21.3 Pre-Engagement Activities, Client Acceptance & Audit Planning

Pre-Engagement Activities, Client Acceptance & Audit Planning

In public accounting practice in the Philippines, an external audit engagement does not commence with the execution of substantive field testing. Rather, professional standards require rigorous pre-engagement evaluation before an audit firm accepts a new client or retains an existing client. Governed by Philippine Standard on Auditing (PSA) 210 (Agreeing the Terms of Audit Engagements), PSA 300 (Planning an Audit of Financial Statements), PSA 220 (Quality Management for an Audit of Financial Statements), and the Philippine Code of Ethics for Professional Accountants, these initial stages establish the ethical, legal, and operational foundation of the audit.

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1. Nature and Objectives of Pre-Engagement Activities

Pre-engagement activities comprise procedures performed prior to entering into a binding contract with an audit client. The overarching objective is to minimize engagement risk—the risk that the audit firm will suffer financial loss, reputational damage, civil litigation, or administrative sanctions from the Professional Regulation Commission (PRC) and Board of Accountancy (BOA) as a result of its association with a particular client.

                             Pre-Engagement Decision Framework
                                              │
                     ┌────────────────────────┴────────────────────────┐
                     ▼                                                 ▼
        Client Acceptance (New Client)                  Client Continuance (Existing Client)
                     │                                                 │
       ┌─────────────┴─────────────┐                     ┌─────────────┴─────────────┐
       ▼                           ▼                     ▼                           ▼
Management Integrity      Ethical & Competence    Prior Disagreements /     Updated Independence
  & Background Checks         Assessments          Fee Payment Record        & Resource Checks

Primary Acceptance and Continuance Criteria

Before accepting a new client or deciding to continue an existing professional relationship, the auditor must establish that:

1. Management and Governance Exhibit Integrity: The firm must investigate the identity, reputation, and character of the entity's principal owners, key executive officers, and Those Charged with Governance (TCWG). An audit conducted for a dishonest management team exposes the auditor to insurmountable engagement and litigation risks.
2. The Engagement Team is Competent and Adequately Resourced: The audit firm must possess the industry experience, technical expertise, personnel capacity, and time necessary to execute the audit in accordance with PSAs and regulatory deadlines.
3. The Firm and Team Comply with Relevant Ethical Requirements: The firm must verify compliance with the fundamental principles of the Philippine Code of Ethics, specifically establishing that the firm and all engagement team members are independent in fact and appearance.
4. No Significant Scope Limitations Exist: Management must be willing to grant unrestricted access to records, personnel, and third parties necessary to obtain sufficient appropriate audit evidence.

Evaluating Management Integrity

Investigating management integrity involves both internal inquiries and external background research:

• Reviewing public databases, corporate filings with the Securities and Exchange Commission (SEC), news articles, and civil/criminal litigation records.
• Inquiring with local financial institutions, commercial bankers, legal counsel, and credit rating agencies regarding the entity's commercial reputation.
• Analyzing unusual ownership structures, complex off-balance-sheet entities, or opaque transactions with related parties.
• Assessing management's attitude toward internal control, compliance with statutory tax obligations under the National Internal Revenue Code (NIRC), and transparency in financial reporting.

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2. Competence, Capabilities, Resources, and Ethical Compliance

Audit Firm Competence and Resources

Pursuant to Philippine Standard on Quality Management 1 (PSQM 1) and PSA 220, the audit firm must evaluate whether it holds the operational capability to perform the engagement. Key considerations include:

• Industry Knowledge: Understanding the regulatory, accounting, and economic environment of the client's industry (e.g., specialized banking regulations from the Bangko Sentral ng Pilipinas [BSP], or Insurance Commission guidelines).
• Personnel Availability: Having seasoned audit partners, senior managers, and audit staff available during the entity's financial reporting crunch window (typically January through April for calendar-year entities in the Philippines).
• Specialist Expertise: Assessing the need for IT audit specialists, actuarial experts (for employee benefit valuations under PAS 19), or certified valuation analysts (for business combinations under PFRS 3 or complex financial instruments under PFRS 9).

Ethical Requirements and Independence Evaluation

The auditor must ensure strict adherence to the Philippine Code of Ethics for Professional Accountants, which outlines five fundamental principles:

1. Integrity: Straightforwardness and honesty in all professional and business relationships.
2. Objectivity: Not compromising professional or business judgment because of bias, conflict of interest, or undue influence.
3. Professional Competence and Due Care: Attaining and maintaining professional knowledge and skill, and acting diligently.
4. Confidentiality: Respecting the confidentiality of information acquired through professional relationships.
5. Professional Behavior: Complying with relevant laws and regulations and avoiding any conduct that discredits the accountancy profession.

                                  Independence Threats
                                           │
         ┌───────────────┬─────────────────┼────────────────┬───────────────┐
         ▼               ▼                 ▼                ▼               ▼
   Self-Interest    Self-Review        Advocacy        Familiarity    Intimidation
  (Financial stake, (Auditing own    (Promoting client (Long personal  (Threats of
   contingent fee)  non-audit work)    shares/claims)   association)   dismissal/fee cuts)

Independence comprises two essential elements:

• Independence of Mind (Independence in Fact): The state of mind that permits the expression of a conclusion without being affected by influences that compromise professional judgment.
• Independence in Appearance: The avoidance of facts and circumstances that are so significant that a reasonable and informed third party would be likely to conclude that an audit firm's integrity, objectivity, or professional skepticism has been compromised.

If threats to independence exist (e.g., unpaid audit fees from prior years creating a self-interest loan threat, or provision of bookkeeping services creating a self-review threat for a public interest entity), the auditor must apply safeguards to eliminate or reduce threats to an acceptable level. If adequate safeguards cannot be implemented, the engagement must be declined or terminated.

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3. Communication with the Predecessor Auditor

When an entity changes external auditors, a crucial pre-engagement step is communication between the prospective (incoming) auditor and the predecessor (outgoing) auditor. This requirement is codified in Section 320 of the Code of Ethics and emphasized across Philippine auditing practice.

                   Communication with Predecessor Auditor Workflow
                                         │
                  Incoming auditor requests WRITTEN permission
                           from the prospective client
                                         │
                     ┌───────────────────┴───────────────────┐
                     ▼                                       ▼
             Client Grants Consent                   Client Refuses Consent
                     │                                       │
         Incoming auditor initiates              Incoming auditor asks client why;
      inquiry to predecessor auditor             refusal is a major red flag;
                     │                           usually DECLINE engagement
     Predecessor responds (unless legal
     barriers exist; must notify if so)
                     │
         Evaluate response before
           accepting engagement

Procedural Rules for Predecessor Communication

1. Initiative Rests with the Incoming Auditor: The proposed incoming auditor is strictly responsible for initiating communication with the predecessor auditor. The predecessor does not volunteer information unsolicited.
2. Mandatory Client Permission: The prospective auditor must obtain prior written permission from the client before contacting the predecessor. Professional confidentiality prohibits both the client and the predecessor auditor from discussing client affairs without authorization.
3. Inquiries to be Made: The incoming auditor's inquiries focus on professional matters that assist in deciding whether to accept the engagement:
   • Information regarding the integrity of management and those charged with governance.
   • Disagreements with management regarding accounting principles, auditing procedures, or financial statement disclosures.
   • Communications to those charged with governance regarding fraud, illegal acts, or significant deficiencies in internal control.
   • Management's reasons for the change of auditors (e.g., opinion shopping vs genuine commercial decisions).
4. Predecessor's Duty to Respond: Upon receiving client permission, the predecessor auditor is ethically bound to respond promptly and candidly. If the predecessor is constrained by ongoing litigation with the client, the predecessor must explicitly state that their response is limited by legal counsel.
5. Client Refusal to Grant Permission: If the prospective client refuses to grant permission for the proposed auditor to communicate with the predecessor auditor, the incoming auditor must:
   • Inquire into the specific reasons for management's refusal.
   • Treat the refusal as a critical red flag indicating potential concealment or impaired integrity.
   • Ordinarily decline the engagement, unless exceptional statutory circumstances apply.

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4. PSA 210: Agreeing the Terms of Audit Engagements

Pursuant to PSA 210, the auditor shall agree upon the terms of the audit engagement with management or those charged with governance. Establishing an agreed understanding prevents misunderstandings regarding the nature, scope, and limitations of the audit.

Preconditions for an Audit

Before agreeing to the terms of the engagement, the auditor must determine whether the preconditions for an audit are present:

1. Acceptable Financial Reporting Framework: The auditor must determine whether the financial reporting framework to be applied in the preparation of the financial statements is acceptable (e.g., PFRS, PFRS for SMEs, or PFRS for Small Entities in the Philippines). Criteria include relevance, completeness, reliability, neutrality, and understandability.
2. Management Acknowledgement of Responsibilities: The auditor must obtain the written agreement of management and, where appropriate, TCWG, acknowledging and understanding their responsibilities:
   • For the preparation and fair presentation of the financial statements in accordance with the applicable financial reporting framework.
   • For such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error.
   • To provide the auditor with unrestricted access to:
     • All information of which management is aware that is relevant to the preparation of the financial statements (books, records, documentation).
     • Additional information that the auditor may request from management for the purpose of the audit.
     • Unrestricted access to persons within the entity from whom the auditor determines it necessary to obtain audit evidence.

Consequence of Missing Preconditions: If the preconditions for an audit are not present, the auditor shall discuss the matter with management. Unless required by law or regulation, the auditor shall not accept the proposed audit engagement.

The Audit Engagement Letter

The agreed terms of the audit engagement must be recorded in an Audit Engagement Letter or other suitable form of written agreement. The engagement letter constitutes a legally enforceable contract between the audit firm and the client.

                       Preconditions and Engagement Letter Flow
                                           │
                   Establish Preconditions for an Audit (PSA 210)
                   ├─ Acceptable Financial Reporting Framework (PFRS)
                   └─ Management Acknowledges Core Responsibilities
                                           │
                                ┌──────────┴──────────┐
                                ▼                     ▼
                            Present              Not Present
                                │                     │
                     Issue Audit Engagement      Discuss with management;
                     Letter (Contract Signed)    Decline engagement

Recurring Audits

On recurring audits, the auditor shall assess whether circumstances require the terms of the audit engagement to be revised and whether there is a need to remind the entity of the existing terms. While an auditor is not required to issue a new engagement letter every single year, a new engagement letter should be issued if any of the following factors occur:

• Any indication that the entity misunderstands the objective and scope of the audit.
• Any revised or special terms of the audit engagement.
• A recent change of senior management, board of directors, or ownership.
• A significant change in nature or size of the entity's business.
• A change in legal or regulatory requirements.
• A change in the financial reporting framework adopted in the preparation of the financial statements.
• A change in other reporting requirements.

Requests to Change the Terms of Engagement

Management may request the auditor to change the terms of the audit engagement, such as converting an audit into a lower-level assurance service (e.g., a review engagement under PSRE 2400) or a related non-assurance service (e.g., an agreed-upon procedures engagement under PSRS 4400 or compilation under PSRS 4410).

• Reasonable Justification Required: A request resulting from a change in circumstances affecting the entity's requirements (e.g., bank no longer requires a full audit, only a review) or a misunderstanding concerning the nature of an audit may be considered reasonable.
• Scope Limitation Unacceptable: If the request arises because management refuses to permit access to essential records or records have been withheld to conceal discrepancies (a scope limitation), the request is not reasonable.
• Action if Change is Refused: If the auditor cannot agree to a change of terms and is not permitted by management to continue the original audit engagement, the auditor shall:
  1. Withdraw from the audit engagement where possible under applicable law or regulation.
  2. Determine whether there is any obligation, either contractual or otherwise, to report the circumstances to other parties, such as those charged with governance, owners, or regulators (e.g., SEC or PRC).

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5. Audit Planning under PSA 300

Planning an audit is not a discrete, static phase; it is a continual and iterative process that often begins shortly after (or in connection with) the completion of the previous audit and continues until the completion of the current engagement. Adequate planning benefits the audit by:

• Helping the auditor devote appropriate attention to important areas of the audit.
• Helping the auditor identify and resolve potential problems on a timely basis.
• Assisting in properly organizing and managing the audit engagement so that it is performed in an effective and efficient manner.
• Assisting in the selection of engagement team members with appropriate levels of capabilities and competence.
• Facilitating the direction, supervision, and review of engagement team members.

                                Audit Planning Architecture
                                             │
                   ┌─────────────────────────┴─────────────────────────┐
                   ▼                                                   ▼
        Overall Audit Strategy                               Detailed Audit Plan
     (High-Level Strategic Roadmap)                     (Tactical Fieldwork Blueprint)
  ├─ Scope & Reporting Characteristics                ├─ Risk Assessment Procedures (PSA 315)
  ├─ Timing & Reporting Milestones                    ├─ Tests of Controls (PSA 330)
  ├─ Direction & Key Risk Areas                       ├─ Substantive Procedures (PSA 330)
  └─ Resource Allocation & Budget                     └─ Other Mandated Audit Procedures

Overall Audit Strategy vs Detailed Audit Plan

A classic distinction tested on the CPALE is the difference between the Overall Audit Strategy and the Detailed Audit Plan:

The Detailed Audit Plan: Nature, Timing, and Extent (NTE)

Pursuant to PSA 300, paragraph 9, the detailed audit plan shall include a description of:

1. The nature, timing, and extent of planned risk assessment procedures, as determined under PSA 315 (Revised 2019).
2. The nature, timing, and extent of planned further audit procedures at the assertion level, as determined under PSA 330 (comprising tests of controls and substantive tests).
3. Other planned audit procedures that are required to be carried out for the engagement to comply with PSAs (e.g., sending legal letters to external counsel under PSA 501, or evaluating going concern under PSA 570).

Dynamic Planning: The auditor shall update and change the overall audit strategy and the audit plan as necessary during the course of the audit. For example, if unexpected misstatements are discovered during interim substantive testing, the preliminary risk assessment must be revised, requiring adjustments to the nature, timing, and extent of planned year-end audit procedures.

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6. Direction, Supervision, and Engagement Performance

Pursuant to PSA 220 (Revised) and PSQM 1, the engagement partner holds ultimate responsibility for the direction, supervision, and performance of the audit engagement in compliance with professional standards and applicable legal/regulatory requirements.

                              Engagement Supervision Hierarchy
                                             │
                                     Engagement Partner
                                (Overall Quality & Opinion)
                                             │
                                      Audit Manager
                              (Continuous Daily Supervision)
                                             │
                                    Audit Senior / In-Charge
                             (Field Execution & Working Paper Review)
                                             │
                                     Audit Staff / Assistants
                                  (Performing Detailed Procedures)

Direction, Supervision, and Review Responsibilities

1. Direction:
   • Informing engagement team members of their responsibilities, including maintaining professional skepticism, complying with ethical requirements, and executing assigned audit programs.
   • Communicating the objectives of the work to be performed, the nature of the entity's business, risk-related issues, and unexpected problems that may arise.
2. Supervision:
   • Tracking the progress of the audit engagement against the operational budget and timeline.
   • Considering the competence and capability of individual team members and ensuring they understand their instructions.
   • Addressing significant matters arising during the engagement, modifying the planned approach where necessary, and resolving technical differences of opinion.
3. Review of Audit Documentation:
   • Work performed by junior staff must be reviewed by more experienced engagement team members prior to the issuance of the auditor's report.
   • Reviewers ensure that:
     • The work has been performed in accordance with professional standards and applicable statutory requirements.
     • Significant matters have been raised for further consideration.
     • Appropriate consultations have taken place and resulting conclusions have been documented.
     • The nature, timing, and extent of work performed are consistent with the audit plan.
     • The evidence obtained is sufficient and appropriate to support the conclusions reached and the auditor's report to be expressed.

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7. Practical Case Illustration: Pre-Engagement & Planning

Case Scenario: Metro Manila Retail Corporation (MMRC), a privately owned department store chain in Luzon, approaches Sy & Partners, CPAs, in November 2026 to conduct its statutory financial statement audit for the year ending December 31, 2026. MMRC previously engaged Santos & Associates, CPAs, as its external auditor for five consecutive years. During the initial interview, MMRC's Chief Financial Officer informs Sy & Partners that they dismissed Santos & Associates due to an "irreconcilable commercial disagreement" over the capitalization of software development expenditures and slow audit turnaround times.

Step-by-Step Engagement Decision Analysis

  1. Obtain Client's Written Authorization
     └─ Sy & Partners requests MMRC's formal written consent to contact Santos & Associates.
  
  2. Inquire with Predecessor Auditor
     └─ Sy & Partners sends formal inquiry regarding management integrity, disputes, and fraud.
  
  3. Evaluate Predecessor's Feedback
     └─ Santos confirms: MMRC insisted on capitalizing PHP 45M of operating research expenses
        contrary to PAS 38; when Santos refused, management threatened non-payment of fees.
  
  4. Evaluate Ethical Threats & Capabilities
     └─ High engagement risk due to management integrity red flags and aggressive accounting stance.
  
  5. Engagement Acceptance Decision
     └─ DECLINE ENGAGEMENT: High risk of intentional material misstatement and management override.

If MMRC had refused to give written authorization for Sy & Partners to communicate with Santos & Associates, Sy & Partners would be ethically obligated to view that refusal as a critical limitation on inquiry, leading to an immediate decline of the proposal. Professional skepticism must never be compromised for client acquisition.