Está en la página 1de 51

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 auditors
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 continuance
THEN
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
Auditors 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 beginsnot 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 Managements use of information
Published Financial
Information
Annual reports
Financial Statements
SEC filings
Information from these documents
Size of the companys 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
Companys earnings calls
Trading activity of the companys 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
managements 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 managements
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 auditors 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
entitys 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 companys 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 companys
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 companys 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 companys audit committee does
not have at least one financial expert this
fact must be disclosed.
Qualifying Characteristics of a
Financial Expert
SEC 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 inaccounting for estimates, accruals
and reserves;
Experience preparing, auditing, analyzing or evaluating financial statementscomparable to
the breadth and complexity of issuesexpected to be raised by the registrants 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 experiencethat 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
clients business activities:
Are the activities within the audit firms
area of industry and audit expertise?
Are the companys activities compatible
with the firms preferences for its client
portfolio?
Are the companys 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 companys 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 partiesincluding
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
Companys 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 firms 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
Managements responsibilities
Auditors 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
Copyright
Copyright 2011 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted
in Section 117 of the 1976 United States Copyright Act without
the express written permission of the copyright owner is
unlawful. Request for further information should be addressed
to the Permissions Department, John Wiley & Sons, Inc. The
purchaser may make back-up copies for his/her own use only and
not for distribution or resale. The Publisher assumes no
responsibility for errors, omissions, or damages, caused by the
use of these programs or from the use of the information
contained herein.

También podría gustarte