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.
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.
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.
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.
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.