The Stages of an Audit – Appointment

1 Overview

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This is an important and useful diagram and it sets out the stages or approach to an audit.

2 The appointment process: before you say ‘Yes’…

Auditors must exercise great caution if asked to be the auditors of an organisation.

• Are they professionally qualified to act? Is it legal and ethical for them to do so? For example, they shouldn’t accept an appointment if the fees exceed the 15% limit for public interest companies, unless there are adequate safeguards.
  

• Do they have adequate resources in terms of staff, time, and expertise? If the potential audit client acts in a specialist area of business and the auditors have no prior experience of that, it would be very unwise for them to accept the appointment.
  

• Investigate the client, its management, and directors. Many firms of auditors have access to databases which, for example, will allow them to search on directors’ names to see if any of the directors have been banned from being directors of companies because of their past behaviour. They may discover that it is too risky to become the auditor of a company if they have no trust in the honesty of the directors. The audit fee is often modest, why risk your reputation by undertaking an audit where the directors may be fraudulent?
  

• Communicate with present auditors. There is a professional requirement to do this and it is essential to find out why the old auditors are retiring or being removed.
  

3 Communication with existing auditors

If the auditor is approached by new audit client, if it’s a new business and this is the first audit there will be no previous auditors to communicate with and new auditors must make their own decision.

If it is not a new business and there is an existing auditor then the new auditor must ask the client for permission to contact the old auditor. If permission is not given, the appointment should be declined. Why would permission not be given? Is a client trying to conceal something? Why else would they not allow a new auditor to communicate with the existing auditor?

Assuming permission is given the new auditor will write to the old auditor for information. The old auditor can’t simply send that information to the new auditor because that is confidential, and the old auditor has to ask the client for permission in turn. If that permission is not given the new auditor should decline the appointment because again the client is trying to stop communication between the old and new auditors.

If the old auditor provides information then the new auditor is more fully equipped to make their accept or reject decision. If the existing auditor decides not to provide information, the new auditor might have to rely on information from other sources.

A new audit appointment does not require the old auditor's consent. If the existing auditor does not reply, the new auditor can write that they will assume 'no matters' unless they receive a reply within a stated period (e.g. seven days).

A proposed auditor is not expected to refuse to act merely on the grounds of unpaid fees owing to the existing auditor.

4 Preconditions for an audit

According to ISA 210 Agreeing the Terms of Audit Engagements, an audit can only be accepted (or continued), if:

• The ‘preconditions for an audit’ are present:
  

  • The financial reporting framework for the preparation of the financial statements is acceptable
    

  • Management agrees that it acknowledges and understands its responsibilities for the financial statements (including internal control) and to provide the auditor with information necessary for the audit.
    

• There is a common understanding of the terms of the audit engagement.
  

These matters must be formally documented in an engagement letter.

An audit engagement must be declined (or discontinued) if:

• Management or those charged with governance impose a limitation on the scope of the audit (i.e. the auditor will not be able to form an opinion)
  

• The preconditions are not present (e.g. the financial reporting framework does not provide suitable criteria for an assurance engagement).
  

5 The engagement letter

Upon appointment, auditors should send an engagement letter to their new client.

Engagement letters are often regarded as rather dull documents, sent once and then forgotten. However, they are of crucial importance because they set out the contractual relationship between the auditor and the client. If the engagement letter is not sent out it’s very difficult for an auditor subsequently to complain that the client hasn’t done what was expected, or it might be difficult for the auditor to defend the firm against a claim that the auditor has not done what was expected. Engagement letters:

• Define the auditor’s responsibilities
  

• Provide written evidence of the auditor’s acceptance of the appointment.
  

• Should be sent to the board of directors or audit committee prior to the first audit.
  

• Identify any reports to be produced in addition to the auditor’s report. For example, for banking or insurance clients who may come under additional scrutiny.
  

• Should be updated for all changes. For example, if the auditor begins to undertake tax work for the client.

6 Typical contents of an engagement letter

• Description of the objective of an audit: to obtain reasonable assurance whether the financial statements are free from material misstatement and issue an auditor's report that include an audit opinion.
  

• Defining responsibilities: management’s is to prepare the financial statements and to set up a system of internal control. It is the auditor’s responsibility to audit the financial statements.
  

• Reference to the applicable financial reporting framework. For example, IFRSs.
  

• Emphasis that audits depend on sampling that there are no guarantees. The audit looks for only material misstatements. It will examine records on a test basis that can only give a reasonable assurance.
  

• The auditors will state that they expect unrestricted access to the company’s records and they expect full explanations for any queries they might have.
  

• They will state that the auditor’s report is a matter between them and the addressees of the auditor’s report (the members of company) and that it should not be relied upon by other parties.
  

• There will be certain matters about planning the audit, such as arranging the interim audit and final audit, attending the inventory counts, organising external confirmation of receivables, and liaison with the internal audit department.
  

• Almost certainly there will be something about fees, and remember fees should never be absolute. They should be estimate but subject to the proviso that if more work needs to be done, it will be done and additional fees will be required.
  

• Description of the expected relationship between the external auditor and internal audit; how the work of internal audit might be reviewed and then relied on by the external auditors.