INSTRUCTIONAL NOTES - & Systems Tool: An Integrated Practice Set Four...

Comprehensive Assurance

& Systems Tool: An

Integrated Practice Set Fourth Edition Laura R. Ingraham J.Gregory Jenkins Solutions Manual for Assurance Module 1 / 4

Copyright © 2019 Pearson Education, Inc.Assurance - 1

INSTRUCTIONAL NOTES

CLIENT ACCEPTANCE:

The Winery at Chateau Americana

INSTRUCTIONAL OBJECTIVES

Understand types of information used to evaluate a prospective audit client Evaluate background information about an entity and key members of management Brainstorm relevant financial and non-financial factors related to client acceptance Perform and evaluate preliminary analytical procedures Make and justify a client acceptance decision Describe matters that should be included in an engagement letter

KEY FACTS

Chateau Americana (CA) is a family-owned winery that is currently considering whether to hire a new public accounting firm.Current year sales - $21,945,000; net income - $1,997,000; total assets - $42,029,000.CA operates a 125-acre vineyard which yields one-fourth of the winery’s production needs. CA is a modest winery with annual production of 385,000 cases of wine.The wine industry is a fragmented industry with more than 8,000 wineries in the United States.Most key management positions are held by members of the Summerfield family. The exception to this rule is Rob Breeden, the CFO.The winery implemented a new accounting information system some fourteen months ago. There has been some employee turnover as a result of the new system.Discussions with the predecessor auditor, William Lawson, revealed no significant disagreements with management; however, Mr. Lawson indicated that Rob Breeden was “more aggressive” than the winery’s former CFO. 2 / 4

Ingraham & Jenkins Copyright © 2019 Pearson Education, Inc.Assurance - 2

SUGGESTED SOLUTIONS

The following solutions relate to steps from the audit program that students were asked to complete.

1.Brainstorm about and briefly describe financial and non-financial factors that are relevant to the decision to accept the potential client.Student responses to this requirement will vary. The following is a partial list of the factors that are likely to be relevant to the firm’s decision.

Financial Factors:

a.CA has strong and upwardly trending sales and has been profitable for the last three years and beyond as evidenced by the retained earnings balance.b.Although CA’s current ratio is below the industry average, its AR and Inventory turnover compare favorably.c.The company’s debt load is lower than the industry average (debt-to-equity ratio for the company is 0.52 [calculation shown in solution to question 3 below] compared to the industry average of 0.99 in the most recent year). The company’s strong sales and earnings have provided sufficient cash to cover debt and interest payments and produce a Times Interest Earned measure above the industry average (9.41 [calculation shown in solution to question 3 below]compared to 6.91 in the most recent year).d.CA’s balance sheet appears to be strong with increasing current assets. Much of the increase in the last year is in the company’s Investments and Production Inventories balances. In addition, the company has invested more than $2,000,000 in productive assets in the last year.e.Accounts payable have increased by more than 35% since the prior year and long term debt has increased slightly.

Non-financial Factors:

a.The company is considering an initial public offering in the near future.

• The wine industry is a highly fragmented industry that is dominated by a small number of large

companies such as Ernest & Julio Gallo and Constellation Brands.c.Wine distribution is primarily achieved through supermarket chains and mass merchandisers.Other distribution outlets offer substantially less growth opportunity.

• The wine industry appears to have a bright future and the industry, as a whole, has significant

growth opportunities in the US. Wine consumption is highest among adults 35-64 years of age, the generation that tends to have the greatest amount of disposable income.e.Significant consolidation has taken place in the wine industry and the trend is likely to continue.f.CA has entered into exclusive distribution agreements with outlets in several large metropolitan areas and is seeking similar opportunities in other areas.g.The Summerfield family owns the winery and members of the family hold most management positions.h.Rob Breeden became the winery’s CFO just two years ago after the company’s CFO of more than 15 years resigned. There are rumors that the resignation was in response to disagreements between the CFO and the president, Edward Summerfield, regarding the need for a new IS.i.The vice-president of winery operations, Jacques Dupuis, was accused of theft of trade secrets form a former employer, but the charges were ultimately dropped due to insufficient evidence.j.CA implemented a new IS some fourteen months ago. The new system is fully integrated with modules for purchasing and accounts payable, sales and accounts receivable, production and inventory, payroll, and the general ledger. Each of these modules provides data that are critical to 3 / 4

CAST: Client Acceptance Solution

Copyright © 2019 Pearson Education, Inc.Assurance - 3 the company’s operations. There has been some employee turnover due to continuing problems with the AP and AR modules.k.Discussions with the predecessor auditor indicate that there were no significant disagreements, but the former partner-in-charge made the comment that Rob Breeden was “more aggressive than CA’s former CFO.” 2.Perform preliminary analytical procedures using the financial statements provided by the client.Calculate ratios for comparison to the industry averages provided.Company Ratios Industry Ratio

20XX 20XX 20XW

Current Ratio

27,076 ÷ 7,082 = 3.82

3.82 4.9 4.7

Accounts Receivable Turnover

21,945 ÷ [(5,241 + 4,816) ÷ 2] = 4.36

4.36 4.42 4.30

Average Days to Collect Accounts Receivable

365 ÷ 4.36 = 83.72

83.72 82.58 84.88

Inventory Turnover

11,543 ÷ [(15,593* + 14,309) ÷ 2] = .77

• Includes production and finished goods

0.77 0.67 0.80

Days in Inventory

365 ÷ 0.77 = 474

474 545 456

Assets to Equity

42,029 ÷ 27,718 = 1.52

1.52 1.99 2.14

Debt to Equity Ratio

14,311 ÷ 27,718 = 0.52

0.52 0.99 1.14

Times Interest Earned

3,386 ÷ 360 = 9.41

9.41 6.91 7.29

Return on Assets

(1,997 + 360) ÷ [(42,029 + 38,322) ÷ 2] = 5.9%

5.9 % 5.56 % 7.61 %

Return on Equity

1,997 ÷ [(27,718 + 25,721) ÷ 2] = 7.5 %

7.5 % 5.92 % 10.76 %

3.Discuss the overall results of the preliminary analytical procedures. Identify relationships or areasthat may be of concern during the audit.Ratios for CA generally compare favorably to industry averages. Certainly the company’s current ratio is below the industry average, but it’s AR and inventory turnover measures compare favorably.In addition, the asset to equity ratio is below the industry average and debt to equity is lower than the industry average. The company is generating a higher return on profits and equity than the industry.This also bears investigation. Notwithstanding the results from the analytical procedures, areas that would generally be treated as significant and requiring more audit effort include accounts receivable, investments, inventory, accounts payable, and long term debt.

4.Based on the information obtained do you recommend that the firm accept or not accept the potential client? Briefly explain the basis for your recommendation.Although there is no correct answer, most CPA firms would accept CA as a client. Student responses should include discussion of the financial and non-financial factors identified in response to question

• / 4