Engagement Letters Required
Under the matrix of Federal and state regulations applicable to the accounting profession, accountants are now confronted with making material adjustments in the ways they conduct their business. Non-attest services generate significant revenues for accountants, but they also raise significant potential professional risks. While Interpretation 101-3 under the AICPA Code of Professional Conduct, by its terms, applies only to the provision of non-attest services for attest clients, its substantive provisions will most likely be considered a "best practice" for all accountants who provide non-attest services for any client.
The performance of non-attest services for an SEC audit client of an accounting firm is strictly limited by Federal securities laws. Item 2-01(c) of Regulation S-X lists the non-attest services which, if performed for an issuer by the issuer’s audit firm, will impair the audit firm’s independence under the securities laws. Furthermore, any non-audit services must be preapproved by the public issuer’s audit committee, and must be documented by a written agreement between the issuer and the accountant.
This article will not focus specifically on permissible non-attest services for SEC audit clients under applicable Federal securities laws, but will, instead, focus on the broader applicability of Interpretation 101-3. Under the AICPA Code of Conduct and applicable state laws and regulations, the performance of non-attest services for any attest client has the potential to impair the independence of the auditor in its attest engagement. Compliance with Interpretation 101-3 creates at least a plausible defense, if not a safe harbor, against an attack on independence resulting from the performance of nonattest services.
General Requirements for Non-Attest Services
Accountants are required to comply with the most restrictive rules on independence to which they are subject. The general principle is that the auditor should not be performing management functions or making management decisions for the attest client. The accountant may, however, provide advice, research materials, and give recommendations to assist the client’s management in performing its functions and making management decisions.
Effective January 1, 2005, under the revised AICPA Interpretation 101-3, an accountant or accounting firm engaged to perform permitted non-attest services for an attest client must document such assignment with a written engagement letter. The Interpretation requires only that the engagement be documented in writing, and does not specify a form to be followed.
Client Responsibilities. In accepting an engagement to perform non-attest services, the accounting firm must assure itself that the potential client is aware of, and has accepted, its responsibilities. The accounting firm, in its capacity as consultant or appraiser or the like, may not perform the following functions for an attest client, and the client is required to undertake these functions:
- Determination of all management decisions
- Designation of a competent senior employee of the client to oversee the non-attest services
- Evaluation of the adequacy and results of the services performed
- Acceptance of responsibility for the results of the services
- Establishment and maintenance of internal controls, including monitoring ongoing activities
The accountant must be in a position to make a reasonably informed judgment that the client is capable of performing these functions. If the accountant does not believe that the client has a senior employee who is sufficiently competent to oversee the non-attest services being provided, the non-attest services could impair the accountant’s independence with respect to the audit function, where independence is required. The written engagement letter, required by Interpretation 101-3, assists the accountant in completing its due diligence that the client can, and is willing to, accept these responsibilities.
Documentation of Non-Attest Services. To the extent that an accounting firm or a separate practice unit is permitted by law to perform non-attest services for an attest client, AICPA Interpretation 101-3 requires that, effective January 1, 2005, the accounting firm must have a specific written engagement letter with the client for such non-attest services. While there is not one prescribed form of letter, Interpretation 101-3 does provide that an engagement letter for permissible non-attest services must contain the following elements:
- objectives of the engagement
- description of services to be performed
- designation of client responsibilities and client’s acceptance of such responsibilities
- accountant’s responsibilities
- limitations on the engagement
The failure to address at least these elements in an engagement letter for non-attest services for an attest client could lead to an impairment of the accounting firm’s independence with respect to its auditing function. The engagement letter requirement does not apply to routine technical questions in the normal course of a client relationship, non-attest services performed prior to January 1, 2005, and non-attest services performed prior to a client’s becoming an attest client.
An engagement letter is mandated for all non-attest services to be performed by an accountant for an attest client. Though this requirement does not expressly apply where a client is not also an attest client, it is certainly advisable to follow the material portions of this procedure for all clients. The written engagement letter will provide clarity and certainty in the client-accountant relationship, and will, in all cases, foster improved client relationships and efficiency in providing services.
The actual form of the engagement letter is not delineated by Interpretation 101-3. In addition to the formal letter, acceptable methods include: a memorandum to audit files copied to the client, and a memorandum of understanding in billing or correspondence, or as part of the report to the client. However, the formal engagement letter with a signed acknowledgment by the client will constitute the best evidence that the accountant has completed its due diligence, and that the client is prepared to accept its responsibilities with respect to the non-audit services.
Examples of Specific Language for Engagement Letters
Objective. The engagement letter should include, at the beginning, a brief statement of the overall objective of the non-attest services to be performed. This will place in context the more detailed descriptions of tasks to be undertaken by the accountant. The following are examples of such objectives:
We will assist you in developing a business plan.
We will advise you with respect to the startup of your [ ] business.
We will provide your company with bookkeeping and other business management services.
We will perform a valuation of your equity interest in [ ].
We are pleased to assist you in determining whether to lease or purchase your new [equipment].
While the possibilities are endless, the short initial statement of the objective of the engagement will frame the context of all of the services to be performed and the allocation of responsibilities between accountant and client.
Specific Description of Services. The specific description of the non-attest services should set forth what the accountant will do and what the accountant will not be doing in pursuit of the stated objective. The breadth and limitation are equally important elements of the description. The description should be sufficiently detailed to show the major components of the non-attest services, and should define the boundaries of the scope of the services.
There is no "right" or "wrong" description, and each situation is unique. The following are merely examples of descriptions of a range of non-attest services:
(1) We will assist you in developing, implementing and maintaining your financial plan to achieve your stated financial goals. We will collect and organize the facts of your current and desired financial status, and will discuss with you the results of our preliminary analysis. We will draft initial recommendations of steps to achieve your goals, and will include projections based on specific assumptions. We will finalize the plan, including its assumptions, after our discussion with you. We will not, as part of these services, be providing you with any specific investment advice or recommendations.
(2) We will conduct a review of your office lease to determine compliance by the landlord of the terms thereof. We shall perform the following procedures: (i) review the lease and all amendments to determine the basis for all rental charges; (ii) inspect the books and records of the landlord for expenditures that affect rental charges, (iii) compute the escalation charges, based on the foregoing information, (iv) review amounts you have paid to the landlord, and determine whether there is a deficiency owed to or refund due from the landlord. It is understood and agreed that our services will not constitute an audit in accordance with generally accepted auditing standards. Furthermore, we will not undertake to determine whether the landlord has adequate supporting documentation for journal or ledger entries. However, if suspicious circumstances come to our attention, we will notify you and extend our procedures as you may further instruct in writing.
(3) You have requested that we assist you in your negotiations with the [ ] bank for the purpose of modifying the financial covenants contained in your existing credit agreement. We will prepare a financial analysis of your compliance with existing financial covenants. We will prepare projections of your compliance, based on information furnished to us by management. Using such analyses, we will assist you in developing negotiating strategies to obtain amendments to the financial covenants that are realistic for the next [five] years. You understand that our services do not constitute a financial audit, and we are not undertaking to review any records provided to us by management.
(4) You have asked us to compare the costs and benefits of purchasing or leasing [equipment]. We will base our analysis on data and assumptions to be provided to us by management, and we will not undertake to verify the accuracy of such underlying data or the reasonableness of such assumptions.
(5) We look forward to assisting you in obtaining new financing. Initially, we will perform a study of your current financing sources and your projected financing needs. Based on that study, we will advise you on the types and sources of financing that is appropriate for your needs. We will also assist you in preparing presentations to the potential sources of financing and in evaluating the available alternatives. Our role is one of assisting, evaluating and advising, and we are not providing you with any assurance that any such financing will be available to you on terms you find acceptable.
Responsibilities of the Client. The engagement letter should be very precise in stating that the ultimate decision-making responsibility lies with the client. For attest clients, this element is necessary to preserve the accountant’s independence on the audit side; for nonattest clients, this is a clear allocation of the respective responsibilities of accountant and client so as to avoid subsequent misunderstandings and miscommunications. Again, there is no exact required formulation of this language, but here are a few examples:
(1) You will be responsible for making all management decisions and performing all management functions in connection with our performance of the services described in this letter. You will also provide us with the information necessary to enable us to perform our services in a timely fashion. Prior to, or simultaneously with, the commencement of our engagement, you agree to designate to us in writing, an employee from among your senior managers who is capable of overseeing our services and with whom we will have our primary contact. Such person should be able to evaluate the adequacy of the results of our services.
(2) You will have all responsibility for [financial planning] decisions. We will assist you in suggesting alternative approaches and in evaluating the likely success of such approaches. Investment recommendations should be made by a registered investment advisor whom you select and engage. We are not responsible for the success or failure of any specific investment recommendation by such advisor.
(3) The purpose of our engagement is to assist you in designing a [ ] system. Your management will be responsible for implementing the recommendations set forth in our study. It is important to recognize that this will be your system to be administered by Company personnel. Our role will be limited to providing advice and training, and we will have no responsibility for any costs, planned or unplanned, resulting from the operation of such system.
(4) This engagement is limited to the [ ] services described in this letter. We reserve the right to decline to take any action or perform any procedure which, in our sole professional judgment, could be interpreted as our participation in the management of the Company.
While the provisions of the revised Interpretation 101-3 expressly apply only to the provision of non-attest services for attest clients, the substance of such provisions should eventually be recognized as a "best practice" in all situations where non-attest services are being performed. A written agreement will allocate responsibilities between accountant and client, and will improve the efficiency of the overall client services.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.