ROOM 3: Auditing and Assurance Principles

Case Study

Bolisay, Reynan

Buenaventura, Janella

De Guzman, Ranz

Felix, Mariah Zephaniah

Paredes, Mica

Regala, Verlie

Umayam, Romiline
Letter A: Evaluate and discuss whether Henson, Davis & Company complied with auditing
standards in their acceptance of McMullan Resources as a new client. 

The audit engagement of Henson, Davis, & Company with McMullan Resources, particularly the
client acceptance procedure, failed to observe PSA 220 and Code of Ethics for Professional
Accountants in the Philippines. The justifications for this claim are elaborated below:

PSA 220 (Para. 12): The engagement partner shall be satisfied that appropriate procedures
regarding the acceptance and continuance of client relationships and audit engagements have
been followed and shall determine that conclusions reached in this regard are appropriate.

While the engagement partner may or may not be the responsible for initiation of
engagement acceptance procedures, he must still ensure the appropriateness of the decision
taken. In this case, it is evident that partner, Winston Black, fell far short of this responsibility.
By claiming that he is busy and occupied with his “largest and most important client”, he
appointed Sarah Beale, a manager, to conduct the new-client acceptance review. Black did not
get any feedback and assumed everything was okay without performing any appropriate action/s.
This is a clear portrayal of Black’s negligence and obstruction of Professional Competence and
Due Care. 

PSA 220 (Para. A8): PSQC 1 (Redrafted) requires the firm to obtain information considered
necessary in the circumstances before accepting an engagement with a new client. Information
such as the following assists the engagement partner in determining whether the conclusions
reached regarding the acceptance and continuance of client relationships and audit
engagements are appropriate:

 The integrity of the principal owners, key management and those charged with
governance of the entity;
 Whether the engagement team is competent to perform the audit engagement and has the
necessary capabilities, including time and resources;
 Whether the firm and the engagement team can comply with relevant ethical
requirements; and
 Significant matters that have arisen during the current or previous audit engagement,
and their implications for continuing the relationship

During Black’s performance of his first review of engagement with McMullan after the
audit was substantially complete, which in itself is inappropriate, various existing significant
audit issues got uncovered. These indicate that the engagement acceptance procedure did not
obtain and consider the necessary information before accepting McMullan.

Firstly, direct communication with the predecessor auditor was interrupted by Ted
McMullan. After acquiring the client’s permission, discussion of client affairs should be done
directly with the predecessor auditor. Moreover, the response of the predecessor auditor is
limited to analyses of fixed assets and equity accounts. These did not cover the major issues that
have arisen during the previous audit engagement of Gardner with McMullan. Beale, the
designated manager for the conduct of acceptance procedure, relied on Ted McMullan’s
statement regarding the replacement of Gardner. Since the firm was unable to properly
communicate with the predecessor auditor, they could have performed alternative means to
acquire the necessary information.

The firm failed to assess the competence of the engagement team, and the necessary time
and resources for the conduct of audit engagement. As a result, Black failed to meet all of its
responsibilities as an engagement partner. He would have performed an initial review during the
planning stage as required by the firm’s policies. However, due to the lack of evaluation of
necessary time and resources under the circumstances of this engagement, the review was
conducted after the audit was substantially complete. 

Code of Ethics Section 210.10: “A professional accountant in public practice who is asked to
replace another professional accountant in public practice, … , should determine whether there
are any reasons, professional or other, for not accepting the engagement, such as circumstances
that threaten compliance with the fundamental principles.”

When Black asked Beale to conduct a review of new-client acceptance, wherein among
the tasks was to contact the prior auditors, the latter was not able to effectively communicate
with the predecessor auditors to determine their reasons for not accepting the engagement with
McMullan. 

Beale left the procedure incomplete when the predecessor auditors did not return her
calls. Instead, Beale raised a conversation with Ted, the client, to address reasons for the change
in auditors. Beale felt it was only appropriate to accept the client’s representations without
keeping in mind the potential bias that might be integrated in its statements. Beale settled with
the information provided by the management. In this case, the firm should have communicated
directly with the predecessor auditor to confirm if there was any conflicting information.

Direct communication with the predecessor auditor is imperative in order to determine

whether their refusal to accept the engagement with the client could be a result of threats to
compliance of fundamental principles. Since processor auditors have prior experiences with the
client, they could be knowledgeable of questionable issues or practices within the company,
which might affect the decision of the current auditors in client acceptance. Inquiries with the
client could be altered to its own interest.

What can they do at this point in the engagement to resolve deficiencies if they exist?

With Black’s discovery of information that may have caused it to decline the audit
engagement had the information had been available earlier, the partner should communicate that
information promptly to the firm, so that the firm and the engagement partner can take the
necessary action. (PSA 220 Para. 13)

It could be possible to resolve the deficiencies at this point of the engagement. When
Sarah Beale failed to communicate directly with the predecessor auditor before accepting the
client and instead considered representations made by the management, they weren’t able to
comply properly with the auditing standards. Thus, Black himself shall immediately
communicate directly with the predecessor auditor to obtain relevant information (which should
have been done in the first place). However, if significant information were obtained that
would’ve initially affected the decision to accept the client, the firm shall decide whether to
withdraw from or continue the engagement. Either way, it would be difficult to remedy such
situations.

Letter B:  Evaluate and discuss whether sufficient audit work has been done with regard to
McMullan’s Montreal contract. If not, what more should be done?
 
The audit engagement of Henson, Davis, & Company with McMullan Resources,
particularly on the sufficiency of work done to McMullan’s Montreal contract, is in fact
insufficient and further work is needed for its completion. The reasons for that answer are stated
below; 

IFRS 15 (para. 31) An entity shall recognise revenue when (or as) the entity satisfies
performance obligation by transferring a promised good or service to a customer. An asset is
transferred when (or as) the customer obtains control of that asset. It’s either satisfied over time
or at a point in time.

IFRS 15 (para. 35): An entity transfers control of a good or service over time and, therefore,
satisfies a performance obligation and recognises revenue over time, if one of the following
criteria is met:
a. the customer simultaneously receives and consumes the benefits provided by the entity’s
performance as the entity performs;
b. the entity’s performance creates or enhances an asset (for example, work in progress)
that the customer controls as the asset is created or enhanced;
c. the entity’s performance does not create an asset with an alternative use to the entity and
the entity has an enforceable right to payment for performance completed to date.

The percentage of completion method falls in-line with IFRS 15, which indicates that
revenue from performance obligations recognized over a period of time should be based on the
percentage of completion provided that its payment and completion must be reasonably assured.
This method recognizes revenues and expenses in proportion to the completeness of the
contracted project. Other than that, it is also important to consider other aspects of the contract
that can affect the accounting aspects, such as considerations, terms, cancellation privileges,
penalties, modifications and contingencies.

IFRS 15 (para. 3): An entity shall consider the terms of the contract and all relevant facts and
circumstances when applying this Standard. An entity shall apply this Standard, including the
use of any practical expedients, consistently to contracts with similar characteristics and in
similar circumstances.
 
For such reason, the contract is required at least to be written in proper form with clear
diction and be signed by the management and its customer. The fact that it was signed causes
Sarah Beale to conclude that contract, even though written in French, can be used as sufficient
evidence in performing audit. But the auditing standards require such evidence given by
management be corroborated, reconciled or verified with other evidence if possible. How could
we easily assume the correctness of its terms and stipulations if we couldn’t understand in the
first place especially when it has material effects in the financial statements?
 
IFRS 15 (para. 10): A contract is an agreement between two or more parties that creates
enforceable rights and obligations. Enforceability of the rights and obligations in a contract is a
matter of law. Contracts can be written, oral or implied by an entity’s customary business
practices. The practices and processes for establishing contracts with customers vary across
legal jurisdictions, industries and entities. In addition, they may vary within an entity (for
example, they may depend on the class of customer or the nature of the promised goods or
services). An entity shall consider those practices and processes in determining whether and
when an agreement with a customer creates enforceable rights and obligations.

Beale’s argument may seem logical; enforceability of the contract provides assurance
whether we should recognize income on percentage-of-completion. But nothing stated in
confirmation form about existing disputes that may affect its enforceability except that it can be
mutually rescinded by both parties. Take note that a contract does not exist if each party to the
contract has the unilateral enforceable right to terminate a wholly unperformed contract without
compensating the other party at the same time, we can’t recognize subsequent income on
partially performed contract if this right is probable to be exercised in the future (para. 12).

Under the Philippine Civil Code, a construction contract falls within the general
classification of a contract for a piece of work whereby the contractor “binds himself to execute
a piece of work for the employer, in consideration of a certain price or compensation. The
contractor may either employ only his labor or skill, or also furnish the material.” Since it is a
contract for a piece of work, compliance to Statute of Frauds is not necessary (Art. 1403) and
can’t be assailed by third parties (Art. 1408). Hence, the enforceability of the contract is rest
upon on the compliance to its terms and significant stipulations, customary business practices;
not only limited to cancellation clause.

Furthermore, it is unrealistic to assume for contract for a piece of work to be “standard”

in terms the first place. This kind of contract is a result of negotiations and specifications agreed
upon by parties involved with rare chance to have exact or very similar with other contracts.
 
To overcome this problem, there is a need for substantial reading and understanding of
the content of the contract and the French-language copy should be translated by the independent
translator and read by the competent auditors (professional scepticism.) The auditors then have
independent work to assess its enforceability and check the appropriateness of accounting
methods used related to it. 

Letter C: Evaluate and discuss whether Black and Beale conducted themselves in
accordance with auditing standards.
 
The audit presented in the case study involves an initial engagement by a successor
auditor. In terms of the auditing standards, there are issues with regards to the compliance of
Black and Beale in conducting the engagement. The noncompliance with the standards occurred
when the partner in charge did not perform the initial review procedures required by the firm, the
audit manager relied on information provided by the client regarding the predecessor auditor, and
when the auditors did not include an expert to determine the contents of the Montreal contract.
 
Conducting his first review after the audit was substantially complete where in fact initial
review is required during the planning phase as provided by his firm’s policies. The given
reasons for not performing the review is not valid.
 
Under PAS 220 (A3), the engagement partner shall take responsibility for the overall
quality on each audit engagement in which he is assigned. In order to make sure the audit quality
of performing work and to see if it is complying with the firm’s quality control policies and
procedures as applicable. In this case, the firm is requiring initial review to be done during
planning phase then they should comply.
 
Throughout the audit engagement, the engagement partner shall remain alert, through
observation and making inquiries as necessary, for evidence of non-compliance with relevant
ethical requirements by members of the engagement team. (PSA 220) If the partner in charge is
focusing on another client while conducting the engagement, he may overlook essential
information with regards to the audit.
 
One of the fundamental principles of professional ethics for  professional accountants is
Professional Competence and Due Care,  it is important to maintain professional knowledge and
skill at the level required to ensure that a client or employer receives competent professional
services based on current developments in practice, legislation and techniques and act diligently
and in accordance with applicable technical and professional standards. But in the scenario, he
neglected his job in conducting the initial review because he is prioritizing his other clients. With
that, this principle is already violated.
 
It is also important to be in contact with the predecessor auditor before accepting an
engagement. Because PSQC 1 (Redrafted) requires the firm to obtain information considered
necessary in the circumstances before accepting an engagement with a new client. That
information will assist the engagement partner in determining whether the conclusions reached
regarding the acceptance of audit engagements are appropriate (PAS 220, A8).
 
The engagement partner shall be satisfied that appropriate procedures regarding the
acceptance and continuance of client relationships and audit engagements have been followed
and shall determine that conclusions reached in this regard are appropriate. (PSA 220) The
partner neglected the firm procedures and did not perform the initial review. 
 
The audit manager should be the one to conduct the interview with the predecessor auditor
and not rely it to the client, she just needed to have a consent from the management in a
form of a confirmation letter that she needs to send by herself and received the reply by
herself as well. Documents that will form part of the evidence should not be in the hand of
the clients because it will affect its reliability and independence. Sarah Beale tried to
communicate with the prior auditors, but the communication was left unfinished. Because
of that Black relied on the information provided by the client Ted McMullan.
 It was discussed in the Code of Ethics for Professional Accountants that  a professional
accountant in public practice who is asked to replace another professional accountant in public
practice shall determine whether there are any reasons, professional or otherwise, for not
accepting the engagement or handling the same engagement. (Code of Ethics, 210.9).
 
This may require direct communication with the predecessor accountant to establish the
facts and circumstances regarding the proposed change so that the professional accountant in
public practice can decide whether it would be appropriate to accept the engagement. (Code of
Ethics, 210.10)
 
A professional accountant in public practice will generally need to obtain the client’s
permission, preferably in writing, to initiate discussion with an existing accountant. Once that
permission is obtained, the existing accountant shall comply with relevant legal and other
regulations governing such requests. (Code of Ethics, 210.14)
 
If the prior period’s financial statements were audited by a predecessor auditor, the auditor may
be able to obtain sufficient appropriate audit evidence regarding the opening balances by
reviewing the predecessor auditor’s working papers. Whether such a review provides sufficient
appropriate audit evidence is influenced by the professional competence and independence of the
predecessor auditor. Relevant ethical and professional requirements guide the current auditor’s
communications with the predecessor auditor. (PSA 510 Redrafted)
 
For the audit to be effective there should be policies and procedures designed to
provide reasonable assurance that the firm, its personnel and, where applicable, others subject to
independence requirements, maintain independence where required (PSA 220)
 
Auditors may obtain inquiries from the management and those responsible for financial  
reporting, inquiries of others within the entity but those inquiries should be supported by an
observation and inspection for it to be reliable and accurate. (PSA 300)
 
Services of an expert is required. Another issue is about with the Montreal contract. Since
they do not understand the contract because it is in French language, Black and Beale
relied again on the client’s definition of standard contract which has cancellation clause in
it, but it requires mutual agreement and could not be cancelled unilaterally by the buyer.
If expertise in a field other than accounting or auditing is necessary to obtain sufficient
appropriate audit evidence, the auditor shall determine whether to use the work of an auditor’s
expert. (PSA 620 Revised and Redrafted)
In addition, the auditor shall evaluate whether the auditor’s expert has the necessary
competence, capabilities and objectivity for the auditor’s purposes. In the case of an auditor’s
external expert, the evaluation of objectivity shall include inquiry regarding interests and
relationships that may create a threat to that expert’s objectivity (PSA 620 Revised and
Redrafted)
For an audit to be effective, an engagement team includes a member using expertise in a
specialized area in cases where they are having a hard time evaluating the process or documents
involved. In this case, they should hire someone that could interpret the contract so that they
could check if it really includes a cancellation clause (PAS 220, A10).