CHAPTER THREE

CLIENT ACCEPTANCE AND PLANNING THE AUDIT

Learning objectives

After studying this chapter, you should be able to:

➢ Explain objectives of planning
➢ Discuss why adequate audit planning is essential
➢ Gain an understanding of the client’s business and industry
➢ Assess client business risk
➢ Perform preliminary analytical procedures
➢ Describe Audit Working paper
3.1 Audit Planning
The first generally accepted auditing standard of field work requires adequate planning.
There are three main reasons why the auditor should properly plan engagements:
✓ To enable the auditor to obtain sufficient appropriate evidence for the circumstances,
✓ To help keep audit costs reasonable, and
✓ To avoid misunderstandings with the client.
Obtaining sufficient appropriate evidence is essential if the CPA/audit firm is to
minimize legal liability and maintain a good reputation in the business community.
Keeping costs reasonable helps the firm remain competitive. Avoiding
misunderstandings with the client is necessary for good client relations and for
facilitating high-quality work at reasonable cost. Suppose that the auditor informs the
client that the audit will be completed before June 30 but is unable to finish it until
August because of inadequate scheduling of staff. The client is likely to be upset with the
CPA firm and may even sue for breach of contract.

Objectives of planning
Adequate audit planning helps to:
➢ Ensure that appropriate attention is devoted to important areas of the audit.
➢ Ensure that potential problems are promptly identified;
➢ Ensure that the work is completed expeditiously;
➢ Utilize the assistants properly; and
➢ Co-ordinate the work done by other auditors and experts.
In planning his audit, the auditor will consider factors such as complexity of the audit, the
environment in which the entity operates, his previous experience with the client and
knowledge of the client’s business.

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The auditor may wish to discuss elements of his overall plan and certain audit procedures
with the client to improve the efficiency of the audit and to coordinate audit procedures with
work of the client’s personnel. The overall audit plan and the audit programme, however,
remain the auditor’s responsibility.

Planning an Audit and Designing an Audit Approach

Accept client and perform initial

audit planning

Understand the client’s business

and industry

Assess client business risk

Perform preliminary analytical

procedures

Set materiality and assess

acceptable audit risk and inherent
risk

Understand internal control and

assess control risk

Gather information to assess fraud

risks

Develop overall audit plan and audit

program

1. Accept client and perform initial audit planning

Initial audit planning involves four things, all of which should be done early in the audit:
i. The auditor decides whether to accept a new client or continue serving an existing
one. This determination is typically made by an experienced auditor who is in a
position to make important decisions. The auditor wants to make this decision early,
before incurring any significant costs that cannot be recovered.
ii. The auditor identifies why the client wants or needs an audit. This information is
likely to affect the remaining parts of the planning process.

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 iii. To avoid misunderstandings, the auditor obtains an understanding with the client
about the terms of the engagement.
iv. The auditor develops an overall strategy for the audit, including engagement staffing
and any required audit specialists.
Even though obtaining and retaining clients is not easy in a competitive profession such as
public accounting, a CPA firm must use care in deciding which clients are acceptable. The
firm’s legal and professional responsibilities are such that clients who lack integrity or argue
constantly about the proper conduct of the audit and fees can cause more problems than they
are worth. Some CPA firms now refuse any clients in certain high-risk industries, such as
software technology companies, health, and casualty insurance companies, and may even
discontinue auditing existing companies in those industries. Some smaller CPA firms will not
do audits of publicly held clients because of the risk of litigation or because of costs
associated with registering the audit firm with the PCAOB. Stated in terms of acceptable
audit risk, an auditor is unlikely to accept a new client or continue serving an existing client if
acceptable audit risk is below the risk threshold the firm is willing to accept.
New Client Investigation: Before accepting a new client, most CPA firms investigate the
company to determine its acceptability. They do this by examining, to the extent possible, the
prospective client’s standing in the business community, financial stability, and relations with
its previous CPA firm. For example, many CPA firms use considerable caution in accepting
new clients in newly formed, rapidly growing businesses. Many of these businesses fail
financially and expose the CPA firm to significant potential liability. The CPA firm must also
determine that it has the competency, such as industry knowledge, to accept the engagement
and that the firm can satisfy all independence requirements.

For prospective clients that have previously been audited by another CPA firm, the new
(successor) auditor is required by auditing standards to communicate with the predecessor
auditor. The purpose of the requirement is to help the successor auditor evaluate whether to
accept the engagement. The communication may, for example, inform the successor auditor
that the client lacks integrity or that there have been disputes over accounting principles,
audit procedures, or fees.
The burden of initiating the communication rests with the successor auditor, but the
predecessor auditor is required to respond to the request for information. However, the
confidentiality requirement in the Code of Professional Conduct requires that the predecessor
auditor obtain permission from the client before the communication can be made. In the event
of unusual circumstances such as legal problems or disputes between the client and the
predecessor, the predecessor’s response can be limited to stating that no information will be

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provided. If a client will not permit the communication or the predecessor will not provide a
comprehensive response, the successor should seriously consider the desirability of accepting
a prospective engagement, without considerable other investigation.
Even when a prospective client has been audited by another CPA firm, a success or may
make other investigations by gathering information from local attorneys, other CPAs, banks,
and other businesses. In some cases, the auditor may even hire a professional investigator to
obtain information about the reputation and background of key members of management.
Such extensive investigation is appropriate when there has been no previous auditor, when a
predecessor auditor will not provide the desired information, or if any indication of problems
arises from the communication.
Continuing Clients: Many CPA firms evaluate existing clients annually to determine
whether there are reasons for not continuing to do the audit. Previous conflicts over the
appropriate scope of the audit, the type of opinion to issue, unpaid fees, or other matters may
cause the auditor to discontinue association. The auditor may also drop a client after
determining the client lacks integrity.
Even if none of the previously discussed conditions exist, the CPA firm may decide not to
continue doing audits for a client because of excessive risk. For example, a CPA firm might
decide that considerable risk of a regulatory conflict exists between a governmental agency
and a client, which could result in financial failure of the client and ultimately lawsuits
against the CPA firm. Even if the engagement is profitable, the long term risk may exceed the
short-term benefits of doing the audit.
Investigating new clients and re-evaluating existing ones is an essential part of deciding
acceptable audit risk. For example, assume a potential client operates in a reasonably risky
industry, that its management has a reputation of integrity, but is also known to take
aggressive financial risks. If the CPA firm decides that acceptable audit risk is extremely low,
it may choose not to accept the engagement. If the CPA firm concludes that acceptable audit
risk is low but the client is still acceptable, the firm may accept the engagement but increase
the fee proposed to the client. Audits with a low acceptable audit risk will normally result in
higher audit costs, which should be reflected in higher audit fees.
Obtain an Understanding with the Client
A clear understanding of the terms of the engagement should exist between the client and the
CPA firm. Auditing standards require that auditors document their understanding with the
client in an engagement letter, including the engagement’s objectives, the responsibilities of
the auditor and management, and the engagement’s limitations.
The engagement letter may also include an agreement to provide other services such as tax
returns or management consulting allowed under the Code of Professional Conduct and

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regulatory requirements. It should also state any restrictions to be imposed on the auditor’s
work, deadlines for completing the audit, assistance to be provided by the client’s personnel
in obtaining records and documents, and schedules to be prepared for the auditor. It often
includes an agreement on fees. The engagement letter also serves the purpose of informing
the client that the auditor cannot guarantee that all acts of fraud will be discovered.
Engagement letter information is important in planning the audit principally because it affects
the timing of the tests and the total amount of time the audit and other services will take. For
example, if the deadline for submitting the audit report is soon after the balance sheet date, a
significant portion of the audit must be done before the end of the year. If unexpected
circumstances arise or if client assistance is not available, arrangements must be made to
extend the amount of time for the engagement. Client-imposed restrictions on the audit can
affect the procedures performed and possibly even the type of audit opinion issued.

Develop Overall Audit Strategy

After understanding the client’s reasons for the audit, the auditor should develop a
preliminary audit strategy. This strategy considers the nature of the client’s business and
industry, including areas where there is greater risk of significant misstatements. The auditor
also considers other factors such as the number of client locations and the past effectiveness
of client controls in developing a preliminary approach to the audit.
The planned strategy helps the auditor determine the resources required for the engagement,
including engagement staffing.
Select Staff for Engagement: The auditor must assign the appropriate staff to the
engagement to meet generally accepted auditing standards and to promote audit efficiency.

2. Understand the client’s business and industry

A thorough understanding of the client’s business and industry and knowledge about the
company’s operations are essential for the auditor to conduct an adequate audit. It establishes
a frame of reference within which the auditor plans the audit and exercises professional
judgment about assessing risks of material misstatement of the financial statements and
responding to those risks.

The nature of the client’s business and industry affects client business risk and the risk of
material misstatements in the financial statements. (Client business risk is the risk that the
client will fail to meet its objectives).
Industry and External Environment
The three primary reasons for obtaining a good understanding of the client’s industry and
external environment are:

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 ➢ Risks associated with specific industries may affect the auditor’s assessment of client
business risk and acceptable audit risk and may even influence auditors against
accepting engagements in riskier industries, such as the financial services and health
insurance industries.
➢ Many inherent risks are common to all clients in certain industries. Familiarity with
those risks aids the auditor in assessing their relevance to the client.
➢ Many industries have unique accounting requirements that the auditor must
understand to evaluate whether the client’s financial statements are in accordance
with accounting standards.

Procedures to Obtain an Understanding

International Standards on Auditing (ISA) provides an overview of the procedures that the
auditor should follow in order to obtain an understanding sufficient to assess the risks and
consider these risks in designing the audit plans. The risk assessment procedures should, at a
minimum, be a combination of the following:
➢ Inquiries of management and others within the entity
It is important to have discussions with the client’s management about its objectives and
expectations, and its plans for achieving these goals. The discussions may encompass short-
term management objectives such as increasing profit, reducing investment in working
capital, introducing new product lines, reducing taxes, or reducing selling and distribution
expenses.
➢ Analytical procedures
These may help the auditor in identifying unusual transactions or positions. Analytical
procedures usually involve a comparison of company results to that of the industry.
➢ Observation and inspection
These procedures may cover a broad area, ranging from the observation of an entity’s core
activities, the reading of management reports or internal control manuals to the inspection of
documents. A visit to the company premises will help the auditor develop a better
understanding of the client’s business and operations. Viewing the facilities helps to identify
some internal control safeguards. Seeing the production process will help the auditor assess
the inventory movement and the use of fixed assets. Observations of the orderliness,
cleanliness, and physical layout of facilities and of the employees’ routine functions and work
habits can often tell the auditor more about the client than can be learned from studying the
accounting records.
Knowing the layout will assist in planning how many audit staff members will be needed to
participate in observing the physical inventory. On the site visit, the auditor may see signs of

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potential problems. The auditors can see the physical extent of segregation of duties within
the client organization by observing the number of office employees.
Other Information Sources
In addition to these procedures, the auditor might consider obtaining information from others
sources, for example, the entity’s external legal counsel, or externally available data sources,
including analysts’ reports, industry journals, government statistics, surveys, texts, financial
newspapers, etc.

3. ASSESS CLIENT BUSINESS RISK

The auditor uses knowledge gained from the understanding of the client’s business and
industry to assess client business risk, the risk that the client will fail to achieve its
objectives.
Client business risk can arise from any of the factors affecting the client and its environment,
such as significant declines in the economy that threaten the client’s cash flows, new
technology eroding a client’s competitive advantage, or a client failing to execute its
strategies as well as its competitors.
The auditor’s primary concern is the risk of material misstatements in the financial statements
due to client business risk.

4. PERFORM PRELIMINARY ANALYTICAL PROCEDURES

Auditors perform preliminary analytical procedures to better understand the client’s business
and to assess client business risk. One such procedure compares client ratios to industry or
competitor benchmarks to provide an indication of the company’s performance. Such
preliminary tests can reveal unusual changes in ratios compared to prior years, or to industry
averages, and help the auditor identify areas with increased risk of misstatements that require
further attention during the audit.

5. Understand internal control and assess control risk (This will be discussed in detail in
chapter five)
6. Develop an Over All Audit Plan and audit program
The last step in the planning the audit is to develop an overall strategy. This involve about the
nature, extent, and timing of audit test to be conducted. The audit strategy is normally
documented in an audit plan and audit program containing specific audit procedures. The
audit program for most audits is designed in three parts:
1. Test of transactions

2. Analytical procedures

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3. Test of details of balance

3.2 AUDIT PROGRAMME

Audit programme is nothing but a list of examination and verification steps to be applied set
out in such a way that the inter-relationship of one step to another is clearly shown and
designed, keeping in view the assertions discernible in the statement of account produced for
audit or on the basis of an appraisal of the accounting records of the client. In other words, an
audit programme is a detailed of the accounting records of applying the audit procedures in
the given circumstances with instructions for the appropriate techniques to be adopted for
accomplishing the audit objectives. Businesses vary in nature, size and composition; work
which is suitable to one business may not be suitable to be rendered by the auditor are the
other factors that vary from assignment to assignment. Because of such variations, evolving
one audit programme applicable to all business under all circumstances is not practicable.
However it becomes a necessity to specify in details in the audit programme the nature of
work to be done so that no time will be wasted on matters not pertinent to the engagement
and any special matter or any specific situation can be taken care of.
An audit programme consists of a series of verification procedures to be applied to the
financial statements and accounts of a given company for the purpose of obtaining sufficient
evidence to enable the auditor to express an informed opinion on such statements.
For the purpose of programme construction, the following points should be kept in view:
➢ Stay within the scope and limitation of the assignment.
➢ Determining the evidence reasonable available and identify the best evidence for
deriving the necessary satisfaction.
➢ Apply only these steps and procedures which are useful in accomplishing the
verification purpose in the specific situation.
➢ Consider all possibilities of error.
➢ Co-ordinate the procedures to be applied to related items.

IMPORTANCE OF AUDIT PROGRAMME

1. It provides the assistant carrying out the audit with total and clear set of
instructions of the work generally to be done.
2. It is essential, particularly for major audits, to provide a total perspective of the
work to be performed.
3. Selection of assistants for the jobs on the basis of compatibility becomes easier
when the work is rationally planned, defined and segregated.

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 4. Without a written and pre-determined programme, work is necessarily to be
carried out on the basis of some ‘mental’ plan. In such a situation there is always a
danger of ignoring or overlooking certain books and records. Under a properly
framed programme, the danger is significantly less and the audit can proceed
systematically.
5. The assistance, by putting their signature on programme, accepts the responsibility
for the work carried out by them individually and, if necessary, the work done
may be traced back to the assistant.
6. The principal can control the progress of the various audits in hand by
examination of audit programmes initiated by the assistants deputed to the jobs for
completed work.
7. It serves as a guide for audits to be carried out in the succeeding year.
8. A properly drawn up audit programme serves as evidence in the event of any
charge of negligence being brought against the auditor. It may be of considerable
value in establishing that he exercised reasonable skill and care
that was expected of professional auditor

3.3 AUDIT WORKING PAPERS

The audit working papers constitute the link between the auditor’s report and the client’s
records.
The objects of an auditor’s working papers are to record and demonstrate the audit work from
one year to another. Therefore, working papers should provide for:
➢ Means of controlling current audit work;
➢ Evidence of audit work performed;
➢ Schedules supporting or additional item in the accounts; and
➢ Information about the business being audited, including the recent history.
Working papers are varied in nature but the foundation of all working paper can be traced to:
➢ The basic constitutional document like memorandum and Articles of association,
partnership Deed, trust deed, etc.;
➢ The contents of the minute books;
➢ The contents of the balance sheet and the profit and loss account; and
➢ The letter of engagement.

IMPORTANCE OF AUDIT WORKING PAPERS:

1. IT provides guidance to the audit staff regards to the manner of checking the
schedules.

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 2. The auditor is able to fix responsibility on the staff member who signs each schedule
checked by him.
3. It acts as evidence in the court in the court of law when a charge of negligence is
brought against the auditor.
4. It acts as the process of planning for the auditor so that he can estimate the time that
may be required for checking the schedules.
The auditor should adopt reasonable procedures for custody and confidentiality of his
working papers and should retained them for a period of time sufficient to meet the needs of
his practice and satisfy any pertinent legal or professional requirements of record retention.

CONTENTS OF AUDIT WORKING PAPERS:

A Permanent Audit File
A permanent audit file normally includes
➢ Information concerning the legal and organizational structure of the entity. In case of
a company, this includes the memorandum and Article of association. In the case of a
statutory corporation, this includes the act and regulations under which the
corporation functions.
➢ Extracts or copies of important legal documents, agreements and minute relevant to
the audit.
➢ A record of the study and the evaluation of the internal controls related to the
accounting system. This might be in the form of narrative descriptions, questionnaires
or flow charts, or some combination thereof.
➢ Copies of audited financial statements for previous years.
➢ Analysis of significant ratios and trends.
➢ Copies of management letters issued by the auditor, if any.
➢ Record of communication with the retiring auditor, if any, before acceptance of the
appointment as auditor.
➢ Notes regarding significant accounting policies.
➢ Significant audit observations of earlier years.
The Current File
The current file normally includes
➢ Correspondence relating to acceptance of annual reappointment.
➢ Extracts of important matters in the minutes of board meetings and general meetings
as relevant to audit.
➢ Evidence of the planning of the audit and audit programme.
➢ Analysis of transactions and balances.

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 ➢ A record of the nature, timing and extent of auditing procedures performed, and the
results of such procedures.
➢ Evidence that the work performed by assistants was supervised and reviewed.
➢ Copies of communication with other auditors, experts and other third parties.
➢ Letters of representation or confirmation received from the client.
➢ Conclusions reached by the auditor concerning significant aspects of the audit,
including the manner in which exceptions and unusual matters, if any, disclosed by
the auditor’s procedures were resolved or treated.
➢ Copies of the financial information being reported on the related audit reports.

3.5 ANALYTICAL PROCEDURE

Analytical procedures consist of the analysis of significant ratios and trends including the
resulting investigation of fluctuations and relationships that are inconsistent with other
relevant information or deviate from predictable amounts. Analytical procedure involves the
use of comparisons and relationships to determine whether account balances or other data
appear reasonable.
Purpose and timing of analytical Review
Purpose of analytical review
• used to understand the client’s industry and business
• used to assess the client’s ability to continue as going concern
• used to indicate possible misstatement in the F/S
• used in reduction of detailed audit test
Timing of analytical review
Analytical review will be applied throughout the audit but the most specific occasions
include:-
A. planning phase
• understand the client’s industry and business
• assess the going concern
• indicate possible misstatement ( attention directing)
• reduce detail test
B. Testing Phase
• Indicate possible misstatement
• Reduce detail tests
C. Completion Phase
• Assess going concern
• Indicate possible misstatement (attention directing)

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Factors that influence analytical procedure
• Nature and operation of the entity
• Knowledge obtained in the audit
• The availability of data
• The reliability, relevance, and comparability of information available
• The cost effectiveness of analytical review in relation to others
• The availability of qualified staff

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