For practicing accountants, a major source of litigation stems from clients’ allegations that their accountant failed to perform services that were outside the scope of the accountant’s engagement. Fortunately, there is a straightforward and cost-effective way to greatly reduce the risk of such litigation: the engagement letter. An engagement letter can reduce the risk of lawsuits by removing doubt about the nature and scope of the agreed-upon services. Without a properly drafted engagement letter, such litigation can be a time-consuming and costly nightmare. With an engagement letter appropriately tailored to the practice and scope of services to be covered, an accountant can greatly decrease the risk of controversy and increase the chances for speedy and favorable resolution of claims.
Ideally, an accounting professional will issue an engagement letter prior to commencing work for a client. The letter should:
- Identify the client
- Identify and define the scope of professional services being provided and the
schedule of the services
- Identify the limitations of the engagement; i.e. for whom and what purpose the report is prepared
- Identify the accounting professional(s) who will provide the services
- Identify the client’s responsibilities
- Define the fees and schedule for payment
- Incorporate appropriate terms and conditions of the accountant’s services
- Be signed by the client and returned to the accounting professional
These are the basics of what an engagement letter should cover. Engagement letters should be customized to fit each individual engagement, particularly when nontraditional services or fee arrangements are being provided. If properly prepared, not only can an engagement letter limit an accountant’s risk of being sued, but it can also limit a client’s ability to avoid paying the fees.
Effective Use of Engagement Letters
In order to get the full benefit of an engagement letter, it is essential that there is a complete understanding of the terms of the engagement by the accountant and the client. If there is no record that the client has signed off on such a letter, an accounting professional faces a more difficult time proving that the client agreed to the terms of the letter. Accordingly, engagement letters should be prepared for all engagements before rendering any type of service, should completely and accurately reflect the scope of services provided, and should be signed by both the accountant and the client.
Maintaining the full protection of an engagement letter does not end, however. More often than not, the scope of an engagement will change from year to year or even within a particular year upon its execution. In cases where the client asks for, or the accountant recommends, additional services and the agreement changes, it is vital that the engagement letter be supplemented to confirm, and document the changes. A follow-up letter, again signed by the client, is necessary. Typically, follow-up letters within the same year should refer back to the engagement letter and indicate that the changes in services will continue to be governed by the terms of the original letter.
Further Benefits of Engagement Letters
Clients are not the only ones who sue accountants. Third parties who rely on accountants’ work—usually lenders, investors or client vendors—have been known to sue accountants for malpractice. A well drafted engagement letter (combined with a clause in the report issued by the accountant limiting the use and purpose of the report) can be the key to defending these troublesome third-party claims. By expressly defining the scope of services and limiting the audience that is meant to rely on the services provided, an engagement letter and the report itself can be potent ammunition in third party suits against accountants. Depending on the type of services performed, another clause in an engagement letter could require the client to indemnify and hold the accountant harmless for any costs incurred in defending the third party claim.
Indemnification, however, is not allowed for certain services provided to public companies. Because laws governing a third-party’s right to sue vary from jurisdiction to jurisdiction and whether an accountant is allowed to seek indemnity for third party claims, first-rate legal advice is necessary in order to prepare a letter that will protect accountants from third-party claims.
A prime example of another beneficial term that can be incorporated into an engagement letter is the assignment of responsibility for detecting illegal acts—a topic that has received much attention of late. A good engagement letter can limit an accountant’s exposure for failure to uncover employee or management fraud. By incorporating customized, explicit disclaimers into the engagement letter, an accountant can protect against liability for not catching a fraud perpetrated by a client-employee. Another feature that can be integrated into an engagement letter is a provision mandating alternative dispute resolute (“ADR”) if a claim arises. ADR is often an effective way to curb the high costs of defending liability claims. It is crucial, however, that an accountant obtain his insurance carrier’s permission before including any ADR language in his engagement letters, as insurers take varying positions on the usefulness of ADR processes such as arbitration and binding/non-binding mediation.
In certain engagements, an accountant can also limit his liability to a client by inserting a clause in the engagement letter limiting any damages arising from an accountant’s alleged negligent acts to a sum certain, be it the fees charged or some other agreed upon number.
Another feature that can be integrated into an engagement letter is a provision that protects an accountant’s employees. It is not uncommon for a client to establish a relationship with staff accountants from its CPA firm. Often that relationship turns into a job offer from the client to the staff accountant. The client understands that the CPA firm expended resources to train the staff accountant and the client obtains the benefit of that training. A provision in the engagement letter could require the client to pay the CPA firm a percentage of the staff accountant’s salary, in exchange for hiring the staff accountant. With this provision, the client gains a beneficial employee and the CPA firm benefits by having a satisfied and loyal client and is reimbursed to a degree for training the employee.
The Non-Engagement Letter
Serving a similar purpose as an engagement letter—to evidence the understanding between parties and avoid lawsuits—a formal non-engagement/rejection letter can also be a valuable tool in reducing liability risk. An accountant will sometimes turn down a new client for reasons such as conflicts of interest and lack of time. In these cases, the accountant should inform the rejected client in writing that the accountant will not be performing the requested services. A non-engagement/rejection letter will prevent the would-be client from blaming the accountant for failure to perform any of the requested services. Non-engagement/rejection letters should also caution that any guidance that the accountant may have given in the course of dealing with the would-be client should not be relied upon, as it was offered without the opportunity for a thorough investigation of the relevant facts and literature.
While no engagement letter can provide 100% protection from client lawsuits, the consistent use of engagement letters provides clients with 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. Establishing and reinforcing of this client communication is a critical element in avoiding “expectation gap” problems that can lead to professional liability claims. To ensure the effectiveness of the engagement letter, it should be prepared with the aid of a knowledgeable attorney who is familiar with the laws of the jurisdiction where the services will be performed. While the engagement letter is not a magic shield to protect accountants from malpractice claims, unless it is incomplete, inaccurate or misleading, any engagement letter is better than none at all.
Nancy M. Reimer is a Shareholder in LeClairRyan’s Boston Office. She defends accountants, lawyers and other professionals in malpractice claims and counsels clients in prevention techniques for avoiding litigation and other risk exposures. She can be reached at 617.502.8215 or at email@example.com.