Why one firm lost a court case
But It Was Only a Review!
In a recent court case, a judge found a CPA firm responsible for thefts perpetrated by the client's bookkeeper despite the fact that the firm had only been engaged to review the client's financial statements. The following factors helped influence the judge's decision:
* There was no engagement letter.
* There was no documentation of any efforts to advise the client of red flags encountered in the course of the engagement.
* The workpapers seemed to have been altered after the thefts were discovered.
* The judge was adversely influenced by certain actions of the partner-in-charge both before and during the trial.
* The testimony of defendant's CPA expert witness was deemed to be biased, whereas plaintiff's expert was considered credible.
A recent unreported decision by a New York State court--in which a CPA firm was held responsible for thefts perpetrated by its client's bookkeeper--provides a number of valuable lessons for CPAs. The case, Collins v. Esserman & Pelter, Supreme Court Broome County, December 1997, was unusual in that it was tried by a judge and not by a jury. In such cases, the court is not only required to state its finding but also to explain how it assessed the evidence. As a result, the court's decision provides rare and valuable insight into how accountants are perceived in the courtroom.
The case arose out of thefts by the client's bookkeeper of over $280,000. The bookkeeper had the owners of her employer, a construction company, sign checks made payable to two companies she had formed with names similar to the employer's principal subcontractors. She then deposited these checks into bank accounts she had established for these entities. The owners not only signed these checks, but did so without insisting the bookkeeper comply with the company's internal controls that required every check submitted for signature be accompanied by supporting documentation. This was particularly negligent in that 1) the owners had only recently been the victim of thefts by their prior bookkeeper, 2) the bookkeeper was known to have been dismissed for cause (if not theft) by her prior employer, and 3) the owners had discovered the bookkeeper had failed to pay the company's withholding taxes and had falsified the company's books to indicate that the payments had been made.
Who Was at Fault?
The court faulted the defendant accounting firm (and not the company's management) for the losses, concluding that the accountants knew or certainly should have realized something was amiss and took no steps to respond to the many warning signs. Specifically, the court found that the accountants knew the client's bookkeeper had been fired by her prior employer for stealing. They also discovered she had made at least three other false bookkeeping entries. And, lastly, they were aware that she had maintained the client's financial records in a constant state of disarray. The court therefore (but perhaps wrongfully) concluded that the defendant accounting firm had a duty to investigate the situation, although it is not clear what the court would have wished the accounting firm to investigate.
While the court acknowledged that the accounting firm had only undertaken to review the client's financial statements and was not engaged to perform an audit, it nevertheless concluded that the firm's duty to exercise due care required it to take further action. The court presumed (there was no express finding to this effect) that such further action would have led to the discovery of the bookkeeper's thefts. In this regard, the court was clearly influenced by the fact that the successor bookkeeper, who had only had limited accounting experience, was able to uncover her predecessor's thefts within a few weeks of taking the job. The court thus concluded that the successor bookkeeper had uncovered the thefts simply by doing things the defendants had promised to do and had told the client they had done. This conclusion, however, was not supported by the facts: The successor bookkeeper had discovered the thefts by trying to reconcile the vendor accounts her predecessor had used to perpetrate her fraud.
The Court's Perception of the Accountants
One has to wonder why an experienced judge, an intelligent, sophisticated, and unbiased arbiter, reached these conclusions. An analysis of the testimony before the court and the court's decision reveals some of the answers.
No Engagement Letter. The accountants did not have an engagement letter, so there was no clear understanding between the accountants and the client as to the scope of services. Naturally, the client's owners contended they were unsophisticated in financial matters and looked to their accountants to do everything that was necessary, including supervising the activities of their bookkeeper. In this regard, even the accountants' invoices were of little assistance because they simply reflected tax preparation and compilation services, never mentioning that the firm would be performing a review of the client's financial statements, as was brought out at trial.
Lack of Documentation. The main error committed by the accountants was that they did not document their efforts, if any, to advise the client of the red flags they were encountering in the course of their engagement. Had they done this, the burden clearly would have been on the client to explain why it did not engage the accountants to perform an investigation or, at least, to perform certain agreed-upon procedures. This omission opened the door to major factual discrepancies between what the accountants claimed they had told the client and what the client's owners admitted they had been told about the bookkeeper's prior thefts and her falsification of the client's records.
There is a serious question whether it would have been adequate under accounting literature for the accounting firm to have simply advised the client of its disturbing findings. Most clients (and presumably the plaintiff in this case) simply lack the sophistication to appreciate the implications of the warning signs the accountants had observed. Moreover, most clients may not appreciate the options available to them. Therefore, at the very least, the accountants should have explained the possible ramifications of their observations and what additional procedures they could perform and what those procedures might reveal. Should the client thereafter decline to engage the accountants to take additional efforts, it would be difficult to fault the accountants for not having uncovered the bookkeeper's thefts.
Workpapers Subsequently Altered. To make matters worse, the partner in charge of the engagement had made notes on his firm's workpapers--apparently after the thefts had been uncovered--that attempted to record actions the accountants had taken and warnings regarding the bookkeeper that they had related to the client. While the record is not clear as to when these alterations were made, because of certain timing inconsistencies they were characterized by the judge as an attempt to "rewrite history." As a result, the judge accorded little or no credibility to the partner's testimony, and all issues of fact were resolved in favor of the plaintiff. The lesson here is that workpapers should be carefully reviewed and completed at the conclusion of each engagement, as any subsequent efforts to complete them may not only prove ineffectual but could actually be counterproductive by destroying the firm's credibility.
Actions of the Partner. The judge was also adversely influenced by the partner-in-charge's refusal to identify which client had previously terminated the bookkeeper for stealing. The court found it difficult to believe that the partner had unequivocally informed the plaintiff of the bookkeeper's prior thefts at the time of hiring when he was now, 11 years later, unwilling to disclose even the name of the client that was the victim of that theft. The judge's unwillingness to accept the engagement partner's account of the warnings he had given to the client regarding the bookkeeper's past was fortified by a letter the partner had sent to the IRS in an effort to have tax penalties levied on the client abated. In the letter, the partner praised the bookkeeper, stating that "her qualifications as a full charge bookkeeper ... are exceeded by very few." Were this not bad enough, the letter goes on to state that the bookkeeper was hired by the plaintiff "on our recommendation." It concludes by stating that in the engagement in which the partner had discovered the nonpayment of payroll taxes and the bookkeeper's false entries, "nothing was found to indicate our confidence level should be reduced."
To say the least, the court did not appreciate the apparent lack of candor that the partner had displayed in his dealings with the IRS. The court's feelings were not assuaged by the partner's excuse that he was trying to help his client avoid the penalties assessed by the IRS. The judge expressed his concern that,
if the partner would lie to save his client a few thousand dollars, imagine what he might do to save himself and his partners a few hundred thousand dollars.
The Court's Perception of the Experts
The judge also did not seem to give much weight to the accountants' expert witness, who testified that the defendants had properly performed their engagement and had no duty to take any actions beyond correcting errors they had observed. The court found her testimony unconvincing, pointing out that in 45 of the 50 cases in which she previously had been engaged to provide expert testimony she had supported the defendant accountants. The defendants' expert espoused (in the court's terms) "self-styled precepts," such as "auditors are not fraud detectors," and "accountants have no fiduciary duty to their clients." The court took such statements as evidence of an inherent bias that "colored her entire testimony."
By contrast, the court found very credible the testimony of plaintiff's accounting expert, who testified that an accountant's duty of due care requires the pursuit of all perceived errors and otherwise questionable matters. While it is not clear what terms plaintiff's expert actually used to describe this duty, the judge clearly gave an expansive interpretation to his views in concluding that, under the circumstances, the accountants were required to "conduct an investigation" as a part of their original review engagement. Thus, the clear lesson for CPAs that serve as experts is that they should make an effort to take cases for both plaintiffs and defendants; and if they are only serving as an expert for plaintiffs or defendants, they should document those cases they have rejected because they could not support the prospective client's position. Moreover, they should bear in mind that they are called as experts to assist the trier-of-fact in understanding the events that transpired and not as advocates for the party that has called them. By crossing this line, experts risk losing credibility with the trier-of-fact.
On appeal, the Appellate Division, Third Department, affirmed the court's decision. The Appellate Court did not address the legal question as to whether the client's negligence should be considered in determining the amount of damages assessable against the CPA firm. Subsequent to this appeal, the case was settled on an undisclosed basis. *
Dan L. Goldwasser, Esq., is a partner of Vedder, Price, Kaufman, Kammholz & Day, concentrating in counseling and defending CPAs. He is a frequent lecturer and author on the subject of accountant's professional liability and is the editor of The CPA Journal's Accountant's Liability column.
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