AUDITING THEORY
Red Sir ug PRELIMINARY ENGA GEMENT ACTIVITIES (PREPLA NNING ACTIVITIES)
Purpose of Preliminary Engagement A ctivit ies: Preliminary engagement activities assist the auditor in identifying and evaluating events or circumstances that may adversely affect the auditor’s ability to plan and per form the audit engagement. Such activities help ensure that: a. There are no issues with client management’s integrity that may affect the willingness to continue the engagement b. The auditor maintains the necessar y independence and ability to perform the engagement c. There is no misunderstanding with the client as to the terms of the engagement Preliminary Engagement Activities: 1. Perfor m procedures regarding acceptance or cont inuance of the client relat ionship
Acceptance or selection procedures – in case of initial audit (prospect ive/new client) a. Evaluate integrity of the client’s management Evaluation of management integrity is necessar y to avoid association with clients whose management lacks integrity. Most of litigations involving CPAs are due to lack of integrity of client’s management. Lack of management integrity usually results to high audit risk. Factors to consider in evaluating client’s integrity: Identity, attitude and business reputation of the client (such as its principal owners, key management or those char ge with cor porate governance, and related par ties, if any) Nature of the client’s operations Indications of an inappropriate limitation in the scope of wor k Involvement in money laundering or other criminal activities The reasons for the proposed appointment of the CPA firm or auditor and non-reappointment of the previous CPA firm or auditor (1) Investigate/research the client’s background Internet searches Review the entity’s financial statements Consider engaging professionals/investigators to evaluate the principals associated with the pr ospective client Obtain credit ratings and reports, if necessar y (2) Inquir ing from other fir m personnel or third parties (such as bankers, legal counsel/advisors, industry peers and others in the financial or business community who may have knowledge regarding the client) (3) Communicate with prospect ive client’s predecessor auditor: Matters to be inquired of or discussed with the predecessor (previous/former) auditor by the incoming/successor auditor: a) Facts/information that might bear on the integrity of the prospective client b) Predecessor auditor’s understanding as to the reasons for the change of auditors c) Any disagreement between the predecessor auditor and the client regarding accounting principles or auditing procedures or other similarly significant matters d) Communication to management, the audit committee, and those charged with gover nance regarding fraud, illegal acts by the client, and matters relating to internal control. Under the Code of Ethics for CPAs, the successor auditor has the responsibility to initiate communication with the predecessor auditor. However, the communication requires prior client’s permission/consent (preferably in writing) to avoid violation of confidentiality principle. If the client is unwilling to agree to such communication (communication is not permitted by the client or the client limits the responses of the predecessor auditor), the successor auditor should:
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b.
Evaluate the reasons for the refusal or limitation Consider the implications of such refusal/limitation, and Decide whether or not to accept the engagement.
Other Considerations: Auditability of client’s financial statements – determine w hether the auditor will be able to accumulate sufficient appropriate audit evidence to render an opinion on the financial statements by considering: a. The adequacy of accounting recor ds b. Quality of internal control High level of public scr utiny and media interest The financial health of the client Ability to pay audit fees
Continuance or retention procedures – in case of recurr ing audit (or exist ing client) To ensure the audit firm’s continuing compliance with acceptance and continuance procedures, existing clients should be evaluated once a year or upon occurrence of the following: Changes in management, directors or ownership Nature of client’s business
2. Evaluate compliance with ethical requirements, including independence a.
Independence – The CPA firm or auditor shall identify, evaluate and respond to any threat to independence The CPA firm or auditor must be independent of the client w hose financial statements are subject to audit. Audit opinion is not credible or of little or no value if the auditor is not independent.
b.
Professional competence – determine if the CPA firm or auditor has the necessary skills and competence Professional accountants should not por tray themselves as having the required expertise w hich they do not possess. The auditor should obtain preliminar y understanding of prospective client’s business and industr y to determine whether the auditor has the required degree of competence. If the auditor does not possess the industry expertise, he should obtain knowledge of matters that relate to the nature of the entity’s business and industr y.
c.
Ability to serve the client proper ly – the CPA firm or auditor must have capability, time and resources to perform the audit Examples: Availability of appropriately qualified staff w hen the w ork is required The firm is able to complete the engagement within the reporting deadline (proximity of the deadline) Consider the need for expert’s assistance and any conflicts of interest Firm personnel have knowledge of relevant industries The firm has sufficient personnel with the necessary capabilities and competence.
3. Establish an understanding of the terms of the engagement The CPA firm or auditor shall accept or continue an audit engagement only when: a. The preconditions for an audit are present: (1) Management has used acceptable financial reporting framework (or suitable criteria or appropriate basis for) in the preparation of the financial statements Factors to consider in determining the acceptability of the financial reporting framework: a. The nature of the entity (for example, whether it is a business enter prise, a public sector entity or a not-for-profit organization); b. The purpose of the financial statements (for example, whether they are prepared to meet the common financial information needs of a wide range of users or the financial information needs of specific users); • Financial statements prepared in accordance with a financial reporting framework designed to meet the common financial information needs of a wide range of users are referred to as general pur pose financial
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statements. Financial statements prepared in accordance with a financial reporting framework designed to meet the financial information needs of specific users are referred to as special purpose financial statements. The nature of the financial statements (for example, w hether the financial statements are a complete set of financial statements or a single financial statement); and Whether law or regulation prescribes the applicable financial reporting framework. •
c. d.
Examples of financial reporting framewor ks: IFRSs PFRSs IPSASs – International Public Sector Accounting Standards (2) Management agrees to the premise that it has acknowledged and understood its responsibilities If the preconditions for an audit are not present, the auditor shall not accept the proposed audit engagement, unless acceptance is required by law or regulation. Preconditions for an audit are within the control of the entity. b.
There is a common understanding between the auditor and management (and, where appropriate, those charged with governance) of the terms of the audit engagement.
Agreement on audit engagement ter ms: The auditor shall agree on the terms of the audit engagement with management or those charged with gover nance, as appropriate. Such agreed terms shall be recorded in an audit engagement letter or other suitable form of written engagement.
Preliminary conference: A preliminary conference with the client is scheduled after the CPA has determined that: The firm is independent The firm is competent to perform the audit The firm can serve the client properly, and The client’s reputation is one of integrity The terms of engagement are usually agreed with the client during a preliminar y conference with the client, and formalized thr ough a signed engagement letter . During the preliminary conference, the auditor and client agree on the following issues: The specific services to be rendered The cooperation and work expected to be performed by the client’s personnel Expected start and completion dates of the engagement The possibility that the completion date may be changed if unforeseen a udit problems arise if unforeseen audit problems arise if adequate cooperation from client’s personnel is not received The nature and limitations of the audit engagement An estimate of the fee to be charged for the engagement
Engagement letter – an agreement between the CPA firm or auditor and the client for the conduct of the audit. It is a letter from the auditor to the client management, and when signed by the client it ser ves as a formal written contract between them.
Engagement letter documents and confirms the: a. Auditor’s acceptance of the appointment b. Client’s acceptance of the terms of the audit engagement c. Responsibilities of both the client management and the auditor d. Arrangements or agreed terms of the engagement (such as the objectives and scope of the audit, the form of any repor ts, etc.)
Importance (pr imary reason) of an engagement letter: It clarifies the nature of the engagement and the responsibilities of management and those of the auditor. This will help in avoiding or minimizing or resolving future misunderstandings /
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disagreement between the auditor and the client with respect to the engagement.
Engagement letter should be sent to the client preferably before the star t of the engagement.
An engagement letter is normally addressed to whoever hired the CPA.
For m and Contents of the Engagement Letter: The form and content of engagement letters may var y for each client. Engagement letters should be adapted according to individual requirements and circumstances of the engagement. Generally, engagement letters should include reference to: 1.
Principal Contents: a. b. c. d. e.
2.
In addition, and audit engagement letter may make reference to, for example:
3.
Objective and scope of the audit of the financial statements Responsibilities of the auditor Responsibilities of management Identification of financial repor ting framewor k for the preparation of the financial statements Reference to any form and content of any reports to be issued by the auditor and a statement that there may be circumstances in w hich a report may differ from its expected form and content Elaboration of the scope of the audit, including reference to applicable legislation, regulations, PSAs, and ethical and other pronouncements of professional bodies to which the auditor adheres. The form of any other communication of results of the audit engagement The fact that because of the inherent limitations of an audit, together with the inherent limitations of internal control, there is an unavoidable risk that some material misstatement may not be detected, even though the audit was properly planned and performed in accor dance with the PSAs Arrangements regarding the planning and per formance of the audit, including the composition of the audit team Expectation that management will provide written representations The agreement of management to make available to the auditor draft financial statements and any accompanying other information in time to allow the auditor to complete the audit in accor dance with the proposed timetable The agreement of management to inform the auditor of facts that may affect the financial statements, of w hich management may become aware during the period from the date of the auditor’s report to the date the financial statements are issued. Basis on which fees are computed and any billing arrangements A request for management to acknowledge receipt of the engagement letter and to agree to the terms of the engagement outlined therein
Other arrangements, when relevant, such as:
Involvement of other auditors and experts in some aspects of the audit Involvement of internal auditors and other staff of the entity Arrangements to be made with the predecessor auditor, if any, in the case of an initial audit Any restriction of the auditor’s liability when such possibility exists A reference to any further agreements between the auditor and the client Any obligations to provide audit working papers to other par ties
Audits of Components: Factors to consider whether to send a separate engagement letter to the component when the auditor of the parent company is also the auditor of its component (subsidiary, branch or division): 1. Who appoints the auditor of the component 2. Whether a separate auditor’s report is to be issued on the component 3. Legal requirements in relation to audit appointments 4. The extent of any work performed by other auditors 5. Degree of ow nership by parent, and 6. Degree of independence of the component’s management from the parent entity Audit Engagement in Recurr ing Audits: 1. The auditor may decide not to send a new engagement letter or other written agreement each period.
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2.
The following factors may make it appropriate to send a new engagement letter: a. Revision of the terms of audit engagement because: Any revised or special terms of the engagement A recent change of senior management or those charged with governance A significant change in ownership A significa nt change in nature or size of the client’s business A change in legal or regulatory requirements A change in the financial reporting framework adopted in the preparation the financial statements A change in other reporting requirements b. Reminder to the client of the existing terms of the engagement Any indication that the client misunderstands the objective and scope of the audit.
Audit procedures when the client requests for a change in engagement: 1. Consider the appropriateness of reasons for the engagement 2. If there is a reasonable j ustification for the change – stop the original engagement and agree on the new terms of engagement. And then proceed with the new engagement To avoid confusing the users of the new repor t, do not mention the following in the new report: a. The original engagement b. Any procedures that may have been performed in the original engagement (except where the engagement is changed to an engagement to under take agreed-upon proce dures and thus the reference to the procedures performed is a normal par t of the report) 3. If there is no reasonable justification – refuse the client’s request, and continue to perform the original engagement and issue the original report If the auditor is not permitted to continue the original engagement, the auditor should withdraw from the engagement and consider reportorial responsibilities to the BOD or shareholders of the client. Whether or not to accept a change in engagement: Change in the ter ms of the audit engagement: The auditor shall not agree where there is no justification/basis for the change in the terms of the audit engagement. Reasonable basis includes: a. A change in circumstances affecting the entity’s requirements For example, the client's bank required an audit before committing to a loan, but the client subsequently acquired alternative financing. b. A misunderstanding as to the nature of the service originally requested Not a reasonable basis: Change that relates to information that is incorrect, incomplete or otherwise unsatisfactory. For example, the entity asks for the audit engagement to be changed to a review engagement to avoid a qualified opinion or disclaimer of opinion.
Change to a lower level assurance engagement: The auditor shall not agree where there is no justification/basis for the change to a lower level assurance engagement. 1. The auditor should agree if there is reasonable basis, such as: a. A change in circumstances affecting the entity’s requirements or need for the ser vice For example, the client's bank required an audit before committing to a loan, but the client subsequently acquired alternative financing. b. A misunderstanding as to the nature of an audit or related service originally requested c. A restriction on the scope of the engagement, whether imposed by management or caused by circumstances If there is a reasonable change, no reference of the same shall be included in the report. 2.
Not agree if there is no reasonable just ification – if the change relates to incorrect, incomplete or otherwise unsatisfactory information.
For example, in an audit engagement, the auditor is unable to obtain sufficient appropriate audit evidence regarding receivables and the client asks for the engagement to be changed to a revie w engagement to avoid a qualified audit opinion or a disclaimer of opinion.
Withdraw from the engagement – if the auditor is unable to agree to the change and is not permitted/allowed to continue the original engagement because of his disagreement
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