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

STUDENT NO.: NAMES: Section: SEC 9 – GROUP 44

2019156201 ALMODOVAR, DANITA MAE O. Grade:
2019130601 ARIAS, ELIZABETH MILEN G.
2019166402 BOCO, SALBE MARIE D.
2019112591 PABLEO, JOSHUA A.
2019158611 REYES, AARON JOSH S.
2019155931 SANTOS, PATRCIA BIANCA A.

Requirements:

1. What are the procedures that an auditor performs before accepting a client or continuing an engagement?
1) Ask permission from the CFO of the company to communicate with the previous auditor to discuss the
company’s misunderstanding especially on the company’s policy in revenue recognition.
2) Assess the company’s background from the past years to see whether they are having difficulties or
ethical issues
3) Evaluate the integrity of management or the client
4) Analyze the competence to start performing the audit
5) Independence assessment (to be performed by the auditor)
6) Review or have an analysis on the company’s financial assessment to have knowledge and acknowledge
the company and the client.

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.
With the financial information presented in the company’s financial statements, the relevant ratios were
calculated. Based on the company’s financial information, these are the company ratios that will be significant in
obtaining a better understanding of the prospective client and determining how the company is doing financially.

Company Ratios: Industry Ratios:

2020 2019 2020 2019
ROE 9.0% 19.53% ROE 20.0% 18.0%
ROA 6.86% 15.08% ROA 15% 16%
Receivable Receivable
Turnover 2.37 3.16 Turnover 4.3 5.2
Ave. collection Ave. collection
period 152.15 113.83 period 83.72 69.23
Debt ratio 0.32 0.19 Debt ratio 0.3 0.25
Current ratio 2.09 4.37 Current ratio 1.15 2.11
Profit margin 4.39% 7.31% Profit margin 10.60% 12.40%
 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

The ratio of net profit to total owner’s equity or the company’s return on equity (ROE) measures the
return on the investment of the firm. The calculated return on equity (ROE) ratio on the company in the prior year
is 19.53% that is generally higher than the industry thereof with the ratio of 18.0%. However, the company’s
return on equity (ROE) ratio declined to the ratio of 9.0% on the subsequent year and this caused the significant
difference between the company’s calculated return on equity (ROE) ratio and the industry’s standard for the
return on equity (ROE) ratio of 20.0%.
The ratio of net profit to total assets or the company’s return on assets (ROA) ratio measures the
profitability of the firm in terms of generating profit with its total assets. The computed return on assets (ROA)
ratio of 15.08% from the previous year is approximately identical with the industry’s standard for the return on
assets (ROA) ratio of 16%. However, the company’s return on assets (ROA) ratio significantly decreased to the
ratio of 6.86% on the succeeding year that causes the significant difference between the company’s calculated
return on assets (ROA) ratio and the industry’s standard for the return on assets (ROA) ratio of 15%.
The receivable turnover ratio measures the firm’s efficiency in collecting receivables from their clients.
The calculated receivable turnover ratios on the company from the prior (3.16) and succeeding year (2.37) is
comparatively lower than the industry’s standard for the receivable turnover ratios of 4.3 from the prior year and
5.2 in the subsequent year. Although the company’s receivable turnover ratios decreased in the subsequent years,
the company’s receivable turnover ratio compared with the industry’s standard for the receivable turnover ratio
would still be considered sustainable.
The average collection period of the firm refers to the average number of days that the firm receives
payment from the firm’s receivables. The average collection period ratio measures the firm’s efficiency in
collecting the firm’s receivables. The calculated average collection period of the company’s prior (113.83) and
succeeding year (152.15) is significantly higher than the industry thereof. These ratios signify that the average
number of days for the company to collect the company’s receivables is greater than the industry’s standard
average collection period of 69.23 from the prior year and 83.72 in the succeeding year. Thus, it takes the company
a longer amount of time to collect the company’s receivables than the industry’s standard average collection
period.
The debt ratio or the ratio of total liabilities to total assets measures the proportion of the company’s
assets that are financed with debt. The calculated debt ratio on the company’s previous year of 0.19 is
comparatively lower than the industry’s standard for the debt ratio of 0.25. This signifies that the company is not
highly leveraged. Thus, it has fewer financial risks. Although the company’s debt ratio increased on its subsequent
year, the company’s debt ratio on the succeeding year does not have a significant difference with the industry’s
ratio of 0.32 since the company’s ratio is approximately identical with the industry’s standard for the debt ratio
of 0.3. Thus, it can be inferred that the company’s assets are mostly financed with the company’s equity.
The current ratio or the ratio of total current assets to total current liabilities measures the firm’s ability
to pay its current liabilities with its current assets. The calculated current ratio on the company in the previous
year of 4.37 is comparatively higher than the company’s current ratio of 2.09 in the succeeding year due to the
decline of the company’s current assets. Although the company’s current ratio decreased in the succeeding year,
the company’s current ratios are significantly higher than the industry’s standard for the current ratio of 1.15 and
2.11 for the prior year. This signifies the company’s ability to pay its short-term liabilities with the company’s
current assets.
And lastly, the profit margin ratio or the ratio of net profit to net sales measures the percentage of net
profit generated from revenue. The calculated receivable turnover ratio on the company from the prior (7.31%)
and succeeding year (4.39%) is comparatively lower than the industry’s standard for the profit margin ratio of
12.40% from the prior year and 10.60% in the subsequent year. The computed profit margin ratio on the company
of 4.39% is comparatively lower than the company’s profit margin ratio of 7.31% from the previous year due to
 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

the decrease in net profit on the succeeding year. Thus, causing the significant difference between the company’s
calculated profit margin ratios and the industry’s standard for the profit margin ratios.

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?
One of the responsibilities of a professional accountant in public practice must do before accepting an
engagement is to evaluate any significant issues or threats associated with the potential client that may affect
with the CPA’s compliance with the fundamental principle of professional ethics. The auditor should influence his
decision of acceptance from the gathered detailed information based on the client’s previous financial reports,
business integrity and reputation, management and financial plans, and information from the previous auditor.
Aside from that, it is also a must that the auditor is skillful, knowledgeable, and competent enough for that
assurance engagement.

In accordance with the information obtained, these are the details of Central Energy Corporation (CEC) that should
be carefully considered or not to be neglected:
First, CEC’s securities are not yet listed in any securities market; however, they are planning to acquire a
long-term loan to finance some of its on-going projects. This move/plan would bring so much growth for the
corporation if it is a huge success especially that they are aiming for attracting more clients. Meanwhile, for
auditors, this plan would force them to increase the risk set to the client.
Second, the nature of CEC. CEC’s type of industry, renewable energy sector, provide solution to our
growing problems related to climate change. Its nature requires huge investment without guarantee of successful
income. As stated by the previous auditor, CEC is too complex as a business. This type of sector, is quite new to
Ritz & Co.. Most of the firm’s client are in the manufacturing and financial services industry. In contrast to what
the firm management feels, the auditor should still consider the unfamiliarity of this sector and the possibility of
might not be an excellent opportunity as an introductory client for this type of market.
Third, a contract worth 10% of corporation’s revenue expired and was not renewed. CEC’s customer base
is small composing huge contract amount since they provide service to various big names in the energy sector.
Thus, this 10% revenue loss will significantly affect the corporation. It will also greatly affect its liquidity since it is
tied upon its ability to collect from the receivables arising from the contracts.
Fourth, applying for a P100 million loan from the financial institutions. Although, CEC have a great loss of
revenue just from a single contract, still, the management is optimistic that they can replace it and secure more
contracts in the future. To set up a good attraction for clients, the P100 million loan will be used for research and
development. CEC also plans on using it for securing those on-going contracts are provided good service by
ensuring smooth operations.
Fifth, the corporation’s use of highly sophisticated computerized accounting system. The risk related with
this manner is the auditor’s more likely to have a misstatement because of its complexity and unfamiliarity.
Sixth, the hesitation at first of the CFO to give permission to communicate with the previous auditor.
When asked for permission to discuss with their previous auditor for further information, the company CFO had
a reservation due to the reason that they had disagreements. This simple hesitation of CFO could rise serious
question such as CEC's willingness for cooperation and openness with its information which could lead doubts for
the corporation and have a reputation of having a questionable integrity.
 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

Seventh, legal and ethical issues of the corporation. CEC has a history of losing a case against the Bureau
of Internal Revenue (BIR). It was being subjected for audit by BIR which resulted to findings that they were
declaring over expenses to lower taxable profits. The corporation was compelled to pay several millions in taxes,
penalties, and surcharges. From then, CEC regularly receive letters of audit each year. Though the case is already
in the past, the fact that the previous auditor and CEC had a disagreement relating to accounting treatment of
revenue, the suspicion of something might wrong with financial reporting process should not be simply
overthrown and, of course, the possibility of encountering fraud risk relating to misstatements. Aside from that,
the CFO admitted using “recreational drugs” which are not legally allowed in the country.
Eighth, independence issues. One of the firm’s partners in Manila has shares in a fund that has an equity
investment with CEC, though the amount of the fund’s investment is only less than 1% of the company’s entire
capitalization. Aside from that, personally, my nephew is having internship with the corporation’s engineering
department. A risk of conflict of interest should be considered.
The details mentioned above should be used as a crucial measurement of risk and capacity of the auditor
in deciding whether to accept the CEC as a client. If these circumstances are not too much threat for the
practitioner’s compliance with code of ethics, then engagement acceptance is a no problem.

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?

PROS

- Accuracy of data in terms of tax returns or tax management

- Saves times by letting the auditors deal with the taxes
- Provides risk-free services because the auditors will be the one to prepare the statements
- Getting expert advice in terms of handling compound problems and foreseeing queries related to tax
- Hassle-free in organizing documents because auditors are always furnishing their works
- Reduced errors when it comes to computing since auditors are professionals and have deep knowledge
about transactions

CONS

- Auditors may encounter difficulties since the company had already changed their auditors many times
and they have a BIR report that they were over declaring expenses and therefore resulting to lower
taxable profits
- Some auditors may have biased audits due to the company’s threat that they will change firms if they
don’t get their desired numbers in audit reports
- Auditor’s independence will be tested in here because they may have their personal interest against the
company
- When an auditor input erroneous data, this may affect the company’s decision and can lead in losing the
credibility to both sides

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 with Code of Ethics for Professional
Accountants in the Philippines?
According to the Code of Ethics for Professional Accountants in the Philippines, Section 290.112, if the firm or
a member of the audit team, or a member of that individual's immediate family, has a financial interest in an
 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

entity and the audit client likewise has a financial interest in that entity, a self-interest risk may arise. However,
independence is not seen to be compromised if these interests are immaterial and the audit client has no
significant influence over the other entity. One of the examples of circumstances that create self-interest threats
for a professional accountant in public practice is when a member of the assurance team has a direct financial
interest in the assurance client, stated in Section 200.4. Furthermore, in Section 290.104, if a member of the audit
team, a member of that individual's immediate family, or a firm has a direct or major indirect financial interest in
the audit client, the self-interest threat presented will be so high that no measures will be able to mitigate it. As a
result, neither a member of the audit team nor a member of that individual's immediate family, nor the firm, shall
have a direct or material indirect financial interest in the client. The situation wherein the partner of the firm has
an investment in a fund that has an equity to the potential client would not constitute a violation of independence.
It is because the investment made was not directly to the company but to the fund that has an equity to the
company. And it was also stated that the investment is only less than 1% of the company’s entire capitalization
which makes the value immaterial.

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.
MEMORANDUM
TO: Earl C. Santos
FROM: Aaron Josh S. Reyes
DATE: September 10, 2020

SUBJECT: Client Acceptance Recommendation, Central Energy Corporation

Central Energy Corporation, a company that is engaged in operations and management services related to
alternative energy and sustainable energy operations, is our prospective client. Before CEC’s request was
accepted, appropriate information is gathered and evaluated as basis for deciding to continue servicing Central
Energy Corporation. The purpose of audit engagement is to minimize the possibility of significant misstatements
that has not been detected by previous auditing firm(s).
The following analysis of the Central Energy Corporation goes over the following: Industry, management, internal
controls, information acquired from the previous auditor. The following information states the strengths and
weaknesses of Central Energy Corporation.
Strengths:
• Central Energy Corporation is known for their alternative energy and sustainable energy operations such as:
hydroelectric power, wind power, solar power generation, manufacture distribution, and sale of alternative fuels.
Despite the huge investments required in the industry, Central Energy Corporation attracted some funds from a
venture capital funds as several investors around the world take an interesting look in the industry.
• The company has been used to using their computerized accounting system for several years that is integrated
into the company’s operations such as marketing, payroll, and even in production.
• As reflected in Return on Equity, it shows that the management may be making efficient decisions on reinvesting
its capital in productive assets and the profits earned based on the owner’s investment is somewhat managed.
 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

Financial Weaknesses and Nonfinancial Weaknesses

• The company provides services to big name companies in the energy sector. However, in 2020, a major contract
with its biggest client that accounts for 10% of the company’s revenue declined and did not renew its contract
with Central Energy Corporation.
• The revenue recognition policy of the company is quite complex with the reason of the company’s industry.
Central Energy Corporation is highly dependent on its small comprising clients with huge contract amount. The
company’s liquidity is relying on the receivables arising from those contracts. Unfortunately, when a project is
declined, contracts were finished, or an unforeseen event occurs, the company will suffer a huge lost because of
its small base contracts.
• Receivable turnover shows that the company may have delay on their receivables being paid. This also shows
that the company’s AR turnover ratio is not being met with the objectives of the firm.
• Debt ratio of the company shows that it has affected the firm negatively because of its loan interest. The
company may drown itself by continuously getting huge loans that aren’t necessary.
Although the company’s industry is unique to the firm, it is required to avoid the unnecessary risk such
as: unbillable time, unpaid fees, additional stress on members of the engagement team, loss of reputation, or a
potential lawsuit. According to their financial reports: In the year 2019 the company had accumulated ₱83.6
million in profit. However, their profit significantly decreases in the year 2020.
The auditor also stated that the company had disagreements in the past specifically with regards to the
company’s policy in revenue recognition. Lastly, the corporation was involved with illegal and ethical issues which
played a huge role in this investigation and research. In conclusion, I do not recommend Ritz & Co., CPAs, accept
Central Energy Corporation as a client.

Looking forward to your reply,

Sincerely,
Aaron Josh S. Reyes
Junior Manager

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.
MEMORANDUM
TO: Mr. Earl C. Santos
FROM: Ritz & CO., CPAs
DATE: September 7, 2021
SUBJECT: Auditing Risk Factors of Central Energy Corporation
Central Energy Corporation is a corporation that is engaged in operation and management services related to
alternative energy and sustainable energy operations. The study of Central Energy Corporation was conducted to
overview its background and history, industry management, and accounting financial reporting. During the
evaluation of Central Energy Corp, we recognized three potential risks. The following is the three risk that we
recognized:
 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

Conflict of Interest
In the previous assessment of the background and history of the corporation, we found that the nephew of one
of the partners of the organization is having an internship in the engineering department of the corporation. This
may affect the companies Code of Ethics and Business Conduct and the Student’s Academic Integrity and Ethics.
To disclose this kind of issue, the involved parties should file a conflict-of-interest disclosure to ensure that the
student who is having an internship in the corporation is just them to learn the actual working environment. Not
for the benefit of the involved partners and his/her nephew.
Compliance in BIR
After checking the client's background, it revealed that the firm was audited by the Bureau of Internal Revenue
(BIR), and the finding is the corporation is declaring an over the expense to have a lower taxable profit. This type
of practice can hinder the Ritz & Co., CPAs to audit the firm’s financial statement because of the Code and Ethics
for the Professional Accountants in the Philippines. This problem can resolve by requesting a financial report to
the BIR and see if the firms still have a problem.

Management Use of Recreational Drugs

Another risk that is identified is the current chief executive officer is using “recreational drugs” to handle the
pressure, but this could hinder the analysis of our team if we ask him about the company’s previous run at such a
moment in time. Furthermore, the use of “recreational drugs” can affect his way of thinking on giving a command
to his employees and his judgment to the firm’s financial problems.
Overviewing the background, history, industry management, and accounting financial reporting of the Central
Energy Corporation helps us to learn and to be exposed to a new industry. However, because of the risk that we
found in overviewing the client's previous run, the Ritz & CO., CPAs agreed not to acknowledge the deal for us to
become fair in our organization's integrity and ethics.

References:
IESBA. (2019, September 30). Revised Code of Ethics - Completed. Retrieved from
https://www.ethicsboard.org/projects/revised-code-ethics-completed

Ireneo, J. M., Ireneo, S. C., & James, G. R. (2018). Audit Assurance Principle. Good Dreams Publishing.

Kchohan. (2021, January 08). Top 8 Genuine Benefits of Tax Preparation Services for your Organization. Retrieved from
https://togethercfo.com/blog/benefits-of-tax-preparation-for-business/

Vale, S. (2017, November 21). The Disadvantages of Audit & Consulting Services on the Same Client. Retrieved from
https://smallbusiness.chron.com/disadvantages-audit-consulting-services-same-client-73857.html

Word_User. (2014, January 14). CODE OF ETHICS AND BUSINESS CONDUCT. Retrieved from
https://www.sec.gov/Archives/edgar/data/1506439/000155335014000031/smtp_ex14z1.htm