Audit Engagement Letters:

Once pre-engagement investigation complete and auditor decides to accept engagement, an engagement
letter is prepared.

The purpose of the letter is:

- to document and confirm auditor’s acceptance of appointment.
- ensure there is no misunderstanding between auditor and client about
- auditor’s and directors’ respective responsibilities,
- scope of audit engagement, and
- form of the reports the auditor is to provide @conclusion of audit.
It confirms the terms and conditions of the audit engagement + serves as a contract for the engagement
between client and auditor.

Although details of the engagement letters vary according to circumstances of audit, they usually inclu.
Statements referring to:

- objective of audit of financial statements;

- directors’ responsibility for preparing financial statements that give a true and fair view of entity’s financial
position and performance, and comply with applicable financial reporting framework and Companies Act
(CA) 2006;
- directors’ responsibility for establishing and maintaining internal control system – a system necessary for
the preparation of financial statements that are free from material misstatement, whether due to fraud or
error;
- directors’ responsibility for ensuring that all company’s records and documents requested in connection
with audit are made available to auditor and auditor will have unrestricted access to them;
- identification of applicable financial reporting framework;
- auditor’s responsibility to form and express an opinion on the financial statement and to report, in the
audit report, if statements do not comply in any material respects, with the applicable financial reporting
framework, unless auditor considers non-compliance is justified in the circumstances;
- other matters the auditor must consider and may need to refer to in the audit report – e.g. whether
adequate a/cing records have been kept by entity, whether info given in strategic and directors’ reports =
consistent with financial statement, and whether financial statements give detail of directors’ remuneration
required by the CA 2006.
- scope of audit and fact that it will be conducted in accordance with applicable legislation, regulations, ISAs
and ethical requirements;
- composition of audit team and arrangements regarding planning and performance of audit;
- involvement of other auditors/ experts in certain aspects of the audit, in appropriate cases;
- the fact that, because of inherent limitations of an audit, together with inherent limitations of internal
control, there is an unavoidable risk that some material misstatements in the financial statements may
remain undiscovered.
- attention to legislative provision under which it is an offence for any person to withhold info from, or to
provide misleading or false info to, the auditor in respect of any matter which is material to the audit.
- basis on which fees are to be billed;
- any restriction on the auditor’s liability that may apply.

In the case of a continuing audit engagement, auditor may decide that a new engagement letter is not
needed, However it may be appropriate to prepare a new engagement letter when there are:

- changes in reporting requirements;

- changes in the financial reporting framework adopted to prepare financial statements;
- changes in legal or regulatory requirements;
- significant changes in nature or size of entity’s business or significant changes in ownership;
- recent changes of senior management;
- revised special terms of the audit engagement or indication that entity misunderstands objective and
scope of audit.

Understanding the client, its business and its industry and how it evaluates its performance:

i) Importance of gaining an understanding of the client and its performance measures

Once audit agreement = formalised, next part of the audit process is to gain an understanding of the client
and the external and internal factors which affect it. As previously mentioned some understanding of the
client and its key personnel – necessary before auditor accepts or tenders for, the audit engagement.
However, in order to plan and perform an effective audit, it is essential that auditor possesses an in-depth
understanding of client org., structure and key personnel; its business, business operations and processes;
its operational, financial and compliance risks; its economic, commercial and competitive environment; the
industry it operates in; and the means by which it evaluates its financial and non-financial performance.
Such an understanding – necessary for auditor to identify and evaluate the client’s business risk and through
this, the risk of its financial statements being materially misstated. Therefore thorough understanding of
client = prerequisite in planning audit.

The link between client’s business risk and risk of its financial statement being materially misstated = most
business risks will eventually have financial consequences and therefore an effect on the financial
statements. Examples of business risk =
- development of new products or services that may fail;
- market which is inadequate to support a product/ service;
- flaws in a product/ service that may result in liabilities and reputational risk..

External factors which affect client:

- economy-wide factors e.g. general economic conditions, interest rates, inflation, availability of financing
and foreign currency exchange rates.
- general economic and competitive conditions of industry within which client operates, and industry’s
vulnerability to changing economic and political factors;
- gov. policies affecting entity’s industry/ business e.g. tax incentives, tariffs and trade restrictions.
- legal or other regulatory requirements which affect client and industry e.g. consumer protection and
employment laws and regulations.
- environmental requirements e.g. waste disposal and pollutants.
- technological changes, cyclical or seasonal activity, changes in consumer tastes and fads, price
competition.
- reporting obligations to external parties e.g. shareholders, debenture holders, regulators etc.

Internal factors which affect client:

- its ownership interests and relationships.
- relationship between client’s owners and directors.
- directors’ objectives, philosophy and general approach e.g. entrepreneurial or conservative.
- org. structure.
- effectiveness of its control environment and internal controls.
- its ethical tone or culture.
- its asset structure and capital investment activities
- any planned or recently executed acquisitions.
- its financial structure and solvency, and its debt structure and related terms.

ii) Key aspects of clients’ financial and non-financial performance measures

Auditor needs to understand how the entity measures its financial and non-financial performance. In
particular, understanding:

- the client’s key financial and non-financial performance indicators and ratios, trends and operating
statistics.
- how its financial and non-financial performance compares with that of its competitors and industry norms.
- client’s preparation and use of budgets and variance analyses.
- the means by which it selects and applies it’s a/cing policies.

A variety of risk assessment procedures are available to assist auditors in the task of understanding the
above matters (i.e. the external and internal environmental factors that affect auditees and elements of
their performance measures that are of importance to external auditor). They inclu:

- visiting client and touring premise.

- having discussions with key personnel inside (e.g. sales and production managers, audit committee
members, finance director…) and outside entity (e.g. legal and financial advisors and experts, industry
regulators…): enables auditor to understand the environment in which the entity’s financial statements are
prepared. Discussion with key client personnel enables auditor to gain insight into objectives, strategic plans
and general approaches/ attitudes of key execs within entity; determine views of key personnel about
entity’s financial position and performance during p Discussion with significant people outside the client
enables auditor to obtain understanding of some of the external factors affecting client.
- inspecting client’s documentation: provides knowledge about internal aspects of auditee and its
performance measures. Documentation inclu:
 Legal docs e.g. loan agreements
 Org. policies and procedures manuals and job descriptions.
 Its code of corporate conduct and compliance procedures.
 Internal audit reports.
 Marketing, sales and production strategies and plans.
 Internal financial management reports, budgets and variance reports, and chart of a/cs.
 Promotional material.

- reviewing industry and business data and publications: e.g. visiting relevant internet sights, reading reports
by analysts and rating agencies and also trade journals, magazines etc relating to client or industry +
provides understanding of general economic, political, commercial and competitive factors and processes
which are likely to affect client’s operational and financial well-being.
- reviewing media reports: on client, its directors and senior execs to enable understanding of the character
attributes of the client’s key personnel and gain insight into changes which have affected client.