Engagement letters: agreeing the terms of an audit engagement

A new audit client, Greenfield Foods Limited, says: "Just audit us. We will tell you what to look at, and please leave the old receivable balances alone because we are in talks with a buyer." If the auditor begins on that basis, two things can go wrong.

The directors may later say they never agreed the auditor would look at everything, and the auditor may find that the audit cannot produce an opinion at all. The way to avoid both problems is to settle the basis of the audit in writing before work starts, in an engagement letter.

This topic covers the preconditions for an audit, when an auditor must refuse, what an engagement letter contains, how recurring audits and changes of terms are handled, and a model outline of a letter. It follows the topic on accepting an engagement and begins the ethics group.

Key terms in plain English

Syllabus check

This topic is in syllabus area A, process of audit and assurance (20% of marks). It covers:

• agreeing the terms of audit engagements (ISA 210)
• the elements of an engagement letter
• changes in the terms of an engagement

CAMA 2020 and the engagement terms

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria. The sections below apply to this topic.

The rules in more depth

The objective of ISA 210

ISA 210, Agreeing the Terms of Audit Engagements, says the auditor's objective is to accept or continue an audit only when the basis on which it will be done has been agreed. The auditor does this by establishing whether the preconditions for an audit are present and by confirming that the auditor and management have a common understanding of the terms.

The preconditions for an audit

The auditor must:

1. decide whether the financial reporting framework that management will use is acceptable, for example International Financial Reporting Standards (IFRS) or International Public Sector Accounting Standards (IPSAS); and
2. obtain management's agreement that it acknowledges and understands its responsibility, called the premise, for: (i) preparing the financial statements; (ii) the internal control needed to make sure the statements are not materially misstated; and (iii) giving the auditor all relevant and requested information and unrestricted access to all the people the auditor needs to speak to.

When the auditor must refuse

The auditor must refuse the engagement where:

• management imposes a limit on the scope of the audit so that the auditor would be unable to express an opinion on the financial statements;
• the financial reporting framework is unacceptable; or
• management does not agree to its responsibilities (the premise).

The one exception is where law or regulation requires the auditor to accept or continue. In the Greenfield example the request to leave the receivables alone is a scope limitation, so the auditor cannot accept on that basis.

The engagement letter

Once appointed, the audit firm submits an engagement letter to the board of directors of the client. It is the basis of the contract between the company and the auditor. It must include:

• the objective and scope of the audit;
• the responsibilities of the auditor;
• the responsibilities of management;
• identification of the underlying financial reporting framework; and
• a reference to the expected form and content of any reports to be issued.

The auditor may add other points when it seems appropriate:

• more detail on scope, such as the legislation, regulations, ISAs and ethical pronouncements that apply;
• a statement that, because of the inherent limits of an audit and of internal control, there is an unavoidable risk that some material misstatements will not be detected even though the audit was properly planned and done under the ISAs;
• arrangements for planning and performing the audit, including the make-up of the audit team;
• the expectation that management will give written representations;
• the basis of fees and billing;
• a request that management acknowledge the letter and agree its terms;
• arrangements for involving other auditors, experts or internal auditors; and
• any limit on the auditor's liability where the law allows one.

Why each extra point matters

Recurring audits

A letter given on the first appointment may say that it applies to all future annual audits until it is revised. ISA 210 still requires the auditor to consider each year whether the terms need to be revised and whether management needs to be reminded of them. Signs that revision or a reminder is needed include:

• any sign that the entity misunderstands the objective and scope of the audit;
• revised or special terms;
• a recent change of senior management;
• a significant change in ownership;
• a significant change in the nature or size of the business;
• a change in legal or regulatory requirements;
• a change in the financial reporting framework; and
• a change in other reporting requirements.

Accepting a change in the terms

The entity may ask for a change in the terms because circumstances have really changed, because it misunderstood what an audit is, or because the auditor cannot get sufficient appropriate evidence on a material item and the entity wants the engagement reduced to a review to avoid a qualified opinion or a disclaimer. The auditor must consider whether there is reasonable justification.

If the request is reasonable, revised terms are agreed and recorded. If the auditor cannot agree to the change, the auditor withdraws and considers whether there is a duty to report the circumstances to those charged with governance, the owners or the regulators. An auditor must not accept a change just to help management avoid a modified opinion.

How the letter links to the law

The letter restates, and does not replace, the company law duties. Section 401 of the Companies and Allied Matters Act 2020 (CAMA 2020) appoints the auditor, section 404 gives the report and its Fifth Schedule content. Section 407(3) gives the right of access to books, accounts and vouchers. Section 405 makes the company answerable for its financial reports. The letter records these so that management cannot later say it did not know them.

A model outline of an engagement letter

1. Addressee: the board of directors, with the company's name and year end.
2. Objective and scope: an audit of the financial statements under the ISAs, to give an opinion on whether they give a true and fair view in line with IFRS and CAMA 2020.
3. Auditor's responsibilities: to plan and carry out the audit under the ISAs and report under section 404.
4. Management's responsibilities: prepare the statements, maintain internal control, give access and information, and provide written representations.
5. Inherent limits: the unavoidable risk of undetected material misstatement.
6. Reports: the form of the auditor's report and any report to management.
7. Fees, timetable and staffing.
8. Acknowledgement: a signed copy returned by the directors.

Worked examples

1. That is a limit on scope, because receivables are material and cannot be confirmed any other way.
2. The auditor could not give an opinion on the financial statements.
3. Under ISA 210 the auditor must refuse, unless the law requires the audit.

1. The signed letter records that management accepted that responsibility.
2. That is why the letter asks management to acknowledge receipt and agree its terms.

1. There is a change of ownership, of senior management and of the framework.
2. Each is a factor that points to a revised letter, or at least a reminder of the terms.

1. The request arises from the lack of evidence on a material item, so it is not a good reason.
2. The auditor should refuse the change and consider the effect on the audit opinion and whether to report to those charged with governance.

How to score full marks

• Quote the two parts of the premise: framework and management's responsibilities.
• List the five required contents of the letter before the optional ones.
• For each extra point give the reason it helps, as in the table above.
• Apply the refusal rule to the facts in the question.

Common mistakes in the exam

• Saying the engagement letter is addressed to the shareholders: it goes to the board.
• Leaving out the management responsibilities.
• Treating the letter as a one-off: recurring audits need a yearly check.
• Agreeing to a change in terms because the client asks.

Quick revision

• Preconditions: acceptable framework; management accepts its responsibilities.
• Refuse on scope limits, unacceptable framework, or no premise.
• Five required contents; eight optional points.
• Recurring audits: revise or remind.
• Change of terms: only for reasonable cause.

Practice questions

Questions 1 to 10 are multiple choice. Questions 11 to 13 are written. Try each before opening the answer.

Model answers

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