Definition
Engagement Letter (Letter of Engagement)
An engagement letter, also known as a letter of engagement, is a document used by auditors to define clearly the scope of the auditors’ responsibilities in an engagement. It provides written confirmation of the auditors’ acceptance of the appointment, the scope of the audit, the form of the report, and details of any non-audit services to be provided. Typically, the contents of the letter are discussed with the management of the business to be audited before sending it.
Examples
Example 1: Audit Engagement for a Small Business
An auditing firm is appointed by a small business to perform its annual financial audit. The auditing firm sends an engagement letter to the business owner outlining the scope of the audit, the timeframe for completion, the form of the audit report, and additional tax advisory services offered.
Example 2: Engagement Letter for Non-Profit Organization
A non-profit organization engages an auditor to perform a compliance audit on its financial statements. The engagement letter sent to the organization details the auditors’ responsibilities, the resources required from the organization, and any additional review services that might be necessary to ensure compliance with regulatory standards.
Frequently Asked Questions (FAQs)
What is included in an engagement letter?
Typically, an engagement letter will include:
- The objectives and scope of the audit.
- The auditors’ responsibilities.
- The client’s responsibilities.
- The audit report’s form.
- Details on any other services, such as tax or advisory services.
- Terms and conditions, including fees and payment terms.
Why is an engagement letter important?
An engagement letter is important as it provides a clear understanding between the auditors and the client about what is expected during the audit. It minimizes misunderstandings and sets clear guidelines for both parties.
When should an engagement letter be issued?
An engagement letter should be issued at the start of an audit engagement, after discussions about the audit’s scope and details have taken place with the client’s management.
Can an engagement letter be modified?
Yes, an engagement letter can be modified if both the auditor and the client agree to the changes in writing. This often occurs when there are significant changes in the scope or nature of the audit services required.
Are engagement letters legally binding?
Yes, engagement letters are considered legally binding contracts that outline the responsibilities and expectations of both parties involved in the audit engagement.
- Audit Engagement: The arrangement in which an auditor is hired to conduct an audit of an organization’s financial statements.
- Scope of Audit: The extent and boundary of the audit work, including the period covered and areas to be audited.
- Non-Audit Services: Additional services offered by auditors that are not directly related to the audit function, such as tax advisory or consultancy services.
Online References
Suggested Books for Further Studies
- Auditing & Assurance Services: A Systematic Approach by William F. Messier Jr., Steven M. Glover, and Douglas F. Prawitt
- Principles of Auditing and Other Assurance Services by Ray Whittington and Kurt Pany
- Audit and Assurance Essentials: For Professional Accountancy Exams by Katharine Bagshaw
Accounting Basics: “Engagement Letter” Fundamentals Quiz
### What is the primary purpose of an engagement letter?
- [ ] To outline the financial health of a company.
- [x] To define the scope of the auditors' responsibilities in an engagement.
- [ ] To serve as a marketing tool for the auditors.
- [ ] To act as a replacement for the audit report.
> **Explanation:** The primary purpose of an engagement letter is to define the scope of the auditors' responsibilities in an engagement, ensuring both parties have a clear understanding of what is expected.
### What should an engagement letter be issued?
- [ ] After the audit has been completed.
- [x] At the start of the audit engagement.
- [ ] When the auditors request payment.
- [ ] Only if there are legal complications.
> **Explanation:** An engagement letter should be issued at the start of the audit engagement, after discussions about the audit's scope and details with the client's management.
### Can an engagement letter be modified?
- [x] Yes, if both parties agree in writing.
- [ ] No, it is a fixed document.
- [ ] Only with the client's consent.
- [ ] Only when the auditors deem it necessary.
> **Explanation:** An engagement letter can be modified if both the auditor and the client agree to the changes in writing.
### What element is NOT typically included in an engagement letter?
- [ ] The scope of the audit.
- [ ] The client's responsibilities.
- [ ] The form of the audit report.
- [x] Detailed financial data of the company.
> **Explanation:** While the engagement letter includes the scope of the audit, client responsibilities, and form of the audit report, it does not include detailed financial data of the company.
### Why is clarity in an engagement letter important?
- [ ] It enhances the company's financial performance.
- [ ] It ensures timely payment of auditors' fees.
- [x] It minimizes misunderstandings and sets clear guidelines.
- [ ] It reduces the workload of auditors.
> **Explanation:** Clarity in an engagement letter is essential as it minimizes misunderstandings and sets clear guidelines for both parties regarding the audit engagement.
### Who must agree to the terms outlined in an engagement letter?
- [ ] Only the auditor.
- [ ] Only the client.
- [x] Both the auditor and the client.
- [ ] Neither party, as it is a customary practice.
> **Explanation:** Both the auditor and the client must agree to the terms outlined in an engagement letter to ensure mutual understanding and adherence to the audit's scope and responsibilities.
### What legal standing does an engagement letter hold?
- [ ] It has no legal standing; it is an informal agreement.
- [ ] It is optional and not enforceable.
- [x] It is a legally binding contract.
- [ ] It acts as a suggestion rather than a requirement.
> **Explanation:** An engagement letter is considered a legally binding contract that outlines the responsibilities and expectations of both parties involved in the audit engagement.
### What is NOT a reason to issue an engagement letter?
- [ ] To establish the auditors' appointment.
- [ ] To define the scope of the audit.
- [ ] To outline fees and payment terms.
- [x] To publicize the findings of the audit.
> **Explanation:** An engagement letter is not issued to publicize the findings of the audit; it is issued to establish the auditors' appointment, define the scope, and outline fees and payment terms.
### What aspect of the audit does the engagement letter primarily address?
- [ ] Market analysis.
- [ ] Client's financial strategies.
- [ ] Auditor's direct financial benefit.
- [x] Auditor's responsibilities and scope of work.
> **Explanation:** The engagement letter primarily addresses the auditor's responsibilities and scope of work, ensuring both parties understand the terms of the audit engagement.
### What service detail might also be included in an engagement letter?
- [ ] Monthly account statements.
- [ ] Financial investments.
- [ ] Marketing strategies.
- [x] Non-audit services provided by auditors.
> **Explanation:** An engagement letter may also include details about non-audit services provided by auditors, such as tax advisory or consultancy services.
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