An Audit Engagement Letter is a document that establishes the terms of service between an auditor or accountant and their client. It helps to reduce legal liability by defining the responsibilities of both parties.
It also contains information such as scope of the audit, fees and other matters. In general, all audits and reviews should have an engagement letter.
Scope of the Audit
The scope of an audit is determined by the nature and extent of the work to be performed. This work can include examining specific transactions; testing controls and internal processes; and obtaining and reviewing documents. The scope of an audit can also vary depending on the size, complexity and industry of a client’s operations.
The auditor should describe the overall objectives of the engagement in an engagement letter and include a time frame for completing the work. This helps to avoid surprises for the client. In addition, the auditing practitioner will need to consider what he can reasonably accomplish in light of the resources available to him and his understanding of the underlying subject matter. He will need to establish the nature and extent of substantive procedures to be performed based on the risks of material misstatement in the financial statements and the level of management’s efforts to control risk.
The engagement letter should also include a statement that the practitioner will not accept an assurance engagement if he is not satisfied that the members of the team assigned to perform the engagement collectively have the necessary professional competences, having regard to the nature and characteristics of the subject matter, the client’s operations and its systems of control. This requirement is in accordance with the AICPA Code of Ethics.
Responsibilities of the Auditor
In addition to describing the scope of the audit, the engagement letter should also outline the auditor’s responsibilities. These include conducting the audit in accordance with the applicable standards, obtaining sufficient appropriate audit evidence, and maintaining professional skepticism and independence. The engagement letter should also specify the client’s responsibilities, such as providing access to information and records, establishing an effective system of internal control, and preparing financial statements in accordance with the applicable financial reporting framework.
The auditor’s goal is to obtain reasonable assurance that the financial statements are free of material misstatement, whether caused by fraud or error. A material misstatement is a significant understatement that, individually or in the aggregate, could reasonably be expected to influence economic decisions taken by users of the financial statements. The auditor’s responsibilities also include investigating any unusual items discovered during the course of an audit and reporting on them in his opinion.
In addition to defining the scope of the audit, the engagement letter can include other terms and conditions that are unique to a particular engagement. These might include a hiring restriction, a requirement that the auditor review printer’s proofs before the report is published, or provisions related to use of the audited financial statements by third parties. Many malpractice insurance carriers require engagement letters as a condition of coverage.
In addition to defining the scope of an audit, the engagement letter should also contain provisions for fees associated with the audit. This is particularly important for recurring service engagements, where an auditor or accountant must clearly outline what services are included with and beyond the yearly fee. This can help prevent misunderstandings between practitioners and clients, which could lead to legal disputes.
This is a common issue that has led to malpractice claims in the past, and it should be addressed by setting clear expectations at the beginning of an engagement. Additionally, the engagement letter should state whether a firm will charge extra for work outside the scope of an audit. This includes providing specialized advice on complex tax matters, such as VAT and capital gains tax. This is important, as if an accountant provides this kind of advice and it results in a liability claim, he or she may not be covered by their professional indemnity insurance.
According to a study by the Federal Reserve Board, fees paid to auditors increase with the quality of the audit. In addition, the researchers found that fees also decrease when a company changes auditors. The researchers suggest that these “fee premiums” are due to several factors, including auditor reputation, resources and competence. However, they can also be the result of unobservable risks and production costs.
While engagement letters are not required under generally accepted auditing standards, they make good business sense and may offer protection against liability claims. They provide a clear definition of responsibilities between practitioners and their clients, which eliminates misunderstandings and reduces the vulnerability of accountants to malpractice claims. Often, obtaining an engagement letter helps to establish a professional relationship with a new client.
An engagement letter should contain the following elements:
The scope of the audit, the form of the report and the details of any non-audit services to be provided. It is generally best to discuss the contents of the letter with management prior to its submission and in most cases before commencement of the first audit assignment.
For audit clients with multiple subsidiaries, a separate letter should be sent for each subsidiary. However, in situations where the subsidiaries have similar audit requirements, a single letter can be sent for all of the subsidiaries as long as the scope and fees are agreed upon prior to the start of the audit.
In the case of a review or compilation engagement, an engagement letter should also contain a description of the specific work to be performed and a provision limiting the use of the report by third parties. It is advisable to include a clause prohibiting the hiring of members of the current audit staff for any position at the company.