A client services firm can benefit from obtaining an effective engagement letter to solidify audit arrangements. An engagement letter typically addresses the scope of the service and the compensation to be paid for the work.
Obtaining an engagement letter is not required by generally accepted auditing standards, but it makes good business sense. It helps eliminate misunderstandings and decreases the vulnerability of accountants to malpractice claims.
Scope of the Audit
The Audit Engagement Letter establishes the scope of the audit, the responsibilities of both the practitioner and the client, and the terms and conditions of the work to be performed. This helps to avoid a common problem known as scope creep, which is when an audit grows over time from what was originally stated in the engagement letter and ultimately leads to a number of problems on both sides.
An engagement letter can also clarify things such as the type of report that will be delivered. This can help to reduce misunderstandings between the client and users of the reports. For example, a proforma report can be attached to the engagement letter to clarify what the report will look like and provide a reference point for discussions with the client on what should be included in the final report.
In addition, an engagement letter can also set out commercial matters such as the fee for the work to be done and the period within which it will be completed. It can also state any additional services that may be available and their cost. It can also include a restriction that prevents the practitioner from accepting a position at the client within a certain timeframe after working on an audit of the client.
The engagement letter should be sent to the management of the client, which would normally be a board of directors for a corporation and the owners for a partnership entity. Where the engagement involves an audit of a group of companies, the letter should be addressed to the directors of the parent or holding company and to each subsidiary.
Responsibilities of the Auditor
An auditor’s primary responsibility is to present a fair and independent view of the financial statements examined by him. He is also expected to exercise his professional judgment and maintain a proper level of professional skepticism. He must assess the risk of material misstatement in the financial statements and design audit procedures accordingly. He must also comply with the relevant ethical standards, such as independence and quality control requirements.
In the case of an audit engagement, a letter is often a good way to establish a clear understanding of the scope and responsibilities involved in the engagement. This helps to reduce any potential liability for the practitioner and demonstrates that the client understands the nature of the services being provided. In fact, many malpractice insurance carriers now offer reduced premiums for practitioners who use engagement letters in their practice.
The letter should also clearly specify the terms and conditions under which the audit is to be conducted. For example, it should outline the deadlines for completion and release of the financial statements. It should also detail any specific assistance that is required from the client, such as obtaining records or retrieving documents. It may also include a description of any specialized procedures that will be used in the examination.
The letter should also indicate who is to receive a copy of the report. In the case of a corporate entity, the letter should be sent to the board of directors. In the case of a group of companies, the auditor should send a separate letter to each of the subsidiary companies being audited.
The engagement letter should clearly specify the auditor’s fees, the client’s responsibilities in providing access to information and records for the audit, and other commercial matters. The client should also sign the engagement letter to confirm that it accepts the terms.
An effective engagement letter reduces legal liability by defining the scope of the services to be performed and the responsibilities of both parties. In addition, it serves to limit the auditor or accountant’s liability to third parties. In fact, many malpractice insurance carriers offer reduced premiums for practitioners who obtain and use engagement letters.
A typical letter would include the identification of the entity being audited, its fiscal year end, and references to the financial statements to be audited or reviewed. It would also state the purpose of the audit, including the objective of providing an independent opinion on the financial statements. It is important that the engagement letter describe the responsibilities of both the auditor and the client in establishing and maintaining independence and objectivity.
The engagement letter should also specify whether the audit will be a full- or limited-scope audit and indicate when the final report is expected. The engagement letter should also provide a disclosure of the total number of hours planned to be spent on the audit, the percentage of those hours that are expected to be performed by professionals other than the principal auditor’s full-time permanent employees (including professional students), and the percentage of those hours that are likely to be spent on the evaluation of internal control.
When an auditor or accountant agrees to audit a client’s financial statements, the engagement letter spells out the nature of the relationship and the responsibilities of both parties. It usually includes a description of the services to be performed, fees, timetable, and ownership and access rights for files. It may also include indemnification provisions and dispute resolution procedures. While an engagement letter is not required by law, it helps to reduce legal liability by establishing a formal contract between the auditor and client and clarifying the parties’ responsibilities.
Generally, the scope of work defined in an engagement letter does not extend to third parties. However, an exception exists for review and compilation engagements. The AICPA Task Force on Accountant’s Legal Liability recommends that the use of specific indemnification, exculpation and damage limitation language should be carefully considered in these types of engagements. The drafting of this type of provision should be reviewed by competent legal counsel to ensure compliance with state law.
While many CPAs and their clients anticipate resistance to signing an engagement letter, a properly drafted document can help to establish the necessary professional relationship and reduce potential legal liability. Educating your clients on the purpose and significance of this document may help to ease their concerns. This might also encourage the client to take a proactive role in the audit process, which can improve the overall quality of the audit.