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How Getting Too Close to Clients Can Lead Accountant Malpractice Claims

Ralph Q. Summerford
President
October 27, 2020

Accountant malpractice claims have been a growth industry for litigators for more than two decades, thanks to increasingly strict professional standards for auditors and accountants.

 

And there’s no letup in sight. In fact, even in 2020, with the coronavirus wreaking havoc with the business community, regulators have continued to crack down on auditors who fail to take seriously their duties to uncover fraud or to follow the rules regarding the conduct of their relationships with clients. Regulatory action leads inevitably to accountant malpractice claims from clients.

 

As we have noted previously, relationships between CPAs and their clients may be very close, especially among smaller accounting firms and businesses. Yet those relationships can quickly disintegrate if the client suffers a fraud scheme that the CPA failed to uncover.  And when an accountant gets too close — and fails to adequately question the data and assumptions made by a company during the audit process — the results can be particularly devastating for a CPA firm and its individual partners.

 

FINES AND PENALTIES

 

Consider this recent action by the U.S. Public Company Accounting Oversight Board (PCAOB) against Texas-based Whitley Penn LLP. The firm and three of its partners were hit with fines and other penalties for violating PCAOB standards while conducting audits for its client United Development Funding (UDF), which specializes in real estate investments.

 

The PCAOB noted that one of the partners had identified a fraud risk involving a significant line of credit, but relied on UDF management’s estimates, data and assumptions without sufficiently evaluating their reasonableness. In their disciplinary report, PCAOB regulators found that the auditor “failed to perform…analysis with due professional care and, as a result, failed to obtain sufficient appropriate audit evidence to support…conclusions about the [line of credit].”

 

The firm and the auditors were cited by the PCAOB for failing to test the “accuracy and completeness of management-provided data” and for their failure to exercise “due professional care, including professional skepticism” in connection with the procedures they performed. In earlier audits, the accountants had neglected to appropriately respond to evidence of potentially fraudulent activity, the PCAOB said. This resulted in regulators citing the firm for “failing to maintain an adequate system of quality control, both during and after those audit failures.”

 

As a result, the firm was hit with stiff penalties, as were the three partners:

 

  • The firm was ordered to pay a $200,000 fine and to take several remedial actions.

 

  • One of the partners was barred from being associated with a public accounting firm for at least two years; fined $25,000; forced to limit audit activities; and required to complete 40 hours of continuing professional education.

 

  • Another partner received a one-year suspension from practice with a public accounting firm and was required to pay a $15,000 fine; limit audit activities; and take additional professional education courses.

 

  • The third partner was fined $10,000, required to complete addition professional education and restricted from audit activities for two years.

 

TOO CLOSE FOR COMFORT

 

The PCAOB’s action against Whitley Penn is just one example of how an accounting firm’s failure to design their audit to detect fraud can lead to legal trouble.

 

Recently, I was engaged in a case where the auditors failed to detect a $4 million fraud scheme. The chief financial officer of the company had written himself personal checks from a related enterprise during a six-year period. All of the checks were for amounts of less than $10,000.

 

Unfortunately, the CPA firm did not catch the fraud. It also had developed a cozier-than-usual relationship with the company and the CFO. First, the CPA firm’s engagement partner had led the company’s audits for more than 15 years. This is an arrangement prohibited by the PCAOB for publicly traded companies. Partners must be rotated out of an audit arrangement on a regular basis. And the lead partner had become personally close to the CFO. They frequently dined together, and the partner regularly accepted tickets to sporting and entertainment events from the CFO.

 

The CFO has been indicted, has pled guilty to the fraud and now is serving time in a federal prison. And the CPA firm? It is facing significant litigation involving accountant malpractice claims.

 

TOUGHER STANDARDS

 

In 1997, the accounting profession adopted the “Consideration of Fraud in a Financial Statement Audit” standard for CPAs. With that new standard, I posited in articles and at industry conferences that accounting firms would be subject to a flurry of lawsuits over failures to detect fraud. My prediction has proven true over the years. Insurers have noted that fraud claims now drive the most significant losses when it comes to accountant malpractice claims.

 

Unfortunately, some firms and CPAs haven’t seemed to receive the message. A number of CPAs who came to the profession before 1997 hold the mistaken belief that they are not responsible to design their audit to detect fraud. Many are relying on outdated teachings. Fraud didn’t even appear in leading accounting textbooks before 1997, and that year was the first time I recall the word being used by the American Institute of Certified Public Accountants. CPAs had been taught that it was not their duty to look for fraud – only to let their clients know if they saw or suspected any “defalcations.”

 

Yet failing to stay up to date on accounting standards or ignoring the ever-growing list of firms held liable for accountant malpractice claims is a highly risky proposition. The public expects auditors to detect and prevent fraud, and so do regulators and the courts. They have said that auditors have a legal responsibility to design their audits to detect fraud. Taking a company’s management at its word is not enough. In fact, if an auditor simply relies upon the word of company officials, it can face legal exposure and regulatory actions (as the examples above show). Auditors must gather corroborating evidence and diligently perform their auditing responsibilities.

 

If they don’t, they will almost certainly face a lawsuit. In almost all cases where a company suffers from a fraud, executives either sue their CPA or strongly consider doing so. This is true no matter what service the CPA provided, including simple compilation services.

 

In the end, it may be difficult to tell a client with whom a firm or CPA has developed a close relationship that fraudulent activities are suspected. But the relationship will become even more fraught if a CPA fails to do so.

 

To learn more about ways we can help investigate accountant malpractice claims, contact us for consultation.

 

 

 

 

 

 

 

CATEGORIZED UNDER: Fraud and Investigations  |  Fraud Examination