Chapter 05 Ans

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 auditor’s ability to meet GAAS and (c) preparing an engagement letter.

2.

For a new client, the auditor can obtain information about the client’s management by (a) inquiring of knowledgeable persons within the community and (b) communicating with the prior (predecessor) audit if the client has been audited previously. For a recurring client, the auditor should consider his prior experiences with the client’s management. Any instances of material errors or irregularities, illegal acts, and untruthful answers to inquiries should be carefully considered.

3.

a.

An audit team typically consists of (1) a partner who has both overall and final responsibility for the engagement, (2) one or more managers who coordinate and supervise the execution of the audit program, (3) one or more seniors who may have responsibility for parts of the audit program and who supervise and review the work of staff assistants, and (4) staff assistants who perform most of the required procedures.

b.

Client personnel may: • • • •

4.

Prepare a trial balance of the general ledger. Reconcile control and subsidiary accounts. Age accounts receivable (i.e., current, thirty days past due, etc.) Prepare schedules of insurance policies in force, notes receivable, and plant assets.

An engagement letter is the agreement or understanding between the CPA and his/her client concerning the nature of the engagement. It provides protection for the CPA in the event of subsequent legal action alleging negligence or breach of contract. By committing the agreement to writing, the engagement letter also minimizes future misunderstandings between the CPA and client concerning the services to be performed by the CPA.

5-2

Solutions Manual - Principles of Auditing and Other Assurance Services

5.

A CPA can use the following sources of information to help decide whether to accept a new audit client. Financial information prepared by the prospective client: Annual reports to shareholders Interim financial statements Securities registration statements Annual report on SEC Reports to regulatory agencies Inquiries directed to the prospect’s business associates: Banker Legal counsel Underwriter Other persons, e.g., customers, suppliers Predecessor auditor, if any, communication, re: Integrity of management, Disagreements with management Analysis: Special or unusual risk related to the prospect Need for special skills (e.g., computer or industry expertise) Internal search for relationships that would comprise independence

6.

Benefits of engagement letters are: • • • •

7.

Helps establish an understanding between client and auditor of the terms of the engagement and the nature of the work. Helps avoid quarrels and misunderstandings between client and auditor. Helps avoid disputes over the audit fee. Helps avoid legal liability assertions based on failure to do work that the CPA may not have contemplated or agreed to do.

For a proposed client, an auditor must evaluate whether any relationships violate the Code of Ethics for Professional Accountants in the Philippines. Relationships that present problems are relationships between the firm (and its personnel) and the client (and its personnel). In addition, the auditor must determine whether a potential client is auditable; that is, whether sufficient competent evidence can be accumulated to render an opinion. For smaller potential client, two issues, the adequacy of accounting records and management

Management of a Public Accounting Practice

5-3

integrity, must be considered. For larger potential clients, the auditor must evaluate the adequacy of accounting records, management integrity, and the quality of internal control. 8.

Since the auditor must evaluate the financial statement assertions of the client, the integrity of the potential client’s management is of critical importance. An auditor usually does not audit 100 percent of a client’s transactions. In addition, certain assertions cannot be evaluated externally.

9.

The successor auditor should ask the client to authorize the predecessor auditor to respond fully to the successor’s inquiries. If the client refuses or limits the responses, the successor should ask the client to explain the reasons. After obtaining the explanation, the successor should consider whether to continue pursuing the engagement. The successor auditor is expected to make specific and reasonable inquiries. These inquiries should address facts that bear on management integrity, disagreements with management on accounting principles, and the predecessor’s understanding of the reason(s) for the change in auditor. In normal situations, the predecessor is expected to respond promptly and fully to reasonable inquiries.

10. An engagement letter is designed to formalize any oral agreements made between the client and the auditor. It should include a description of the scope of services to be provided; an explanation of the services to be provided, including a disclaimer of responsibility for detecting fraud; a statement about the obligations of client’s staff to assist in the engagement; a statement about fees, or method of determining fees, and payment of expectations; and a statement about other services to be performed. 11. To obtain information about the client’s business and industry, an auditor can review prior-year working papers, review current-year client information, inquire of management and the audit committee, read PICPA industry audit and accounting guides relevant to the client, and significant industry publications and manuals maintained by the firm on the industry. 12. Refer to pages 172 to 174. 13. Refer to page 174. 14. Refer to pages 174 to 175. 15. Refer to pages 174 to 176. 16. Refer to pages 61 to 64.

5-4

Solutions Manual - Principles of Auditing and Other Assurance Services

II. Multiple Choice Questions 1. 2. 3. 4. 5. 6. 7.

a d b a c a d

8. 9. 10. 11. 12. 13. 14.

b c d a b d a

15. 16. 17. 18. 19. 20. 21.

c a b c b a a

22. 23. 24. 25. 26. 27. 28.

b a d a c d c

III. Comprehensive Cases Case 1.

a. Prior to acceptance of the engagement, Argante & Tan should have communicated with the predecessor auditor regarding: • • • •

b.

Facts that might bear on the integrity of management. Disagreements with management concerning accounting principles, auditing procedures, or other significant matters. The predecessor’s understanding about the reason for the change. Any other information that may be of assistance in determining whether to accept the engagement.

The form and content of engagement letters may vary, but they would generally contain information regarding: • • • • • •

• • • •

The objective of the audit. The estimated completion date. Management’s responsibility for the financial statements. The scope of the audit. Other 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 risk that even some material misstatement may remain undiscovered. Access to whatever records, documentation, and other information may be requested in connection with the audit. Arrangements with respect to client assistance in the performance of the audit engagement. Expectation of receiving from management written confirmation concerning representations made in connection with the audit. Notification of any changes in the original arrangements that might be necessitated by unknown or unforeseen factors.

Management of a Public Accounting Practice

5-5

•

Case 2.

a.

Request for the client to confirm the terms of the engagement by acknowledging receipt of the engagement letter. • The basis on which fees are computed and any billing arrangements. Typical engagement letter generally includes the following: • • • • • • • • • • • •

b.

The name and address of the person or persons who 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 CPA firm that will conduct the examination. A statement that the examination will be performed in accordance with generally accepted auditing standards. A description of the scope of the services to be rendered, which should establish the nature of the engagement. Any scope restrictions or special limitations and their effect on the auditor’s report. A statement regarding the auditor’s responsibility for the detection of fraud. An indication of the possible use of client personnel in connection with the audit work to be performed. A statement that the auditor will provide a management letter if required in the circumstances. The method and timing of billings as well as billing rates and fee arrangements. Space for the client representative’s signature, which indicates “acceptance” of the letter and the understandings, therein.

The benefits of preparing an engagement letter include the avoidance of possible problems between the CPA and the client concerning (1) the scope of the work, (2) the service to be rendered, and (3) the audit fee. In addition, the “in-charge” auditor conducting the examination can avoid misunderstanding the nature and scope of the engagement if the engagement letter is included in the permanent section of the audit working papers. The letter should eliminate misunderstandings and confusion about the type of financial statements to be examined, the estimated report date, and the type of opinion expected. In addition to avoiding possible misunderstandings, any legal problems relating to the auditor’s failure to perform certain procedures can be reviewed with reference to the contractual commitment assumed. (For example, if scope limitations prevent the auditor from performing normal audit procedures, the auditor

5-6

Solutions Manual - Principles of Auditing and Other Assurance Services cannot be legally responsible if an irregularity is not detected when clearly it would have been detected if such procedures were performed.) The engagement letter is also useful as a reference document when preparing for future engagements. c.

The CPA usually prepares the engagement letter as a follow-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 CPA. It also is acceptable for the client to prepare his own letter summarizing his understanding of the nature of the engagement.

d.

Preferably the engagement letter should be sent at the beginning of the engagement so that misunderstandings, if any, can be remedied.

e.

Obviously, the engagement letter will be most useful in clarifying misunderstandings on a first engagement. But it is desirable that the letter be renewed periodically. Client personnel or the nature of the engagement may change, and the resubmission of the letter gives both parties an opportunity to review the circumstances. Accordingly, for recurring examinations of financial statements, it is appropriate to prepare an engagement letter at the start of each examination. For other continuing engagements, the engagement letter also should be updated periodically – probably on a yearly basis.

Case 3.

a. The procedures that Francis should follow prior to accepting the engagement include the following: (1) Francis should explain to Nikolai the need to inquire of Jo and should request permission to make such inquiries. (2) Francis should request that Nikolai authorize Jo to respond fully to all of Francis’ inquiries since Jo would be prohibited from disclosing confidential information obtained in the course of his professional engagement with Nikolai. (3) Francis should advise Jo of Nikolai’s decision to change auditors as an act of professional courtesy. (4) Francis should make reasonable inquiries of Jo regarding matters that will aid in deciding whether to accept the engagement. (Francis’ inquiries should include questions regarding facts which might bear on the integrity of management, disagreements with management as to accounting principles, auditing procedures or other significant matters, and Jo’s understanding of the reason(s) for the change of auditors.) (5) Francis should weigh all the information received from Jo. If Jo does not respond fully to Francis’ questions, Francis should consider the implications of the limited response in deciding whether to accept the engagement.

Management of a Public Accounting Practice

5-7

(6) After weighing all information received from Jo, Francis should inform Nikolai that a first-time audit is more time-consuming than a recurring audit because the new auditor is generally unfamiliar with client’s operations and does not have the benefit of past knowledge of company affairs to use a guide. (7) A discussion with Nikolai of the estimated required audit time and fee arrangement should be coordinated with a clear explanation of the purpose and scope of the audit. Any work that can be done by client personnel should also be discussed so that excess audit time might be eliminated and proposed report deadlines can be reasonably met. (8) To satisfy Francis’ quality control objectives, Francis should use procedures such as reviewing the financial statements of Nikolai; inquiring of third parties such as Nikolai’s banks, legal counsel, investment bankers, and others in the business community as to Nikolai’s reputation; and evaluating his ability to serve Nikolai properly with reference to industry expertise, size of engagement, and available staff. (9) If Francis has no reservations, after all significant factors have been considered, discussed, and agreed to, Francis should accept the engagement and confirm the understanding in an engagement letter. b.

Francis’ procedures on this first-time audit should include the following: (1) Francis should review the workpapers of Jo to obtain information that will help plan the audit work. (2) Francis should make arrangements as early as possible for the initial meeting with “key” company personnel who will be contacted throughout the engagement. (3) Since basic information about the company is not readily available to Francis on this first-time audit, information of a general nature should be obtained as early in the planning stage as possible. (Such 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, tax status, etc. Client procedures manuals and manuals of accounts should be read to obtain such information.) (4) Francis should immediately start obtaining the data needed to create a permanent working 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.) (5) Francis must determine the scope of work necessary to verify the opening balances. Such balances must be reviewed to determine whether they are stated on a basis comparable with those of the period under review. If Francis cannot verify the opening balances, Francis

5-8

Solutions Manual - Principles of Auditing and Other Assurance Services should consider disclaiming an opinion on the earnings statement and statement of changes in financial position. (6) The composition of all important accounts should be reviewed. Francis should limit his examination of prior period accounts to a review or survey of such accounts, without a detailed examination, unless the results of Francis’ survey and analyses indicate the need for further investigation of accounting methods in the prior years. (7) Francis must consider whether the financial statements are prepared using generally accepted accounting principles that were consistently applied. If, after performing necessary audit procedures, Francis cannot be satisfied as to consistency, considerations must be given to qualifying the auditor’s report as to consistency. (8) Francis should use professional judgment to determine the extent of reliance that should be placed on the work of Jo. The scope of Francis’ work may be reduced as a result of Francis’ consultation with Jo and a review of the prior-year workpapers of Jo.

Case 4.

a. If the auditor finds that a client’s staff member who possesses needed information is frequently out of the office (perhaps for good reasons), the auditor should prepare a list of the questions or information he desires for presentation to the client’s employee, and then carry on his audit program until the staff member returns. The auditor may have the fault of continually interrupting the client’s staff with questions that should be accumulated and asked at one time. Indeed, numerous questions by an auditor may be a strong indication of his lack of competence in accounting matters. On 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 take the necessary corrective measures, an official outranking the controller should be warned that the situation may result in an increase in the auditor’s fee.

b.

Although it is generally held not to be within the province of the auditor to comment upon the deportment of client’s office staff, in this instance he must draw the attention of a responsible official to the laxity in the disciplinary control of the office staff. Management expects the auditor to report any weaknesses 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, would bring management’s attention to the three-week delay in accounting work which is conducive to manipulative practices such as lapping of accounts. Inasmuch as management might conclude in error that the delay arose from

Management of a Public Accounting Practice

5-9

a heavy office workload, the report should clearly state that the backlog was caused by office malpractices. The report should also point out the possibility of theft because several employees responsible for safeguarding the company’s assets, the supply room attendant and the showroom technicians, are frequently out of the office. The frequent absences of office personnel from the office should be mentioned to illustrate the auditor’s statement that the office is inefficiently managed and also, if necessary, to provide grounds for justification of an increase in the auditor’s fee if the absences were 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 six months, long enough for him to have demonstrated his managerial abilities. It may be that the auditor’s report will lead to a subsequent discussion with management which the auditor would welcome as an opportunity for gaining increased confidence from the client. Perhaps management, aware of the controller’s deficiencies, has been seeking confirmation of its own evaluation. The auditor therefore may be in a position to draw upon his experience, probably more varied than management’s, to offer guidance in determining the corrective steps to be taken. c.

If numerous errors are found in the books, they should be brought to the attention of the controller so that corrections can be made. Although these errors may not be due exclusively to internal control weaknesses, management should be told of them because they spring in part from deficiencies in the system of internal control. Furthermore, the numerous errors would cause the auditor to extend his auditing procedures and to test a greater number of transactions.

d.

If the auditor finds certain records and accounting evidence to be unreliable because of numerous substantial errors, he must determine whether they are so unreliable as to cause him to qualify his opinion or, in gross circumstances, disclaim an opinion on the financial statements.

Case 5.

a. The sources of information and inquiries are listed in the solution to Review Question no. 5.

b.

Students can decide this acceptance question either way, although the brief facts prejudice the conclusion toward nonacceptance. The CPA’s own firm decided to resign only 10 years ago, presumably over matters of ownermanager integrity. Yet, Mr. Sello appears to be a respected member of his new community. Maybe his “fast and loose” accounting past is behind him. Maybe not.

5-10

Solutions Manual - Principles of Auditing and Other Assurance

Services Case 6.

(a) Egan should explain to Filan that an independent audit is an examination of the financial statements in accordance with generally accepted auditing standards. The objective of an audit is to render an opinion on the fairness with which the financial statements present financial position, results of operations, and cash flows in conformity with generally accepted accounting principles. The CPA, after an objective evidencegathering audit, expresses an opinion and “bears witness” to the fair presentation of financial statements. An independent expert is needed to lend credibility to the financial statements. It would not be meaningful for a company to report on itself without the attestation of an independent party because the company itself might not be objective.

(b) Egan should inform Filan of the following ways in which an independent audit can be beneficial (only five required): (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16)

To serve as a basis for the extension of credit. To supply credit rating agencies with required information. To serve as a basis for preparation of tax 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 bankruptcy and insolvency cases. To determine proper execution of trust agreements. To furnish estates with 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 tax audits, court actions, and so forth. To discourage employees from perpetrating errors and irregularities. To provide industry-wide comparisons. To provide a realistic look at assets. To assist in review of adequacy of insurance coverage. To provide the professional knowledge of an external auditor, which may help company in a number of ways.

Case 7. Auditing standards indicate that auditors should report major issues discussed with the entity’s management prior to being retained as auditor, including discussions regarding the application of accounting principles and auditing standards. Discussion of such matters may place pressure on the auditor to yield to management’s view. Making the audit committee members aware of such matters should enable them to better monitor the auditor’s independence. Standards do not preclude clients from making suggestions about

Management of a Public Accounting Practice

5-11

audit staff. Clients frequently make requests to have persons on the audit who have experience in the industry. If a client requests that minority persons not be assigned to an audit, however, the auditor must carefully consider the ethical implications of that request. Case 8.

b.

a. The auditor normally reviews the audit report with the audit committee, calls to the attention of the board any accounting disagreements with the client, calls to the board’s attention any material frauds, and identifies any reportable conditions. Yes. The audit committee members serve as quasi-trustees for the stockholders in monitoring the accounting.

c.

Auditing standards require an auditor to communicate certain matters related to the conduct of the audit to those responsible for the oversight of the financial reporting process.

d.

Standards require reporting to those responsible for oversight of the financial reporting process. When boards do not transfer that responsibility to an audit committee, the responsibility rests with the whole board, and the auditor must report to the board.

Case 9. The letter should explain that the purpose of a financial statement audit is to ascertain whether financial statements fairly present financial position, results of operations, and cash flows in conformity with GAAP. In contrast, the purpose of an operational audit is to evaluate the effectiveness and efficiency of operations. Most firms obtain financial audits because they are required to do so by the SEC, the stock exchange on which their stock is traded, or a major lender. A financial audit provides credibility to the financial statements so that creditors, investors, and others will make financial resources available to the firm. Operational audits are performed to determine whether an entity is effective and/or efficient. Case 10.

a. An audit committee is an important part of a company’s organizational structure. It is a special committee formed by the board of directors. It is ideally a group of outside directors who have no active day-to-day operations role and who are a liaison between the independent auditor and the board of directors.

b.

Audit committees have been formed to satisfy the shareholders’ need for assurance that directors are exercising 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 whose financial statements are being examined by the auditor.

c.

The functions of an audit committee may include the following:

5-12

Solutions Manual - Principles of Auditing and Other Assurance

Services • • •

•

• • • • • • • • • • •

Select the independent auditor; discuss audit fee with the auditor; review auditor’s engagement letter. Review the independent auditor’s overall audit plan (scope, purpose, and general audit procedures). Review the annual financial statements before submission to the full board of directors for approval.

Review the results of the auditor’s examination including experience, restrictions, cooperation received, findings, and recommendations. Consider matters that the auditor believes should be brought to the attention of the directors or shareholders. Review the independent auditor’s evaluation of the company’s internal control system. Review the company’s accounting, financial and reporting controls. Review the reports of internal audit staff. Review interim financial reports to shareholders before they are approved by the board of directors. Review company policies concerning political contributions, conflicts of interest, and compliance with laws and regulations, and investigate compliance with those policies. Review financial statements that are part of prospectuses or offering circulars; review reports before they are submitted to regulatory agencies. Review independent auditor’s observations of financial and accounting personnel. Participate in the selection and establishment of accounting policies; review the accounting for specific items or transactions as well as alternative accounting treatments and their effects. Review the impact of new or proposed pronouncements by the accounting profession or regulatory bodies. Review the company’s insurance program. Review and discuss the independent auditor’s management letter.