Lecture Notes: Auditing Theory L. R. Cabarles AT.1807-Preliminary Engagement Activities OCTOBER 2013
Lecture Notes: Auditing Theory L. R. Cabarles AT.1807-Preliminary Engagement Activities OCTOBER 2013
LECTURE NOTES
Preliminary Engagement Activities The following are the management’s responsibilities, which
constitute the premise on which the audit is conducted:
During this phase of audit, the auditor shall undertake the
Preparation and presentation of the financial
following activities:
statements
Performing procedures regarding the acceptance of the
Design, implementation and monitoring of internal
client relationship and the specific audit engagement;
control to financial statements
Establishing preconditions for an audit;
To provide the auditor with:
Agreeing the terms of the engagement; and
o Access to all information relevant to audit
Communicating with the predecessor auditor, if
o Additional information the auditor may request
applicable.
o Unrestricted access to persons within the entity
Client Acceptance and Continuance
Limitation on Scope Prior to Audit Engagement Acceptance
As discussed in “Quality Controls”, the auditor shall only
The auditor shall not accept an audit engagement, if
undertake or continue audit engagement where the
management or those charged with governance imposes a
auditor:
limitation on the scope of work that will result to disclaimer
is competent to perform the engagement and has the
of opinion unless required by law or regulation to do so.
capabilities, time and resources to do so;
complies with relevant ethical requirements; and
Agreement on Audit Engagement Terms
considers the integrity of the client.
After the auditor has decided to accept or continue an
Basis of Audit Engagement audit engagement, the auditor and the client should agree
the terms of the engagement, preferably through the audit
In addition, the auditor shall accept or continue an audit committee, if any. The agreed terms need to be recorded
engagement only when the basis of audit engagement has in an audit engagement letter or other suitable form of
been agreed, through: contract. Audit engagement letter is a written terms of an
Establishing preconditions for an audit; and engagement in the form of a letter by the auditor to the
Confirming common understanding between the client. An engagement letter documents and confirms the
auditor and management and, where appropriate, auditor’s acceptance of the appointment.
those charged with governance (TCWG) on the terms
of the audit engagement. It is in the interest of both the client and the auditor that
the auditor sends the engagement letter, preferably before
Preconditions for an Audit the commencement of the audit to help avoid
misunderstandings with respect to the engagement.
The auditor shall establish the presence of the
preconditions for an audit by:
Contents of the Audit Engagement Letter
determining that the financial reporting framework
(FRF) is acceptable and is available to intended user Primary Content of the Audit Engagement Letter
applied to FSs; and
Engagement letter primarily includes:
obtaining the agreement of management regarding its
The objective and scope of the audit;
responsibility and, where appropriate, TCWG to the
The responsibilities of the auditor;
premise on which an audit is conducted.
The responsibilities of management;
If the preconditions are not present, the auditor shall Identification of the applicable FRF; and
discuss the matter with management, if not resolved, the Reference to form and content of audit reports and
auditor should not accept the engagement unless required statement regarding deviation from form and content,
by law or regulation. in certain circumstances.
Acceptable Financial Reporting Framework Additional Contents of the Audit Engagement Letter
A financial reporting framework is the benchmark or Engagement letter may additionally include:
criteria in an audit. As discussed under the framework of Elaboration of the scope of the audit
assurance engagements, criteria must be suitable to be The form of any other communication of results of the
considered acceptable. audit
Audit and internal control inherent limitations
In an audit of historical financial statements, the FRF used Planning and performance of the audit, including the
is generally the GAAP. In the Philippines, the following are composition of the audit team
the acceptable FRF depending on the type of client: Written representations from management
a. The Full Philippine Financial Reporting Standards Draft financial statements from management
(PFRSs) Audit fees, including computation and billing
b. The PFRS for Small and Medium-sized entities (SMEs) Acknowledgement from management
c. Other acceptable basis of reporting Involvement of other auditors and experts
Involvement of internal auditors and other staff
Management’s Responsibilities Arrangements with the predecessor auditor
Any restriction of the auditor’s liability
Further agreements between the auditor and the entity
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EXCEL PROFESSIONAL SERVICES, INC.
Any obligations to provide audit working papers to a misunderstanding as to the nature of an audit as
other parties originally requested; or
Audit Fees, Computation and Billing a restriction on the scope of the audit engagement,
whether imposed by management or caused by other
The requirement for fees charged should be reflective of circumstances.
the fair value of the work performed and to be performed,
and should take into account the following, among others: The auditor considers the justification given for the
a. The skill and knowledge required for the type of work request, particularly the implications of a restriction on the
involved; scope of the audit engagement.
b. The level of training and experience of the persons
engaged on the work; Request to Change to a Review or a Related Service
c. The time necessarily consumed by personnel engaged
If, prior to completing the audit engagement, the auditor is
on the work; and
requested to change the audit engagement to an
d. The degree of responsibility assumed and urgency that
engagement that conveys a lower level of assurance, the
the work entails.
auditor shall determine whether there is reasonable
justification for doing so considering any legal or
The mere fact that the fees charged to the client is lower
contractual implications of the change.
than that of normally quoted by another auditor is not in
itself unethical.
If the change is justifiable, record the new terms in a new
engagement letter. The new report should not include
The typical billing methods used by the auditor are:
reference to:
Fixed or flat The client is billed a lump sum and all- the original audit engagement; and
fee basis inclusive amount for the engagement. any procedures performed in the audit engagement,
Actual time Billing is done on the basis of actual time except if changed to an agreed-upon procedures
charges (Per spent by the staff multiplied by the
Diem) basis rates/hour agreed upon. Declining a Change in Engagement
Maximum The client is charged on a per diem basis,
The auditor shall not agree to a change of engagement
fee basis but will not exceed up to a certain
where there is no reasonable justification for doing so. An
maximum amount.
example might be a restriction on the scope of the audit
Retainer’s The client is billed a fixed fee periodically engagement where the auditor is unable to obtain
fee basis for the services rendered during a sufficient appropriate audit evidence regarding receivables
designated period of time, either on a and the entity asks for the audit engagement to be
monthly, semi-annually or annual basis. changed to a review engagement to avoid a qualified
opinion or a disclaimer of opinion.
Audits of Components
When the auditor of a parent entity is also the auditor of a If the auditor is unable to agree to a change of the terms
component, the following factors are considered whether of the audit engagement and is not permitted by
to send a separate engagement letter to the component: management to continue the original audit engagement,
Who appoints the component auditor; the auditor shall:
Whether a separate auditor’s report is to be issued on withdraw from the audit engagement (unless required
the component; by law or regulation); and
Legal requirements in relation to audit appointments; determine whether there is any obligation to report to
Degree of ownership by parent; and other parties, such as those charged with governance,
Degree of independence of the component owners or regulators.
management from the parent entity.
Communication with Predecessor Auditor
Recurring Audits For prospective clients that have previously been audited
New engagement letter may not be sent annually to the by another CPA firm, the new (successor) auditor is
same client. However, the auditor should consider the required, under the code of ethics, to communicate with
following factors when sending new engagement letter: the predecessor auditor is to help the successor auditor
Misunderstanding of the objective and scope evaluate whether to accept the engagement.
Any revised or special terms
A recent change of senior management The burden of initiating the communication rests with the
A significant change in ownership successor auditor. However, confidentiality requires that
A significant change in entity’s nature or size the predecessor auditor obtain permission from the client
A change in legal or regulatory requirements before the communication can be made.
A change in the financial reporting framework
A change in other reporting requirements The successor auditor normally inquires the following from
the predecessor auditor about the prospective client:
Acceptance of a Change in the Terms of the Audit Integrity of management
Engagement Disagreements with management about audit
procedures or accounting principles
Request to Change the Terms of the Audit Engagement Communication with Audit Committee about fraud,
The auditor shall not agree to a change in the terms of the illegal acts, or internal control
audit engagement where there is no reasonable Reason for change in auditor
justification for doing so.
If a client will not permit the communication or the
A request from the entity for the auditor to change the predecessor will not provide a comprehensive response,
terms of the audit engagement may result from: the successor should seriously consider the acceptability of
a change in circumstances affecting the need for the a prospective engagement, without considerable other
service; investigation.
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EXCEL PROFESSIONAL SERVICES, INC.
Because of the inherent limitations of an audit, together The form and content of our report may need to be
with the inherent limitations of internal control, there is an amended in the light of our audit findings.
unavoidable risk that some material misstatements may
not be detected, even though the audit is properly planned Please sign and return the attached copy of this letter to
and performed in accordance with PSAs. indicate your acknowledgement of, and agreement with,
In making our risk assessments, we consider internal the arrangements for our audit of the financial statements
control relevant to the entity’s preparation of the financial including our respective responsibilities.
statements in order to design audit procedures that are
appropriate in the circumstances, but not for the purpose XYZ & Co.
of expressing an opinion on the effectiveness of the
entity’s internal control. However, we will communicate to Acknowledged and agreed on behalf of ABC Company by
you in writing concerning any significant deficiencies in (signed)
internal control relevant to the audit of the financial ......................
statements that we have identified during the audit. Name and Title
Date
- done -
MULTIPLE CHOICE
1. Which of the following would an auditor least likely 2. In making a decision to accept or continue with a
perform as part of the auditor’s preliminary client, the auditor should consider:
engagement activities or pre-planning or pre- a. b. c. d.
engagement phase? Its competence Yes Yes Yes Yes
a. Perform procedures regarding the continuance of Its independence Yes No Yes No
the client relationship and specific engagement. Its ability to serve the client Yes Yes Yes No
b. Evaluate compliance with ethical requirements, properly
including independence. The integrity of client’s Yes Yes No Yes
c. Establish an understanding of the terms of the management
engagement. That understanding of the Yes No Yes No
d. Obtain understanding of the legal and regulatory terms of engagement has
framework applicable to the entity. been obtained with the
management
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EXCEL PROFESSIONAL SERVICES, INC.
7. When should an auditor obtain an engagement letter? 15. A type of billing audit client which combines lump sum
a. Whenever a prospective client offers to hire the and per diem methods is known as
audit firm a. Retainer’s fee basis
b. During the interim audit period, after the auditor b. Maximum fee basis
has evaluated the client’s internal control and c. Either (a) and (b) above
estimated the amount of time required for the d. None of the above
audit
c. When a new client is accepted by the auditor 16. Which of the following factors do not influence the
d. At the conclusion of the field work, just prior to decision of the auditor to send a separate engagement
signing the audit report letter to the parent entity and its component
(subsidiary, branch or division) assuming the same
8. It is in the interest of both client and auditor that the auditor handles both entities?
auditor sends an audit engagement letter, preferably a. legal requirements
before b. degree of ownership by parent
a. The performance of substantive testing. c. ethical requirements
b. The commencement of the engagement. d. whether a separate audit report is to be issued on
c. The completion of audit. the component
d. Before the issuance of audit report.
17. Assuming a recurring audit, in which of the following
9. Which of the following normally signs the engagement situations would the auditor be unlikely to send a new
letter for an audit of a public company? engagement letter to the client?
a. Corporate treasurer.
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EXCEL PROFESSIONAL SERVICES, INC.
a. A recent change in partner and/or staff involved in c. Maria and Peta Manufacturing, Inc. consent
the audit engagement. d. Maria and Pedro consent
b. A change in the terms of engagement.
c. A recent change of client management. 25. Prior to the acceptance of an audit engagement with a
d. A significant change in the nature or size of the client who has terminated the services of the
client's business. predecessor auditor, the CPA should
a. Contact the predecessor auditor without advising
18. On recurring audits, the auditor may decide not to the prospective client and request a complete
send a new engagement letter each year. However, report of the circumstances leading to the
he might decide to send a new letter when: termination with the understanding that all
a. Any indication that the entity misunderstands the information disclosed will be kept confidential.
objective and scope of the audit. b. Accept the engagement without contacting the
B A change in the financial reporting framework predecessor auditor since the CPA will include
adopted in the preparation of the financial procedures to verify the reason given by the client
statements or other reporting requirements for termination.
c. A significant change in ownership c. Not communicate with the predecessor auditor
d. All of the above because this would in effect be asking the auditor
to provide the confidential relationship between the
19. When a change in the type of engagement from higher auditor and client.
to lower level of assurance is reasonably justified, the d. Advise the client of the intention to contact the
report based on the revised engagement predecessor auditor and request permission for the
a. Should not contain a separate paragraph that contact.
refers to the original engagement.
b. Should not refer to any procedures that may have 26. Which of the following will an auditor most likely
been performed in the original engagement. discuss with the former auditors of a potential client
c. Omits reference to the original engagement. prior to acceptance?
d. All of the above a. Integrity of management.
b. Reasons for changing audit firms.
20. Which of the following would ordinarily be considered a c. Disagreements with management regarding
reasonable basis for requesting a change in the accounting principles.
engagement d. All of the above must be discussed.
a. a change in circumstances.
b. a misunderstanding as to the nature of the audit. 27. Janie Jones, CPA is proposing on a prospective audit
c. a restriction on the scope of the engagement, engagement for White Mountain Enterprises. After
whether imposed by management or caused by obtaining written permission of White Mountain, Janie
circumstances. is required to perform what procedure prior to
d. Both a and b accepting it as a new client?
a. Provide full disclosure of fees that will be billed to
21. The auditor should not agree for a change of White Mountain.
engagement when there is no reasonable justification b. Contact the former auditor to ensure all
for doing so. disagreements have been resolved.
c. Contact the former auditor about certain matters
If the auditor is unable to agree to a change of the of interest in Janie’s decision to accept White
engagement and is not permitted to continue the Mountain as a client.
original engagement, this will have an effect on the d. Contact the former auditor to determine if all fees
auditor’s report. have been paid, the change in auditors have been
a. True, False c. True, True approved and integrity issues have been
b. False, False d. False, True overcome.
22. Which of the following actions may be appropriate if 28. An incoming auditor should request the new client to
the auditor is unable to agree to a change of the authorize the predecessor auditor to allow a review of
engagement and is not permitted to continue the the predecessor ‘s
original engagement? Engagement letter Working paper
I. Auditor should withdraw from the engagement a. Yes Yes
II. Consider whether there is any obligation to report b. Yes No
to the board of directors or shareholders the c. No Yes
circumstances necessitating withdrawal d. No No
a. I c. II
b. I, II d. Neither I nor II 29. Which of the following factors most likely would cause
an auditor not to accept a new audit engagement?
23. In audit situation, communication between successor a. An inadequate understanding of the entity’s
and predecessor auditors should be internal control structure.
a. authorized in an engagement letter b. The close proximity to the end of the entity’s fiscal
b. acknowledged in a representation letter year.
c. either written or oral c. Concluding that the entity’s management probably
d. written and included in the working papers lacks integrity.
d. An inability to perform preliminary analytical
24. Pedro, CPA, is succeeding Maria, CPA, on the audit of procedures before assessing control risk.
Peta Manufacturing, Inc. Pedro plans to consult Maria
and to review Maria’s prior year working papers. Pedro 30. The auditor will utilize many resources to assess
may do so if management integrity in the client acceptance process.
a. Maria consents Which of the following will an auditor most likely
b. Peta Manufacturing, Inc. consents refrain from using in this search?
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EXCEL PROFESSIONAL SERVICES, INC.
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EXCEL PROFESSIONAL SERVICES, INC.
concerning auditing procedures and accounting c. Greenworth may decide not to accept Kool
principles Connections based upon the perceived risk of
b. the predecessor’s evaluation of matters of being associated with Kool.
continuing accounting significance d. Greenworth will contact the BOA or the PICPA and
c. the degree of cooperation the predecessor received ask for a review of the proposal prior to
concerning the inquiry of client’s lawyer acceptance.
d. the predecessor auditor’s assessment of inherent
risk and judgments about materiality 14. Which of the following factors most likely would
influence an auditor’s determination of the auditability
12. The successor auditor requested permission to of the entity’s financial statements
communicate with the predecessor auditor and review a. The complexity of the accounting system.
certain portions of the predecessor auditor’s working b. The existence of related party transactions.
papers. The prospective client’s refusal to permit this c. The adequacy of the accounting records
will bear directly on the successor auditor’s decision d. The operating effectiveness of control procedures.
concerning the
a. adequacy of the preplanned audit program 15. If the auditor believes that an understanding with the
b. ability to establish consistency in application of client has not been established, he or she should
accounting principles between years ordinarily
c. apparent scope limitation a. Perform the audit with increased professional
d. integrity of management skepticism
b. Assess the control risk at the maximum level and
13. Kool Connections, Inc. requests that Wreath and perform a primarily substantive audit
Greenworth Auditors make a proposal to provide audit c. Decline to accept or perform the audit
services for the company. Which of the following is a d. Modify the scope of the audit to reflect an
correct assumption surrounding the result of the increased risk of material misstatement due to
proposal? fraud
a. Greenworth is required to accept Kool Connections
if selected as its auditors. - end of AT.1507 -
b. Greenworth should interview the prior audit firm
prior to releasing the proposal to Kool Connections.
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