CHAPTER 2 ESSMENT: ss PHASE I - RISK ACT ACTIVITIES PRELIMINARY ENGAGEME UANCE DECISION CLIENT ACCEPTANCE A? Introduction One of the most important decisions that an audit firm can make is determinin: cept or which client relationships to retain. A_ poor additional stress on partners ang what engagements to a decision can lead to unbillable time, uny staff, potential lawsuits and worst of all, loss of reputi ation. Even though obtaining and retaining clients is not easy In a Competitive profession such as public accounting, a CPA firm must use care in deciding which clients are acceptable. The firm’s legal and professional responsibilities are such that clients who lack integrity or argue constantly about the proper conduct of the audit and fees can cause more problems than they are worth. Some CPA firms now refuse clients in certain high-risk industries, such as savings and loans, health, and casualty insurance companies, and may even discontinue auditing existing clients in those industries. New Client Inv ion igat Before accepting, a new client, most CPA firms investigate the company to determine i ceptability. To extent possible, the Prospective client’s standing es community, financial stability, and relations with its previous en should be evaluated. For example, many CPA firms use considerable in accepting new clients in newly formed, rapidly growing businesses. Many of these businesses fail financi atl iene inancially and expose the CPA firm to significantPhase l Risk Assessment: Preliminary Engagement Activities 28 Even when a prospective client has been audited by another CPA firm, other investigations are often made. Sources of information include local attorneys. other CPAs, banks, and other businesses, In some eases, the auditor may hire a professional invest zator to obtain information about the reputation and background of the key members of man: yement. More extensive investigation is appropriate when there has been no previous auditor, when a predecessor auditor will not provide th lesired information, or if any indication of problems arises from the communication. Many practitioners take advantage of the Internet as a search tools to learn more about the potential new client and its key operations, by studying available client web sites and by using search engin 8 for other sites that discuss the potential client, ¢ Clients Many CPA firms evaluate existing clients annually to determine whether there are reasons for not continuing to do the audit, previous conflicts over such things as the appropriate scope of the audit, the type of opinion to issue, or fees may cause the auditor to discontinue association. The auditor may also determine that the client lacks integrity and therefore should no longer be a client. If the client files a lawsuit against a CPA firm or vice versa, the firm cannot do the audit similarly, if there are unpaid fees for services performed more than | year previously, the CPA firm cannot do the current year audit, To do an audit in either of these circumstances violates the Code of Ethics for Professional Conduct rules on independence. Even if none of the previously discussed conditions exists, the CPA firm may decide not to continue doing audits for a client because of excessive risk. For example, a CPA firm might decide that there is considerable risk of regulatory conflict between a governmental agency and a client, which could result in financial failure of the client and ultimately lawsuits against the CPA firm. Even if the engagement is profitable, the risk may exceed the short-term benefits of doing the audit. Investigation of new clients and reevaluation of existing ones is an essential part of deciding acceptable audit risk. Assume a potential client in a reasonably risky industry, where management has a reputation of integrity, but is also known to take aggressive financial risks. If the CPA firm decides that acceptable audit risk 'S extremely low, it may choose not to accept the engagement. If the CPA firm Concludes that acceptable audit risk is low but the client is still acceptable, it iswith a tow acceptable andy hould be reflected in biph 1, Audits rowed to the chen! «, whieh 5! ikely to affect the fee prey oon risk will normally result in audit fees higher audi T SELECTION «RE avE TO CLIE QUALITY CONTROL, POLICIES RELATIVE AND RETENTION for the acceptance and ent policies and procedure s, designed t and specific eng virance that it will only undertake or \. The firm shall implem continuance of elicnt relationships provide the firm with reasonable ass vill continue relationship s and engagements where the firm rement and has the eapabilitic a) Is competent to perform the eng: including time and resources to do so; equirements; and b)_ Cam comply with relevant ethics not have ¢) Has considered the integrity of the client, and do information that would lead it to conclude that the client lack integrity. The auditor shall be satisfied that appropriate procedures regarding, the acceptance and continuance of client relationships and audil engagements have been followed, and shall determine that the conclusions reached in this regard are appropriate. If th i ins inf no information that would have caused the firm (0 le audit engagement has that i i 1 the engagement partner shall Feoumtnieane era Stes the firm, so that the firm and the e necessary action. icate that information promptly (0 Ngagement partner can take the C. The auditor shall he undertaki initial audit: rt; a) Performing procedure: b) Communicating withPhase I~ Risk Assessment: Preliminary Engagement Activities 27 D. Strict client acceptance / continuance guidelines should be established to screen out the following: © Clients that are in financial and/or organizational difficulty ~ For example, clients that could go bankrupt or clients with poor internal accounting controls and sloppy records © Clients that constitute a disproportionare percemage of the firm's toral practice — Clients may attempt to influence the auditor into allowing unacceptable accounting practices or issuing inappropriate opinions. ¢ Disreputable clients — External audit firms cannot afford to have their good reputation tarnished by serving a disreputable client or by associating with a clear that has disreputable management. ¢ Clients that offer an unreasonably low free for the auditor's services ~ In response. the auditor may attempt to cut corners imprudently or lose money on the engagement. Conversely, auditors may bid for audits at unreasonably low prices. PROCESS TO ACCEPT OR CONTINUE WITH AN AUDIT ENGAGEMENT Determine the nature of the engagement and whether it can be undertaken in accordance with the firm’s policy. Then address the following questions, and document the findings and conclusions. L Are the engagement risks acceptable to the firm? What are the values (“tone at the top”) and future goals of the entity 2. How competent are the entity’s senior management and staff? 3. Has the firm conducted an Internet search and had discussions with firm Personnel and other third parties (such as bankers) to identi any reasons why the firm should not accept the engagement? 4. Are there difficult or time-consuming issues to address (accounting Policies, estimates, compliance with legislation, etc.) 5. What changes have taken place this period that will impact the engagement (business trends and initiatives, personnel changes, financial Teporting, IT systems, purchase / sale of assets, regulations, ete.)? Is there a high level of public scrunity and media interest?t. | 2. 3. 4. 5. Does the firm have the competence, resources, =a it have the ability to pay does it have y ry Is the entity in good financial health and the firm’s professional fees? Will the entity provide help to frm 0 iding preparing schedules, analysis of balances, Pro” He dale leat ommunic: Sor For new engagements, has the firm ¢ ctaieenlinatte eal a determine if there are any reasons for pling engagement? aining information and in obt sani data files, etc? and time required? What is the nature and scope of the audit? What accounting framework will be used? How will the auditor’s report and financial statements be used? What is the deadline (if any) for completing the audit? Does the firm have sufficient personnel with the necessary competence and capabilities? Do the selected firm personnel have: - Knowledge of relevant industries or subject matters, - Experience with relevant regulatory or reporting requirements, or ~ Ability to gain the necessary skills and knowledge effectively? Are experts available, if needed? . Where applicable, are there qualified persons avai engagement quality control review? ilable to perform the F eleven t low Nenly-five auditors. They appe" went quality and exposure ©ont Activities 29 Phase | ~ Risk Assessment: Preliminary Engagement Activites °” [11 Is the firm / staff independent and free from conflict? lL Can the firm and the engagement team comply with ethical and independence requirements? Where conflicts of interest, lack of independence, or other threats have been identified ate those threats or or - Has appropriate action been taken to elimi reduce them to an acceptable level by applying safeguards = Have steps been taken to withdraw from the engagement? If the entity being audited is a component of a larger group, the group engagement team may request certain work to be performed on the financial information of the component. In such cases, the group engagement would first obtain an understanding of the following: - Whether the component auditor understands and will comply with the ethical (including independence) requirements that are relevant to the group audit, - The component auditor’s professional competence, - Whether the group engagement team will be able to be involved in the work of the component auditor to the extent necessary to obtain sufficient appropriate audit evidence, and - Whether the component auditor operates in regulatory environment that actively oversees auditors. IV. Can the client be trusted? I, Is there any reason (or recent event) that casts doubt on the integrity of the principal owners, senior management, and those charged with government of the entity? Consider the entity’s operations, including business practices, the business? reputation, and history of any ethical or regulatory infringements. Are there any indications that the entity might be involved in money laundering or other criminal activities? What is the identity and business reputation of related Parties? Does management have a poor attitude toward Aggressive attitude toward Consider corporate culture, complexity of transactions, etc. 0 ; internal control and an interpretation of accounting standards? organizational structure, risk tolerance,i ation obt nsure that the informe Via ation Cou! what third-party inform could avert proble! include information from source income tax returns, credit reports, oa from the prospective client) discussto! etc. sibly and Oh key advisors such as bankers, and ing third parties sae re : I partners and staff are aware of: client, take steps to ensure that al © The firm’s poll clients; © Requirements of any privacy legislation; and © Requirements of the applicable code of ethics. Figure 2-1 shows a sample questionnaire that could be used in assessing client acceptance / continuance. Figure 2-1 Illustrative Questionnaire That Could Be Used in Assessing Client Acceptance / Continuance (Partial) Client: CYZ Company Yes | No | Comments | Have the audit preconditions been met? Have the acceptance / continuance re | guality control manual been followed? Any change in the terms of refer it ailteneonat fence or requirements for the quirements in the firm's Consider: family / personal relati i io Non-audit services such as cng oa icy a ther business felationships. M8 Financial i cumstances that would cast dour ay 6 td pesetnacon, oat Ste anctions, suspicion Se Fegutat Or fraud, police investigations, and aq on tion of legal act, , 'gations, and any San legal "2nd any negative pubjiciny | 2S Publicity, lent people, interest, and ms later on. Examples Wak asessment. This simple St COUN) Ot ous financial statements (after receiving permission ollecting information on a prospective icies to protect confidential information maintained on Any independence issues or conficls of interest? —Phase I — Risk A. essment: Preliminary Engagement Activities 34 Does the firm have the capacity in time, competencies, and resources to complete the engagement in accordance with professional and firm standards? TL ibs ‘Are there any issues identified in previous audits and other engagements for this entity that need to be addre: ‘Are there any new circumstances that engagement risk? Can the client continue to pay our fees? Conclusion: Overall assessment of engagement risk We should client. Clais Garcia Santos & Associates, CPAs * accept / decline * continue with / discontinue with PRECONDITIONS FOR AN AUDIT In order to establish whether the preconditions for an audit are present, the auditor shall: a) Determine whether the financial reporting framework to be applied in the preparation of the financial statements is acceptable; and b) Obtain the agreement of management that it acknowledges and understand its responsibility: jal statements in accordance with the ‘amework, including where relevant (i) For the preparation of the finan practicable financial reporting their presentation; (ii) For such internal control as management determines is necessary to enable the presentation of financial statements that are free from material misstatement, whether duc to fraud or error; andment is aware that is statements such as records, documentation an he auditor may request from iE t of mation thal ie and Additional inforn of the audit: a urpose © 7 agement for the P' . m who . manag’ 7 ersons within the entity from whom the © Unrestricted access ( P' ry to obtain audit evidence. auditor determines is necessa i ibilities or agree to provide Where management does not acknowledge its responsibilities ° oe 2 it the written representations, the auditor will not be able to obtain sufficient ce: where the financial ic +h circumstances, or appropriate audit evidence. In suc stances, OF Mee reporting framework is not acceptable, the auditor is required by PSA to decline the engagement unless required by law or regulation. Likewise, the auditor should determine whether management or those charged with governance imposes any type of limitation on the scope of the audit. This could include unrealistic deadlines, not accepting certain firm’s staff to perform the work, and denial of access to a facility, key personnel, or relevant documents. If such a limitation would result in a disclaimer of opinion, the firm would decline the engagement, unless the firm is required by law or regulation to proceed with the engagement. : AGREEING THE TERMS OF ENGAGEMENT Engagement Letter A clear understanding of the : terms of th clint and the cao “ie engagement should exi: the & firm. PSA requires that auditors Tmust document th understanding of an ¢ n ngagement engagement’s objectives, thy sie op ht ; H the engagement’s impar'® FeSPONSibilities of th atene. ineluding te gement’s limitations. Treen '€ auditor and management, and his is typically q The engagement lett er is a the conduct of the a i r ‘sreement bet dit and related services. The engagement letter there should be no do System as to the ee! wen the CPA firm and the client for States the Sco] * Pe of | mpeg the mind of Ke ane 0 be done on the audit so that 'S agreed Tent, ex; . to by the external seit or the court T and the client.1 Risk Assessment: Preliminary Engagement Activities 33 The agreed terms of the audit engagement shall be recorded in an audit engagement letter or other suitable form of written agreement aad shall include: a) The objective accounting framework, and the form of auditor’s report resulting from scope of the audit of the financial statements; b) Identification of the applicable financial reporting framework for the preparation of the financial statements; c) Reference to the expected form and content of any reports to be issued by the auditor and a statement that there may be circumstances in which a report may differ from its expected form and content; d) The responsibilities of the auditor, e) The responsibilities of management; and £) Arrangements on how the audit will be conducted, involvement of other auditors and experts, if any, dispute resolution, obligation and the basis ‘on the computation of fees and billing, The client should confirm the terms of the engagement by acknowledging receipt of the engagement letter. Figure 2-2 presents a sample engagement letter. If the terms of the audit engagement are changed, the auditor and management shall agree on and record the new terms of the engagement in an engagement letter or other suitable form of written agreement. If the auditor is unable to agree to a change of the terms of the audit engagement and is not permitted by management to continue the original audit engagement, the auditor shall: a) Withdraw from the audit engagement where withdrawal is possible under applicable laws or regulations; and b) Determine wether there is any obligation, either contractual or otherwise, to report the circumstances to other parties, such as those charged with governance, owners or regulators.34. Chapter 2 ative Engagement Letter i Figure 2-2: Mlustr: = ta | Santos & Cs. OP! ; | 7560 Sen. Gi Puyat Avenue, Makati City October 15, 20X8 Mr Alberto Cruz, Managing Director | ABC, Inc | 165 Tendang Sore, Quezon City | Dear Mr. Cruz | | You have requested that we audit the financial statements of ABC, Inc. which comprise the statement of | financial position as at December 31, 20X8, and the income statement, statement of changes in equily and | cashfiow statement for the year ended, and 2 summary of significant accounting policies and other | explanatory information. We are pleased to confirm our acceptance and our understanding of this audit | engagement by means of this letter. Our audit will be conducted with the objective of our expressing an | opinion on the financial statements. | Our Responsibilities We will conduct our audit in accordance with Philippine Standards on Auditin 19. Those standards require that he comely with ethical requirements and plan and perform the audit to oblain reasonable assurance abou! et the financial stements are free ftom material misstatement. An audit involves. performing Because of the inherent limitations of an audit tit it logether withthe inherent an unavoidable tisk that some matealmissatements may ra iiations of intemal contol, there planned and performed in accordance with PSAS. fed, even though the auaitis propel!1— Risk A. ‘sessment: Preliminary 35 ingagement Activiti Management's Responsibility Our audit will be conducted on the basis that Management and those charged with governance acknowledge and understand that they have responsibility’ a) For the preparation and fair presentation of the financial statements in accordance with Philippine Financial Reporting Standards; b) For such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error; and ©) Toprovide us with: i) Access to all information of which you are aware that ,is relevant to the preparation of the financial statements such as records, documentation and other matters; li) Additional information that we may request from you for the purpose of the audit; and iil) Unrestricted access to persons within the company from whom we determine it necessary to obtain audit evidence. As part of our audit process, we will request from management and, where appropriate, those charged with governance written confirmation concerning representations made to us in connection with the aucit. We look forward to full cooperation from your staff during our audit Fees Our fees which are based on the time required by individuals assigned to the engagement will be Php100,000 Plus out-of-pocket expenses and will be billed as work progresses. Individual hourly rates vary according to ‘he degree of responsibility involved and the experience and skill required. This letter willbe effective for future periods unless its terminated, amended, or superseded, Pease sign and return the attached copy ofthis ltr to indicate that itis accordance with your understanding Ofthe arrangements for our audit of the financial statements. Yours truly, Acknowledged on behalf of ABC, Inc. by ee Alvin Santos Mr. Alberto Cruz Santos & Co,, CPAs Managing Director (Date)