Audits of Special Purpose Frameworks: Obtaining Substantive Evidence from Engagement Letters, Part 2
In my last article, I discussed the requirements of the Clarified Statement on Auditing Standards Terms of Engagement (AU-C Section 210). In this article, we're going to continue our focus on the practical aspects of engagement letters, particularly the opportunities an auditor has to obtain substantive evidence from the delivery and discussion of the letter. It all starts with Quality Control.
Thoughts on Leadership Involvement
Before even getting to the letter, let's first reflect on Statement of Quality Control Standard No. 8 (QC Section No. 10). The purpose of a CPA firm's system of quality control is to enhance the quality of evidence gathered on an attest engagement (audits, reviews, and compilations) and to improve the efficiency of evidence gathering.
The first of the six elements of quality control is leadership involvement. Engagement leaders (such as a partner or sole proprietor) are, in effect, the pinnacle of quality control on attest engagements through their involvement throughout the planning, performance and review phases of an engagement.
A CPA firm must communicate quality control policies and procedures in writing to all CPA firm personnel. In addition, the engagement leader demonstrates compliance with the quality control standards by providing training for staff personnel, solving engagement problems as they arise, and providing higher levels of supervision necessary to mitigate risk at the financial statement level. Documentation of the leader's involvement in memos, working papers, engagement time records, and firm administrative files will evidence compliance with a firm's quality control policies and procedures.
Showing Commitment to Quality with the Letter
And that takes us to the letter. The engagement leader's involvement should begin with delivering and discussing the engagement letter with the management of a reporting entity. While this audit function has become a routine compliance function for some auditors, it remains an excellent opportunity to accomplish leadership quality control responsibilities, to carry out preliminary risk assessment procedures and to communicate auditor and client responsibilities on the audit. Issues and tasks that normally should be discussed with the top financial management person of an entity, and/or a representative from its board of governance, include the following:
- Review and discuss the terms of engagement in the letter.
- Discuss the entity's applicable reporting framework and, if it is a special purpose framework, its appropriateness and reasonableness for use by the entity.
- Make inquiries about potential risks of material misstatements due to error or fraud.
- Discuss ethical requirements when the auditor performs non-attest services (ET 101-3)
- Arrange for proper workspace to provide freedom from distractions, uncomfortable environmental conditions and avoidable interruptions.
- Arrange for maximum client assistance with working papers preparation, retrieving invoices and other data and drafting financial statement and footnotes.
- Discuss business and environmental circumstances affecting the entity's operations and financial information.
- Discuss any going concern issues and, if necessary, management's plans for overcoming threats to the continued existence of the entity.
- Finalize dates for interim and yearend fieldwork and other target dates, such as the planned date of release of financial statements.
- Discuss a range of audit fees and the effects of variables such as problems, no client assistance, etc.
- Discuss the client's need for additional services and if the audit firm can provide the services (without impairing independence), or if the services should be referred to another provider.
Substantive Evidence Obtained from Discussing the Engagement Letter
The Clarified Auditing Standards require an auditor to evaluate the appropriateness and reasonableness of an entity's applicable reporting framework; this ordinarily should be done when discussing the terms of the engagement. Discussing the appropriateness of the applicable reporting framework is the starting place for audit decision making.
When the framework is evaluated during the engagement letter discussion, the engagement leader can provide training and guidance regarding the applicable reporting framework for engagement personnel before the engagement begins, and build the audit strategy around the applicable framework.
By providing a clear understanding of the responsibilities of management personnel of a reporting entity, the engagement leader can pave the way for maximizing client assistance and facilitate the communication process between management and audit engagement personnel.
Most important, the engagement leader's audit and business experience is essential in evaluating potential risks of material misstatement that can impact the design of a cost-beneficial audit strategy. Significant potential risks discovered during this discussion can be investigated and evaluated during planning instead of later in the engagement when performing any additional procedures may be more costly.
The involvement of the engagement leader in this evaluation of potential risks enables early and efficient engagement with potential problems. For example, the engagement leader's knowledge of an entity's business and its current environment enables the leader to determine the most effective and efficient overall and specific audit responses for performance by audit engagement personnel.
Documentation of the Evidence
The issues discussed during the delivery of the engagement letter, and the determination of appropriate audit responses to any identified risks, should be documented in either a separate memorandum or in a planning document. Additional audit worksheets or schedules may be necessary to provide evidence of the performance of audit responses related to the issues and risks.
In addition to a supervision practice aid, an engagement leader may prepare a chronological memorandum that documents involvement throughout an audit engagement. The memorandum can provide specific evidence of compliance with the leadership-involvement component of the quality control standards. Dates of the engagement leader's participation on an engagement, starting with pre-engagement planning meetings and delivery of the engagement letter, can provide specific documentation of the leader's involvement throughout an engagement.
For more information about engagement letters, watch for my one-hour, free webcast entitled Obtaining Key Audit Correspondence on AccountingWeb.com later in 2014.