In these videos, we walk through 5 AUD practice questions in each to teach about the terms covered in engagement letters. These questions are from AUD content area 1 on the AICPA CPA exam blueprints: Ethics, Professional Responsibilities, and General Principles.
The best way to use each video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Terms Covered in Engagement Letters
When auditors and clients agree to begin an audit, they typically document their understanding in an engagement letter. This letter lays out the foundation of the professional relationship, clarifies expectations, and reduces the risk of any misunderstandings. Below is a detailed overview of the key terms and elements you can usually find in an engagement letter:
Purpose and Scope of the Audit
One of the first points covered is the purpose and scope of the engagement. This section outlines what the auditor will examine—typically focusing on the client’s financial statements—along with the professional standards they will follow (for instance, Generally Accepted Auditing Standards). The scope clarifies the areas the auditor will focus on, the time frame for the audit, and the general procedures to be performed.
Management’s Responsibilities
The engagement letter clearly states what management is responsible for to ensure a smooth audit. Key duties often include:
- Preparing the financial statements in accordance with the applicable financial reporting framework.
- Maintaining effective internal controls to prevent and detect errors or fraud.
- Providing all necessary information and access to records and personnel requested by the auditor.
- Offering written representations at the conclusion of the audit, confirming that management has fulfilled its responsibilities.
This section underscores that the accuracy and completeness of the financial statements ultimately rest with management—not the auditor.
Auditor’s Responsibilities
The auditor’s role is also spelled out in detail, specifying that they will:
- Conduct the audit in accordance with professional standards designed to obtain reasonable assurance (but not absolute assurance) about whether the financial statements are free of material misstatement.
- Plan and perform audit procedures to assess the risk of material misstatement, whether caused by error or fraud.
- Communicate significant deficiencies or material weaknesses in internal controls discovered during the audit.
- Express an opinion on the financial statements based on the evidence obtained.
This part of the engagement letter often emphasizes that the audit is not designed to detect every instance of fraud or error, reinforcing the concept of reasonable (rather than absolute) assurance.
Inherent Limitations of an Audit
Engagement letters typically include a statement about the inherent limitations of an audit. Because the process involves professional judgment, sampling, and reliance on the information provided by management, there is a risk that not all material misstatements (including fraud) will be detected. This warning helps manage expectations and clarifies that auditors cannot guarantee perfection.
Communication with Management and Those Charged with Governance
A standard term in most engagement letters is the auditor’s commitment to communicate important matters to management or those charged with governance (e.g., the board of directors or audit committee). Such communications can include:
- The audit plan and timing—how the auditor intends to approach the engagement and when key procedures will occur.
- The involvement of specialized personnel if complex accounting issues or valuations require expert input.
- Any significant findings or deficiencies noted as the audit progresses.
Billing Arrangements and Fees
Since the engagement letter serves as a contract, it generally covers fee arrangements for the audit. Auditors might work on an hourly rate, a fixed fee, or a combination of both. The letter will also spell out when payment is due—sometimes in installments as work progresses, sometimes upon completion. This section helps avoid payment disputes later on.
Signatures and Acceptance
Finally, the letter typically requires signatures from both the client (usually a representative of management or those charged with governance) and the audit firm. This formal acceptance ensures that both parties understand the terms and agree to proceed under the stated conditions.
Conclusion
An engagement letter is crucial for setting the tone and expectations of the audit relationship. By detailing the purpose, scope, and responsibilities of both the auditor and management—and by clarifying limitations, communication protocols, and billing terms—it lays the groundwork for a professional, transparent, and well-run engagement.
