ch05 by uc86


									                            Review Questions Solutions
                 Chapter 5, Client Acceptance and Continuance and
                       Preliminary Engagement Procedures

Page 178
A1 Distinguish between client acceptance and client continuance.

       Client acceptance refers to the process used by an auditing firm as it decides
whether to begin performing audit work for a company with which it has not been
associated in the past. Client continuance deals with continuing to perform audit work for
a company that is an ongoing client.

A2 What guidance exists in the professional standards literature regarding client
acceptance and continuance?

       Guidance regarding: the auditor’s qualifications; the firm’s processes for
considering potential and continuing clients; engagement letters

Page 180
B1 What is a request for proposal? Is a formal RFP always used? What information
is included in an RFP?

       A communication to potential service providers inviting them to submit a
proposal to provide the service

B2 What would cause a CPA firm to immediately rule out proposing on a
company’s audit, in terms of independence?

        If independence can be impaired by various financial interests and business
relationships with the company or its affiliates and by providing certain non-audit
services to the client

Page 184
C1 What performance indicators are found in a 10K?

       Profit performance
       Financial or cash flow problems, going concern problems
       Risk factors
               Sensitivity to changing economic conditions
               Likelihood of being affected by industry condition
               Regulations affecting financial performance
               Potential lawsuits
               Vulnerability to global conditions such as trade agreements and exchange
               Domestic and global competition
       Other information
              Business activities
              Cash flows, and sales needed to satisfy fixed financial commitments
              Economies of scale available and achieved
              Ability to limit production if needed
              Ability to maintain sufficient inventory
              Historical instances of needing to reduce inventory
              Customer recognition of product differentiation from other suppliers in the
              Reputation for quality among customers

C2 Why would firms review a potential client’s financial disclosures for information
about management’s choices on accounting principles?

        The accounting treatments management has selected may give the auditor
information regarding management’s philosophy and attitudes. This enables the auditor
to assess whether management’s philosophy on accounting treatment and presentation
will increase audit risk if the company is added as an audit client.

C3 What are related party transactions?

      These are transaction in which one party has the ability to influence the decisions,
management or operating policies of the other party. Related parties may be an affiliated
company or any entity with which a client deals.

Page 189
D1 Why is management and Board of Directors integrity important to an audit

       It increases the auditor’s confidence that what people are telling them is truthful
and that the documents and information they are inspecting are valid and legitimate.

D2 Why might an auditor be concerned if all of the company’s management
authority is centered in one or two individuals?

       This situation means all the power and decision making authority is centered in
those people so there is less segregation of duties and also a greater opportunity that
management can get away with doing whatever it wants to do – for example, fraud.

D3 What is the auditor’s concern regarding a company that lacks a competent
management team?

        They may not be able to run the company properly and implement suitable
internal control policies resulting in greater risk, both to the company and the auditor.
D4 What is financial statement restatement? Why does the auditor investigate
whether a company has restated its financial statements when addressing client

        A restatement occurs when previously issued financial statements are changed to
correct an error or as a result of new information that was not previously available.
(Retrospective application of a new accounting standard is not restatement.) Restatement
can indicate a problem with ICFR and raises the need to be sure it does not reflect on
management integrity or competence.

D5 In what way would management misrepresenting a company’s performance in
public speeches be a problem to an auditor?

       Misleading outsiders by presenting an unrealistically positive picture raises
questions of integrity.

Page 192
E1 What are the concerns regarding an obscure or a very complex organizational

       Whether management is using the organizational structure to withhold
information or keep secrets.

E2 What does “going concern” mean?

        Questions exist about whether a company is a going concern if there is
uncertainty about its ability to continue as a viable entity for the next year. Evaluation of
going concern includes considering a company’s resources, cash and borrowing capacity
relative to its obligations for the coming year.

E3 What happens to the audit report if there is a question about the client’s ability
to continue as a going concern?

       The audit report includes this information.

E4 What impact does multiple geographical business locations have on the client
acceptance decision?

         The auditor considers whether the audit firm has the resources to complete the
engagement at the locations. The auditor also addresses the business reasons for the
multiple locations. If there is not apparent business reason, it may indicate risk pertaining
to (1) the type of transactions conducted at that location and (2) management integrity.

E5 Would the auditor have questions about a potential client having an operating
location or bank account in another country when no readily apparent business
purpose for the foreign location?

E6 Why is complexity of a potential client’s IT system important to the proposing

        It provides the audit firm with background regarding the situation it is likely to
encounter on the audit of a potential new client and aids in estimating the amount of work
that will be involved, audit firm personnel needed, and how long it will take to complete
the audit.

Page 193
F1 What are the auditor’s sources of information about a potential client?

       The company’s website
       Its prior year financial statements and auditor’s reports
       Reports filed with the SEC
       The outgoing or prior auditor
       Resources within the business community, media reports, published data and
       special investigations

F2 What is an 8K? Annual report? Management discussion and analysis?

       An 8K is a report that provides information on events that may be of interest such
as ownership and management changes, acquisitions and dispositions, and auditor
       An annual report is a document prepared by a company that presents various
kinds of information about the entity, including a letter to shareholders, financial reports
and the audit report.
       Management discussion and analysis is disclosure required in reports filed with
the SEC including, among other things, risk information and trend analysis.

F3 Why does an incoming auditor communicate with the predecessor auditor?
What information does the proposing or incoming (successor) auditor request?

       The auditing standards require that an incoming auditor communicate with the
predecessor auditor. The information that may be communicated through this type of
communication includes:
       management integrity concerns
       reasons for the change in audit firms
       management’s openness and cooperation with the auditor
       Board of Directors and audit committee availability and involvement
       disputes the auditor has had with management
       problems encountered on the audit, such as fraud or illegal acts
The successor auditor may also ask to see the predecessor auditor’s work papers.
F4 Does the predecessor have to respond to the successor auditor? Why might the
prior auditor not be willing or able to communicate fully with the successor
auditor? Is this okay, according to professional standards?

The predecessor auditor must respond, but is allowed to limit the response. The auditor
must state that the response is limited. This would occur if there is a lawsuit or some
other dispute involving the client and prior auditor.

Page 203
G1 What is a media or data search?

This is a search for information in the media or other public available databases or
sources of information. Examples are: (1) an investigation to identify instances when the
potential client has been discussed in the print media, and (2) background checks of
significant personnel such as top management and directors.

G2 What are some reasons an audit firm might decide to refrain from proposing on
an engagement?

The firm might decide it does not have sufficient personnel for the engagement.
The client is planning an initial public offering and the audit firm has limited or no
experience with that type of engagement.
If the potential client is in an industry that is highly regulated or for which significant
industry expertise is required, or even if it has a very complex IT system, the auditor may
determine that it does not have the professional expertise for the engagement.

G3 What is an engagement letter, and what are its contents?

An engagement letter is, effectively, the contract between the auditor and the client. It
sets out the items about which the auditor and client should establish an understanding.
An engagement letter under PCAOB standards includes the following:
1. The objective of an integrated audit is to express an opinion on the financial statements
and ICFR
2. Management is responsible for the entity’s financial statements and for establishing
and maintaining effective ICFR
3. Management is responsible for identifying and ensuring that the entity complies with
the laws and regulations applicable to its activities
4. Management is responsible for making all financial records and related information
available to the auditor
5. At the conclusion of the engagement, management will provide the auditor with a letter
that confirms certain representations made during the audit
6. The auditor is responsible for conducting the audit in accordance with the standards of
the PCAOB (and then a description of what that means)
7. An audit includes planning and performing the audit to obtain reasonable assurance
about reporting…and making certain required communications to management, the audit
committee and the Board of Directors.
8. Management is responsible for adjusting the financial statements to correct material
misstatements and for affirming to the auditor in the representations letter that the effects
of any uncorrected misstatements …are immaterial.
9. Other matters that may be included are:
       Conduct of the engagement
       Involvement of specialists or internal auditors
       Involvement of a predecessor auditor
       Fees and billing
       Any limitations of or other arrangements regarding the liability of the auditor or
       the client
       Conditions under which access to the auditor’s work papers may be granted to
       Additional services to be provided relating to regulatory requirements
       Other services to be provided in connection with the engagement

                                 Review Questions Solutions
                     Chapter 5, Appendix A, Industry Descriptions

Page 225
Identify the most important accounts, management assertions, and risks for each of
the following industries:

H1 manufacturing

Accounts: Raw Materials Inventories, Accounts Payable
Assertions: existence or occurrence, completeness, rights and obligations, valuation
Risks: control over inventory as it moves through the manufacturing process; proper
accumulation of costs that make up inventory

H2 retailing

Accounts: Inventory, Accounts payable
Assertions: for Inventory, existence, valuation and cutoff; for Accounts Payable,
completeness; for Cash, existence, rights
Risks: physical control of inventories; preventing theft by customers and employees; IT
controls for e-commerce sales

H3 health care

Accounts: Sales, Allowance for Contractual Discounts, Unbilled Services, Accounts
Receivable, Allowance for Uncollectible Accounts, Payroll Expense
Assertions: for Sales and Unbilled Services, occurrence; for Allowance for Contractual
Discounts, valuation and completeness; for Net Receivables, valuation; for Payroll,
occurrence, completeness
Risks: Capture and proper billing of all services revenue earned; complex tracking of
contracts into Allowance for Contractual Accounts; industry regulations

H4 banking

Accounts: Cash, Liability for Customers Deposits, Interest Payable, Loans Receivable,
Interest Receivable, Allowance for Doubtful Accounts
Assertions: for Cash, existence, rights; for Liability for Customers Deposits, occurrence,
completeness; Loans Receivable (net of Allowance for Doubtful Accounts), valuation
Risks: compliance with regulation; valuation of collateral for Loans Receivable; controls
over IT

H5 service

Accounts: Revenues, Unearned Revenues, Cash, Accounts Receivable, Allowance for
Doubtful Accounts, Payroll Expense
Assertions: existence or occurrence, completeness, rights and obligations, valuation and
Risks: revenues are properly accrued and posted; personnel expense is all a valid expense

H6 real estate development
and construction

Accounts: Sales, Land held for development, Notes Payable, Construction-in-progress,
Assertions: Sales, occurrence; Receivables, existence, valuation; Land held for
development, Construction-in-progress, valuation; Notes Payable, completeness
Risks: proper revenue recognition; proper inventory valuation; proper matching of costs
to recognized revenue

H7 hospitality

Accounts: Sales, Inventory, Fixed Assets, Payroll Expense
Assertions: Given the hybrid nature of the industry all the assertions are important for
different activities
Risks: timing of revenue recognition (recognized only when earned); theft from
customers and employees; control over cash and receivables; personnel expense is valid

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