What is the letter of engagement?
The engagement letter is one of the most fundamental elements within an audit engagement. It is in fact, the first step which every audit must start from. In basic terms, this is the written document which both the client and the audit firm conform to, and it outlines the terms and conditions on which the audit is to be based. ISA 210, Agreeing the terms of audit engagements, is the main regulatory component which functions as a backbone to build a proper LOE.
It is structured in a way to illustrate the various topics which will be dealt with throughout the audit engagement, mainly the defining of the scope and objectives of the audit, specifying the responsibilities of both parties, establishing a proper and fixed timeline for when the audit is to commence and when it is to end, as well as denoting a variety of other components such as the terms of the deliverables, which might include invoices or any other documentation that is required.
Other than this, the LOE is mainly used as a stepping stone for fee arrangements and to liaise the ultimate responsibilities that are borne from both the parties in question. It is also beneficial to mention the limitation of scope set by the client for the audit before it commences as this will be a great strong point for auditors to decide whether to accept a client or not.
The following are the main topics found within the LOE:
| Responsibility of auditors | Responsibility of client | Fee arrangements |
| Timeframe and how it is affected | The regulations on deliverables | How working papers are designed |
| Limitations of scope imposed | Element of confidentiality | Rules on recurring audits |
Section I – Functions and pre-conditions of an LOE
As illustrated in ISA 210, article 3, one of the main objectives of the LOE is to establish “whether the preconditions for an audit are present”. These are imperative as they offer a roadmap in the preparation of the financial statements and the agreement of management, as well as those charged with governance, being the client, on which the audit engagement is conducted for. The standard discusses these main pre-conditions from Article A1 forward.
Article A1 mentions that assurance engagements may only be accepted when the auditor considers the relevant ethical requirements, mainly including independence and professional scepticism. The pre-conditions dealt with in ISA 210 are those which are within the control of a company, and which both the client and the auditor need to agree to.
On the other hand, article A3, mentions that if the auditor doesn’t have an acceptable financial reporting framework, the client would not have a proper basis for preparation of the FS and the auditor would not have suitable criteria to give reasonable assurance. The acceptability of the accounting framework might be determined mainly by:
– Considering the nature of the entity.
– The purpose of the FS.
– The nature of the FS.
– Whether law or regulation prescribes the applicable financial reporting framework.
Article A7 states that if any deficiencies directly attributable to the reporting financial framework were to arise after the engagement has been accepted, which might temper the audit to be dropped, the auditor may instead adopt a new financial reporting framework. If this were to take place, a new engagement letter is to be drawn up, reflecting the change in the framework.
Together with this, article A15 prescribes for a fair presentation framework in accordance with the preparation of the FS, the premise of offering a “true and fair view” of the FS in question must be denoted in the LOE.
Other than the matters discussed, article A20 illustrates that when having smaller entities, the preparation of the LOE is very much so relevant and imperative since by avoiding misunderstandings between the parties, indirectly, one can help in reducing the time it takes for the audit to conclude, among other concepts.
Section II – Limitations of LOEs
The Letter of engagement is very beneficial for auditors; however, it also has its many limitations relating to it.
Firstly, as ISA 210 mentions in article 7, there exists the limitation of scope. The section basically states that if the client in any way, shape, or form effects the auditor’s opinion, in the sense that the auditor will be restricted in how they express their opinion on the truthfulness and fairness of the financial statements, then the auditor has the right to either decline the terms instigated by the client, or decline the client entirely, ‘unless required by law to do so’.
Notwithstanding the fact that there also exists, as mentioned by ISA 210, the concept of the auditor accepting the audit engagement only if, through their own professional scepticism, they deem that the financial reporting framework used in the preparation of the financial statements is proper and up to date. If this is not the case, the auditor must decline the audit all together, unless law and regulation deem otherwise.
There is also the element of the recurring audit. This is basically where the auditor takes charge of the client’s audit for consecutive years and decides to write up one audit LOE rather than one for each year mentioned. The problem with this arises when a revision or a change in the terms is required, for example an increase in fee arrangements, as the whole document needs to be re-read, sent to the client, and be signed. Notwithstanding that both parties need to agree on the change/revision being implemented.
| Limitations of the LOE | What these effects |
| Limitation of Scope | It instigates that the auditor is restricted by the client regarding the audit. If it exists, the auditor has the right to decline the audit and work on their own merit, or else decline the client entirely. |
| Acceptable financial reporting framework | This is required within an audit for the financial statements to be built on a strong backbone. |
| Problems with recurring audits | This arises when one has a change, amendment, or revision of different parts of the LOE. It should be redrafted and re-signed by both parties, if both agree to the changes made. |
It is therefore imperative for both parties to understand all these limiting factors and try and go about them in a manner that tries to avoid the aforementioned limitations, whilst also benefiting the client and the auditor.
Section III – Benefits of the LOE
Other than the mentioned drawbacks and limitations, the LOE has a variety of different benefits for why both the auditor and the client should sign for.
The main and ultimate benefit for the parties to enter and agree to sign the LOE is to reduce the risk of having disputes. ISA 210 denotes and mentions the scope, objectives, and responsibilities of the engagement letter clearly, done to minimize the mentioned risk of misunderstandings all throughout, whilst also offering protection for both parties from unrealistic expectations.
Conjoint with this, there is also the concept of enhancing the overall audit quality. The pre-conditions mentioned in section I are those which must be met before the engagement starts. This mainly constitutes ensuring the client’s management completely comprehends the responsibilities that they have. Acknowledging and adhering to this will increase the overall viability and dependence of the audit.
The LOE could be used to enhance the cognitive element and improve communication between both parties in question. The document ensures that all formal documents are communicated too, promoting collaboration and fostering trust between the auditor and the client.
Both the auditor’s and client’s responsibilities are an imperative element described within the company’s LOE. It specifies both the auditor’s responsibilities, mainly being to conduct the audit in accordance to ISAs, obtaining reasonable assurance on the truthfulness and fairness of the financial statements, and whether the FS are free from any material misstatements, whilst also enlisting the client’s responsibilities, mainly being to prepare the FS, maintain adequate accounting records and proper internal controls, and provide the auditor with reasonable deliverables, including any documents requested.
To summarize, the LOE helps distinguish clear expectations, promote communication between both the parties in question, and protect all the interests of the parties, highlighting a key concept of a high-quality audit.
| Benefits of the LOE | What these effect |
| Reduce risks of disputes | By mentioning the scope and objectives, risk of misunderstanding is reduced. |
| Enhance the overall audit quality | It instructs the main responsibilities of the auditor, and when this is understood, a viable audit is to occur. |
| Improve overall communication | The document ensures that all documentation is communicated well, promoting collaborating and trust. |
| Offer protection to both the parties | By signing to the terms and conditions designated in the LOE, one ensures that they can trust the other party with confidentiality. |
| Specifies both parties’ responsibilities | By specifying both the parties’ responsibilities one would know what role they have when it comes to conducting the audit. |
Conclusion
In conclusion, the LOE is one of the most crucial documents for an auditing firm, that is required to be entered into and signed by both the client and the auditor themselves. It illustrates all the terms and conditions, among other elements such as the fee arrangement and any limitations of scope, which could be seen throughout the audit engagement.
Other than that, ISA 210 offers a roadmap, in the form of the pre-conditions, allowing for the LOE to act as a link between the two parties and committing the auditor the freedom they require to be able to give a proper assured opinion regarding the truthfulness and fairness of the financial statements.
