Question

Busch Corporation has an existing loan in the amount of $6 million with an annual interest rate of 6.0%. The company provides an internal company-prepared financial statement to the bank under the loan agreement. Two competing banks have offered to replace Busch Corporation’s existing loan agreement with a new one. United National Bank has offered to loan Busch $6 million at a rate of 5.0% but requires Busch to provide financial statements that have been reviewed by a CPA firm. First City Bank has offered to loan Busch $6 million at a rate of 4.0% but requires Busch to provide finan- cial statements that have been audited by a CPA firm. Busch Corporation’s controller approached a CPA firm and was given an estimated cost of $35,000 to perform a review and $60,000 to perform an audit. a. Explain why the interest rate for the loan that requires a review report is lower than that for the loan that does not require a review.

QUESTIONS

A.Explain why the interest rate for the loan that requires an audit report is lower than the interest rate for the other two loans.

b. Calculate Busch Corporation’s annual costs under each loan agreement, including in- terest and costs for the CPA firm’s services. Indicate whether Busch should keep its existing loan, accept the offer from United National Bank, or accept the offer from First City Bank.

c. Assume that United National Bank has offered the loan at a rate of 4.5% with a re- view, and the cost of the audit has increased to $80,000 due to new auditing standards requirements. Indicate whether Busch should keep its existing loan, accept the offer from United National Bank, or accept the offer from First City Bank.

d. Discuss why Busch may desire to have an audit, ignoring the potential reduction in interest costs.

e. Explain how a strategic understanding of the client’s business may increase the value of the audit service.

Answer 1

Part a)

An audit involves review and verification of data/information provided by the company in its financial statements. An audit report can be treated as a certification by an independent entity (CPA firm) of the information contained in the financial statements of the company. An accurate audit report would indicate the company's financial ability to repay its loans/debts which is of prime importance to any lending institution. It reduces the information risk for the users of financial statements and makes it easier for the lender/bank/financial institution to extend loan to the company on better terms and conditions (such as lower interest rate) because of lower default/credit risk associated with the company. It is because of this lower information and credit/default risk (for a given company) that the loan gets extended at a lower interest rate.

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Part b)

The value of annual cost under each agreement is determined as below:

	Existing Loan	United National Bank	First City Bank
Annual Interest	360,000 (6,000,000*6%)	300,000 (6,000,000*5%)	240,000 (6,000,000*4%)
CPA Firm Costs	0	35,000 (Cost of Review)	60,000 (Cost of Audit)
Total Annual Costs	$360,000	$335,000	$300,000

Based on the above calculations, we can conclude that the Busch Corporation should accept the offer from First City Bank as it results in the lowest total annual costs (of $300,000) for the company.

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Part c)

The value of annual cost under each agreement is arrived as follows:

	Existing Loan	United National Bank	First City Bank
Annual Interest	360,000 (6,000,000*6%)	270,000 (6,000,000*4.5%)	240,000 (6,000,000*4%)
CPA Firm Costs	0	35,000 (Cost of Review)	80,000 (Increased Cost of Audit)
Total Annual Costs	$360,000	$305,000	$320,000

Based on the above calculations, we can conclude that the Busch Corporation should accept the offer from United National Bank as it results in the lowest total annual costs (of $305,000) for the company.

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Part d)

Audited financial statements are used by various stakeholders (such as investors, creditors, employees, etc.) to evaluate the financial stability of the company. Audit provides assurance to such users that the company's financial statements are free from any kind of defects, are accurate and in compliance with applicable accounting rules and regulations, thereby, helping in evaluating the creditworthiness of the company. Audit also helps in identifying frauds that may have taken place during the relevant year. Because of these benefits, Busch may desire to have an audit.

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Part e)

It is essential to understand the business of the client before providing any type of audit service. A strategic understanding of the client’s business will help the auditor in evaluating other risks (such as business risks) besides the financial risks that may be impacting the organization. Additionally, the auditor will be in much better position to identify areas/opportunities for improvement, thereby, providing additional value to the client in the form of reduced costs or removal/modification of non-value adding activities and so on.