New Client Acceptance: Engagement Letter

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Accounting
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Question description

(New Client Acceptance) Comprehensive Case: Mt. Hood Furniture, Inc.

Company Background Information: Your employer, Reddy & Abel, LLP, Certified Public Accountants (who is registered with the PCAOB and audits public companies), has been approached by a prospective client, Mt. Hood Furniture, Inc., about your firm taking on their account. The firm has adopted procedures for the acceptance and retention of clients following the AICPA guidelines for quality control in an accounting practice. The firm requires that a partner interview all prospective clients to determine what services the client needs and the ability of the firm to provide those services. As the prospective senior on the engagement, you accompanied the partner on the interview. The following is a summary of your notes from the interviews with senior management.

Notes from Client Interview: Mt. Hood Furniture, Inc. is an Oregon corporation incorporated in 1961. The company is a regional manufacturer of office furniture and cabinetry. The product line includes desks, chairs, filing cabinets, bookcases, credenzas, and European-style cabinets. Approximately 80 percent of fiscal year 20X3 net sales were in office furniture and 20 percent in cabinetry. The cabinetry unit underwent major retooling commencing in 20X2, which approximated 85 percent of the capital expenditures that year. The retooling was financed with significant long-term debt. The improvements enabled the company to manufacture ready-to-assemble furniture products, and develop a modular ready-to-install cabinet line, which has resulted in an increase in sales. The company has developed new, award-winning designs in office furniture, designs that stress the efficient and ergonomic use of technology. Ample opportunity exists to expand sales of the existing product lines. Management estimates that the current physical plant can support up to $50 million in sales without significant additions of manufacturing and distribution capacity. Additional sales up to $50 million are expected to result in additional costs associated with the variable cost of production and variable overheads but should not require increases in fixed costs.

Office furniture is a highly competitive, multibillion-dollar annual market. With a strong economy the market has grown about 15 percent per year over the last two years; however, industry experts expect this growth to slow down in the years ahead. Mt. Hood does not have significant market share and competes with a number of nationally recognized companies. Mt. Hood's primary advantages are competitive pricing and consistently high-quality products. Its low-profit margins are part of a pricing strategy to build market share by undercutting the competition. The custom office cabinetry grants the company a wider profit margin and substantial sales growth potential. This is a unique product line; it offers a custom-built look that is not readily available from other manufacturers. Demand is steadily growing. The company plans to expand its marketing in this niche.

The company's manufacturing and executive offices are located in facilities leased from the founder, adjacent to shipping and transportation facilities in the Pacific Northwest. Two adjacent buildings house the corporation, with the offices located above the warehouse. The company purchases raw materials including coil steel, bar stock, hardware, laminated particleboard, casters, fabric, rubber and plastic products, and shipping cartons. Materials are delivered to the dock by common carriers or by suppliers' trucks. Finished products are shipped FOB from the warehouse or picked up by the customer. Mt. Hood has a delivery truck for smaller, local orders.

The company has 180 employees involved in manufacturing operations and 20 in the executive offices. The company's workforce is stable and highly skilled. Many of the employees have been with the company for more than 15 years. The company's work environment and solid reputation have allowed it to attract and keep employees in a tight marketplace. Mt. Hood offers both pension and profit-sharing plans; the plans have been in place for over 25 years.

The company distributes its products through a small network of approximately 150 office furniture dealers in major U.S. cities. Recently, the company placed its product with several national chains and warehouse-club chains. Most of the sales growth over the last two years is attributed to this new distribution channel; it represented 35 percent of year-20X3 sales. Their largest single customer accounts for 8 percent of sales. The company also produces a catalogue and has an information web site with an order link. The office cabinetry line offers custom orders for on-site installation. Customers include major hotels and professional and corporate offices. Today 20 percent of sales come from this line, and the chief operating officer would like to see this line grow to a total of $25 million in sales in the next three to five years. Individuals, which comprise about 5 percent of total sales, can order directly from Mt. Hood Furniture using the company's web site. A large showroom is maintained at the corporate offices; customers may also place orders at the showroom.

Mt. Hood Furniture is subject to a variety of federal, state, and local laws and regulations relating to the use, storage, handling, generation, transportation, treatment, emission, discharge, disposal and remediation of, and exposure to, hazardous and nonhazardous substances, materials, and wastes. In particular, the U.S. Environmental Protection Agency standards for the wood furniture manufacturing industry require reduction of emissions of certain volatile organic compounds found in the coatings, stains, and adhesives used by Mt. Hood. Company officers believe that Mt. Hood's operations are in substantial compliance with all environmental laws.

Mt. Hood Furniture, Inc. is family owned and not publicly traded; 1 million shares of $1 par common stock are authorized. Major stockholders include the founder, who recently retired as chairman of the board, Robert S. Saws. He holds 30 percent of the outstanding shares. Mr. Saws is 70 years old and until his retirement was closely involved in all major decisions affecting the company. He personally signed corporate checks and supervised the company's operations. He is very proud of his company's strong reputation for being ethical and for meeting its commitments and promises. His son, Conrad P. Saws, has worked in the business for the last 15 years, is the current president and chairman of the board, and under his father's guidance during the last 5 years, has assumed the responsibility of overseeing the business's day-to-day operations. Conrad is also a 30 percent owner. Other family members own an additional 30 percent of the business. The chief operating officer (COO) and chief financial officer (CFO) are the only nonfamily owners at 5 percent each.

Mt. Hood's senior management is comprised of Conrad Saws, the president and chairman of the board; James Doyle, the COO; and Julia Anderson, the CFO. Doyle joined the company two years ago after working for 13 years in the industry for a major office furniture manufacturer. Anderson has worked for the company for about 15 months. She was an audit manager with Reddy and Able prior to joining Mt. Hood Furniture, Inc.

The board of directors includes the retired chairman (Robert Saws), the president and current chairman (Conrad Saws), a family member with a business background in the retail residential furniture sector (Howard Saws), another family member trained in architecture and interior design (Catherine Saws), and the senior president of a large regional bank. During the on-site interview, you and Mr. Reddy met with Robert Saws privately for over two hours, then were introduced to and interviewed individually the other members of the senior management team. Each of these interviews extended beyond an hour and allowed Mr. Reddy the opportunity to explore the business goals driving the company.

Robert and Conrad Saws have been the driving force behind the company's success over its long history. They made it clear they know and understand the industry. In their view, succeeding in the increasingly competitive office furniture marketplace necessitates that the company focus its resources on taking calculated risks to increase its market share and name recognition. They also believe the company must specialize its product lines. They see the office cabinetry niche as one the company can develop more fully so that this product line will be able to cater to the growing preference for a customized office work environment at reasonable cost. They explained that Mt. Hood has two general directions in production. The fastest growing sales are in product lines marketed through warehouse outlets. In this market, price and availability are the overriding purchase determinates. The dynamics of the workplace dictate the other growing sales line: office furniture that caters to a technology-based work environment where increasing the productivity and flexibility of increasingly expensive office space is the driver. They are confident the company has assembled a management team capable of improving profitability and sales.

When asked about the change in accounting firms, Conrad Saws informed Mr. Reddy that the prior accountant was very skilled at completing the audit to meet debt covenants, but the company needed an accounting firm capable of helping Mt. Hood move beyond the present. This included assistance with financial planning (both personal and for the company), developing better performance measures for the company, and improving the incentive compensation plan for key employees. Beginning this year, the company put a bonus plan in place for key executives based on sales growth. They saw no reason for any scope limitations, and they expect the firm of Reddy & Abel to offer suggestions to facilitate the firm's desire to successfully negotiate the expansion. They also said that they would contact their previous auditor and grant them permission to talk candidly with Reddy and Abel about the potential change in auditors. Mr. Saws' banker and attorney separately recommended Reddy & Abel as a firm capable of understanding the forces driving business success, and capable of forming a mutually beneficial working relationship. Robert Saws also volunteered that his niece is a senior accountant with Reddy & Abel. She owns a few shares of Mt. Hood Furniture, and is also the executor of Mr. Saws' will.

The interview with the other senior management team members added details to the company's business position. The COO explained that the current information systems have been stressed by the company's growth over the past three years. Significant computer system improvements are in process (which represents major capital expenditures in 20X3). The timeline for completing the implementation of a new database system indicates that it should go on-line in the second quarter of year 20X4. The upgrade is a major capital expenditure and is seen as a vehicle for improving information throughput and providing timely information on the company's financial performance. The company expects to spend between $75,000 and $85,000 in 20X4 to complete the project. Maintaining the physical plant at its current production capacity is estimated to run $250,000 to $400,000 per year.

The CFO is concerned about improving cash flow from operations and speeding up the operating cycle, changes that could involve reassessing Mt. Hood's credit and payment terms. The COO is worried that tightening credit terms would hinder sales growth. The president is adamant about maintaining sufficient inventory to make sure orders can be shipped with minimal backorders. The CFO commented that the major reason for the audit is to satisfy a debt covenant of the lender and explained the company's debt maturities are accelerating, hampering cash flows available for investing to expand sales. In expanding capacity to grow sales beyond $50 million, the CFO suggests that the company consider venture capital to grow the company until it is ready for an IPO. In the past, the major lender has been the primary financial statement user, along with several creditors, but the CFO plans to show the financial statements and in-house projections to potential venture capitalists as well. Current planned expansion costs are estimated to require about $3 million in land, manufacturing, and distribution facilities, which could raise revenues to $100 million.

Other Information: After the interview, Mr. Reddy contacted the prior auditor, Mr. Will B. Dunn, CPA, regarding the potential change in auditor. Mr. Dunn was not surprised that Mt. Hood Furniture was considering a change in auditor. He had been Robert Saws' accountant for nearly 30 years. In recent years, Conrad had taken more responsibility and had been more aggressive about growing the company. Mt. Hood hired outside management for the first time in company history, and with the hiring of a CFO for the first time, he had expected this phone call. Mr. Dunn expressed no concern about the integrity of management. Several years ago, Mr. Dunn said that Conrad Saws had raised several questions with Mr. Dunn about revenue recognition on some possible “bill-and-hold” sales in advance of negotiating a sales agreement with a national office supply and furniture chain. No problems were noted in the subsequent audit. Mr. Dunn expressed concern about the current accounting system that was expected to be replaced in 20X4. Audit adjustments in the last few years resulted from cutoff problems, from an adjustment due to an error in counting inventory, and from discussions over bad debt reserves. Dunn noted that Ms. Anderson was challenged by an accounting staff that needed more training and an accounting system that was having difficulty keeping up with the company's recent trend associated with the increased volume of transactions. Finally, he noted that if Mr. Reddy's firm was selected as auditor, he would cooperate by allowing Mr. Reddy to review his working papers to the extent needed to prepare for the upcoming audit. Discussions with Mt. Hood Furniture's banker and outside legal counsel confirmed that company management had a reputation of acting with integrity and honesty.

Financial Information: Audited financial results for 20X1 and 20X2, along with unaudited financial information for 20X3 are included in Chapter 8 (Figure ) as part of Problem 8-18 along with relevant industry statistics.

Required

  1. Draft an engagement letter for partner review. You may assume that the fee estimate for audit services will run between $20,000 and $25,000, and the fee for tax services is estimated between $7,500 and $10,000. Separate proposals may be presented at a later date for additional services based on audit findings.

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