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Case 5-4
Audit Client Considerations and Risk Assessment
Lanny Beaudean joined the CPA firm of Cardinal & Coyote LLP in 200 11after working for two years for
the IRS in Phoenix, Arizona. Cardinal & Coyote is a second-tier CPA firm just below the Big Four in size.
Beaudean had passed all four parts of the CPA Exam in Arizona and decided to work for a locally based
CPA firm with international clients to gain a broad base of experience that might help him become a CFO
at a public company in the future. Beaudean has been advancing rapidly and just became a senior auditor at
Cardinal & Coyote.
Yancy Corliss is a new audit partner at Cardinal & Coyote. One day Corliss was summoned to the office
of Sharon Rules, the managing partner of the firm. Rules told Corliss that she had been approached by a
new client, Jost Furniture International. Jost Furniture (Jost) is a large southwestern chain of home furniture
rental catering to young upscale individuals who might live in a city for two years or so and then move on.
It recently opened an office in Canada and plans to expand to Europe in the not-too-distant future. Top
management at Jost seemed to imply that the firm would get the audit as long as it submitted a reasonable
bid.
Rules asked Corliss to do background checks on Jost and make whatever inquiries were necessary to
assess the potential business risk of Jost as a future client including an assessment of the integrity of
management. Corliss was given three days to do the work and report back to Rules with a recommendation.
If the decision is to go ahead, then Cardinal & Coyote would submit a bid and compete with one other CPA
firm for the account. The firm believes it will be a lucrative account, especially since the company has been
in an expansion mode and will require advice on acquisitions and other advisory services in the future.
Corliss assembled his team to review the background and other information about Jost Furniture, and he
asked Beaudean to head up the assessment and report back to Corliss in two days. During that time,
Beaudean would have two other staff members to help with the assignment. Beaudean was excited about
his first opportunity to work on new client assessment.
Beaudean met with Vinnie Gabelli, a transplanted Brooklyn native who had graduated from Arizona State
University (ASU) at Phoenix. Gabelli was like a fish out of water in Arizona even though he had spent 16
months in the master’s of accounting program at ASU. Gabelli thought a prickly pear was someone who
could not make it in Staten Island and moved to Brooklyn for a better life.
Gabelli told Beaudean that he welcomed the opportunity to work with a native of Phoenix and learn
about its colorful history. Beaudean also asked Jackie Oloff, a native of Minneapolis, to join the team.
Jackie had moved to Phoenix two years ago with her husband, who is a professor of accounting at ASU.
The team discussed mutual responsibilities, data sources for the information, key areas of risk, and then
they broke up to start their work. At the end of the day, the team reassembled to share information. Here is
a brief list of the findings:
1. The predecessor firm had helped Jost Furniture with its initial public offering and audited the financial
statements of the company for five years. The firm resigned the account in 2010, following the
issuance of a modified opinion on the 2009 financial statements. The firm had issued this opinion
because of differences with management over the proper accounting for inventories.
2. A second firm audited the financial statements for 2010. That firm also issued a modified opinion.
3. Jost’s financial statements for 20 11 and 2012 were audited by a third firm that was dismissed after two
years for reason that were unclear.
4. The financial statements for 2013 had not been audited and on March 19, 2014, the CEO of Jost
Furniture, Jerry Jost, approached Sharon Rules at a community event and asked her to submit a bid for
the Jost audit. Jost asked that the bid be submitted by March 23.
5. A memorandum to the file prepared by Rules indicated that Jost had admitted to Rules that the
company had past problems with various auditors, but Jost assured Rules the accounting issues had
been resolved. He also told Rules that the company’s controller had recently quit – the third time in
four years there had been a turnover at that position. Jost told Rules the company had two candidates
and he wanted her to help with the final decision since the CPA firm would work closely with the
controller.
6. Beaudean, with the help of Gabelli and Oloff, reviewed the financial statements of Jost Furniture for
the past four years during which the modified opinions has been issued. They went through a checklist
of risk assessment issues for new clients and stopped when they came to the following: Verify the
circumstances of any prior auditor dismissal or withdrawal by first asking the client for permission to
approach the predecessor auditor(s).
One final discovery that gave the auditors pause with respect to taking on Jost Furniture as a client was a
statement in the report on internal control over financial reporting for 2012. That statement indicated the
existence of a material weakness in internal control that had not been mentioned in management’s internal
control assessment.
At the meeting at the end of the first day, the auditors discussed the unusual number of auditor changes in
a short period of time apparently due to going-concern issues that were raised in the audit reports for the
years 2009 through 2012. Beaudean asked Gabelli to contact Jerry Host and ask permission to speak with
the auditors for the 2011 and 2012 financial statements. Gabelli was also asked to contact the two banks
where the company does business and check into its payment record. Oloff had a past business relationship
with Miles Frazer, the attorney for Jost Furniture. Oloff agreed to contact Frazer to determine whether there
are any outstanding litigation issues or other legal matters that the firm should know about. They all agreed
to get these matters done by the end of the second day and a meeting was set for 5:00 p.m. With respect to
the material weakness in internal controls, the decision was made to ask Sharon Rules to discuss the matter
directly with Jerry Jost.
Gabelli found out that a $1 million loan payable to Phoenix Second National Bank had been overdue
before payment had been made March 15, 2014. The president of the bank told Gabelli that Jost had been
in violation of a debt covenant agreement that obligated Jost to maintain a current ratio of 1.5:1 at all times
and that the bank was concerned about Jost’s ability to continue as a going concern, pointing out that Jost
had gone below the ratio twice. The first time Jost had violated the covenant, the bank accepted the
explanation of a temporary cash flow problem. The bank granted the company a three-month extension to
meet the requirements of the debt covenant. It subsequently found out the cash flow problem had been due
to the fact Jerry Jost withdrew $500,000 from the Jost cash account at Second National Bank to help put a
down payment on a mortgage loan to buy an upscale house in Scottsdale. The second time it occurred, the
bank began foreclosure on the loan on January 31, 2014, but by the time the process had been completed,
Jost had paid off the entire $1 million balance.
Oloff had no luck with the Frazer, the attorney for Jost. When she called his offices, the secretary always
told Oloff that Frazer was on another line and she’d take a message. When Oloff asked to leave a voice-
mail message, she was told Frazer did not have voice mail. How about leaving an e-mail message? She
asked. No, the secretary said, no e-mail either. Can I text him, tweet him, or just do it the old-fashioned way
and set up an appointment? No, no, no were the answers. Oloff had left five messages for Frazer by the
time of the team’s second meeting, and she had nothing to report except to make an editorial comment
about lawyer responsiveness (or lack thereof).
As for permission to speak with the predecessor auditor, Jerry Jost was indignant with the request. Gabelli
wasn’t sure why or whether it meant problems existed with the 2011-2012 audits. He reported to the audit
team that Jost asked for more time to consider the request.
At 5:00 p.m. on March 22, the auditors met in the firm’s conference room to discuss their findings. After
hearing about Gabelli’s concerns and the internal control issue and Oloff’s lack of success with Frazer,
Beaudean expressed serious concerns about taking on Jost as a client.
Questions
1. From an ethical perspective, why do auditors evaluate business risk before deciding whether to
accept a new client?
This case looks at due diligence assessment before bidding for an audit client. It is an important element of
It is important for an audit firm to do due diligence testing and risk assessment before making a bid for an
audit client. Once an audit client is accepted and the engagement letter is signed, the audit firm has made an
The potential red flags for the Jost Furniture audit include high turnover in the position of controller over
the last four years; disputes with audit firms; the existence of a material weakness in internal controls; the
low current ratio and financial distress; violations of loan covenants (loan default) and late pay-off of the
loan; withdrawal of company funds by the chief officer and founder; avoidance of the Jost attorney in
speaking to a former business associate; and the initial refusal to let the successor auditors speak to the
predecessor auditors. Many of these issues increase the risk of fraud and misstatements in the financial
2. Integrity is an essential element in the relationship between client management and the auditor.
Evaluate the issue of integrity from the perspective of possibly taking on Jost Furniture as a new
client. Use Josephson’s Six Pillars of Character to support your decision whether to submit a bid for
the Jost Furniture audit.
From the red flags above, Jost Furniture seems to have some ethical issues or a problem with the tone at the
top. Underlying all ethical issues almost always includes an integrity problem. The company appears to
make decisions that threaten its ability to continue and fairly deal with all stakeholders. Using Josephson’s
Six Pillars of Character, we would have doubts about the honesty of management, reliability of the
3. Some CPA firms have started to add an indemnification clause to their engagement letters that
provides that the client would release, indemnify, defend, and hold the auditor harmless from any
liability and costs resulting from knowing misrepresentations by management. Would inclusion of
such an indemnification clause in engagement letters impair independence? Why or why not? What
if, as a condition to retaining an auditor to perform an audit engagement, a prospective client
requests that the firm enter into an agreement providing that the firm indemnify the client for
damages, losses, or costs arising from lawsuits, claims, or settlements that relate, directly or
indirectly, to client acts. Would entering into such an agreement impair independence?
If a CPA knew that he was held harmless on an engagement it could affect the quality of work product. The
CPA might take shortcuts or omit steps in the attestation engagement since he could not be sued. Often,
If the CPA firm had to indemnify the client, the CPA firm would lose its independence since the CPA firm’s
financial future is tied to the client’s future. For instance, if the client was committing financial statement
fraud, then the CPA firm would be liable for the damages, losses, and costs arising from legal claims
