Loss Prevention for Accountants: Avoiding Malpractice, Litigation while Keeping Your Clients Happy
by Terri Eyden on
By George J. "Jay" Coleman, III, J.D.
The accounting profession first became a lucrative target for plaintiffs' lawyers after the savings and loan industry collapsed in the mid-1980s, and little has changed since then. Accountants continue to be seen as deep pockets whenever financial transactions go sour, and regulatory scrutiny of the profession has increased.
It is no fun to be sued for malpractice. Even a defensible lawsuit in which you ultimately prevail will cost attorneys' fees below your insurance deductible, and will intrude upon your and your colleagues' time, attention and emotions.
Moreover, what about the damage to you and your firm's hard-earned reputation? The buzz around town will be that you got sued. The favorable resolution three years later will be yesterday's news and may be confidential in any event.
Your goal, then, is not to get sued in the first place.
The first part of this article discusses common ways accountants can get into trouble. The second part covers what to do if you are sued.
Part 1. Common Sources of Liability
While reviews and compilations have generated litigation, the most significant claims in terms of dollar value arise from audit work. Like it or not, auditors are viewed by the public at least as "watchdogs," and perhaps as "bloodhounds." Regardless of what the auditor's opinion letter says on its face, the public views it as a guarantee concerning management's integrity and, for better or worse, juries often do so too. The "expectations gap" is alive and well.
Maintain your independence from your client, and avoid actions that might suggest you are anything but independent. An auditor's presumed lack of independence is a plaintiff's favorite button simply because it is something a jury can appreciate and will react to. While a jury may fall asleep listening to experts talk about GAAS and GAAP, it may become incensed if the "independent" auditor vacationed in Hawaii as his client's guest.
So don't let your friendship or long-standing relationship with your client cloud your judgment. Problems start to occur precisely when you start to relax – which is why regulators are again pushing for auditor term limits and rotation of engagement partners. Have a healthy skepticism; if you see a problem, don't ignore it. Ask questions until you are satisfied. If the client is honest it will work with you. If the client is dishonest, then it should find another accountant.
Tax advice and return preparation result in the greatest number of claims against accountants, though their monetary value is not as significant as audit claims. This isn't surprising. Not only is tax work a mainstay of most accountants' practices, but your work product in that area – the tax return – is subject to a hindsight examination by the government.
Tax malpractice results most frequently from simple lapses. Tax claims range from missed deadlines and elections to poor advice to, most of the time, return errors. Malpractice occurs more from simple inattentiveness and poor client communications than from errors due to the complexities of the tax code. Many problems can be prevented by simple quality control procedures, such as an adequate tickler system.
Be careful when giving spur-of-the-moment tax advice. If your client calls during the rush of tax season with a "quick question," take a moment to evaluate if the question is easy enough, and the client sophisticated enough, that you will be able to answer the question competently without taking the time to research the issue. If you do proceed with giving "quick advice," dictate a file memo summarizing the advice. If your client is unsophisticated and/or the question is complex – or if large dollars are involved – confirm the advice with a short letter summarizing the information you were given, the advice you gave, reminding that it was a general discussion, and inviting the client to discuss the matter in more detail with you when time permits.
Also be careful when preparing last-minute extensions based upon what a client has told you but not confirmed in writing. It's easy during tax season to forget unusual items that should be included when calculating the extension payment. Document your discussions with your client and confirm in writing that the extension is based upon and only as good as the information provided by the client.
The best practice is to make sure you have all the facts before you give sensitive tax advice. Tell the client you need more time and/or more facts before you can be in a position to give advice. Do not let the client rush you.
Think twice about keeping your clients' books, lest they say it's your own fault you didn't have the information needed to prepare the now-tardy tax return. Make sure your engagement letter states that it is the client's responsibility to timely provide you with the information necessary to prepare the return. Without such documentation, a jury may have to decide whose job that was based upon your word against your client's.
Finally, be careful representing your clients before the IRS or other taxing authorities. Not only is there no attorney-client privilege but your "mea culpa" attempts to exonerate your client may come back to haunt you when the client sues you. You will also be extending the time your client has to decide whether or not to sue. Regardless of when the statute of limitations for tax malpractice begins to run in your state, it may not run at all while you continue to represent your client in dealing with the IRS. If you have some exposure, it's probably best that you cease representing the client.
Consulting and Other Work
Offering consulting or management advisory services, such as litigation support and trustee services, can create exposure. If the consultant (or even your tax preparer) is not a CPA, tell your client that a non-CPA is doing their work. Otherwise, the client may think your staff person is a CPA, which can form the basis for a "bait and switch" fraud claim.
Remember that information learned in a consulting engagement (e.g., that the client is losing a large account) may be relevant to your firm's audit or tax engagement and vice versa, and the knowledge of the consultant can be imputed to the auditor – so communicate with each other. And beware of conflicts of interest: Consulting can compromise auditor independence.
While beyond the scope of this article, other traditional accounting work like business valuation and preparing projections can lead to exposure. Use appropriate disclaimers when submitting your work to the client. Doing work for employee benefit plans and implementing a computer system for your client can also spawn litigation.
Exposure to Third Parties
In most states nowadays, accountants can be liable not only to their clients but also, under certain circumstances, to non-clients. Lenders, investors, acquirers, insurance commissioners, bankruptcy trustees and receivers have all sued accountants. Don't make it easier for these potential plaintiffs. Disclaim responsibility to non-clients in your engagement letter. If a bank calls to say it's going to lend based on your work, don't say that's fine. Investors finance a company for any number of reasons; it is only in hindsight, after the deal goes sour, that they say all they relied on was your audit opinion. Don't let them escape the responsibility of doing their own due diligence.
Part 2. What to Do If You Are Sued
Being served with a lawsuit or getting a letter from your state board or the AICPA can ruin your day. But you can't ignore the situation. What you do next could make matters worse and affect your ability to mount a strong defense.
First, don't try to "fix" the problem yourself. Don't try to talk your unhappy client out of suing you. He may have already gone to a lawyer. You won't change his mind, and anything you say to him can and will be used against you in litigation. Don't prepare a mea culpa memo to your partner justifying your work, and think twice even about getting a second opinion from your colleague. That memo and conversation will be discoverable by the opposition in litigation.
Do not destroy any documents. The last thing you need is to defend a spoliation case on top of a malpractice case. Document destruction ranks with auditor independence problems as a plaintiff's preferred "spice" to inflame a jury.
Don't "supplement" or "update" your workpapers with what you now remember was done. Workpapers are supposed to be contemporaneous documents; that's why they're a powerful defense tool. If you kept them properly, they will refresh your memory and help convince the jury that you did solid work. Otherwise, you'll have to convince them with only your own hindsight testimony.
Notify your insurance carrier as soon as you think there may be a claim, and do it in the precise manner stated in the policy. If you wait too long, coverage might be denied. If you simply call your local agent, and don't follow the formal notification procedures, coverage might be denied.
The sooner you get a lawyer, the sooner the attorney-client privilege will attach to protect your communications and your work product. Otherwise, what you say and do will be discoverable. Your attorney can help you prepare a proper disengagement letter, if you haven't already disengaged, and then guide you through the litigation or regulatory process.
About the author:
George J. "Jay" Coleman, III, J.D., is with Mack Watson & Stratman., a law firm in Phoenix, Ariz. He represents clients in complex commercial litigation and other forms of dispute resolution. His practice has an emphasis on matters involving allegations of securities and business fraud and representation of accounting firms and law firms in malpractice litigation. Contact him at email@example.com.