San Diego Corporation
San Diego Corporation ("San Diego"), a private company, has
$7,000,000 from a local financial institution. The annual interest rate for the loan
is 6.5%. In accordance with the loan agreement, San Diego provides internal,
company-prepared financial statements to the lender.
Two other local lenders have approached San Diego and have offered to replace
San Diego's existing loan with a new one with new terms. Southern California
Bank has offered to loan San Diego $7,000,000 at 5.5% interest. Under the terms
of the loan, San Diego will be required to engage an independent public
accounting firm to "review" their financial statements prior to providing them to
the Bank. A review is an assurance engagement that provides less assurance on
the financial statements than does an audit.
Southern Regional Bank has also approached San Diego, and has made an offer
to lend San Diego $7,000,000 at a rate of 4.5% interest. Southern Regional will
require that San Diego engage an independent public accounting firm to conduct
an audit of its financial statements.
Interested in the various possibilities, San Diego's CFO approached a public
accounting firm, and learned that a review would likely cost San Diego $45,000,
and an audit would have an estimated cost of about $80,000.
1. Explain why the interest rates on the various loan offers differ from each
2. Calculate San Diego's costs under the different loan proposals, and
indicate which of the loan proposals that San Diego should accept.
3. Assume that Southern California Bank offer is as described above, but the
cost of the audit has risen to $125,000 due to the costs of implementing new
auditing standards. Which loan offer should San Diego accept?
4. Setting aside your analysis above, and the consideration of interest rates,
are there other reasons that San Diego might desire to have their financial statements audited?
5.As part of an audit, the CPA firm will gain an understanding of San
Diego's internal business operations and internal control, as well as an
understanding of the industry in which San Diego is situated. Why is this
important to the auditor
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