Tax preparation work can also take on an advisory capacity, as basic tax compliance services often expand into tax planning, estate planning, business succession planning, investment advice, and other areas with tax implications. Consequently, tax professionals handle a variety of complex technical issues, many of which have long-term impacts.

Loss Prevention Tip for Tax Engagements

Put tax advice in writing. A significant number of tax claims against CPAs result when tax clients are given oral advice. The following are reasons to stick to written advice:

Tax engagement letters are recommended for all separate tax engagements. A firm should consider adding the following language to its engagement letter to limit risk exposure that oral tax advice can cause:

Although we are available to provide you with tax planning advice, we are not obligated to do so unless you specifically request it. It is our policy to put all tax planning advice in writing. You should not rely on any advice that has not been fully reviewed and put in writing by our firm.

To avoid misunderstandings with a client, and because tax laws change so often, firms should consider using the following wording in tax advice letters:

It is important to realize that the tax advice discussed in this letter is based on our understanding of the facts as you have presented them to us, and on the tax law as it currently exists. Unless you specifically ask us to do so, we can accept no responsibility for updating this advice to reflect future changes in the tax law or to allow for changes in your individual circumstances.

Engagement letter language also should include the limits of a firm’s scope of services, especially when those limits help distinguish tax advice from investment advice:

In our relationship, we are often advisors, not advocates, with regard to investment advice. We will advise you on the implications, if any, of specific matters you bring to our attention. We are not (choose appropriate title: investment counselors, brokers, stock agents). We can only advise you on the implications of this investment in light of today’s tax laws and economy.

While small to mid-sized CPA firms generally handle more tax work than audit work, the average dollar amount per claim is significantly higher for audit claims than for other types of claims (See Exhibit 2). The costs of resolving audit claims, which include indemnity and legal defense, run about $341,000 per claim, by far the costliest type of service in terms of average claim size.

The underlying causes of audit engagement claims are attributed in part to the high standards applied to those engagements. While the accounting profession imposes high standards on CPAs that conduct audit engagements, the public, including jury members, often imposes higher standards. This elevated level of accountability is particularly evident in audit claims involving fraud and defalcation—the leading causes of loss in audit claims (See Exhibit 3).

In describing professional standards for audit engagements, SAS No. 82 (AU 316.10) states:

Because of 1) the concealment aspects of fraudulent activity, including the fact that fraud often involves collusion or falsified documentation, and 2) the need to apply professional judgment in the identification and evaluation of fraud risk factors and other conditions, even a properly planned and performed audit may not detect a material misstatement resulting from fraud.

Public perception does not always concur with these benchmarks, however. A Camico jury study examining public attitudes toward audit engagements asked jurors to respond to the following statement: “The purpose of an audit is to uncover any type of fraud or wrongdoing.”

Jurors’ responses indicate a preponderance of high expectations: 64% agreed with the statement, 18% disagreed, and 18% were neutral.CPAs that conduct audits do not have the benefit of 20/20 hindsight that is afforded to jurors that later assess material misstatements. Because the circumstances surrounding an audit look clear to jurors, public standards imposed on CPAs can grow even higher. Participants also responded to the following statement: “Accountants have the responsibility to police the financial reporting a company makes to investors.” Based on the responses, the public believes CPAs have a watchdog role: 63% agreed with the statement, 11% disagreed, and 26% were neutral.

Creditor decisions by lending institutions and other lenders are another major liability area for audit engagements. While less frequent than claims involving fraud, claims involving creditor decisions tend to be large, averaging about $668,000—a substantial sum for a small or mid-sized CPA firm (See Exhibit 4). Claims involving creditor decisions can also involve some type of fraud that went undetected by the auditor. For example, assume an auditing firm sends out confirmations for specific customer receivables. After 98% of the confirmations have been returned, the auditor discusses two of the unconfirmed receivables with the client’s controller and is told that they pertain to two customers that are considering moving their business to a competitor.

The controller assures the auditor that he understands that the two customer receivables need to be confirmed, but he asks the auditor not to bother the customers at that specific time. The controller appears cooperative, and the auditor does not regard the situation as fraudulent. The matter is dropped. Three years later, however, the client’s bank sues the auditing firm after discovering that management created large fictitious receivables and inventory entries in order to increase its credit line. The two receivables that the auditor left unchecked are found to be fictitious. Although the auditor’s conclusions appeared reasonable at the time, jurors, with the luxury of having all the facts before them, often see things differently.

A firm can be sued simply through association with an unethical or incompetent client. Because public perception deems that audited financial statements can be relied upon to make creditor decisions, a bank or other financial institution suffering a loan loss may seek recourse against the borrower’s CPA firm. Many CPA firms have discontinued their audit practices because of severe liability exposure. Again, juror hindsight, combined with high public expectations, can harm CPAs.

Nonattest Engagements

Fraud extends far beyond audit engagements. It is responsible for more than 30% of all Camico claims losses greater than $100,000 (See Exhibit 5). Though CPAs are not responsible for detecting fraud in nonattest engagements, the public believes they should police these tasks. Professional standards are vitally important, but juries often consider such standards to be a minimum. CPAs are often expected not only to follow professional standards, but to uncover all irregularities. If they cannot do both, complying with standards may not help them avoid liability.

Many jurors are uncomfortable with accounting and numerical information and generally do not understand the differences between the types of services CPAs perform. The collected responses to a statement made in a Camico jury study illustrated this point. The statement read:

The purpose of having an accountant examine a company’s books is to uncover any and all irregularities, even if the accountant is not hired to conduct an audit.

Sixty percent of jurors agreed with the statement, while 21% disagreed and 19% were neutral. Consequently, professional standards for a review or compilation may have little relevance to a jury.

Another hurdle in court is the assumption that because she is sitting at the defendant’s table the CPA must have done something wrong. As evidence of this bias against the defendant, consider the responses given to the following Camico jury study statement: “If a case comes to trial, it must have some merit.” Fifty-six percent of jurors agreed with the statement, while 44% disagreed. According to the study, the majority of jurors will be trying to determine the extent of the CPA’s wrongful behavior before the trial ever begins. Given the inclination to prejudge a defendant and the advantage of hindsight, avoiding liability claims can be an uphill battle.

Loss Prevention Tips for Audit and Nonattest Engagements

Communicate with clients in writing. To help avoid liability claims, a firm’s services and advice should be conveyed through written communication, just as they should for tax engagements. SAS No. 83, “Establishing an Understanding with the Client,” requires the auditor to make certain the client understands the services that will be performed. An audit engagement letter that records the business relationship and details the terms of the engagement can eliminate many future problems. Matters that generally should be covered in an engagement letter include—

Depending on the engagement, CPAs may want to include other matters in the letter, such as—

Only accurate and precise descriptions of services, objectives, and responsibilities to be covered should be included in the engagement letter, as the document is not the proper vehicle for embellishing or marketing the firm’s capabilities. The engagement letter is designed to limit risk exposure, not expand it. The audit engagement letter can also clarify the following: