Editor's Note: This article is a continuation of a series focusing on how to improve the quality of practice in your firm by complying with professional standards.

Generally accepted auditing standards are silent with respect to obtaining engagement letters. Therefore, on audits there are no requirements for their use. With respect to reviews and compilations, SSARS 1 states: "...the accountant should establish an understanding with the entity, preferably in writing, regarding the services to be performed."

So again, with respect to reviews and compilations, there is no requirement for the use of engagement letters, but their use is strongly encouraged.

Obtaining an engagement letter is a matter of good business practice. Generally, it affords the opportunity to detail the scope of the engagement and to define the responsibilities between the auditor or accountant and the client. The engagement letter provides the opportunity to limit and define the nature of the specific services to be rendered in unusual and out-of-the-ordinary engagements. The AICPA Liability Insurance Plan Committee strongly endorses the use of engagement letters by all practitioners as an effective means of reducing liability claims. Some malpractice insurance carriers offer reduced premiums for firms that, among other things, use engagement letters.

Engagement letters are not a panacea for all disputes and disagreements, and they do not immunize practitioners from litigation. Some additional benefits of obtaining engagement letters are as follows:

* It helps prevent any misunderstanding between the auditor or accountant and the client by describing, in writing, the mutual understanding of the terms and conditions of the engagement.

* It eliminates any staff misunderstanding by providing those assigned to the engagement with the specifics of the services to be rendered.

* It reduces any potential legal liability by defining the responsibilities of both the auditor or accountant and the client. The engagement letter is a contract for the performance of services by the auditor or accountant and the payment of those services by the client. The contract is between the two parties and generally does not extend to third parties. However, in 1988, the AICPA Task Force on Accountant's Legal Liability issued a paper entitled, "Using the Engagement Letter to Minimize Liability to Nonclients," that recommends adding clarifying language in engagement letters in order to reduce legal risk to third parties. The task force believes that in certain instances it may be beneficial to identify any third-party users in the engagement letter that the accountant knows will rely on a review or compilation report. It is advisable, though, that the accountant consult with legal counsel on whether and how to modify review and compilation engagement letters, before adding any clarifying language to the engagement letter.

When and How Often

Engagement letters should be used for all engagements. One engagement letter could cover several types of services to be rendered or a separate engagement letter can be used for each type of service to be rendered. The ideal situation is to have one or more engagement letters preparated that relate to each assignment to be performed for a client.

Generally, an engagement letter does not have to be obtained more often than annually. However, as a practical matter, in recurring service engagements, the auditor or accountant might consider drafting an engagement letter that extends beyond one year. Since the engagement letter is a contract, in those cases where it is intended to cover more than one fiscal period, it should contain a provision that either party have the right to terminate upon written notice to the other party. It is good practice, however, to institute procedures for periodic reissuance of engagement letters for continuing engagements, perhaps once every three years.

Regardless of the expected duration, the content of engagement letters should be reviewed on an annual basis to determine if there are any changes in the services to be rendered. In situations where services to change, a new engagement letter or a supplemental letter should be obtained.

Engagement Letter Contents and Considerations

When an auditor or accountant is engaged to provide interim audit, review, or compilation services, in addition to an annual audit, review, or compilation of financial statements, the engagement letter could include those interim services. In addition to financial statement services, other types of services can be combined into one letter. Those services could include the following:

* Write-up services;

* Tax services (tax review preparation, tax return review, tax examinations, proposed tax transactions or tax opinions); and

* Review of financial data in connection with the acqusition of a business.

Generally, when management advisory services, unique matters, and special engagement services, including those in connection with special reports, prospective financial statements, and personal financial statements are to be rendered, a separate engagement letter should be obtained.

Other matters often considered when drafting engagement letters are as follows:

* The letter should be addressed to the individual retaining the firm and approving the engagement; generally, the Board, its Chairperson, the Chief Executive Officer, or the individual(s) in management (owner or partner) retaining the firm.

* An expression of thanks for the opportunity to provide professional services for the client.

* Identification of the entity, its name, and fiscal year end. Reference should also be made to the financial statements to be audited, reviewed, or compiled.

* Description of the scope of services to be rendered, including any limitations that may be imposed by the client.

* Provision for limitations regarding the auditor's or accountant's responsibility for the discovery of fraud and other irregularities.

* Provision for the fee, whether stated as a range, in hourly rates, as a standard per diem charge, or as a flat fee. In addition, a retainer provision, if applicable, out-of-pocket costs, absorption of start-up costs when changing auditors or accountants, and the terms of billing and payment should be stated. A provision for progress billing should be included in order to accelerate the collection process, rather than waiting until the engagement is completed.

* If there is reason to believe the client may publish all or a portion of a report, a statement should be made in the engagement letter providing for the firm to review all printer's proofs of the report and any of the other accompanying material.

* Provision should be made if other auditors or accountants are doing part of the work.

* Provision should be made for any underwriters requirements in connection with public offerings.

Client Relations and Acceptance

Many auditors or accountants generally anticipate client resistance in signing that initial engagement letter, especially in small business engagements and in situations involving long-standing clients. Explaining the reasons for the engagement letter, especially with the client, could reduce such resistance. A brochure published by the AICPA entitled, "The Engagement Letter," is available and can be used to educate the client about the engagement letter.