When should you implement engagement letters?
For many practicing accountants, their main cause of litigation is the result of client allegations that they failed to perform a scope of services that may or may not have been outside their engagement. According to Accounting Web, this is where engagement letters come into play for CPAs because it enables them to protect themselves from liability. An engagement letter is best practice to eliminate doubts over the scope of agreed-upon services between the client and accountant – and thus significantly reduce risk of litigation.
However, do you really need to use engagement letters?
According to research cited in a Bloomberg BNA report by Sarah Beckett Ference, CPA and risk control director at CNA Insurance, 49 percent of CPA firms in the AICPA Professional Liability Insurance Program that had professional liability claims brought against them did not use engagement letters. The reason? These contracts were deemed to be an administrative burden, so it is not a required practice at many firms.
The issue is that in lieu of a properly drafted contract, lawsuits can prove to be even more of an administrative nightmare, as well as costly and time-consuming. Appropriately customized engagement letters detailing the practice and scope of services decreases the potential for controversy and greatly improves the odds of favorable resolutions.
Some benefits of engagement letters
One of the most significant misconceptions about the value of the engagement letter is that third parties can also bring lawsuits against a CPA firm. Third parties such as investors, vendors and lenders can sue accountants for malpractice if they rely on a firm’s accounting work. This is where engagement letters can reduce the audience who is meant to rely on the services. That is a crucial clause in an engagement letter because third party rights to sue vary from state to state, so this is where expert legal assistance is important. A prime example of what CPAs can do if third party rights to sue are limited in their jurisdiction is to require the client to indemnify, which would effectively remove any liability for the accountant.
Another benefit of engagement letters is that provisions can be added to mandate alternative dispute resolution in the event of a claim brought against a firm. These ADRs could potentially cut out thousands of dollars in liabilities to client or third party claims. With the CPA’s insurer’s approval, accountants can include language in the engagement letters to involve ADRs like arbitration or mediation.
The bottom line on engagement letters
There are no certainties that engagement letters can completely protect CPA firms against client or third party claims. But the use of these contracts can at the very least provide a detailed list of accurate information regarding the services they have retained the accountant to perform, the limitations of those services, and the responsibilities of both the accountant and the clients arising from the engagement. By bridging the information and expectation gaps, firms can cover their bases against many issues that lead to professional liability claims.
This is why CPAs should consult with knowledgeable attorneys to prepare engagement letters that cover the scope of services provided to clients in order to ensure their effectiveness.