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:

• 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.

4. 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.
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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:

• 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.

7. 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.

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II. Multiple Choice Questions

1. a 8. b 15. c 22. b
2. d 9. c 16. a 23. a
3. b 10. d 17. b 24. d
4. a 11. a 18. c 25. a
5. c 12. b 19. b 26. c
6. a 13. d 20. a 27. d
7. d 14. a 21. a 28. c

III. Comprehensive Cases

Case 1. a. Prior to acceptance of the engagement, Argante & Tan should have
communicated with the predecessor auditor regarding:
• 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.
b. 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
• 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.
Case 2. a. Typical engagement letter generally includes the following:
• 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.
b. 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
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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
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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 owner-
manager 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.
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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 evidence-
gathering 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) To serve as a basis for the extension of credit.
(2) To supply credit rating agencies with required information.
(3) To serve as a basis for preparation of tax returns.
(4) To establish amounts of losses from fire, theft, burglary, and so
forth.
(5) To determine amounts receivable or payable under various
agreements.
(6) To provide data for possible sale or merger.
(7) To serve as a basis for action in bankruptcy and insolvency
cases.
(8) To determine proper execution of trust agreements.
(9) To furnish estates with information in order to obtain proper
settlements and avoid costly litigation.
(10) To establish and/or improve internal control structures.
(11) To provide aid in cases of tax audits, court actions, and so forth.
(12) To discourage employees from perpetrating errors and
irregularities.
(13) To provide industry-wide comparisons.
(14) To provide a realistic look at assets.
(15) To assist in review of adequacy of insurance coverage.
(16) 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. 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.
b. 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:

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• 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.