Accounting Office Management & Administration Report

March 2007

Expert Advice on Protecting Your Firm From Costly Claims

Busy season is the time when most firms handle the highest volume of engagements. As a result, it might be the time when your firm has the greatest exposure to potential liability issues. Is your firm as protected as it should be?

Protection may or may not involve adding insurance. What is most important is making sure that your practices and processes are designed to protect the firm, and that everyone knows about and is following the correct procedures.

A session at the Association for Accounting Administration’s annual conference in Indianapolis provided ideas on how CPA firms can make sure that their firms are protected for the busy season and beyond.

Two experts in accountants’ liability insurance and related issues gave the presentation: Stephen Vono (stevev@naplia.com), founding owner of NAPLIA (North American Professional Liability Insurance Association, an independent insurance agent with about 10,000 CPA clients), and Ralph Picardi (rpicardi@lappingandpicardi.com) who is partner in charge of the litigation practice at Lapping & Picardi LLP. Picardi is an attorney and CPA who defends accountants in lawsuits.

Risk management for your accounting practice begins with education: You need to understand where claims come from, said Vono. The objective is to adopt effective quality control policies and procedures.

The goal is to minimize claims, Picardi said, explaining that it isn’t possible to completely eliminate risk and claims. "You can do all right and still be sued," he noted. A program at your firm to minimize the risk of claims that do arise should be the goal.

Where do claims arise? According to information from NAPLIA, AccountingMalpractice.com, Lapping & Picardi, and other sources, tax is the area that tends to draw the most claims: 55% of claims, to be exact (see Figure 1). While audit accounts for just 10% of claims, these tend to be the most costly.

This becomes clear, said Vono, when you consider actual payouts on claims (see Figure 2). Audit claims are responsible for 37% of claims payments, with "other" payouts at 20% (including bookkeeping and write-up services); and tax runs third, at 17%. Tax claims are far from cheap, however; Vono noted that tax payouts now average $30,000 to $35,000. While the payouts for compilation and review appear low, he said that they are on the rise.

"You need communication, so the client understands what the services include," said Vono, and so that claims can be minimized and some avoided altogether.

Tax claims are the top cause of the malpractice suits accountants face. Individual and corporate tax claims are 60% of all such claims, and the reasons are often similar (see Figures 3 and 4): 25% of claims stem from untimely filings and 23% from computation and form preparation errors.

"Try to get all people responsible for tax prep to follow the same system to avoid these problems," Vono advised.

A written engagement letter that is signed by the client is the ideal, Picardi said. It may be hard to obtain signed letters from every individual tax client, so as an alternative, he suggested changing the wording of the letter to instruct clients to sign and return it to the firm. Add language stating that if the client fails to do so, but sends the CPA his or her organizer and/or materials, that act is deemed to be acceptance of the engagement letter’s terms and would be the basis of an enforceable provision should a claim later arise.

Additional tips on avoiding tax claims offered by Picardi include:

Document all verbal advice in detail in the working-paper file.
Follow up any specific advice with a letter of explanation. Include specific limitations or concerns.
Request additional information needed to provide a more precise opinion.
Provide clear filing instructions in writing.
Make sure your clients understand their responsibilities.
Get receipts for important documents provided to clients.
Keep current with tax law changes and software changes/updates.
Evaluate all client engagements annually.
Monitor your staff and review their work.
Watch for such warning signs as staff ill health or personal problems, client complaints about missed appointments, or calls not being returned by partners or staff.
Set standards for service and professionalism.
Provide in-house training and mentors.
Have open-door policies for staff to share concerns and issues.

Audit claims are costly, thanks largely to fraud-related concerns, Picardi pointed out. These claims can be especially painful to your firm’s pocketbook because juries tend to hold accountants to higher standards than those promulgated by the accounting profession. "Make sure your staff are skeptical and know the right questions to ask of management," he suggested. "Send people to seminars to see examples of typical frauds and how to detect them."

Fraud actually comes in very low as a stated reason for an audit claim, although those claims can be expensive. Failure to detect a problem is the most common reason, at 40% of claims (see Figure 5). And certain industries are more likely to bring a claim against a CPA or CPA firm in an audit (see Figure 6).

Most audit claims arise from these areas, the speakers noted:

Client management that is suing for failure to detect embezzlement or other fraud.
Shareholders suing for failed investments.
Lenders alleging that they relied upon auditors’ report to make loans. Picardi noted that exposure to liability from these kinds of claims varies by state.

Red flags that could lead to audit-related claims include:

Client records are consistently disorganized, incomplete, or missing.
High employee turnover for bookkeepers, controller, or CFO.
Absentee owner with little involvement in day-to-day operations.
Client fails to provide financial records timely and is unresponsive to repeated requests.
Client owns several businesses and has extensive transactions among them.
Client changes lending institutions frequently.
Suggestions from Picardi on minimizing audit risk include:
Perform only audit engagements that the firm is qualified to perform and has experience with.
Adequately plan the engagement.
Stay current with training, reference manuals, and practice aids.
Supervise all work and adopt a thorough review structure.
Document all communications with clients in the work papers.
Use a thorough client pre-engagement screening process including reference from prior auditor.
Don’t become complacent about identifying and reporting internal control issues.
Maintain skepticism about inventory discrepancies, year-end adjustments, and significant changes to bank loans or credit lines.
Be careful when accepting management representations of accounts receivable and collectibility (one-third of all audit claims grow out of this area).

Because of the high cost of audit claims, a centralized and agreed-upon partner review of new audit clients is wise, Picardi added. "The firm needs to decide how risk- averse it is and how to handle problem situations."