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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
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
 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?
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General reputation
Willingness to be associated with the company
Management integrity
 Can we effectively perform this audit?
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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
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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
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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:
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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 Expert
SEC rules define an audit committee financial expert as a person with the
following attributes:
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An understanding of generally accepted accounting principles and financial statements;
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The ability to assess the …application of such principles in…accounting for estimates, accruals and reserves;
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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;
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An understanding of internal controls and procedures for financial reporting;
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An understanding of the audit committee functions.
These attributes may have been acquired through:
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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;
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Experience actively supervising a principal financial officer, principal accounting officer, controller, public
accountant, auditor or person performing similar functions;
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Experience overseeing or assessing the performance of companies or public accountants with respect to the
preparation, auditing or evaluation of financial statements;
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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
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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
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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
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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
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 Cash and credit card sales
Commonalities with retail
Need to control cash received
Need to control credit approval process
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Hospitality continued
 Entertainment venues, important issues
 Sells food like a restaurant
 Sells services (tickets for events)
Right of return
Cancellation
Revenue recognition issues
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 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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