Loss prevention: it can no longer be ignored. (includes related article)by Goldwasser, Dan L.
Until 1970, civil liability claims against CPAs were relatively rare, with CPAs enjoying a relatively low profile in the nation's court houses. Since that time, however, CPAs have become one of the favorite targets of the plaintiffs' bar. As of 1989, a relatively moderate year for such claims, there was approximately one claim for every 120 insured accounting professionals. As a result of the current economic downturn, the frequency of such claims will undoubtedly increase, with the result that in 1992 there is likely to be one claim for approximately every 80 insured CPAs. Stated another way, a firm of 10 CPAs will have a one-in- eight chance of being sued in 1992.
Tax Prep and Advice--Highest Number of Claims
Although there have been new types of services offered by CPAs over the past 40 years, which has given rise to a wider variety of claims against CPAs, the great majority of claims continue to fall into traditional patterns. By far, the largest number of claims against CPAs arise out of tax preparation and tax advisory engagements. Such claims represent approximately 43% to 48% of all claims asserted against CPAs.
The second largest category of claims arises out of alleged misstatements in financial statements covered by a CPA's report. To be sure, the greatest number of claims involve audit reports; however, a growing number arise out of compilation and review engagements. In recent years, there has been a growing number of claims against accounting firms based upon the CPA's failure to detect and disclose client-employee thefts. Such claims have even been asserted even where the CPA only undertook to perform write-up services on the theory that in doing so, the CPA reviewed the client's canceled checks and bank statements. Defalcation cases tend to be relatively serious and are extremely expensive to defend.
With the expansion of CPAs' services into less traditional areas, there has been a growing number of claims that CPAs negligently or recklessly caused damage to their clients or third-parties by failing to perform their services with due care or in accordance with standards of the profession.
There are a number of reasons for these trends, including a sharp increase in the number of attorneys asserting these cases, liberalized court decisions, expanding concepts of civil liability, state and federal legislation creating new causes of action, and a general increase in the public's preference to resolve disputes through litigation.
More Attorneys=More Lawsuits
To be sure, the number of attorneys in the U.S. has grown dramatically over the past two decades, a factor lamented by Vice President Quayle in his address to the 1991 Annual Meeting of the American Bar Association. During the 1960s, a significant percentage of the plaintiffs' bar was involved in litigations arising out of automobile accidents. This problem became so serious that in the late 1970s, many states adopted no-fault legislation to eliminate this largely wasteful form of litigation. This prompted many members of the plaintiffs' bar to turn to other areas to apply their advocacy skills. As a result, the number of product liability and securities fraud suits expanded exponentially. It did not take long for the plaintiffs' bar to discover that in securities law cases, CPAs are one of the few persons remaining in the wake of a fraud capable of paying a substantial verdict. Thus, the plaintiffs' bar began to focus on the accounting profession, with the resuit that CPAs today are named in securities fraud suits almost as a matter of routine.
Not only is there an increasing number of attorneys who are bringing cases against CPAs, those attorneys are becoming far more adept at doing so, and are no longer being deterred by their unfamiliarity with accounting and auditing standards and terminology. Today, there is a large segment of the plaintiffs' bar with accounting backgrounds. Equally important, they are supported by a growing coterie of CPAs providing litigation support services. Ks a result, suits against CPAs are being resolved at a much higher percentage of the damages suffered by plaintiffs. Whereas in the 1970s, a typical case against an accounting firm may have been resolved for 1596 of plaintiff's actual damages. Today, the average settlement is much higher as a percentage of the plaintiff's damages.
The Role of the Courts
In the 1970s, the federal courts greatly expanded liability under the federal securities laws by extending the definitions of "security" and "material misstatement" and by eroding the scienter requirement in securities fraud suits. Moreover, federal courts began to recognize the doctrines of "aiding an abetting," pursuant to which CPAs or other third-parties might be held liable for financial misstatement caused by their clients, and "fraud-on-the-market," which eliminates the necessity for a plaintiffs' counsel to prove that the class of plaintiffs actually received and relied on the CPAs' report.
In the 1980s, the courts also began to erode the privity doctrine which had long limited the scope of persons who can assert a claim against a CPA or other professional on a negligence standard. Today, the courts in most states have abandoned the privity doctrine and four states have adopted a "foreseeability standard," making CPAs liable to any person whose reliance upon their reports was reasonably foreseeable.
Notwithstanding the erosion of the privity doctrine, in the last two years there have been signs that the judicial pendulum is swinging back the other way, with courts generally refusing to further extend the liability exposure of CPKs, and in a few cases, actually limiting it. Nevertheless, the decisions of the 1970s and 1980s will continue to have a devastating impact on the accounting profession.
The RICO Plague
Among the principal litigation plagues that have been thrust upon the accounting profession in recent years are the RICO statutes. Both the federal government, as well as approximately 35 states, have adopted RICO legislation which subjects violators to treble damages and requires them to pay the litigation costs of the plaintiffs. In view of the large amount of damages available under these statutes, plaintiffs try. very hard to frame their cases against CPAs so as to assert a claim under them. This tactic has the added advantage of allowing plaintiffs to bring their claims in federal courts which have more liberal discovery rules and which generally move cases more expeditiously. Although there have been many legislative efforts to curb the RICO statutes so as to limit the liability of CPAs and other high profile liability targets, there has been virtually no progress on this front, with the result that the federal and state legislatures have been net contributors to the current liability crisis faced by the accounting profession.
On the more positive side, the U.S. Supreme Court has agreed to consider during the 1991/92 term whether a faulty audit can make an auditor subject to RICO. The case involves the audit of a farm cooperative operating in Oklahoma and Arkansas. The suing investors have appealed on the basis of conflicting rulings at the appellate level. Although the Supreme Court refused to narrow the scope of RICO in the mid-1980s, a recent Supreme Court decision imposed a strict rule of causality, offering some hope that the court might impose a further limitation on the use of RICO claims against accountants.
Changed Public Attitudes
Perhaps the greatest contributor to the increased number of cases against the accounting profession has been the changed attitude of the public regarding litigation. Twenty years ago, only a small part of the population would have even considered asserting a liability claim against a CPA. After two decades of seeing headlines in the news media heralding multi-million dollar verdicts against accounting firms and an almost continuous stream of Congressional hearings on financial frauds, public attitudes toward CPAs have changed drastically.
Today, banks whose loans to business enterprises have proven uncollectible regularly seek to recoup their losses by suing their borrowers' CPAs. Similarly, trustees-in-bankruptcy now try to find additional assets for the bankrupt estate, and thereby increase their own fees, by asserting claims against the bankrupt company's CPAs. Moreover, the investing public now regularly seeks to blame CPAs for their own improvident investments and for tax assessments levied against them as a result of their own aggressive tax positions. To be sure, the litigation genie has been let out of the bottle, probably never to be confined again.
DIMINISHING INSURANCE COVERAGE
While at the same time that claims against CPAs have increased, professional liability insurance coverage has been rapidly diminishing. As late as the early 1970s, insurance comp|mies had great difficulty getting accounting firms to purchase liability insurance at almost any price. At that time, available insurance coverage was virtually unlimited and, by current standards, was ridiculously inexpensive. CPAs who purchased professional liability insurance looked upon it as a "security blanket," allowing them to carry on their practices, safe in the knowledge that if a liability claim were asserted against them, it would be handled by their insurers with little or no costs or inconvenience to them.
This situation began to change in the mid-1970s, as claims arising out of the recession of 1973 began to mount. From approximately 1975 through 1978, malpractice insurance premiums for CPAs increased on the average of approximately 30% a year. Even so, the available limits of liability were generally high, and most firms had little or no difficulty obtaining insurance that would cover their largest foreseeable claim. Moreover, in 1979 and 1980, the costs of malpractice insurance actually declined in the face of high interest rates which prompted insurers to engage "cash flow underwriting." This brief period of high policy limits and modest costs abruptly ended in 1985, when the claims arising out of the recession of 1981/82 reached a crescendo. As a result, there was a crisis in all liability insurance markets, with a number of insurers that had written professional liability for CPAs withdrawing from the marketplace. Malpractice insurance premiums rose overnight by over 400%; and the available limits of liability came tumbling down, with many accounting firms being unable to obtain any insurance during 1985 and 1986.
In the years that followed, the limits of liability available to CPAs increased back to their pre-1985 levels; however, premium costs only dropped approximately 20% from their 1986 level.
Even though the currently available limits of liability for small and medium sized firms are generally comparable to those of the early 1980s, the size of claims against CPAs has continued to grow dramatically. As a result, accounting firms can no longer obtain insurance coverage likely to satisfy their largest foreseeable claim. Moreover, because the price of insurance has increased so dramatically, most accounting firms as a matter of economy, simply opt to purchase lower than the maximum limits currently available. In addition, they are also accepting larger deductible amounts as a further cost-cutting measure. As a result, their former security blanket now provides far less than full protection. In fact, of those accounting firms that carry professional liability insurance, the vast majority have coverage equal to less than one third of their maximum foreseeable liability exposures. To make matters worse, the events of the last two decades have made it clear that liability insurance policies are as much lightning rods in attracting claims as they are security blankets protecting CPAs from such claims.
The problems, however, do not stop here. Insurance companies in reaction to the losses incurred in the mid-1980s, have sought to limit coverage under their policies. Whereas in the early 1980s, the average insurance policy contained five or six exclusions, today's policies frequently have between 10 and 15 exclusions, each of which diminishes the insurance company's responsibility for claims against the insured. In addition, today's policies also generally provide for defense costs to be charged against the limits of liability under the policy, thereby further reducing the effective amount of coverage offered by the insurer.
The shrinking scope and amount of coverage is compounded by the fact that insurance companies today have become far more zealous in disclaiming liability. In the 1970s and early 1980s, an insurance company faced with a claim arguably falling outside the scope of its policy would typically defend the claim while reserving its right to disclaim liability at a later date. Eventually, the insurer would settle the claim, notwithstanding its earlier reservation rights. Today, insurance companies faced with serious claims arguably outside the scope of their policies are seeking to limit their liability by bringing declaratory| judgment actions in the hope of obtaining an early ruling that they will not be responsible for any adverse outcome. Thus, not only is the CPA's securitv blanket too short and has lightning rod characteristics, it also contains a number of holes.
THE REACTION OF THE PROFESSION
The growing problem of increasing claims and diminishing insurance coverage has compelled the accounting profession to rely more and more upon loss prevention techniques. To be sure, loss prevention is not wholly new. As early as the late 1970s, the accounting profession began to recognize the need for loss prevention measures. In this connection, the profession started recommending the use of engagement letters and began a concerted effort to increase standards of practice. As new liability exposures were revealed, new auditing standards were adopted to eliminate practices which had given rise to those liabilities.
Moreover, during this period, accounting societies, as well as state legislatures, started to call for mandatory continuing professional education to assure that practicing CPAs remained up-to-date in what was becoming a rapidly changing professional environment. Some accounting societies also began to work with the malpractice insurers to provide premium credits to those CPA firms which satisfied continuing professional education requirements or took other loss prevention measures then being explored.
By the early 1980s, the AICPA had established its Division for CPA Firms and was mandating peer review for all member firms. More recently, the AICPA has adopted rules requiring firms that are not members of the Division for CPA Firms, to undergo Quality Review.
MORE IS REQUIRED
Although these efforts by the profession have clearly enhanced the overall quality of practice, they have by no means stemmed the tide of liability claims against CPAs. Unfortunately, by increasing practice standards, the profession has created liability, traps for those members who wish to conduct their practice as they have in the past. The sheer volume of new professional pronouncements make it difficult for even those who strive to satisfy their continuing professional education requirements to keep up-to-date on the latest pronouncements. While the larger firms have established technical staffs to update operating procedures to comply with such new pronouncements, smaller firms have had to deal with the "standards overload" problem by either limiting the scope of their practices or by trying to exercise greater caution in accepting engagements.
The Plague of Great Expectations
Equally plaguing the profession is the "expectation gap." Fueled by newspaper headlines and Congressional investigations, the public has come to expect near perfection from the accounting profession, which has done little to educate the public as to the limitations of its services. On the contrary, the reaction by the accounting profession has largely been to assure the public that its expectations are reasonable. In promulgating the socalled "expectation gap SASs," the Auditing Standards Board proclaimed that its new auditing standards would help eliminate the "expectation gap."As a result, public expectations may have even been increased while the ability of the profession to deliver more effective auditing services has been little changed.
The Plaintiffs' Bar Learns Its Lessons Well
While efforts of the accounting profession in increasing professional standards have managed to eliminate certain types of claims previously asserted against its members, the plaintiffs' bar has continued to grow in sophistication, focusing on new and different oversights on the part of CPAs. For example, in recent years, the plaintiffs' bar has begun to focus on internal control weaknesses, blaming CPAs for failing to point out those weaknesses to clients which later facilitate client-employee defalcations. In fact, in one recent case, the plaintiffs were successful in blaming the client's CPAs for misstatements in interim financial statement reports not covered by the CPAs' opinion, based solely upon the CPAs' failure to have advised the client's management of internal control weaknesses. Suits based upon these theories are likely to persist for several years until compliance with SASs 55 (internal control structure) and 61 (audit committees) become well ingrained, drying up such potential areas of liability exposure. By the time that happens, the plaintiffs' bar will undoubtedly have found other areas of weakness, such as auditing for potential environmental liabilities. In short, the growing sophistication of the plaintiffs' bar has made it essential for the profession to be on a constant vigil, reacting quickly to developing trends in CPAs' liability litigation.
Although efforts of the accounting profession to enhance overall quality of practice through enhanced practice standards and mandatory continuing professional education has clearly been effective, those efforts have not and will not eradicate liability claims against CPAs. Equally important is the fact that the continuing professional education offered by the profession does not generally teach CPAs how to avoid professional liability claims. Indeed, in many states, such courses do not even qualify for mandatory continuing professional education credits. As a result, CPA.s tend to spend their tightly budgeted educational funds on those courses which both satisfy their mandatory continuing education requirements and enable them to expand (or, at least, maintain) the scope of their practices. This has become particularly important as competitive pressures within the profession have grown.
In summary, not only is insurance (the traditional protection of the accounting profession against liability claims), proven inadequate, but the efforts of the accounting profession itself to enhance practice standards have done little, if anything, to fill the void created by a growing liability exposure and the elimination of insurance coverage.
The developments outlined herein make it clear why loss prevention must become part of the daily life of every accounting firm. Many accounting firms do practice loss prevention, (sometimes referred to as "risk management") in one form and degree or another. Those efforts, however, tend to be less than comprehensive and are undertaken only as time and resources permit. Moreover, they are generally, undertaken in reaction to prior unfortunate experiences and rarely focus on practices that will lead to new problems in the future. Loss prevention assumes that clients and third-party users of financial reports will continue to incur losses and will continue to assert claims against CPAs in an effort to recoup their losses. Loss prevention also assumes that, CPAs services will have been inadequate, giving rise to the unhappy likelihood that the plaintiffs claim will be invulnerable to defense counsel's effort to have the claim dismissed prior to trial. Accordingly, everv claim incurred, irrespective of the professionalism of the defendant CPA, is likely to prove costly to the defendant-CPA. Loss prevention techniques, seek to steer CPAs out of harm's way, so that they will never be forced to prove that they have complied with the standards of the profession. While this is a formidable task, the cost- benefit relationship of loss prevention efforts is distinctly positive. To be sure, loss prevention efforts for the accounting profession are still in their infancy, as little is still known about the various causes of claims against CPAs and relative importance of each of those sources of claims. Moreover, the claims data that currently exists has been jealously guarded by professional liability insurers which have only recently begun to express an interest in fostering loss prevention. The increase in claims against CPAs over the past 20 years has prompted many insurers to turn their attention to loss prevention techniques.
Indeed, claims have now grown to such a high level that many insurers are currently concerned that they may not even be able to offer realistic insurance protection at prices which the profession can afford if something is not done to curb the current upward trend in liability claims.
Started with Education
To date, most loss prevention efforts have been of an educational nature. Insurers have begun publishing newsletters describing changes in the law and claims brought against CPAs. More recently, a few professional liability insurers have offered seminars to their insureds to further increase the level of consciousness of CPAs to the threat of professional liability. These efforts, however, entail little involvement by practitioners, with the result that their effectiveness in reducing liability claims is unclear.
At least three insurers have also provided insureds with loss prevention manuals and have initiated hotline services which permit insureds to receive timely advice on how to deal with situations that could give rise to liability claims. Unfortunately, these insurers only insure a small percentage of all practicing CPAs. Moreover, many CPAs may be reluctant to take advantage of hotline services offered by an insurer, for fear that the insurer may receive an insight into their practices which would prompt them to either raise premiums or cancel coverage.
For loss prevention efforts to have a significant effect on reducing the accounting profession's exposure to liabilitv claims, it must more heavily involve the active participation of CPAs themselves. It is simply not sufficient for CPAs to be reminded periodically that they must exercise diligence in avoiding liability-breeding situations. This is because such reminders are quickly forgotten in the heat of daily practice; effective loss prevention efforts usually require a diversion of efforts and occasionally foregoing non-producing engagements.
The Ten-Foot Pole Approach
It has long been understood that an effective way of avoiding liability is to avoid clients with a high potential for generating claims. (See "Client Acceptance: What to Look For and Why" by John W. Hardy and Larry A. Deppe, The CPA Journal, May 1992.) Such clients would include companies in financial difficulty and individuals with a propensity for illegal or unethical actions. Unfortunately, almost every accounting practice may have literally dozens of clients that come within these two categories of dangerous clients; and the odds are great that only one or two of these are likely to be the cause of a malpractice claim. As a result, few accounting firms are prone to terminate every potentially dangerous client in the absence of a fee dispute. What is clearly needed is a better system for identifying problem clients so that all clients falling with broad categories of identifiable risk factors need not be relinquished. Also needed is a resolve on the part of accounting firms to take reasonable measures to avoid liability risks posed by clients that do fall in high-risk categories.
A second area of risk management relates to the type of engagements that CPA firms accept. Accounting firms must carefully screen the engagements which they accept, not only for conflicts of interest and the client's ability to pay for services, but also to make sure that the firm has the requisite expertise and resources with which to perform the engagement. Most firms, however, are simply unwilling to forego an engagement in a new area, usually out of the hope that the engagement will permit the firm to expand its services. Such decisions should only be made after an assessment of the liability dangers posed by the engagement, the likely profitability of the engagement (considering the amount of extra effort that will be required to perform an engagement in a new area) and the realistic likelihood that the firm, in fact, will be able to expand its services into a new practice area as a result of the engagement.
The Right People
Another problem that CPA firms must confront if they are to reduce their liability exposure is the operating limitations of the members of their professional staffs. Most CPAs are endowed with a high sense of loyalty to staff members and frequently decline to terminate loyal staff members who display signs of incompetence or personal problems which detract from their performance. Such decisions are generally rationalized on the basis that the firm has substantial work which such employees can perform competently or that the employee's problems are temporary. Unfortunately, staff member infirmities are frequently forgotten with the result that such persons are placed on risky or sensitive engagements or are permitted to work without adequate supervision. If accounting firms are to protect themselves against potential liability claims, they must periodically evaluate their professional employees and establish operating policies to deal with those whose services must be restricted.
Another major mistake commonly made by CPAs is failing to seek professional advice at the first sign of a potential liability problem. This is especially true of smaller firms that do not have the resources to employ technical experts or to regularly engage the services of an attorney experienced in professional liability matters. Indeed, outside the major metropolitan areas, there may not even be attorneys with the requisite understanding of accounting practices to offer such advice. Even where such attorneys are available, their charges may be sufficiently high as to deter most firms from seeking their advice until it becomes readily apparent that a claim is about to be made, at which time there may be little that can be done to avoid the claim.
The hotline services that are being offered by some malpractice insurers offer some help in this regard; however, they are limited to brief telephonic assistance which, in many cases, will not be sufficient to guide the accounting firm though a protracted and potentially explosive situation, such as in the days or weeks following the discovery of a client employee defalcation, when every communication with the client could have a profound effect on the firm's liability exposure.
No One Is Safe
These are but a few of the loss prevention (risk management) practices that CPAs will have to adopt if they are to protect their practices from the threat of litigation. In view of the limited professional liability coverage available today, CPAs simply cannot expect to conduct their practices without having at least one or more malpractice claims in the course of their career, claims which could conceivably wipe out a lifetime of savings or a promised pension, a lesson which many former partners of Laventhol & Horwath recently learned.
Moreover, because claims against CPAs frequently arise out of actions taken up to six years prior to the claim, CPAs cannot postpone adopting loss prevention measures until a claim begins to appear. Loss prevention actions begun today will have their maximum impact in three to six years. Accordingly, now is the time to consider how to most effectively guard a practice from potential liability claims. EXAMPLE OF A LOSS PREVENTION PROGRAM
Accountants Risk Management Services, Inc., plans to offer, beginning in the summer of 1992, a loss prevention program which will consist of the following six services designed to assist accounting firms in reducing their exposure to professional liability claims.
Risk Management Audit--to be given once every three years focusing on the subscriber's clients operating procedures and professional staff (including principals).
Liability Hotline--available to all subscribers on an unlimited basis, answering questions involving potential liability situations so as to enable the subscriber to avoid or, at least, minimize his or her potential liability exposure.
Communications Support Services--available to all hotline callers who require professional assistance in: 1 ) responding in writing to threatened liability claims or demands for documents, or 2) drafting engagement letters, management letters, "rep" letters, financial statement footnotes or opinions that involve unique circumstances. __
Loss Prevention Manual-to be provided to each subscriber (and updated annually), giving practical advice on how to deal with situations which give rise to professional liability claims.
Quarterly Loss Prevention NeWsletter--highlighting developments in the law of accountants' liability and designed to keep the threat of liability claims in the forefront of each CPA's thoughts..
Video Seminar-to be distributed annually to each subscriber not only reporting developments in the law of accountants' liability, but also featuring attorneys who bring and defend liability claims against CPAs who will discuss those actions on the part of the defendant-CPA which gave rise to or enhanced the liability claim.
Dan L. Goldwasser, Esq., is a member of the law firm of Veddet; Price, Kaufman, Kammholz & Day, which serves as counsel to the NYSSCPA for professional liability matters Mr. Goldwasser is a frequent contributor to The CPA Journal and other professional journals He is editor of the Accountants'Liability department of The CPA Journal.
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