CHAPTER 7

ACCEPTING THE ENGAGEMENT AND PLANNING

THE AUDIT
Learning Check
7-1.

7-2.

7-3.

a.

The steps in accepting an audit engagement are (a) evaluating integrity of

management, (b) identifying special circumstances and unusual risks, (c)
assessing competence to perform audit, (d) evaluating independence, (e)
determining ability to use due care, and (f) preparing engagement letter.

b.

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) auditor if the client has been audited
previously. For a recurring client, the auditor should consider 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.

a.

The integrity of the client's management is an important consideration in deciding

whether to accept an audit engagement. Thus, knowledge of management
acquired by the predecessor auditor is considered to be essential information for
the successor auditor.

b.

The successor auditor should make inquiries of the predecessor auditor about (1)
the integrity of management, (2) disagreements with management about
accounting principles and auditing procedures, and (3) the predecessor's
understanding of the reasons for a change in auditors. The auditor might also
make communications with the audit committee regarding fraud, illegal acts,
internal control and the quality of accounting principles.

a.

The identity of intended users is important because the auditor has legal
responsibilities to intended users. Additional reporting requirements might also
mean that the auditor might have to assign more competent personnel to the audit,
incur additional audit costs, or be exposed to additional legal liability exposure.

b.

Clients that lack legal or financial stability pose a high risk of litigation for
auditors no matter how professionally they perform their services. Many auditors
get caught up in their clients bankruptcies because the auditor is associated with
the client, and is solvent.

7-4.

7-5.

7-6.

7-7.

c.

Conditions that raise a question as to the auditability of a prospective client

include (1) absence or poor condition of accounting records, (2) management
disregard of its responsibilities to maintain adequate internal controls, and (3)
restrictions imposed by the client on the conduct of the audit.

a.

Competency is required by the first general standard of GAAS which states: "The
audit is to be performed by a person or persons having adequate technical training
and proficiency as an auditor."

b.

Determining competency generally involves identifying the key members of the

audit team that can competently provide the required services, and considering the
need to seek assistance from consultants and specialists during the course of the
audit.

a.

The typical audit team consists of:

A partner, who has both overall and final responsibility for the engagement.
One or more managers, who coordinate and supervise the execution of the
audit program.
One or more seniors, who may have responsibility for parts of the audit
program and who supervise and review the work of staff assistants.
Staff assistants, who perform many of the required procedures.

b.

Yes, it is appropriate if consultants and specialists can be obtained to provide the

competence that the audit team lacks.

a.

Auditors may use specialists as:

Appraisers to provide evidence about the valuation of assets such as art.
Engineers to determine the quantities of mineral reserves on hand.
Actuaries to determine amounts used in accounting for a pension plan.
Attorneys to assess the probable outcome of pending litigation.

b.

Before using a specialist, the auditor should become satisfied as to the

professional qualifications, reputation, and objectivity of the specialist.

c.

The auditor may use a specialist that has a relationship with the client only if it
does not impair the objectivity of the specialist.

a.

Independence is required in meeting the second general standard of GAAS which

states: "In all matters relating to the assignment, an independence in mental
attitude is to be maintained by the auditor or auditors." Independence is also
required by the PCAOB, the SEC, the AICPA's Code of Professional Conduct,
and the AICPA's quality control standards.

b.

7-8.

7-9.

a.

If independence requirements cannot be met, the auditor should decline the

engagement or the potential client should be notified that the firm will have to
issue a disclaimer of opinion on the financial statements.
The auditor might choose not to accept a potential audit client because of any of
the following reasons: (1) concerns about the integrity of management, (2) the
existence of unusual circumstances and risks, (3) concerns about the ability to
audit the entity, (4) concerns about the ability to field an audit team that has
adequate competence to perform the audit due, or (5) concerns about
independence issues. (Note: More than 3 reasons are provided.)

b.

An auditor might conclude that it is appropriate to resign from an existing audit

client because of any of the following reasons: (1) concerns about the integrity of
management, (2) the existence of unusual circumstances and risks, (3) concerns
about the ability to audit the entity, (4) concerns about the ability to field an audit
team that has adequate competence to perform the audit due to changes in the
clients circumstances, or (5) concerns about independence issues. (Note: More
than 3 reasons are provided.)

c.

The decisions to accept an audit engagement, or to continue an existing audit

engagement, are quite similar. With an existing client changes in the clients
management or business may lead the auditor to conclude that it is time to resign
the engagement as discussed in (b) above. In the case of a new engagement,
auditors will take steps, including communication with the predecessor auditor, to
assess the same issues.

a.
b.

The primary purpose of an engagement letter is to indicate clearly the nature of

the services to be performed and the responsibilities of the auditor.
The engagement letter is prepared and sent by the auditor to the client. The client
should indicate approval of the engagement terms on the letter and return it to the
auditor. The letter constitutes a legal contract between the auditor and the client.

7-10. The seven steps in performing risk assessment procedures are: (1) identify relevant
financial statement assertions, (2) obtain an understanding of the entity and its
environment, (3) make preliminary judgments about materiality, (4) performing
analytical procedures, (5) considering audit risk (including the risk of fraud), (6) develop
preliminary audit strategies for significant assertions, and (7) obtaining understanding of
entitys system of internal control.
7-11. a.

The following bullet points summarize important aspects of the industry,

regulatory environment, and other external factors that the auditor should
understand.
Industry conditions
o The market and competition, including demand, capacity and price
competition

7-12.

o Cyclical or seasonal activity

o Product technology relating to the entitys products
Regulatory environment
o Accounting principles and industry specific practices
o Regulatory framework in a regulated industry
o Government policies currently affecting the conduct of the entitys
business, such as tariffs and trade restrictions
Other external factors affecting the entitys business
o General level of economic activity
o Interest rates and availability of financing
o Inflation and currency revaluation

b.

Following are two examples of how the auditor might use this knowledge in
planning the audit. First, the auditor would use knowledge of the cyclical nature
of a retail company when developing expectations about sales and expenses. For
example, the auditor might expect that a significant portion of retail revenue
might be earned during the months of November and December. Depending on
dating obtained from vendors, some retailers might have to borrow to fund the
needed inventory growth to prepare for seasonal activity. Second, the auditor
might use knowledge of specific industry accounting principles, such as the
challenges of recognizing revenues on bundled products and services in the
software industry, to determine the risk of material misstatement in the financial
statements.

a.

The following bullet points summarize important aspects of understanding the

nature of the entity being audited.
Business Operations
Method of obtaining revenues (e.g., manufacturing, retailing, banking,
etc.)
Products or services and markets (e.g., major customer and contracts,
market share or reputation of products).
Conduct of operations (e.g., stages and methods of production,
business segments)
Alliances, joint ventures, and outsourcing activities
Involvement in e-commerce, including internet sales
Geographic dispersion and industry segmentation
Locations of production facilities, warehouses, and offices
Important suppliers of goods and services (e.g., stability of supply or
methods of delivery, such as just-in-time)
Transactions with related parties
Investments
Capital investment activities
Acquisitions, mergers or disposals of business activities
Investments and disposition of securities and loans

Financing
Group structure, including consolidated and nonconsolidated entities
Debt structure, including covenants, guarantees and off balance sheet
financing arrangements
Use of derivative financial instruments
Financial Reporting
Accounting principles and industry specific practices
Accounting for fair value
Industry-specific significant categories (e.g., research and development
for pharmaceuticals)

7-13.

7-14.

b.

Following are two examples of how the auditor might use this knowledge in
planning the audit. First, knowledge of the entitys products, services and markets
will help the auditor understand what to expect in the way of gross margins.
Retail companies that sell commodity type products (e.g., retail grocers) tend to
have low margins and a relatively high proportion of sales to total assets. Second,
knowledge of the business might also assist the auditor in auditing disclosures.
Knowledge of financing arrangements and debt maturities is necessary to audit
the adequacy of note disclosures related to long-term debt.

a.

The following bullet points summarize important aspects of understanding the

entitys objectives, strategies, and related business risks.
Entity objectives and strategies (and related business risk)
New products and services (increased product liability)
Expansion of the business (demand has not been accurately estimated)
Response to industry or regulatory requirements (decreased industry
demand or increased legal exposure due to regulations)

b.

Following are two examples of how the auditor might use this knowledge in
planning the audit. First, a pharmaceutical companys business strategy might
include the development of new products that are currently in research and
development. Failure to obtain Food and Drug Administration of a propose drug
may provide evidence that any capitalized in-process research and development
costs related to the drug should be written-off. Second, if a company over
estimates demand for its product, there is a risk that it might engage in channel
stuffing in order to move product, or make concessions in selling products such
that the shipment of goods is essentially a consignment sale.

a.

The following bullet points summarize important aspects of understanding the

nature of the entity being audited.
The entity may use the following tools to monitor or review its financial
performance.
Key ratios and operating statistics
Key performance indicators
Use of forecasts, budgets, and variance analysis


b.

Analyst reports and credit rating reports

Following are two examples of how the auditor might use this knowledge in
planning the audit. First, if the auditor of a small business finds that the client
prepares financial statements only quarterly, and then does not rely on them to
monitor the entitys performance, there is a higher risk of material misstatement in
the underlying accounting data. Second, if the entity regularly compares business
performance with underlying nonfinancial measures (e.g., hours worked to
percentage of completion on a construction project) the auditor may have
increased confidence that client financial controls might detect and correct
misstatements in payroll on a timely basis.

7-15. Chapter six described a number of audit procedure normally performed during the course
of an audit. The following audit procedures might be used to obtain an understanding of
the entity and its environment.
Inquiry
Observation
Inspection of tangible assets
Inspection of documents and records

Comprehensive Questions
7-16. (Estimated time - 30 minutes)
a.

Risks
The company is a sales and research organization. It does no manufacturing. Its
largest asset is unrecovered development costs.
The company is very thinly capitalized. The present owners having invested
$78,000 will own 60 percent of the company's stock after the proposed offering,
while the public will invest $1,000,000 for 40 percent of the company's stock.
The two officers are being sued by the SEC for misusing funds raised by another
company in a public offering. In fact, the suit touches Sunny Energy in that the
funds allegedly misused were used for the benefit of Sunny's predecessor
company.
This is a highly speculative and highly competitive area. The company has no
patents to protect it from competition.
Canadian Brass has been accused by the SEC of reporting improper income while
Float was the chief executive.

b.

Accounting and auditing problems

Valuation and write-off of unrecovered development costs (FASB 2).
Valuation of stock subscriptions receivable.

Type of opinion to be rendered. The continuation of the company is subject to

realization of unrecovered costs. Thus, an uncertainty exists that has a material
affect on the financial statements.

c.

Additional data
Marketing success or marketing studies and projections.
Outcome of the various lawsuits.
Use of proceeds of the offering.
Identify who will be doing the research for the company and determine their
qualifications.

d.

The uncertainty concerning the company's future as a going concern and the
questionable integrity of the two officers of the company appear to be pervasive in a
decision to reject the engagement.

7-17. (Estimated time - 20 minutes)

a.

Prior to acceptance of the engagement, Tish & Field 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 an
audit, together with the inherent limitations of any internal controls, 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.

7-18.

Notification of any changes in the original arrangements that might be

necessitated by unknown or unforeseen factors.
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.

(Estimated time - 20 minutes)

a.
The factors Kent should consider in the process of selecting Park include
Park's professional certification, license, or other recognition of Park's
competence.
Park's reputation and standing in the views of Park's peers and others familiar
with Park's
capability or performance.
Park's relationship, if any, to Davidson Corporation.
b.

The understanding among Kent, Park, and Davidson's management as to the

nature of the work to be performed by Park should cover
The objectives and scope of Park's work.
Park's representations as to Park's relationship, if any, to Davidson.
The methods or assumptions to be used.
A comparison of the methods or assumptions to be used with those used in the
preceding period.
Park's understanding of Kent's corroborative use of Park's findings.
The form and content of Park's report that would enable Kent to evaluate
Park's findings.

7-19. Estimated time - 25 minutes)

Deficiency
examination of the financial
statements
We will examine....
for the purpose of auditing them.
to assure that the financial
statements are correct
supporting the financial
statements.
accounting methods used
-----------------------our audit cannot detect all material
irregularities.
that looks suspicious.
--------------------------

Proper Wording
audit of the financial statements
We will audit....
for the purpose of expressing an opinion on them.
to obtain reasonable assurance that the financial
statements are not materially misstated.
supporting the amounts and disclosures in the
financial statements.
accounting principles used.
and evaluate the overall financial statement
presentation.
a properly designed and executed audit may not
detect all material irregularities.
to be unusual or abnormal.
should add paragraph highlighting management's
responsibility for (1) the preparation of the

on a cost plus basis.

including travel costs.

financial statements including adequate

disclosure, (2) the selection and application of
accounting policies, (3) the maintenance of
internal controls, and (4) providing written
representations concerning information provided
to the auditor during the audit (see sample
wording in Figure 7-2 on page 242-3 of the
text).
at our regular per them rates.
plus travel and other costs.

7-20. (Estimated time - 25 minutes)

a.
The procedures Hall should perform before accepting the engagement include the
following:
Hall should explain to Adams the need to make an inquiry of Dodd and should
request permission to do so.
Hall should ask Adams to authorize Dodd to respond fully to Hall's inquiries.
If Adams refuses to permit Dodd to respond or limits Dodd's response, Hall
should inquire as to the reasons and consider the implications in deciding
whether to accept the engagement.
Hall should make specific and reasonable inquiries of Dodd regarding matters
Hall believes will assist in determining whether to accept the engagement,
including specific questions regarding:
Facts that might bear on the integrity of management;
Disagreements with management as to accounting principles, auditing
procedures, or other similarly significant matters;
Dodd's understanding as to the reasons for the change of auditors.
If Hall receives a limited response, Hall should consider its implications in
deciding whether to accept the engagement.
b.

The additional procedures Hall should consider performing during the planning
phase of this audit that would not be performed during the audit of a continuing
client may include:
Hall may apply appropriate auditing procedures to the account balances at the
beginning of the audit period and, possibly, to transactions in prior periods.
Hall may make specific inquiries of Dodd regarding matters Hall believes
may affect the conduct of the audit such as
Audit areas that have required an inordinate amount of time;
Audit problems that arose from the condition of the accounting system and
records.
Hall may request Adams to authorize Dodd to allow a review of Dodd's
working papers.
Hall should document compliance with firm policy regarding acceptance of a
new client.


7.21.

Hall should start obtaining the documentation needed to create a permanent

working paper file.

(Estimated time - 25 minutes)

Generally, the first step in preparing to supervise and plan the field work for an audit is to
review and/or study current and background information on the client and industry. The
most important sources in this preparatory stage are as follows:
Engagement letter.
Audit permanent file.
Last year's work papers.
Client correspondence files.
Last year's reports, including management letter and/or internal control memorandum.
Last year's in-charge auditor.
General news publications
Industry and governmental publications.
AICPA industry audit guides or firm audit guides.
Discussions with the client personnel.
A tour of the clients facilities.

The purpose of this preparatory review and study is to become familiar with such things as:
Industry, regulatory and other external factors
The nature of the entitys business operations, investing activities, financing
activities, and financial reporting and accounting policy choices.
The entitys objectives, strategies, and related business risks.
How the entity measures and reviews its financial performance.
The preliminary review allows the auditor to develop a knowledgeable perspective about the
entity to be audited and to make very preliminary decisions about the risk of material
misstatement in the financial statements.
After the above review, the in-charge accountant can make preliminary plans for the field work.
For example, the in charge will usually determine what audit tests can be done on an interim
basis and what must be done on or after the balance sheet date including tests which should be
done on a surprise basis. Based on an understanding of the risk of material misstatement, the incharge should consider whether he or she needs special expertise for the engagement, e.g., a
computer specialist. The general experience needed on the engagements will also depend on the
various risk of material misstatement associated with the entitys industry and financial reporting
issues.
Audit programs can usually be prepared based on the prior year's review of internal control and
any related current correspondence, as well as suggestions in last year's work papers. It is often
possible to use last year's programs with revisions for changed conditions or desired audit
emphasis.

7.22. (Estimated Time 30 minutes)

Following is a brief description of how knowledge of the business and industry would assist the
auditor of a start-up company in the music industry that plans to deliver music to customers over
the internet.
Key Issue
Industry conditions

Describe knowledge used to develop

a knowledgeable perspective about
HipStar

Describe how knowledge would be

useful in performing the audit.

Knowledge of the market and

competition. This is a growing
market area and has some very big,
well capitalized companies competing
for this market space.
Knowledge of how has competition
affected the entitys pricing structure.
Knowledge of how the clients
technology has been accepted in the
market space with respect to ease of
downloading products and ability to
store songs for use on computers,
MP3 players, or other technologies.
Knowledge of how the clients
process meets copyright and other
legal requirements.
Knowledge of the entitys legal
requirements that must be met when
customers exist in other countries.

This knowledge will assist the

auditor in developing an expectation
of revenue growth. In addition,
competitive pressures and
acceptance of the entitys
technology will affect the
companies ability to compete with
well established competitors that
might be better capitalized.

Regulatory risks are significant,

given the experience of major
record labels suing companies that
allow customers to download music
over the internet. The auditor needs
to consider this when evaluating the
disclosure of commitments and
contingencies.
If the company is able to address
competitive pressures, the company
may be able to experience
significant growth rates. However,
the auditor needs to be sensitive to
the entitys product life cycle.
Again, this will assist the auditor in
evaluating the reasonableness of
revenue recognition.
Understanding the entitys cost
structure will help the auditor
evaluate the reasonableness of
reported profitability, particularly in
terms of the volume of sales need to
break even.
Evaluating the reasonableness of
the entitys profitability depends on
the mix of fixed costs, variable
costs, and contribution margins.

Regulatory
environment

Other external
factors affecting the
business

General consumer demand for

downloading songs rather than
purchasing music through traditional
channels. This area may grow faster
than the economy as a whole.

The clients
business operations

How does the client obtain new

recording artists or rights to sell songs
where rights are held by others?
What are the level of fixed costs
associated with storing music to be
downloaded by customers?
How does the entity obtain payment
for songs sold to customers?
Are there other sources of revenues in

Key Issue

Describe knowledge used to develop

a knowledgeable perspective about
HipStar

The entitys
investing and
financing activities

The entitys
financial reporting
activities

The entitys
objectives,
strategies and
related business
risks

How the entity

measures and

Describe how knowledge would be

useful in performing the audit.

addition to selling music to

customers?
How does the entity promote is
products? What are the costs
associated with product promotion?
What is the level of the entitys
general and administrative costs?
Are there any significant transactions
with related parties?
What is the entitys burn rate if the
company is not cash flow positive?

If the entity is unable to profitable

in early years, the auditor needs to
consider how well capitalized the
entity is. If the entity is
inadequately capitalized, the auditor
needs to evaluate the significance of
going concern issues.

What level of investments in

technology are needed to meet
customer demands?
Does the entity need to invest in
intangible assets (whether capitalized
or directly expensed)?
What financing sources and terms are
available to fund the needed
investments?
Is financing need because the client is
growing faster than its sustainable
growth rate?
What accounting principles are used?
Are there industry specific practices?
How is revenue recognized?
What are the significant accounts and
transaction classes?

Knowledge of expected investing

activities will help the auditor
evaluate the existence of recorded
assets.
Knowledge of expected financing
activities to cover investments or
growth in operations will help the
auditor evaluate the completeness of
recorded debt obligations.

What are the entitys overall strategies

for obtaining rights to sell the music
of new and existing artists?
Does the entity have sufficient
infrastructure to meet growth if it
materializes?
Does the entity have contingency
plans if actual demand does not meet
estimated demand?
How does management review and
approve day-to-day revenues and

Knowledge of the accounting

principles used will aid in the
determination of proper
presentation in accordance with
GAAP.
Knowledge of revenue recognition
policies (especially with internet
sales) will aid the auditor in
determination of proper recognition
in accordance with GAAP.
If the entity obtains rights to music
that is not marketable, the entity
may have net realizable value issues
with various recorded assets.
If the client over invests in
infrastructure the auditor should
consider whether asset impairment
issues exist.
Extensive and careful review of
accounting data by management

Key Issue
reviews its
financial
performance

Describe knowledge used to develop

a knowledgeable perspective about
HipStar

Describe how knowledge would be

useful in performing the audit.

expenditures?
How does management and the board
of directors review the overall
performance of the entity?
What non-financial measures are used
to monitor entity performance?
What review exists of the entitys
selection of accounting policies?

may improve the reliability of

accounting information.
Particularly if the information is
used in making business decisions.
If accounting data is not used for
evaluating performance or for
holding management accountable,
there is less reason to believe that
controls are effective over
developing reliable information.
The auditor may be concerned by
whether the business risks are
heightened by management pushing
the boundaries of accounting
principles, revenue recognition,
capitalizing transactions that should
be expensed, and accounting
estimates to improve reported
financial results.

7-23. (Estimated Time 30 minutes)

Following is a brief description of how audit procedures performed to obtain an understanding of
the business and industry would assist the audit when planning and performing an audit for a
small, independent college.
Audit Procedure

Review industry data

Review key internal

information about the entity

Tour client operations

Make inquiries of the audit

committee
Make inquiries of
management
Review prior years
working papers
Determine the existence of
related parties

Describe how the audit procedure would assist you in planning and
performing the audit.

Understanding industry data about industry will assist the auditor in

understanding the resources needed to deliver a competitive level of service in a
service industry. This will assist the auditor in understanding the clients
competitive advantage in enrolling students. Further, it will assist in developing
analytical procedures to assess the reasonableness of revenues, costs, and
reported resources.
Reviewing such items as board of directors minutes, enrollment reports, and
interim financial statements will assist the auditor in understanding
managements strategic initiatives, unusual transactions, and their implications
for the financial statements. Understanding enrollment will assist the auditor in
developing expectations regarding both revenues and costs.
Taking a tour of the clients operations will allow the auditor an understanding
of the entitys operations, its capacity, and the extent to which the entity is
operating at capacity. The auditor will also want to inspect the security over
computer systems, particularly the accounting system.
Discussions with the audit committee will provide the auditor with an
understanding of the committees concerns about internal control issues,
potential operating problems, or the need for any additional services.
Discussions with management should disclose important plans and strategies,
changes in operations, investing activities and how they were financed. These
discussions should also reveal any new risks taken on by management.
Review of prior working papers may disclosure problems in prior audits that are
likely to recur, such as internal control weakness that may not have been
corrected or issues associated with recurring audit adjustments.
Understanding the existence of related parties is important for evaluating
disclosures regarding related party transactions.

7-24. (Estimated time - 30 minutes)

This is a research question that would require that the student research the professional auditing
standards, AU 334 on Related Parties, to determine information about procedures to identify
related parties that are normally performed during the planning stages of an audit engagement.
The audit procedures Temple should apply to identify Ford's related party relationships and
transactions include the following:
Evaluate the company's procedures for identifying and properly reporting related
party relationships and transactions.
Request from management the names of all related parties and inquire whether there
were any transactions with these parties during the period.
Review tax returns and filings with other regulatory agencies for the names of related
parties.

Determine the names of all pension plans and other trusts and the names of their
officers and trustees.
Review stock certificate book to identify the stockholders.
Review material investment transactions to determine whether the investments
created related party relationships.
Review the minutes of board of directors' meetings.
Review conflict-of-interest statements obtained by the company from its
management.
Review the extent and nature of business transacted with major customers, suppliers,
borrowers, and lenders.
Consider whether transactions are occurring, but are not being given proper
accounting recognition, e.g. personal use of company vehicles, interest-free loans, etc.
Review accounting records for large, unusual, or nonrecurring transactions or
balances, paying particular attention to transactions recognized at or near the end of
the reporting period.
Review confirmations of compensating balance arrangements for indications that
balances are or were maintained for or by related parties.
Review invoices from law firms that have performed services for the company for
indications of the existence of related party relationships or transactions.
Review confirmations of loans receivable and payable for indications of guarantees,
and determine their nature and the relationships, if any, of the guarantors to the
reporting entity.

Cases
7-25. See separate file with answers to the comprehensive case related to the audit of Mt. Hood
Furniture that is included with this chapter.
7-26. See separate file with answers to the comprehensive case related to the audit of Mt. Hood
Furniture that is included with this chapter.

Professional Simulation
Research
Inquiry of
Predecessor

Situation

Draft
Report

AU 315.09 lists specific items that should be covered in a successor auditors inquiry of the
predecessor auditor.
AU 3115.11 also discusses the successor auditors request to review the predecessor auditors
working papers.
Inquiry of
Predecessor
Situation

Research

Draft
Report

The following items are specifically identified in AU 315.09 as matters that should be included
in the successor auditors inquiry of the predecessor auditor.

Included in Discussion with

1. Information that might bear on the integrity of management.
2. Disagreements with management about accounting principles
3. The predecessors understanding of the reasons for the change

Predecessor Auditor

in auditors.
4. The extent of procedures performed in the prior year.
5. Communication with the audit committee about fraud or illegal

acts.
6. Disagreements with management about auditing matters.
7. The predecessors evaluation of internal control.
8. Communication with the audit committee about auditor

independence.

Draft
Report
Situation

Research

Inquiry of
Predecessor

To:
Robert Hawkins, Senior Partner
Re:
Understanding the business and industry
From: CPA Candidate
Following a some example factors of how understanding Big Dog Constructions business and
industry will help the auditor better plan the audit.
Key items to be included in the
understanding of the industry,
regulatory, and other external factors.
Competitive bidding practices in the
industry.
Accounting principles specific to the
industry.

Regulations that the client must follow in

completing the signed construction
projects.
Expected changes in interest rates

General economic factors affecting the

construction industry.

Explain how the understanding identified to the

left is relevant to the audit.
Knowledge of the degree of competition in bidding
for the oil pipeline contract will help the auditor
develop an expectation regarding expected
profitability on the contract.
The construction industry may use the percentage
of completion method on this type of a long-term
contract. Recognition of revenues and costs
represents a significant accounting estimate that
needs audit attention.
The auditor should understand the risk of asserted
claims regarding potential violation of law when
evaluating potential contingent liabilities.
The client may need external financing to fund
major construction projects. This may impact
profitability for projects with thin margins.
If the construction industry is booming, it may be
difficult to obtain raw materials, pipe, or labor for
projects. This could result in cost over runs or not
meeting project deadlines, either of which could
influence profitability.