Far Eastern University

Institute of Accounts Business and Finance

Accountancy and Internal Auditing Department
ACT1202 Auditing and Assurance Principles
Case Study No. 1 – Preliminary Engagement Activities

Learning Objectives

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

Introduction1

From Ritz & Co., CPAs

• Mr. Earl C. Santos (ECS), partner of the Clark office
• You, a junior manager who was recently transferred to the Clark office

From the Client

• Mr. Sean Baker, CEO
• Ms. Loren Ng, COO
• Mr. Arnold Ty, CFO
• Mr. Simon Collins, Controller

R
itz & 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 firm’s
expansion strategy. The partner has attended several
events already in the area and scored a number of lead Figure 1. Photo credit: Biboy Martinez via Flickr
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 company’s financial year-end is December 31 and it is now mid-

1 The case was prepared by the Auditing Cluster of Accountancy Department of Institute of Accounts Business and Finance
(IABF) of Far Eastern University (FEU), as a basis for classroom discussion. Central Energy Corporation (CEC) is a fictitious
company and all characters and names represented are fictitious; any similarity to existing companies or persons is purely
coincidental.
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 Far Eastern University
Institute of Accounts Business and Finance
Accountancy and Internal Auditing Department
ACT1202 Auditing and Assurance Principles
Case Study No. 1 – Preliminary Engagement Activities

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 client’s industry is quite new to the firm. Most of the firm’s 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 office’s
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 team’s 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 company’s 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 company’s 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

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 Far Eastern University
Institute of Accounts Business and Finance
Accountancy and Internal Auditing Department
ACT1202 Auditing and Assurance Principles
Case Study No. 1 – Preliminary Engagement Activities

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 company’s 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 company’s 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 company’s 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 company’s 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 company’s liquidity.

Furthermore, the company invests heavily in its research and development activities that is why for the first few
years of the company’s 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 company’s 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 company’s 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

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 Far Eastern University
Institute of Accounts Business and Finance
Accountancy and Internal Auditing Department
ACT1202 Auditing and Assurance Principles
Case Study No. 1 – Preliminary Engagement Activities

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 company’s 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 company’s 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 fund’s investment in the company is minimal (less than 1% of the company’s 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 company’s financial statements for the past three years including the company’s 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 company’s financials and see if you can get any information from them.

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 Far Eastern University
Institute of Accounts Business and Finance
Accountancy and Internal Auditing Department
ACT1202 Auditing and Assurance Principles
Case Study No. 1 – Preliminary Engagement Activities

Central Energy Corporation

Balance Sheets
(In million Php)
31-Dec 31-Dec 31-Dec
2020 2019 2018
Cash 20.1 35.2 11.9
Investments 2.0 4.1 3.0
Receivables, net 211.0 549.0 174.4
Other assets 12.0 16.6 9.1
Current assets 245.1 604.9 198.4
Plant & equipment 152.0 149.1 156.0
Total assets 397.1 754.0 354.4

Payables 112.0 134.4 91.3

Short-term borrowings 5.5 4.0 10.0
Current liabilities 117.5 138.4 101.3
Long-term loans 8.8 7.3 5.3
Total liabilities 126.3 145.7 106.6
Equity 270.8 608.3 247.8
Total liabilities & equity 397.1 754.0 354.4

Profit or Loss
(In millions Php)
2020 2019 2018
Revenue 899.1 1,143.9 204.6
Cost of sales (594.2) (712.5) (122.1)
Gross profit 304.9 431.4 82.5
Expenses (248.5) (312.0) (44.3)
Profit before tax 56.4 119.4 38.2
Taxes (16.9) (35.8) (11.5)
Profit 39.5 83.6 26.7

Industry Ratios:

2020 2019
ROE (Profit / Equity) 20.0% 18.0%
ROA (Profit / Total Assets) 15.0% 16.0%
Receivable Turnover (Sales / Ave. Receivables) 4.3 5.2
Ave. collection period (360 / Receivable TO) 83.72 69.23
Debt ratio (Liabilities / Assets) 0.3 0.25
Current ratio (Current Assets / Current Liabilities) 1.15 2.11
Profit margin (Profit / Sales) 10.60% 12.40%

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 Far Eastern University
Institute of Accounts Business and Finance
Accountancy and Internal Auditing Department
ACT1202 Auditing and Assurance Principles
Case Study No. 1 – Preliminary Engagement Activities

Requirements:

1. What are the procedures that an auditor performs before accepting a client or continuing an engagement?
2. Using the company’s 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 company’s 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.

Submission guide:

Write your name, student number, and section.

Letter size (8.5” x 11”)

Font style: Calibri, Font size: 11
Single Spaced

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