An engagement letter is a good practice for all audits, reviews, compilations, and other accounting services. It allows you to detail the scope of the engagement and defines the responsibilities between the auditor or accountant and client. It can also help reduce liability claims from going beyond the scope of the engagement.
Scope of the Audit
The scope of an audit is the process by which an auditor determines the extent to which they will examine a client’s financial statements. This process involves assessing the risk of material misstatement and designing audit procedures accordingly. It also includes determining the nature of the audit (including the number and scope of procedures) and establishing lines of enquiry. Effective scoping is essential to an efficient and effective audit. This requires thorough planning, consideration of the characteristics of the underlying subject matter and the criteria, the nature and extent of evidence to be obtained, and a willingness to adapt the scope in light of changing circumstances or new risks.
Having a clear understanding of the scope and objectives of an audit helps to prevent misunderstandings between the auditor and the client and to manage expectations. It also assists the auditor in performing an efficient audit and preparing a high quality audit report.
An engagement letter should set out the audit scope and responsibilities of both parties. It should specify the audit objectives, including expressing an independent opinion on the fairness of the financial statements in accordance with the applicable financial reporting framework. It should also state the responsibilities of the client, such as providing access to information, records and personnel, and maintaining an effective system of internal control.
Responsibilities of the Auditor
An important component of an Audit Engagement Letter is a description of the auditor’s or accountant’s responsibilities in the audit. This includes identifying the type of service to be rendered and its objectives (e.g., expressing an opinion on financial statements). It also describes any non-audit services to be performed and how they will be performed. It also identifies the entity, its name and fiscal year end. It should also note any restrictions on access to facilities and accounting records, as well as the auditor’s and firm employees’ duties and responsibilities in relation to the audit.
The task force also recommends including a provision in the engagement letter that specifies whether the scope of work extends to third-party users, such as investors, lenders and creditors. This would be particularly appropriate in the case of review and compilation engagements that may be relied upon by users outside of the client’s organization.
In addition, an engagement letter typically identifies those who can contact the auditor or accountant for questions and comments during the audit. This helps to eliminate misunderstandings between the practitioner and clients, and reduces the vulnerability of the accountant or auditor to legal liability. Generally, a letter of engagement is addressed to the board of directors, chief executive officer or the owners of a corporation. It should also include a statement that the auditor or accountant has complied with all ethical requirements regarding independence and has communicated to those charged with governance all relationships and other matters that may reasonably be thought to bear on his or her independence.
Limitations of the Audit
An engagement letter helps limit the scope of the audit. It specifies the areas in which the auditor can express an opinion on the financial statements, and limits the extent of the work he can perform to those areas. This limits the potential for what is known as “scope creep,” in which the scope of an audit grows incrementally over time and can result in a much larger audit than originally planned.
The letter also specifies the type of report that will be delivered and who will receive it. This reduces the possibility of misunderstandings between practitioners and third parties who rely on review or compilation reports. It is recommended that a draft of the form and wording of the final report be included as an appendix to the engagement letter, although the practitioner should consult with legal counsel before including any language in the engagement letter intended to minimize liability to nonclients.
It may be helpful to include a clause describing the process for resolving disagreements between the client and the auditor. This might include mediation or binding arbitration, depending on the circumstances. In addition, the audit engagement letter should contain a termination clause that defines how and when the agreement can be terminated. It is also a good idea to identify the board of directors or the corporate officers responsible for approving the engagement letter, and to request confirmation from them that the terms of the letter are acceptable.
The audit engagement letter is a formal contract between the auditor or accountant and the client for the performance of services. It establishes a clear understanding of the nature and scope of services to be performed, defines responsibilities, and contains provisions for fees. It should be sent soon after the auditor’s appointment and in any event before the commencement of the first audit assignment. In a group audit, the letter should be addressed to the directors of the parent or holding company who are responsible for forwarding it to the boards of the subsidiary companies which the auditor is engaged to audit.
An engagement letter helps to reduce the vulnerability of practitioners to legal liability by clearly defining the responsibilities and limits of an audit engagement. In addition, obtaining an engagement letter helps to eliminate misunderstandings and manage expectations between the client and the auditor.
While there is no requirement in generally accepted auditing standards that an engagement letter be obtained, it makes good business sense to do so. In addition, engagement letters provide an opportunity to limit the nature of specific services to be rendered in unusual and out-of-the-ordinary audits. They also help to distinguish fees that are based on the level of risk of material misstatement from traditional audit fee residuals. In their paper, “Does Client Satisfaction Correlate with Audit Quality: Evidence from Auditor Fee Premiums,” James “Robbie” Moon, Jonathan Shipman, Quinn Swanquist and Robert Whited offer new evidence that distinguishing between these two components of an audit fee improves the ability to determine whether a higher fee is justified.