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Engagement Letters: Your First Line of Defense against Malpractice Claims

by Alvin Fennell | Sep 10, 2015   ()

A certified public accountant has been preparing income tax returns for a trucking firm for 10 years.  Out of the blue, the CPA is named in a lawsuit.  It appears that an employee at the trucking firm with a gambling problem was stealing money from their accounts for years.  More than $250,000 is now gone.  

Looking to recoup their finances, the client alleges the CPA should have detected the discrepancy on their books.  When the CPA notifies his professional liability insurance carrier of the claim, the first question the defense attorney asks is:  “Did you have an engagement letter?”*

An engagement letter helps protect the CPA from allegations, including negligence, by providing a record of the contract between your firm and the client. The client, by signing, dating and returning a copy of this letter, demonstrates their acceptance of the contract.

In the illustration above, if the CPA has an engagement letter that outlines his responsibility for tax preparation services only – not fraud detection –it serves as a powerful defense tool.  If he does not have a signed engagement letter, there’s no telling what may happen in the courtroom.

In 2014, 50 percent of all professional liability claims in the AICPA Professional Liability Insurance Program alleging failure to detect theft or fraud arose from tax and consulting engagements,” said Jeffrey Day, vice president and accountants global practice leader at CNA, the underwriter of the AICPA Program.  “A well-drafted engagement letter can help prevent these types of claims, as CPAs were not hired to perform those services in these engagements.”

What are the key ingredients of an engagement letter?

“A good engagement letter clearly details what services the CPA will be performing for the client—and what they won’t be performing,” said Richard Bacher, a professional liability specialist at Aon Insurance Services, the administrator of the AICPA Professional Liability Insurance Program.  “When executed properly, the engagement letter may go a long way toward limiting the liability of the CPA firm.”

While there is no standard engagement letter, they can vary according to the type of services offered and the type of client, here are the basic components:

  • Scope of services – a description of the nature of the services to be performed and the deliverables.
  • Responsibilities of the firm – the specific professional standards and responsibilities of the CPA.
  • Responsibilities of the client – Since conducting certain work requires the client’s assistance, such as providing records, to comply with regulatory deadlines, the letter should identify time frames in which such documents will be provided.
  • Limitations of the service – To help avoid client misunderstandings, this section explains any limitation of the services, including that they are not designed to detect fraud or illegal activities.
  • Fees and payment terms – This section addresses payment terms, late charges, additional fees and stop-work provisions for nonpayment.
  • Dispute resolution – By establishing how disputes will be resolved, such as using arbitration or mediation, this section can help keep a potential dispute from escalating into an insurance claim.
  • Termination provision – A good engagement letter will also define the steps necessary to terminate the engagement.

To craft your engagement letter, begin by contacting your state CPA society, AICPA, or your professional liability insurance carrier.  They may provide templates you can use as the foundation for your letter.

“The AICPA Professional Liability Insurance Program provides templates because they are a CPA’s first line of defense against claims,” said Debbie Tomlinson, a professional liability specialist at Aon Insurance Services.  According to Tomlinson, the engagement letter templates on the AICPA Professional Liability Insurance Program Policyholder Resource Center are the most downloaded documents on the website.

“Amend the templates as necessary for each client,” said Tomlinson.  “Sometimes, there may be some nuance to that engagement that doesn’t fit the standard template.  If a client has difficulty, we encourage them to call CNA’s risk control hotline, and a knowledgeable team member will offer assistance.”

How often should I review the engagement letter with my client?

At minimum, the engagement letter should be reviewed annually and even sooner, if the scope of services changes significantly during the course of the engagement.  As new services are added, to avoid any misunderstandings, updating the engagement letter should be a routine part of the discussion.

For example, if you began performing audits for a subsidiary of the company and now you’re auditing the parent company—be sure to amend the engagement letter to include these services.

“As the scope of the engagement changes, be sure to have the client sign an updated engagement letter,” said Tomlinson.  Otherwise you can fall prey to something known as engagement creep.  “For example, if you’re now providing investment advice in addition to your other services, be sure to add it during your annual client discussion.”

When should I be using an engagement letter?

Ideally, you should be using engagement letters in 100 percent of your engagements.  While use over time has increased, not all CPAs have made engagement letters a routine part of their practice.

“CNA has been tracking engagement letter use in malpractice claims reported to the AICPA Program since 1995,” said Day.  “During that time, engagement letter use in claims arising from tax practice improved from 20 percent to more than 65 percent.  In our experience, there is no question that engagement letters have proven to be a key factor in defending claims when the scope of services is in dispute.”

The engagement letter should be an important part of a firm’s internal controls.  Ensuring this document is signed by the client before services begin should be a part of the firm’s quality control process.  

Once you have the engagement letter on record, as you’re communicating with your client, it should become an integral part of your documentation procedures.  If you step outside the scope of services defined in the engagement letter or are asked to perform additional services, adjust the engagement letter accordingly.

How do I approach my client about using an engagement letter?


Recognizing that the accounting profession is very relationship driven, it’s understandable that CPAs are sensitive to anything that might disrupt that relationship.  The CPA is often viewed as an advisor or a friend.  The CPA may have had a client for 10 years and never used an engagement letter, and may feel tentative about inserting one into the relationship.

What CPAs may not understand is that the engagement letter is going to help the relationship grow.  It’s going to help define your role, so there’s little question if a problem should arise.

“Most people have contracts in place with service providers,” said Bacher.  “Whether it’s an electrician or a plumber, usually there’s a contract. A CPA firm is no different.  Most clients will see it as a standard document and just sign it.”

If you’re still nervous about broaching the subject, Bacher recommends, “Talk to the client and let them know you’re professional liability program is strongly advising you to start using engagement letters.  You are simply complying with your carrier’s recommendation.”

Are there any additional reasons to use engagement letters?

Because engagement letters help defend against malpractice claims, many carriers in the insurance industry may offer incentives that reward CPAs for the use of engagement letters:

  • Premium credit – Many insurance companies will provide a discount on your professional liability insurance premium.  The percentage of the discount depends on the percentage of your practice that is using engagement letters.  The higher the use, the higher the credit typically.  Conversely, underwriters may surcharge your premium if you’re not using them at all.
  • Mediation deductible credit – In the event of a claim, if there is a signed engagement letter in place that stipulates the dispute must go through mediation first, in many cases the insurance company will offer a sizeable credit on the claim deductible.  This credit may be as high as $5,000, which can go a long way toward cutting the firm’s expenses during a claim.
  • Deductible credit – Several insurance carriers offer a deductible credit on claims reported from non-attest services, in which the CPA had a signed engagement letter in place.  This credit may be as high as 50 percent, and can also help reduce a firm’s expenses through the claim process.

What does using engagement letters say about my firm?

As a CPA, you’re held to a high standard.  Using engagement letters demonstrates your professionalism.  It says you’re not going to leave your firm exposed to potential litigation.  It illustrates you’re using the tools at your disposal to protect your staff, your finances and your reputation.  Moreover, the establishment of a written understanding with a client regarding the services to be performed is required by AICPA Professional Standards for most services.  What better way to establish this understanding than through an engagement letter.

In the opening of this article, we began with a story of a possible claim scenario.  Imagine this scenario.  You receive an angry phone call.  Your client claims they hired you to prepare a compilation and in the course of your work you missed the fact that their controller stole more than $500,000 from their accounts.  They threaten to sue for damages.

You respond by saying, “Let’s review the engagement letter.”  You and the client look at it together.  Clearly defined in the limitation of services section is a statement that you are not responsible for detecting fraud or illegal activities.  The client noticeably calms down.  

“If that conversation takes place,” said Bacher, “it may help avoid the client filing a lawsuit.  They may realize it’s not worth it. They signed a document that says you’re not responsible.  In many cases the engagement letter is going to help you and us.”

While we know engagement letters provide a strong line of defense if a professional liability claim is filed, what we don’t know is just how many conversations like the one above, result in stopping a potential lawsuit.  

When you consider the advantages of using engagement letters, it’s a bit mystifying that CPAs are not using them in 100 percent of their engagements.

*The claim example is for illustrative purposes only.
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Alvin Fennell is a vice president at Aon Insurance Services, a division of Affinity Insurance Services, the consumer, association and program business of Aon plc (NYSE: AON), the world’s leading insurance brokerage.  Aon Insurance Services has been the administrator of the AICPA Professional Liability Insurance Program since 1967.  The AICPA Program provides coverage to more than 25,000 CPA firms nationwide.  To learn more, visit cpai.com or contact Alvin at 215.773.4713 or alvin.fennell@aon.com.  

This article is provided for general informational purposes only and is not intended to provide individualized business, insurance or legal advice, You should discuss your individual circumstances thoroughly with your legal and other advisors before taking any action with regard to the subject matter of this article. Only the relevant insurance policy provides actual terms, coverages, amounts, conditions, and exclusions for an insured.

Source: Aon Insurance Services

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