Before coming to a decision whether or not accepting an audit engagement at Prefab Sprout Company, the auditor should obtain business-related background information and evaluate the risk factors associated with the potential client on which a well-grounded judgment can be made (Knechel et al., 2007).
In this respect, the auditor especially needs to become aware of the wide-ranging family ties between executives of Prefab and closely related business partners. With the president, the vice president and the treasurer being members of the Warner family, it is doubtful whether the objectivity and the reliability of Prefab’s internal control system can be guaranteed. Moreover, family members are financially involved in the Sun Atlantic Bank which provides Prefab with loans, as well as in JRW Realty, Prefab’s most important purchaser of modular home developments. Consequently, there is a risk that transactions between these more or less affiliated parties are not carried out at arm’s length (Knechel et al., 2007).
A further problem that should already be detected in the pre-engagement risk evaluation process is the composition of the audit committee. The Sarbanes-Oxley Act of 2002 and the accompanying SEC standards prescribe that publicly-traded companies in the United States establish an audit committee that consists of at least three members, with all of them being outsiders to the company (SEC, 2003). At Prefab however, the audit committee is composed of the vice-president, the treasurer and a local college professor. Thus, only one member can be regarded as not being directly associated with the company. This situation is a serious weakness in Prefab’s accounting and internal control system, thereby increasing the risk of fraudulent activities in regard of the financial statements.
A similar problem arises with the compensation committee, which comprises Prefab’s lawyer and an employee who is selected on a rotating basis. As there are no explicit conditions for compensation committee membership, Prefab does not infringe upon any law. However, it is commonly agreed that the compensation committee should be representative of the company’s shareholders. Even if the Warner family still has a 40% stake in Prefab, it is problematic that the top executive is part of the committee. Moreover, the lawyer and the employee can be expected to be biased in their decisions as both are financially dependent on the company. Neither of them would probably risk their financial stakes by for instance lowering top management’s salaries.
Auditors that are new to an engagement are obliged by law to get in touch with the predecessor auditor of the prospective client. This regulation facilitates the information gathering process of new auditors and can already give first indications about where problems could possibly emerge during the audit. Unfortunately, the predecessor auditor to be contacted in this case has been appointed to become the controller of Prefab. As this appointment imposes restrictions on the unconfined impartiality of the predecessor auditor, his assertions should be handled with care.
Whether an auditor should accept the engagement with Prefab Sprout Company depends on the one hand on factors under the control of the auditor, like expertise, staffing and being independent of the client. These factors will probably not cause any problems at Prefab as they can be...