Avoiding Accounting Malpractice

Accounting firms are not immune. Every member of the firm, from the partner in-charge down to the staff accountant, runs the risk of committing accounting malpractice. However, several steps can be taken to avoid costly mistakes and liabilities.

Accounting malpractice can happen in any firm, no matter how large or small, in a number of different situations. Without adequate experience, training and supervision, accountants can make critical mistakes that result in serious consequences for their firms and their carriers.

Case in Point

Take for example the case of John R., a recent accounting graduate who knew very little about auditing liability. Because of a heavy workload, John's accounting firm provided him with minimal guidance--especially the risks involved in auditing and reviewing the financial statements of a large corporation with significant accounts receivable. The accounting firm also failed to instruct him on the Statement on Auditing Standards (SAS) 82 in regards to the consideration of fraud in financial statement audits that had recently been released.

While auditing the financial statements of a new wireless telephone company that had recently gone public, John failed to confirm several large accounts receivable. Most of the accounts he failed to confirm turned out to be fraudulent. These accounts exceeded $4 million and provided the company with a positive net worth. As a result of the unsupervised work performed by John R., the accounting firm issued an unqualified opinion. The client subsequently used the opinion, along with the fraudulent financial statements, to obtain a $3 million loan from a local Miami-Dade bank.

Three months later, the wireless telephone company filed for Chapter 11 bankruptcy protection and the fraudulent accounts were discovered. The bank and the company's shareholders sued the accounting firm for accounting malpractice. The suit was ultimately settled for $2.5 million, not including attorney's fees and costs.

In a different scenario, a wealthy client sought estate-planning advice from a midsize accounting firm. The client's goal was to avoid any "generation-skipping" tax. An accountant, who had very little gift and estate tax experience, was asked to attend the initial meeting with the client and was then instructed to complete the appropriate tax forms.

At the time, the Internal Revenue Service had not issued regulations on the key provisions of the "generation-skipping" tax. Unfortunately, the accountant misunderstood the statute and failed to properly complete and check the appropriate generation-skipping portion of the tax form. A senior partner briefly reviewed the tax form and approved it without revision. As a result of the oversight, the client faced a substantial increase in tax liability and sued the accounting firm for malpractice. After a lengthy jury trial, the accounting firm was found liable and had to pay the client millions of dollars in damages.

Overview of the Law

Courts have always held accountants liable to their clients for negligence. Courts, however, were initially hesitant to hold accountants liable to third parties. In 1931, the New York Supreme Court in "Ultramares Corp. vs. Touche, Niven & Co." held that an accounting firm could not be sued for ordinary negligence by a third-party who lacks privity with the accounting firm. They may be sued for fraud or gross negligence if the third party could be expected to rely on fraudulent financial statements.

Since Ultramares, four lines of authority have been developed with respect to whether an accountant can be sued for negligence by third parties that are not in privity with the accountant. The first line of authority following Ultramares holds that, except in cases of fraud, an accountant is only liable to one with whom he is in privity.

As a number of courts throughout the United States were dissatisfied with the Ultramares decision, the courts of Nebraska, Rhode Island, Texas, Georgia, and New Hampshire replaced it with a new standard--later codified in Section 552 of the Restatement (2d) of Torts. The restatement provides that accountants will be held liable to individuals actually known to them or intended third-party users of financial statements, including members of a "known or intended class" of users of financial statements.

For example, in the first scenario discussed above, if the accounting firm knew that the financial statements were to be used to obtain a bank loan, then the accounting firm would be liable to any bank that they specifically knew would rely on the financial statements or could be expected to rely on the financial statements.

In 1983, the New Jersey Supreme Court in "Rosenblum Inc. vs. Adler" created the third line of authority expanding on the restatement. The court held that a CPA is liable at common law to reasonably foreseeable third parties that detrimentally relied on negligently audited financial statements. In other words, even if the accountant does not know of the third-party or the third-party is not within the "intended users of financial statements," the accountant is liable if the third-party is within a class of persons "who might reasonably be foreseen to rely upon the financial statements and the accountant's opinion.

Courts following the fourth line of authority hold that a court must perform a balancing test in determining whether an accountant is liable to third-parties. In performing the balancing test, the court is to take into account, among other things, the extent that the transaction was expected to affect the third-party; the foreseeability of the harm; degree of certainty that the third party would be injured and closeness of connection between the third-parties' injury and the malpractice that occurred.

In 1990, the Florida Supreme Court in "First Florida Bank, N.A. vs. Max Mitchell & Co." adopted the restatement approach. Thus, in Florida, an accountant is liable for negligence to members of a "known or intended class" of users of financial statements.

In today's litigious environment, an accounting firm can be sued for a number of causes of actions; including, but not limited to, RICO, negligence, aiding and abetting, injunctive relief, willful understatement of liabilities, and for criminal and civil penalties.

Protecting Accounting Firms from Malpractice

Accounting firms can reduce the possibility of committing malpractice by adhering to the following guidelines:

1. Accountants should always perform services with due professional care. This term is often referred to as "due diligence" and requires each professional to perform his or her work with reasonable care.

2. All newly hired accountants should receive extensive training and orientation as to all of their duties and responsibilities. Accountants should be provided with an audit program and checklist to follow in performing their tasks. The audit program should be developed or, at the very least, extensively reviewed and approved by the engagement partner based on the assessed audit risk. The accounting firm should also ensure that the accountants receive continuing education to meet their CPA state requirements and to remain informed of the latest changes in all rules, regulations and court decisions affecting their areas of practice and client base.

3. Specifically, in the audit field, the accounting firm should place strong emphasis on each auditor's compliance with Generally Accepted Auditing Standards (GAAS) and the Code of Professional Conduct.

4. SAS 82, titled Consideration of Fraud in a Financial Statement Audit that is effective this year, requires that auditors "prepare a plan and perform an audit to obtain reasonable assurances about whether the financial statements are free of material misstatement; whether caused by error or fraud." This new SAS also provides certain procedures that must be followed by auditors. This new standard would appear to increase an auditor's duty of care for detecting fraud and misappropriation of assets. Therefore, all parties in the firm should be aware of this new SAS, as well as other new pronouncements that are released from year to year.

5. The partner and manager involved in each engagement must closely supervise junior accountants to ensure that their work is being accurately performed. All work should be extensively reviewed, first by the manager and then by a partner, prior to being finalized-as the partner in charge of the particular engagement is ultimately responsible for the work performed by staff accountants.

6. If accountants market themselves as experts in particular fields, they will be held to a higher standard of review. Therefore, it is not a good idea for an accountant to market himself/herself as an expert in an unfamiliar area.

7. If an accounting firm is not familiar with the applicable law in a particular area, seek the advice and guidance of an attorney. The lead accountant may also want to advise the client to hire an attorney who can analyze the particular issues from a litigation standpoint and attempt to limit the client's exposure.

8. When necessary, an accounting firm should select an attorney specializing in accounting malpractice issues and request advice on any potentially dangerous situations.

9. The accounting firm should maintain adequate insurance coverage. Although insurance is not a substitute for compliance, accounting firms must protect themselves from financial losses. Also, today's accounting firms provide a wide variety of services which do not fall within the traditional accounting practice, including investment services, financial planning, business consulting, and management advisory services. Accounting firms that provide these services must be aware of potentially increased exposure and obtain extra insurance coverage.

Client Selection

When selecting clients, an accounting firm should keep the following suggestions in mind:

1. Conduct a thorough investigation of all prospective clients. Accounting firms should develop a reliable screening process to determine whether to undertake representation in the first place. A background check should be performed on the officers and directors of the client to obtain a comfort level regarding the management of the company. If the client is currently having financial difficulties, the accounting firm should consider the risks involved in such a representation- especially when asked to perform an audit or review. Such a client may tend to overstate its assets and revenues, as well as understate its liabilities and expenses. Therefore, the partner or senior manager involved in the engagement should review the client's current and past financial statements and tax returns to identify potential problem areas.

2. The accounting firm must contact the client's prior auditors and lawyers to determine why a change in auditors has occurred and if there were any problems with the client to cause such a change. The accounting firm can learn a great deal about a client and their management from speaking to the prior accounting firm and any attorneys representing the client in prior engagements. If the client does not permit such a conference, the accounting firm should immediately inquire as to the reasons for such a denial.

3. Once the accounting firm decides to undertake the representation of a client, it should obtain a thorough knowledge of the client's business practices. The partner in charge of the engagement should prepare a risk assessment checklist on the engagement.

4. Accounting firms should prepare, and have executed, detailed engagement letters. The engagement letter should include exactly what the accounting firm will perform and its responsibilities to the client. This will protect against misunderstandings as to what services the accounting firm was hired to perform.

5. The accounting firm must obtain a management representation letter documenting any issues arising during the audit. The client must sign the letter affirming the representations relating to such issues.

6. The accounting firm must maintain appropriate documentation to support all of the work performed and options provided.

Practical Applications

With respect to John R., the accounting firm should have provided him with training on how to conduct an audit. John R. should have been provided with an audit program and checklist to follow that included the new procedures set forth in SAS 82. The manager or partner on the project should have reviewed the type of engagement with John R and the other members of the audit team, and discussed any areas that could present a problem. Such a procedure would have alerted John R. to the large accounts receivable balances, requiring him to conduct adequate tests to verify them. These tests may have detected the fraudulent accounts, thereby warning the accounting firm not to issue an unqualified opinion.

Second, the partner and manager involved in the audit should have extensively reviewed John's work, or at least instructed him on the tests to conduct and to report back with his results. If this procedure were in place, the partner would have been forewarned not to issue an unqualified opinion on the financial statements.

Regarding the generation-skipping oversight, the accountant should have been given intensive training regarding gift tax issues, and the appropriate tax forms. However, even with adequate training, mistakes can happen. Thus, a senior accountant should always review the work of less-experienced accountants. Such a thorough review would most likely have discovered the simple mistake of failing to check the generation-skipping box on the tax form.

Conclusion

In all cases, the most qualified accountants must be assigned to each specific engagement. The partner on each transaction must be actively involved. Simple mistakes can be very costly to an accounting firm. If an accountant realizes that a specific issue has arisen which may lead to potential liability, the accountant should immediately notify the partner or manager in charge of the engagement. To this extent, an accounting firm should always be aware of clients with financial difficulties. Such a situation may increase the potential risks of misleading and inaccurate financial statements.

In conclusion, awareness of the aforementioned guidelines is key and whenever the possibility of malpractice is involved, an attorney or fellow accountant should be consulted to review the engagement or financial statements in question.

Manuel A. Garcia-Linares, Esq., is a shareholder with the law firm of Richman, Greer, Weil, Brumbaugh, Mirabito & Christensen, P.A., a Miami and West Palm Beach, Florida based law firm where he practices commercial litigation, class action litigation, inland marine defense, and performs corporate and transactional work.

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