CHAPTER 7 ACCEPTING THE ENGAGEMENT AND PLANNING THE AUDIT Fall 2007

1. CHAPTER 7ACCEPTING THE ENGAGEMENT AND PLANNING THE AUDITFall 2007 • Client Acceptance and Retention • Planning the Audit • Obtaining an Understanding of the Client’s Business and Industry

2. Overview of a Financial Statement Audit 4 Phases of an Audit 1. Client Acceptance and Retention 2.Planning the Audit 3. Performing Audit Tests (field work) 4. Reporting the Findings

3. Client Acceptance: Guidance Authoritative Guidance • SAS’s (AICPA) • Quality Control Standards (AICPA) • Court cases • SOX if public company (available at www.pcaobus.org)

4. Client Acceptance: Steps • This is a two way street • Clients solicit proposals • Auditors investigate situation considering their own business risk • Evaluate the integrity of management • Identify special circumstances and unusual risks • Assess competence to perform audit • Evaluate independence • Decision to accept or decline • Prepare engagement letter for accepted clients

5. Client Acceptance: Management Integrity • Required communication with the predecessor auditor • Make inquiries of other third parties • Review previous experience with existing clients

6. Client Acceptance: Identify Special Circumstances & Unusual Risks Focus on the auditor’s business risks • Identify intended f/s users • Assess prospective client’s legal and financial stability • Identify scope limitations • Evaluate the entity’s financial reporting systems and auditability

7. Client Acceptance: Assess Competence to Perform the Audit • Services desired • Identify the audit team • Need for consultation and use of specialists

8. Client Acceptance: Evaluating Independence & Decision to Accept • Evaluate whether there are any circumstance that would impair independence • Other services performed by the firm • Engagement team • Put it all together and decide if you want this client! And if you do….

9. Client Acceptance: Prepare Engagement Letter • Identify entity and F/S to be audited • Objective and purpose of the audit • Reference to professional standards to be used • Nature and scope of audit and responsibilities • Audit may not detect all material irregularities • Management is responsible for F/S & I/C • Timetable and client support • Management asked for written representations • Any auxiliary services to be provided • Basis for fees and billing arrangements • Request for client signature and return of letter

10. Audit Planning and Risk Assessment • Identify relevant f/s objectives • Obtain understanding of entity & its environment • Make preliminary judgments about materiality • Perform analytical procedures • Consider audit risk including fraud risk • Develop preliminary audit strategies • Obtain understanding of I/C

11. Understanding the Entity and Its Environment • Fundamental assumption: Client’s business risks correlated with the auditor’s audit risk. • Basic Idea: • Think about business & industry in context of larger economic situation. Where “problems” likely for the business, the f/s are most likely to be misstated. • Where the f/s most likely to be misstated, we need to do the most audit work. • Pervasive vs. account specific factors

12. The Entity and Its Environment: Factors to Consider • Difficult Economic Times • Reductions in capital spending • Restructurings, inventory liquidations, write-offs • Downward pressure on earnings • Liquidity issues • Pressures to Perform • Analysts, creditors and shareholders focus on short-term performance • Earnings targets, debt covenants, performance based compensation

13. The Entity and Its Environment: Factors to Consider • Complexity and Sophistication of Business Structures and Transactions • Goal is to meet specific reporting and economic objective • Purchase/sales of assets, derivative transactions, SPE’s etc to transfer risk of ownership • Complex and Voluminous Standards • Complex accounting rules follow complex transactions • Opens up opportunities to “get around rules”