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CHAPTER 7
ACCEPTING THE ENGAGEMENT AND PLANNING
THE AUDIT
COMPREHENSIVE CASE
Cases
7-25. (Estimated Time 45 Minutes)
a.

The professional guidance that assist Reddy and Abel in making a decision about
client selection are the Statements on Quality Control Standards, particularly
those that address the acceptance and continuance of clients and engagements.
A suggested solution regarding the issues associated with new client acceptance is
displayed below and labeled as working paper PF-1. (PF = Permanent File)

b.

A suggest solution for the client engagement letter is presented below on the
working paper labeled as GF-1. (GF = General File)

7-26. (Estimated Time 2 hours)

A suggested solution discussing issues associated with understanding the business and
industry is presented below and labeled as working paper GF-4.

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Mt. Hood Furniture, Inc.

Issues Related to New Client Acceptance
December 31, 20x3

W/P Ref: PF-1 page 1 of 2

Prepared By:
Date:
Reviewed By:
Date:

Discussion and Resolution of Issues Related to New Client Acceptance

Important Issues
Regarding New Client
Acceptance
Integrity of senior
management.

Positive Factors

Potential Issues of Concern

Solutions or possible resolutions for

issues of concern

Special circumstances
and risks

Major reason for the audit is to satisfy

lenders and related debt covenants. Financial
statements and financial plans may be shown
to venture capitalist in an effort to obtain
capital to support growth with the long-term
objective of preparing for IPO.

The audit should be approached with an

appropriate level of professional skepticism
given the high level of interest by a variety
of investors and potential investors.

Special circumstances
and risks

The rapid growth in sales and operations has

stressed the companys information and
accounting systems.

Special circumstances
and risks

The client appears to report significant

negative cash flows from operations, which
were was funded with some issuance of
common stock and a significant increase in
long-term debt. Negative cash flow can be
expected with a year of 28% sales growth,
but the level of interest in the financial
statements is high, given the companys need
for capital.

Attention needs to be focused on internal

control and in key areas we may consider a
primarily substantive approach due to poor
condition of current system.
The audit should be approached with both
a level of professional skepticism and
particular attention paid to the growth in
receivables, inventories, and fixed assets
that have accompanied the growth. The
firm needs to be alert to possible operating
problems associated with rapid growth,
such as building inventories too fast.

Discussion with the predecessor

auditor indicated that there were no
concerns about management integrity.
The predecessor auditor also noted
that management made proposed audit
adjustments that were found during
the audit.
In addition, the CFO is a former
employee, Julia Anderson, who
demonstrated integrity and objectivity
in all of her work with our firm.

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Mt. Hood Furniture, Inc.

Issues Related to New Client Acceptance
December 31, 20x3
Important Issues
Regarding New Client
Acceptance
Special circumstances
and risks

Special circumstances
and risks
Independence

Independence

Positive Factors

W/P Ref: PF-1 page 2 of 2

Prepared By:
Date:
Reviewed By:
Date:
Potential Issues of Concern

Solutions or possible resolutions for

issues of concern

The prior auditor reports that audit

adjustments have resulted from cutoff
problems, errors in counting inventories, and
from discussions of the allowance for
uncollectible accounts.
The client is growing fast, needs external
capital, and hopes to prepare itself for an
initial public offering.
Robert Saws niece, Ms. Heather Giger, is a
senior accountant in our firm. She currently
works both on audit and tax engagements,
and she owns (a few) equity shares in Mt.
Hood Furniture, Inc. She is also an executor
of Mr. Robert Saws will.

Areas noted in the current audit represent

higher inherent risk areas that demand an
appropriate level of professional
skepticism, particularly given the stresses
on the accounting system.
The firm is registered with the PCAOB and
has experience auditing public companies.

Julia Anderson, the Chief Financial Officer is

a former employee of Reedy and Able,
CPAs.

Ms. Giger is not a close relative and that

does not raise independence problems by
itself.
However, Heather has what appears to be
an immaterial direct financial interest in a
privately held company. She cannot be
allowed to work on the audit or any client
activities for Mt. Hood Furniture, Inc..
Further, acting as an executor of the estate,
with the power to vote a significant block
of shares while acting in that capacity,
represents a significant independence issue
that should be resolved before accepting
the engagement.
Julia Anderson was not an employee of our
firm at any time during the period of the
financial statements that we are auditing,
nor was she an employee of our firm
during the period of the audit engagement.
There are no independence problems with
respect to our former employee, Julia
Anderson.

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Mt. Hood Furniture, Inc.

Draft Engagement Letter
December 31, 20x3

W/P Ref: GF-1 page 1 of 2

Prepared By:
Date:
Reviewed By:
Date:

REEDY AND ABEL CERTIFIED PUBLIC ACCOUNTANTS

Mr. Conrad P. Saws, President
Mt. Hood Furniture, Inc.
80 Fast Lane
Portland, Oregon 97207
Dear Mr. Saws:
We are pleased to confirm our understanding of the services we are to provide for Mt. Hood Furniture,
Inc. for the year ending December 31, 20X3.
We will audit the balance sheet of Mt. Hood Furniture, Inc as of December 31, 20X3 and the related
statements of income, retained earnings, and cash flow for the years then ended. The objective of our
audit is the expression of an opinion about whether your financial statements are fairly presented, in all
material respects, in conformity with generally accepted accounting principles. Our audit will be
conducted in accordance with generally accepted auditing standards and will include test of your
accounting records and other procedures we consider necessary to enable us to express such an opinion.
If we are unable to complete the audit, or are unable to form or have not formed an opinion, we may
decline to express an opinion or to issue a report as a result of this engagement.
Our procedures will include tests of documentary evidence supporting the transactions recorded in the
accounts, tests of the physical existence of inventories, and direct confirmation of receivables and certain
other assets and liability by correspondence with selected customers, creditors, and banks. At the
conclusion of the audit we will require certain written representations from you about the financial
statements and related matters.
An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements; therefore, our audit will involve judgment about the number of transactions to be
examined and the areas to be tested. Also, we will plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material misstatement. Because of the
concept of reasonable assurance and because we will not perform a detailed examination of all
transactions, there is a risk that material errors, fraud, or other illegal acts, may exist and not be detected
by us. In addition, an audit is not designed to detect errors, fraud, or illegal acts that are immaterial to the
financial statements. Our responsibility as auditors is limited to the period covered by our audit and does
not extend to any later periods for which we are not engaged as auditors.
Our audit will include obtaining an understanding of internal control sufficient to plan the audit and to
determine the nature, timing, and extent of audit procedures to be performed. An audit is not designed to
provide assurance on internal control or to identify reportable conditions, that is, significant deficiencies
in the design or operation of internal control. However, during the audit, if we become aware of such
reportable conditions, we will communicate them to you.
We understand that you are responsible for making all financial records and related information available
to us and that you are responsible for the accuracy and completeness of that information. We will advise
you about appropriate accounting principles and their application and will assist in the in the preparation
of your financial statements, but the responsibility for the financial statements remains with you. This
responsibility includes the establishment and maintenance of adequate records and effective internal
controls over financial reporting, the selections and application of accounting principles, and the

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Mt. Hood Furniture, Inc.

Draft Engagement Letter
December 31, 20x3

W/P Ref: GF-1 page 2 of 2

Prepared By:
Date:
Reviewed By:
Date:

safeguarding of assets. Management is also responsible for identifying and ensuring that the entity
complies with applicable laws and regulations.
We understand that your employees will prepare all cash, accounts receivable, and other confirmations we
request and will locate any documents selected by us for testing.
As part of our engagement, we will also prepare the federal and state income tax returns for your
company for the year ended December 31, 20X3.
We expect to begin our audit on approximately September 15, 20X3 and to complete your tax returns and
issue our report not later than March 1, 20X4. We will observe the counting of inventories on December
31, 20X3.
We estimate our fees for those services will range from $20,000 to $25,000 for the audit and $7,500 to
$10,000 for the tax return. You will also be billed for travel and other out-of-pocket costs such as report
production, typing, postage, etc. Additional expenses are estimated to be $1,500. The fee estimate is
based on anticipated cooperation from your personnel and the assumption that unexpected circumstance
will not be encountered during the audit. If significant additional time is necessary, we will discuss it
with you and arrive at a new fee estimate before we incur the additional costs. As we discussed earlier,
we will provide you with separate proposals at a later date for additional value-added services that you
might request based on the findings of our audit. Our invoices for these fees will be rendered each month
as work progresses and are payable on presentation. In accordance with our firm policies, work may be
suspended if your account becomes 60 days or more overdue and will not be resumed until your account
is paid in full. If we elect to terminate our services for nonpayment, you will be obligated to compensate
us for all time expended and to reimburse us for all out-of-pocket expenditures through the date of
termination.
We appreciate the opportunity to be of service to you and believe this letter accurately summarizes the
significant terms of our engagement. If you have any questions, please let us know. If you agree with
the terms of our engagement as described in this letter, please sign the enclosed copy and return it to us.
Your truly,

Reddy and Abel, Certified Public Accountants

This letter correctly sets forth the understanding of Mt. Hood Furniture, Inc.
Mr. Thomas Thorp, President

Date

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Mt. Hood Furniture, Inc.

Summary of Analytical Procedures
December 31, 20x3

W/P Ref: GF- 5 page 1 of 2

Prepared By:
Date:
Reviewed By:
Date:

The following table summarizes key issues associated with our understanding the Mt. Hood Furniture, Inc. and its environment.
Issues Noted
Industry
conditions

Regulatory
environment

Other external
factors affecting
the business

How the knowledge will assist in developing a knowledgeable

perspective about the financial statements.
Mt. Hood Furniture inc is a regional manufacturer of office
furniture and cabinetry. Office furniture is a highly competitive,
multibillion-dollar annual market. With a strong economy the
market has grown about 15 percent per year over the last two
years; however, industry experts expect this growth to slow down
in the years ahead. Mt. Hood does not have significant market
share and competes with a number of nationally recognized
companies. Mt. Hoods primary advantages are competitive
pricing and consistently high-quality products.

How the knowledge increases or mitigates potential risks of

material misstatement.
It might be reasonable to expect softening profit margins. The
auditor should also be alert to issues associated with revenue
recognition associated with a high emphasis on sales growth
coupled with softening economic conditions.

Mt. Hood Furniture, Inc. is family owned and not publicly traded.
However, the CFO suggests that the company consider venture
capital to grow the company until it is ready for an IPO,
sometime in the future.

In the longer term the company is considering an IPO. It will

need to meet SEC requirements for 3 years prior to and IPO.

Mt. Hood Furniture is subject to a variety of federal, state, and

local laws and regulations relating to the use, storage, handling,
generation, transportation, treatment, emission, discharge,
disposal and remediation of, and exposure to, hazardous and
nonhazardous substances, materials, and wastes. In particular, the
U.S. Environmental Protection Agency standards for the wood
furniture manufacturing industry require reduction of emissions
of certain volatile organic compounds found in the coatings,
stains, and adhesives used by Mt. Hood. Company officers
believe that Mt. Hoods operations are in substantial compliance
with all environmental laws.

Review potential indirect effect illegal acts during work on

commitments and contingent liabilities.

No significant issues noted.

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Mt. Hood Furniture, Inc.

Summary of Analytical Procedures
December 31, 20x3
Issues Noted
The clients
investing
activities and
financing
activities
The clients
financial
reporting
activities

W/P Ref: GF- 5 page 2 of 2

Prepared By:
Date:
Reviewed By:
Date:

How the knowledge will assist in developing a knowledgeable

perspective about the financial statements.
Mt. Hood furniture has sufficient capacity to grow sales to
approximately $50 million. It is currently at approximately $35
million.

How the knowledge increases or mitigates potential risks of

material misstatement.
Current year growth in inventory and receivables was financed
with debt. Continued expansion will probably require additional
equity financing.

Current capital expenditures were for equipment replacement and

information system upgrade.

Determine if the company has appropriately followed GAAP

regarding the capitalization of costs regarding internal use
software in system development costs.
Carefully review debt agreements for debt covenants. Test to
see that debt covenants have not been violated. Also review
covenants and extent to which the bank has provided funding by
asking for pledges of receivables and inventory.

Growth in receivables and inventory has been primarily financed

with increased debt.

The Companys information systems, and related personnel, are

stressed to accommodate sales growth.

Carefully review stresses on the accounting system. The audit

may require a primarily substantive approach for some or many
assertions.

The prior auditor said that Conrad Saws had raised several
questions with him about revenue recognition on some possible
bill-and-hold sales in advance of negotiating a sales agreement
with a national office supply and furniture chain. No problems
were noted in the subsequent audit.

Carefully review revenue recognition and consider a primarily

substantive approach given the bonus system and prior concerns
about bill and hold sales.

The company covers employees with a pension and profit sharing

plan.

Review pension and profit sharing plans and determine if the

company has a defined benefit or defined contribution plan.
This could be a key audit area.

The companys manufacturing and executive offices are located

in facilities leased from the founder.

The audit needs to be alert to disclosures of related party

transactions.

The largest customer is currently 8% of total sales.

Look carefully at volume with key customers to determine

adequacy of disclosure.

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Mt. Hood Furniture, Inc.

Summary of Analytical Procedures
December 31, 20x3
Issues Noted
The cleints
objectives,
strategies and
related business
risks.

How the client

measures and
review the
entitys
financial
performance.

W/P Ref: GF- 5 page 3 of 2

Prepared By:
Date:
Reviewed By:
Date:

How the knowledge will assist in developing a knowledgeable

perspective about the financial statements.
Currently the custom cabinetry line accounts for approximately
$7 Million in sales. The COO would like to see this line grow to
$25 Million in the next 3 to 5 years. This line has the potential
for product line expansion.

How the knowledge increases or mitigates potential risks of

material misstatement.
Carefully review revenue recognition and consider a primarily
substantive approach given the fact that deposits might be
received on custom cabinet work in advance of revenue
recognition.

The office furniture line (see below) accounts for 80% of current
sales. The Companys primary advantages in this line are
competitive pricing and consistently high quality products. Key
goals in this industry include increasing market share and name
recognition.

Look carefully at sales growth and the collectibility of

receivables given a softening market for products and concerns
raised internally regarding the risk of not tightening credit terms.
Also look at marketability of inventory given goals to have a
minimal amount of backorders.

The CFO is concerned about improving operating cash flows and

speeding up the operating cycle. However, the COO is
concerned that tightening credit terms will slow sales growth.
The President is adamant about maintaining sufficient inventory
to make sure backorders are minimal.
Mt. Hood furniture has placed a significant emphasis on sale
growth. Beginning this year, the company put a bonus plan in
place for key executives based on sales growth.

As noted above there are significant risk associated with

accounting estimates associated with the collectibility of
receivables and the net realizable value of inventory.
Because the company places a significant emphasis on sales
growth, the auditor should be alert to revenue recognition issues
and prior concerns about bill and hold sales.

More attention is paid to sale growth than to declining cash flow

due to growth.

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