POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

[Case Analysis No. 1]

A Case Study
Presented to Mr. Mark Anecito R. Perlas, CPA
Polytechnic University of the Philippines
Sta. Mesa, Manila

In Partial Fulfillment of the Requirements in Subject

Auditing and Assurance Principles

Abadingo, Precious Mikee B.

Anzaldo, Kathlyne Dinese G.
Asesor, Kyla Camille E.
Hortal, Angel V.
Mendoza, Angela Fhaye R.
Molina, Maria Mikaela L.
Pines, Prince Adrian P.
Tadlas, Pauline Angela T.
Tajadao, Venice Jane P.

November 2022
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

COMPANY BACKGROUND

From Ritz & Co., CPAs

• Mr. Earl C. Santos (ECS), partner of the Clark office
• You, a junior manager who was recently transferred to the Clark office

From the Client

• Mr. Sean Baker, CEO
• Ms. Loren Ng, COO
• Mr. Arnold Ty, CFO
• Mr. Simon Collins, Controller

Located in Makati City that offers broad range of Ritz & Co., CPAs is a
professional services firm services to its clients including audit and assurance, tax
services, and advisory and consulting. The firm has also recently established offices
in Davao, Cebu, and Clark in Pampanga. The firm has also over 800 professionals
employed in its various offices.

You are a junior manager in the firm who was recently transferred to the newly
established office of the firm in Clark, Pampanga owing to the fact that you grew and
studied in a prestigious university in Pampanga. One of the assignments given to you
is to assist the partner in Clark to establish a client base there as part of your firm’s
expansion strategy. The partner has attended several events already in the area and
scored several lead clients in the process. One of these potential clients is Central
Energy Corporation (CEC) located in the special economic zone in Clark, Pampanga.
According to the partner, CEC recently cut its ties with its previous auditor and is now
scrambling to find a new auditor to have its financials audited since the company
expects to take a huge loan from a leading financial institution and also to keep its
accreditation with a government agency. The company’s financial year-end is
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

December 31, and it is now mid-January, so your team needs to expedite the client
acceptance decision to allow for proper planning and execution of the engagement.

Furthermore, the firm management in Makati is also pushing your team to

accept the engagement since the prospective client’s industry is quite new to the firm.
Most of the firm’s clients are in the manufacturing and financial services industries
and although the firm has a number of clients also in the energy sector, the firm has
none on the specific type of industry of Central Energy Corporation which is the
renewable energy sector. Thus, the firm management feels that this is an excellent
opportunity to enter this type of market due in part of the new office’s location near an
industrial hub. However, the Clark partner wants to carefully consider the risks that
this client and new market will bring to the firm in general. That is why he is asking
you to make a thorough research about the client and the industry to determine
whether you should ultimately accept this client for the upcoming audit.

QUESTIONS

1. What are the procedures that an auditor performs before accepting a client or
continuing an engagement?

2. Using the company’s financial information, calculate relevant ratios to obtain a

better understanding of the prospective client and to determine how the
company is doing financially. Compare the company’s ratio to the industry
ratios and identify any significant differences.

3. What other information should be considered before accepting CEC as a

client? How important are these issues to the client acceptance decisions and
why?
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

4. The prospective client also indicated its interest in obtaining tax services from
the firm. What are the pros and cons of providing this service to the company?

5. It was noted that a partner of the firm has an investment in a fund that has an
equity to the potential client. Would this situation constitute a violation of
independence in accordance to Code of Ethics for Professional Accountants in
the Philippines?

6. Prepare a memo to the partner making a recommendation as to whether the

firm should or should not accept Central Energy Corporation as am audit
client. Justify your position in light of the information in the case.

7. Prepare a separate memo to the partner briefly listing and discussing three to
five most important issues or risk areas that will likely affect how the audit is
conducted if the prospective client is accepted and how the firm can address
such issues.

ANSWERS

Question 1: What are the procedures that an auditor performs before accepting a
client or continuing an engagement?

Accepting a new client or continuing an engagement is part of the initial phase

of an audit engagement, which is governed by ISA 210 or PSA 210, which includes
the pre-conditions for an audit and where the terms of audit engagements must be
agreed upon. This includes determining whether the financial reporting framework to
be used in the preparation of financial statements is applicable and obtaining
management agreement demonstrating acknowledgement and comprehension of the
auditor's responsibilities. Furthermore, if the audit preconditions are not met and
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

there are disagreements between the auditor and the client, the auditor must discuss
the matter with management and decline the engagement unless required by law. An
auditor should investigate a prospective client prior to accepting an engagement. This
includes the following tasks:

 Obtain and review available information for auditing sources like annual
reports, financial statements, income tax returns and others. Also, carry out
checks that will ensure that the firm can be independent.

o In which the auditor obtained the company's financial statements for the
previous three years, as well as related information regarding other
transactions on their major accounts, such as revenue, and how they
report the accounting and financial information, which is computerized.

 Inquire third parties about any information concerning the integrity of the
prospective client and its management.

o In line with this, we received information about the CEO, Mr. Sean
Baker, the chief operations officer (COO), Ms. Loren Ng, the chief
financial officer (CFO), and the new controller, Mr. Simon Collins. Also,
the reason for the previous controller's recent departure from the
company.

o In this regard, management, specifically Mr. Arnold Ty, the chief

financial officer (CFO), agreed to grant permission to meet with the
previous auditor despite the fact that he had previously stated that there
were numerous disagreements between the previous auditors.
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

o It is also consistent with what the previous auditor told us, that there is
disagreement between the client and the auditor, specifically regarding
the revenue recognition method that the client employs.

• Consider whether the prospective client has any circumstances that will
require special attention or that may represent unusual business or audit risks
such as litigation or going-concern problems or background check regarding
the business problems and the management of the prospective client.

o It should be noted that after conducting background checks on the

entity's problems, they were subjected to an audit by the Bureau of
Internal Revenue (BIR), which revealed that they were over-declaring
expenses, resulting in lower taxable profits for which they paid millions
in tax, penalties, and surcharges. Furthermore, they are still subject to
audit letters on a regular basis.

o Furthermore, the company's liquidity is linked to its capacity to collect

receivables emerging from large contracts per client, thus unanticipated
occurrences might have a big impact on the company's liquidity.

o We also learned about the Chief Executive Officer (CEO), Mr. Seam
Baker, who, although being renowned as a visionary and outstanding
entrepreneur, promotes recreational drugs and uses them when under
pressure. This might lead to complications such as legal and ethical
concerns that the company and CEO will have to deal with in the near
future.

• Determine whether the audit team is independent of the client and able to
provide desired services.
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

o According to the independent review, one of the partners in Manila

Office owns stock in a fund that has an equity investment in Central
Energy Corporation. Also, an auditor discovered that his nephew is
interning in the engineering department of the company. Finally, the new
controller is a schoolmate and a university senior, but I've never had the
opportunity to speak with him and have only interacted with him through
student organization activities.

• Determine if the audit team has the necessary technical skills and knowledge
of the industry to complete the engagement.

o It is stated that the auditor who determines whether or not the

prospective client must be accepted by the firm was a junior manager
who was recently transferred to the office and grew up and studied at a
prestigious university in Pampanga. The partner, on the other hand, is in
charge of the overall and financial aspects of the engagement.

• Determine if acceptance of the client would violate any applicable regulatory or

ethical requirements and if accepting the new client is low risk for the auditor; if
it is a high risk, then refuse the role.

o There is a high risk as there are already existing notable legal and
ethical issues which may also happen in the future.

• An engagement letter shall be sent to the auditor before the audit.

o It is critical that an engagement letter be sent prior to the start of the

engagement because it contains the confirmation of the auditor's
acceptance of the engagement, the objective and scope of the
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

engagement, management's responsibilities, auditor's responsibilities,

the form of any reports, and the limitations of the engagement, and it is
in the interest of both parties that the engagement letter be sent prior to
the start of the engagement. Lastly, it is a written contract between the
auditor and the client because both parties' agreed terms are included in
the letter.

The information gathered by the auditor regarding the client's acceptance and
continuation serves as a valuable understanding of the entity and its environment,
and it will help guide the auditors in assessing risk and planning the audit, which is
why the decision to accept the client or continue the relationship with an existing
client should not be taken lightly.
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

Question 2: Using the company’s financial information, calculate relevant ratios to

obtain a better understanding of the prospective client and to determine how the
company is doing financially. Compare the company’s ratio to the industry ratios and
identify any significant differences.

The relevant financial ratios of Central Energy Corporation were computed and
compared to the industry ratio to identify their significant differences. The financial
measures used in the process are intended to assess the company’s financial
position and are then presented below.

Central Energy
Industry Ratios
Relevant Ratios Corporation Ratios

2020 2019 2020 2019

1. Return on Equity 14.59% 13.74% 20.0% 18.0%

2. Return on Assets 9.95% 11.09% 15.0% 16.0%

3. Receivables 2.37 3.16 4.3 5.2

Turnover

4. Average Collection 152.15 113.83 83.72 69.23

Period

5. Debt Ratio 0.32 0.19 0.3 0.25

6. Current Ratio 2.09 4.37 1.15 2.11

7. Profit Margin 4.39% 7.31% 10.60% 12.40%

Table 1. Relevant Ratios of Central Energy Corporation and the Industry

 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

The ratios shown in Table 1 were gathered using data from the company's
financial statements from the beginning of 2019 to the end of 2020. In the analysis of
the ratios, the following observations were found:

It is evident from the Return on Equity (ROE) that there is a significant

difference between the CEC and the industry even though it may be observed both
has exhibited an uptrend on the said. In comparison to the industry's ROE of 20.0%
in 2020 and 18.0% in 2019, the CEC's returns on net assets in 2020 and 2019 were
14.59% and 13.74%, respectively. Although the 0.85% increase from 2019 to 2020
indicates the company is probably becoming more efficient in converting equity
capital to profit, the 5.41% and 4.26% differences between the company and the
industry in 2020 and 2019, respectively, suggest that the company is not as effective
at generating profit from its shareholders' equity when compared to the average
performance of the other companies in the same industry.

In terms of Return on Assets (ROA), the company reported 9.95% and 11.09%
in 2020 and 2019, which are less than the 15.0% and 16.0% for the corresponding
years in the industry. The difference in ROA percentages imply that the company is
less profitable relative to its total assets than the aggregate of the businesses in the
sector in both years. The figures show a decline in the return of assets in the
company and the industry as a whole from 2019 to 2020. In addition, the ROA
decrease of 1.14% between 2019 and 2020, suggests that the corporation may be
overinvesting in assets that do not generate enough income. The business must
maximize the use of its assets and resources and make better capital investment
decisions.

In 2020, the company's receivables turnover dropped from 3.16 to 2.37 along
with the industry average. Although it can be observed that regardless of both
experiencing a decline, the company's efficiency in collecting its outstanding amounts
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

is lower when compared to the industry's 4.3 and 5.2 in 2020 and 2019, respectively.
This could limit the amount of cash that can be used for operations. Due to a decline
in the turnover of receivables, the company may experience a loss because its credit
sales are not collected. The company must improve its collection strategy, conduct
more transactions on a cash-to-cash basis, and only extend credit to reliable clients
in order to mitigate the declining receivables turnover.

In comparison to the industry average of 69.23 days in 2019 and 83.72 days in
2020, CEC's average collection period in 2019 and 2020 are significantly longer at
113.83 days and 152.15 days, respectively. Given that they take longer than the
industry average for days of collection, it shows that the business is inefficient in
collecting its receivables. To prevent the extended collection time that could
negatively impact the company and cause issues, the organization must set stronger
credit conditions and stricter regulations.

The debt ratio, meanwhile, was calculated to assess the financial leverage,
where the company recorded 0.19 and 0.32 in 2019 and 2020, respectively. The
company's debt ratio is lower in 2019 than the industry average, which suggests that
the business is more stable and has fewer liabilities during that year. However, the
company's debt-to-equity ratio climbed to 0.32 in 2020, which is 0.02 more than the
industry average of 0.30. Although the rise may be seen as a negative point, the
corporation still has the ability to cover its liabilities with its assets because the debt
ratio is below 0.50, the considered highly leveraged ratio.

The CEC had a current ratio of 4.37 in 2019 in comparison to the industry’s
2.11 while in 2020, the current ratio was 2.09, of which is a ratio significantly higher
than the industry average of 1.15. It can be assumed that the company was able to
fulfill and cover its short-term obligations or liabilities using its current assets and has
more than enough to support its operations. The comparison shows that the company
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

has a relatively high current ratio and to control this, the management must make
more appropriate use of their assets to increase profits and prevent it from sitting idle.

As presented, the profit margin of the company in 2019 was 7.31% and 4.39%
in 2020. In comparison to the industry’s 12.40% and 10.60% profit margins for 2019
and 2020, wherein a sizable gap can be observed between the company and industry
along with a significant drop in both. The industry's and company's declining profit
margins indicate that there are issues with the renewable energy sector that are to
blame for the decline in profit. In order to boost profit margins, the CEC must review
their annual performance, reduce operating costs, and assess the effectiveness of
their business strategies.

To summarize, it may be observed that all the relevant ratios of the company
and the industry follows the same trend, may it be a rise or a decline but, further
observation and analysis will show that the company is financially underperforming in
comparison to the aggregate of the companies in the said industry. It has failed to
rise above the conditions, nor does it meet at least the average performance of the
companies from the same sector. The assessment and evaluation of the relevant
ratios as matched to the industry ratios showed which aspects should have
improvements and how far behind the company is in the industry. The analysis would
then serve as a guide in implementing changes so that the company can grow and
perform better in the future.
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

Question 4: The prospective client also indicated its interest in obtaining tax services
from the firm. What are the pros and cons of providing this service to the company?

To help them comply with existing regulations related to their industry, Central Energy
Corporation expressed their interest to obtain tax services from Ritz & Co., CPAs.
Accordingly, the advantages and disadvantages of performing such service are as
follows:
Advantages:

• Since Central Energy Corporation is Ritz & Co., CPAs’ first client under the
renewable energy sector, this will be an opportunity for the firm’s tax
professionals to expand their existing knowledge as they will be carefully
reviewing the relevant laws and tax provisions that are peculiar to this sector.
This could also possibly create a new market for Ritz and Co., CPAs.

• Preparation of tax return and providing tax advice to firms is a service that is
distinct from the audit engagement. Since this is an additional service that will
be performed by the accountants, this will require additional compensation,
thereby giving additional revenue to the Ritz & Co., CPAs.

• Another advantage of providing tax services to Central Energy Corporation is

that it will guide the client in preventing the recurrence of their tax violations.
This will also in turn help them to avoid incurring losses due to penalties and
surcharges that may be imposed if such violation will be committed again.

• By providing tax services, we can also assist the client in terms of legally
minimizing their taxes, or in what is also known as tax avoidance. It was
mentioned that there are numerous incentives available to businesses who are
engaged in providing alternative and sustainable energy. As experts, Ritz and
Co., CPAs can take advantage of these incentives that the client may not be
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

aware of, allowing the company to retain more income to sustain their
operations.

• The company's tax return will be less questionable than previous tax returns
submitted to the BIR. According to a study published in The Accounting
Review in January 2016, corporate tax returns prepared by the company's
external auditors have 30% fewer questionable tax benefits than the tax
returns prepared by non-auditors including in-house accountants. This is
because external auditors are more likely to avoid questionable tax positions
because they face reputational risk and have more to lose than other tax
preparers.

Disadvantages:

• Providing tax services alongside with audit services may compromise the
auditor’s independence in appearance. Even though tax services provided by
the same auditor is not prohibited, there are still some users of information
who believes that performing tax services for an audit client creates a conflict
of interest.

• The company’s reputation might be negatively affected if they become

associated with a client who has a bad record in the Bureau of Internal
Revenue (BIR) and in the higher courts. It has been explicitly stated that
Central Energy Corporation was forced to pay millions in surcharges and
penalties as a result of the case they lost. The said case was filed against
them due to over declaring expenses, which reduced their taxable profits and
ultimately their tax due.
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

• The preparation of tax return will be quite challenging for the firm given that the
firm has no experience in preparing tax returns for this specific type of
business. It may require additional time and costs for the accountants to be
sufficiently knowledgeable about the industry-specific tax regulations that
apply to this sector, in order to arrive at the correct amount of tax that the
company owes.
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

Question 5: It was noted that a partner of the firm has an investment in a fund that
has an equity to the potential client. Would this situation constitute a violation of
independence in accordance to Code of Ethics for Professional Accountants in the
Philippines?

Yes. Included in the preconditions of an audit is the compliance to ethical

requirements. The Code of Ethics for Professional Accountants outlines requirements
in which professional accountants are expected to comply with. It is in the public
interest and mandated under the Code that members of audit teams, firms, or
network firms remain independent of audit clients. The Code establishes fundamental
principles and provides a conceptual framework for applying those principles. To
avoid bias, conflicts of interest, and undue influence when giving an opinion, an
accountant must adhere to the principles of objectivity and must have independence
of mind and in appearance. However, there are several factors that could
compromise their independence. One of these is a self-interest threat or a threat
wherein a financial or other interest will inappropriately influence the professional
judgment or behavior. As per Section 200.4 of the Code, one circumstance that
creates self-interest threats is when a member of the team has a direct financial
interest in the client.

In the given situation, it has been determined that a partner from the Manila
office has an investment in a fund that holds less than one percent of the total
capitalization of the Central Energy Corporation. According to Section 290.102, if the
issue involves holding a financial interest in an audit client (CEC), it may create a
self-interest threat that would be so significant that no safeguards could reduce the
threat to an acceptable level. Existence and significance of any threat are contingent
on:
• The role of the person holding the financial interest.
• Whether the financial interest is direct or indirect, and;
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

• The materiality of the financial interest.

Considering that the person holding the financial interest is a partner and its
interest is a direct financial interest, as he has control over the investment vehicle, or
has the ability to influence its investment decision. Thus, regardless of its materiality,
it would create a self-interest threat that could be so significant that no safeguards
could reduce the threat to an acceptable level. In this case, if there are no necessary
safeguards that can be applied, the professional accountant may compromise
compliance with the fundamental principles and may inadvertently violate the
provision of the Code, once accepted. In addition, Section 290.108 also mentioned
that other partners in the office where the engagement partner practices in relation to
the audit engagement, shall not hold any direct financial interest or material indirect
financial interest in the audit client. The office where the audit engagement partner
practices is not necessarily the office to which that partner is assigned (Section. 290.
109). The rationale behind this is because it can be an avenue for them to increase
their financial interest in the future.

Therefore, based on the above-mentioned facts, we can conclude that the

investment, despite its minimal amount, would constitute violation of independence
as defined in the Code of Ethics for Professional Accountants in the Philippines,
unless they eliminate the circumstance or relationship creating the threats, such as
disposing the partner’s shares beforehand, or declines or terminates the audit
engagement.
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

Question 6: Prepare a memo to the partner making a recommendation as to whether

the firm should or should not accept Central Energy Corporation as am audit client.
Justify your position in light of the information in the case.

MEMORANDUM

TO                      :   MR. EARL C. SANTOS

Audit Partner, Clark Office

 FROM                 :   GROUP 4

Junior Audit Manager, Clark Office

SUBJECT           :   CENTRAL ENERGY CORPORATION AUDIT     

                                           ENGAGEMENT REJECTION

 DATE                  :   January 15, 2021

Central Energy Corporation is engaged in project operations and management

services related to alternative energy and sustainable energy operations including
those involved in hydroelectric power, wind power, solar power generation, and the
manufacture, distribution, and sale of alternative fuels. This memorandum deliberates
about whether to accept or reject Central Energy Corporation as an audit client,
considering the information and background of it.

Conflicting Auditor Arrangements with Dates

Under PAS A53, one of the information obtained during the process of
acceptance is the entity’s timetable for reporting. The company Central Energy
Corporation is finding an auditor beyond the date that it should be. The reporting
cycle for CEC concludes on December 31 and it is now January 15. The potential
customer shall file the Annual Income Tax Return and the Audited Financial
Statements with the Securities and Exchange Commission (SEC) and the Bureau of
Internal Revenue (BIR) on or before April 15 and June 1, respectively, of the following
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

year. Our company must work quickly and decisively in order to obtain enough
relevant data and carry out the audit engagement. It could cause conflict to the
financial statements and source documents.

The CFO'S Reticence to be Transparent

Stated under PAS A55, the IESBA Code requires that the predecessor auditor,
on request by a proposed successor auditor, provide all relevant facts and other
information concerning such non-compliance that, in the predecessor auditor’s
opinion, the proposed successor auditor needs to be aware of before deciding
whether to accept the audit appointment. Mr. Arnold Ty, the CFO, had some
reservations about the communication with the previous auditor because of some
disagreements, and it caused some suspicious perspectives to the company.

Ethical Concerns

The first information listed under PAS A50 to consider in accepting client
relationships is the integrity and ethical values of the principal owners, key
management, and those charged with governance of the entity. A background check
on the business discovered that the Bureau of Internal Revenue (BIR) had audited it
several years prior and found that it had overstated its expenses, which had reduced
its taxable profits. The business was successful in taking the matter to a higher court,
but ultimately lost. Taxes, fines, and surcharges totaling several million dollars were
imposed onto the corporation. Second of the unethical issues of Central Energy
Corporation is its company’s chief officer, Mr. Sean Baker, uses recreational drugs
and it affects the firm’s decision given that it is forbidden by the law and values of the
company. In addition to that, it may affect the views of other clients as the names and
reputation of the companies are involved.
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

Complicated Industry

Disclosed in PAS A53, information about the size, complexity, and nature of
the entity are significant factors in accepting clients. The previous auditor of Central
Energy Corporation declared that the business also has a practice of establishing
various provisions to plan for potential losses in the future. However, the auditor
acknowledged that they had never worked with a corporation with such a
sophisticated business model. Due to its complex business activities, CEC has
regularly changed auditors despite being a newcomer to the market. The auditors
would struggle to complete the audit procedures because of the industry's intrinsic
complexity and our firm's lack of experience with the services it offers.

Ritz and Co. appreciates the proposal and determination of the Central Energy
Corporation to be one of its clients. Yet, the junior manager of the entity recommends
rejecting Central Energy Corporation due to all the imparted details above. There are
risks being handled and some of it can affect future endeavors of the company.

Poorly Managed Finances

Following PAS A53, information about the size, complexity, and nature of the
entity, including whether it is a group audit, the industry in which it operates, and the
applicable financial reporting framework are key aspects of the acceptance and
continuance process. The comparison between the ratio of Central Energy
Corporation and the Industry shows the poor financial management of the company
because the profit margin, return on equity, and return on assets are below the
industry average. A low return on equity and return on assets can harm Central
Energy Corporation because it indicates lower earnings with high investment (ROA)
and capital (ROE), which is not favorable in the industry threshold. Comparatively
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

speaking, Central Energy Corporation is not managing the investments made by their
shareholders to increase earnings effectively or efficiently.

Ritz and Co. appreciate the proposal and determination of the Central Energy
Corporation to be one of its clients. Yet, the junior manager of the entity recommends
rejecting Central Energy Corporation due to all the imparted details above. There are
risks being handled and some of them can affect the future endeavors of the
company.
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

Question 7: Prepare a separate memo to the partner briefly listing and discussing
three to five most important issues or risk areas that will likely affect how the audit is
conducted if the prospective client is accepted and how the firm can address such
issues.

MEMORANDUM

TO                      :   MR. EARL C. SANTOS

Audit Partner, Clark Office

FROM                 :   GROUP 4

Junior Audit Manager, Clark Office

SUBJECT           :   RISK FACTORS AFFECTING CENTRAL ENERGY

CORPORATION’S AUDIT ENGAGEMENT

DATE                  :   January 15, 2021

This memorandum outlines the review team’s understanding of Central Energy

Corporation’s structure, accounting practice, and system of internal control. By
performing preliminary analytical procedures, the team has identified several potential
risk areas affecting the conduct of audit on CEC if the engagement is accepted.

Appointment of Auditor Subsequent to Year-End Date

CEC’s reporting period ends on December 31. In accordance with the Bureau
of Internal Revenue (BIR) and Securities and Exchange Commission (SEC), the
prospective client must file their Annual Income Tax Return and Audited Financial
Statements on or before April 15 and June 1, respectively, of the following year. This
necessitates swift and immediate action from our firm to gather sufficient appropriate
evidence and conduct the audit engagement. To address this issue, the firm must
employ a document management system to promptly notify our prospective client of
our deadlines and the documents they must furnish. Additionally, in order to give the
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

corporation a greater incentive to adhere to the firms’ deadlines, the firm must be
upfront about the repercussions for missing such deadlines by outlining our scope of
services, standards for communication, and expectations of receiving the necessary
documents promptly in the engagement letter. Furthermore, after year-end audit
engagements result in cut-off and inventory issues. Alternative procedures, such as
tests of transactions and rollbacks in determining the corporation’s ending inventory
balance, must be carried out to make up for the inability to witness the client's
inventory procedures in real time.

BIR Case

As a result of conducting a client background check, the review team

discovered that CEC was subjected to an audit by the BIR for over-declaring
expenses to reduce its taxable income. The corporation was made to pay several
million in taxes, fines, and surcharges after they lost to a higher court. This would
make it difficult for auditors to reinforce their audit conclusions since the integrity of
the corporation’s work could be questioned at any time. This suggests that the firm
must pay special attention to the corporation’s recognition of expenses and verify the
previous accounting records’ fair representation and conformity to the BIR.

Management

Mr. Sean Baker, the corporation's chief executive officer, is a well-known

supporter and admits to using recreational substances. This implies that the company
will be more vulnerable to committing errors if we cannot guarantee the stability of
communication when such a time happens. The firm must seek the assistance of the
corporation's CEO to confirm the legitimacy, security, and prescription of the
recreational substances through a medical professional.
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

Complex Line of Business

Despite being relatively new in the industry, CEC has frequently changed
auditors as a result of its intricate corporate operations. Due to the industry’s inherent
complexity and our firm’s unfamiliarity of the nature of services it provides, the
auditors would find difficulty in performing the audit procedures. Hence, the firm must
employ experts with sufficient knowledge and experience in the renewable energy
sector to aid us in performing the audit engagement. Aside from this, the firm must
inquire with the corporation’s predecessor auditors regarding their experience and
treatment of the CEC.

Conflict of Interest

A partner from Manila owns stock in a fund that is invested in less than one
percent of CEC's total capitalization. By disposing the partner's shares in advance,
the corporation may eliminate the situation that is posing risks. In addition, it was
recently found out that the nephew of one of the auditing staff is having his internship
with the client’s engineering department. The firm must determine the internship and
client acceptance periods. If the two proceedings overlap, the firm must detach the
relevant audit staff from the engagement to safeguard independence and derive
objective judgment. On the other hand, if the two will not overlap, such case will not
result to any problem.

Considering the prior risks, the audit - if CEC is accepted as an audit client -
shall have additional undertakings. Exerting additional effort to areas where it is
necessary is likely to occur - of course, subject to evaluation for high risk of material
misrepresentation. It is important to note that accepting the engagement would also
impose a threat to the image of the firm, considering the past of the to-be audit client,
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

if the engagement is not done properly. Extra caution is advised if the decision is to
proceed with the engagement.

Sincerely,

Group 4
Junior Audit Manager, Clark Office
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

REFERENCES

Ang, M. (n.d.). Audit of Inventories. Institute of Singapore Chartered Accountants.

Retrieved from https://isca.org.sg/media/3696/dec-36-39-audit-of-inventories.pdf

Baldres, R. N., De Leon, E. M., & Magadia, G. A. (n.d.). Auditing and Other 
Assurance Services. Author.

Bureau of Internal Revenue. (n.d.). Income Tax Return. Retrieved from

https://www.bir.gov.ph/index.php/bir-forms/income-tax-return.html#:~:text=Filing
%20Date,for%20the%20preceding%20taxable%20year

International Ethics Standards Board for Accountants (IESBA). (2016). Handbook of

the code of ethics for professional accountants. New York, NY: IFAC. Retrieved
November 17, 2022, from https://www.ifac.org/system/files/publications/files/2016-
IESBA-Handbook.pdf 

Kaplan Financial Limited. (n.d.). Chapter 4: Ethics and acceptance of appointment.

Kaplan Financial Knowledge Bank. Retrieved November 17, 2022, from
https://kfknowledgebank.kaplan.co.uk/acca/chapter-4-ethics-and-acceptance-of-
appointment 

McCann, D. (2021, November 1). Should Your Auditor Prepare Your Tax Return?
CFO. https://www.cfo.com/accounting-tax/2016/02/auditor-prepare-tax-return/

PAS 2020

PSA 210
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

PSA 220 A49-A58

Ovaska-Few, S. (2019, September 1). How to deal with last-minute clients. Journal of
Accountancy. Retrieved from
https://www.journalofaccountancy.com/issues/2019/sep/dealing-with-last-minute-
clients.html

Securities and Exchange Commission. (2021, May 19). Extension of the Deadline for
the Submission of Annual Reports for the Calendar Year Ended December 31, 2020
and Quarterly Report as of March 31, 2021. Retrieved from
https://www.sec.gov.ph/notices/extension-of-the-deadline-for-the-submission-of-
annual-reports-for-the-calendar-year-ended-december-31-2020-and-quarterly-report-
as-of-march-31-2021/
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

APPENDIX

Relevant Ratio Formulas:

• Return on Equity (ROE) = Profit / Equity
• Return on Assets (ROA) = Profit / Total Assets
• Receivable Turnover = Sales / Average Receivables
• Average Collection Period = 360 / Receivable Turnover
• Debt Ratio = Liabilities / Assets
• Current Ratio = Current Assets / Current Liabilities
• Profit Margin = Profit / Sales