Question

Write about Engagement letter and its importance? What is Engagement risk?

When an Auditor finds misstatements in entities financial statements which may be the result of fraudulent act, what should be the role of an auditor under that situation?

Answer 1

Engagement letter is a written agreement to carryout services in exchange for return. This is conventionally used by certain professional service firms, mostly in the fields of finance, accounting, law and consulting, to define the particulars of the business relationship.

The importance of engagement letter are as follows,

• The letter defines the scope of work to be performed and the particular responsibilities of the auditor and the client under the engagement.
• This helps in avoiding misunderstandings between the client and the auditor as regards to the scope of the work to be carried out and the respective responsibilities of both parties.
• The letter documents and confirms the auditor’s acceptance of the appointment
• It explains the forms of any reports to be issued under the engagement
• To educate the client on: -
  • Client’s duty to maintain proper books of accounts and to prepare financial statements that show a true and fair view.
  • Client’s duty to prevent errors and frauds.
  • Client’s duty to provide all the necessary information that the audit should not be relied upon to detect errors and frauds.
  • To explain the that the audit will be carried out on a test basis.
  • Basis of charging his fees.

• Lessen auditor’s liability to third parties.
• Obligate client to his obligations in an audit

Engagement risk is the potential risk faced by the auditor when performing the audit. This risk normally categorized as client’s business risk, audit risk and auditor’s business risk. The business risk is normally associated with organization’s survival and profitability.

In general, this risk arises from the risk of material misstatement, the risk to one's reputation from being related with a particular client, the failure of the client to pay the firm, or potential financial losses.

Role of the auditor under fraud situation

If the auditor finds a fraud they should communicate the matter on a timely basis to the proper level of management (i.e. those with the primary responsibility for prevention and detection of fraud). If the suspected fraud involves management the auditor shall communicate such matters to those charged with governance. If the auditor has doubts about the integrity of those charged with governance they should seek legal advice regarding an appropriate course of action.

In addition to these responsibilities the auditor must also consider whether they have a responsibility to report the occurrence of a suspicion to a party outside the entity. Whilst the auditor does have an ethical duty to maintain confidentiality, it is likely that any legal responsibility will take precedent. In these circumstances it is advisable to seek legal advice.