The importance of engagement letters for small firms.

• Author: Sawyers, Roby B.

Tax issues are the most common source of malpractice claims against CPA firms, accounting for 72% of total claims in 2016, according to CNA Financial Corporation, the carrier for the AICPA's professional liability insurance program. Common reasons for those claims often include issues that arise from misunderstandings between firms and their clients. According to CNA Financial and discussions with Kevin M. Murphy, partner and managing attorney at Carr Maloney PC, during the AICPA Tax Practice Responsibilities Committee meeting on May 9,2018, among those reasons are:

* Failure to advise clients or providing improper advice;

* Filing errors such as late elections, underreporting revenue, overstating deductions, and math and clerical errors;

* Errors related to specific transactions such as Sec. 1031 exchanges and mergers and acquisitions;

* Defalcations by client personnel;

* Conflict claims in divorces or business separations;

* Tax return identity theft;

* Actions against a CPA or firm by a state board or other agency;

* Lack of disclosure when there is a questionable basis for a deduction; and

* Foreign asset disclosure forms (e.g., FinCEN Form 114, Report of 'Foreign Bank and Financial Accounts (FBAR)).

Failure to advise clients (or providing improper advice) is the most frequent cause of claims in the AICPA Professional Liability Insurance Program. Often, these disputes are a result of scope-of-service disagreements between firms and their clients. Engagement letters are the first and most critical line of defense against scope-of-service claims, helping to prevent claims by establishing clear responsibilities and managing client expectations as well as defending against claims by defining the scope of services and establishing limitations on the services to be provided to a client. Using engagement letters is also associated with reducing the severity, i.e., the dollar amount, of claims (see Ference, "Professional Liability Spotlight: Setting Expectations," 224-4 Journal of Accountancy 16 (October 2017)). Unfortunately, small firms and sole practitioners are the least likely to regularly use engagement letters (id.).

While firms may be reluctant to send multiple-page engagement letters to clients (the sample AICPA letter for individual clients is eight pages, with an additional eight-page addendum of terms and documents) and may have difficulty getting clients to sign and return the letters, best practice standards in Section 10.33 of Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), require "[c]ommunicating clearly with the client regarding the terms of the engagement."

Limiting...