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Accountant Malpractice Claims Are Likely to Rise. Are You Prepared?

by | Aug 11, 2020


CPAs, especially those in smaller accounting practices, usually have close relationships with their clients—and rightfully so. After all, who else is better positioned to understand clients’ finances and businesses than their trusted accountants?

That is until they suffer a financial fraud scheme that a CPA has failed to uncover. Then, what I call the “client appreciation curve” takes a precipitous bend toward the negative, as the client questions whether their CPA should have done more to detect fraud. 

It’s a scenario that often ends in an accounting malpractice case against the CPA. And given the pressure businesses are facing in 2020, such litigation is likely to become a growth industry in the months ahead. This year, as a result of the financial effects of the COVID-19 pandemic, Insurance Risk & Management reports that business failures are expected to increase by 25 percent. Yet, many companies appear unprepared for the rapidly rising fraud risks that accompany such economic turmoil. 

PwC’s 2020 Global Economic Crime and Fraud Survey notes that of the 5,000 companies surveyed, half have experienced fraud in the last two years – and the majority of those failed to conduct an investigation into the incidents. Companies are also lagging in deploying modern tools to detect fraud: For instance, only a quarter of the businesses surveyed by PwC said they are using artificial intelligence tools (AI) to help spot fraudulent activity. Auditors appear even less equipped to detect fraud. A report by the Public Company Accounting Oversight Board (PCAOB) succinctly summarized the reasons: Auditors lack the knowledge, training, and experience necessary for fraud detection.

Given the growing threat, and to avoid being swept up in a wave of fraud-related accounting malpractice claims, accountants need to act now to ensure they have the training and tools necessary to uncover fraud. They also need to understand how the role of the CPA has changed—and will continue to change—in the years to come.

A Turning Point for Malpractice Claims

In December 1997, the American Institute of CPAs (AICPA) enacted a new fraud-detection standard for accountants. The “Consideration of Fraud in a Financial Statement Audit,” holds that “the auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud.”

At the time, I predicted that the new standard would help trigger a substantial increase in the number of lawsuits against accountants for failing to detect fraud. How true that prediction has become! Without fail, in almost all cases where fraud has occurred, a company will sue its CPA (or consider suing them). This is true no matter what service the CPA has provided, including tax and consulting and simple compilation services.

I based my prediction at the time on the fact that this was the first time that the AICPA had used the word “fraud” in its standards. At the time, fraud wasn’t even included in accounting textbooks. CPAs had been taught that it was not their duty to look for fraud—they only had a responsibility to let their clients know if they saw or suspected any “defalcations.” 

Fraud Is Serious Business

Unfortunately, many CPAs, especially the older ones, still hold the mistaken belief that they are not responsible for detecting fraud. Too many CPAs have failed to take their duty to detect fraud seriously. In fact, in a presentation I made to CPAs in 2019, 92% said they had no responsibility to detect fraud.

Professional standards require greater vigilance—and so do the public and the courts. A study by the CAMICO Insurance Services found that the public expects CPAs to detect fraud and that fraud drives the largest losses in terms of accounting malpractice claims.

Regulators have stepped up their efforts, as well. The Dodd-Frank Act lowered the legal bar to go after accounting firms for their failures, and the Commodity Futures Trading Commission has been particularly active in pursuing cases against firms that fail to detect fraud.

Scrutiny of CPAs’ actions has only intensified in the near quarter-century since 1997. The famed WorldCom and Enron frauds are just a few of the early examples. Significant fraud cases are now a matter of routine. Just last year, PwC’s failure to properly plan its audit to detect fraud at Colonial Bancorp Inc. led a federal court to award more than $625 million to the FDIC.

My prediction remains the same as in 1997: Accounting malpractice litigation is a growth industry. The coronavirus will only accelerate existing trends, creating more claims and inflating awards against accounting firms. CPAs who fail to take precautionary steps—for example, leveraging AI technology to help spot fraud—or who adhere to the notion that they aren’t obligated to find fraud are likely to pay the price. 

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