Clarified Auditing Standard--Terms of Engagment--Part 1 (AU-C 210)

Objective of the auditor

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 and

·      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.

Definitions

·      Preconditions for an audit. 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.

·      Recurring audit. An audit engagement for an existing audit client for whom the auditor performed the preceding audit.

Requirements

·      Preconditions for an audit—covers whether the preconditions for an audit are present which include:

o       Determining whether the financial reporting framework to be applied in the preparation of the financial statements is acceptable

o       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:

ü      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;

ü      Additional information that the auditor may request from management for the purpose of the audit; and

ü      Unrestricted access to persons within the entity from whom the auditor determines it necessary to obtain audit evidence.

·      Management-imposed limitation on scope prior to audit engagement acceptance that would result in a disclaimer of opinion.  If this entity:

o       Imposes a scope limitation on the auditor such that the auditor believes the limitation will result in the auditor disclaiming an opinion on the financial statements as a whole, the auditor should not accept such a limited engagement as an audit engagement.

o       However if the entity is required by law or regulation to have an audit and it imposes such a scope limitation and a disclaimer of opinion is acceptable under the applicable law or to the regulator, the auditor is permitted, but not required, to accept the engagement.

·      Other factors affecting audit engagement acceptance

o       If the preconditions for an audit are not present, and the auditor is not required by law or regulation to accept the proposed audit engagement, the auditor should discuss the matter with management and decline to accept the proposed engagement.

o       If the auditor has determined that the financial reporting framework to be applied in the preparation of the financial statements is unacceptable or if the agreement referred to above has not been obtained the auditor should not accept the engagement.

·      Agreement on audit engagement terms

o       The auditor should agree upon the terms of the audit engagement with management or those charged with governance, as appropriate.

o       The terms of the audit engagement should be documented in an audit engagement letter or other suitable form of written agreement and should include the following:

§         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.

Practical Note

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 or partner. 

My next article will discuss other engagement letter issues, as well as some of the audit planning issues that should be discussed with management of a reporting entity when the engagement leader or partner delivers the engagement letter.

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