CHAPTER 5 MANAGEMENT OF A PUBLIC ACCOUNTING PRACTICE

I. Review Questions 1. The steps in accepting an audit engagement are (a) evaluating the integrity of management, (b) assessing the auditors ability to meet GAA and (c) preparing an engagement letter. "or a ne# client, the auditor can obtain information about the clients management by (a) in$uiring of %no#ledgeable persons #ithin the community and (b) communicating #ith the prior (predecessor) audit if the client has been audited previously. "or a recurring client, the auditor should consider his prior e&periences #ith the clients management. Any instances of material errors or irregularities, illegal acts, and untruthful ans#ers to in$uiries should be carefully considered. a. An audit team typically consists of (1) a partner #ho has both overall and final responsibility for the engagement, (!) one or more managers #ho coordinate and supervise the e&ecution of the audit program, (') one or more seniors #ho may have responsibility for parts of the audit program and #ho supervise and revie# the #or% of staff assistants, and (() staff assistants #ho perform most of the re$uired procedures. )lient personnel may* (. +repare a trial balance of the general ledger. ,econcile control and subsidiary accounts. Age accounts receivable (i.e., current, thirty days past due, etc.) +repare schedules of insurance policies in force, notes receivable, and plant assets.

!.

'.

b.

An engagement letter is the agreement or understanding bet#een the )+A and his-her client concerning the nature of the engagement. It provides protection for the )+A in the event of subse$uent legal action alleging negligence or breach of contract. .y committing the agreement to #riting, the engagement letter also minimi/es future misunderstandings bet#een the )+A and client concerning the services to be performed by the )+A.

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0.

A )+A can use the follo#ing sources of information to help decide #hether to accept a ne# audit client. Financial information prepared by the prospective client* Annual reports to shareholders Interim financial statements ecurities registration statements Annual report on 1) ,eports to regulatory agencies Inquiries directed to the prospects business associates* .an%er 2egal counsel 3nder#riter 4ther persons, e.g., customers, suppliers Predecessor auditor, if any, communication, re* Integrity of management, 5isagreements #ith management Analysis* pecial or unusual ris% related to the prospect 6eed for special s%ills (e.g., computer or industry e&pertise) Internal search for relationships that #ould comprise independence

7.

.enefits of engagement letters are* 8elps establish an understanding bet#een client and auditor of the terms of the engagement and the nature of the #or%. 8elps avoid $uarrels and misunderstandings bet#een client and auditor. 8elps avoid disputes over the audit fee. 8elps avoid legal liability assertions based on failure to do #or% that the )+A may not have contemplated or agreed to do.

9.

"or a proposed client, an auditor must evaluate #hether any relationships violate the )ode of 1thics for +rofessional Accountants in the +hilippines. ,elationships that present problems are relationships bet#een the firm (and its personnel) and the client (and its personnel). In addition, the auditor must determine #hether a potential client is auditable: that is, #hether sufficient competent evidence can be accumulated to render an opinion. "or smaller potential client, t#o issues, the ade$uacy of accounting records and management integrity, must be considered. "or larger potential clients, the auditor must

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evaluate the ade$uacy of accounting records, management integrity, and the $uality of internal control. ;. ince the auditor must evaluate the financial statement assertions of the client, the integrity of the potential clients management is of critical importance. An auditor usually does not audit 1<< percent of a clients transactions. In addition, certain assertions cannot be evaluated e&ternally. The successor auditor should as% the client to authori/e the predecessor auditor to respond fully to the successors in$uiries. If the client refuses or limits the responses, the successor should as% the client to e&plain the reasons. After obtaining the e&planation, the successor should consider #hether to continue pursuing the engagement. The successor auditor is e&pected to ma%e specific and reasonable in$uiries. These in$uiries should address facts that bear on management integrity, disagreements #ith management on accounting principles, and the predecessors understanding of the reason(s) for the change in auditor. In normal situations, the predecessor is e&pected to respond promptly and fully to reasonable in$uiries. 1<. An engagement letter is designed to formali/e any oral agreements made bet#een the client and the auditor. It should include a description of the scope of services to be provided: an e&planation of the services to be provided, including a disclaimer of responsibility for detecting fraud: a statement about the obligations of clients staff to assist in the engagement: a statement about fees, or method of determining fees, and payment of e&pectations: and a statement about other services to be performed. 11. To obtain information about the clients business and industry, an auditor can revie# prior>year #or%ing papers, revie# current>year client information, in$uire of management and the audit committee, read +I)+A industry audit and accounting guides relevant to the client, and significant industry publications and manuals maintained by the firm on the industry. 1!. ,efer to pages 19! to 19(. 1'. ,efer to page 19(. 1(. ,efer to pages 19( to 190. 10. ,efer to pages 19( to 197. 17. ,efer to pages 71 to 7(.

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Solutions Manual - Principles of Auditing and Other Assurance Services

II. Multiple Choice Questions 1. !. '. (. 0. 7. 9. a d b a c a d ;. =. 1<. 11. 1!. 1'. 1(. b c d a b d a 10. 17. 19. 1;. 1=. !<. !1. c a b c b a a !!. !'. !(. !0. !7. !9. !;. b a d a c d c

III. Comprehensive Cases Case 1. a. +rior to acceptance of the engagement, Argante ? Tan should have communicated #ith the predecessor auditor regarding* b. "acts that might bear on the integrity of management. 5isagreements #ith management concerning accounting principles, auditing procedures, or other significant matters. The predecessors understanding about the reason for the change. Any other information that may be of assistance in determining #hether to accept the engagement.

The form and content of engagement letters may vary, but they #ould generally contain information regarding* The ob@ective of the audit. The estimated completion date. Aanagements responsibility for the financial statements. The scope of the audit. 4ther communication of the results of the engagement. The fact that because of the test nature and other inherent limitations of any system of internal control, there is an unavoidable ris% that even some material misstatement may remain undiscovered. Access to #hatever records, documentation, and other information may be re$uested in connection #ith the audit. Arrangements #ith respect to client assistance in the performance of the audit engagement. 1&pectation of receiving from management #ritten confirmation concerning representations made in connection #ith the audit. 6otification of any changes in the original arrangements that might be necessitated by un%no#n or unforeseen factors.

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Case 2. a.

,e$uest for the client to confirm the terms of the engagement by ac%no#ledging receipt of the engagement letter. The basis on #hich fees are computed and any billing arrangements. Typical engagement letter generally includes the follo#ing* The name and address of the person or persons #ho retained the auditor to perform the auditing services. An opening paragraph that confirms the understanding of the auditor and the client. A summary of significant events that lead to the retention of the services of the auditor. A general description of the )+A firm that #ill conduct the e&amination. A statement that the e&amination #ill be performed in accordance #ith generally accepted auditing standards. A description of the scope of the services to be rendered, #hich should establish the nature of the engagement. Any scope restrictions or special limitations and their effect on the auditors report. A statement regarding the auditors responsibility for the detection of fraud. An indication of the possible use of client personnel in connection #ith the audit #or% to be performed. A statement that the auditor #ill provide a management letter if re$uired in the circumstances. The method and timing of billings as #ell as billing rates and fee arrangements. pace for the client representatives signature, #hich indicates BacceptanceC of the letter and the understandings, therein.

b.

The benefits of preparing an engagement letter include the avoidance of possible problems bet#een the )+A and the client concerning (1) the scope of the #or%, (!) the service to be rendered, and (') the audit fee. In addition, the Bin>chargeC auditor conducting the e&amination can avoid misunderstanding the nature and scope of the engagement if the engagement letter is included in the permanent section of the audit #or%ing papers. The letter should eliminate misunderstandings and confusion about the type of financial statements to be e&amined, the estimated report date, and the type of opinion e&pected. In addition to avoiding possible misunderstandings, any legal problems relating to the auditors failure to perform certain procedures can be revie#ed #ith reference to the contractual commitment assumed. ("or e&ample, if scope limitations prevent the auditor from performing normal audit procedures, the auditor

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cannot be legally responsible if an irregularity is not detected #hen clearly it #ould have been detected if such procedures #ere performed.) The engagement letter is also useful as a reference document #hen preparing for future engagements. c. The )+A usually prepares the engagement letter as a follo#>up to a verbal understanding that he and his client have reached. It is desirable that the client endorse and return an approved copy of the engagement letter to the )+A. It also is acceptable for the client to prepare his o#n letter summari/ing his understanding of the nature of the engagement. +referably the engagement letter should be sent at the beginning of the engagement so that misunderstandings, if any, can be remedied. 4bviously, the engagement letter #ill be most useful in clarifying misunderstandings on a first engagement. .ut it is desirable that the letter be rene#ed periodically. )lient personnel or the nature of the engagement may change, and the resubmission of the letter gives both parties an opportunity to revie# the circumstances. Accordingly, for recurring e&aminations of financial statements, it is appropriate to prepare an engagement letter at the start of each e&amination. "or other continuing engagements, the engagement letter also should be updated periodically D probably on a yearly basis. The procedures that "rancis should follo# prior to accepting the engagement include the follo#ing* (1) "rancis should e&plain to 6i%olai the need to in$uire of Eo and should re$uest permission to ma%e such in$uiries. (!) "rancis should re$uest that 6i%olai authori/e Eo to respond fully to all of "rancis in$uiries since Eo #ould be prohibited from disclosing confidential information obtained in the course of his professional engagement #ith 6i%olai. (') "rancis should advise Eo of 6i%olais decision to change auditors as an act of professional courtesy. (() "rancis should ma%e reasonable in$uiries of Eo regarding matters that #ill aid in deciding #hether to accept the engagement. ("rancis in$uiries should include $uestions regarding facts #hich might bear on the integrity of management, disagreements #ith management as to accounting principles, auditing procedures or other significant matters, and Eos understanding of the reason(s) for the change of auditors.) (0) "rancis should #eigh all the information received from Eo. If Eo does not respond fully to "rancis $uestions, "rancis should consider the implications of the limited response in deciding #hether to accept the engagement.

d. e.

Case 3. a.

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(7) After #eighing all information received from Eo, "rancis should inform 6i%olai that a first>time audit is more time>consuming than a recurring audit because the ne# auditor is generally unfamiliar #ith clients operations and does not have the benefit of past %no#ledge of company affairs to use a guide. (9) A discussion #ith 6i%olai of the estimated re$uired audit time and fee arrangement should be coordinated #ith a clear e&planation of the purpose and scope of the audit. Any #or% that can be done by client personnel should also be discussed so that e&cess audit time might be eliminated and proposed report deadlines can be reasonably met. (;) To satisfy "rancis $uality control ob@ectives, "rancis should use procedures such as revie#ing the financial statements of 6i%olai: in$uiring of third parties such as 6i%olais ban%s, legal counsel, investment ban%ers, and others in the business community as to 6i%olais reputation: and evaluating his ability to serve 6i%olai properly #ith reference to industry e&pertise, si/e of engagement, and available staff. (=) If "rancis has no reservations, after all significant factors have been considered, discussed, and agreed to, "rancis should accept the engagement and confirm the understanding in an engagement letter. b. "rancis procedures on this first>time audit should include the follo#ing* (1) "rancis should revie# the #or%papers of Eo to obtain information that #ill help plan the audit #or%. (!) "rancis should ma%e arrangements as early as possible for the initial meeting #ith B%eyC company personnel #ho #ill be contacted throughout the engagement. (') ince basic information about the company is not readily available to "rancis on this first>time audit, information of a general nature should be obtained as early in the planning stage as possible. ( uch information should include company history, nature of the business, credit policies, financing methods, sales methods and terms, seasonal business patterns, products, services, plant locations, internal procedures, accounting policies, ta& status, etc. )lient procedures manuals and manuals of accounts should be read to obtain such information.) (() "rancis should immediately start obtaining the data needed to create a permanent #or%ing paper file. (The file should include items such as articles of incorporation, minutes, internal audit reports, deeds of trust, pension agreements, loan agreements, leases, important contracts, and other pertinent data.) (0) "rancis must determine the scope of #or% necessary to verify the opening balances. uch balances must be revie#ed to determine #hether they are stated on a basis comparable #ith those of the period under revie#. If "rancis cannot verify the opening balances, "rancis

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should consider disclaiming an opinion on the earnings statement and statement of changes in financial position. (7) The composition of all important accounts should be revie#ed. "rancis should limit his e&amination of prior period accounts to a revie# or survey of such accounts, #ithout a detailed e&amination, unless the results of "rancis survey and analyses indicate the need for further investigation of accounting methods in the prior years. (9) "rancis must consider #hether the financial statements are prepared using generally accepted accounting principles that #ere consistently applied. If, after performing necessary audit procedures, "rancis cannot be satisfied as to consistency, considerations must be given to $ualifying the auditors report as to consistency. (;) "rancis should use professional @udgment to determine the e&tent of reliance that should be placed on the #or% of Eo. The scope of "rancis #or% may be reduced as a result of "rancis consultation #ith Eo and a revie# of the prior>year #or%papers of Eo.

Case 4. a.

If the auditor finds that a clients staff member #ho possesses needed information is fre$uently out of the office (perhaps for good reasons), the auditor should prepare a list of the $uestions or information he desires for presentation to the clients employee, and then carry on his audit program until the staff member returns. The auditor may have the fault of continually interrupting the clients staff #ith $uestions that should be accumulated and as%ed at one time. Indeed, numerous $uestions by an auditor may be a strong indication of his lac% of competence in accounting matters. 4n the other hand, if the absences are seriously impeding the progress of the audit and the offending personnel are reluctant to cooperate, the controller>office manager should be advised of the problem. If he fails to ta%e the necessary corrective measures, an official outran%ing the controller should be #arned that the situation may result in an increase in the auditors fee.

b.

Although it is generally held not to be #ithin the province of the auditor to comment upon the deportment of clients office staff, in this instance he must dra# the attention of a responsible official to the la&ity in the disciplinary control of the office staff. Aanagement e&pects the auditor to report any #ea%nesses that he uncovers in his study of the system of internal control and his observation of its operation. The report, usually prepares as a letter, #ould bring managements attention to the three>#ee% delay in accounting #or% #hich is conducive to manipulative practices such as lapping of accounts. Inasmuch as management might conclude in error that the delay arose from

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a heavy office #or%load, the report should clearly state that the bac%log #as caused by office malpractices. The report should also point out the possibility of theft because several employees responsible for safeguarding the companys assets, the supply room attendant and the sho#room technicians, are fre$uently out of the office. The fre$uent absences of office personnel from the office should be mentioned to illustrate the auditors statement that the office is inefficiently managed and also, if necessary, to provide grounds for @ustification of an increase in the auditors fee if the absences #ere the cause of inefficiencies in the conduct of the audit. In the preparation of his report the auditor should remember that the controller has been employed for si& months, long enough for him to have demonstrated his managerial abilities. It may be that the auditors report #ill lead to a subse$uent discussion #ith management #hich the auditor #ould #elcome as an opportunity for gaining increased confidence from the client. +erhaps management, a#are of the controllers deficiencies, has been see%ing confirmation of its o#n evaluation. The auditor therefore may be in a position to dra# upon his e&perience, probably more varied than managements, to offer guidance in determining the corrective steps to be ta%en. c. If numerous errors are found in the boo%s, they should be brought to the attention of the controller so that corrections can be made. Although these errors may not be due e&clusively to internal control #ea%nesses, management should be told of them because they spring in part from deficiencies in the system of internal control. "urthermore, the numerous errors #ould cause the auditor to e&tend his auditing procedures and to test a greater number of transactions. If the auditor finds certain records and accounting evidence to be unreliable because of numerous substantial errors, he must determine #hether they are so unreliable as to cause him to $ualify his opinion or, in gross circumstances, disclaim an opinion on the financial statements. The sources of information and in$uiries are listed in the solution to ,evie# Fuestion no. 0. tudents can decide this acceptance $uestion either #ay, although the brief facts pre@udice the conclusion to#ard nonacceptance. The )+As o#n firm decided to resign only 1< years ago, presumably over matters of o#ner> manager integrity. Get, Ar. ello appears to be a respected member of his ne# community. Aaybe his Bfast and looseC accounting past is behind him. Aaybe not.

d.

Case 5. a. b.

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Solutions Manual - Principles of Auditing and Other Assurance

Case 6. (a) 1gan should e&plain to "ilan that an independent audit is an e&amination of the financial statements in accordance #ith generally accepted auditing standards. The ob@ective of an audit is to render an opinion on the fairness #ith #hich the financial statements present financial position, results of operations, and cash flo#s in conformity #ith generally accepted accounting principles. The )+A, after an ob@ective evidence>gathering audit, e&presses an opinion and Bbears #itnessC to the fair presentation of financial statements. An independent e&pert is needed to lend credibility to the financial statements. It #ould not be meaningful for a company to report on itself #ithout the attestation of an independent party because the company itself might not be ob@ective. (b) 1gan should inform "ilan of the follo#ing #ays in #hich an independent audit can be beneficial (only five re$uired)* (1) (!) (') (() (0) (7) (9) (;) (=) (1<) (11) (1!) (1') (1() (10) (17) To serve as a basis for the e&tension of credit. To supply credit rating agencies #ith re$uired information. To serve as a basis for preparation of ta& returns. To establish amounts of losses from fire, theft, burglary, and so forth. To determine amounts receivable or payable under various agreements. To provide data for possible sale or merger. To serve as a basis for action in ban%ruptcy and insolvency cases. To determine proper e&ecution of trust agreements. To furnish estates #ith information in order to obtain proper settlements and avoid costly litigation. To establish and-or improve internal control structures. To provide aid in cases of ta& audits, court actions, and so forth. To discourage employees from perpetrating errors and irregularities. To provide industry>#ide comparisons. To provide a realistic loo% at assets. To assist in revie# of ade$uacy of insurance coverage. To provide the professional %no#ledge of an e&ternal auditor, #hich may help company in a number of #ays.

Case 7. Auditing standards indicate that auditors should report ma@or issues discussed #ith the entitys management prior to being retained as auditor, including discussions regarding the application of accounting principles and auditing standards. 5iscussion of such matters may place pressure on the auditor to yield to managements vie#. Aa%ing the audit committee members a#are of such matters should enable them to better monitor the auditors independence. tandards do not preclude clients from ma%ing suggestions about audit staff.

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)lients fre$uently ma%e re$uests to have persons on the audit #ho have e&perience in the industry. If a client re$uests that minority persons not be assigned to an audit, ho#ever, the auditor must carefully consider the ethical implications of that re$uest. Case 8. a. The auditor normally revie#s the audit report #ith the audit committee, calls to the attention of the board any accounting disagreements #ith the client, calls to the boards attention any material frauds, and identifies any reportable conditions. Ges. The audit committee members serve as $uasi>trustees for the stoc%holders in monitoring the accounting. Auditing standards re$uire an auditor to communicate certain matters related to the conduct of the audit to those responsible for the oversight of the financial reporting process. tandards re$uire reporting to those responsible for oversight of the financial reporting process. Hhen boards do not transfer that responsibility to an audit committee, the responsibility rests #ith the #hole board, and the auditor must report to the board.

b. c.

d.

Case 9. The letter should e&plain that the purpose of a financial statement audit is to ascertain #hether financial statements fairly present financial position, results of operations, and cash flo#s in conformity #ith GAA+. In contrast, the purpose of an operational audit is to evaluate the effectiveness and efficiency of operations. Aost firms obtain financial audits because they are re$uired to do so by the 1), the stoc% e&change on #hich their stoc% is traded, or a ma@or lender. A financial audit provides credibility to the financial statements so that creditors, investors, and others #ill ma%e financial resources available to the firm. 4perational audits are performed to determine #hether an entity is effective and-or efficient. Case 10. a. An audit committee is an important part of a companys organi/ational structure. It is a special committee formed by the board of directors. It is ideally a group of outside directors #ho have no active day>to>day operations role and #ho are a liaison bet#een the independent auditor and the board of directors. Audit committees have been formed to satisfy the shareholders need for assurance that directors are e&ercising due care in the performance of their duties. Also, they have been formed to reinforce auditor independence, particularly the appearance of independence, from management of a company #hose financial statements are being e&amined by the auditor. The functions of an audit committee may include the follo#ing*

b.

c.

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Solutions Manual - Principles of Auditing and Other Assurance

elect the independent auditor: discuss audit fee #ith the auditor: revie# auditors engagement letter. ,evie# the independent auditors overall audit plan (scope, purpose, and general audit procedures). ,evie# the annual financial statements before submission to the full board of directors for approval.

,evie# the results of the auditors e&amination including e&perience, restrictions, cooperation received, findings, and recommendations. )onsider matters that the auditor believes should be brought to the attention of the directors or shareholders. ,evie# the independent auditors evaluation of the companys internal control system. ,evie# the companys accounting, financial and reporting controls. ,evie# the reports of internal audit staff. ,evie# interim financial reports to shareholders before they are approved by the board of directors. ,evie# company policies concerning political contributions, conflicts of interest, and compliance #ith la#s and regulations, and investigate compliance #ith those policies. ,evie# financial statements that are part of prospectuses or offering circulars: revie# reports before they are submitted to regulatory agencies. ,evie# independent auditors observations of financial and accounting personnel. +articipate in the selection and establishment of accounting policies: revie# the accounting for specific items or transactions as #ell as alternative accounting treatments and their effects. ,evie# the impact of ne# or proposed pronouncements by the accounting profession or regulatory bodies. ,evie# the companys insurance program. ,evie# and discuss the independent auditors management letter.