Chapter 5

Client Acceptance and Continuance and Preliminary Engagement Procedures

Learning Objectives

1. Understand the purpose and role of client acceptance and continuance activities.

2. Recognize the professional standards relating to client acceptance and continuance.

3. Analyze various considerations in an auditor’s client acceptance and continuance decisions.

4. Learn the important components of the understanding between the audit firm and client regarding terms of the engagement that are documented in the engagement letter.

Client Acceptance and Continuance Decisions

Auditors should only perform audits that they can complete with professional competence.

consider the reputation risk that comes with selecting and accepting clients.

recognize that a variety of risks are associated with clients.

Overview of Client Acceptance

Do we want this client? Can we effectively perform this audit? Research the client Do we still want the audit? Present proposal Did we win the engagement? Complete preliminary engagement

procedures

Steps Before the Audit Begins Auditor proposal and client acceptance,

OR client continuanceTHEN

Confirm and communicate auditor independence In writing and before the engagement starts if

it is the first year of auditing a public company

Establish understanding of terms of the engagement

Guidance in Professional Literature

First GAAS states that the audit is to be performed only by those having technical proficiency as an auditor

Auditor’s “Quality Control Standards provide guidance.

COSO Treadway Commission Internal Control Framework provides guidance.

Independence standards apply

Opportunity for a New Client

The audit firm receives a Request for Proposal (RFP) Do we want this client?

General reputation Willingness to be associated with the company Management integrity

Can we effectively perform this audit? Client needs Sufficient knowledge Personnel with appropriate experience and skills Ability to provide appropriate supervision and review Firm independence …the firm has to have ability to do the audit by the time

the engagement begins…not at the time of proposing

Investigating the Potential Client Influences the Auditor Considers:

Published financial information Financial statement restatements

Performance information Information releases

Accounting practices and disclosures Organizational structure

Management and BOD integrity Financial difficulty, going concern

Company leadership Multiple business locations

Audit committee and BOD Client accounting function

Potential client business activities Management’s use of information

Published Financial Information

Annual reports Financial Statements SEC filings Information from these documents

Size of the company’s assets, revenue and market capitalization

Publicly traded? Plans for an IPO? …these are indicators that help the firm

assess the size of the audit job and expertise required

Performance Information

Profit performance Quality and potential of the business Risk Going concern

Cash flow Industry characteristics Financial performance Business performance

Sources of Performance Information

10K Sensitivity to changing economic conditions Likelihood of being affected by industry

conditions Regulations affecting financial performance Potential lawsuits Vulnerability to global conditions Domestic and global competition

Company’s earnings calls Trading activity of the company’s stock

Business Performance Information from the 10K

Additional information from the 10K that may be useful to the auditor in client acceptance decisions:

Business activities Cash flows and sales needed to satisfy fixed

commitments Economies of scale available and achieved Ability to limit production if needed Historical instances of needing to reduce inventory Recognition of the companies product Reputation for quality

…guidance from the auditing standards…

Caution Indicator: Recurring negative cash flows from operations and an inability to generate cash flows from operations while reporting earnings and earnings growth.

Caution Indicator: Significant declines in customer demand and increasing business failures in either the industry or overall.

Caution Indicator: High degree of market saturation, accompanied by declining margins.

Caution Indicator: New accounting, statutory or regulatory requirements. [AU 316.85 A.2 (Incentives/Pressures) a]

Accounting Practices and Disclosures

Auditor may be able to infer information about management’s philosophy and operating style.

Does management prefer aggressive or conservative accounting treatment?

Does top management excessively intrude in selecting accounting principles ? Does it appear that top management attempts to “manage earnings”?

Does the company engage in related party transactions?

…guidance from the auditing standards…

Caution Indicator: Recurring attempts by management to justify marginal or inappropriate accounting on the basis of materiality. [AU 316.85 A.2 (Attitudes/Rationalizations)]

Caution Indicator: Nonfinancial management’s excessive participation in or preoccupation with the selection of accounting principles or the determination of significant estimates. [AU 316.85 A.2 (Attitudes/Rationalizations)]

Caution Indicator: Significant related party transactions not in the ordinary course of business or with related entities not audited or audited by another firm. [AU 316.85 A.2 (Opportunities)a]

Management and BOD Integrity Affects auditor’s decision on whether to accept or

continue a client One of the most important considerations Addressed in multiple sources of auditor guidance Any type of management fraud is considered a

strong indication of a material weakness in ICFR Sources of information

Investigations or actions by law enforcement or regulatory agencies

Media searches and background checks Adverse publicity Company code of ethics

…guidance from the auditing standards…

Caution Indicator: Known history of violations of securities or other laws or other laws and regulations, or claim against the entity, its senior management, or board members alleging fraud or violations of laws and regulations.

Caution Indicator: Ineffective communication, implementation, support, or enforcement of the entity’s values or ethical standards by management or the communication of inappropriate values or ethical standards. [AU 316.85 A.2 (Attitudes/Rationalizations)]

Company Leadership

COSO Enterprise Risk Management Framework Competent and skilled management and BOD Able to set objectives, identify risks, respond to risk Commitment to competence throughout the company Personnel appropriately assigned and delegated responsibility

Management philosophy and operating style Power and authority concentrated in one or a few people? Structure, size and composition of management team? Potential for management fraud?

Turnover rate of the company’s executives Particularly accounting and finance: If it is high, why is that

occurring?

Company Leadership continued

Auditor assess whether the individuals in management and director positions have the necessary attributes to make the company a desirable client. Composition of top management team Each individuals’ time with the company Industry experience Organizational structure Management compensation structure

…guidance from the auditing standards…

Caution Indicator: Domination of management by a single person or small group (in a nonowner-managed business), without compensating controls.

Caution Indicator: High turnover of senior management, counsel, or board members. [AU 316.85 (Opportunities) b-c]

Audit Committee and Board of Directors

If the BOD and Audit Committee are not actively involved in the company’s governance there may be a greater risk in accepting the company as an audit client

Lack of sufficient involvement in the financial reporting function by the Board of Directors and Audit Committee may suggest a material weakness in ICFR

Auditor Questions about the Board of Directors

What percentage of the BOD is somehow connected to the company through financial investments or transactions, or a management position?

What employment and educational backgrounds do the directors have?

Do the directors have the knowledge and experience needed to oversee the company’s management?

How much work is involved in being on the BOD? Is the compensation structure for directors

appropriate given the qualifications and what is expected of them?

Audit Committee

SOX definition: A committee (or equivalent body) established by and amongst the board of directors of an issuer for the purpose of overseeing the accounting and financial reporting processes of the issuer and audits of the financial statements of the issuer.

NYSE requires a company to have an audit committee to be listed.

If a public company’s audit committee does not have at least one financial expert this fact must be disclosed.

Qualifying Characteristics of a Financial ExpertSEC rules define an audit committee financial expert as a person

with the following attributes: An understanding of generally accepted accounting principles and financial statements;

The ability to assess the …application of such principles in…accounting for estimates, accruals and reserves;

Experience preparing, auditing, analyzing or evaluating financial statements…comparable to the breadth and complexity of issues…expected to be raised by the registrant’s financial statements, or experience actively supervising one or more persons engaged in such activities;

An understanding of internal controls and procedures for financial reporting;

An understanding of the audit committee functions.

These attributes may have been acquired through: Education and experience as a principal financial officer, principal accounting officer,

controller, public accountant or auditor or experience…that involve(s) the performance of similar functions;

Experience actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor or person performing similar functions;

Experience overseeing or assessing the performance of companies or public accountants with respect to the preparation, auditing or evaluation of financial statements;

Other relevant experience

Potential Client Business Activities

Auditors need to know a potential client’s business activities: Are the activities within the audit firm’s

area of industry and audit expertise? Are the company’s activities compatible

with the firm’s preferences for its client portfolio?

Are the company’s activities too risky for the audit firm to want to be associated with the company?

Financial Statement Restatement Occurs

To correct an error in previously published financial statements

When more information or evidence becomes available after the financial statements were released

Information about a restatement is in publicly available documents if the company is publicly traded

Auditor considers the reason why the financial statements need to be restated Does it indicate anything negative about management

integrity or competence? Does it indicate problems with the company’s internal

accounting function? Restatement to correct a misstatement or error is a strong

indicator that there is a material weakness in ICFR

Public Information Releases by Management

How does management present the company to outsiders? “puffing” may be ok, but misleading

outsiders by presenting an unrealistically positive picture raises questions about management integrity

…guidance from the auditing standards… Caution Indicator: Profitability or trend level

expectations of investment analysts, institutional investors, significant creditors or other external parties…including expectations created by management in, for example, overly optimistic press releases or annual report messages. [AU 316.85 A.2 (Incentives/Pressure) b]

Organizational Structure Is the information easy to obtain and understand?

If not, the auditor considers why. Is there a legitimate business reason? Or, to obscure ownership and organizational structure to hide something?

No particular structure is better than an other. Structure should be appropriate for the company Should fit the business needs and management style

….guidance from the auditing standards… Caution Indicator: Difficulty in determining the organization or

individuals that have controlling interests in the entity. Caution Indicator: Overly complex organizational structure involving

unusual legal entities or managerial lines of authority. [AU 316.85 A.2 (Opportunities) c]

Financial Difficulty and Going Concern Evaluating whether a business has the resources

to continue as a viable entity for the next year is referred to as assessing whether the business is a going concern.

…guidance from the auditing standards… Caution Indicator: Operating losses making the threat

of bankruptcy, foreclosure, or hostile takeover imminent. Caution Indicator: Marginal ability to meet exchange

listing requirements or debt repayment or other debt covenant requirements.

Caution Indicator: Perceived or real adverse effects of reporting poor financial results on significant pending transactions, such as business combinations or contract awards. [AU 316.85 A.2 (Incentives/Pressures) a-b]

Multiple Business Locations Important to the auditor:

Are there multiple locations and where are they? Important is assessing audit resources (people) needed.

Does the company have legitimate business reasons for those locations?

…guidance from the auditing standards… Caution Indicator: Significant operations located or conducted

across international borders in jurisdictions where differing business environments and cultures exists.

Caution Indicator: Significant bank accounts or subsidiary or branch operations in tax haven jurisdictions for which there appears to be no clear business justification. [AU 316.85 A.2 (Opportunities) a]

Client Accounting Function

Does the company have: An accounting system with effective

controls Sufficient accounting personnel to

get the work done A budgeting process An appropriate internal audit

function How complex is the IT system?

…guidance from the auditing standards…

Caution Indicator: Inadequate monitoring of controls, including automated controls and controls over interim financial reporting

Caution Indicator: High turnover rates or employment of ineffective accounting, internal audit or information technology staff.

Caution Indicator: Ineffective accounting and information systems

Caution Indicator: Inadequate internal control over assets that may increase the susceptibility of misappropriation of those assets. [AU 316.85 A.2-3 (Opportunities) b,d]

Sources of Publicly Available Information

Company’s web site SEC filings Annual report, letter to shareholders Proxy statements

Other Sources

Interviewing the potential client Communication with the predecessor auditor

Successor auditor is required to communicate with predecessor auditor

Predecessor auditor must obtain permission from the client before disclosing confidential information

Predecessor responds, even with “unable to respond” statement; must say if the response is limited

Business resources: lawyers, bankers Media and data searches Investigations by professional outsiders

Firm Resources and Expertise

If a potential client company is very large, or has multiple geographic locations, the audit firm may decide it does not have sufficient personnel for the engagement.

Therefore, audit firms consider whether a potential client is the most profitable way to utilize the firm’s human resources.

Do we still want the audit?

After completing the research, the auditor assesses the information gathered.

If the client is desirable, the auditor prepares a proposal.

If the auditor is selected the next steps are Agreeing on terms of the engagement and

executing an engagement letter Confirming independence

Note that at this stage it is a verification; the auditor would not have gone this far without investigating independence

Engagement Letter

“Engagement letter” is the label used for the contract between the auditor and client

Provides: Objective of an audit Management’s responsibilities Auditor’s responsibilities

Includes fees and financial arrangements Requirement for an engagement letter and

list of required contents are included in both PCAOB and AICPA auditing standards

Appendix A: Industry Descriptions

What are the risks of companies in different industries?

Why do auditors need industry knowledge?

Manufacturing

Physical controls over inventory to prevent shrinkage from employee theft

Documentary controls as items move through the manufacturing process

Accounting system to capture inputs like direct labor and overhead

Possibly, integration of human resources and inventory

Cost accounting system Controls for cutoff – matching sales and cost

of sales

Retail

Control over purchasing Keeping up with what sells and does not sell to

prevent lost sales because of stock outages and inventory obsolescence

Control over cash Control over credit processes

Following procedures for credit sales to limit nonpayment risk or shift it to an outsider

Theft prevention and detection, from employees and outsiders

Managing inventory obsolescence E-commerce; sales over the Internet

Credit approval, inventory availability, shipping

Health Care

Complete and accurate capture and recording of services provided Link to HR system and supplies inventory when appropriate IT impacts

Accurate billing process Affects receivables and cash flows Insurance verification is parallel to credit verification

Allowances for contractual discounts; difficult account to audit

Quality control issues Regulation Sales contracts with 3rd party payers (capitation

contracts)

Banking

Regulation Documentation Cash reserves Collateral quality Multiple regulators

Loans and collateral Collectibility Valuation

Service Revenue recognition: Payment may occur in advance. When is

revenue earned? Unearned service account

A liability account, so concern for completeness assertion; relates to proper revenue recognition

Payroll expenses Large dollar amount; probably material Year end accruals: payroll, vacation, sick leave, other

benefits Engagement management systems: Interface between payroll

and engagement management system for accumulating job costs and billing functions; possibly sophisticated IT

Unbilled service revenue: Accrued correctly at year end? Valuation of AR

Real Estate Development and Construction Land and construction as inventory Construction in process: proper capture of

inputs, proper valuation (FMV), allocation of common costs

Percentage of completion Estimates are long term; matching relies on

estimates because costs AND revenues are estimated

Estimates are used for Percentage of completion Fair market value Allocation of common costs

Hospitality

As used here, a hybrid. Includes lodging, restaurants, entertainment venues

Hotels, important issues Debt on the property Are reported sales correct? Can audit using

analytical procedures based on capacity, room rate and rate of occupancy.

Expenses Biggest risks: Can the debt on the property be

paid on time? How sensitive is the entity to changes in the price it can collect for room sales or occupancy rate?

Hospitality continued

Restaurants, important issues Risk to the owner is shrinkage: food, cash,

alcohol Highly perishable inventory

Commonalities with manufacturing Need to control inventory purchasing and use

Cash and credit card sales Commonalities with retail Need to control cash received Need to control credit approval process

Hospitality continued

Entertainment venues, important issues Sells food like a restaurant Sells services (tickets for events)

Right of return Cancellation Revenue recognition issues

May sell lodging Sells products like retail

Appendix B: Audit Committees and Corporate Governance

SOX defines audit committees SOX states that if the company does not have an

audit committee the entire BOD serves that function

SOX Section 301 sets out specific audit committee responsibilities

NYSE has requirements for existence, composition and responsibilities of the audit committee

Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees published its recommendations in September 1998

Audit Committees

Provide a counterbalance to the powers held by management

Are specifically charged with understanding and oversight of the financial workings of the company

Receive certain communications from the auditor

Have specific responsibilities, for example NYSE: meet regularly, handle complaints SOX: appoint, set compensation for and oversee

work of the independent auditor; have procedures for receiving and handling complaints

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