Question

Summary:

In 2020, XYZ Co. has an existing loan in the amount of $1.5 million with an annual interest rate of 9.5%. The company provides an internal company prepared financial statement to the bank under the loan agreement.

Two competing banks have offered to replace XYZ’s existing loan agreement with a new one, starting 2021.

Sadaf Remo Bank has offered to loan XYZ $1.5 million at a rate of 8.5% but would require XYZ to provide financial statements that have been reviewed by an audit firm. Amaranth Bank has offered to loan XYZ $1.5 million at a rate of 7.5% but would require XYZ to provide financial statements that have been audited by an audit firm.

The controller of XYZ approached an audit firm, BRONX Partners, and was given an estimated cost of $12,000 to perform a review and $20,000 to perform an audit. The controller of XYZ approached another audit firm, Essen & Co. for an estimate. Essen & Co, has quoted $15,000 to perform a review, and $30,000 to perform an audit.

XYZ Co. has been audited by Essen & Co. for two years (2017-2019) under a senior auditor Linda. After numerous discussions and reminders from Linda, XYZ controller promised that the audit fee would be paid before the audit report for 2019 was issued. Linda called the partner at Essen & Co., Dr. Essen, to ensure that the audit report was not issued because XYZ had only paid 10% of the outstanding amount. She discovers that Dr. Essen is about to sign the audit report.  

REQUIRED:

Explain why the interest rate for the loan that requires a review report is lower than that for the loan that did not require a review. Explain why the interest rate for the loan that requires an audit report is lower than the interest rate for the other two loans.

Calculate XYZ’s annual costs under each loan agreement, including interest and costs for the audit firm's services. Indicate whether XYZ should keep its existing loan, accept the offer from Sadaf Remo Bank, or accept the offer from Amaranth Bank.

Explain why XYZ may desire to have an audit performed anyway, ignoring the potential reduction in interest costs.

Explain the ethical problem faced by Linda (and/or her audit firm) with XYZ. Why is it a problem? What can be done about it?

Answer 1

1) Reasons for Variances in interest Rates:

Interest rates of banks depends upon the risk of recovery. The more accurate information about the borrower reduces the risk of recovery, hence the lower the interest rate.

a) The interest rate for the loan that requires a review report is lower because a review lowers information risk. Lowering information risk benefits lenders because it reduces the possibility that the information used to approve the loan was inaccurate.

b) An audit is the examination of the financial reports for an entity in order to determine whether the information presented reflects the financial position of the entity at a given date. An audit aims to identify material misstatements in financial statements and includes, but is not limited to, misstatements resulting from fraud where reasonable suspicion exists. An audit provides a reasonable level of assurance in the form of a positive statement, such as ‘presents fairly’ or ‘presents a true and fair view’.

A review provides limited assurance rather than a reasonable amount of assurance, so in simple terms, a review reports on the plausibility of the financial statements. The opinion given would be in a form such as ‘we have not become aware of any matter’ that the statements are not in accordance with the required framework. A review involves less detail than an audit and involves more enquiry of management/staff and analytical review work rather than substantiating balances.

The interest rate for the loan that requires an audit report further lowers information risk which is why the rate is lower than the other two.

2) Calculation of Annual Costs

Existing Loan:

Annual Interest = $142,500 (1.5 million*9.5%)

Cost of CPA firm = $0

Annual Cost = $142,500

Sadaf Remo Bank (BRONX partners):

Annual Interest = $127,500 (1.5 million*8.5%)

Cost of audit firm= $12,000

Annual Cost = $139,500

Amarnath Bank (BRONX partners):

Annual Interest = $112,500 (1.5 million*7.5%)

Cost of audit firm = $20,000

Annual Cost = $132,500

The cost of review and audit, proposed by BRONX partners is less than Essen & Co. Therefore we have considered the cost of the audit firm per BRONX partners in calculating annual Cost.

Per the above calculations, XYZ Co. should accept the loan offer from Amarnath Bank as the annual cost is less than the other two options

3) Audit of financial statements

XYZ Co. may want an audit anyway to make sure the financial statements are accurate and to make sure that the business can repay the loan. XYZ Co. would not want the business to not be able to pay the loan due to poor management decisions or unexpected competition in the market. Also, audited financial statements provide assurance of financial information used for decision making. The audit may detect errors or fraud and provide management information about effectiveness of controls. In addition, the audit may result in recommendations to management that will improve efficiency or effectiveness.

4) Ethical Problems faced by Essen & Co.

In the event of unpaid audit fees, the audit firm had two options: it could conclude it was not independent and resign; or proceed to complete the audits.

In this case, the Essen & Co could have done a better job in communicating with the client. It appeared that the client did not fully appreciate how unpaid professional fees could be a threat to auditor independence, nor did the client fully appreciate how it could constitute unprofessional conduct if the audit firm were to complete the audit reports in the face of significant unpaid fees.

Where there are significant unpaid fees from prior year’s engagements, this decision suggests that audit firms should:

1. Arrange for payment of outstanding professional fees from prior year’s engagements, or make satisfactory arrangements for payment; and
2. Be clear to the XYZ Co. that the audit firm is prohibited from issuing audit reports where there are significant outstanding professional fees from a prior year.