Engagement letter stories — when they hurt and when they worked

As a risk management professional at CNA, professional liability insurance carrier for nearly 25,000 CPA firms, I am often asked if engagement letters are worth all the effort. The answer, based on my personal and CNA’s claim experience, is a resounding YES!

I’ve experienced firsthand the value these letters bring to the table. When an engagement letter is used, and a claim arises related to that engagement, the losses are typically less severe (meaning less expensive) than if an engagement letter had not been used. But what means more (especially to a CPA) than more money in your pocket? Many professional liability insurance carriers provide premium credits or other benefits for firms that use engagement letters.

If it’s not enough to just trust the numbers, consider the following experiences of CPA firms that have or have not used engagement letters.

One that hurt — no engagement letter meant higher risk

A CPA was engaged to prepare income tax returns for a small business and its owner for many years. The owner regularly spoke with the CPA about his plans to sell the business and ultimately retire. One day, the client did just that and moved away.

In his new hometown, he employed a local CPA. As part of the new CPA’s due diligence, she reviewed the business and personal tax returns for the prior three years. In doing so, she noticed that if the client had elected S corporation status prior to the sale, he would have saved a boatload on taxes.

As a result, the client sued his original CPA for failure to advise him about the benefits of electing S status. Without an engagement letter that limited the scope of the CPA’s services to income tax return preparation, the client successfully convinced a jury that the CPA was engaged to be his business advisor in addition to preparing tax returns. The CPA was held responsible for the additional tax.

An engagement letter is not a “get out of jail free” card. But a clearly defined scope of service, including a provision that tax advice would be subject to a separate engagement letter, may help mitigate a claim.

The engagement letter that worked

A CPA provided compilation services for a small plating company. The client’s cousin was the bookkeeper, but not the most honest person. She stole money from her cousin’s business.

After realizing his cousin was a thief, the business owner sued his CPA, arguing that he relied upon the firm to identify and communicate all accounting irregularities.

Defense counsel for the CPA argued that the engagement letter specifically noted that the CPA would not perform procedures to identify theft or fraud. Through a series of emails, the CPA had made the business owner aware that his cousin had unfettered access to his accounts, and suggested he segregate her duties. The CPA had also pointed out some questionable transactions. In response, the owner directed the CPA to discuss any irregularities with his cousin.

Despite the CPA’s engagement letter and emails, the client sued. The jury understood that the owner and his cousin were equally, if not more responsible, for preventing the theft than the CPA. As a result, the court ruled in favor of the CPA.

My story

I spent almost 20 years as a tax practitioner. I specialized in state and local tax.

When I started practicing, I only obtained engagement letters for tax compliance work. As my practice grew, my engagement letter use did too. Thank goodness, because an engagement letter helped me get out of a jam.

I was engaged to do a nexus study for a client. After completing the nexus matrix, I presented it with my conclusions to the client, who promptly asked for the promised memo. I told the client I would check on it, but couldn’t remember anything about a memo.

I reviewed my engagement letter and associated deliverables. Sure enough, the letter assigned me two deliverables: a nexus matrix (check!) and a memo detailing the sales tax consequences for states in which the client had nexus. As a result, I completed the additional work, prepared the memo, and avoided a dispute.

The best story of them all

These stories may be interesting to read, but the best story is the one we will never hear. That’s the story of the claim that was never filed because the engagement letter saved the day.

While anyone can sue a CPA at any time for any reason, a well-drafted engagement letter provides a CPA’s defense attorney something to defend. My advice is to use engagement letters for everything you do. Don’t view them as an administrative burden, but your best friend in the event of a client dispute.

The AICPA Personal Financial Planning group offers a sample engagement letter for personal financial planning services to get you started. And AICPA Tax Section members have access to the Annual Compliance Kit, which includes samples for fourteen tax services, including tax audit representation and consulting. Review these as you draft your own engagement letters.

Deborah K. Rood, CPA, MST, is a Risk Control Consulting Director for the Accountants Professional Liability Insurance Program of Continental Casualty Company, a CNA company and the underwriter of the AICPA Professional Liability Insurance Program. She previously practiced public accounting for 19 years with regional public accounting firms, leading her firm’s state and local tax practice.

Engagement letter courtesy of Shutterstock,

Engagement letter stories — when they hurt and when they worked

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