Case Study: Client Acceptance
Winston Black was an audit partner in the firm of Henson, Davis & Company. He
was in the process of reviewing the audit files for the audit of a new client, McMullan
Resources. McMullan was in the business of heavy construction. Black was conducting
his first review after the audit was substantially complete. Normally, he would have done
an initial review during the planning phase as required by his firm’s policies; however,
he had been overwhelmed by an emergency with his largest and most important client.
He rationalized not reviewing audit planning information because (1) the audit was
being overseen by Sarah Beale, a manager in whom he had confidence, and (2) he
could “recover” from any problems during his end-of-audit review. Now, Black found that
he was confronted with a couple of problems.
First, he found that the firm may have accepted McMullan without complying with
its new-client acceptance procedures. McMullan came to Henson, Davis & Company on
a recommendation from a friend of Black’s. Black got “credit” for the new business,
which was important to him because it would affect his compensation from the firm.
Because Black was busy, he told Beale to conduct a new-client acceptance review and
let him know if there were any problems. He never heard from Beale and assumed
everything was okay. In reviewing Beale’s preaudit planning documentation, he saw a
check mark in the box “Contact prior auditors” but found no details indicating what was
done. When he asked Beale about this, she responded with the following: “I called
Gardner Smith [the responsible partner with McMullan’s prior audit firm] and left a
voicemail message for him. He never returned my call. I talked to Ted McMullan about
the change, and he told me that he informed Gardner about the change and that
Gardner said, “Fine, I’ll help in any way I can.” Ted said Gardner sent over copies of
analyses of fixed assets and equity accounts, which Ted gave to me. I asked Ted why
they replaced Gardner’s firm, and he told me it was over the tax contingency issue and
the size of their fee. Other than that, Ted said the relationship was fine.” The tax
contingency issue that Beale referred to was a situation in which McMullan had entered
into litigation with a bank from which it had received a loan. The result of the litigation
was that the bank forgave several hundred thousand dollars in debt. This was a windfall
to McMullan, and they recorded it as a gain, taking the position that it was non-taxable.
The prior auditors disputed this position and insisted that a contingent tax liability
existed that required disclosure. This upset McMullan, but the company agreed in order
to receive an unqualified opinion. Before hiring Henson, Davis & Company as their new
auditors, McMullan requested that the firm review the situation. Henson, Davis &
Company believed the contingency was remote and agreed to the elimination of the
disclosure.
The second problem involved a long-term contract with a customer in Montreal.
Under accounting standards, McMullan was required to recognize income on this
contract using the percentage-of-completion method. The contract was partially
completed as of year-end and had a material effect on the financial statements. When
Black went to review the copy of the contract in the audit files, he found three things.
First, there was a contract summary that set out its major features. Second, there was a
copy of the contract written in French. Third, there was a signed confirmation confirming
the terms and status of the contract. The space requesting information about any
contract disputes was left blank, indicating no such problems. Black’s concern about the
contract was that to recognize income in accordance with accounting standards, the
contract had to be enforceable. Often, contracts contain a cancellation clause that might
mitigate enforceability. Because he was not able to read French, Black couldn’t tell
whether the contract contained such a clause. When he asked Beale about this, she
responded that she had asked the company’s vice president for the Canadian division
about the contract and he told her that it was their standard contract. The company’s
standard contract did have a cancellation clause in it, but it required mutual agreement
and could not be cancelled unilaterally by the buyer.
Requirements:
a. Evaluate and discuss whether Henson, Davis & Company complied with auditing
standards in their acceptance of McMullan Resources as a new client. What can they
do at this point in the engagement to resolve deficiencies if they exist?
b. Evaluate and discuss whether sufficient audit work has been done with regard to
McMullan’s Montreal contract. If not, what more should be done?
c. Evaluate and discuss whether Black and Beale conducted themselves in accordance
with auditing standards.
