Posted on Jan 13, 2016 by Julie Jeffords Moose
In my experience as both an attorney and a formerly licensed CPA, true accounting malpractice is rare. But, when there are claims, they can be expensive. It’s incumbent on accountants, as well as clients, to take steps to minimize the misunderstandings that can lead to litigation.
Unlike most malpractice cases against doctors or attorneys, suits against accountants often are brought by third parties – people or companies that didn’t hire the accountant and of whom the accountant may not even have been aware. That’s because third parties – investors or lenders – depend on audited financial statements when making business decisions. There is an expectation gap between what third parties expect and what auditors do, however. The auditor gathers information to identify risks of material misstatements, and evaluates the risks based upon the company’s internal controls and accounting procedures. Auditors do not examine every transaction, so there is no guarantee that a material misstatement, whether caused by error or fraud, will be detected. Misstatements and fraud that go undetected can cost third parties millions of dollars, but in many cases it is not the result of accounting malpractice.
Investors know that accountants can be held liable to reasonably foreseeable users of audited financial statements who relied on the statements for a business purpose if the auditor negligently performed the audit. The perceived deep pockets of an accounting firm and its insurers then become targets as third parties attempt to recoup losses.
Accounting cases are difficult because they pit one set of expert witnesses against another set, arguing over whether an accountant deviated from the applicable professional standard of care. In South Carolina, the statute of limitations to file an accounting malpractice case is three years from the date a party knew or should have known of the malpractice.
Protection starts with the engagement letter
We have found that the best tool to avoid misunderstandings and to defend lawsuits, if it comes to that, is the engagement letter.
An engagement letter is an accounting firm’s contract with the client. It is the starting point, and sometimes the ending point, for the relationship. The letter defines the precise scope of the work, such as conducting an audit, compiling financial statements, preparing tax returns, and/or offering tax advice.
Just as important, the letter should state what will not be done and outline the client’s responsibilities, such as providing – and being accountable for – accurate information.
Some engagement letters place limits on how the work or advice can be used and who can rely on it.
For example, financial statements prepared with numbers solely provided by management will include language confirming that the information has simply been compiled, as opposed to audited or reviewed. Most potential acquirers require audited financial statements or extensive due diligence to evaluate the company’s financial health.
One problem we sometimes see is that the parties relied on an engagement letter from years ago. If the original engagement letter covered tax work and the accountant is now doing an audit, there needs to be a new engagement letter. Often, we see situations where there is no letter, just a handshake agreement. This serves neither party well.
The management letter calls attention to problems
Problems arise when clients fail to fully disclose relevant information to their auditors or have inadequate internal controls. While auditors who prepared audited financial statements based on inaccurate information provided by management will focus on the client’s responsibility and liability, an investor who relied on the auditor’s work will counter that the auditor should have discovered the error or fraud. A jury might see it either way.
The Sarbanes-Oxley Act speaks to this issue and directs auditors to review and then prepare a separate attestation report that assesses the company's internal controls over financial reporting. This review must be filed with the company’s annual report. Although management is responsible for establishing and maintaining adequate internal controls over financial reporting for the company, auditors can be held liable if they do not insist that the company make appropriate corrections.
Communication and precision are key
By nature, accountants tend toward precision in their work with numbers, and they should apply that same discipline to managing their engagements with clients. Engagement and management letters should leave nothing to interpretation. In today’s litigious world both sides to a contract expect – and appreciate – knowing exactly what is expected of them.
Julie Jeffords Moose is a shareholder in Turner Padget’s Florence, S.C. office. She represents clients in complex accounting, financial and business issues, and provides counsel in drafting corporate and organizational documents, including contracts, operating agreements employment contracts and other business agreements. She was a Licensed Certified Public Accountant in South Carolina from 1987 to 2005. She may be reached at (843) 656-4418 or by email at firstname.lastname@example.org.