Launching the Audit Process

Accepting the Client and the Engagement Letter 

Whenever the auditor is deciding whether to accept a client or not, the auditor wants to minimize the chance of associating with management lacking integrity. If management lacks integrity, the entire audit process is going to be very difficult. Management may lie to the auditors, and then based on that information, maybe the auditors issue an unmodified report when it should have been a qualified report. This is why management integrity is crucial to consider.

Once the auditors feel confident in management’s integrity, there are two preconditions to meet before accepting the audit. First, the auditor must assess whether the applicable financial reporting framework is acceptable. The applicable financial reporting framework is simply the accounting framework that the company uses (i.e., U.S. GAAP). Second, the auditors must receive a letter for management that recognizes its responsibilities (i.e., the engagement letter).

Management Responsibilities – Pre-Audit Phase 

What are the three key areas that management is responsible for in an audit?

First is the preparation and fair presentation of the financial statements (memorize that phrase!). Management is required to prepare the financial statements and fairly present them (i.e., make sure that they are truthful). Second, management is responsible for the design, implementation, and maintenance of internal control. Third, management is responsible for providing the auditor with access to information (including employees and documents).

Engagement Letter

The engagement letter is the most important document of the planning phase of the audit. The engagement letter is a document to agree to the terms of the engagement between the auditor and the company’s management (i.e., a contract for the audit). It outlines what the auditors expect of management, and what management expects from the auditors.

Engagement Letter – Required Elements 

First, the engagement letter shows the objective and scope of the audit (e.g., we will audit this year’s financial statements). Next, it shows the auditor’s responsibilities and management responsibilities. Next, it explains that the auditors provide giving reasonable assurance, not absolute assurance (i.e., the auditors might not detect a material misstatement).

Next, the engagement letter identifies the applicable financial reporting framework (e.g., U.S. GAAP). Lastly, the engagement letter says the reports that the client can expect to receive from the auditors (e.g., audited financial statements).

Engagement Letter – Optional Elements

What is optional to include in the engagement letter? First is the price of the audit. Next is the involvement of other auditors (e.g., component auditors). Next is the plan to communicate with the predecessor auditor. Lastly are any additional communications that the auditor will send to the client (e.g., control deficiencies letter).

Engagement Letter – Excluded Elements

What do the auditors specifically not mention in the engagement letter? First, the auditors do not mention materiality. Additionally, the auditors will not mention specific audit procedures that they’re going to perform. The main idea is that the auditors should not mention anything that would allow the client to manipulate the audit. For example, if the client knows that materiality is set at $100,000, the client might intentionally make mistakes below $100,000. Because of this risk, the auditors don’t want to give the client any kind of inside information about the audit.

Check out this example of an engagement letter…