ENGAGEMENT LETTERS AS A RISK MANAGEMENT TOOL

By Bruce M. Bird, Steven M. Platau, and Steve Busby

Many lawsuits are the result of a communication breakdown between CPAs and their clients. A well-drafted engagement letter can prove helpful to a CPA in preventing--or defending against--a negligence or breach of contract claim. The breakdown in communications between the client and CPA is often referred to as the "expectation gap." In many situations, the client's understanding of the scope of the services to be provided and how the work product will be utilized may be quite different from the CPA's understanding of these issues. By helping reduce the expectation gap that may exist in the client/CPA relationship, an engagement letter can prove to be a helpful risk management tool.

Professional Standards

In the fall of 1997 the AICPA issued SAS No. 83 (the statement) and SSAE No. 7, Establishing an Understanding with the Client. The statements are effective for engagements for periods beginning after June 15, 1998

SAS No. 83 requires an auditor to establish an understanding with the client that includes the objectives of the engagement, the responsibilities of management and the auditor, and any limitations of the engagement. The statement requires the auditor to document his or her understanding with the client in the working papers, preferably through a written communication with the client. These matters may be communicated in the form of an engagement letter. If the auditor believes an understanding with the client has not been established, he or she should ordinarily decline to accept or perform the engagement.

In addition, SAS No. 82 reaffirms that the auditor has the responsibility to plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement due to error or fraud.

Taken together, both SASs underscore the importance of using an engagement letter for audit engagements.

For compilations and reviews, the professional standards contain guidance concerning the use of engagement letters. The Statement on Standards for Accounting and Review Services No. 7 (SSARS 7) states the accountant should establish an understanding with the entity, preferably in writing, regarding the services to be performed. In addition, Appendix B and Appendix C of SSARS 7 contain an illustrative engagement letter for a compilation and review engagement.

Moreover, SSAE No. 7 indicates that the practitioner should establish an understanding with the client relating to the services to be performed. The practitioner should document the understanding in the working papers, preferably through a written communication with the client.

A Risk Management Tool

A properly drafted engagement letter can serve as a helpful risk management tool. While the engagement letter itself may vary with the level of service or type of engagement to be provided, common provisions in most engagement letters include the following:

* Identification of client;

* Description of the engagement and its limitations;

* Timing of the work and staffing of the engagement;

* Client information and responsibilities;

* Designation of the party to work with the CPA;

* Identification of intended users of the CPA's work product;

* Fees and payments;

* Withdrawing from and/or terminating the engagement;

* Responding to discovery requests, subpoenas, and outside inquiries;

* Alternative dispute resolution as a means of resolving disputes;

* Where applicable, disclosures recommended or required by the AICPA; and

* Client signature.

Identification of Client. A properly drafted engagement letter should identify who will receive the CPA's services. The CPA may be working for an individual, a group, an entity, or a portion of an entity. For example, if the CPA's client is a corporation that has subsidiaries or other corporate affiliations, it may be necessary to identify the entities to be included in the engagement.

Description and Limitations of Work to Be Performed. The engagement letter should indicate what services are to be rendered. In general, the CPA should outline the procedures to be performed and any reports to be issued. In so doing, the engagement letter can help guard against the client developing unreasonable expectations about the nature and the scope of the services to be provided.

Timing of Work and Staffing of Engagement. This section of the engagement letter indicates when the engagement will begin and end. This section may vary by type of engagement. For example, an audit engagement may contain a provision indicating the date field work will begin and end and the date of delivery of the audit report. A tax engagement may contain a provision indicating any known filing deadlines and the parties' understanding concerning the use of extensions should the information not be received by the CPA to timely prepare the return.

Some CPA firms may indicate who will be staffing the engagement. This provision may prove helpful, for example, where a client expects to work with certain employees of the CPA firm.

Client Information and Responsibilities. In most engagements, the client is required to collect certain information and provide certain records to the CPA. If this information is necessary for the CPA to complete the engagement, these client responsibilities, and any applicable deadlines for the completion of work by the client, should be described.

For example, a tax engagement would normally contain a provision indicating it is the client's responsibility to sign and file tax returns prepared by the CPA along with an explanation of the consequences of the client's failure to sign and file such returns.

Designation of the Party to Work with the CPA. Some engagement letters request the client to designate the party to work with the CPA. This provision can help the CPA avoid situations in which conflicting requests or instructions are received from more than one of the client's employees.

Identification of Intended Users of the CPA's Work Product. In some jurisdictions, a CPA can limit or avoid liability to third parties by identifying in the engagement letter the intended users of the work product. In addition to identifying these users, this provision often contains language prohibiting the client from distributing the CPA's work product to any party other than these users. In deciding whether or not the engagement letter should contain this provision, competent legal counsel should be consulted. This is especially true for jurisdictions, such as New York and New Jersey, that have privity standards for establishing auditor negligence.

Fees and Payments. An engagement letter can help avoid fee disputes before the work begins. This section details how and when the client will be billed. It may describe the amount of retainer (if any), how the fee will be computed, when payment will become due, the client's obligation to pay promptly, and the CPA's rights should the client fail to give prompt payment. In some cases, the CPA may charge interest for late payments. In more extreme cases, it may be necessary for the CPA to suspend work--or terminate the engagement--for fees not paid.

Withdrawing from and/or Terminating the Engagement. At times it may be necessary for the CPA to withdraw from the engagement. The engagement letter should outline the conditions that might lead to the CPA's withdrawal and the procedures the CPA will follow in the event of withdrawal. Examples of situations in which the CPA's withdrawal from the engagement may be required include issues of conflict of interest, management ethics or integrity, and/or the CPA's
real or apparent lack of independence.

This section should also discuss policies and procedures related to the termination of the engagement including--

* return of client files,

* preparation of the final bill,

* work paper retention, and

* date of termination of services.

Responding to Discovery Requests, Subpoenas, and Outside Inquiries. Occasionally, a CPA may receive a discovery request, subpoena, or outside inquiry. While several states have established a CPA/client privilege with respect to communications, most states do not have such a privilege. Moreover, there is no Federal CPA/client privilege. This section of the engagement letter can help avoid future misunderstandings between the client and the CPA regarding whether, and to what extent,
the CPA may be required to respond to such requests.

Alternative Dispute Resolution. Alternative dispute resolution, or ADR, refers to methods of resolving disputes outside of the courtroom. One of these methods is known as arbitration. In arbitration, the opposing parties select one or more arbitrators who decide the outcome of the dispute. In most cases, the decision of the arbitrator cannot be appealed. Typically, the pre-arbitration discovery process is limited, and third parties are not bound by the arbitrator's decision.

Another method of resolving disputes outside of a court of law is mediation. During mediation, a mediator attempts to find the "common ground" that exists between the opposing parties that may lead to a mutually agreed upon settlement. In the event the mediation is not successful, the parties, if they so desire, may litigate their dispute.

Prior to inserting a provision in the engagement letter regarding alternative dispute resolution, a CPA should consult with legal counsel regarding the provision's enforceability. In addition, inserting a provision concerning alternative dispute resolution in an engagement letter may have insurance coverage implications. For example, while most insurers encourage the use of mediation, under many policies the use of an arbitration clause may limit or void the CPA's professional liability insurance coverage for any claims that are arbitrated.

Where Applicable, Disclosures Recommended or Required by the AICPA. The AICPA recommends the inclusion in an engagement letter of certain disclosures for certain types of engagements. These disclosures may be incorporated into, or have an effect upon, other provisions of the engagement letter.

Client Signature. This section should request the client sign and return an executed copy of the engagement letter to the CPA. It should provide that if the client does not agree the engagement letter accurately reflects the agreement of the parties to the engagement, the client will promptly notify the CPA. If the client does not return a signed engagement letter, the CPA may send a certified letter indicating that, unless otherwise notified, the CPA will assume the client agrees to the terms of the engagement letter. In any event, the most effective engagement letter is one signed by the client prior to the CPA beginning work on the engagement.

Some Problems with "Sample" Engagement Letters

Although a number of sources of sample engagement language for various types of engagements are readily available, the engagement letter for each type of engagement should be reviewed by competent legal counsel. All too often a CPA may "cut and paste" together an engagement letter that may not comply with the law of the state in which the CPA practices.

Defending Against Claims

Perhaps the most compelling argument for the use of engagement letters across all types of engagements is to examine how the lack of an engagement letter can affect a CPA's litigation posture in defending against a negligence or breach of contract claim. Information culled from insurance claims data, case law, and state board disciplinary hearings illustrate several situations in which the lack of a written engagement letter presumably had a negative effect upon the CPA's defense:

Example 1--Misunderstanding as to the Nature and Scope of Services to Be Provided. At a pre-acceptance conference, a CPA and prospective client discussed a number of services the CPA could provide. The CPA indicated these services included an audit, review, and compilation. The CPA left the meeting convinced he had agreed to provide his new client with a compilation engagement. The CPA did not remember to provide his new client with an engagement letter for him to sign.

After a problem with the engagement surfaced, the former client sued his accountant. At trial, the former client testified that his recollection of the pre-acceptance conference was that the CPA had agreed to perform a review engagement.

In the jury trial that ensued, the CPA discovered--much to his surprise--that, absent a written agreement, conflicting testimony regarding the scope and nature of services to be rendered in an engagement is a question of fact to be decided by the jury.

Example 2--Misunderstanding as to Who Should Perform Certain Services. A client met with her CPA and attorney to set up an S Corporation. At the meeting, the client anticipated the S Corporation would lose approximately $400,000 in its first year of operations. The CPA assured her that, if properly structured, the S Corporation could provide her with a $400,000 loss pass-through.

Unfortunately, after the meeting, the attorney thought the CPA would make the S election while the CPA thought the attorney had agreed to make the election.

The following year, the client discovered the S election for her new corporation had not been filed. Due to the client's inability to use the loss pass-through, the client did not have enough Federal income tax withheld resulting in substantial interest and penalties.

The former client sued both her attorney and CPA.

Example 3--Misunderstanding Concerning Termination of the Engagement. A CPA agreed to provide consulting services along with other accounting services to his client. A number of years later, the client became dissatisfied with certain aspects of the consulting engagement.

The former client sued his accountant for negligence and breach of contract. No engagement letter existed indicating the termination date of the consulting engagement. The former client alleged in court that because the engagement had not ended, the statute of limitations had not begun, and thus the negligence and breach of contract actions had been brought within the applicable statute of limitations. *

Bruce M. Bird, JD, CPA, is a professor and Steve Busby, CPA, an associate professor, both at the State University of West Georgia. Steven M. Platau, JD, CPA, is an associate professor and chairman at the University of Tampa.