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.
Accounting Glossary
accounting equation
The equation Assets = Liabilities + Equity, which demonstrates the two-sided nature of accounting and is useful for explaining the concept of double-entry accounting (or double-entry bookkeeping).
Accounting Glossary
accounting period
The time period for which financial information is being tracked in a business, such as monthly, quarterly, or annually.
Accounting Glossary
accounts receivable
An account that records the amounts that customers owe to a business.
Accounting Glossary
adjusting entry
A correction made to a bookkeeping account that adjusts for accounting errors or other necessary changes at the end of the accounting period.
Accounting Glossary
cash flows
Used to describe the source or sources of cash or how cash is used.
Accounting Glossary
Chart of Accounts
A list of all the accounts used by a business, including what types of transactions go into each account.
Accounting Glossary
debit
An accounting entry that increases an asset or expense account, and decreases a liability or income account.
Accounting Glossary
dividends
A portion of a company’s profits paid by share of common stock on a quarterly or annual basis.
Accounting Glossary
FASB
Financial Accounting Standards Board. FASB is the highest-ranking authority in the private (non-government) sector of the U.S. for making pronouncements on GAAP and for keeping accounting standards up-to-date.
Accounting Glossary
Federal Unemployment Tax
In the U.S., the fund that used to be known simply as Unemployment. Employers contribute to the fund, and states also collect taxes to fill their unemployment fund reserves. (The acronym FUTA means Federal Unemployment Tax Act.)
Accounting Glossary
fidelity bonds
A type of insurance — typically carried by employers for their employees — that helps guard against theft and reduce the risk of loss.
Accounting Glossary
FIFO
First-in, first-out. A method for costs of goods sold in which a business charges out product costs to cost of goods sold expense in the chronological order in which the goods were acquired.
Accounting Glossary
fungible
Describes a product that is interchangeable and virtually indistinguishable from another product.
Accounting Glossary
General Ledger
A summary of all of a business’s accounts and transactions.
Accounting Glossary
IASB
International Accounting Standards Board. The IASB (based in London) is the main authoritative accounting standards setter outside the U.S.
Accounting Glossary
Journals
The location in which bookkeepers keep records (in chronological order) of daily company transactions.
Accounting Glossary
LIFO
Last-in, first-out. A method for costs of goods sold that selects the last item you purchased first, and then works backward until you have the total cost for the total number of units sold during the period.
Accounting Glossary
LLP
Limited liability partnership. A legal structure that state laws offer to qualified professionals in which all the partners have limited liability.
Accounting Glossary
PC
Professional corporation. A legal structure that state laws offer to qualified professionals who otherwise would have to operate as an unlimited partnership liability.
Accounting Glossary
petty cash
A cash account that businesses keep on hand for unexpected expenses.
Accounting Glossary
revenue
Monies that are collected in the process of selling a company’s goods and services.
Accounting Glossary
salvage value
The amount that an asset is worth after it has been fully depreciated.
Accounting Glossary
statement of cash flows
A financial statement that summarizes a business’s cash inflows and outflows during an accounting period.
Accounting Glossary
transactions
Economic exchanges between a business or other entity and the parties with which the entity interacts and makes deals.
Accounting Glossary
worker’s compensation insurance
A type of insurance carried by employers that covers its employees in case they are injured on the job.
