Question

Dynamic Corporation has an existing loan in the amount of 10 million with an annual interest rate of 5.5%. The company provides an internal company-prepared financial statement to the bank under the loan agreement. Two competing banks have offered to replace  Corporation's existing loan agreement with a new one.  Money Tree Bank has offered to loan Dynamic $10 million at a rate of 4.4% but requires Dynamic to provide financial statements that have been reviewed by a CPA firm.  Credit One Bank has offered to $10 million at a rate of 3.3% but requires Dynamic to provide financial statements that have been audited by a CPA firm. Dynamic Corporation's controller approached a CPA firm and was given an estimated cost of $34,000 to perform a review and $69,000 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. 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 Dynamic Corporation's annual costs under each loan agreement, including interest and costs for the CPA firm's services. Indicate whether Dynamic should keep its existing loan, accept the offer from  Money   Tree Bank, or accept the offer from Credit   One Bank.

c. Assume that Money Tree Bank has offered the loan at a rate of 4.4% with a review, and the cost of the audit has increased to   $129,000 due to new auditing standards requirements. Indicate whether Dynamic should keep its existing loan, accept the offer from Money Tree   Bank, or accept the offer from Credit   One Bank.

d. Discuss why Dynamic 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

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

 

The interest rate for the loan that requires a review report is lower than the loan that does not require a review because of the lower information risk. A review report provides moderate assurance to financial statement users. Compared to a review report, an audit provides further assurance and thus lower information risk. As a result, the interest rate is lowest for the loan with the audit report.

Requirement b. Calculate Dynamic Corporation's annual costs under each loan agreement, including interest and costs for the CPA firm's services. Indicate whether Dynamic should keep its existing loan, accept the offer from Money Tree Bank, or accept the offer from Credit One Bank.

Begin by calculating the annual costs under each loan agreement. (Complete all input fields. Enter a "0" for any zero balances.)

 

 

Lender	Cost of CPA Services	Annual Interest	Annual Loan Cost (CPA services + annual interest)
Existing loan (No CPA service)	$0	$440,000 (8 million x 5.5%)	$440,000
Money Tree Bank (CPA Review service)	$34,000 given	$352,000 (8 million x 4.4%)	$386,000
Credit One Bank (CPA Audit service)	$69,000 given	$264,000 (8 million x 3.3%)	$333,000

Requirement c. Assume that Money Tree Bank has offered the loan at a rate of 4.4% with a review, and the cost of the audit has increased to $129,000 due to new auditing standards requirements. Indicate whether Dynamic should keep its existing loan, accept the offer from Money Tree Bank, or accept the offer from Credit One Bank. Begin by calculating the annual costs under each loan agreement. (Complete all input fields. Enter a "0" for any zero balances.)

Lender	Cost of CPA Services	Annual Interest	Annual Loan Cost (CPA services + annual interest)
Existing loan (No CPA service)	$0	$440,000 (8 million x 5.5%)	$440,000
Money Tree Bank (CPA Review service)	$34,000 given	$352,000 (8 million x             4.4%)	$386,000
Credit One Bank (CPA Audit service)	$129,000 given	$264,000 (8 million x 3.3%)	$393,000

 

Indicate whether Dynamic should keep its existing loan, accept the offer from Money Tree Bank, or accept the offer from Credit One Bank.

Based on the analysis in the preceding step, Dynamic should accept the offer from Money Tree Bank.

 

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

Dynamic may desire to have an audit because of the many other benefits that an audit provides (discovery of errors/fraud, suggestions of improved efficiency/effectiveness, etc.).

 

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

Possessing a strategic understanding of the client's business will help the auditor identify risks that may affect whether the financial statements are fairly stated and ways to help the client improve operations