An important protection for auditors

A letter of representation is typically one of the final pieces of the puzzle to fall into place when completing an audit. However, reviews suggest deficiencies in the production process, possibly due to a lack of understanding of their purpose.

The key objectives of letters of representation are widely understood by audit firms. They allow management to confirm certain responsibilities relating to the preparation of the financial statements and the audit. They provide auditors with written confirmation of oral assertions received during the audit, and provide an opportunity for management to clarify its position on specific matters.

However, there is another purpose that firms may be less aware of. Although the letter cannot be a substitute for a robust audit performed with appropriate management challenge and professional judgement, the courts may consider letters of representation in determining if auditors were deliberately misled by management, or if auditors ignored red flags.

A letter of representation is not just a formality - a thoughtful and active approach to preparation can contribute to a defence in a negligence claim. Recent case law suggests that auditors need to be prepared to challenge management representations, which may be dishonest, or not justifiable. Auditors should not simply assume that representations are reasonable.

What can go wrong, and how to fix it

Timescale drift

It is unusual, but not unheard of, for a letter of representation to be completely missing from an audit file. A robust procedure for audit file assembly is important. Reviewers are likely to take a dim view if an audit team does not upload the letter of representation onto the file within the required timescale because it is sitting in someone’s inbox.

This also compromises the firm’s ability to defend a negligence claim. It is hard to show that auditors used the representations as audit evidence if they cannot demonstrate that they were reviewed before signing the audit report.

The date of the letter is also important. Paragraph 14 of ISA (UK) 580 states that “the date of the written representations shall be as near as practicable to, but not after, the date of the auditor's report on the financial statements.”

This requirement can be hard to comply with if the letter is signed in anticipation of a particular date of signing the audit report, only for the audit to take longer to finalise than expected.

Low levels of entity involvement

For a letter of representation to constitute an effective defence in negligence, the audited entity must be appropriately engaged with the process. To this end, the letter should be produced on the entity’s letterhead. ISA (UK) 580 only makes brief reference to this in Appendix 2 and some firms wrongly conclude that this is an unimportant consideration. It isn’t.

Reviews also sometimes reveal that the entity’s finance director has reviewed and signed off the letter of representation, but no other board member has had any involvement.

If a letter of representation is to be effective it is generally better for it to be approved by the board in its entirety. Rushed processes during audit completion for many firms mean that this does not happen.

Ambiguous wording

Reviews often reveal important omissions and ambiguous wording in letters of representation. The wording of specific representations is important.

Standard wording provided by methodology providers can be useful, but auditors should be willing to make appropriate adaptations. Crucially, they should ensure that standard templates are up to date.

There are resources available to help auditors with the wording of the letter of representation – ICAEW’s Technical Advisory Service helpsheet Letters of representation, for example – to help firms ensure that the wording in their letters of representation are sufficiently clear and precise.

Missing representations

Another issue commonly seen in negligence cases is auditors seeking to defend a claim by asserting that they used information provided orally by directors, but did not include it in the letter of representation. Auditors need to check that all representations they need to use as audit evidence are included in the letter.

However, the letter should never be relied upon as a substitute for, or a reason to forgo, necessary audit work; it serves only to supplement that work.

It is helpful to take a step back following the drafting of the letter of representation and ask whether it is fit for purpose. Were any significant matters raised during the audit that should also appear in the letter of representation? Conversely, are there matters in the letter of representation that do not have any relevance at all?

Reviewing a sample of letters of representation as part of the monitoring and remediation work a firm undertakes to comply with ISQM (UK) 1 can be a useful way to highlight points for improvement and will, in turn, help to ensure that a firm’s letters of representation afford it the best protection that they can.

Authors

Peter Herbert, Director, Insight Training

Karen Eckstein, Founder of Karen Eckstein Ltd, providers of risk management advice and training