Why is there a need to have an engagement letter for an audit engagement?

An audit engagement letter or EL is a written agreement required by auditing standards that signifies the business relationship between two parties. These two parties are the auditor and the client. This letter must be signed before the start of all audit engagements.

In the letter, the parties will set out their expectations so that there will be no conflict or confusion between the parties when the engagement is carried out later.

And it should be signed once the client passes the auditor’s KYC process.

The letter will detail the time and scope of the engagement, the terms for their relationship, such as the responsibilities and the rights of each party based on the relevant accounting and auditing standards and the applicable laws and regulations. Sometimes, the costs of the engagement will also be included.

Both parties are required to sign the letter. Once it is signed, this letter becomes legally binding, although it is more straightforward and is not as formal as a contract. When needed, it can be used to defend the parties in a court of law.

The importance of an audit engagement letter

As we mentioned earlier, it allows both the auditor and the client to set their expectations out clearly. This will ensure that the client knows what end product they are getting when it will be completed and how much it will cost them.

As the scope, terms, and conditions will be clearly stated, this will allow the auditor to work within the scope without worrying about scope creep. An audit engagement letter will also protect the auditor by stating that there may be additional costs if the work required to be performed the expected budgeted hours due to unforeseen circumstances.

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If any disputes happen in the future, this audit engagement letter will be instrumental in managing the conflict. Hence it is vital to every audit engagement and should be in place before all audit engagements.

It is also vital that the letter be signed and updated every year for every recurring audit engagement. Any changes that happened during the year and all circumstances that the auditor learned from prior audits relevant to the engagement should be included to improve the legality of the engagement letter.

The content of the audit engagement letter

Now that we know the importance of the audit engagement letter, we learn about the content of the audit engagement letter so that we know how to prepare a good audit engagement letter. You can also refer to ISA 210 Agreeing with the Terms of Audit Engagements for more details.

The content required can be split into six main elements, as follows:

1) The objectives and scope of the audit engagement

Since the main purpose of an audit engagement letter is to set out the expectations of the two parties involved, i.e., the auditor and the client, it needs to have the objectives and the scope of the audit engagement.

Although the objectives will vary depending on the countries where the two parties are located, the scope will always mention which items the auditor will review during the engagement.

2) The management’s responsibilities

The audit engagement letter will set out the responsibilities of the management of the audit client. These responsibilities are important to the successful completion of the audit. It will also ensure that the audit can be carried out smoothly.

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Such responsibilities include the supply of a written representation letter and appropriate support and assistance to the auditor whenever requested by the auditor.

With the responsibilities clearly stated, the audit engagement letter can be referred to when disagreements arise between the two parties.

Management responsibilities on preparing the financial statements should also be included to ensure that they clearly know and aware of this matter.

3) The auditor’s responsibilities

Other than management’s responsibilities, the audit engagement letter will also include the responsibilities of the auditor. This is essential as it ensures that the client understands what the auditor is expected to perform during the audit engagement.

Similar to what we mentioned in point number 2, a clear statement of the auditor’s responsibilities will help clear the confusion if disagreements arise.

4) The relevant financial reporting framework

It is also important to set out the financial reporting framework used by the client during the preparation of the financial statements. This will set out the criteria that the auditor requires to review the financial statements.

It is only with the suitable criteria that an auditor will perform an effective and fruitful audit.

5) Type and scope of the report(s) to be issued by the auditor

At the end of every audit engagement, a report will be issued. Therefore, the audit engagement letter will also need to state the type and scope of the report.

6) Others

Every audit engagement letter must include the five elements above. In some circumstances, there are other elements to be included, they are:

• The limitations related to the audit engagement.
• The limitations to the auditor’s liability.
• How the fees will be calculated and the basis.
• The points of contact for both parties.
• Relevant regulations and applicable professional standards.
• A statement that the on-time completion of the audit depends largely on whether the management provides the draft financial statements within the agreed timeline.
• Deliverable from auditor to client should also include. For example, number of report to be issued.

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Summary

It is a written agreement between the auditor and the audit client. It defines the scope of an audit engagement, the rights and responsibilities of the two parties, and other relevant terms and conditions. Costs of the engagement will sometimes be included as part of the engagement letter.

Six main elements make up the content of an audit engagement letter. They are the objectives and scope of the engagement, the management’s responsibilities, the auditor’s responsibilities, the relevant financial reporting framework, the type of report(s) to be issued by the auditor, and other elements such as how the fees will be calculated, the limitations and so on.

Although it is not as formal as a contract, it is legally accepted as a legal supporting document in the court of law.

As with all accounting procedures, there are strict procedures to follow in an audit. This begins with an audit engagement letter, which clarifies expectations for a smoother audit process.

What is an audit engagement letter?

Accounting standards require that both the client and auditor must agree on terms and conditions. Therefore, before a company begins its auditing process, an audit engagement letter lays out the scope of the agreement. This includes general details such as the terms, costs, and processes of the audit, described in brief but accurate terms.

Although it contains many of the same elements as a written contract, an audit engagement letter is less formal. It's written in an easily understandable style without the legal jargon of a contract. However, it's still considered legally binding and can be used as evidence in a court of law.

Audit engagement letter purpose

The purpose of any engagement letter is to clearly state expectations from both sides at the start of any business relationship. It details important factors like the audit's timeline, its costs, and what processes will be involved so that there are no surprises.

The audit engagement letter's purpose is also to limit the company's services by defining the scope. An audit won't go beyond these predefined limits of scrutiny. For example, if the audit is meant to only look at compliance, it won't stray from this to inventory management.

Benefits of an engagement letter

So, why is it important to set and manage expectations? There are benefits of audit engagement letters on both sides. The client receives reassurance of what the audit will entail, how long it will take, and how much it will cost. If additional costs outside of the agreement are required later, they must be approved individually.

From the auditor's end, an engagement letter prevents scope creep. This means that boundaries are set on the work that is due to be performed. When additional services are required outside of this agreement, they must be added in the future with the corresponding cost estimates.

An audit engagement letter should normally include guidance for managing disputes. While all parties hope this won't be needed, it's useful to have mediation or arbitration clauses built in from the start.

Audit engagement letter examples: reasons to engage

There are many circumstances in which an engagement letter is needed. Some audit engagement letter examples include:

• Engagement letter for any new clients, before the first audit engagement is performed

• Letters for existing clients who may not have received an engagement letter in the past

• If an auditor of a parent company is auditing its subsidiaries, separate engagement letters are required for each branch

• When an assignment changes in scope or size, a new engagement letter must be issued

Elements of an audit engagement letter

Keeping these purposes and benefits in mind, an audit engagement letter should normally include the following elements.

• Auditor's Responsibilities: Any engagement letter should clearly state the auditor's professional duties, as well as the reporting responsibilities.

• Client's Responsibilities: It will also state what is expected from the client's end. For auditing purposes, this usually includes preparing financial statements, applying accounting policies, and instituting internal controls.

• Scope: This is one of the most critical elements of an audit engagement letter, as it helps prevent the common issue of scope creep. The scope will include information about what tests and procedures will be performed by the auditor. It should also outline the international auditing standards that the auditor will adhere to and which evaluations of controls will be used.

• Irregularities: It's common for irregularities to be detected during a standard audit process, but this isn't the auditor's primary goal. The engagement letter should make clear that fraud prevention is up to the client or management.

• Additional Services: Most of the services to be performed are included in the engagement letter's scope portion. If additional services are needed, these should be outlined as well.

• Costs: This section of the letter should include a breakdown of all fees for services and supplies, along with any necessary explanation of how costs are calculated.

• Confirmation: Finally, an audit engagement letter will finish by requesting confirmation, in writing, that the client has read all of these terms and conditions.

By incorporating all these elements, you can write more effective audit engagement letters that satisfy both parties.

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