Assignment case Smith and Jones LLP PDF

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EPM Assingment 2020 Semester 2...

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Smith & Jones LLP: Charting a Path to the Future* NORMAN T. SHEEHAN, University of Saskatchewan ABSTRACT This case requires accounting students to shift their focus from learning about the practice of auditing to learning about the business of auditing. It describes the strategy, vision, and mission of a medium-sized, Canadian audit firm and the external and internal challenges the firm faces as it looks to improve its profitability. Students should reflect on which behaviors Smith & Jones would like to encourage and what the partners can do to encourage its employees to exhibit these behaviors. Keywords

Balanced scorecard; Incentive systems; Performance measurement; Professional accounting firm; Strategy mapping SMITH & JONES LLP : TRACER LA VOIE DE L’AVENIR

RÉSUMÉ L’auteur propose un cas exigeant des étudiants en comptabilité qu’ils envisagent la vérification sous l’angle de l’activité commerciale plutôt que de l’activité professionnelle. Il décrit la stratégie, la vision et la mission d’un cabinet de vérification canadien de taille moyenne, ainsi que les défis externes et internes que doit relever le cabinet dans ses efforts pour améliorer sa rentabilité. Dans cette étude de cas, les étudiants sont appelés à réfléchir aux comportements que Smith & Jones a intérêt à encourager de même qu’à ce que les associés peuvent faire pour inciter leurs employés à adopter ces comportements. Mots clés : cabinet comptable, évaluation du rendement, grille stratégique, programmes d’incitation au rendement, tableau de bord

Sally Jones is preparing for next month’s partner retreat in Phoenix. Sally is one of three founding partners and is currently the lead partner for the Assurance Services unit of Smith & Jones LLP. She worries about the performance of her unit, and that of the firm as a whole, because there has been no bottom-line growth, and revenues increased by only 2 percent in 2007 (see Appendix 1). There are a number of other issues that she is sure will dominate discussions at the partner meeting: the profit available for partners is below industry average, and in the past year her firm has lost several larger audit clients to rival audit firms and to * The author thanks Fred Phillips, Gary Entwistle, Doug Kalesnikoff, Mark Klassen, Nathalie Johnstone, Kenneth Fox, and Martin McInnis for their comments on earlier versions of this case. Thanks also go to Hugh Gove, Gary Spraakman, Irene Gordon, and Eldon Gardner for their helpful reviews and comments at the 2008 Canadian Academic Accounting Association (CAAA) Conference in Winnipeg. An earlier version of this case won the CAAA English Case Competition Award in 2008. AP Vol. 8 No. 2 — PC vol. 8, no 2 (2009) pages 165 – 77 © CAAA / ACPC doi:10.1506/ap.8.2.4

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clients’ bankruptcies and mergers. Although the audit partners have stepped up their efforts to win new clients, the firm has not yet won any significant new audits. Things have not gone well on the staff front either — her unit has lost a number of staff CAs and students as well as two partners. Further still, her unit, Assurance Services, has the lowest billable hours and realization rate,1 due to client miscommunications that led to files being redone. Smith & Jones has rapidly grown from a small, local firm to a medium, regional firm through organic growth and mergers. When her own firm was small, it was easy to see whether everyone was on the same page — they all worked within 10 feet of each other in the same, cramped office. But now with 16 partners and 96 professional staff divided between four offices in western Canada, Sally is unsure whether her staff understand the vision and whether they are living the firm’s core values. Sally knows the Business Advisory Services unit of Smith & Jones regularly helps clients to improve their performance, but wonders whether what was “good for the patient” is also “good for the doctor”. She invites you, Morgan Jaille, to her office to discuss what is ailing Smith & Jones, and to ask whether you can provide recommendations to improve the firm’s performance. You have been with the firm since your graduation and are almost finished your CASB coursework. You enjoy the people you work with and the camaraderie, and although you have shown a talent for assurance work, your heart is set on working as a business consultant. Your objective, once you receive your professional designation, is to work in the Business Advisory unit, helping firms to improve their bottom lines. You see this assignment as a chance to impress Smith & Jones’ Business Advisory partners with your consulting abilities. Sally limits the scope of the assignment by asking you to focus your efforts on the Assurance Services unit of Smith & Jones. Your goal is to make recommendations that will increase her unit’s profitability, and thus increase the partners’ take-home pay. SMITH & JONES’ STRATEGY At the 2006 partner retreat, Sally and the other partners sat down and formalized Smith & Jones’ strategy, vision, and core values (see Figure 1). To reinforce this message, the firm had its strategy and vision printed on the back of each staff members’ business card. THE PAST AND FUTURE OF SMITH & JONES After graduating from the University of Saskatchewan in the late 1980s, Sally Jones started her career with, and earned her CA designation while working for, one of the Big 8 audit firms in Calgary. She decided to move back home to Saskatoon and strike out on her own in 1996 because she was tired of working long hours without adequate compensation, and the long commutes in Calgary. She was extremely competent and personable and soon grew 1. Chargeable hours are hours that are spent working on the client’s file. Staff are typically expected to have 1,200 chargeable hours a year. Billable hours are hours that are billed to a client. In a perfect world, billable hours would equal chargeable hours, but for various reasons this may not occur. The realization rate is the percentage of hours billed to clients that are ultimately collected from clients. The realization rate may be lower than 100 percent because of the client’s inability to pay or the clients’ unwillingness to pay disputed invoices. Smith & Jones had a realization rate of 88 percent in the past year. AP Vol. 8 No. 2 — PC vol. 8, no 2 (2009)

SMITH & JONES LLP: CHARTING A PARTH TO THE FUTURE

Figure 1

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Smith & Jones’ strategy, vision, and core values

Smith & JoneS LLP STRATEGY Smith & Jones will apply its professional expertise in Assurance, Tax and Advisory Services to create value for its clients. Through excellent customer service the firm will increase its practice by acquiring and retaining the best clients in Western Canada. VISION Helping our clients and profession succeed by exceeding expectations the first time, every time.

CORE VALUES

• We promote work–life balance because our employees are our most important asset.

• Success is achieved through competence and life-long learning.

• Highly responsive to our clients needs—we always listen and act in their best interests.

• Integrity and honesty in all dealings. • Teamwork and cooperation are prized above all.

• We seek to improve both our profession and our communities.

her firm, Jones & Co., to a substantial size. In 2000, she was approached by a larger accounting firm from Regina, Smith and Partners LLP, regarding a merger. Sally agreed and was made partner of the larger firm, which is now called Smith & Jones LLP. Like other audit firms, Smith & Jones’ assurance division struggled before 2003 as firms bid their audit work below cost in order to cross-sell more profitable services such as tax and business advisory. Auditing even lost status in the eyes of some recruits and some audit firms started up consulting arms just to be able to continue to attract the brightest and best business students. Sally recalled that the auditing profession’s darkest hour was the implosion of Arthur Andersen in 2002. In the turbulence that followed, investors, the general public, government, and regulators criticized audit firms, and some pundits even questioned their existence, noting they had done little to prevent huge financial misstatements, such as Enron, WorldCom, HealthSouth, and Nortel. Fortunately, cooler heads prevailed and instead of reducing the requirement for statutory audits, new regulations, such as the Sarbanes-Oxley Act (SOX), significantly increased the need for assurance services. The passage of SOX meant increased compliance testing, especially in the area of internal controls (section 404).2 For many clients, this meant their audit hours and total assurance fees increased by as much as 50 percent. 2. Unfortunately, even with the additional SOX control work, in the aftermath of the 2008 global finance crisis, several large financial firms, all of which had recently received a clean audit opinion from a Big 4 audit firm (shown in brackets), either filed for bankruptcy, such as Lehman Brothers (E&Y), or were close to bankruptcy, such as Washington Mutual (Deloitte), AIG (PwC), Fannie Mae (Deloitte), Freddie Mac (PwC), Bear Stearns (Deloitte), Countrywide (KPMG), and New Century (KPMG). As of December 2008, all the named finance firms were being investigated by the FBI; however, no formal charges had been laid. At present, two of the Big 4 audit firms had been named as co-defendants in class action lawsuits (Deloitte as the auditors of Washington Mutual and Bear Stearns and KPMG as the auditors of Countrywide and New Century). AP Vol. 8 No. 2 — PC vol. 8, no 2 (2009)

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For example, it is estimated that in 2003 PotashCorp of Saskatchewan paid approximately $1.2 million for its audit and $0.6 million for its first year of SOX compliance work. Almost overnight the fortunes of audit units improved. In fact, in the wake of the introduction of SOX, most of the Big 4 accounting firms struggled to meet the demand for assurance services. In response to this increased demand and the prohibitive cost of a bad audit, some larger CA firms cut loose higher-risk clients and increased the audit fees for their remaining clients. Because of this, Smith & Jones was able to pick up a number of clients in the areas in which they specialized: small business, credit unions, and agribusiness. Although their revenues rebounded in the wake of SOX, a significant issue for Smith & Jones was the hiring and retaining of staff. In the past couple of years, Smith & Jones lost over 10 percent of its staff and two partners to industry or rival audit firms. Sally had reasons to believe that the demand for CAs would not recede in the near future. As more baby boomers reach retirement age, the number of CAs leaving the profession is increasing. Unfortunately, the number of students entering the profession is not enough to offset these retirements. Even with UFE (uniform evaluation) pass rates at unprecedented high levels, the supply of CAs is inadequate to meet demand. To make the profession even more attractive to prospective university students, the Canadian Institute of Chartered Accountants (CICA) now allows students to become CAs without working in an audit firm and performing any assurance work as part of their professional work experience requirement. Unfortunately, this will further reduce the number of audit hours available to firms like Smith & Jones, because all CA students currently have to complete a minimum of 600 audit hours as part of their professional work experience. Another issue is that fewer than 40 percent of CAs remain in public practice after qualifying for their CA designation. The majority of CAs leave public practice to work in industry, where many enjoy larger compensation packages after taking into account stock-based incentives. As a result of the increased competition for CAs, their salaries have been bid up, especially in areas where the economy is booming. Sally knows that Smith & Jones is not well equipped to win the CA talent war. Smith & Jones offers a mentorship program, flexible hours, and a broad variety of audit assignments. However, the Big 4 accounting firms offer higher wages, signing bonuses, international assignments, subsidized child care, concierge services, superb in-house training programs, flexible benefit packages, and a UFE passing bonus. To get a better handle on why Smith & Jones is losing its staff members, Sally reviewed the exit interviews from staff who had recently left the firm. Specific complaints from CAs and students included long hours, many of which were uncompensated, and because of all the work, they were often denied time off for training and development. Sally was disappointed to read this because all Smith & Jones’ staff are entitled to 150 hours of training each year. Staff also complained that the number of hours budgeted for files was often insufficient, so they had to work extra unpaid hours just to make budget. The partners who left observed that not everyone lived the firm’s stated values, commenting that some partners refused to help when another partner or manager had requested it. One partner, who volunteered many hours on the executive of the United Way and the Rotary Club, grumbled that this contribution was not recognized, as did another who coached several children’s sports teams. Finally, a partner harped on a perennial bone of contention at the partner meetings: the firm has several partners who are outstanding “rainmakers”. However, while these partners were adept at bringing in new AP Vol. 8 No. 2 — PC vol. 8, no 2 (2009)

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clients, they sometimes subsequently lost the business because they did not effectively manage their staff or adequately service clients. Partners who had a better bedside manner with clients and effectively managed their staff, but were less effective in bringing in new engagements, wanted some of these clients assigned to them. While you are meeting with Sally, an audit partner interrupts to ask her whether she has had time to read the proposed new audit standard. Sally sighs while thinking about the continuous stream of new audit standards. Like many of her colleagues, she has become “standard-fatigued”: it seems like every week a new accounting or auditing standard must be read, understood, and incorporated into Smith & Jones’ standard audit procedures. Smith & Jones can sometimes use the introduction of new auditing regulations to justify higher audit fees to its clients. Most of the time, however, the new regulations only reduce its audit margins. In addition, changes in professional practice rules have increased the volume of documentation required for the audit, and for demonstrating adherence to stricter independence rules. Unfortunately, these changes have a larger cost per employee for smaller accounting firms than larger firms. In fact, Sally has heard that several smaller CA firms stopped performing statutory audits because the investment needed to maintain their practice was outstripping the benefit. The coming introduction of international reporting financial standards (IFRS) also weighs heavily on smaller audit firms. While IFRS remain a bright spot for larger audit firms with clients forced to adopt IFRS, because of the higher fees that will ensue, the picture is not as positive for smaller audit firms that may only have few or no clients who will implement the new standards. For these smaller audit firms, it may not be worth the cost to train employees and update audit practices to IFRS. Indeed, one reason why the two smaller audit firms, one in Brandon and the other in Lethbridge, sought to merge with Smith & Jones was that these firms were struggling to keep up with the new professional practice standards. Before adjourning the meeting, Sally shares with you her concern about the potential risk of a failed audit. If a client company experiences financial distress and it is subsequently determined that Smith & Jones had failed to detect a violation of generally accepted accounting principles (GAAP), Smith & Jones’ reputation would suffer, driving away current and future clients. Sally tells you that Smith & Jones is scheduled to be scrutinized by the Canadian Public Accountability Board (CPAB) in the coming year.3 PRACTICE AREAS Smith & Jones has three practice units: • Assurance Services undertakes notice to readers/compilations, financial reviews, and audit engagements. Sally Jones is the lead partner for Assurance Services. Ten partners, 16 audit managers, and 50 full-time professional staff report to Sally. • Tax Services assists clients with preparing and filing corporate and personal tax returns, tax planning, succession and estate planning, sales taxes, and payroll filings. 3. CPAB examines a CA firm’s audits using six criteria: tone at the top / leadership, independence and ethics, client acceptance and continuance, human resource policies, engagement performance, and quality monitoring. AP Vol. 8 No. 2 — PC vol. 8, no 2 (2009)

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Bob Smith is the lead partner for the Tax Services unit. Three partners, five managers, and six staff report to Bob. • Business Advisory Services provides advice on operational improvements (including implementing performance measurement systems), business valuations, strategic planning, and enterprise risk management. Bill Dopp is the lead partner for the Business Advisory Services. Three partners, ten managers, and nine staff report to Bill. THE AUDIT CYCLE The assurance process at Smith & Jones starts with the audit bid. Clients typically tender their statutory audit every five years. Acquiring new audit clients involves gaining expertise in an industry (including hiring staff with industry expertise), raising the audit firm’s profile to companies in the industry, and networking with key stakeholders, such as lawyers, bankers, and other professionals. This is necessary because clients will only invite those seen to possess the requisite industry expertise to submit a written proposal. If Smith & Jones is invited to bid, a partner reviews the client and industry to see whether it is attractive from an audit fee and risk perspective. If it is, Smith & Jones submits a bid and then, if selected as a finalist, presents its bid to the client’s audit committee. The client’s audit committee then evaluates each audit firm on the basis of its audit ability, industry expertise, meeting /presentation skills, and the audit fee proposal before making a decision. Deciding what audit fee to quote is a delicate issue, but in general Smith & Jones sets its audit fees in terms of the number and type of hours needed (i.e., how many specialists are required), the riskiness of the client (i.e., risk of financial misstatement), and what its competitors are expected to bid for the audit engagement. If Smith & Jones wins the audit, its staff completes the audit using a proprietary, riskbased audit methodology: 1. Audit planning • meet with the client to document their expectations; • review the prior year’s file; • review client and industry changes; • review current accounting and financial reporting guidelines; • confirm independence; • set materiality in light of user needs, and then develop an audit plan that is based on an in-depth assessment of the client’s financial reporting risk; and • form the audit engagement team and prepare/ approve an engagement time budget. 2. Assurance testing • substantive tests; • tests of internal controls, computer systems, and processes; and • assessment of accounting principles applied and estimates. AP Vol. 8 No. 2 — PC vol. 8, no 2 (2009)

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3. Complete and review audit • review contingent liabilities and subsequent events; • evaluation of audit results by the engagement partner; • review of audit file and statements by the risk partner; • complete and issue auditor’s report; and • meet wit...