Strategies for litigation risk control.by Rezaee, Zabihollan
In today's world, anyone who performs a professional service is a prime candidate for a lawsuit. The accounting profession is no exception. Users tend to expect more from the accountant's report than it sets forth. The business community's perception is that accountants should be white collar security guards and spot financial fund, irregularities, and business failure which would result in material misleading financial statements.
Compliance with professional pronouncements and conducting oneself in an ethical as well as professional manner is the foundation to limiting liabilities, but by itself may not be enough. The environment in which accountants operate today is a highly litigious one. Recent court cases have broadened the accountant's liability to certain third parties. In some jurisdictions these parties can be anyone relying on the accountant's report for unlimited amounts for an unlimited time. In other jurisdictions, third parties must have been specifically foreseen. In this environment, a proper precautionary attitude is essential. The purpose of this article is to develop a program to build a good defense against accountants' liability claims. This program is divided into two strategies: 1) client-related strategies; and 2) firm-related strategies. These strategies cannot eliminate all risks of liability, but they can help set a cautious, optimum level of due professional care.
These strategies should be designed to minimize or limit exposure to potential litigations. Client-related strategies include: screening the potential client systematically and more effectively by looking at the nature and scope of the audit engagement, reviewing relevant documents, and looking for any potential problems associated with the client. The following preventive client-related strategies should be helpful.
1. Client acceptance and retention. Evaluate prospective clients thoroughly. By systematically screening clients, you can spot clients who may cause problems. Periodically evaluate each client to determine if the relationship should be terminated. Review the potential clients for litigation experience, integrity, ability to pay for services, management experience, and potential conflicts of interest.
2. Exercise an attitude of "professional skepticism" in all audit engagements. The attitude of professional skepticism does not require you to presume without reason that your client's management is dishonest. However, in assessing the risk of material misstatements in the financial statements, honesty is not the issue. The attitude of professional skepticism recognizes that management may have incentives to intentionally misstate amounts or disclosures in the financial statements. These incentives can be derived from a variety of sources and factors.
3. Avoid business outside you firm's area of expertise. Do not accept a client who you may not be able to properly handle.
4. Obtain complete knowledge of the client's business. Contact previous auditors, banks, lawyers, and other business associates. Review prior period financial statements, tax returns, and the history of the client's development. Notice such things as changes in management, ownership, financial conditions, litigation status, and nature of the client's business.
5. Avoid overextending the accounting-client relationship. A firm that has an equity position in a client or has members who serve as directors or officers in associated firms, may be subject to a claim of conflict of interest if something goes wrong. Good client relations could also provide protection from litigation. Some things that can help the relationship are negotiating fees in advance, making progress reports and explaining how long the work will take.
6. Use engagement letters to prevent misunderstandings. Some important items that should be included in engagement letters are: 1) type of work to be done--audit, compilation, review, or tax work; 2) scope of services, including any limitations. A good engagement letter can be an important tool of protection in the event of a lawsuit, but will not be much good if the service obligations are not met.
7. Perform a legal review on each audit engagement. Avoid or exercise extreme care in audits of clients that have a high degree of legal risk, as indicated by such factors as lack of management integrity, disputes with the IRS, rapid turnover in key financial positions, and inadequate internal controls.
Firm-related strategies require sound practice management methods, which generally involve retaining or improving the quality of services provided. They include compliance with applicable standards and quality control procedures, proper documentation of working papers, maintenance of good legal counsel, and liability insurance. The following investigative and corrective firm-related strategies should be helpful:
1. Know your personnel. Attempt to solve problems such as alcohol and drug abuse which might cause an employee not to exercise due professional care.
2. Quality control. Place emphasis within the firm on compliance with GAAS, quality control policies and procedures, and professional ethics.
3. Personnel assignment. Assign enough qualified personnel to conduct the audit engagement and make sure they are properly supervised, trained and that they understand fully the degree of professional care required.
4. Encourage personnel to seek consultation when needed. The firm should also participate continuously in peer reviews or a practice assistance consultation program.
5. Continuing professional education. Concentrate continuing education on professional standards. Courts are applying higher standards to those who call themselves professionals. The standards of the profession are sometimes updated or changed completely. The accountant must be up to date in order to protect himself. An example of this is tax reform. Tax accountants are having to re-learn the law so they can give good, sound tax advice. Required continuing education is always a good idea.
6. Independence. Attempt to be independent both in fact and in appearance. Lack of independence is the reason for many lawsuits against accountants. So, logically, if the accountant will make sure of independence, he will reduce the possibility of being sued. There are several ways to insure independence. You start by informing all staff members of new clients in writing. If this procedure is followed, a staff member can inform you of any conflict of which you were not aware, such as financial interest. The CPA should determine if he is representing any adverse parties. Meetings should be held periodically to discuss all active clients. The accountant should also have policies for any past due fees not paid. Having to sue your client for fees can open the door for a countersuit.
7. Lawsuits against other professionals. Review recent court cases to determine why other professionals, whether in real estate, law, medicine, accounting, etc., are being sued. Awareness of a problem is the first step in solving or avoiding it.
8. Due professional care. At all times and under all conditions, act professionally and exercise due professional care. If you do, you will always have a good defense against clients and third party users. Due professional care is said to be established when you perform the accounting engagements with the level of skill expected of reasonably prudent accountants.
9. Adequate working papers. Maintain adequate working papers and review their completeness and accuracy. Your working papers should indicate the extent of the procedures applied, evidence gathered during the engagement and compliance with GAAS and applicable laws and regulations. If you were charged with negligence, your working papers would be a major factor in refuting or substantiating the charge. Working papers should be reviewed at every supervisory level of your firm.
10. Limit reliance by third parties. Attempt, to the extent practicable, to limit reliance by third parties on your reports. While the engagement letter may be used to create limitations, your report is preferable inasmuch as the third party receiving the document will be on notice of its items. Place emphasis on the following items in preparing your reports: 1) describe the specific purpose of your engagement; 2) identify the person or class of persons other than the client entitled to rely on the report; 3) disclaim liability to others than intended party users; and 4) whenever possible restrict the use of your report.
11. Avoid giving opinions. Do not give opinions, especially regarding a subject in which your knowledge is limited and expert opinion is available. When appropriate consult with experts as a means of gathering competent and sufficient audit evidence to verify management assertions. Never rely solely on management assurances. Management representations are the weakest and least persuasive evidence upon which to base conclusions for the audit opinion.
12. Legal counsel. Retain legal counsel that is familiar with your legal liability. See your attorney before trouble arises. It is better to see your attorney too early and too often than too late and too little. Notify your attorney at the first sign of legal complications, not as a last resort. Attorney's advice and services can prevent a lawsuit or stop it in the early stage.
13. Insurance. Maintain adequate professional liability insurance. Malpractice insurance cannot help you avoid a lawsuit but it is a defense against damages resulting from one. Periodically check aspects and terms of the malpractice coverage, such as the type of risk coverage, policy limits, out-of-court settlement provisions, and deductibles. Adequate professional liability insurance could be the only thing that saves your firm if a judgment goes against you.
14. Public relations. Good public relations and involvement in social responsibility activities, which extends beyond just handling complaints, can also be effective in avoiding lawsuits.
15. Avoid discrimination. When possible avoid conversations relating to race, religion, sex, etc. Statements about such topics may later be used against you in a discrimination suit. An additional recommendation is that all clients be asked a uniform set of questions.
16. Letter of representation. Obtain a letter of representation from your client's management. The main objective for obtaining letters of representation is to remind the clients that they are primarily responsible for the fair presentation of financial statements. This letter should disclose all material matters such as the recording of all known liabilities, events occurring subsequent to year-end, the existence of contingent liabilities, and the existence and valuation of inventory. Although obtaining letters of representation does not relieve the auditor of the responsibility to gather sufficient, competent evidential matter, it can be used as a basis for claiming the client's "contributory negligence" in the case of a lawsuit.
17. Restructure your firm's organization. Protect your firm's assets and assets of your partners through restructuring your firm's organization. The limited liability obtained by incorporation in some states may help protect you from the damages caused by lawsuits. However, incorporation does not protect against litigation from personal negligence or fraud, even if committed by a subordinate.
18. Client's internal control system. Perform a comprehensive study and review of the client's internal control system during every audit engagement. The present auditing standards require the review of internal control systems when they are to be relied on to determine timing, nature, and extent of substantive tests. Even if the controls are not to be relied upon, an understanding of the organizational structure, the methods used to communicate responsibility and authority as well as techniques utilized to supervise the accounting system, will allow the auditor to identify weak areas which could signal a problem for the company.
19. Responsibility for fraud detection. Clarify your responsibility for fraud detection and take affirmative steps i each audit engagement to assess the potential for fraudulent financial reporting and corresponding test procedures to provide reasonable assurance of detection.
20. New standard audit report. Adopt the new standard audit report (SAS No. 58) to differentiate management's responsibility for financial statements from your role in issuing an opinion on them. The new auditor's report attempts to narrow the difference between what, very often, the public, Congress and juries mistakenly believe accountants' responsibilities are or should be and what they actually are in accordance with the applicable professional regulatory standards. The new report is longer than the previous version and contains three paragraphs, rather than the familiar two. It is intended to communicate more clearly the nature of the auditor's work, what an audit entails, the responsibility assumed, as well as the auditor's conclusions about the financial statements.
21. Defensive auditing. Exercise the practice of defensive auditing in all engagements. In all stages of an audit engagement, ask yourself this question, "Am I able to defend my work?" This should be the last check on your work before signing off on an engagement.
Accountant's legal responsibilities and liability potential have been on the increase. Accountants must take more precautions in order to minimize their potential legal exposure. Not enough emphasis is put on avoidance of liability. Insurance should only be considered as something to fall back on in case you cannot avoid a lawsuit. Note that even an inquiry can increase your insurance rates and/or cause a cancellation of insurance. Furthermore, by having to legally defend your actions, you can tarnish your reputation and that of your firm.
In an age of litigation, a well-developed liability prevention program is essential. The goal of such a program should be to make each member of the accounting firm fully aware of the growing risk of a libility suit. First, a review of statutory and common laws regarding accountants' liabilities should be an effective means of accomplishing this objective. Second, the program should emphasize the value of caution and the practice of defensive auditing and exercising due professional care. Finally, there is no substitute for a sound program of professional liability insurance and retention of legal counsel.
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