What Is an Engagement Letter?
An engagement letter is a written agreement that describes the business relationship to be entered into by a client and a company. The letter details the scope of the agreement, its terms, and costs. The purpose of an engagement letter is to set expectations on both sides of the agreement.
Key Takeaways
- An engagement letter defines a business relationship between two parties.
- A letter of engagement limits the responsibilities of the company, directly or by inference.
- A wide range of businesses including attorneys, auditors, accountants, and consultants use engagement letters routinely, whether their clients are individuals or large corporations.
How an Engagement Letter Works
A letter of engagement serves the same purpose as a contract between two parties. However, its format is less formal than a contract and it generally avoids legal jargon.
The letter is intended to briefly but accurately describe the services to be delivered, the terms and conditions, the deadline or deadlines, and the compensation. A letter of engagement is a legal document and binding in a business deal.
An engagement letter is less formal than a contract, but still a legally binding document that can be used in a court of law.
An engagement letter also serves to limit the scope of the company's services. For example, when an individual or business secures the services of an attorney, the letter might describe the specific purpose or area of expertise in which their services can be used.
A contractor who hires an attorney to draw up a land purchase cannot call the attorney for advice about his divorce. The engagement letter will not state that fact as baldly, but the meaning will be clear.
An engagement letter doesn't become legally binding until it is signed by all parties.
Advantages of an Engagement Letter
Setting expectations is important. The client gets the reassurance of knowing when a service will be completed, and how much it will cost. The letter also makes it clear if other costs are involved that are not covered in the agreement, such as required software that must be purchased separately by the client.
The business has set boundaries on the work that is expected to be performed. This is intended to prevent "scope creep," something that every tax accountant and attorney dreads. The letter may also cite services that lie outside the current agreement but may be added in the future as needed, with an estimate of the costs of these additions.
An engagement letter may include a clause regarding mediation or binding arbitration for the relationship. This clause provides guidance for managing any disputes arising between the parties.
Special Considerations
If the relationship is long-term, many companies require their engagement letter to be updated and signed again by the client annually.
This allows for any changes in the business relationship over time and strengthens the legal standing of the document. It also reminds the client of the scope of the agreement, perhaps forestalling "scope creep."
Who Prepares the Letter of Engagement?
The engagement letter is drafted by the company rendering the service, often with the help of a lawyer.
Is an Engagement Letter the Same as a Contract?
Engagement letters are less formal and generally shorter than a traditional contract. However, they also share some important traits, such as being legally binding and designed to reduce liability.
When Should an Engagement Letter Be Sent?
Engagement letters need to be presented to the client at the beginning of the relationship before work commences. They should also periodically be reissued, especially when the scope of services changes.
How Often Should Engagement Letters Be Updated?
To play it safe, companies generally require their engagement letter to be updated and signed on an annual basis. A new one should always be issued if the scope of services changes. However, even if the agreement remains the same, it can still be wise to redraft an engagement letter to increase the legal standing of the document.
The Bottom Line
Companies offering a service can face all sorts of problems if they don’t lay out their boundaries in a written, legally binding contract. Engagement letters essentially help protect firms from lawsuits while offering customers clarity over what services they can expect to receive and when. In short, they seek to avoid misunderstandings and basically function as a cheaper, simpler alternative to a regular contract.
An audit engagement letter or EL is a written agreement required by auditing standards that signifies the business relationship between two parties. These two parties are the auditor and the client. This letter must be signed before the start of all audit engagements. In the letter, the parties will set out
their expectations so that there will be no conflict or confusion between the parties when the engagement is carried out later. And it should be signed once the client passes the auditor’s KYC process. The letter will detail the time and scope of the engagement, the terms for their relationship, such as the responsibilities and the rights of each party based on the relevant accounting and auditing standards and the applicable laws and
regulations. Sometimes, the costs of the engagement will also be included. Both parties are required to sign the letter. Once it is signed, this letter becomes legally binding, although it is more straightforward and is not as formal as a contract. When needed, it can be used to defend the parties in a court of law. As we mentioned earlier, it allows both the auditor and the client to set their expectations out clearly. This will
ensure that the client knows what end product they are getting when it will be completed and how much it will cost them. As the scope, terms, and conditions will be clearly stated, this will allow the auditor to work within the scope without worrying about scope creep. An audit engagement letter will also protect the auditor by stating that there may be additional costs if the work required to be performed the expected budgeted hours due to unforeseen circumstances. If any disputes
happen in the future, this audit engagement letter will be instrumental in managing the conflict. Hence it is vital to every audit engagement and should be in place before all audit engagements. It is also vital that the letter be signed and updated every year for every recurring audit engagement. Any changes that happened during the year and all circumstances that the auditor learned from prior audits relevant to the engagement should be included to improve the legality of the engagement
letter. Now that we know the importance of the audit engagement letter, we learn about the content of the audit engagement letter so that we know how to prepare a good audit engagement letter. You can also refer to ISA 210 Agreeing with the Terms of Audit Engagements for more details. The content required can be split into six main elements, as follows: Since the main
purpose of an audit engagement letter is to set out the expectations of the two parties involved, i.e., the auditor and the client, it needs to have the objectives and the scope of the audit engagement. Although the objectives will vary depending on the countries where the two parties are located, the scope will always mention which items the auditor will review during the engagement.The importance of an audit engagement letter
The content of the audit engagement letter
1) The objectives and scope of the audit engagement
2) The management’s responsibilities
The audit engagement letter will set out the responsibilities of the management of the audit client. These responsibilities are important to the successful completion of the audit. It will also ensure that the audit can be carried out smoothly.
Such responsibilities include the supply of a written representation letter and appropriate support and assistance to the auditor whenever requested by the auditor.
With the responsibilities clearly stated, the audit engagement letter can be referred to when disagreements arise between the two parties.
Management responsibilities on preparing the financial statements should also be included to ensure that they clearly know and aware of this matter.
3) The auditor’s responsibilities
Other than management’s responsibilities, the audit engagement letter will also include the responsibilities of the auditor. This is essential as it ensures that the client understands what the auditor is expected to perform during the audit engagement.
Similar to what we mentioned in point number 2, a clear statement of the auditor’s responsibilities will help clear the confusion if disagreements arise.
4) The relevant financial reporting framework
It is also important to set out the financial reporting framework used by the client during the preparation of the financial statements. This will set out the criteria that the auditor requires to review the financial statements.
It is only with the suitable criteria that an auditor will perform an effective and fruitful audit.
5) Type and scope of the report(s) to be issued by the auditor
At the end of every audit engagement, a report will be issued. Therefore, the audit engagement letter will also need to state the type and scope of the report.
6) Others
Every audit engagement letter must include the five elements above. In some circumstances, there are other elements to be included, they are:
- The limitations related to the audit engagement.
- The limitations to the auditor’s liability.
- How the fees will be calculated and the basis.
- The points of contact for both parties.
- Relevant regulations and applicable professional standards.
- A statement that the on-time completion of the audit depends largely on whether the management provides the draft financial statements within the agreed timeline.
- Deliverable from auditor to client should also include. For example, number of report to be issued.
Summary
It is a written agreement between the auditor and the audit client. It defines the scope of an audit engagement, the rights and responsibilities of the two parties, and other relevant terms and conditions. Costs of the engagement will sometimes be included as part of the engagement letter.
Six main elements make up the content of an audit engagement letter. They are the objectives and scope of the engagement, the management’s responsibilities, the auditor’s responsibilities, the relevant financial reporting framework, the type of report(s) to be issued by the auditor, and other elements such as how the fees will be calculated, the limitations and so on.
Although it is not as formal as a contract, it is legally accepted as a legal supporting document in the court of law.