September 2000

Managing Risk with Engagement Letters

By Ric Rosario, CPA, CFE

The engagement letter is the primary tool in CPA risk management. Every engagement, routine or complex, warrants an effective engagement letter. Camico strongly urges the use of engagement letters with all engagements: new, repeat, and especially those that have changed since the last client-CPA agreement.

An engagement letter is in many respects a written contract between CPA and client stating both parties' understanding of the professional relationship. It allocates, in limiting language, the responsibilities of the engagement for the CPA and client and serves as an excellent communication link, providing both parties with a focus. The engagement letter also provides an opportunity to identify and describe additional services agreed upon by both parties.

Scope of Engagement

Unless the CPA states in writing what the engagement entails, the client might approach it from a completely different point of view. The CPA might perceive the engagement as a write-up of the client's books and a preparation of federal and state income tax returns while the client might think the CPA is undertaking the responsibility not only to prepare income tax returns, but also to provide advice about compliance for property tax returns, business licenses, sales tax, workers' compensation insurance coverage, fidelity bonds, and other insurance needs, including auto, property, and general liability. Courts and clients often do not understand the role of accountants. While engagement letters do not provide immunity against lawsuits, they can be the first line of defense if a client makes a claim.

The following example illustrates the value of an engagement letter: An accounting firm performed a compilation for a small manufacturing company. The accountant reviewed the monthly cash flow, checked the bank reconciliation, compiled balance sheets, and prepared quarterly financial statements. During the fourth year of the engagement, the accountant began having difficulty getting information necessary to finish the quarterly review from the company’s bookkeeper. The accountant expressed this frustration to client management and eventually disengaged from the company.

The following year, the company's new accountant discovered that the uncooperative bookkeeper was embezzling funds. The company sued the accountant who had disengaged, demanding $110,000 in damages. The case was quickly settled prior to trial, in the accountant's favor, as the direct result of a good engagement letter signed by the client specifically stating that the engagement was not designed to detect fraud. Without the engagement letter, it could have cost a great deal to prove the accountant's case. As it turned out, the cost of the case was $10,000 in expenses.

Another case demonstrates the consequences of having no engagement letter: An accountant prepared the tax returns for a client who was a doctor and a longtime friend. When the doctor passed away, his heirs discovered that his nurse and assistant had been embezzling money from him for years. The heirs sued the accountant, alleging that the accountant not only prepared tax returns, but also gave business advice and oversaw the work of the doctor's bookkeeper. The accountant had no engagement letter to dispute the allegation. This case was settled out of court for $130,000.

The Engagement Letter

The engagement letter should cover -

• purpose of the engagement
• scope of the engagement (specifically what the CPA "will and won't do") ? client instructions and responsibilities
• reliance on facts the client gives the CPA
• known adverse or negative conditions or circumstances
• billing rates and estimates
• request for the client's signature and
• instructions to return the signed engagement letter.

In addition, engagement letters can include -

• warnings about inadequate internal control
• limitations on distribution of financial statements (what the client intends to do with them)
• mediation clause
• binding arbitration clause for fee disputes only and
• record retention

The engagement letter should not cover marketing information: An engagement letter is not a vehicle for convincing clients that the firm is the answer to all their problems. An engagement letter limits services rather than sells them. Wording such as "We are particularly suited for this type of work" is appropriate for a proposal but not for an engagement letter. If the firm takes on work as the result of a proposal letter, the engagement letter for that work shouldn't deviate from the terms in the proposal. The engagement letter should have the final word, and the proposal letter can reflect that by stating, "The terms of the engagement will be defined in more detail in an engagement letter."

In addition, the engagement letter should not include all-encompassing language: An engagement letter limits the scope of the work, so superlatives, absolutes, and words that expand rather than contract the CPA’s responsibility should be avoided (See the sidebar).

Any ambiguity in the engagement letter would most likely be decided in the client's favor in a court of law, so the language should be simple and clear - with no legal jargon. Furthermore, the client will be less intimidated by clear, simple language and will have a better opportunity to understand the terms of the engagement.

If the client does not review or sign the letter before the CPA does the work, a court of law might decide that the client did not agree to the terms of the engagement letter. The fact that the CPA proceeded with the work could also suggest that the engagement was completed under terms different from those contained in the unsigned engagement letter.

Regular Update of Engagement Letters

The "evergreen" engagement letter is becoming a thing of the past: No engagement is so static that the same engagement letter will work year after year. Ongoing engagements that extend into a new fiscal or calendar year need new engagement letters annually. Guidelines for updating engagement letters would include updating them at least once a year or whenever engagements change and establishing a procedure to follow up on unsigned or unreturned engagement letters.

Sample Engagement Letters

Sample engagement letters should not be used as form letters. Some Camico policyholders have asked for sample letters with blanks where client names and CPA services can be filled in, but CPAs should avoid boilerplate letters.

The engagement letter should be customized to the specific client's situation and to the specific needs of the CPA’s practice. Form letters impede the process of evaluating the client and the job to be undertaken. An individualized engagement letter shows that the CPA has put some thought and consideration into the agreement and the way it is communicated to the client.

Disengagement

Disengagement is a unilateral cancellation of a contract - as well as an art - whereas the engagement letter is a bilateral agreement. It is usually not feasible to include a disengagement clause in an initial engagement letter unless the clause refers specifically to nonpayment of fees.

If a problem is foreseen at the outset of an engagement, the CPA should think it through, discuss it with his or her partners and attorney, and decide whether to propose disengagement terms to the client while discussing the scope of the engagement. If done before finalizing the engagement letter, this exercise might help focus on the key issue of whether the engagement should be accepted in the first place.

If a problem is encountered midengagement, the CPA might be in a position to notify the client that agreement is required on certain terms of the engagement as a condition of the continued performance of services. An accountant can legally terminate an engagement if a conflict exists between performance of the engagement and the accountant’s ethical obligations or if the client fails to pay, fails to cooperate, or agrees to the disengagement.

When the CPA disengages before completing work for a client, a greater risk of liability exposure can stem from damages resulting from the successor CPA's inability to complete the work by its deadline. A delay of this nature can seriously damage the client's business. CPAs should be aware of this exposure and should not wait until the last minute to disengage. Consultation with an attorney or risk advisor is strongly advised, as is cooperation with the client and the successor accountant. On the other hand, workpapers should not be turned over without first consulting with an attorney or risk advisor.

Every engagement, routine or complex, warrants an effective engagement letter. Taking that principle one step further, every client deserves a written agreement that facilitates the understanding of the engagement.