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.
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
Limitations of the Engagement
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.
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|
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.
Accepted and agreed to:
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.