ACCT 622 Week 8 Audit Risk Analysis Project Critique Example

Critiquing a Classmate's Decision to Accept a Fast-Growing Specialty Pharmacy as an Audit Client

The Recommendation and Its Strength

Jason, your memo recommends that the firm accept Cedar Valley Specialty Pharmacy as an audit client ahead of its planned initial public offering, at a fee 30 percent above the firm's standard rate. Your analysis of reimbursement risk is the strongest part of the memo: you showed clearly how a pharmacy that depends on insurer and government payments for high-cost drugs faces risk in its revenue estimates and receivables, and you named the procedures the team would need. Reading the memo as a reviewing partner, though, I am not yet persuaded by the recommendation, because three judgments it depends on need more support.

Fees as a Cure for Integrity Risk

Your memo identifies concerns about the chief executive, who overruled the controller on two revenue estimates last year according to your interview notes, and then concludes that a higher fee compensates the firm for the added risk. The research suggests that fees and integrity risk are different problems. Johnstone and Bedard (2003) found that firms use higher billing rates mainly for going-concern and trading-status risks, and use specialist personnel for fraud and error risks. Neither strategy addresses a chief executive willing to override accounting staff, because that risk is about whether the evidence management provides can be trusted. Johnstone (2000) describes risk adaptation as a way to bring an engagement to an acceptable level when the risks can be planned for; a management override problem is the case where adaptation reaches its limit. A fee premium compensates the firm for more work, not for doubt about whether the work can find the truth.

Related-Party Leases

The memo mentions in one sentence that Cedar Valley leases four of its six pharmacies from a company owned by the chief executive. That deserves far more attention. The auditing standard on related parties requires the auditor to obtain an understanding of the company's relationships and transactions with related parties, to evaluate whether they have been properly identified, accounted for and disclosed, and to assess their business purpose (Public Company Accounting Oversight Board [PCAOB], n.d.-b). Leases with a chief executive who also overrides estimates are exactly the kind of arrangement through which results can be shaped, for example by adjusting rent ahead of the offering. Your memo should state what the leases cost, whether the terms are at market rates and how the team would test them.

The Fraud Risk Factors the Memo Left Implicit

Your memo describes the offering as an opportunity for the firm, but it is also a pressure on management. The fraud standard asks auditors to consider the conditions that commonly accompany fraud: pressure or incentive, opportunity, and a rationalizing attitude (PCAOB, n.d.-a). Cedar Valley shows all three. The offering creates pressure to report growth, the chief executive's willingness to overrule the controller creates opportunity, and the explanation your notes record for those overrides, that the controller was too conservative for a growth company, is a familiar rationalization. Naming the three conditions together would make the memo's own evidence speak more clearly.

Going Concern Before the Offering

The memo also does not discuss going concern. Cedar Valley has burned cash for two straight years and plans to repay its credit line from the offering's proceeds. If the offering were delayed, the company might not meet its obligations for a reasonable period, and the auditor would have to evaluate whether substantial doubt exists and whether management's plans, which depend on a transaction outside its control, alleviate it (PCAOB, n.d.-c). That analysis should appear in the memo even if the conclusion is favorable.

Three Risks in One Paragraph

Your risk section discusses reimbursement, management, the offering and litigation together. Separating them would sharpen the recommendation. Client business risk includes reimbursement pressure and dependence on a few payers. Audit risk includes revenue estimates and related parties. The firm's own business risk is driven by the offering, since a new public company that later restates exposes its auditor to securities claims. Johnstone and Bedard (2004), studying one large firm's choices about which clients to take on and keep, found that it shed riskier clients, that its new clients carried less risk than those it kept, and that audit risk factors counted for more than financial ones. Laid out that way, your memo would show that the risks it treats as manageable fall mostly in the category firms are least willing to accept.

What Would Change the Recommendation

I would accept Cedar Valley if three things were true: an independent appraisal showed the leases at market terms, the audit committee confirmed in writing that it reviewed the controller's concerns and resolved them, and the predecessor reviewers of the company's financial statements reported no disagreements with management. Those are testable conditions, and adding them would turn your recommendation from a judgment into a plan.

A Closing Reflection

Proverbs observes that whoever trusts in his own mind is a fool, while one who walks in wisdom will be delivered (English Standard Version Bible, 2001/2016, Proverbs 28:26). Client acceptance is a decision where confidence is easy and evidence is scarce. Your memo is thorough; with conditions that test its key assumptions, it would also be wise.

References

English Standard Version Bible. (2016). Crossway. (Original work published 2001)

Johnstone, K. M. (2000). Client-acceptance decisions: Simultaneous effects of client business risk, audit risk, auditor business risk, and risk adaptation. Auditing: A Journal of Practice & Theory, 19(1), 1-25. https://doi.org/10.2308/aud.2000.19.1.1

Johnstone, K. M., & Bedard, J. C. (2003). Risk management in client acceptance decisions. The Accounting Review, 78(4), 1003-1025. https://doi.org/10.2308/accr.2003.78.4.1003

Johnstone, K. M., & Bedard, J. C. (2004). Audit firm portfolio management decisions. Journal of Accounting Research, 42(4), 659-690. https://doi.org/10.1111/j.1475-679X.2004.00153.x

Public Company Accounting Oversight Board. (n.d.-a). AS 2401: Consideration of fraud in a financial statement audit. https://pcaobus.org/oversight/standards/auditing-standards/details/AS2401

Public Company Accounting Oversight Board. (n.d.-b). AS 2410: Related parties. https://pcaobus.org/oversight/standards/auditing-standards/details/AS2410

Public Company Accounting Oversight Board. (n.d.-c). AS 2415: Consideration of an entity's ability to continue as a going concern. https://pcaobus.org/oversight/standards/auditing-standards/details/AS2415