Chapter 5, Client Acceptance and Continuance And
Review Questions Solutions
Chapter 5, Client Acceptance and Continuance and
Preliminary Engagement Procedures
Page 178
A1 Distinguish between client acceptance and client continuance.
Client acceptance refers to the process used by an auditing firm as it decides whether to begin performing audit work for a company with which it has not been associated in the past. Client continuance deals with continuing to perform audit work for a company that is an ongoing client.
A2 What guidance exists in the professional standards literature regarding client acceptance and continuance?
Guidance regarding: the auditor’s qualifications; the firm’s processes for considering potential and continuing clients; engagement letters
Page 180
B1 What is a request for proposal? Is a formal RFP always used? What information is included in an RFP?
A communication to potential service providers inviting them to submit a proposal to provide the service
B2 What would cause a CPA firm to immediately rule out proposing on a company’s audit, in terms of independence?
If independence can be impaired by various financial interests and business relationships with the company or its affiliates and by providing certain non-audit services to the client
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C1 What performance indicators are found in a 10K?
Profit performance
Financial or cash flow problems, going concern problems
Lawsuits
Risk factors
Sensitivity to changing economic conditions
Likelihood of being affected by industry condition
Regulations affecting financial performance
Potential lawsuits
Vulnerability to global conditions such as trade agreements and exchange rates
Domestic and global competition
Other information
Business activities
Cash flows, and sales needed to satisfy fixed financial commitments
Economies of scale available and achieved
Ability to limit production if needed
Ability to maintain sufficient inventory
Historical instances of needing to reduce inventory
Customer recognition of product differentiation from other suppliers in the industry
Reputation for quality among customers
C2 Why would firms review a potential client’s financial disclosures for information about management’s choices on accounting principles?
The accounting treatments management has selected may give the auditor information regarding management’s philosophy and attitudes. This enables the auditor to assess whether management’s philosophy on accounting treatment and presentation will increase audit risk if the company is added as an audit client.
C3 What are related party transactions?
These are transaction in which one party has the ability to influence the decisions, management or operating policies of the other party. Related parties may be an affiliated company or any entity with which a client deals.
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D1 Why is management and Board of Directors integrity important to an audit firm?
It increases the auditor’s confidence that what people are telling them is truthful and that the documents and information they are inspecting are valid and legitimate.
D2 Why might an auditor be concerned if all of the company’s management authority is centered in one or two individuals?
This situation means all the power and decision making authority is centered in those people so there is less segregation of duties and also a greater opportunity that management can get away with doing whatever it wants to do – for example, fraud.
D3 What is the auditor’s concern regarding a company that lacks a competent management team?
They may not be able to run the company properly and implement suitable internal control policies resulting in greater risk, both to the company and the auditor.
D4 What is financial statement restatement? Why does the auditor investigate whether a company has restated its financial statements when addressing client acceptance?
A restatement occurs when previously issued financial statements are changed to correct an error or as a result of new information that was not previously available. (Retrospective application of a new accounting standard is not restatement.) Restatement can indicate a problem with ICFR and raises the need to be sure it does not reflect on management integrity or competence.
D5 In what way would management misrepresenting a company’s performance in public speeches be a problem to an auditor?
Misleading outsiders by presenting an unrealistically positive picture raises questions of integrity.
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E1 What are the concerns regarding an obscure or a very complex organizational structure?
Whether management is using the organizational structure to withhold information or keep secrets.
E2 What does “going concern” mean?
Questions exist about whether a company is a going concern if there is uncertainty about its ability to continue as a viable entity for the next year. Evaluation of going concern includes considering a company’s resources, cash and borrowing capacity relative to its obligations for the coming year.
E3 What happens to the audit report if there is a question about the client’s ability to continue as a going concern?
The audit report includes this information.
E4 What impact does multiple geographical business locations have on the client acceptance decision?
The auditor considers whether the audit firm has the resources to complete the engagement at the locations. The auditor also addresses the business reasons for the multiple locations. If there is not apparent business reason, it may indicate risk pertaining to (1) the type of transactions conducted at that location and (2) management integrity.
E5 Would the auditor have questions about a potential client having an operating location or bank account in another country when no readily apparent business purpose for the foreign location?
Yes
E6 Why is complexity of a potential client’s IT system important to the proposing auditor?
It provides the audit firm with background regarding the situation it is likely to encounter on the audit of a potential new client and aids in estimating the amount of work that will be involved, audit firm personnel needed, and how long it will take to complete the audit.
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F1 What are the auditor’s sources of information about a potential client?
The company’s website
Its prior year financial statements and auditor’s reports
Reports filed with the SEC
The outgoing or prior auditor
Resources within the business community, media reports, published data and special investigations
F2 What is an 8K? Annual report? Management discussion and analysis?
An 8K is a report that provides information on events that may be of interest such as ownership and management changes, acquisitions and dispositions, and auditor changes.
An annual report is a document prepared by a company that presents various kinds of information about the entity, including a letter to shareholders, financial reports and the audit report.
Management discussion and analysis is disclosure required in reports filed with the SEC including, among other things, risk information and trend analysis.
F3 Why does an incoming auditor communicate with the predecessor auditor? What information does the proposing or incoming (successor) auditor request?
The auditing standards require that an incoming auditor communicate with the predecessor auditor. The information that may be communicated through this type of communication includes:
management integrity concerns
reasons for the change in audit firms
management’s openness and cooperation with the auditor
Board of Directors and audit committee availability and involvement
disputes the auditor has had with management
problems encountered on the audit, such as fraud or illegal acts
The successor auditor may also ask to see the predecessor auditor’s work papers.
F4 Does the predecessor have to respond to the successor auditor? Why might the prior auditor not be willing or able to communicate fully with the successor auditor? Is this okay, according to professional standards?
The predecessor auditor must respond, but is allowed to limit the response. The auditor must state that the response is limited. This would occur if there is a lawsuit or some other dispute involving the client and prior auditor.
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G1 What is a media or data search?
This is a search for information in the media or other public available databases or sources of information. Examples are: (1) an investigation to identify instances when the potential client has been discussed in the print media, and (2) background checks of significant personnel such as top management and directors.
G2 What are some reasons an audit firm might decide to refrain from proposing on an engagement?
The firm might decide it does not have sufficient personnel for the engagement.
The client is planning an initial public offering and the audit firm has limited or no experience with that type of engagement.
If the potential client is in an industry that is highly regulated or for which significant industry expertise is required, or even if it has a very complex IT system, the auditor may determine that it does not have the professional expertise for the engagement.
G3 What is an engagement letter, and what are its contents?
An engagement letter is, effectively, the contract between the auditor and the client. It sets out the items about which the auditor and client should establish an understanding. An engagement letter under PCAOB standards includes the following:
1. The objective of an integrated audit is to express an opinion on the financial statements and ICFR
2. Management is responsible for the entity’s financial statements and for establishing and maintaining effective ICFR
3. Management is responsible for identifying and ensuring that the entity complies with the laws and regulations applicable to its activities
4. Management is responsible for making all financial records and related information available to the auditor
5. At the conclusion of the engagement, management will provide the auditor with a letter that confirms certain representations made during the audit
6. The auditor is responsible for conducting the audit in accordance with the standards of the PCAOB (and then a description of what that means)
7. An audit includes planning and performing the audit to obtain reasonable assurance about reporting…and making certain required communications to management, the audit committee and the Board of Directors.
8. Management is responsible for adjusting the financial statements to correct material misstatements and for affirming to the auditor in the representations letter that the effects of any uncorrected misstatements …are immaterial.
9. Other matters that may be included are:
Conduct of the engagement
Involvement of specialists or internal auditors
Involvement of a predecessor auditor
Fees and billing
Any limitations of or other arrangements regarding the liability of the auditor or the client
Conditions under which access to the auditor’s work papers may be granted to others
Additional services to be provided relating to regulatory requirements
Other services to be provided in connection with the engagement
Review Questions Solutions
Chapter 5, Appendix A, Industry Descriptions
Page 225
Identify the most important accounts, management assertions, and risks for each of the following industries:
H1 manufacturing
Accounts: Raw Materials Inventories, Accounts Payable
Assertions: existence or occurrence, completeness, rights and obligations, valuation
Risks: control over inventory as it moves through the manufacturing process; proper accumulation of costs that make up inventory
H2 retailing
Accounts: Inventory, Accounts payable
Assertions: for Inventory, existence, valuation and cutoff; for Accounts Payable, completeness; for Cash, existence, rights
Risks: physical control of inventories; preventing theft by customers and employees; IT controls for e-commerce sales
H3 health care
Accounts: Sales, Allowance for Contractual Discounts, Unbilled Services, Accounts Receivable, Allowance for Uncollectible Accounts, Payroll Expense
Assertions: for Sales and Unbilled Services, occurrence; for Allowance for Contractual Discounts, valuation and completeness; for Net Receivables, valuation; for Payroll, occurrence, completeness
Risks: Capture and proper billing of all services revenue earned; complex tracking of contracts into Allowance for Contractual Accounts; industry regulations
H4 banking
Accounts: Cash, Liability for Customers Deposits, Interest Payable, Loans Receivable, Interest Receivable, Allowance for Doubtful Accounts
Assertions: for Cash, existence, rights; for Liability for Customers Deposits, occurrence, completeness; Loans Receivable (net of Allowance for Doubtful Accounts), valuation
Risks: compliance with regulation; valuation of collateral for Loans Receivable; controls over IT
H5 service
Accounts: Revenues, Unearned Revenues, Cash, Accounts Receivable, Allowance for Doubtful Accounts, Payroll Expense
Assertions: existence or occurrence, completeness, rights and obligations, valuation and allocation
Risks: revenues are properly accrued and posted; personnel expense is all a valid expense
H6 real estate development
and construction
Accounts: Sales, Land held for development, Notes Payable, Construction-in-progress, Receivables
Assertions: Sales, occurrence; Receivables, existence, valuation; Land held for development, Construction-in-progress, valuation; Notes Payable, completeness
Risks: proper revenue recognition; proper inventory valuation; proper matching of costs to recognized revenue
H7 hospitality
Accounts: Sales, Inventory, Fixed Assets, Payroll Expense
Assertions: Given the hybrid nature of the industry all the assertions are important for different activities
Risks: timing of revenue recognition (recognized only when earned); theft from customers and employees; control over cash and receivables; personnel expense is valid