Despite that Murphy Tymshare (MTS) already has business relationship with the firm in the tax field, it is a new client in the auditing area. Evaluation on MTS should be done before making decision of whether to accept the client or not. Otherwise, the acceptance of a poor client may result in potential problems such as lawsuits, loss of professional reputation and financial loss to the auditing firm. Basing on the scenario provided in the case, both positive and negative factors are identified and analyzed against the seven categories of factors1 suggested by Knechel (2001).
These seven factors actually cover the steps of obtaining background information of the client and evaluating the associated risks. Therefore, they are particular useful in analyzing the MTS case2. After that, the necessity of the need of more information will be discussed, then it is followed by the discussion on whether to accept MTS or not and if accepted, what should be planned for MTS’s auditing. 2. Discussion on the acceptability of MTS as a client 2. 1. Factors that may lead to potential risks in Murphy’s auditing engagement Firstly, there is problem of integrity.
Integrity deals with the issue of whether the management of the company
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That at least indicates MTS does not create a universal accepted good image in the business world. Similarly, while Jake is famous for his success in his professional commercial activities, such as the dramatically profits generated from the time-share project in Arizona, he is also well-known and criticized for his personalities and dishonored behaviors in life, such as the lawsuits and showy dressing. Moreover, MTS has high turn over rate in the lower ranks which may cause problems in the employment relationships and statues.
All of these establish a conflicting reputation and image of MTS. The association with such a client could imply potential danger to the reputation and profitability of the auditing firm. Thirdly, there are also problems of accounting practices. The prior auditor proved that MTS tended to choose accounting methods in favor of revenue recognition and expense defer, which may not truly and fairly reflect the business performance. Although there is an accounting system in place, it was designed by the predecessor accountant three years ago.
It was proved too simple. Therefore, doubt should be cast over its functionality of whether the system can actually record and reconcile all the transaction timely and accurately, which naturally leads to the questioning of whether the financial statements really reflect the business situation of MTS. Moreover, the stock options held by the senior management may also indicate the possibility of manipulation of accounting policies. Because those options have a higher exercise price than the current market and are going to expire in three years.
It is likely that the senior management may try to manipulate accounting policies within the three years, such as “have a bath”3 in 2000 due to the lower profits, to make the market share price increase at the end of the third year so that those options can be exercised to make money. All of these indicate potential conflicts with the management of MTS and higher risks in both Alpha risk4 and Beta risk5.
Fourthly, there is problem of the financial status of MTS. Although there is not indication of a bankruptcy or a closure in near future the financial statement did reflect a dramatic drop in the profits in 2000, which is 38.8% less than that in 1999. Moreover, the business nature of MTS, which builds and sells resort time-share project, usually associates with higher business risks due to the reliance on the overall economic environment, people’s disposable income6 and a longer time on project7. Any insufficient cash flow or economic sluggish will have significant negative impact on the operation of MTS. That will lead to risks that MTS is unable to pay auditing fees timely or even goes to insolvency. Lastly, there may be profitability problem out of the MTS’s auditing engagement.
The prior auditor warned that although Jake was reasonable about fees he only likes to deal with superb experts. That would cause staffing assignment and scheduling problems to the auditing firm. Jake could refuse to pay the fee if he were unsatisfied with the provided services. Moreover, judging from the tax department’s experience with Jake, he may be unwilling to pay the auditing fee which is larger than the tax fee because he is already hostile on the tax return, which suggests that he could be aggressive on the auditing fee as well. 2. 2. Positive actors that may offset the effects of the negative factors
Firstly, there is an auditing committee consisting of four board members. They are Robert McCallum (a college professor), Steven Polmikala (a shareholder of Murphy Insurance), Christopher Murphy (an artist) and Harold Bauser (a lawyer). According to their job descriptions, they do not hold management positions in MTS so that they can be assumed of being independent. Since an auditor should directly report to an auditing committee instead of to the management, an independent auditing committee can assure the auditor of communication recourse in case of problems encountered during the auditing processes and conflicts with the management.
Secondly, the firm already worked with MTS in the aspect of tax return. With an existing business relationship, the initial set up costs of getting known about the client should be less than to establish a completely new relationship. Detailed and reliable Information regarding MTS’s business background, strategies and operations could be obtained from the tax department. Thirdly, MTS already operated for five years and accumulated reasonable profits from its business.
MTS serve a niche market and such a market is growing under the current economic environment in America. The bright future may ease the worry of potential insolvency if MTS could perform well. Fourthly, MTS hired in-house legal counsel to take over the legal issues regarding the real estate transactions. Such a behavior at least creates the images that MTS cares about its customers as well as its reputation. That, if operated and managed appropriately, should be able to act as effective internal controls over the sales of the real estate.