The accounting firm of Pioneer, is a medium-sized. CPA firm. The firm mainly provides auditing and tax services, but it has recently had success in building the information systems-consulting side of the business. It is mid-January 2003, and you are a newly promoted audit manager in an office of Pioneer, located in the Pacific Northwest. You have been a senior auditor for the past three years of your five years with Pioneer. Your first assignment as audit manager is to assist an audit partner on a client acceptance decision. The partner explains to you that the prospective client, Delta Corporation, is a medium-sized manufacturer of small home appliances that its shareholders equity is $39,130,434 and has outstanding shares of 10 million. The partner recently met the company's president at a local chamber of commerce meeting. He indicated that, after some difficult negotiations, the company has decided to terminate its relationship with its current auditor. The president explained that the main reason for the switch is to establish a relationship with a more nationally known CPA firm because the company plans to make an initial public offering (IPO) of its common stock within the next few years. Delta's annual financial statements have been audited each of the past 12 years in order to comply with debt covenants and to receive favourable interest rates on the company's existing line of credit. Because the company's December 31 fiscal year-end has already passed, time is of the essence for the company to contract with a new auditor to get the audit under way. The partner is intrigued with the idea of having a client in the home appliance industry, especially one with the favourable market position and growth potential of Delta Corporation. Most of Pioneer's current audit clients are in the healthcare services industry. Thus, the partner feels the engagement presents an excellent opportunity for Pioneer to enter a new market. On the other hand, knowing the risks involved, the partner, Jane Hunter, wants to make sure the client acceptance decision is carefully considered. BACKGROUND ABOUT DELTA CORPORATION Delta Corporation, Inc. manufactures small- to medium-sized home appliances. The company is planning an IPO in the next few years in hopes that they will be able to trade the stock on the stock market. You have been assigned to gather information in order to make a recommendation on whether your firm should accept Delta Corporation as a client. Delta wants to hire your firm to issue an opinion on their December 31, 2002 financial statements and has expressed interest in obtaining help in getting their recently installed information technology (IT) system in better shape. They also want your firm's advice and guidance on getting everything in order for the upcoming IPO. During the initial meeting with Delta's management, the following information was obtained about the industry and the company. The Home Appliances Industry Over the past several years, the domestic home appliances industry has been growing at a steady, moderate pace. The industry consists of a wide variety of manufacturers who sell to a large number of wholesale and retail outlets. Though responsive to technological improvements, product marketability is linked to growth in the housing market. Retail outlets are served by both wholesale and manufacturer representatives. Delta Corporation, Inc. Delta's unnudited December 31, 2002 financial statements report total assets of 76 million sales revenues of $145 million, and net profit of $3.4 million. In the past, the company has Page 1 of 2 not attempted to expand aggressively or develop new product lines. Rather, it has concentrated on maintaining a steady growth rate by providing reliable products within a moderate to low price range. However, Delta hopes to use the capital from the upcoming IPO to aggressively expand from a regional to a national market. Delta primarily sells its products in small quantities to individually owned appliance stores. Over the last few years. the company has begun to supply larger quantities to three national retail chains. Two of these larger retailers started buying Delta's products about two years ago. In order to handle the increased sales, Delta significantly expanded its Corporation capacity. The company's products include items like toasters, blenders, and trash compactors. Though shaken by recent management turnover and ongoing difficulties with the company's new accounting system, management feels that Delta is in a position to grow considerably. They note that eamings have increased substantially each year over the past three years and that Delta's products have received increasing acceptance in the small appliance marketplace. Three years ago, the company received a qualified audit opinion relating to revenues and receivables. Delta has changed auditors three times over the past 12 years. Management In October 2002, the company experienced significant management turnover when both the vice-president of operations and the controller resigned to take jobs in other cities. The reason for their leaving was disclosed by management as being related to "personal issues". A new vice-president, Jack Zachery, was hired in November, and the new controller joined early last monthJack is an MBA with almost 12 years of experience in the industry. Theodore Jones, the new controller, has little relevant experience and seems frustrated with the company's new IT system. The company president. Andrew Cole, has a BBA and, as the founder, has worked at all levels of the business. Mr Zachery, who is principally in charge of the company's procurement and Corporation functions, meets weekly with Mr Cole, as does Frank Stevens, who has served as vice-president over finance for the past eight years. Accounting & Control Systems The company switched to a new, integrated central accounting system in early 2002. This new system maintains integrated inventory, accounts receivable, accounts payable, payroll, and general ledger software modules. The transition to the new system throughout last year was handled mainly by the former controller. Unfortunately, the transition to this new system was not well managed, and the company is still working to modify it to better meet company needs, to retrain the accounting staff, and to adapt the company's accounting controls to better complement the system. Problems still exist in inventory tracking and cost accumulation, receivables billing and aging, payroll tax deductions, payables, and balance sheet account classifications. The company stopped parallel processing the old accounting system in April 2002. During several brief periods throughout 2002, conventional audit trails were not kept intact due to system failures and errors made by untrained personnel The company's accounting staff and management are both frustrated with the situation because, among other problems, intemal management budget reports, inventory status reports, and receivables billings are often late and inaccurate, and several shipping deadlines have been missed. Your office has never audited a company with the specific IT system in place at Delta. However, your local office's IT team is fairly confident they will be able to diagnose Delta's control weaknesses and help Delta overcome current difficulties. Predecessor Auditor When you approached Frank Stevens, Delta's V.P. of finance, to request permission to speak with the previous auditor, he seemed hesitant to discuss much about the prior audit firm. He explained that, in his opinion, the previous auditor did not understand Delta's business environment very well and was not technically competent to help the company with its new IT system. He further indicated that the predecessor auditor and Delta's management had disagreed on minor accounting issues during the prior year's audit. In Mr Stevens' opinion, the disagreement was primarily due to the auditor's lack of understanding of Delta's business and industry environment. According to Mr Stevens, the previous auditor felt that because of the accounting issues, he would be unable to issue a clean opinion on the financial statements. In order to receive an unqualified opinion, Delta had to record certain adjustments to revenues and receivables. Mr Stevens noted that Delta's management feels confident that your firm's personnel possess better business judgment skills and have the knowledge and ability to understand and help improve Delta's IT system. Mr Stevens also indicated that Delta wants to switch auditors at this time to prepare for the upcoming IPO, noting that companies often switch to larger accounting firms with national reputations in preparation for going public. Your firm has been highly recommended to him by a friend who is an administrator of a hospital audited by Pioneer. After some discussion between Mr Stevens and Mr Cole, Delta's president, you are granted permission to contact the previous auditor During your visit with the previous auditor, he indicated that the problems his firm had with Delta primarily related to (1) the complexities and problems with Delta's new IT system and (2) management's tendency to aggressively reflect year-end accruals and revenue in order to meet creditors' requirements. The auditor also disclosed that the dissolution of the relationship with Delta was a mutual agreement between the two parties, and that his firm's relationship with management had been somewhat difficult almost from the beginning Apparently, the final straw that broke the relationship involved a disagreement over the fee for the upcoming audit. Client Background Check A check on the background of Delta's management revealed that five years ago Delta's vice president of finance was charged with a misdemeanour involving illegal gambling on local college football games. According to the news reports, charges were later dropped in return for Mr. Stevens' agreeing to pay a fine of $500 and perform 100 hours of community service. The background check revealed no other legal or ethical problems with any other Delta executives Independence Review As part of Pioneer's quality control program, every three months cach employee of Pioneer is required to file with the firm an updated disclosure of their personal stock investments. You ask a staff auditor to review the disclosures as part of the process of considering Delta as a potential client. She reports to you that there appears to be no stock ownership issue except that a partner in Pioneer's Salt Lake City office owns shares in a project capital fund which in turn holds a private investment in Delta common stock. The project capital fund holds 50,000 shares of Delta stock, currently valued at approximately $18 a share. The stock is not publicly traded, so this value is estimated. This investment represents just over a half of one percent of the value of the fund's total holdings. The partner's total investment in the mutual fund is currently valued at about $56,000. According to Rule 101 of the AICPA Code of Professional Conduct, independence is considered to be impaired if "During the period of the professional engagement, a partner or professional employee of the firm, his or her immediate family, or any group of such persons acting together owned more than 5 percent of a client's outstanding equity securities or other ownership interests. Page 3 of 2 immediate family, or any group of such persons acting together owned more than 5 percent of a client's outstanding equity securities or other ownership interests. Page 3 of 2 Required: Answer the following questions: 1. What are the five procedures that must be adopted by auditors in deciding whether to accept a client. 2. Which of these five are required by auditing standards and identify the applicable standards? 3. The case mentioned that one of the partners has invested in a project capital fund that owns shares of Delta Corporation. Would this situation institute a violation of independence according to the of Professional Conduct Code? Why or why not? 4. Use your analysis in the above case to discuss the non-financial matters that auditors must take into consideration before accepting a new client. How important are these issues to the client acceptance decision? Why