Client acceptance, planning and understanding the entity

An audit is won or lost in planning. A team that understands the client's business knows where misstatements are likely, spends its time there, and recognizes an unusual number when it sees one. A team that does not understand the business tests everything evenly, spends too much effort on low-risk balances and too little on the ones that matter. This lesson covers the first phase of the audit: deciding whether to accept the client, agreeing the terms of the engagement, developing an overall strategy, and building the understanding of the entity and its environment from which the auditor identifies the risks of material misstatement. It applies all of this to the planning of the Fairhaven audit for the year ending December 31, 2026.

Accepting or continuing a client

Before agreeing to audit, a firm must decide whether it should. Under the firm's quality management system, acceptance and continuance decisions consider three questions. Does management have integrity? Can the firm perform the engagement competently, with the time, people and expertise it needs? Can the firm and the team comply with independence and other ethical requirements? A client whose management lacks integrity is the single largest source of audit failure; no amount of testing reliably detects a well-designed fraud by people determined to deceive the auditor.

For a new client, the proposed auditor gathers information from public sources, background checks on key executives and, with the client's permission, communication with the previous auditor. The codes of conduct require the proposed auditor to ask the client for permission to contact the predecessor, and a refusal is a serious warning sign. The predecessor should respond promptly and say whether there were disagreements with management, concerns about integrity, communications about fraud or illegal acts, or problems with internal control.

For issuer and non-issuer audits, AS 2610 and AU-C 210 require the successor to attempt communication with the predecessor before accepting the engagement. AU-C 510 and AS 2610 deal with opening balances in an initial audit, including reviewing the predecessor's working papers.

Terms of the engagement

Once the firm accepts, it agrees the terms of the engagement in writing, normally in an engagement letter signed by management and acknowledged by those charged with governance. The letter states the objective and scope of the audit, the responsibilities of the auditor, the responsibilities of management, the financial reporting framework, and the expected form of the report.

A critical precondition is management's acknowledgment of its responsibilities: preparing the statements in accordance with the framework, designing and maintaining internal control, and giving the auditor access to all relevant information and people. Without that acknowledgment, the auditor cannot accept the engagement. The letter also typically covers fees, timetables, the use of the firm's specialists and any limitation of liability permitted by law.

AS 2015 requires the auditor of an issuer to establish an understanding with the audit committee in an engagement letter and to have the audit committee, not just management, appoint the auditor. AU-C 210 sets out the equivalent requirements for non-issuer audits.

Overall audit strategy and audit plan

Planning produces two documents. The overall audit strategy sets the scope, timing and direction of the audit: the reporting framework, the locations and components to be audited, key dates, materiality, preliminary risk areas, and the resources to be assigned. The audit plan is more detailed: it sets out the nature, timing and extent of the risk assessment procedures and the further audit procedures to be performed at the assertion level. Planning is not a one-time event; the strategy and plan are revised as the audit progresses and new information emerges.

Understanding the entity and its environment

AS 2110 requires the auditor of an issuer to obtain an understanding of the company and its environment, including relevant industry, regulatory and other external factors, the nature of the company, its objectives, strategies and related business risks, and its measurement and review of financial performance, along with internal control over financial reporting. For non-issuer audits, SAS 145, effective for periods ending on or after December 15, 2023, revised AU-C 315 to align it with the international standard and introduced a spectrum of inherent risk.

In practice, the understanding covers several areas. Industry, regulatory and other external factors include competition, seasonality, supplier and customer concentration, exchange rates and regulation. The nature of the entity includes its operations, ownership and governance, investments, financing and the accounting policies it uses. Objectives, strategies and business risks matter because a business risk, such as the risk that a rapid expansion strains systems, often becomes a risk of misstatement. Measurement and review of performance, such as management bonuses based on profit targets, can create pressure to misstate.

For Fairhaven, the team's understanding includes several facts that bear directly on risk. The business is seasonal, with about 40 percent of sales in the fourth quarter, so year-end cut-off matters. Wholesale customers have extended payment terms and rights to return unsold goods in some contracts. Inventory includes technical apparel with rapidly changing styles, so obsolescence is a judgment. Management bonuses depend on reaching 12 million in income before tax, a target the draft statements exceed by only 0.6 million. And the company replaced its warehouse management system in July 2026.

Risk assessment procedures

The auditor obtains the understanding through risk assessment procedures: inquiries of management and others within the entity, analytical procedures, and observation and inspection. Inquiries should go beyond the CFO to people such as warehouse managers, sales staff, in-house legal counsel and internal auditors, who often know about problems that never reach the finance department. Observation and inspection include touring the premises, reading board minutes and business plans, and walking through processes. The engagement team also holds a discussion, often called a brainstorming session, about where the statements are susceptible to material misstatement, including through fraud.

Preliminary analytical procedures

Analytical procedures evaluate financial information by studying plausible relationships among financial and non-financial data. In planning, they help the auditor identify unusual transactions, events, amounts, ratios and trends that may indicate risk. The program below computes common ratios from Fairhaven's draft statements and flags any that moved by more than 10 percent.

# Preliminary analytical procedures on Fairhaven's draft 2026 statements (thousands of dollars)
cy = {"revenue": 184_000, "cost_of_sales": 110_400, "opex": 58_600, "interest": 2_400,
      "receivables": 21_400, "inventory": 38_500, "payables": 17_800, "cash": 6_200,
      "current_liabilities": 31_600, "debt": 46_000, "equity": 64_400}
py = {"revenue": 168_000, "cost_of_sales": 102_500, "opex": 54_100, "interest": 2_200,
      "receivables": 16_100, "inventory": 31_200, "payables": 16_900, "cash": 9_800,
      "current_liabilities": 29_900, "debt": 42_000, "equity": 56_100}

def ratios(d):
    pretax = d["revenue"] - d["cost_of_sales"] - d["opex"] - d["interest"]
    current_assets = d["cash"] + d["receivables"] + d["inventory"]
    return {
        "Gross margin %": 100 * (d["revenue"] - d["cost_of_sales"]) / d["revenue"],
        "Pre-tax margin %": 100 * pretax / d["revenue"],
        "Days sales outstanding": 365 * d["receivables"] / d["revenue"],
        "Days inventory on hand": 365 * d["inventory"] / d["cost_of_sales"],
        "Days payables outstanding": 365 * d["payables"] / d["cost_of_sales"],
        "Current ratio": current_assets / d["current_liabilities"],
        "Debt to equity": d["debt"] / d["equity"],
        "Interest coverage": (pretax + d["interest"]) / d["interest"],
    }

a, b = ratios(cy), ratios(py)
print(f"{'Measure':<28}{'2026':>9}{'2025':>9}{'Change':>9}")
for k in a:
    ch = a[k] - b[k]
    flag = "  <- investigate" if abs(ch) / abs(b[k]) > 0.10 else ""
    print(f"{k:<28}{a[k]:>9.2f}{b[k]:>9.2f}{ch:>+9.2f}{flag}")

Measure                          2026     2025   Change
Gross margin %                  40.00    38.99    +1.01
Pre-tax margin %                 6.85     5.48    +1.37  <- investigate
Days sales outstanding          42.45    34.98    +7.47  <- investigate
Days inventory on hand         127.29   111.10   +16.18  <- investigate
Days payables outstanding       58.85    60.18    -1.33
Current ratio                    2.09     1.91    +0.18
Debt to equity                   0.71     0.75    -0.03
Interest coverage                6.25     5.18    +1.07  <- investigate

Several measures stand out. Days sales outstanding rose from about 35 to about 42 days, which could reflect slower collections, a change in customer mix toward wholesale, or revenue recorded before it was earned. Days inventory on hand rose from about 111 to about 127 days, which could mean slow-moving stock that needs writing down. Pre-tax margin improved sharply, and interest coverage improved with it, at the same time as the bonus target was just met. Taken together, these patterns point the auditor toward revenue recognition and cut-off, the valuation of receivables and the valuation of inventory, which lessons 9 and 10 test in detail.

Using the work of others

Planning also decides whose work the auditor will use. Auditors' experts, such as valuation specialists or actuaries, may be needed for complex estimates. Management's experts, such as an appraiser hired by the company, produce evidence the auditor must evaluate for competence, capability and objectivity. Internal auditors' work may be used to change the nature, timing or extent of the external auditor's procedures, within limits. Where the client outsources processes such as payroll to a service organization, the auditor may rely on a service auditor's report on controls at that organization.

For audits involving other auditors, AS 1206 and amendments to AS 2101, effective for fiscal years ending on or after December 15, 2024, strengthened the lead auditor's responsibilities for planning and supervising other auditors. For non-issuers, SAS 149, the revised AU-C 600, applies for periods ending on or after December 15, 2026 (as of October 2026). ACCT-431 covers group audits in more depth.