A CPA firm prepared tax returns for an individual and his two businesses (Business A and Business B), all of which had separate, signed engagement letters for the return preparation work. The client asked the firm to research how a state income tax credit applied to Business A but did not ask about Business B. The CPA performed the requested research and responded to the client but did not have anything that documented the scope of services or fee arrangement for this additional research, such as an engagement letter. When the client balked at the bill for the additional services, the CPA discounted the work as an accommodation, took the loss, and begrudgingly put the matter behind him … or so he thought.
 

Several years later, the client left the CPA for another firm. The new firm asked the client why their previous firm didn’t apply for the state income tax credit for Business B, indicating it would have qualified. Unfortunately, the statute of limitation had expired, and the client was unable to apply for the credit. The client sued the former CPA firm asserting that since the former CPA firm performed research related to Business A, the client assumed the firm had also performed similar research on Business B and had concluded Business B did not qualify for the credit.
 

While the former CPA firm argued that the client had only asked about Business A, the lack of an engagement letter or any other sort of documentation related to the requested research made it difficult to defend the claim that the CPA firm was engaged to perform the same work for Business B. Unfortunately, in a war of words, clients often prevail over the professionals.

Defense of the CPA firm proved challenging, and the claim was settled.

Most CPAs know that a dually signed engagement letter, including applicable terms and conditions, is the best way to document the agreed-upon services, especially if a disagreement arises. Despite this knowledge, claim experience demonstrates that many CPAs provide services without an engagement letter.

Many professional liability claims arise because of the three “M’s” — mistakes, misunderstandings, and misrepresentations. CPAs are human and make mistakes sometimes — an engagement letter cannot prevent that. Misunderstandings and misrepresentations, however, may be avoided if there is clear documentation that describes the scope of services and each party’s responsibilities.

Sometimes, it may seem that preparing an engagement letter is not valuable because it takes more time to prepare the letter than it takes to deliver the service. Is there a different approach?
 

Alternatives to an engagement letter

An engagement letter is highly recommended for a new client or additional services to an existing client if the service falls under different professional standards than the initial engagement. Also, if an additional service would take significant time or could have a material impact on the client or other stakeholder, such as year-end tax planning, a separate engagement letter should be obtained.

In certain situations, however, other forms of documentation, such as an engagement letter addendum or email, while not ideal, may be sufficient. These circumstances may include minor changes to an existing engagement, such as preparing a tax return for an additional state or modifying the analysis period in a due diligence engagement. Alternative documentation might also be used to memorialize less time-consuming services related to a client’s quick question or request, such as assisting a tax client with their response to a tax notice or calculating withholding required on a bonus to avoid underpayment penalties.
 

Requirements of alternative documentation

A primary benefit of an engagement letter is alignment of the CPA’s and the client’s expectations regarding the scope and limitations of the service to be performed. To derive the same benefit from alternative documentation, it is imperative that the alternative documentation include the following:

• The nature of the client’s question or request;
• The CPA’s response;
• Additional fees; and
• A statement that the CPA’s terms and conditions included in the original engagement letter between the parties apply to the additional services.

If the CPA’s response is based on limited information or summarizes preliminary thoughts, in addition to the above, the alternative documentation should state the following:

• The thoughts and advice provided by the CPA are based on limited information and are preliminary in nature;
• Changes in circumstances or additional information may change the CPA’s preliminary advice; and
• The client should not act or make decisions based upon the CPA’s advice without a more complete analysis.

What not to do

Providing advice or responses to client questions via text and other informal communication methods is not recommended, as the brief, generally informal nature of these communication methods is not conducive to including the critical documentation requirements described above.
 

Communication and training

Use of alternative documentation is an area ripe for inconsistent application across the firm. To ensure all firm owners and employees help manage the firm’s risk, communicate the firm’s documentation protocol, including when and how to use it, and provide routine training on it.

Consider beginning all staff meetings with a story about when scope expanded and how it was documented. This understanding is every professional’s responsibility, not just the partners’. Give accolades to the individual who identified the scope expansion, especially if it is a junior professional. Alternatively, a weekly communication to the firm could highlight these success stories.

When conducting technical training, consider adding a section on how to document additional services. For example, an email may be sufficient to document an initial discussion with a client regarding a new tax law, but if the client requests research as to how it will apply to their specific facts, will the firm require a new engagement letter? An engagement letter addendum?
 

A better ending

A CPA was asked to calculate the tax implications of a hypothetical sale of a family business. The client was billed one hour for a preliminary, “back-of-the envelope” calculation, which was sent via email to the client along with a note explaining that this was a preliminary calculation only based on a hypothetical sale, that the client should not take action based on this information, and that the terms and conditions of the CPA’s tax preparation engagement letter applied.

Despite the CPA’s warning, the client sold the business without confirming the tax implications with the CPA. Unfortunately, the client did not tell the CPA a material fact, and the client paid over $2 million more in tax than anticipated.

The client asserted that, had it known the actual amount of tax due from the sale, it would not have sold the business, and, as a result, the CPA should pay the additional tax, not the client. Additionally, the client’s damages claim included missed investment gains from the lost opportunity to invest the money paid in taxes.

Fortunately, the CPA’s email proved instrumental in defending the case. The firm argued that the client requested a preliminary calculation, and the CPA clearly stated the client should not rely on the calculation before proceeding with an actual sale. Further, the firm’s terms and conditions limited its liability to three times fees and excluded indirect damages such as missed investment opportunities. Based on these defenses, the claim was dismissed.