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July 1990

Updating your audit engagement letter for the 1990s.

by McNair, Frances

    Abstract- Audit engagement contracts must be individually written for specific clients and auditing situations. The areas to consider in writing an audit engagement letter include: arbitration clauses; expectation gap standards, wherein an audit is not a guarantee of the accuracy of financial statements; and clear identification of the time to which the audit applies as separate and distinct.

The purpose of this article is to suggest four special areas for consideration in drafting the audit engagement letter. The four areas include:

* Use of arbitration clauses in contracts. Supreme Court decisions in the 1980s have encouraged this.

* Need to express an explicit statement that the audit is not a guarantee of the accuracy of the financial statements. Auditing standards have clarified the auditors' responsibility for detecting fraud.

* Inclusion of a careful statement of the period to which the work applies. This is necessary to avoid the continuous representation rule, thereby limiting the time period to which legal liability can apply.

* Need to refer to special purpose if the audit is to be used to determine value by contracting parties. Failure to do so can subject the CPA to liability as an arbitrator without benefit of immunity accorded to arbitrators.

The Arbitration Clause Finds Friends at the U.S. Supreme Court

Obviously there would be an advantage to adding a clause to the engagement letter that would be effective in reducing the risk of litigation for the CPA. Please note that limitation of liability clauses inserted in an audit engagement letter will not be binding upon third parties who rely upon the audit. However, 80% of all malpractice claims are brought by clients. The cost of litigating a dispute can easily run in the $175,000 range, e.g., $10,000 for initial investigation, pleadings and motions, $100,000 for discovery including depositions, interrogatories, and preparation, and $65,000 for trial including expert witness fees.

The insertion of an arbitration clause may well serve to effectively reduce exposure for CPAs in a variety if situations. To date there has been very little use of such clauses by CPAS. However, the U.S. Supreme Court has upheld their validity in a number of recent cases. In one decision the Supreme Court upheld the validity of the agreement to arbitrate claims arising under federal antitrust laws, (1) and in another decision, upheld the arbitration agreement relating to both RICO and Exchange Act claims. (2) Also, in a 1989 decision, the court upheld the arbitration agreement as to claims arising under the 1933 Securities Act. (3) Although these cases did not concern accounting firms, the same protection should apply to CPA firms where there is a contractual agreement. Some observers have encouraged experimentation with such clauses by CPAs to lower the cost of resolving disputes." When an arbitration clause is added, certain other factors should be considered, such as limiting the period during which claims may be presented and limiting the amounts that may be recovered. It is wise to consult with the firm's lawyer when drafting these special provisions'

Here is a clause that partners and their attorneys can consider as a starting point for drafting selected engagement contracts for public practice in the 1990s:















If you do this you will be plowing new ground, which should be fertile in growing protection for the CPA. An Audit is Not a Guarantee

The recent adoption of expectation gap standards cannot be taken lightly by the practicing CPA. It is not unlike requiring surgeons to undertake to perform only successful surgery or requiring attorneys to draft invincible contracts and wills. It is important to note, however, that surgeons do not guarantee the results of surgery and lawyers do not guarantee the viability of their contracts or wills. Auditors should clearly state in the engagement letter that an audit is not a guarantee of the accuracy of the financial statements. in that way it will be made clear to clients, third parties, and the courts that any inaccuracy is not a breach of warranty. For instance, consider this statement in 1984 by a state court dealing with unaudited financial statements:






















The authors believe that this court's concept of the auditor's warranty is wrong. Auditors do not guarantee the accuracy of financial statements any more than surgeons guarantee that surgery will prove successful or that lawyers warrant that their documents or opinions will prove infallible. However, it is up to the practicing CPA to communicate the distinction between a duty to use reasonable care and a guarantee or a warranty. The best place to do this is in the engagement letter with the statement that:

"An audit is not a guarantee of the accuracy of the financial statements."

Defining Separate and Distinct Engagements

When problems arise, one of the best defenses is that the statute of limitations has run out on the client's claim. The period for bringing suit is governed by state or federal law that applies to the particular claim filed, e.g., contract, tort, fraud, RICO, etc.

Many states have relatively short time limits for filing malpractice claims against accountants; some are as short as two years. However, benefits of this short period can be lost by engagement provisions to perform services of a continuing nature such as "annual reviews" or "annual audits." The reason is the continuous representation rule derived from the continuous treatment rule in medical malpractice. The theory behind this rule is that the client cannot discover the malpractice as long as the professional relationship involving the malpractice continues.

The application of this rule is demonstrated in a 1989 New York case. (6) A malpractice suit was brought against the CPA firm conducting annual "review" examinations. In New York, this type of claim was subject to the three-year limitation period that generally starts to run when the malpractice occurs. However, the accountant undertook an obligation "to perform annual reviews" which invoked the "continuous relationship rule." Consequently, the court held that the statute of limitations did not start to run as long as the relationship continued. Similarly, in a 1988 Virginia case, remedial services performed by the accounting firm in attempting to extricate the client or minimize the damage from an IRS audit invoked the continuous representation rule. (7)

Since the period is sometimes longer for suits on written contracts than for oral contracts, an engagement letter can have the effect of lengthening the time period during which the accountant can be sued for malpractice. CPAs operating in these situations might consult counsel as to whether the period for bringing suit may be limited by contract. Such contractual limits have been upheld in some states including New York. (8)

Where accounting firms have established distinct and separate engagements, or the state does not follow the continuous representation rule, claims against accounting firms have been barred. For example, in a Missouri case, the limitation period started to run when the IRS examiner issued his report calculating the deficiency. (9) The limitation period continued to run on the initial engagement while the accountant attempted to work out a settlement with the IRS because the two engagements were distinct and separate. Also, in a Nebraska case the claim for negligent tax advice was barred by the statute of limitations. (10) The accounting firm's negotiations with the IRS did not extend the statute of limitations under the continuous representation rule because the negotiations constituted a separate engagement outside the services covered by the original contract.

Immunity from Liability for Valuation Engagements

Accounting firms are often engaged to perform an audit in the context of determining a valuation for contracting parties. This may involve the purchase of the interest of a shareholder in a closely held corporation, (11) the settlement of property interest pursuant to a pending divorce, (12) or determining a price adjustment between the buyer and seller of a business. (13) The courts have generally upheld the validity of contracts that established a binding valuation determination by a CPA if the intent and scope of the contract was clear and unambiguous. (14) However, valuation contracts have been set aside when the accountant's determination failed to follow intent or when gross error in the valuation occurred. (15)

The problem for the CPA is the high risk nature of engagements in which money will change hands solely on the basis of the parties' reliance upon the determination made by the CPA. Damages can result from any mistake by the CPA or dissatisfaction of the interested parties. Because of the necessity for independence, judges have been given absolute immunity from civil actions for damages when acting in their judicial capacity. Likewise, in certain situations CPAs may also be afforded immunity from suit. However, in order to invoke this immunity, it is necessary for the CPA to identify the special nature of the engagement by special reference to the arbitrator role in the engagement letter. in repeated situations CPAs have learned only too late that protection could have been obtained by appropriately structuring their engagement. (16)

In a 1989 California case, Coopers & Lybrand v. Superior Court, (17) the CPA could have easily invoked immunity from suit under California law. However, the CPA firm used an ordinary engagement letter without making special reference to its appointment by the parties to act as arbitrator. The contract between die parties provided:













In the above case, one party was dissatisfied with the result and filed suit against the accounting firm. The California court conceded that under California law:

1. An arbitrator has the immunity of a judicial officer from civil liability when acting in the capacity of arbitrator under any statute or contract;

2. judicial officers are not amenable to any civil action for damages when they are acting in their judicial capacity; and

3. An agreement to arbitrate includes, but is not limited to, agreements providing for valuations, appraisals, and similar proceedings.

However, in denying dismissal of the action against the accounting firm, the court noted that the Coopers' engagement letter, in which it accepted the appointment to examine Federated's balance sheet, contained no suggestion that Coopers would be acting in the capacity of arbitrator. The court then concluded that an agreement for a binding audit is not necessarily an agreement to submit to arbitration:








Because the intent of the parties was unclear, the court declined to dismiss the action against the CPA.

Considering the numerous instances in which CPAs have been unsuccessful in obtaining the benefits of immunity when acting as arbitrators, it would be appropriate and proper for the AICPA and other professional accounting organizations to develop guidance and standards for CPAs performing valuation functions. As the courts have concluded long ago:






Developments in the 1980s have indicated four special areas where CPAs may appropriately review their audit engagements letters for the 1990s. These include:

* insertion of arbitration clauses in selected audit engagement letters, and possibly other selected engagement letters, to avoid the cost of defense in a lawsuit.

* Stating in the audit engagement contract that an audit is not a guarantee of the accuracy of the financial statements. The reason is that some courts have concluded that an audit is, in fact, a warranty of the financials.

* Defining each year's engagement as separate and distinct, and thereby avoiding the continuous representation rule whereby the limitation never runs on an engagement to perform "annual reviews."

* Making special reference to the role of arbitrator for all valuation engagements. Some CPAs may elect to resolve all doubts by inserting an immunity clause signed by all interested parties; the nature of valuation makes it unreasonable to perform without protection.

A sample engagement letter is presented in Table 1 omitted illustrating the incorporation of provisions relating to these four special areas. It also illustrates provisions relating to management responsibilities and representations, and the establishment of a fee payment schedule. The CPA considering implementing these suggestions should discuss them with legal counsel prior to use.


1 Mutsubishi Motors Corp. v. Soler Chrysler-Plymouth, 473 U.S. 614 (1985).

2 Shearson/American Express, Inc. v. McMabon, 107 S.Ct. 2332 (1987).

3 Rodriguez de Quijas v. Shearson/American Express, Inc., 57 LW 4539 (1989) The Court held that predispute agreements to arbitrate claims arising under Section 12(2) of the 1933 Securities Act are enforceable.

4 Richard S. Banick and Douglas C. Broeker, "Arbitration: An Option for Resolving Claims against CPAs," Journal of accountancy, October 1987, pp. 124-128.

5 Robert Wooler Co. v. Fidelity Bank, 479 A.2d 1027 (Pa Super. 1984).

6 Hall & Co., Inc. v. Steiner & Mondore, 543 N.Y.S.2d 190 (App. Div. 1989).

7 H. C. Boone v. C Arthur Weaver Co., 365 S.E.2d 764 (Va. 1988).

8 Farris Engineering Corp. v. Service Bureau Corp., 406 F.2d 519 (3d Cir. 1969) (applying New York law); IBM v. Catamore Enterprises, Inc., 548 F.2d 1065 (1st Cir. 1976).

9 Bower v. Davidson, Deckert, Schutter & Glassman, 686 S.W.2d 1 (Mo. App. 1984).

10 Klosure v. Johnson Grant & Co., 427 N.W.2d 44 (Neb. 1988).

11 Kobler v. Kobler Col, 319 F.2d 1059 (9th Cir. 1972)(CPA allegedly did not consider differences in pension accounting when estimating the value of closely held stock).

12 Levine v. Wiss & Co., 478 A.2d 397 (N.J. 1983) (parties to a divorce appointed a CPA to value the husband's interest in a corporation pursuant to an agreement embodied in a consent order).

13 Franklin Supply Co. t,. Tolman, 454 F.2d 1059 (9th Cir. 1972) (dispute over whether current replacement value meant prices on the salvage market or prices from usual sources of supply)

14 See Parkside Memorial Chapels Inc. v. E.R.B. Reorganization Corp., 389 N.Y.S.2d 629 (App. Div. 1976), and National Department Stores Corp. v. House of Fashion, Inc., 96 So. 2d 473 (La. 1957).

15 See Estate of Kaplan, 384 N.E.2d 874 (Ill. App, 1978) and Polinsky v. Vaugban, 73 Cal. Rpter. 764 (Cal. App. 1968).

16 See Arthur Andersen & Co. v. Wilson, 353 S.E.2d 446 (Ga. 1987), where the accounting firm hired by a court-appointed special auditor to determine the value of stock for a buy-sell agreement was not protected by judicial immunity. Also, in Levine v. Wiss & Co., 478 A.2d 397 (N.J. 1983), there was no immunity to bar a suit by the husband because the CPA was appointed to the valuation engagement by the parties to a consent order, and not by the court. The above CPAs could have been protected if they had insisted on direct appointment by the court or by acting only after obtaining contractual immunity, in an engagement contract with the interested parties.

17 Coopers & Lybrand v. Superior Court, 260 Cal. Rpter. 713 (Cal. App. 1989).

18 Ibid.

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