What is an Engagement Letter?

An engagement letter is an agreement for a services firm to provide services to a client. The letter is essentially an abbreviated contract that defines the services to be performed and the amount of compensation to be paid. Engagement letters are commonly required by services firms engaged in tax, audit, finance, consulting, and legal advice.

Contents of an Audit Engagement Letter

The main items found in an audit engagement letter are as follows:

Addressee. The letter is typically addressed to the client's management or those charged with governance (e.g., board of directors).
Objective and scope of the audit. This is a clear explanation of the audit's purpose, usually to express an opinion on the client's financial statements.
Responsibilities of the auditor. This is a statement of the auditor's responsibilities, such as conducting the audit in accordance with applicable standards, and obtaining reasonable assurance that the financial statements are free from material misstatement.
Responsibilities of management. This is a statement of the responsibilities of the client’s management, including the preparation of financial statements in accordance with applicable accounting standards, maintaining effective internal controls, and providing access to all necessary information and documentation.
Audit limitations. An explanation that the audit is based on sampling and does not guarantee the detection of all material misstatements, whether due to fraud or error.
Reporting. The form and content of the audit report to be issued.
Fees and billing arrangements. This is the basis for determining the audit fee, payment terms, and any additional costs.
Use of the audit report. This is any limitations on the use or distribution of the audit report (e.g., intended for the client and its stakeholders).
Governing law. This is the jurisdiction and applicable legal framework for resolving disputes.
Acknowledgment and agreement. This is a request for the client to acknowledge and agree to the terms of the engagement by signing and returning a copy of the letter.

When is an Engagement Letter Legally Binding?

An engagement letter must be signed by authorized representatives of both parties before it is considered to be a legally binding arrangement. Since this letter is treated as a contract, it should address the obligations of both parties. These obligations include the exact services to be provided (including any due dates), performance criteria, the exact amount and timing of payments to be made by the client, any warranties of performance, and how either party can terminate the contract.

When to Use an Engagement Letter

An engagement letter can be used when one or both parties are not willing to enter into a more detailed contractual arrangement. An advantage of using it is to mitigate the risk incurred by both parties, since it clearly defines the responsibilities of both parties. In addition, it prevents the contractor from being subjected to scope creep, where the customer might demand more services than the contractor initially agreed to.