FAR EASTERN UNIVERSITY

INSTITUTE OF ACCOUNTS BUSINESS AND FINANCE

ACT1202 – Auditing and Assurance Principles

Case Study No. 1 Answer Sheet

Name: Section: 1
Student No.: Grade:

1. What are the procedures that an auditor performs before accepting a client or continuing an engagement?

According to the ISA 210, auditors should only accept the new client and continue the existing engagement if the
precondition for an audit that is required by ISA 210 is present. This precondition includes that the auditor should
determine if the financial reporting framework applied to the firm's financial statements is appropriate and if the
agreement of the management acknowledges and understands its responsibilities. If the preconditions are not
present, the auditor should explain unacceptance before the auditor accepts the new client. The auditor should do
some procedures:

 The auditor should ask the client to contact the outgoing auditor to ask permission to have a new auditor; if
the new client refuses to contact the auditor should reject the role.

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 Contact the outgoing auditor and ask why they should not accept the role. If there is no reply, it is required
to contact the outgoing auditor in other means of contacting to determine if the new auditor will accept the

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role.
 Ensure that the firm has met all requirements in removing the outgoing auditor and having a new auditor to

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ensure that the firm's new auditor is legal and in the right process.
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Check out for the necessary auditing sources like financial statements and carry out checks that will ensure
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that the firm can be independent.
 Have an assessment if accepting the new client is low risk for the auditor; if it is a high risk, then refuse the
role.
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 It is also essential to assess the integrity of the firm's management.

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 An engagement letter shall be sent to the auditor before the audit.

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The engagement letter is important because it includes the ISA 210 Agreeing the Terms of Audit Engagement
which includes the objective and scope of the audit, responsibilities of the auditor, responsibilities of the
management, identification of the applicable financial framework and expected form and contents of any reports to
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be issued. The engagement letter will also serve as a reference to the auditor in accepting the role.
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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
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industry ratios and identify any significant differences.

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Company Ratios: 2020 2019 Industry Ratios 2020 2019

Return on Equity 8.99% 19.53% Return on Equity 20.00% 18.00%
Return on Assets 6.86% 15.08% Return on Assets 15.00% 16.00%
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Receivables Turnover 2.37 3.16 Receivables Turnover 4.3 5.2

Ave. Collection Turnover 151.90 113.92 Ave. Collection Turnover 83.72 69.23
Debt Ratio 0.32 0.19 Debt Ratio 0.30 0.25
Current Ratio 2.09 4.37 Current Ratio 1.15 2.11
Profit Margin 4.39% 7.30% Profit Margin 10.60% 12.40%

 On company ratios, there is a large decline on the return on equity from 19.53% on 2019 to only 8.99% on
the year 2020. This also goes for return on assets. On the other hand, the return of equity on the industry
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 FAR EASTERN UNIVERSITY
INSTITUTE OF ACCOUNTS BUSINESS AND FINANCE
ACT1202 – Auditing and Assurance Principles

Case Study No. 1 Answer Sheet

ratios, it shows that return on equity has increased by 2% while return on assets decreased by 1%.
Comparing the two, in general, the industry’s return on asset and equity is significantly greater than the
company’s ratios.
 The company and industry’s receivables turnover has become significantly shorter which is a good sign for
both parties however it seems that the company’s turnover is still shorter that the industry’s which means
receivables become cash faster. While receivables turnover have become shorter, average collection
turnover has become longer for both company and industry.
 Moving on to debt ratio, the financial information presented shows that the industry has lesser liabilities
during 2019 than 2020 and inn comparison to company’s 0.19 in 2019 and increasing to 0.32. Alongside with
the decrease in current ratio for both company and industry. This is an implication that both are incurring
more liabilities and their ability to pay short term debts have decreased.
 Lastly, both company and industry have decreased their profits over the span of one year with the industry
earning more than the company.

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3. What other information should be considered before accepting CEC as a client? How important are these issues to

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the client acceptance decisions and why?

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The Central Energy Corporation wants their financial statements audited because they want to take a significant
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amount of loan from a leading financial institution. Hence, there are some issues that needs to be given attention
and a much deeper understanding before deciding to accept CEC as a client. According to the CEC’s background, in
the field that they are currently in, which is the renewable energy sector, huge investments are needed but there are
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no guarantee of a successful outcome, this should be noted because they are aiming to apply for a significant
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amount of loan whereas financial institutions check whether the companies applying for one has the ability to pay
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them back. So, information regarding their plans in paying such a loan and their expected profit in the future should
be provided for additional evidence. Also, the major contract with their biggest client that ended where the client
did not want to renew the contract needs to be investigated further as to what was the reason behind that lead
them to say that they no longer want to renew the contract. Since, there can be some illegal and unethical practices
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happening inside the company that the big client didn’t like other than the openly use of recreational drugs by the
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CEO of CEC, Mr. Sean Baker. On the other hand, these illegal and unethical practices can lead to the ruin of CEC and
in turn, a huge loss for the financial institution who will grant them a loan.
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Another issue is an issue of auditor independence, Mr. Simon Collins is acquainted with me even though we
didn’t interact much, we still share a past. Also, a partner in our Manila office has shares in a fund that has an equity
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investment with CEC although the amount is minimal, we still need to double check whether this amount is material
for them or not, as they are a valued partner of us, this can affect our decision in accepting CEC as a client. In
addition, my nephew is having his internship in the engineering department of CEC so if the audit resulted with a
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negative conclusion, it might backfire to the career of my nephew which is why there is a possibility that there will no
longer be independence to speak of as the forming of conclusion might turn biased due to the factors mentioned
above.

Next is the issue with their past auditor, practitioners should never perform assurance engagements that the
skills and knowledge they currently have will not satisfy or those that are beyond what they absolutely understand.
Thus, despite the disagreements and confusion, it is questionable as to why their past auditor still issued an
unqualified opinion which means this opinion is unreliable and cannot be used as an evidence. And, this is where I
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 FAR EASTERN UNIVERSITY
INSTITUTE OF ACCOUNTS BUSINESS AND FINANCE
ACT1202 – Auditing and Assurance Principles

Case Study No. 1 Answer Sheet

should also ponder carefully whether I understand their company in a deep manner to be qualified to perform an
assurance service. Lastly, knowing that they were confirmed by the BIR to over declaring their expenses to lower
taxable profits, it is important that a thorough investigation before forming a conclusion be done, but they are
requiring me to expedite the acceptance decision which I think cannot be done as they are the one who mentioned
that the business they are engaged to is overwhelmingly complex. Hence, everything should be done with the
utmost care and caution since it involves a significant amount of money and the livelihood of many people.

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?

The pros of being able to offer tax services to the same business you audited will analyze whether the company
is able to apply by compliance or payments for any tax deduction that could decrease by the other accounting
standards. Compared to ordinary auditing of a financial statement, delivering this service often constitutes another

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tax, making the same job cost more due to the use of the same data you assessed for two types of jobs.

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The cons of providing the company with this service is that if one person does not have the two skills needed by

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the job, you will need separate people to audit and provide the company with tax services. If they lack the

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manpower or do not have anyone capable of providing it, this circumstance will cause additional costs for the

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company.
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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?
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Independence in auditing refers to the act of taking an impartial route in viewing financial records: in the
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performance of examining the records and in the preparation of creating a financial report. Accordingly, the
opinions given by the auditors should be upright and unbiased simply because these accounts and reports are
going to determine the financial position of the company that will be useful to potential shareholders. Moreover,
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if these financial statements are created in a subjective manner, the certified public accountant (CPA) will lose
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their credibility by being dependent on the relationship they have with the client they are working for. As it is
necessary for CPAs to be unbiased, it is also pivotal that they are critical when giving a report as this a simple
mistake could eventually lead to a disaster that may put their profession at risk, making their work impractical to
those who depend on them.
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In the provided situation, a firm conducted an independence review on the personnel of the company
before assigning to an assurance engagement. With the details given, it has been noted that a partner from the
Manila office has an existing share of equity investment in the Central Energy Corporation, the client in this case,
but the share is not more than 1% of the entire capitalization of the company and the question for this situation
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is, does it violate independence? Unfortunately, yes. According to the Code of Ethics for Professional
Accountants in the Philippines, it is a requirement in independence of auditing that for financial statements audit
or review engagements, the members of the assurance teams, the firm and network firms are required to be
independent of the audit client. Furthermore, when it comes to financial interest it is necessary to consider the
type of financial interest and its materiality. Hence, the aforementioned financial interest refers to a direct
financial interest wherein it violated the independence of auditing regardless if it is material or immaterial.
Consequently, this violates the independence that the Code of Ethics for Professional Accountants in the
Philippines embodies despite the amount of the investment being in the minimal range.
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 FAR EASTERN UNIVERSITY
INSTITUTE OF ACCOUNTS BUSINESS AND FINANCE
ACT1202 – Auditing and Assurance Principles

Case Study No. 1 Answer Sheet

6. Prepare a memo to the partner making a recommendation as to whether the firm should or should not accept
Central Energy Corporation, as an audit client. Justify your position in light of the information in the case.

Memorandum for Recommendation:

Ritz & Co., CPAs
Audit and Consulting

TO: The Partner

FROM:

DATE: February 13, 2021

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RE: Accept Central Energy Corporation as a new Audit Client

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This memorandum asks for your recommendation if Ritz & Co. CPAs will accept Central Energy Corporation as
the new client.
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The Central Energy Corporation is requesting assistance and advice in auditing their financial statements to have
an opinion on its financial statement date December 31, 2020, and considering availing our tax services.
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Consideration of reasons for acceptance:

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 It would allow entry into a new market.

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 The CEC has a good reputation in its business field.

 It will expand the clients of Ritz & Co., CPAs.
 The company will have financial support to expand.
 It can help CEC to correct its error before.
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Consideration of reasons against acceptance:

 It may damage the company’s control over its core audit.
 The company need to prepare a strong strategy not to damage its goodwill
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 It is revealed that it is over declaring expenses and lower taxable profits.

 There are unaudited financial statements in the past years.
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 The company refuses to contact the outgoing auditor.

I am inclined to disprove the Central Energy Corporation as a potential client. Even though the imminent client
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industry is unique to the firm, the danger essentially exceeds the likely expense. As indicated by their money
related reports, we can get some data: In the year 2019, the organization had collected Php 83.6 million in
benefit and demonstrated a monstrous diminishing in the year 2020. Ultimately, the organization was associated
with a few legitimate and moral issues that assumed a function in this examination and exploration.

Looking forward to your reply.

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 FAR EASTERN UNIVERSITY
INSTITUTE OF ACCOUNTS BUSINESS AND FINANCE
ACT1202 – Auditing and Assurance Principles

Case Study No. 1 Answer Sheet

Sincerely,

Junior Manager,
Ritz & Co., CPAs

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

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Ritz & Co., CPAs

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Audit and Consulting

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TO: The Partner

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FROM:
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DATE: February 13, 2021

Subject : Important factor and risk areas for conducting the audit
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The firm had studied Central Energy Corporation’s background and history, industry management, accounting
procedures and controls systems, a management background check, along with the feedback of its previous
auditor. During the analysis of CEC, it identified six potential risk factors that Ritz & Co. shall consider prior to
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bring CEC on as a client. The risks associated with it are:

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 Due to the insufficient internal control structure of the CEC, monitoring and identifying transactions and the
possibility of material mistakes would be difficult. Risk of material misstatement is high in cost accumulation
and inventory tracking, payroll deduction, receivable billing and aging, payable balance, and balance sheet
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account classifications. The corporation has been switched auditors because they had problems agreeing on
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auditing fees.
 Audit findings must be brought to the attention of the client with due care before issuing an audit report.
The previous auditor had major problems with the company’s system and management that aggressively
reflect year-end accruals and revenues to meet creditor requirements.
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 Our company will have a challenge exercising professional skepticism and its management if questionable
accounting practices are found and they are not acknowledging the failures. This has the potential to cause
engagement complications.
 The previous auditor disclosed that there were disputes with the organization about the accounting
treatment of profits. The business also has this practice of recording different provisions to predict potential
losses for the future. However, the auditor agreed that the business of the company is too difficult, and they
have never handled similar business before.

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 FAR EASTERN UNIVERSITY
INSTITUTE OF ACCOUNTS BUSINESS AND FINANCE
ACT1202 – Auditing and Assurance Principles

Case Study No. 1 Answer Sheet

Looking at the past record of Central Energy Corporation with its previous audit service provider partnership, a
dispute about the audit fees was undermined by the conclusion of something that broke the relationship. Also
looking at the brand value of the past few years that the company’s chief officer was known a supporter of
“recreational drugs” and admitted to it.

Unfortunately, in my opinion, Ritz & Co. should not accept Central Energy Corporation as a client because the
risks associated with the company could ultimately harm our firm. These potential risks and issues can be
addressed by the firm by focusing on internal control over financial reporting, professional skepticism and
engaging in quality review.

Thanks for considering our firm.

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Sincerely,

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Arianne Garcia

Junior Manager,
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Ritz & Co., CPAs

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