Vial-tek has an existing loan in the amount of $1.5 million with an annual interest rate of 9.5 percent. The company provides an internal company-prepared financial statement to the bank under the loan agreement. Two competing banks have offered to replace Vial-tek’s existing loan agreement with a new one. First National Bank has offered to loan Vial-tek $1.5 million at a rate of 8.5 percent but requires Vial-tek to provide financial statements that have been reviewed by a public accounting firm. Second National Bank has offered to loan Vial-tek $1.5 million at a rate of 7.5 percent but requires Vial-tek to provide financial statements that have been audited. The controller of Vial- tek approached a public accounting firm and was given an estimated cost of $12,000 to perform a review and $20,000 to perform an audit.
REQUIRED
a. Explain why the interest rate for the loan that requires a review report is lower than that for the loan that does not require a review. Explain why the interest rate for the loan that requires an audit report is lower than the interest rate for the other two loans.
b. Calculate Vial-tek’s annual costs under each loan agreement, including interest and costs for the public accounting firm’s services. Indicate whether Vial-tek should keep its existing loan, accept the offer from First National Bank, or accept the offer from Second National Bank.
c. Assume that First National Bank has offered the loan at a rate of 8 percent with a review, and the cost of the audit has increased to $25,000 due to new auditing standards requirements. Indicate whether Vial-tek should keep its existing loan, accept the offer from First National Bank, or accept the offer from Second National Bank.
d. Explain why Vial-tek may desire to have an audit, ignoring the potential reduction in interest costs.
e. Explain how knowledge of e-commerce technologies and a strategic understanding of the client’s business may increase the value of the audit service.