Improving Your Audit Process, Part 3: More Effective Use of Engagement Lettersby
Both requirements in AU-C Section 210 of the Clarified Auditing Standard, Terms of Engagement, offer opportunities to improve the effectiveness and efficiency of audit engagements.
Preconditions for an audit include the use by management of an acceptable financial reporting framework in the preparation of the financial statements and the agreement of management and, when appropriate, those charged with governance, to the premise on which an audit is conducted.
This 10-part series of articles will focus on ways to improve the audit process, reduce audit costs, and enable CPA firms to make some money on audit engagements.
To clarify the aforementioned, in AU-C Section 210 of the Clarified Auditing Standard, Terms of Engagement, the auditor’s objective is to accept an audit engagement for a new or existing audit client only when the basis upon which it is to be performed has been agreed upon through:
- Establishing whether the preconditions for an audit are present.
- Confirming that a common understanding of the terms of the audit engagement exists between the auditor and management and, when appropriate, those charged with governance.
An Acceptable Framework
First, what is an acceptable financial reporting framework and which framework is most appropriate for the reporting entity? The starting place, of course, is US GAAP, the only authoritative framework. Many users of financial statements are accustomed to US GAAP and require its complex and time-consuming presentation and disclosures.
On the other hand, an increasing number of financial statement users desire a simpler presentation of financial position and results of operations, such as a special-purpose framework. Cash basis, income tax basis, and the AICPA’s Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs) are considered special-purpose frameworks. When users do not require US GAAP or prescribed format financial statements, a special-purpose framework may be appropriate. Making a change to a special-purpose framework early in a reporting period may save time preparing the financial statements, as well as simplifying the audit process.
Gaining Management’s Agreement
The premise upon which an audit is conducted requires obtaining the agreement of management that it acknowledges and understands its responsibility for:
- The preparation and fair presentation of the financial statements in accordance with the applicable financial reporting framework;
- The design, implementation, and maintenance of internal controls relevant to the preparation and fair presentation of financial statements that are free from material misstatement, whether due to fraud or error; and
- To provide the auditor with:
- Access to all information of which management is aware that is relevant to the preparation and fair presentation of the financial statements, such as records, documentation, and other matters;
- Additional information that the auditor may request from management for the purpose of the audit; and
- Unrestricted access to persons within the entity from whom the auditor determines it necessary to obtain audit evidence.
This agreement is the foundation of the engagement letter. Additional matters in the engagement letter include:
- The objective and scope of the audit of the financial statements.
- The responsibilities of the auditor.
- The responsibilities of management.
- A statement that, because of the inherent limitations of an audit, together with the inherent limitations of internal control, an unavoidable risk exists that some material misstatements may not be detected, even though the audit is properly planned and performed in accordance with GAAS.
- Identification of the applicable financial reporting framework for the preparation of the financial statements.
- Reference to the expected form and content of any reports to be issued by the auditor and a statement that circumstances may arise in which a report may differ from its expected form and content.
More Effective Use of Engagement Letters
Because an engagement letter forms a contract between the reporting entity and the auditor, and because both parties to the contract must understand its contents for it to be valid, the letter should be delivered by the engagement leader, normally a sole practitioner or partner. In addition to gaining management’s agreement to the matters above, other important planning considerations should be discussed and documented when the letter is delivered.
Following are some additional items that should be discussed to improve the audit process:
- Reach an understanding about the nature of the engagement, as well as client and CPA firm responsibilities.
- Discuss management’s responsibilities for selecting the most appropriate financial reporting framework, designing and maintaining internal control systems, and preparing financial statements and footnotes.
- Discuss current client issues, including any effects of economic climate.
- Request management to contact the predecessor auditor (if prior-period statements were audited) to obtain permission for review of the prior year audit documentation or discuss the necessary additional audit procedures applicable to opening balances.
- Make fraud inquiries.
- Arrange for proper workspace (Avoid stuffy closets and smoke-filled rooms!).
- Arrange for client assistance (Keep the audit fee down!).
- Finalize dates for interim and year-end fieldwork.
- Discuss target dates.
- Discuss range of audit fees and effects of variables (problems, no client assistance, etc.). Some CPA firm partners and sole practitioners also include and discuss specific dates and amounts of fee payments, as well as whether audit work will continue if such payments are not made!
- Document discussions in a planning document or separate memo.
- Discuss financial statements and footnotes. If possible, prepare a rough draft or block out financial statements and footnotes for discussion.
This is the bottom line: Delivery and discussion of the engagement letter with management of the reporting entity provides important information for planning the audit, preventing disagreements during the audit, and facilitating prompt payments of the audit fee. In short, it improves the audit process!