Preliminary Conference

When an executive of a prospective client expresses an interest in retaining your firm to perform professional services, a representative of your firm should arrange for a preliminary conference to discuss this possibility with the official. The preliminary conference should be held as soon as practicable after the expression of interest has been received.

Topics to be discussed at the preliminary conference will vary depending upon a variety of factors including your firm's familiarity with the client and the client official's familiarity with your firm. At a minimum, you should be prepared to provide information concerning your firm's capabilities, competence in the client's industry, and other types of professional services provided. At the conclusion of the conference, you should know whether a predecessor auditor exists (and if so, why the client is considering changing auditors), whether the appointment is competitive (and if possible, the names of other firms under consideration), and whether a formal engagement proposal is desired. Finally, at the preliminary conference, it is important to advise the client that before any agreement to render services is concluded, it will be necessary for your firm 1) to communicate with any predecessor auditor (both to comply with generally accepted auditing standards and as a professional courtesy to the predecessor auditor), and 2) to perform a pre-acceptance evaluation of the client.

Pre-acceptance Procedures

A pre-acceptance evaluation of a prospective client consists principally of two phases: information gathering and information evaluation. Specific procedures a CPA firm may perform during the information- gathering phase are noted below. These procedures are adapted in part from Statement on Quality Control Standards 1 (QC 90), which provides guidance to CPA firms on policies and procedures a firm should adopt concerning acceptance and continuation of clients.

* Obtain and analyze financial statements of the prospective client and other relevant financial information. As part of this analysis, obtain the names of the prospective client's key executives and principals.

* Make inquiries of knowledgeable third parties within the business community as to the reputation of the prospective client's business and the integrity of the prospective client's management and principals. In this regard, comments of existing clients operating in the prospective client's industry are frequently useful, as are comments of the prospective client's legal counsel and bankers and other bankers and lawyers in the business community. In many circumstances, credit reports on a prospective client may prove useful, especially if communications with third parties raise questions concerning the prospective client's acceptability. In isolated instances, a CPA firm may retain a business investigation agency to provide a detailed report on certain prospective client's executives or principals.

* If a predecessor auditor exists, request the prospective client to authorize the predecessor to respond to your inquiries and then make appropriate inquiries of the predecessor. As indicated in SAS 7 (AU 315), the successor should make specific and reasonable inquiries of the predecessor regarding matters that will assist the successor in deciding whether to accept the engagement. Inquiries should be made specifically about matters that bear on the integrity of management; disagreements, if any, over accounting principles, auditing procedures, or similarly important matters; and the predecessor's understanding of the reasons for the change of auditors. Of course, an unreasonable refusal by the prospective client to authorize the predecessor to respond to the successor's inquiries ordinarily would cause the successor to decline acceptance of the engagement.

Pre-acceptance Evaluation

Independence and Technical Competence. Early in the pre-acceptance evaluation process, a CPA firm should evaluate whether any independence problems will be encountered if the prospective engagement is accepted, and whether the firm has the technical abilities to perform the work. If such problems cannot be resolved, the firm should decline acceptance of the engagement.

Assuming independence and requisite technical abilities, the pre- acceptance evaluation of a prospective audit engagement normally focuses on three factors: 1) personal integrity of the prospective client's management and principals, 2) presence of circumstances pointing towards unusual risks in the engagement or requiring special attention, and 3) other practice management considerations.

Integrity of Management and Principals. Personal integrity is an essential quality of the management and principals of a prospective audit client. A CPA firm can rarely perform enough work to compensate for the increased audit risk produced by clients whose management and principals lack integrity.

The assessment of personal integrity is based principally upon impressions formed by firm personnel and evaluation of information obtained from third parties. Frequently, partners and managers of your firm have previously formed impressions of the prospective client's managers and principals and these impressions can be solicited within a firm in a variety of ways. In addition, if a predecessor auditor exists, the successor may inquire of the predecessor whether all fees billed to the prospective client have been paid. Although full payment of such fees may reflect upon the integrity of the prospective client's management or principals, the fact that such fees have not been paid may affect your firm's assessment of the desirability of the prospective engagement.

Unusual Risks. Different CPA firms may evaluate the inherent risks in a prospective audit engagement differently. For example, one CPA firm may decline acceptance of a prospective engagement involving a public offering of securities, while another CPA firm with extensive experience in public offerings may actively seek such prospective clients. Here are some questions that may be useful in deciding whether unusual risks exist in a prospective audit engagement:

* Who will use the audited financial statements, and for what purposes will the statements be used? For example, will the statements be used with a material placement of debt or equity, with other transfers of interests, with litigation?

* Does the prospective client appear to be a viable going-concern? How adequate are measures of financial strength, profitability, and solvency? Is the entity in violation of important debt covenants?

* Has profitability or solvency deteriorated significantly in recent years? What is the trend of revenues? Does the entity operate in a depressed or high-risk industry?

* What appears to be management's attitude towards financial reporting? Is a significant portion of management's compensation tied to reported earnings? Are owner/managers excessively concerned about minimizing taxes, perhaps to the point of underreporting earnings?

* What appears to be management's attitude towards accounting and controls? Does the chief accounting official of the entity appear competent? Is his or her counsel valued by management and owners? What are management's attitudes concerning internal controls, including how controls apply to them?

* What is management's attitude towards external auditing? Do they view the external audit purely as a "necessary evil?" Are there considerable constraints on fees? If a predecessor auditor exists, is management evasive in discussing reasons for the change of auditors? Does the company have a history of changing auditors, or other business professionals?

* Will obvious accounting or auditing problems be encountered on the audit? Are there significant related-party transactions that will raise conflict-of-interests questions? Does the company engage in complex, nonrecurring transactions that pose form-over-substance questions?

* What general impression can be formed of the entity's management and principals? Do they appear to value ethical conduct and to act with a sense of responsibility to others? On the negative side, do they have a reputation for engaging in "sharp" or "hardball" business transactions, or in transactions that frequently lead to litigation? Are key executives and principals known to be experiencing personal financial difficulties?

Practice-management Considerations

Even if the prospective client's management and principals are of sterling repute and the business poses no unusual risks, practice- management considerations may still control the decision to accept a prospective engagement. Clearly, one very important consideration in accepting an engagement is whether satisfactory fees will be collected for the work performed. Another important consideration is how the engagement will affect future workloads and scheduling constraints.

Provided below are a few other practice-management questions a firm may consider in deciding whether to accept a prospective audit engagement:

* Is the client selecting the appropriate level of service, or might a compilation or review of financial statements better suit the client's needs?

* How likely is it that the engagement will lead to other services rendered to firm (for example, tax and advisory services), or to services rendered to the prospective client's management and principals? Is the engagement likely to lead to other engagements in the client's industry? Is the new client likely to provide referrals leading to additional engagements?

* Will fixed costs increase if the engagement is accepted, and have these incremental fixed costs been considered in assessing the desirability of the prospective engagement? For example, must new personnel be added? Will substantial costs be incurred in studying industry practices? Are there substantial "hidden" costs associated with accepting the engagement (for example, unreimbursed travel expenses, increased professional-liability insurance premiums, disrupted training and vacation schedules)?

You Are Known By The Company You Keep.

A major objective of many pre-acceptance procedures is to minimize the likelihood of association with a client whose management or principals lack integrity. Usually the simplest and most effective way a CPA firm can protect its professional reputation--and its practice--is to avoid questionable client associations in the first place.