Do We Understand Each Other?

Clear communication at the start averts trouble later.
BY KIM M. GIBSON, KURT PANY AND STEVEN H. SMITH

EXECUTIVE SUMMARY
  • THE AUDITING STANDARDS BOARD issued SAS no. 83 and SSAE no. 7 to provide CPAs with guidance on establishing an understanding with the client.
  • THE TWO NEW STATEMENTS ARE IN LINE with SQCS no. 2, which requires firms to have policies and procedures in place for obtaining an understanding.
  • CPAs MUST DOCUMENT THEIR UNDERSTANDING of an engagement in the working papers and include its objectives, the responsibilities of the auditor and of management and the engagement's limitations.
  • A VARIETY OF OTHER ITEMS MAY be included in an engagement letter, including how the engagement is to be conducted, fee and billing arrangements and the use of specialists or internal auditors.
Kim M. Gibson , CPA, is a technical manager in the American Institute of CPAs audit and attest division.
Kurt Pany , CPA, PhD, is a professor in the school of business at Arizona State University, Tempe, and a member of the auditing standards board and auditor communications task force.
Steven H. Smith is a doctoral student in the school of business at Arizona State University. Ms. Gibson is an employee of the American Institute of CPAs and her views, as expressed in this article, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.


In October 1997, the American Institute of CPAs auditing standards board issued Statement on Auditing Standards no. 83 and Statement on Standards for Attestation Engagements no. 7, both titled Establishing an Understanding With the Client . These standards provide guidance on the understanding a CPA should have with a client when performing auditing and other attestation services. This article explains why the American Institute of CPAs issued the standards and provides guidance on how to apply them.


Why Issue New Standards?
Statement on Quality Control Standards (SQCS) no. 2, System of Quality Control for a CPA Firm's Accounting and Auditing Practice , which became effective on January 1, 1997, requires firms to have policies and procedures for obtaining an understanding about the services to be performed. These policies and procedures are intended to minimize the risk of misunderstandings with the client regarding the nature, scope and limitations of engagements.

While most CPAs have always—at least implicitly—realized the need for such an understanding, SQCS no. 2's explicit requirement suggested to the ASB the need to provide related guidance for audit and attestation engagements. The board issued the new standards to provide that guidance and to help firms comply with the SQCS requirement.


What's Required?
Both statements require the CPA to establish an understanding with the client for each engagement and provide details on the nature of the understanding. Auditors must document that understanding in the working papers, preferably in writing. CPAs generally can meet these requirements with an engagement letter.

The understanding addresses four areas:

  • The objectives of the engagement.

  • The responsibilities of management.

  • The responsibilities of the practitioner.

  • The limitations of the engagement.

Rather than simply identify the areas that need to be addressed, in SAS no. 83 the board provides illustrations of matters that must be included. Exhibit 1 , presents the required elements of an understanding in an audit. Exhibit 2 , is a sample engagement letter, containing the elements and several other items frequently included in an understanding.


Using Professional Judgement In Attestation Engagements
While SSAE no. 7, like SAS no. 83, requires an understanding in the four areas, it does not provide a list of matters that must be included. The board concluded that the wide variety of attestation services made it impossible to develop such a list. Therefore, a CPA should use judgment on what matters to include. However, for any attestation service, the list included in SAS no. 83 (exhibit 1) may provide a valuable starting point.

Exhibit 1: Required Elements of an Understanding With the Client for a Financial Statement Audit

Objective of the Engagement

  • The objective of the audit is the expression of an opinion on the financial statements.

Management's Responsibility

  • Management is responsible for the entity's financial statements.
  • Management is responsible for establishing and maintaining effective internal control over financial reporting.
  • Management is responsible for identifying and ensuring that the entity complies with the laws and regulations applicable to its activities.
  • Management is responsible for making all financial records and related information available to the auditor.
  • Management will provide the auditor with a letter that confirms certain representations made during the audit.

Auditor's Responsibility

  • The auditor is responsible for conducting the audit in accordance with generally accepted auditing standards.
  • The auditor is responsible for ensuring that the audit committee or others with equivalent authority or responsibility are aware of any reportable conditions that come to his or her attention.

Limitations of the Engagement

  • GAAS requires that the auditor obtain reasonable, rather than absolute, assurance that the financial statements are free of material misstatement, whether caused by error or fraud. Accordingly, a material misstatement may remain undetected. Also, an audit is not designed to detect error or fraud that is immaterial to the financial statements.
  • If, for any reason, the auditor is unable to form or has not formed an opinion, he or she may decline to express an opinion or decline to issue a report as a result of the engagement.
  • An audit includes obtaining an understanding of internal control sufficient to plan the audit and to determine the nature, timing and extent of audit procedures performed. An audit is not designed to provide assurance on internal control or identify reportable conditions.



Additional Matters
In addition to the matters listed in exhibit 1, SAS no. 83 presents other items that may be included in the engagement letter:

  • Arrangements regarding the conduct of the engagement (for example, timing, client assistance regarding the preparation of schedules and availability of documents).

  • Arrangements concerning any involvement of specialists or internal auditors.

  • Arrangements involving a predecessor auditor.

  • Arrangements regarding fees and billing.

  • Any limitation of or other arrangements regarding the liability of the auditor or the client, such as indemnification to the auditor for liability arising from knowing misrepresentations by management to the auditor. (Regulators, including the Securities and Exchange Commission, may restrict or prohibit such liability limitation arrangements.)

  • Conditions under which access to the auditor's working papers may be granted to others.

  • Additional services relating to regulatory requirements.

  • Arrangements regarding other services to be provided in connection with the engagement.

Exhibit 3, contains sample wording that may be used in an engagement letter. However, the evolving nature of the law and differences in each state's laws make it advisable for CPAs to consult with legal counsel to develop acceptable wording in some areas.


Implementation Issues
The brevity of SAS no. 83 and SSAE no. 7 may lead to questions concerning how they should be implemented. Some guidance follows.

Alternatives to engagement letters. The auditing standards board realizes that in some circumstances these letters will not be used. For some engagements, a formal contract might include all details on the needed understanding. Alternatively, an oral discussion with the client may be summarized in a memo. Board members unanimously believe, however, that following up an oral discussion with an engagement letter is a much better approach than relying entirely on a discussion. The standards state a preference for written communication with the client.

Timing. The standards are silent on when the CPA must obtain the understanding. The first standard of fieldwork reads: "The work is to be adequately planned and assistants, if any, are to be properly supervised." Therefore, we anticipate that CPAs will obtain an understanding during the planning phase. Often CPAs will be able to obtain a signed engagement letter from a client before beginning audit fieldwork. However, occasions may arise in which a CPA obtains the understanding during the audit process. In those situations, the practitioner should consider that the later the understanding is obtained, the more likely the occurrence of misunderstandings.

Exhibit 2: Sample Engagement Letter

ABC Co.
123 Main Street
Anytown, USA 12345

Dear _________________________:

This will confirm our understanding of the arrangements for our audit of the financial statements of ABC Co. for the year ending December 31, 1999.

We will audit the company's financial statements of the year ending December 31, 1999, for the purpose of expressing an opinion on the fairness with which they present, in all material respects, the financial position, results of operations and cash flows in conformity with generally accepted accounting principles.

We will conduct our audit in accordance with generally accepted auditing standards. Those standards require that we obtain reasonable, rather than absolute, assurance that the financial statements are free of material misstatement, whether caused by error or fraud. Accordingly, a material misstatement may remain undetected. Also, an audit is not designed to detect error or fraud that is immaterial to the financial statements; therefore, the audit will not necessarily detect misstatements less than this materiality level that might exist due to error, fraudulent financial reporting or misappropriation of assets. If, for any reason, we are unable to complete the audit or are unable to form or have not formed an opinion, we may decline to express an opinion or decline to issue a report as a result of the engagement.

While an audit includes obtaining an understanding of internal control sufficient to plan the audit and to determine the nature, timing and extent of audit procedures to be performed, it is not designed to provide assurance on internal control or to identify reportable conditions. However, we are responsible for ensuring that the audit committee (or others with equivalent authority or responsibility) is aware of any reportable conditions that come to our attention.

The financial statements are the responsibility of the company's management. Management is also responsible for (1) establishing and maintaining effective internal control over financial reports, (2) identifying and ensuring the company complies with the laws and regulations applicable to its activities, (3) making all financial records and related information available to us and (4) providing to us at the conclusion of the engagement a representation letter that, among other things, will confirm management's responsibility for the preparation of the financial statements in conformity with generally accepted accounting principles, the availability of financial records and related data, the completeness and availability of all minutes of the board and committee meetings, and, to the best of its knowledge and belief, the absence of fraud involving management or those employees who have a significant role in the entity's internal control.

Assistance to be supplied by your personnel, including the preparation of schedules and analyses of accounts, is described on a separate attachment. Timely completion of this work will facilitate the completion of our audit.

As part of our engagement of the year ending December 31, 1999, we will also prepare the federal and state income tax returns for ABC Co.

Our fees will be billed as work progresses and are based on the amount of time required at various levels of responsibility, plus actual out-of-pocket expenses. Invoices are payable upon presentation. We will notify you immediately of any circumstances we encounter that could significantly affect our initial estimate of total fees of $___________________.

If this letter correctly expresses your understanding, please sign the enclosed copy and return it to us.

We appreciate the opportunity to serve you.

Sincerely,

______________________________
Partner's Signature

______________________________
Firm Name

Accepted and agreed to:

______________________________
Client Representative's Signature

Title ______________________________

Date ______________________________

Who is the client? While the requirement is to establish an understanding with the client, SAS no. 83 and SSAE no. 7 do not indicate the identity of the client for this purpose. Because the Code of Professional Conduct in AICPA Professional Standards defines the client in ET section 92.01, the board did not believe a redefinition was necessary. ET section 92.01 defines a client as "any person or entity, other than the member's employer, that engages a member or a member's firm to perform professional services or a person or entity with respect to which professional services are performed." The board anticipates that practitioners ordinarily will obtain an understanding with management, including the chief executive officer and the chief financial officer, on behalf of the company.

Changes during engagement. A CPA must use judgment when the understanding changes. For example, if the client requests significant additional services, the CPA may wish to use an additional engagement letter to provide assurance that an understanding has been obtained. If a practitioner does not use an engagement letter, at a minimum he or she should discuss the change with the client and document the understanding in the working papers.

Documentation. An understanding in the form of an engagement letter signed by the client ordinarily is adequate. If no engagement letter is used, the practitioner must use judgment on documentation. In certain government audits, a signed contract may serve as proper documentation. In other engagements, the working papers should document the information discussed, including the matters in exhibit 1.

No understanding. Both standards require that a CPA decline an engagement when he or she believes that an understanding with the client has not been obtained. However, the board believes this will be very rare. SAS no. 83 also says that if the auditor is unable to complete the audit or is unable to form or has not formed an opinion—for any reason—he or she may decline to express an opinion or decline to issue a report as a result of the engagement.

Codification and dates. SAS no. 83 amends AU sec. 310, "Relationship Between the Auditor's Appointment and Planning," of AICPA Professional Standards and renames that section "Appointment of the Independent Auditor." SSAE no. 7 amends SSAE no. 1, Attestation Standards , AT sec. 100, "Attestation Standards." Both standards are effective for engagements for periods ending on or after June 15, 1998.

Exhibit 3: Additional Topics Relating to an Understanding
Additional Topics   Sample Wording

Use of a specialist   Due to the complex and/or subjective nature of the subject matter of [ name area of complexity ], which is potentially material to the financial statements, during our audit we will require the special skill and knowledge of [ include name of specialist and area of expertise ].
Use of internal auditors   We will consider many factors in determining the nature, timing and extent of the auditing procedures to be performed. One is the existence of internal auditors in the organization who may be used during the audit. Because we ultimately have the responsibility to express an opinion on the financial statements, judgments about assessments of inherent and control risks, the materiality of misstatements, the sufficiency of tests performed, the evaluation of significant accounting estimates and other matters affecting our audit report will always be ours.
Predecessor auditor   Since this is the initial audit of the company, inquiry of the predecessor auditor and review of the prior-period working papers are necessary procedures because they may provide us with information that will assist in the planning of the engagement. You will agree to authorize the predecessor auditor to respond fully to our inquiries and grant us access to the working papers. If the predecessor auditor requests that authorization in writing, you will comply with that request.
Indemnification clause   The company will indemnify [ name of CPA firm ] and its partners, principals and employees and hold them harmless from any claims, liabilities, losses and costs arising in circumstances where there has been a knowing misrepresentation by a member of [ name of company ]'s management, regardless of whether such person was acting in the company's interest. Note: Regulators, including the Securities and Exchange Commission, may restrict or prohibit such liability limitation arrangements. Practitioners who wish to include this clause in an engagement letter should consult with their legal counsel before using this clause.
Jury waiver clause   In the unlikely event that differences concerning our services or fees should arise that are not resolved by mutual agreement, we both recognize that the matter probably will involve complex business or accounting issues that would be decided most equitably to us both by a judge hearing the evidence without a jury. Accordingly, you and we agree to waive any right to a trial by jury in any action, proceeding or counterclaim arising out of or relating to any of our services or fees for this engagement. Note: Practitioners who wish to include this clause in an engagement letter should consult with their legal counsel first.
Alternative dispute resolutions/binding arbitration   In the event either party claims a breach of any term of this engagement, the dispute first shall be submitted to voluntary mediation. If this is unsuccessful, then the dispute will be brought to binding arbitration conducted under the rules then prevailing of the American Arbitration Association in the city where this agreement is signed, and the judgment or award of the arbitration shall be binding and conclusive upon the parties and may be entered in any court having proper jurisdiction. Note: Certain professional indemnity liability insurers may prohibit the insured from agreeing to binding arbitration in these circumstances. Practitioners need to check their insurance policies, contact their insurance carriers or consult with legal counsel.
Access to working papers   The working papers for this engagement are the property of [ name of CPA firm ] and constitute confidential information. Except as discussed below, any requests for access to our working papers will be discussed with you before making them available to requesting parties.
  1. Our firm, as well as other accounting firms, participate in a peer review program covering our audit and accounting practices. This program requires that once every three years we subject our system of quality control to an examination by another accounting firm. As part of this process, the other firm will review a sample of our work. It is possible that the work we perform for you may be selected for review. If it is, the other firm is bound by professional standards to keep all information confidential.

  2. We may be requested to make certain working papers available to [ name of regulator ] pursuant to authority given to it by law or regulation. If requested, access to such working papers will be provided under the supervision of [name of CPA firm ] personnel. Furthermore, upon request, we may provide photocopies of selected working papers to [ name of regulator ]. The [ name of regulator ] may intend, or decide, to distribute the photocopies or information contained therein to others, including other government agencies.
Electronic filings   With regard to electronic filings, such as in connection with the SEC Electronic Data Gathering Analysis and Retrieval (EDGAR) system or the WorldWide Web area of the Internet, you understand that electronic sites are a means of distributing information and, therefore, we are not required to read the information contained in these sites or to consider the consistency of other information in the electronic site with the original document.
Year 2000   Because many computerized systems use only two digits to record the year in date fields (for example 1998 is recorded as 98), such systems may not be able to accurately process dates ending in the year 2000 and after. The effects of this problem will vary from system to system and may adversely affect an entity's operations as well as its ability to prepare financial statements. An audit of financial statements conducted in accordance with generally accepted auditing standards is not designed to detect whether a company's information systems are Year 2000 compliant. Further, we have no responsibility with regard to the company's efforts to make its information systems, or any other systems, such as those of the company's vendors, service providers or any other third parties, Year 2000-compliant or provide assurance on whether the company has addressed or will be able to address all of the affected systems on a timely basis. However, for the benefit of management, we may choose to communicate matters that come to our attention relating to the Year 2000 issue.
Other services to be provided   You have requested that we provide other services [ list other services ] in connection with the engagement. The terms of these other services will be provided in a separate engagement letter.

Or

The engagement includes only those services described in this engagement letter. Any additional time spent regarding judicial proceedings, government organizations or regulatory bodies will be billed to you separately.

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