Lanny Beaudean joined Cardinal & Coyote LLP in 2011 after working for two years for the IRS in Phoenix, Arizona. Cardinal & Coyote is a second-tier CPA firm just below the Big Four in size. Beaudean had passed all four parts of the CPA Exam in Arizona and decided to work for a locally based CPA firm with international clients to gain a broad base of experience that might help him become a CFO at a public company in the future. Beaudean has been advancing rapidly and just became a senior auditor at Cardinal & Coyote.

Yancy Corliss is a new audit partner at Cardinal & Coyote. One day, Corliss was summoned to the office of Sharon Rules, the managing partner of the firm. Rules told Corliss that she had been approached by a new client, Jerry Jost of Jost Furniture International. Jost Furniture (Jost) is a large chain of home furniture rental companies in the Southwest catering to young, upscale individuals who might live in a city for two years or so and then move on. It recently opened an office in Canada and plans to expand to Europe in the not- too-distant future. Top management at Jost seemed to imply that the firm would get the audit so long as it submitted a reasonable bid.

Rules asked Corliss to do background checks on Jost and make whatever inquiries were necessary to assess the potential business risk of Jost as a future client, including an assessment of the integrity of management. Corliss was given three days to do the work and report back to Rules with a recommendation. If the decision was to go ahead, then Cardinal & Coyote would submit a bid and compete with one other CPA firm for the account. The firm believes that it will be a lucrative account, especially because the company has been in expansion mode and will require advisory services in the future including advice on acquisitions and other consulting services.

Corliss assembled his team to review the background and other information about Jost, and he asked Beaudean to head up the assessment and report back to Corliss in two days. During that time, Beaudean would have two other staff members to help with the assignment. Beaudean was excited about his first opportunity to work on new client assessment.

Beaudean met with Vinnie Gabelli, a transplanted Brooklyn native who had graduated from Arizona State University (ASU) at Phoenix. Gabelli was like a fish out of water in Arizona, even though he had spent 16 months in the Master’s of Accounting program at ASU. Gabelli thought a prickly pear was someone who could not make it in Staten Island and moved to Brooklyn for a better life.

Gabelli told Beaudean that he welcomed the opportunity to work with a native of Phoenix and learn about its colorful history. Beaudean also asked Jackie Oloff, a native of Minneapolis, to join the team. Jackie had moved to Phoenix two years ago with her husband, who is a professor of accounting at ASU. The team discussed mutual responsibilities, data sources for the information, and key areas of risk, and then they broke up to start their work. At the end of the day, the team reassembled to share information. Here is a brief list of the findings:

1. The predecessor audit firm had helped Jost Furniture with its initial public offering (IPO) and audited the financial statements of the company for five years. The firm resigned the account in 2010 following the issuance of a qualified (i.e., modified) opinion on the 2009 financial statements. The firm had issued this opinion because of differences with management over the proper accounting for inventories.

2. A second firm audited the financial statements for 2010. That firm also issued a qualified opinion.

3. Jost’s financial statements for 2011 and 2012 were audited by a third firm, which was dismissed after two years for reasons that were unclear.

4. The financial statements for 2013 had not been audited, and on March 19, 2014, the CEO of Jost Furniture, Jerry Jost, approached Sharon Rules at a community event and asked her to submit a bid for the Jost audit. Jost asked that the bid be submitted by March 23.

5. A memorandum to the file prepared by Rules indicated that Jost had admitted to Rules that the company had past problems with various auditors, but Jost assured Rules that the accounting issues had been resolved. He also told Rules that the company’s controller had recently quit—the third time in four years there had been a turnover in that position. Jost told Rules that the company had two candidates to replace the controller, and he wanted her to help with the final decision because the CPA firm would work closely with the controller.

6. Beaudean, with the help of Gabelli and Oloff, reviewed the financial statements of Jost Furniture for the past four years, during which time the qualified opinions had been issued. They went through a checklist of risk assessment issues for new clients and stopped when they came to the following: Verify the circumstances of any prior auditor dismissal or withdrawal by first asking the client for permission to approach the predecessor auditor(s).

One final discovery that gave the auditors pause with respect to taking on Jost Furniture as a client was a statement in the report on internal control over financial reporting for 2012. That statement indicated the existence of a material weakness in internal control that had not been mentioned in management’s internal control assessment.

At the meeting at the end of the first day, the auditors discussed the unusual number of auditor changes in a short period of time, apparently due to the accounting differences that were raised in the audit reports for the years 2009 through 2012. Beaudean asked Gabelli to contact Jerry Jost and ask permission to speak with the auditors for the 2011 and 2012 financial statements. Gabelli was also asked to contact the two banks where the company does business and check into its payment record. Oloff had a past business relationship with Miles Frazer, the attorney for Jost Furniture. Oloff agreed to contact Frazer to determine whether there are any outstanding litigation issues or other legal matters that the firm should know about. They all agreed to get these matters done by the end of the second day, and a meeting was set for 5:00 p.m. With respect to the material weakness in internal controls, the decision was made to ask Sharon Rules to discuss the matter directly with Jerry Jost.

Gabelli found out that a $1 million loan payable to Phoenix Second National Bank had been overdue before payment was made on March 15, 2014. The president of the bank told Gabelli that Jost had been in violation of a debt covenant agreement that obligated Jost to maintain a current ratio of 1.5:1 at all times, and that the bank was concerned about Jost’s ability to continue as a going concern, pointing out that Jost had gone below the ratio twice. The first time that Jost violated the covenant, the bank accepted the explanation of a temporary cash flow problem. The bank granted the company a three-month extension to meet the requirements of the debt covenant. It subsequently found out that the cash flow problem had happened because Jerry Jost withdrew $500,000 from the Jost Furniture cash account at Second National Bank to help put a down payment on a mortgage to buy an upscale house in Scottsdale. The second time that it occurred, the bank began foreclosure on the loan on January 31, 2014, but by the time the process completed, Jost had paid off the entire $1 million balance.

Oloff had no luck with Frazer, the attorney for Jost. When she called his office, the secretary always told Oloff that Frazer was on another line and she’d take a message. When Oloff asked to leave a voicemail message, she was told Frazer did not have voicemail. How about leaving an e-mail message? She asked. No, the secretary said, no e-mail either. Can I text him, tweet him, or just do it the old-fashioned way and set up an appointment? No, no, and no were the answers.

Oloff had left five messages for Frazer by the time of the team’s second meeting, and she had nothing to report except to make an editorial comment about lawyer responsiveness (or lack thereof).

As for permission to speak with the predecessor auditor, Jerry Jost was indignant with the request. Gabelli wasn’t sure why or whether it meant problems existed with the 2011-2012 audits. He reported to the audit team that Jost asked for more time to consider the request.

At 5:00 p.m. on March 22, the auditors met in the firm’s conference room to discuss their findings. After hearing about Gabelli’s concerns, the internal control issue, and Oloff’s lack of success with Frazer, Beaudean expressed serious concerns about taking on Jost as a client.

Questions

1. From an ethical perspective, why do auditors evaluate business risk before deciding whether to accept a new client?

2. Integrity is an essential element in the relationship between client management and the auditor. Evaluate the issue of integrity from the perspective of possibly taking on Jost Furniture as a new client. Use Josephson’s Six Pillars of Character to support your decision whether to submit a bid for the Jost Furniture audit.

3. Some CPA firms have started to add an indemnification clause to their engagement letters that provides that the client would release, indemnify, defend, and hold the auditor harmless from any liability and costs resulting from knowing misrepresentations by management. Would inclusion of such an indemnification clause in engagement letters impair independence? Why or why not? What if, as a condition to retaining an auditor to perform an audit engagement, a prospective client requests that the firm enter into an agreement providing that the firm indemnify the client for damages, losses, or costs arising from lawsuits, claims, or settlements that relate directly or indirectly to client acts. Would entering into such an agreement impair independence?