Based upon claim experience of the AICPA Professional Liability Insurance Program, we have learned that accountant malpractice claims often arise in engagements in which the CPA believed actions were taken in the best interests of the client, but the related liability risks to the accounting firm were ignored. CPAs placing client demands above potential liability exposure often face lawsuits filed by clients and third parties. What are the key indicators of engagements susceptible to this common problem? This article addresses the “red flags” as well as recommended practices for terminating a client relationship to help mitigate the risk of experiencing a malpractice claim.
Public accounting is a client service industry, and CPAs strive to meet client needs in fulfilling their professional duties. Claim experience from the
AICPA Professional Liability Insurance Program has demonstrated that CPAs encountering litigation often permitted client interests to supersede their own standards of professional responsibility. Clients can create numerous issues for CPAs, such as failing to provide requested information, pay outstanding fees, or placing the CPA in the middle of business or personal disputes. CPAs are often reluctant to terminate a client relationship because doing so is perceived as poor customer service and ultimately results in a loss of business. When withdrawal may provide the best course of action, continuing to serve the client often increases the risk of experiencing a claim and may inflate potential damages. This article illustrates pitfalls that can arise in serving such clients and provides strategies to manage risk when withdrawal should be considered.
Consider the following engagement scenarios:
Broker-Dealer Audit/Regulatory Examination
A CPA firm audited the financial statements of a broker-dealer for multiple years. The broker-dealer had significant outstanding debt with a bank, including multiple lines of credit, and was in the process of refinancing its debt with its lender to improve poor cash flow conditions contingent upon submission of audited financial statements for the most recent year. As part of the audit for that year, the audit team performed management inquiries which led to the discovery of an outstanding regulatory examination by the Financial Industry Regulatory Authority (FINRA). Management indicated there were preliminary oral findings communicated by the regulators that could result in immaterial penalties. The audit team pressed management to obtain more information concerning the nature and extent of the regulator’s findings and the timing to finalize the examination. However, management provided little information and reminded the audit team of the time-sensitive deadline for submitting audited financial statements to its lender. Although the firm wasn’t completely satisfied with the information provided by management, it agreed to complete the audit and issue its report. The notes to the financial statements mentioned the outstanding examination but failed to provide any comment on the nature of the findings. The audited financial statements were provided to the bank, and the broker-dealer successfully completed its refinancing arrangement.
Subsequently, the FINRA examination was finalized and substantial penalties were imposed on the broker-dealer, which were material to the financial statements. The broker-dealer later defaulted on the restructured loan, and the lender sued the CPA firm, alleging reliance on the financial statements in renewing the loan arrangement. The complaint alleged that the footnotes to the financial statements didn’t adequately disclose the nature and extent of the preliminary findings. It further alleged that had the lender known of the nature of the findings, it wouldn’t have waived debt covenant violations or extended the terms of the loan. The complaint sought recovery of losses that the lender allegedly incurred following the refinancing.
The auditors issued an unqualified audit opinion despite their lack of knowledge regarding the status of the open regulatory examination due to their desire not to delay the client’s refinancing arrangement.
During litigation, the plaintiff expert noted that the audit team should have discussed the status of the open examination with FINRA, rather than relying upon management inquiry alone to determine the impact on the financial statements. Had management refused to consent to the auditor’s inquiry of FINRA, the auditor should have withdrawn from the engagement due to management’s scope limitation. The case settled prior to trial for 75% of alleged damages incurred.
Tax Preparation/ Estate Tax Return
A CPA who had previously prepared income tax returns for an older couple was contacted by the husband with a request to prepare their most recent year’s return. The CPA informed the husband that an extension to file was required and that an extension payment would need to be made as well. The extension was filed, but when the wife called the next day to inform the CPA that her husband had died suddenly, the CPA neglected to tell her that an extension payment should promptly be made to avoid late payment penalties and interest charges. The CPA advised her to compile available tax records and scheduled an appointment to meet and discuss preparation of both the outstanding income tax returns and the estate tax return. The widow was only able to locate a Form 1099, reflecting stock sales and an income statement pertaining to rental property. The CPA left her several voice mails and sent additional emails requesting more information, but she never responded. The CPA eventually gave up, presuming she had engaged other tax professionals to assist with the tax returns.
The following year, the CPA received a letter from the widow’s attorney alleging that the CPA failed to advise the client of the need to pay estimated taxes and to inform her of the due date to file the estate tax return. The claim sought recovery of underpayment and late payment penalties and interest.
The CPA tried to follow up with the widow to help her fulfill her tax filing obligations but gave up when he was unable to elicit a response. He assumed the client engaged another tax preparer without confirming this with the client. Although in the CPA’s view the engagement was never undertaken--because the client failed to provide requested information--deposition testimony by both the widow and the CPA established the existence of an initial agreement with the husband to prepare their income tax returns. The CPA failed to advise the widow, in writing, of the need to make an extension payment on Form 4868 and of the due date for the estate tax return. He also failed to formally withdraw from the engagement when requested information was not provided. Therefore, the plaintiff attorney asserted that the CPA owed a continuing duty to the client based upon both the oral agreement with the deceased husband and the fact that the CPA had prepared the prior year tax returns for them. The matter was settled for 50% of the underpayment and late payment penalties and interest costs incurred.
Liability and Withdrawal Considerations
In any engagement that involves any level of assurance – even, perhaps, a meeting with a banker – the CPA’s actions or inactions can be interpreted as offering assurances regarding the client’s financial condition. A common misconception by CPAs is that the law recognizes assurance as a formal written opinion issued in accordance with applicable professional standards. The reality, however, is that as a legal concept, assurance is pliable and dependent upon the specific facts and circumstances under which an accountant makes representations to a client or third parties, and can be oral or written.
Due diligence should be performed before accepting any new client and engagement. In rendering financial statement attestation services, consent to undertake the engagement is a sign that the accountant has sufficient confidence in the client’s books and records and the integrity of management to complete the assignment. Issuing a clean review report or audit opinion indicates the CPA is not aware of any material modifications or that the financial statements are free of material misstatements, respectively. Continuing the work when concerns exist about the financial statements, management integrity, or accuracy of the books and records could support a claim of reliance by both the client and third-party users. In non-attest engagements, other potential consequences may arise. Tax clients who have failed to respond to information requests could assert reliance on the CPA to prepare their tax returns with little information, unless the CPA clarifies that the failure to receive the necessary information in a timely manner to prepare an accurate and complete tax return will result in withdrawal.
When the client-CPA relationship is deteriorating, continuing to perform work for the client poses a serious risk of misunderstanding, claims for inappropriate advice or failure to advise, or other allegations. This is particularly problematic when the client has solicited advice from the CPA related to a planned or proposed transaction (real estate purchase, sale of business assets, etc.) or the CPA has provided continuing tax advice to the client in the past.
Factors for Withdrawal
In general, a CPA can withdraw from an engagement at any time upon a showing of reasonable cause. An accountant performing an attest engagement should consider modifying his or her report or withdrawing from the engagement when any of the following situations occur 1:
- Information supplied by the client is incorrect, incomplete or otherwise unsatisfactory, and the CPA is unable to obtain additional or
- The CPA becomes aware of a going concern issue and, upon discussions with management, there is a disagreement between the CPA and management on the going concern conclusion.
- The CPA becomes aware that the client’s financial statements have departed from GAAP, and management refuses to correct
the financial statements and disclosures in the notes to the financial statements.
- The CPA learns that internal controls are inadequate to allow a conclusion that the records are sufficiently reliable, or develops doubts about the ability to rely upon management representations.
In review and audit engagements, if circumstances develop that threaten the CPA’s independence, withdrawal may become appropriate or necessary. While professional standards allow options to issue modified reports and qualified, adverse or disclaimer of opinions, upon encountering any of the above situations,
CPAs should consider withdrawing from the engagement as the optimal course of action. Furthermore, CPAs are required to comply with Circular No. 230 and the Statements on Standards for Tax Services in tax engagements. A CPA should consider withdrawal if the client insists upon taking tax positions that are unreasonable or contrary to the law, refuses to amend returns for errors and omissions, or ignores filing obligations. The tax preparer should withdraw to avoid possible preparer penalties and criminal prosecution in cases where the client is engaging in tax fraud.
Situations common to all types of engagements where withdrawal may be appropriate include but are not limited to:
- Non-payment of fees by the client.
- Disagreements or disputes between the CPA and the client (i.e. fees, tax positions, accounting treatments, etc.).
- Disputes among partners or shareholders.
- Difficulty in obtaining or consistent delays in receiving requested information.
- Client patterns of failing to ignore advice.
- Lack of management integrity.
- Conflicts of interest between the CPA and the client.
- Potential conflict of interest among the CPA’s clients (i.e. divorcing or divorced clients).
- Client service complaints.
Often, CPAs do not withdraw from risky engagements due to anxiety regarding the potential consequences of withdrawal. The engagement letter may not contain a right to withdraw provision, or there may be no engagement letter. They may be concerned that the withdrawal may cause damage to the client or about the client’s ability to find a successor. In short, their concerns focus upon the possibility that a withdrawal will create problems for the client and potential liability for their CPA firm.
What measures should a CPA take to mitigate risk?
- The engagement letter should include a provision for withdrawal, noting that the CPA reserves the right to withdraw for any reason. Failure to timely pay fees should also be indicated as a basis for withdrawal.
- The engagement letter also should specify client responsibilities, including contacting the CPA for questions or issues or when additional services are needed. Otherwise, the client may be under a false impression that it is the CPA’s duty or responsibility to unilaterally contact them or to perform additional services, as needed.
- Do not let the desire to help the client override the professional obligation to act responsibly, in accordance with professional standards, laws and regulations, and in a manner that minimizes liability.
- Document in the workpapers:
–– Follow up requests made for client information.
–– Circumstances leading to a withdrawal.
- If there are disagreements with the client, these should be expressed in writing, and required communications should be made to those charged with governance in accordance with the professional standards.
- The client should be informed of the withdrawal in writing, and the letter should be sent using a delivery method that can provide documented evidence that the letter was received on a specific date.
In some situations, withdrawal is not sufficient. For example, an auditor must take measures to notify those charged with governance about timely observations and various matters including, but not limited to, significant findings, disagreements with management, uncorrected misstatements, and notification of withdrawal. For certain audits, notifications made to those charged with governance also must be transmitted to applicable regulatory bodies 2. If previously issued financial statements may no longer be relied upon, the auditor must request that management place users of those financial statements on notice. If the auditor is not satisfied that notifications were made, he or she should directly contact known users about the inability to further rely on those financial statements 3. Once a withdrawal determination has been made and the client has been informed, the CPA should not provide any further professional services to clients, including helping them to finalize any outstanding tax and accounting matters.
Continuing an engagement based upon an honorable desire to help the client is inherently risky. In the above scenarios, continuing with the engagement resulted in malpractice claims. The clients’ later legal actions could have been prevented or mitigated by a timely and properly documented withdrawal, which would have limited both the exposure and defense expenses. When clients become difficult, CPAs should consider the available courses of action, determine the protocols that best serve their needs and those of their firm, and take the appropriate steps to terminate the client relationship. Once a decision is made, do not waver.
1 These circumstances are not exhaustive of situations in which a CPA should issue an opinion other than unqualified or should withdraw from an attest engagement. The guidance is found in AICPA AU Section 500 and AICPA AT Section 101.
2 The guidance is found in AICPA AU Section 380 (or Statement on Auditing Standards No. 114).
3 The guidance is found in AICPA AU Section 561 (or Statement on Auditing Standards No. 1).
• CNA Accountants Professional Liability Risk Control. “Client Termination Letters.” Available at www.cpai.com. May 2008.
Accountants Professional Liability Risk Control, CNA, 333 South Wabash Avenue, 36th Floor, Chicago, IL 60604.
Continental Casualty Company wishes to acknowledge the contributions to this article by Charles Jones, Meagher & Geer, P.L.L.P. Charles is the head of Meagher and Geer’s Professional Liability group. He focuses his practice on defending lawyers and accountants against allegations of malpractice and representing employers in disputes with former and current employees. Charles has handled cases in 28 state and federal jurisdictions throughout the United States. In a statewide survey conducted by American Research Corporation, Charles has been selected as a Leading Attorney. Before joining Meagher & Geer in March, 2003, he was Associate General Counsel for a Minnesota-based software development and consulting company. He handled all lawsuits for the company and advised senior officers and managers on a wide range of legal and business issues.
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