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TUTORIAL 4 QUESTION 2

You are an audit partner with Bailey and Brown Company Auditors (BBCA). You have been
asked to audit the accounts of Chelsea Pty Ltd (Chelsea), a manufacturer and wholesaler of
pharmaceuticals, for the year ending 30/06/X0. Chelsea has revenue of $600m and net
assets of $290m. It has a staff of 60. Chelsea said that it decided to change auditors
because, having undergone a recent expansion, it felt that its existing auditor no longer
possessed the requisite skills and knowledge to be effective. Chelsea approached your
audit firm because one of the partners in your firm is involved in a joint venture (a boutique
winery) with one of the directors of Chelsea and felt that the two had established a good
relationship. You are keen to accept the audit because you believe that Chelsea has a good
future and you would like to gain experience auditing such companies and be seen as an
expert in this field of work.

Chelsea Pty Ltd was established sixty years ago as a small, family-run, suburban pharmacy.
Over the years, the descendants of the original proprietor (the Busby family) saw
opportunities for expansion. In particular, the technological advances of the 1980s, which
facilitated mass production of complex pharmaceuticals, permitted the company to become a
respected manufacturer of drugs. In recent years, Chelsea Pty Ltd significantly increased its
research and development capability, and has grown into the one of the country’s largest,
privately owned drug companies. During this expansion phase, Chelsea Pty Ltd. purchased
a number of patents and some state-of-the-art drug manufacturing equipment.

In order to fund the expansion, Chelsea Pty Ltd sought direct equity investments from a
number of private investors. While members of the Busby family continue to own the majority
of shares, and occupy the majority of seats on the Board; others own 25% of the company,
and hold three of the thirteen seats on the Board. One of those Board Members is also a
major customer of Chelsea Pty Ltd.

REQUIRED: Outline the main issues to be considered with respect to accepting the audit of
Chelsea Pty Ltd. Why are such issues important? Ensure you refer to the facts of the case
when answering this question.

LEARNING OBJECTIVE: Lecture 4 (Part 2) Learning Objective (1) Understand the process
of client acceptance and continuance.

REFERENCES: Lecture Slides: Lecture 4 (Part 2), all slides


Textbook: Ch. 5 pp. 237-247

1
ANSWER:
Client acceptance requires consideration of seven matters:
1) Obtain ethical clearance from the previous auditor
2) Evaluate management integrity
3) Determine whether the preconditions for an audit are present.
4) Assess the auditor’s ability to comply with the ethical requirements including auditor
independence
5) Assess auditor’s technical competence to perform the audit
6) Agree the engagement/ decide to accept the engagement.
7) Prepare the engagement letter

1: Obtain ethical clearance from the previous auditor


REQUIREMENTS:
• Communicate with the existing auditor (with Chelsea’s knowledge)
• Ascertain the veracity of Chelsea’s claim
• Existing auditor should respect Chelsea’s confidentiality (unless there are
extenuating factors, but there are no facts relating to these)
IMPORTANCE
• Protects both the existing auditor (independence issues and or unfair competition
from another auditor) and BBCA (obtains knowledge of any problems and is more
fully apprised of the situation)

FACTS:
• Chelsea states that the reason for the change is that the existing auditor no longer
has the necessary capacity

2: Evaluate management integrity


REQUIREMENTS
Consider whether the integrity of management presents a risk to the auditor and for
completing the audit successfully.

IMPORTANCE:
• Damage to BBCA’s reputation if it is associated with low integrity clients
• Management integrity has a significant influence on internal control
• BBCA’s ability to undertake the audit may be threatened if integrity is poor.

2
FACTS:
• Chelsea is well respected
• However there are two issues that need to be considered because of their risk
potential.
• One family owns 75% of Chelsea and has 11/13 board seats. There is,
therefore, the potential for decision making to take place outside corporate
governance structures.
• Related party. One board member is a major customer.

3 Establish that the preconditions for an audit exist


REQUIREMENTS:
• Determine whether the financial reporting framework is acceptable.
• Obtain agreement from management that:
• it understands its responsibilities regarding the preparation of financial
statements, and
• access for the auditor and the provision of information to the auditor

IMPORTANCE
• The audit opinion deals with the question of whether or not the financial statements
are prepared in accordance with the applicable financial framework. The framework
must be satisfactory. Also, the auditor is required to collect and test sufficient
appropriate evidence. Management agreement is thus required. Without these
requirements, the effectiveness and propriety of the audit is compromised.

FACTS
Chelsea is a large Pty Ltd Company. It is required to prepare a financial report under the
Corporations Act (See Reading 2). The financial reporting framework is compliance with the
accounting standards and the provision of a true and fair view. It is acceptable.

The question provides no facts about management’s understanding of its responsibilities for
the preparation of the financial reports and maintaining internal controls. Nor does it say
anything about management’s agreement to allow access to the auditor and to provide the
auditor with information required to conduct the audit. BBCA will have to discuss these
issues with Chelsea.

3
4: Assess the auditor’s ability to comply with the ethical requirements including
auditor independence
REQUIREMENTS:
• Auditor must form a conclusion on whether or not it is possible to comply with the
code of ethics , including the independence requirements that apply to an audit
engagement.
• Examples include independence requirements of Corporations Act and Code of
Ethics. Essentially the auditor should avoid any conflicts of interest. .

IMPORTANCE
• Independence is the “cornerstone” of auditing. The value of the audit report is
undermined if the auditor is not independent, and not seen to be independent
Independence is a fundamental condition for an audit.

FACTS:
• One of the partners in your firm is involved in a joint venture (a boutique winery) with
one of the directors of Chelsea and felt that the two had established a good
relationship.
• Need to document this and to ensure that there is sufficient separation between the
partner and the audit engagement (Note to tutors- we will deal in more detail with
such issues later in the course. I think this is sufficient for now- but please discuss if
you are asked to).

5: Assess auditor’s technical competence to perform the audit


REQUIREMENTS:
• Auditors must only take on work they are competent to perform.
• Can bring in an expert.

IMPORTANCE:
• Audit effectiveness would be compromised.
• Could lead to a claim for negligence if the firm was not competent

FACTS:
• Chelsea is a large Pty Ltd Company. It is required to have its financial reports audited
by a registered Company Auditor, unless ASIC approves otherwise (See Reading 2).
• Chelsea is in the pharmaceutical industry
• It has high technology plant and equipment
• It has research and development
• It has intellectual property rights

4
• From the facts, we do not know if the auditor (you) is a registered company auditor
(or, if ASIC has provided an exemption). Also
• BBCA does not possess experience with clients such as Chelsea.

6: Decide to accept the engagement


REQUIREMENTS
• Structured decision
• Must document the decision

IMPORTANCE:
• The auditor enters into a contractual relationship with the client as a consequence of
accepting the engagement. This brings with it significant rights and responsibilities.
FACTS:
• Nothing specific provided in the case

6: Prepare the engagement letter


REQUIREMENTS
• Must agree the terms in a letter that sets out the objectives and scope of the audit;
responsibilities of the auditor management; identification of the reporting framework;
and the nature of expected reports.

IMPORTANCE:
• Sets out the rights and responsibilities of both parties, the auditor and client.
• Establishes a foundation for the relationship

FACTS:
• Nothing specific provided in the case

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