Accepting a Client with a Going Concern Shadow
You are the engagement partner considering acceptance of Fenwick Retail Ltd, a chain of 22 stores with £45m turnover. The company has a £12m term loan with a covenant test at 31 December: net debt/EBITDA must be below 3.5x. The draft management accounts show 3.9x, but the finance director says a planned sale-and-leaseback of two stores will complete in January and cure the breach retrospectively. The bank has not confirmed this in writing. The previous auditor resigned last year; the company will not say why beyond 'a disagreement about provisioning'. Fenwick's owner is also a 30% shareholder in a supplier that provides 25% of Fenwick's stock. The audit fee would be £95,000, and the firm has spare capacity.
1. Evaluate the acceptance decision using the client acceptance and continuance requirements, and identify the risks you would need to resolve before accepting.
Read the worked answer
Acceptance is a risk assessment, not a capacity decision.
Integrity and management
- The previous auditor resigned and the company will not explain why. Under the Code and ISA 220 (revised), you must communicate with the predecessor auditor and obtain the facts. A refusal to allow this is itself a red flag.
- 'A disagreement about provisioning' could mean the prior auditor was qualified or threatened to resign. You need to know which.
Going concern and covenants
- A 3.9x ratio against a 3.5x covenant is a breach or near-breach. The FD's 'retrospective cure' is not confirmed by the bank and may not be contractually valid. This is a significant risk and a potential going concern issue.
- Before accepting, you would want the loan agreement, the covenant calculation, and the bank's position in writing. If the bank has not agreed, the accounts may need a going concern disclosure or a modified report.
Related party
- The owner's 30% stake in a supplier providing 25% of stock creates a related party and potential transfer pricing/fair value issue. It also raises a self-interest/familiarity risk if the owner controls both sides.
Fee and capacity
- Spare capacity is irrelevant if the risks are unacceptable. £95,000 does not compensate for a client with unexplained predecessor departure, covenant pressure, and undisclosed related party dealings.
Recommendation: Do not accept until the predecessor communication is complete, the bank's position is confirmed, and the related party is understood. If any of these cannot be resolved, decline.
2. Assume you accept the client. What matters would you raise with those charged with governance at the planning stage?
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Raise them early and in writing, so there is no surprise at the reporting stage.
- Predecessor auditor: explain that you have communicated and what you were told; confirm the company's account of the resignation.
- Covenant and going concern: set out the covenant test, the FD's proposed cure, and the evidence you will need (loan agreement, bank confirmation, sale-and-leaseback completion). Explain that if the cure is not confirmed, the accounts may need disclosure and the report may be modified.
- Related party transactions: the owner's interest in the supplier, the terms of supply, and whether they are at arm's length and disclosed.
- Provisioning: the area the predecessor disagreed about. Ask management to explain the accounting and the judgements.
- Audit approach and timetable: significant risks, the involvement of specialists if needed, and the fee basis.
- Independence: confirm there are no relationships that impair independence, and document it.
Governance communication at planning is not a formality; it is how you avoid a late dispute about a qualified report.