company selected your firm to issue audit and issue an opinion on its December 31, 2020 financial statements. In addition, the company is also interested to get tax services from your firm as the nature of their activities needs specialized knowledge to assist them in complying with existing regulations related to their industry. The heard that the government provides a lot of incentives to companies engaged in their line of business and they want to maximize those as much as possible. During the initial meeting with the companys management, you were able to obtain the following information about the company:

The Renewable Energy Sector

Renewable energy has gained much popularity in recent years as nations around the world seek ways to provide solution to our growing problems related to climate change. Many companies accepted the challenge and ventured to this type of industry despite the huge investments required and without a guarantee of successful outcome.

Central Energy Corporation

The companys audited financial statements as of and for the year ended December 31, 2020 (unaudited) report total assets of P397.1 million, total liabilities of P126.3 million, revenues of P0.90 billion and profit of P39.5 million. The company provides services to various big-name companies in the energy sector; however, in 2020, a major contract with its biggest client has finally ended and such client did not express anymore to renew its contract with the company. Such contract accounts for 10% of the companys revenue. The management strongly believes that it will be able to secure more contracts in the future to replace the loss in revenue that its previous contract provides. If fact, the company is set to apply an additional P100 million loan from a leading financial institution to finance its research and development department as well as to ensure the smooth operations of its on-going contracts.

Management

The company got some of its funding from venture capital funds as investors around the world take a keen interest to the industry where CEC is at. The companys chief executive officer (CEO) is Mr. Sean Baker, a well-known visionary and business leader and has run a number of successful startups in the energy sector in recent years. The chief operations officer (COO) is Ms. Loren Ng, an engineer and scientist by profession, and she oversees the projects being undertaken by the company. Meanwhile, Mr. Arnold Ty is the chief financial officer (CFO) and under him works the company controller. Interestingly, the company controller who was just hired this year, was your university senior, Mr. Simon Collins, and was the top of his class when he graduated. Both of you had served in your university student organization in the past but never really had much interaction with each other aside from the student organization related activities. The previous controller resigned this year because his family will transfer to Manila already.

Accounting and Financial Reporting

The company has been using a highly sophisticated computerized accounting system for the most of its years in operations and such accounting system is also integrated into the companys other aspects of its operations such as marketing, payroll, and even production.

Major Accounts

The company has a number of existing contracts with few big clients during the year and the revenue recognition policy of the company is quite complex owing the nature of activities that the company performs. The customer base of the company is small comprising of huge contract amount per customer that is why when a customer leaves the company or a major contract is completed, it will significantly affect the revenue that the company will earn during that period. Consequently, the companys liquidity is tied upon its ability to collect from the receivables arising from those contracts. When a project drags along or an unforeseen event prevent the company from complying with contract provisions, such can significantly affect the companys liquidity.

Furthermore, the company invests heavily in its research and development activities that is why for the first few years of the companys existence, it reported recurring losses. It is only in recent years that the company saw profitable operations and hopes to keep it that way moving forward.

Previous Auditor

You asked for permission from the companys CFO to discuss with their previous auditor. However, Mr. Ty had some reservations about your plan to speak with their previous auditor owing to the fact that they had disagreements in the past especially regarding the companys policy in revenue recognition. Mr. Ty disclosed that they had switched auditors a number of times before because local firms there in the area are somewhat overwhelmed with the complexity of business that the company is engaged to. That is why the management finally decided to look for a national auditing firm and came across with your partner in an event. Mr. Arnold Ty, the CFO, nevertheless gave you the permission to meet the previous auditor.

In your discussions with the previous auditor, the auditor disclosed that there were disagreements with the accounting treatment of revenue with the company. The company has also this practice of recording various provisions to anticipate for future possible losses. The auditor though admitted that the companys business is too complex, and they have never handled similar company before. They issued unqualified opinion anyway because the CFO agreed to book their proposed adjustments even though the CFO believes that they were not necessary.

Client Background Check

A check on the background of company revealed that several years ago the company was subjected to audit by Bureau of Internal Revenue (BIR) and resulted to findings that they were over declaring expenses and thus resulting to lower taxable profits. The company was able to raise the case to a higher court but ultimately lost the case. The company was made to pay several millions in taxes, penalties, and surcharges. The company receives regular letters of audit almost each year moving forward.

Furthermore, Mr. Sean Baker, the companys chief officer, though known as a visionary and a great entrepreneur, he is also popularly known a supporter of use of recreational drugs and admits to use some for himself if the pressure is really high at times. Other than that, there were no other legal or ethical issues noted by you with their other executives.

Independence Reviews

In your firm, all personnel conduct regular independence confirmation at least quarterly and every time personnel are to be assigned to an assurance engagement. Based on the information you have gathered, you noted that a partner in your Manila office has shares in a fund that has an equity investment with Central Energy Corporation but the amount of the funds investment in the company is minimal (less than 1% of the companys entire capitalization). You also found out personally that the son of your sister (your nephew) is having his internship in the engineering department of the company. There are no other independence issues noted by you.

Financial Statements

You acquired the companys financial statements for the past three years including the companys unaudited financial statements as of and for the year ended December 31, 2020. The information is presented below, and the partner wants you go over the companys financials and see if you can get any information from them.

Balance Sheets (In million Php)

31-Dec 2020 Cash 20.1 Investments 2.0 Receivables, net 211.0 Other assets 12.0 Current assets 245.1 Plant & equipment 152.0 Total assets 397.1

Payables 112.0 Short-term borrowings 5.5 Current liabilities 117.5 Long-term loans 8.8 Total liabilities 126.3 Equity 270.8

31-Dec 2018 11.9 3.0 174.4 9.1 198.4 156.0 354.4

91.3

10.0 101.3 5.3 106.6 247.8 354.4

Central Energy

Corporation

31-Dec 2019 35.2 4.1 549.0 16.6 604.9 149.1 754.0

134.4 4.0 138.4 7.3 145.7 608.3 754.0

2018

204.6 (122.1) 82.5 (44.3) 38.2 (11.5) 26.7

2020

20.0% 15.0% 4.3 83.72 0.3 1.15 10.60%

Total liabilities & equity

Profit or Loss (In millions Php)

397.1

2019

1,143.9 (712.5) 431.4 (312.0) 119.4 (35.8) 83.6

2020

Revenue 899.1 Cost of sales (594.2) Gross profit 304.9 Expenses (248.5) Profit before tax 56.4 Taxes (16.9) Profit 39.5

Industry Ratios:

ROE (Profit / Equity) ROA (Profit / Total Assets) Receivable Turnover (Sales / Ave. Receivables) Ave. collection period (360 / Receivable TO) Debt ratio (Liabilities / Assets) Current ratio (Current Assets / Current Liabilities) Profit margin (Profit / Sales)

2019

18.0% 16.0% 5.2 69.23 0.25 2.11 12.40%

Requirements:

1. What are the procedures that an auditor performs before accepting a client or continuing an engagement?
2. Using the companys 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 companys ratio to

the industry ratios and identify any significant differences.

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?

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?

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?

6. Prepare a memo to the partner making a recommendation as to whether the firm should or should not accept

Central Energy Corporation as am audit client. Justify your position in light of the information in the case.

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.