In the defense of a professional liability claim, CPAs should know the critical role played by engagement letters. Engagement letters help define the scope of services, manage client expectations, communicate limitations of the service provided, and outline the CPA's and client's responsibilities. They also demonstrate a CPA's compliance with the requirement to obtain an understanding with the client regarding services to be rendered—a requirement included in the AICPA professional standards for most services.
Despite this awareness, claim experience of the AICPA Professional Liability Insurance Program indicates that there is room for improvement, not only when it comes to consistently obtaining engagement letters, but also the type of engagement letter CPAs use.
An annual engagement letter, issued for every engagement, reflecting a complete and accurate scope of services, derived from templates which are routinely reviewed and updated, and signed by both the CPA firm and the client, is one of the best tools a CPA can employ when defending a professional liability claim. However, some CPAs may hesitate to follow this approach due to concerns about time spent updating engagement letters and misplaced fears that it may negatively affect the client relationship. In an effort to streamline the engagement letter process, CPA firms have elected to use other types of engagement letters, including:
- Evergreen or self-renewing engagement letters: A one-time engagement letter that indicates the scope of services will continue unchanged until either party terminates the professional relationship and does not specify when the engagement will end.
- Unilateral or negative assurance engagement letters: These engagement letters are signed solely by the CPA firm, and not by the client. They include a statement that, through the client's provision of information to the CPA, the client and CPA agree to and accept the scope of the engagement and the firm's terms as set forth in the engagement letter provided to the client.
In the battle for engagement letter domination, does one type of engagement letter rise to the top? In three rounds, we evaluate each engagement letter contender—annual, evergreen, and unilateral—to determine which one is the undisputed champion for CPA firms.
Round 1: Client Relationship Management
Does the type of engagement letter used help strengthen the client relationship? Ideally, engagement letters are the written version of a conversation you have already had with your client regarding services. Annual engagement letters encourage, at a minimum, annual discussion with the client, which helps ensure the parties' expectations are aligned. Regular discussions also enable the firm to understand the client's recent developments and activities. This provides an opening for the firm to suggest new services or revise an outdated scope to meet the client's needs.
Evergreen engagement letters inherently do not facilitate discussion or confirmation of engagement expectations, scope and services. Over time, the client's needs, and, consequently, services delivered by the firm, may change, and the engagement letter may not keep pace with these developments. As a result, engagement or scope creep may occur, which introduces an unnecessary risk to any practice.
Unilateral engagement letters also have the effect of minimizing verbal communication between the client and the firm. While this may save time, the lack of client discussion diminishes the firm's ability to demonstrate the value of its services. Like the evergreen engagement letter, a unilateral engagement letter also may not accurately reflect a client’s needs if they have evolved.
Round 1 winner: Annual engagement letters
Round 2: Risk Exposure
Failure to align expectations regarding the scope and limitations of services has led to numerous professional liability claims. The regular client discussion encouraged by annual engagement letters as noted in the "Client Relationship Management" section of this article is an effective professional liability risk management practice.
In some professional liability claims, clients attempt to assert the claim several years after the services were rendered. In many cases, these claims would be time-barred based upon the applicable state statute of limitation. The statute of limitation, which depends upon both fact-specific and jurisdiction-specific issues, establishes a time limit within which legal proceedings may be instituted, including those against CPA firms. A successful statute-of-limitation defense may require evidence that an engagement ended on a specific date, such as an engagement letter that defines when the engagement will end. For example, it may specify that the engagement will end upon the delivery of a work product, written notification by either party, or no later than one year from the execution of the engagement letter.
Evergreen engagement letters, by their nature, do not include this language, and therefore using evergreen letters may negate an available statute-of-limitation defense. In contrast, both annual and unilateral engagement letters typically include affirmative statements regarding when the engagement will conclude. For the avoidance of doubt, especially for recurring or consulting engagements where the end may be difficult to identify, some firms issue closure letters to clients. This letter confirms the termination of services encompassed by a particular engagement letter.
Finally, some plaintiff attorneys will contend that terms in unilateral letters were not agreed to by the client since only the CPA firm's signature is present. Consequently, a unilaterally signed engagement letter may weaken the defense of a professional liability claim.
Round 2 winner: Annual engagement letters
Round 3: Return On Investment
Creating and updating annual engagement letters for every engagement is typically considered a low-value, time-consuming task. It is understandable that firms would seek to streamline administrative processes. While issuing annual engagement letters may seem onerous, use of templates, including those provided by the AICPA or your professional liability insurer, and use of a standard terms-and-conditions document help make the process more efficient.
Evergreen engagement letters may appear to be the most efficient option, but what about the time spent clarifying the scope of services or resolving client questions that could have been addressed by an updated engagement letter? Additionally, claim experience of the AICPA Professional Liability Insurance Program indicates the perceived time saved may be outweighed by the impact on professional liability claims. The cost in time and money to resolve a claim related to engagements in which evergreen engagement letters were used is significantly higher than claim amounts related to engagements with annual engagement letters or even no engagement letter at all. In the long run, evergreen engagement letters are not truly the most time-efficient option.
Annual engagement letters with two signatures and unilateral engagement letters both require more upfront time than evergreen letters. But, as stated above, they can offer greater overall savings and ROI when liability is factored in. That said, the unilateral letter is appropriate only for certain engagements, which limits its use and overall value when compared to an annual letter.
Round 3 winner: Annual engagement letters
Let’s Go To The Scorecards!
Our ringside judges have scored the bout. Three rounds to zero for your winner by unanimous decision, and still the undisputed heavyweight champion of the engagement letter world—the annual engagement letter!!! While not the champion, unilateral letters are still a strong contender. They are best suited for high-volume, low-dollar engagements, such as straight-forward individual income tax preparation services. Evergreen letters? They may need to go back to the gym. In a professional liability claim, their poor defense can leave CPAs on the canvas and down for the count.
CNA Accountants Professional Liability policyholders may access and download sample engagement letter templates by logging into the Policyholder Resource Center.
A version of this article originally appeared in the Journal of Accountancy.
Sarah Beckett Ference is a risk control director at CNA. For more information about this article, contact specialtyriskcontrol@cna.com.