CHAPTER 7CHAPTER 7Accepting the Engagement and Planning the Audit

Learning Check

7-1. 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.

7-2. 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.

7-3. 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.

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.

7-4. 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.

7-5. 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.

7-6. 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.

7-7. 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.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.

7-8. a.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.

7-9. a.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.

b. 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

The market and competition, including demand, capacity and price competition

Cyclical or seasonal activity

Product technology relating to the entitys products

Regulatory environment

Accounting principles and industry specific practices

Regulatory framework in a regulated industry

Government policies currently affecting the conduct of the entitys business, such as tariffs and trade restrictions

Other external factors affecting the entitys business

General level of economic activity

Interest rates and availability of financing

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.

7-12. 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)

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.

7-13. 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.

7-14. 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

Analyst reports and credit rating reports

b.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 concerningrepresentations made in connection with the audit.

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.

7-18. (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'scapability 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

Proper Wording

examination of the financial statements

audit of the financial statements

We will examine....

We will audit....

for the purpose of auditing them.

for the purpose of expressing an opinion on them.

to assure that the financial statements are correct

to obtain reasonable assurance that the financial statements are not materially misstated.

supporting the financial statements.

supporting the amounts and disclosures in the financial statements.

accounting methods used

accounting principles used.

------------------------

and evaluate the overall financial statement presentation.

our audit cannot detect all material irregularities.

a properly designed and executed audit may not detect all material irregularities.

that looks suspicious.

to be unusual or abnormal.

--------------------------

should add paragraph highlighting management's responsibility for (1) the preparation of the 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).

on a cost plus basis.

at our regular per them rates.

including travel costs.

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 andrecords.

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.

Hall should start obtaining the documentation needed to create a permanent working paper file.

7-21. (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 in-charge 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

Describe knowledge used to develop a knowledgeable perspective about HipStar

Describe how knowledge would be useful in performing the audit.

Industry conditions

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.

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 environment

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.

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.

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.

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.

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 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?

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.

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.

The entitys investing and financing activities

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?

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.

The entitys financial reporting activities

What accounting principles are used?

Are there industry specific practices?

How is revenue recognized?

What are the significant accounts and transaction classes?

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.

The entitys objectives, strategies and related business risks

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?

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.

How the entity measures and reviews its financial performance

How does management review and approve day-to-day revenues and 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?

Extensive and careful review of accounting data by management 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

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

Review industry data

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.

Review key internal information about the entity

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.

Tour client operations

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.

Make inquiries of the audit committee

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.

Make inquiries of management

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 prior years working papers

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.

Determine the existence of related parties

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

Situation

Inquiry of Predecessor

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 Predecessor Auditor

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 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.

Explain how the understanding identified to the left is relevant to the audit.

Competitive bidding practices in the industry.

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.

Accounting principles specific to the industry.

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.

Regulations that the client must follow in completing the signed construction projects.

The auditor should understand the risk of asserted claims regarding potential violation of law when evaluating potential contingent liabilities.

Expected changes in interest rates

The client may need external financing to fund major construction projects. This may impact profitability for projects with thin margins.

General economic factors affecting the construction industry.

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.