An Audit Engagement Letter solidifies audit arrangements between an accounting firm and its clients. It also helps reduce the likelihood of misunderstandings between the auditor and the client.

Obtaining an engagement letter is considered good practice by many firms and can help reduce malpractice claims. Every effort should be made to obtain one with all new and recurring service engagements.

Objectives

The audit engagement letter provides the auditor or accountant with an opportunity to define the scope of his work and responsibilities with the client. It also allows the auditor to clarify his understanding of the client’s business, its financial statements and internal controls.

The engagement letter should include the general objectives of the audit, the auditor in charge, the projected time frame for completion and information the auditor may need to collect early in the process. Depending on the entity being audited, the letter should specify the audience, such as the board of directors for a corporation or the owner of a small partnership entity.

When an auditor accepts a new client, the law requires that he perform a preliminary investigation to evaluate the integrity of the company and its management. This includes assessing the client’s standing in the community, its financial stability and relationships with its previous CPA firm. Auditors must also consider the possibility of fraudulent financial reporting, a problem that is difficult to detect. In addition, the audit engagement letter should state that the auditor will investigate the effectiveness and efficiency of the client’s operations.

Scope of Work

An important element of any contract is the scope of work. Clearly defining the boundaries of what will be included in the service can help reduce misunderstandings between practitioner and client. It also can help mitigate a professional liability claim, which may arise from going outside the scope of the engagement, such as when an accountant provided advice that went beyond their level of expertise.

The scope section of the letter should include a description of what is to be audited, along with expected delivery dates. It should also clearly state that if additional services are needed, written client approval is required and fees will be charged.

The letter should also address who will review and approve the scope of work, including a hiring restriction if the client is a corporation. For small entities that don’t have a board of directors, the letter should be addressed to the chief executive officer or to partners if the entity is a partnership. It should also describe the objectives of the engagement. For example, for a financial statement audit, the objective would be to express an opinion on the company’s financial statements.

Fees

An engagement letter establishes audit arrangements with a client and sets forth the fees to be charged. The agreement helps to avoid misunderstandings and manage expectations between the parties. A client should be encouraged to sign the document to acknowledge that he or she agrees with its terms.

The letter should also include a description of any additional services that may be available, and the cost for such services. This will help to prevent unexpected costs in the future. In addition, the letter should cite any other expenses that may be required for the auditor, such as the use of software.

Many auditors or accountants anticipate resistance from a client when it comes to signing an engagement letter, particularly in situations involving small businesses and long-standing clients. Educating the client about why the practice creates an engagement letter could help to reduce this resistance. In addition, an engagement letter is important for establishing an initial legal basis for the professional relationship. This can be especially important if the engagement is expected to last more than one year.

Limitations of Liability

An engagement letter helps to mitigate legal liability by clearly defining the roles and responsibilities of both the auditor or accountant and the client. The contract also serves to reduce the potential for misinterpretation in case of disagreements. The document is usually addressed to the company’s board of directors in a corporation, or to the sole proprietorship owner in a small business entity.

The American Institute of Certified Public Accountants, the governing body for the profession, has created specific templates for audit engagement letters. These are often used as a guide by the designated audit firm for each client engagement, which is then tailored to that client’s circumstances.

While many of the terms in an engagement letter are considered standard and non-negotiable, it is always advisable to ask for more detailed information in any instance where a particular term may be a cause of concern or misunderstanding between parties. For example, if a high-net-worth client wants to strike a limitation of liability provision that has been in place for years, it may be worthwhile to evaluate whether the removal of this term increases the overall risk to an unacceptable level.

Indemnification

The audit engagement letter should define the responsibilities of the client and the auditor. This helps to avoid misunderstandings and reduce the exposure of the practitioner to liability claims.

The letter should describe the scope of work to be performed, the basis for determining fees and billing arrangements, and any other terms and conditions that are relevant to the relationship between the client and the auditor. The letter should also clarify the limitations of an audit, such as that it is not designed to detect all instances of fraud or error and cannot provide absolute assurance regarding the accuracy of a client’s financial statements.

The letter should identify the client’s management, preferably the board of directors or person with similar authority. A provision should be included that a draft of the form and wording of the final report will be provided to management for discussion and agreement prior to its production. This reduces the risk that a practitioner will provide advice relating to a matter outside of the scope of the engagement and may be liable to third parties for doing so.