Home Trends, Inc.
The New Client Acceptance Decision
The accounting firm of Gibbs and Slater, LLP, is a medium-sized, national CPA firm. The partnership, formed in 1954, now has over 6,000 professionals on the payroll. The firm mainly provides auditing and tax services, but it has recently had success building the information systems consulting side of the business for non-audit clients and for audit clients that are not publicly traded.
It is mid-January 2012, and you are a newly promoted audit manager in an office of Gibbs and Slater, located in the Pacific Northwest. Your first assignment as audit manager is to assist an audit partner on a client acceptance decision. The partner explains to you that the prospective client, Home Trends, is a medium-sized manufacturer of small home appliances. The partner recently met the company’s president at a local chamber of commerce meeting. The president indicated that, after some difficult negotiations, the company has decided to terminate its relationship with its current auditor. The president explained that the main reason for the switch is to build a relationship with a more nationally established CPA firm because the company plans to make an initial public offering (IPO) of its common stock within the next few years. Home Trends’ annual financial statements have been audited each of the past 12 years in order to comply with debt covenants and to receive favorable interest rates on the company’s existing line of credit. Because the company’s December 31 fiscal year-end has already passed, time is of the essence for the company to contract with a new auditor to get the audit under way.
The partner, Rosa Martin, is intrigued with the idea of having a client in the home appliance industry, especially one with the favorable market position and growth potential of Home Trends. Although there are several manufacturers of small home appliances in the area, your office has never had a client in the industry. Most of your office’s current audit clients are in the healthcare services industry. While the partner feels the engagement presents an excellent opportunity for Gibbs and Slater to enter a new market, knowing the risks involved, he wants to make sure the client acceptance decision is carefully considered.
Home Trends, Inc. manufactures small- to medium-sized home appliances. The company’s products include items like toasters, blenders, and trash compactors. Although Home Trends’ common stock and other securities are not publicly traded, the company is planning an IPO in the next few years in hopes that it will be able to trade Home Trends’ common stock on the NASDAQ. You have been assigned to gather information in order to make a recommendation on whether your firm should accept Home Trends as a client.
Home Trends wants to hire your firm to issue an opinion on its December 31, 2011 financial statements and has expressed interest in obtaining help to get its recently installed information technology (IT) system in better shape. Home Trends also wants your firm’s advice and guidance on getting everything in order for the upcoming IPO. During the initial meeting with Home Trends’ management, the following information was obtained about the company.
Home Trends, Inc.
Home Trends’ unaudited December 31, 2011 financial statements report total assets of $76 million, sales revenues of $145 million, and net profit of $3.4million. In the past, the company has not attempted to expand aggressively or develop new product lines. Rather, it has concentrated on maintaining a steady growth rate by providing reliable products within a moderate to low price range. However, Home Trends hopes to use the capital from the upcoming IPO to aggressively expand from a regional to a national market. Home Trends primarily sells its products in small quantities to individually owned appliance stores. Over the last few years the company has begun to supply larger quantities to three national retail chains. Two of these larger retailers started buying Home Trends’ products about two years ago. In order to handle the increased sales, Home Trends significantly expanded its manufacturing capacity.
Though shaken by recent management turnover and ongoing difficulties with the company’s new accounting system, management feels that Home Trends is in a position to grow considerably Management notes that earnings have increased substantially each year over the past three years and that Home Trends’ products have received increasing acceptance in the small appliance marketplace. Three years ago, the company received a qualified audit opinion relating to revenues and receivables. Home Trends has changed auditors three times over the past 12years.
In October 2011, the company experienced significant management turnover when both the vice- president of operations and the controller resigned to take jobs in other cities. The reason for their leaving was disclosed by management as being related to “personal issues.” A new vice-president, Jessica Wood, was hired in November, and the new controller joined early last month. Jessica is an MBA with almost 12 years of experience in the industry. Theodore Jones, the new controller, has little relevant experience and seems frustrated with the company’s new IT system. The company’s president, Andrew Cole, has a BBA and, as the founder, has worked at all levels of the business. Mr. Zachery, who is principally in charge of the company’s procurement and manufacturing functions, meets weekly with Mr. Cole, as does John Smyth, who has served as vice president over finance for the past eight years.
Accounting andControl Systems
The company switched to a new, integrated central accounting system in early 2011. This new system maintains integrated inventory, accounts receivable, accounts payable, payroll, and general ledger software modules. The transition to the new system throughout last year was handled mainly by the former controller. Unfortunately, the transition to this new system was not well managed. The company is still working to modify it to better meet company needs, to retrain the accounting staff, and to adapt the company’s accounting controls to better complement the system.
Problems still exist in inventory tracking and cost accumulation, receivables billing and aging, payroll tax deductions, payables, and balance sheet account classifications. The company stopped parallel processing the old accounting system in April 2011. During several brief periods throughout 2011, conventional audit trails were not kept intact due to system failures and errors made by untrained personnel.
The company’s accounting staff and management are both frustrated with the situation because, among other problems, internal management budget reports, inventory status reports, and receivables billings are often late and inaccurate, and several shipping deadlines have been missed.
Your office has never audited a company with the specific IT system in place at Home Trends. However, your local office’s IT team is fairly confident they will be able to diagnose Home Trends’ control weaknesses and help Home Trends overcome current difficulties.
Accounts Receivable, Cash, and Inventories
The sales/receivables system handles a volume ranging from 2,900 to 3,400 transactions per month, including sales and payments on account for about 1,200 active credit customers. The six largest customers currently account for about 15% of accounts receivable, whereas the remainder of the accounts range from $1,500 to $32,000, with an average balance around $8,000.
Finished goods inventories are organized and well protected, but in-process inventories appear somewhat less organized. The company uses a complicated hybrid form of process-costing to accumulate inventory costs and to account for interdepartmental in-process inventory transfers for its four major product lines.
When you approached John Smyth, Home Trends’ vice-president of finance, to request permission to speak with the previous auditor, he seemed hesitant to discuss much about the prior audit firm. He explained that, in his opinion, the previous auditor did not understand Home Trends’ business environment very well and was not technically competent to help the company with its new IT system. He further indicated that the predecessor auditor and Home Trends’ management had disagreed on minor accounting issues during the prior year’s audit. In Mr. Smyth’s opinion, the disagreement was primarily due to the auditor’s lack of understanding of Home Trends’ business and industry environment. According to Mr. Smyth, the audit partner indicated that because of the accounting issues, he would be unable to issue a clean opinion on the financial statements. In order to receive an unqualified opinion, Home Trends had to record certain adjustments to revenues and receivables. Mr. Smyth believed the adjustments were unnecessary but felt forced to make them to receive a clean audit opinion.
Mr. Smyth noted that Home Trends’ management feels confident that your firm’s personnel possess better business judgment skills and have the knowledge and ability to understand and help improve Home Trends’ IT system. Mr. Smyth also indicated that Home Trends wants to switch auditors at this time to prepare for the upcoming IPO, noting that companies often switch to larger accounting firms with national reputations in preparation for going public. Your firm has been highly recommended to him by a friend who is an administrator of a hospital audited by Gibbs and Slater. After some discussion between Mr. Smyth and Mr. Cole, Home Trends’ president, they granted you permission to contact the previous auditor.
During your visit with the previous auditor, he indicated that the problems his firm had with Home Trends primarily related to (1) the complexities and problems with Home Trends’ new IT system and (2) management’s tendency to aggressively reflect year-end accruals in order to meet creditors’ requirements. The auditor also disclosed that the dissolution of the relationship with Home Trends was a mutual agreement between the two parties, and that his firm’s relationship with management had been somewhat difficult almost from the beginning. Apparently, the final straw that broke the relationship involved a disagreement over the fee for the upcoming audit.
A checkon thebackground of Home Trends’ management revealed that five yearsago Home Trends’vice president of finance wascharged with a misdemeanor involving illegal gambling on local college football games. According to the news reports, charges were later dropped in return for Mr. Smyth’s agreeing to pay afine of $500 and perform 100 hours of community service. The background check revealed no other legal or ethical problems with any other Home Trends executives.
As part of Gibbs and Slater’s quality control program, every three months each employee of Gibbs and Slater is required to file with the firm an updated disclosure of their personal stock investments. You ask a staff auditor to review the disclosures as part of the process of considering Home Trends as a potential client. She reports to you that there appears to be no stock ownership issue except that a partner in Gibbs and Slater’s Salt Lake City office owns shares in a venture capital fund which in turn holds a private equity investment in Home Trends common stock. The venture capital fund holds 50,000 shares of Home Trends stock, currently valued at approximately $18 a share. The stock is not publicly traded, so this value is estimated. This investment represents just over a half of one percent of the value of the fund’s total holdings. The partner’s total investment in the mutual fund is currently valued at about $56,000, No other independence issues were noted.
Read the attached audit case and complete the following:
Prepare a memo to the audit partner making a recommendation as to whether Gibbs and Slater should or should not accept Home Trends, Inc. as an audit client. Carefully justify your position in light of the information in the case. In your memo, be sure to discuss ALL the following points.
1. Asindicated in the case, one of the partners in another office has invested in a venture capital fund that owns shares of Home Trends common stock. Would this situation constitute a violation of independence according to the AICPA Code of Professional Conduct? Why or why not?
2. Discuss at least three other matters that should be considered before accepting Home Trends as a client? How important are these issues to the client acceptance decision? Why?
3. Home Trends wants Gibbs and Slater to aid in developing and improving its IT system. Given current auditor independence rules, will Gibbs and Slater be able to help Home Trends with its IT system and still provide a financial statement audit?
4. Discuss the three most important risk areas that will need to be considered in how the audit is conducted if the Home Trends engagement is accepted. (Regardless of whether your recommendation is to accept the client or not)
5. Clearly state whether or not you recommend the acceptance of Home Trends as a new audit client.