Preliminary Engagement Activities Learning

Purpose of Preliminary Engagement Activities:

Preliminary engagement activities assist the auditor in identifying and evaluating events or circumstances that
may adversely affect the auditor’s ability to plan and perform the audit engagement. Such activities help ensure that:

a. There are no issues with client management’s integrity that may affect the willingness to continue
the engagement
b. The auditor maintains the necessary independence and ability to perform the engagement
c. There is no misunderstanding with the client as to the terms of the engagement

Preliminary Engagement Activities:

1. Perform procedures regarding acceptance or continuance of the client relationship

Acceptance or selection procedures – in case of initial audit (prospective/new client)

a. Evaluate integrity of the client’s management

Evaluation of management integrity is necessary to avoid

association with clients whose management lacks integrity.

Most of litigations involving CPAs are due to lack of integrity

of client’s management.

Lack of management integrity usually results to high audit

risk. Factors to consider in evaluating client’s integrity:

Identity, attitude and business reputation of the

client (such as its principal owners, key
management or those charge with corporate
governance, and related parties, if any)

Nature of the client’s operations

Indications of an inappropriate limitation in the
scope of work
 Involvement in money laundering or other criminal
activities

The reasons for the proposed appointment of

the CPA firm or auditor and non-reappointment
of the previous CPA firm or auditor

(1) Investigate/research the client’s background

Internet searches

Review the entity’s financial statements

Consider engaging professionals/investigators to evaluate the

principals associated with the prospective client
Obtain credit ratings and reports, if necessary

(2) Inquiring from other firm personnel or third parties (such as bankers, legal
counsel/advisors, industry peers and others in the financial or business
community who may have knowledge regarding the client)

(3) Communicate with prospective client’s predecessor auditor: Matters to be

inquired of or discussed with the predecessor (previous/former) auditor by the
incoming/successor auditor:

a) Facts/information that might bear on the integrity of the prospective client

b) Predecessor auditor’s understanding as to the reasons for the change of auditors

c) Any disagreement between the predecessor auditor and the client regarding accounting principles
or auditing procedures or other similarly significant matters

d) Communication to management, the audit committee, and those charged with governance regarding fraud,
illegal acts by the client, and matters relating to internal control.

Under the Code of Ethics for CPAs, the successor auditor has the responsibility to initiate communication with the
predecessor auditor. However, the communication requires prior client’s permission/consent (preferably in writing)
to avoid violation of confidentiality principle.

If the client is unwilling to agree to such communication (communication is not permitted by the client or the client
limits the responses of the predecessor auditor), the successor auditor should:

 Consider the implications of such refusal/limitation, and

 Decide whether or not to accept the engagement.

b. Other Considerations:

Auditability of client’s financial statements – determine whether the auditor will be able to
accumulate sufficient appropriate audit evidence to render an opinion on the financial
statements by considering:

a. The adequacy of accounting records

b. Quality of internal control

High level of public scrutiny and media interest

The financial health of the client

Ability to pay audit fees

 Continuance or retention procedures – in case of recurring audit (or existing client)

To ensure the audit firm’s continuing compliance with acceptance and continuance procedures,
existing clients should be evaluated once a year or upon occurrence of the following:

Changes in management, directors or ownership

Nature of client’s business

2. Evaluate compliance with ethical requirements, including independence

a. Independence – The CPA firm or auditor shall identify, evaluate and respond to
any threat to independence

The CPA firm or auditor must be independent of the client whose

financial statements are subject to audit.

Audit opinion is not credible or of little or no value if the auditor is not

independent.

b. Professional competence – determine if the CPA firm or auditor has the

necessary skills and competence

Professional accountants should not portray themselves as having the

required expertise which they do not possess.
The auditor should obtain preliminary understanding of prospective client’s business
and industry to determine whether the auditor has the required degree of competence.

If the auditor does not possess the industry expertise, he should obtain
knowledge of matters that relate to the nature of the entity’s business
and industry.

c. Ability to serve the client properly – the CPA firm or auditor must have capability,
time and resources to perform the audit

Examples:

Availability of appropriately qualified staff when the work is

required The firm is able to complete the engagement within the

reporting
deadline (proximity of the deadline)
Consider the need for expert’s assistance and any conflicts of interest

Firm personnel have knowledge of relevant industries

The firm has sufficient personnel with the necessary capabilities and
competence.

3. Establish an understanding of the terms of the engagement

The CPA firm or auditor shall accept or continue an audit engagement only when:

a. The preconditions for an audit are present:

1. Management has used acceptable financial reporting framework (or suitable criteria or appropriate basis
for) in the preparation of the financial statements

Factors to consider in determining the acceptability of the financial reporting framework:

 a. The nature of the entity (for example, whether it is a business enterprise, a public sector entity or a not-
for-profit organization);

b. The purpose of the financial statements (for example, whether they are prepared to meet the common
financial information needs of a wide range of users or the financial information needs of specific
users);

 Financial statements prepared in accordance with a financial reporting framework designed to meet the
common financial information needs of a wide range of users are referred to as general purpose
financial statements.

 Financial statements prepared in accordance with a financial reporting framework designed to meet the
financial information needs of specific users are referred to as special purpose financial statements.

b. The nature of the financial statements (for example, whether the financial statements are
a complete set of financial statements or a single financial statement); and

c. Whether law or regulation prescribes the applicable financial reporting framework.

Examples of financial reporting frameworks:

IFRSs

PFRSs

IPSASs – International Public Sector Accounting Standards

2. Management agrees to the premise that it has acknowledged and understood its responsibilities

If the preconditions for an audit are not present, the auditor shall not accept the proposed audit
engagement, unless acceptance is required by law or regulation. Preconditions for an audit are
within the control of the entity.
b. There is a common understanding between the auditor and management (and, where appropriate,
those charged with governance) of the terms of the audit engagement.

Agreement on audit engagement terms:

The auditor shall agree on the terms of the audit engagement with management or those
charged with governance, as appropriate. Such agreed terms shall be recorded in an audit
engagement letter or other suitable form of written engagement.

Preliminary conference: A preliminary conference with the client is scheduled

after the CPA has determined that:

The firm is independent

The firm is competent to perform the audit
The firm can serve the client properly, and
The client’s reputation is one of integrity

The terms of engagement are usually agreed with the client during a preliminary conference with the
client, and formalized through a signed engagement letter. During the preliminary conference, the
auditor and client agree on the following issues:

The specific services to be rendered

 The cooperation and work expected to be performed by the
client’s personnel
Expected start and completion dates of the engagement

The possibility that the completion date may be changed if

unforeseen a udit problems arise if unforeseen audit problems
arise if adequate cooperation from client’s personnel is not
received

The nature and limitations of the audit engagement

An estimate of the fee to be charged for the engagement

Engagement letter – an agreement between the CPA firm or auditor and the
client for the conduct of the audit. It is a letter from the auditor to the client
management, and when signed by the client it serves as a formal written
contract between them.

Engagement letter documents and confirms the:

a. Auditor’s acceptance of the appointment
b. Client’s acceptance of the terms of the audit
engagement

c. Responsibilities of both the client management

and the auditor

d. Arrangements or agreed terms of the

engagement (such as the objectives and
scope of the audit, the form of any
reports, etc.)

Importance (primary reason) of an engagement letter: It

clarifies the nature of the engagement and the responsibilities of
management and those of the auditor. This will help in avoiding or
minimizing or resolving future misunderstandings disagreement
between the auditor and the client with respect to the
engagement.

Engagement letter should be sent to the client preferably before the start of
the engagement.

An engagement letter is normally addressed to whoever hired the CPA.

Form and Contents of the Engagement Letter:

The form and content of engagement letters may vary for each client. Engagement letters should be adapted
according to individual requirements and circumstances of the engagement. Generally, engagement letters should
include reference to:

1. Principal Contents:
a. Objective and scope of the audit of the financial statements
b. Responsibilities of the auditor
c. Responsibilities of management

d. Identification of financial reporting framework for the preparation of the financial

statements
 e. Reference to any form and content of any reports to be issued by the auditor and a
statement that there may be circumstances in which a report may differ from its
expected form and content

2. In addition, and audit engagement letter may make reference to, for example:

Elaboration of the scope of the audit, including reference to applicable legislation,

regulations, PSAs, and ethical and other pronouncements of professional bodies to which the
auditor adheres.

The form of any other communication of results of the audit engagement

The fact that because of the inherent limitations of an audit, together with the inherent
limitations of internal control, there is an unavoidable risk that some material misstatement
may not be detected, even though the audit was properly planned and performed in
accordance with the PSAs

Arrangements regarding the planning and performance of the audit, including

the composition of the audit team

Expectation that management will provide written representations

The agreement of management to make available to the auditor draft financial statements
and any accompanying other information in time to allow the auditor to complete the audit in
accordance with the proposed timetable

The agreement of management to inform the auditor of facts that may affect the financial
statements, of which management may become aware during the period from the date of the
auditor’s report to the date the financial statements are issued.

Basis on which fees are computed and any billing arrangements

A request for management to acknowledge receipt of the engagement letter and to agree to
the terms of the engagement outlined therein

3. Other arrangements, when relevant, such as:

Involvement of other auditors and experts in some aspects of the audit

Involvement of internal auditors and other staff of the entity

Arrangements to be made with the predecessor auditor, if any, in the case of an initial audit
Any restriction of the auditor’s liability when such possibility exists

A reference to any further agreements between the auditor and the client

Any obligations to provide audit working papers to other parties

Audit Engagement in Recurring Audits:

1. The auditor may decide not to send a new engagement letter or other written agreement each period.

2. The following factors may make it appropriate to send a new engagement letter:
a. Revision of the terms of audit engagement because:
Any revised or special terms of the engagement

A recent change of senior management or those charged with

governance A significant change in ownership

A significant change in nature or size of the client’s business

A change in legal or regulatory requirements

 A change in the financial reporting framework adopted in the preparation the
financial statements
A change in other reporting requirements
b. Reminder to the client of the existing terms of the engagement
Any indication that the client misunderstands the objective and scope of the
audit.

Audit procedures when the client requests for a change in engagement:

1. Consider the appropriateness of reasons for the engagement

2. If there is a reasonable justification for the change – stop the original engagement and agree
on the new terms of engagement. And then proceed with the new engagement
To avoid confusing the users of the new report, do not mention the following in the
new report:

a. The original engagement

b. Any procedures that may have been performed in the original engagement
(except where

the engagement is changed to an engagement to undertake agreed- upon procedures and thus the
reference to the procedures performed is a normal part of the report)

3. If there is no reasonable justification – refuse the client’s request, and continue to perform the
original engagement and issue the original report

If the auditor is not permitted to continue the original engagement, the auditor should
withdraw from the engagement and consider reportorial responsibilities to the BOD or
shareholders of the client.

Whether or not to accept a change in engagement:

Change in the terms of the audit engagement: The auditor shall not agree where there is no
justification/basis for the change in the terms of the audit engagement.

Reasonable basis includes:

a. A change in circumstances affecting the entity’s requirements

For example, the client's bank required an audit before committing to a loan, but the client
subsequently acquired alternative financing.

b. A misunderstanding as to the nature of the service

originally requested Not a reasonable basis:

Change that relates to information that is incorrect, incomplete or otherwise unsatisfactory.

For example, the entity asks for the audit engagement to be changed to a review engagement to avoid a
qualified opinion or disclaimer of opinion.

Change to a lower level assurance engagement: The auditor shall not agree where there is no
justification/basis for the change to a lower level assurance engagement.

1. The auditor should agree if there is reasonable basis, such as:

a. A change in circumstances affecting the entity’s requirements or need for the service
 For example, the client's bank required an audit before committing to a loan,
but the client subsequently acquired alternative financing.

b. A misunderstanding as to the nature of an audit or related service originally requested

c. A restriction on the scope of the engagement, whether imposed by

management or caused by circumstances

If there is a reasonable change, no reference of the same shall be

included in the report.

2. Not agree if there is no reasonable justification – if the change relates to

incorrect, incomplete or otherwise unsatisfactory information.

For example, in an audit engagement, the auditor is unable to obtain sufficient

appropriate audit evidence regarding receivables and the client asks for the engagement
to be changed to a revie w engagement to avoid a qualified audit opinion or a disclaimer
of opinion.

Withdraw from the engagement – if the auditor is unable to agree to the change and is
not permitted/allowed to continue the original engagement because of his disagreement