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Auditing Basics: How to Prepare an Engagement Letter

When taking a new client, an auditor creates an engagement letter to solidify audit arrangements between the audit firm and the client. The letter serves as the contract, detailing the duties and obligations on either side of the table. Your CPA firm prepares the engagement letter.

Although you aren’t required to have a written agreement with an audit client (per SAS No. 108), it is unwise to undertake an audit with only a verbal agreement.

Who you address the engagement letter to depends on the type of business entity. If you’re working with a corporation, address the letter to the board of directors. If your client is a small corporation that doesn’t have a board of directors, address the letter to the chief executive officer. If you’re auditing a sole proprietorship, address it to the owner. For a partnership entity, address it to the partners.

Here are the topics you should cover in an engagement letter:

  • The objectives of the engagement: For example, for a financial statement audit, the objective is to express an opinion on the financial statements.

  • Responsibilities of management: These can vary based on the terms and conditions of the engagement. For example, the financial statements and the proper application of generally accepted accounting principles are the responsibility of management.

  • Responsibilities of the auditor: These also vary. For a financial statement audit, one responsibility is that you conduct the audit in accordance with GAAS.

  • Limitations of the engagement: You should address the fact that the audit is meant to provide reasonable assurance regarding whether the financial statements are free of material misstatements. However, because you don’t examine all transactions, there’s a risk that material errors, fraud, or illegal acts exist and aren’t detected.

  • Hiring restriction: A general engagement letter condition is that the client won’t try to hire anyone on the current audit team. Usually there’s a required, one-year cooling-off period between working on a client audit and accepting a position with that company.

Other items you should clear up through the engagement letter are your fees and when you expect the company to pay them. If you plan on using specialists in the company’s field to assist you, include that fact as well. It’s wise to spell out the conditions under which you’ll terminate the engagement — for example, if the client’s books render you unable to express an opinion.

What not to include in the engagement letter? Don’t use jargon that only CPAs understand. Doing so will make your client uncomfortable and may cause the client to refuse to sign the letter. Also, don’t overstate what you can do. And certainly don’t include any promotional or marketing information.

The engagement letter is signed by your CPA firm — for example, “Smith and Jones.” It can also be signed by the firm’s contact person, such as “Joe Smith, Partner.” The engagement letter also has a place for the client to sign, acknowledging that it accepts the letter’s terms.

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