Chapter 5
Learning Objectives 5.1
After studying this chapter, you should be able to:
1 Explain what is meant by client acceptance.
2 Describe the seven primary procedures involved in the client acceptance process.
3 Understand the main reasons for obtaining an understanding of client’s business and industry.
4 Know the sources of client information and the methods for gathering the information.
5 Discuss the ethical and competency requirements of the audit team.
6 Know what is required in using the work of another auditor.
7 Understand the auditor’s responsibility in using the work of an expert.
8 Describe the procedures for communicating with an existing (predecessor) auditor.
9 Know the contents of a client audit engagement proposal.
10 Express the differences between items covered in an audit engagement proposal to existing clients and one for new clients.
11 Explain on what basis audit fees are negotiated.
12 Understand what an audit engagement letter includes and why its contents are important.
13 Describe the differences between items covered in an audit engagement proposal to existing clients and one for new clients.
The client acceptance phase of the audit has two objectives:
1 examination of the proposed client to determine if there is any reason to reject the engagement (acceptance of the client);
2 convincing the client to hire the auditor (acceptance by the client).
The procedures to acceptance of the client are: acquiring knowledge of the client’s business; examination the audit firm’s ethical requirements and technical competence;
possible use of other professionals (including outside specialist) in the audit; communi- cation with the predecessor auditor; preparation of client proposal; assignment of staff and the submission of the terms of the engagementin the form of an audit engagement letter. See Illustration 5.1.
An auditor must exercise care in deciding which clients are acceptable. An accounting firm’s legal and professional responsibilities are such that clients who lack integrity can cause serious and expensive problems. Some auditing firms refuse to accept clients in certain high-risk industries. For example, in the USA and Northern Europe during the 1990s many large auditing firms were very careful when accepting audit engagements of financial institutions after the legal judgments and fines resulting from audits of Lincoln Savings, Standard Charter Bank, and International Bank of Credit and Commerce (BCCI). At the beginning of the twenty-first century, there were great problems in the energy business (Enron, Dynergy, Pacific Gas and Electric, the State of California), the telecommunications industry (WorldCom, Global Crossing, Qwest), and health care (Health South, ImClone), and even in old-line industries such as retailing (K-mart, Ahold) and food products (Parmalat).
Client Acceptance: the First Step on the Journey to an Opinion 5.2
CLIENT ACCEPTANCE: THE FIRST STEP ON THE JOURNEY TO AN OPINION
ILLUSTRATION 5.1
Standard Audit Process Model – Phase I Client Acceptance
Objective Determine both acceptance of a client and acceptance by a client.
Decide on acquiring a new client or continuation of relationship with an existing one and the type and amount of staff required.
Procedures 1 Evaluate the client’s background and reasons for the audit [sec. 5.3].
2 Determine whether the auditor is able to meet the ethical require- ments regarding the client [sec. 5.4].
3 Determine need for other professionals [sec. 5.5].
4 Communicate with predecessor auditor [sec. 5.6].
5 Prepare client proposal [sec. 5.7].
6 Select staff to perform the audit.
7 Obtain an engagement letter [sec. 5.8].
■ Audit Clients
The client – audit firm relationship is nota one-way street where the audit firm evaluates the client and then, judging the client “acceptable”, sends out an engagement letter closing the deal. The market for audit services is competitive and, just like in any other business, there are highly desirable clients with whom any audit firm would like to have an audit relationship. Although not always the case, audit firms prepare and submit engagement proposalsto many of their (potential) clients, especially the large ones.
■ Steps in the Client Acceptance Process
The next section in this chapter discusses the importance of obtaining a preliminary understanding of the client, in order to both evaluate the client’s background and the risks associated with accepting the engagement. There must also be an understanding of the auditors’ relationship to the client to enable the auditor to consider if the ethical and professional requirements (independence, competence, etc.) typical to the specific engagement can be met. That is the second step in the client acceptance process.
The balance of the chapter concerns acceptance by the client (called responsible party in assurance services terms). Here we discuss competition and audit market; cost considerations; and quality of audit services. The audit firm must write and present to the client an engagement proposal (some auditors consider this a beauty contest). The chapter also discusses the components of a client engagement proposal for existing and new clients; and briefly discusses the International Standard Organization (ISO) quality control standard 9000 and how that applies to an auditing firm and its engagement services.
The auditor should obtain a knowledge of the client’s business that is sufficient to enable him to identify and understand the events, transactions, and practices that may have a significant effect on the financial statements or on the audit report.!1 Main reasons for obtaining this understanding are (1) to evaluate the engagement risks associated with accepting the specific engagement and (2) to help the auditor in determining whether all professional and ethical requirements (including independence, competence, etc.) regarding this client can be met.
Auditors do not just obtain knowledge of the client preliminary to the engagement, during the client acceptance phase (Phase I of the audit process model). Once the engage- ment has been accepted, auditors will do a more extensive search for knowledge of the client, its business and industry in the planning phase (Phase II of the model – see Chapter 6 Understanding the Entity, Risk Assessment and Materiality).
Auditors may do a preliminary examination of both new and existing clients by visiting their premises, reviewing annual reports, having discussions with client’s management and staff, and accessing public news and public information databases, usually via the internet. If the client is an existing one, prior years’ working papers should be reviewed.
Evaluate the Client’s Background
5.3
If the client is new, the auditor should consult prior auditors and increase the preliminary information search. (See Illustration 5.2.)
Auditors get their information about an audit client from three basic sources: their experience with the client, publicly available information, and from the client themselves.
Methods used to assess the information varies from database search for public information to discussions with staff and management at the client entity. (See Illustration 5.2.)
EVALUATE THE CLIENT’S BACKGROUND
ILLUSTRATION 5.2
Sources of Information for Client Evaluation
Publicly available information
Audit firm experience
Information clientfrom
Method:
Search (1) Media and government databases (2) Client, Industry, and government websites Examples:
ABI inform,
Lexis/Nexis, sec.gov, commerce.gov, IBM.com,
finance.yahoo.com, www.riaa.com, aicpa.org
Method:
Review documentation, discuss with client lawyer, banker, prior audit manager Examples:
Prior workpapers, client financials
Method:
(1) Review client documentation (2) Discussions with staff and management Examples:
Client press releases, minutes important meetings, government correspondence, people associated with entity, internal audit personnel, employees, management
Certification Exam Question 5.1
2Which of the following factors would be most likely to cause a professional auditor in public practice to decline a new audit engagement?
(A) The prospective client has already completed its physical inventory count.
(B) The auditor lacks an understanding of the prospective client’s operations and industry.
(C) The auditor is unable to review the predecessor auditor’s working papers.
(D) The prospective client is unwilling to make all financial records available to the auditor.
■ Topics of Discussion
Discussions with client’s management and staff is important to evaluate governance, internal controlsand possible risks. These discussions might include such subjects as:
■ changes in management, organizational structure, and activities of the client;
■ current government regulations affecting the client;
■ current business developments affecting the client such as social, technical and economic factors;
■ current or impending financial difficulties or accounting problems;
■ susceptibility of the entity’s financial statements to material misstatement due to error or fraud;
■ existence of related parties;
■ new or closed premises and plant facilities;
■ recent or impending changes in technology, types of products or services and production or distribution methods;
■ changes in the accounting system and the system of internal control.
■ New Client Investigation
Before accepting a new client an audit firm will do a thorough investigation to determine if the client is acceptable and if the auditor can meet the ethical requirements of independence, specific competence, etc.
Other sources of information include interviews with local lawyers, other CPAs, banks and other businesses, although many of them, depending on local circumstances, might be bound by obligations of confidentiality. Sometimes the auditor may hire a professional investigator or use its forensic accounting department to obtain information about the reputation and background of the key members of management. If there has not been a previous auditor, more extensive investigation may be undertaken.
■ Continuing Clients
Many auditing firms evaluate existing clients every year. In addition to the research discussed above, the auditor will consider any previous conflicts over scope of the audit, type of opinion and fees, pending litigation between the audit firm and client, and management integrity. (See Illustration 5.3.) These four factors strongly influence whether the relationship will continue. For continuing engagements, the auditor would update and re-evaluate information gathered from the prior years’ working papers. The auditor should also perform procedures designed to identify significant changes that have taken place since the last audit.
The auditor may also choose not to continue conducting audits for a client because he feels excessive risk is involved. For example, there may be regulatory conflict between a governmental agency and a client which could result in financial failure of the client and perhaps ultimately lawsuits against the auditor. It may be that the auditor feels that the industry (such as financial services) offers more risk than is acceptable to the specific auditor.
EVALUATE THE CLIENT’S BACKGROUND
ILLUSTRATION 5.3
Three Major Influences on the Continuance of the Relationship
Serious doubts about the integrity of client’s management
Previous conflicts over scope of the audit, type of opinion and fee
Whether there is any pending litigation between client and auditor
Client Auditor
relationship
Concept and a Company 5.1
An auditor must consider company and industry background before accepting an audit client.
“Auditors shouldn’t be allowed to act like God,” said Hideyuki Aizawa, a senior member of Japan’s major political party the LDP. “Resona should be the first and last time this happens.” Mr. Aizawa’s comments came in reaction to the government’s decision to inject Y2,000 billion ($17 billion, £10.4 billion) into Resona after auditors found that Japan’s fifth largest bank was badly undercapitalized. (Pilling 2003)
The Resona filing was the first-ever test of emergency assistance under the Deposit Insurance Law. Resona had already received around Y1,000bn ($8.5bn) from the government in two previous rounds of fund injections. (Nikkei Weekly2003)
Auditor Says No
Shin Nihon, one of Japan’s Big Four accounting firms, in effect forced Resona to seek government help by refusing to accept the bank’s estimate of how much deferred tax assets it should be allowed to include as capital. This was after co-auditor Asahi & Co refused to sign off on the banks accounts. Shin Nihon’s move stunned the Japanese business community, which had been accustomed to more lenient treatment from auditors.
Troubles at Resona
Resona Bank was created after the integration of Daiwa Bank and Asahi Bank, and began operating March 3, 2003. Neither bank wanted to merge, but both were forced to do so by
Resona, the Auditor, and Japan’s Banking Industry
Concept
Story
s
the combined efforts of the Ministry of Finance and the Financial Services Agency, which were overseeing the consolidation of Japan’s banking industry from 13 large lenders to five mega-lenders. (Ibison 2003)
Resona admitted that its capital-adequacy ratio (i.e. its capital divided by its assets, weighted by risk) had fallen to around 2 percent, half the required minimum for domestic banks that do not have international operations.
Resona’s Tier 1 capital comprised 70 percent deferred tax assets (DTAs) according to Moody’s Investors Service, the credit rating company. This compares with about 40 percent at Japan’s four other largest banks – Mizuho, SMFG, MTFG and UFJ – and is enormous compared with US regulations, which limit banks to using DTAs of just 10 percent of their capital. (Ibison 2003)
Deferred tax assets are generated through the losses from taxable bad-loan write-offs by entities such as banks. The losses can be set off against future taxable income. Since the tax burden on the bank is effectively reduced, the deferred amount is counted toward the entity’s shareholders’ equity.
Combined with the dual pressures of a more strict calculation of its non-performing loans and exposure to a declining stock market, the circumstances for Resona’s bailout were created. Their solvency was also affected by participation in government development schemes.
Japan’s Banking Industry in Early 2004
Resona is an example of the problems that are occurring in the Japanese banking industry.
Other major banks staved off a crisis in March 2003 by procuring more than 2 trillion yen in capital from the government, but by year end 2003, they still needed to bolster their capital bases.
At that time Japan’s seven biggest banks held around Y6,510 billion ($60.5 billion) as deferred tax assets. Mizuho Holdings held over Y1,500 billion in net deferred tax assets – accounting for over 41 percent of its tier 1 capital – even though it reduced them by 22 percent in March and December 2003. Bank of Mitsubishi-Tokyo Group and Sumitomo Trust Bank have made similar-sized efforts to reduce their deferred tax assets, which at the beginning of 2004 accounted for 30 percent and 26 percent of their tier 1 capital, respectively. Mitsui-Sumitomo Banking Group, Mitsui Trust and UFJ Holdings made virtually no effort to reduce their deferred tax asset levels, cutting them by just single-digit percentage amounts. The most worrying in early 2004 was Mitsui Trust, with deferred tax assets accounting for 77 percent of its capital. (Accountant 2003)
■ If Shin Nihon will not audit Resona in 2004, what concerns would a replacement auditor have?
■ What kind of industry risks would be encountered by audit firms wishing to audit a Japanese bank in 2004?
The Accountant, 2003, “Japan’s top seven banks slash deferred tax assets by 18 percent,” December 31.
Ibison, D., 2003, “Unholy Japanese alliance ends in tears,” Financial Times, May 19, p. 23.
Nikkei Weekly, 2003, “Resona accepts 2 trillion yen bailout,” Nihon Keizai Shimbun, May 19.
Pilling, D., 2003, “Japanese bailout prompts political backlash,’. Financial Times, May 22.
Resona, the Auditor, and Japan’s Banking Industry (continued)
Discussion Questions
References
Based on the evaluation obtained regarding the background of the client, the auditor should determine whether all ethical requirements, as discussed in Chapter 3, Ethics for Professional Accountants can be met with regard to the specific engagement. Probably the most important procedure in this step of the engagement acceptance process is verifica- tion of the auditor’s independence. Given the facts and circumstances identified in the client evaluation phase, a determination is made whether the auditor and the audit team collectively possess the specific competence required to deal with the issues that the auditor is likely to encounter in the audit.
This audit team evaluation is also important for step six in the client acceptance process – selecting staff to perform the audit.
Ability to Meet Ethical and Specific Competence Requirements 5.4
ABILITY TO MEET ETHICAL AND SPECIFIC COMPETENCE REQUIREMENTS
Concept and a Company 5.2
Evaluation of a client and the audit firm for client acceptance.
In late November 1981, without prior warning, B.P “Beep” Jennings, CEO of Penn Square Bank notified Harold Russell, managing partner of audit firm Arthur Young Oklahoma City, that Peat Marwick would be the new auditor for the bank’s 1981 financial statements.
For the years ending December 31, 1976, through December 31, 1979, Penn received unqualified (clean) opinions from Arthur Young (predecessor of Ernst & Young). In 1980, Arthur Young issued a qualified opinion on Penn Square’s financial statements stating that the auditors were unable to satisfy themselves “as to the adequacy of the reserve for possible loan losses.”
Penn Square Bank – Loans to Wildcatters
Penn Square Bank, an Oklahoma City, USA, bank named for a shopping mall, served small business and residents of the surrounding community until 1974 when the bank was acquired by Jennings. From that date onward, the bank expanded its deposit base by offering interest rate premiums on “jumbo” bank certificates of deposit that carried interest rates 25 to 150 basis points above prevailing market rates.
The money deposited was loaned to the highest risk oil and gas speculators (“wild- catters”). Because of the rapid growth in their loan portfolio that doubled the bank’s assets every two years from 1976 to 1982, they joint-ventured the loans with major metropolitan banks around the country. Penn Square performed all necessary administrative functions for these loans, including obtaining appraisals and engineering estimates of oil reserves.
Oil and gas prices worldwide plummeted in 1980. Many of the Penn Square-backed exploration ventures were aimed at recovering oil and gas from the deepest reservoirs, which, because of large exploration costs, were not economically feasible when the price of crude oil dropped.
Also in 1980, the bank’s large profits and rapidly increasing high-risk loan volume caused an investigation by the US Office of the Comptroller of the Currency (OCC) federal bank examiners. The investigation uncovered numerous violations of banking laws by Penn
New Client Acceptance – Penn Square Bank
Concept Story
s
■ Independence
The auditor will ensure that the members of the auditor team as well as the entire audit firm meet the relevant independence requirements (see Chapter 3 Ethics for Professional Accountants). This will require procedures to check personal financial investments of partners and employees and the business relationships with the potential audit client.
Square, including insufficient liquidity, inadequate capital, and poor loan documentation.
In late 1980, the OCC forced the bank’s directors to sign an “administrative agreement” that required them to take remedial measures to correct these problems. (Knapp 2001)
Qualified Opinion – Management Not Pleased
Russell reported (US Congress 1982) that there were loan considerations that led to the qualification of the 1980 audit opinion. The bank’s loan documentation practices had deteriorated between 1979 and 1980. Many loans did not have current engineering reports documenting oil reserves. Other loans had engineering reports that did not include an opinion of the engineer or did not list the assumptions used in estimating the reserves.
When Russell discussed these problems with client management they were “not pleased.”
Peat Marwick Steps In
Peat Marwick officials testified (US Congress 1982) that their firm made the standard inquiries required of predecessor auditor Arthur Young. Arthur Young responded to these inquiries by stating that its relationship with Penn Square Bank had been “free of significant problems.” However, Arthur Young did bring to Peat Marwick’s attention the qualified opinion that it had issued on Penn Square’s 1980 financial statements.
Jim Blanton, the managing partner of Peat Marwick’s Oklahoma City office, told the US Congress committee (US Congress 1982) that several members of his firm were well- acquainted with Penn Square’s top executives. Peat Marwick disclosed that several Oklahoma City partners had previously obtained more than $2 million in loans and a $1 million line of credit from Penn Square. To resolve a possible independence problem an agreement reached between the two parties required Penn Square to “fully participate out”
(sell) the loans and the line of credit to other banks.
The results of the Peat Marwick’s 1981 Penn Square audit were an unqualified (clean) opinion. On July 5,1982, bank examiners from the Federal Deposit Insurance Corporation (FDIC) locked the doors of the Penn Square Bank. The more than $2 billion in losses suffered by Penn Square, its affiliated banks, uninsured depositors, and the FDIC insurance fund made this bank failure the most costly in US history at the time.
■ When Penn Square Bank replaced Arthur Young in late 1980, what concerns should have been apparent to any proposed new auditor?
■ What independence issues were at stake for the new auditor Peat Marwick?
Knapp, M., 2001, “Penn State Bank,” Contemporary Auditing Real Issues & Cases, South Western College Publishing, Cincinnati, Ohio.
US Congress, 1982, House Committee on Banking, Finance and Urban Affairs, Penn Square Bank Failure, Part 1, US Government Printing Office, Washington, DC.
New Client Acceptance – Penn State Bank (continued)
Discussion Questions
References