While doctors, lawyers, and national CPA firms had seen an exposure growth in the 1970s, local CPA firms were impacted a decade later. Professional liability lawsuits and claims continued to escalate into the 1980s, resulting in higher premiums for insurance coverage, lower amounts of coverage available, and insurers withdrawing from the market, creating a malpractice insurance crisis for CPAs. In one decade, the typical local CPA firm’s malpractice insurance premiums went from a few hundred dollars per year (often paid as an afterthought) to the firm’s third largest expense, after people and facilities.
As a result of the crisis, many CPA firms were unable to obtain professional liability insurance in the mid-1980s, or maintain sufficient policy limits in their coverage, thereby exposing firms to liability and claim amounts that made the assets of the firm and its owners vulnerable to the financial consequences of a claim. In 1985, the California Society of CPAs was notified that its professional liability insurer was withdrawing from the market, prompting the society to form a mutual insurance company specializing in CPA professional liability coverage; Cal Accountants Mutual Insurance Company would change its name to Camico as the company branched out first into other western states, then nationwide. (This author was hired by Camico to manage claims the year it was formed, 1986, and I have been with the company ever since.)
Savings-and-Loan Crisis
The claims from audit services tended to be relatively large at the time, and such claims continue to be relatively large today (Exhibits 1 and 2). CPA firms in the 1980s also had several other exposures to liability as a result of other services and developments in the business world. For example, the deregulation of the savings-and-loan industry in the early 1980s gave some thrift institutions enough leeway to get themselves into trouble with high-risk ventures, and their auditors failed to assess and expose these risks. There were so many thrift failures that the Federal Savings and Loan Insurance Corp. became insolvent in 1986. Many CPA firms learned the hard way that they needed to focus more on client acceptance procedures and their ultimate liability exposures.
Exhibit 1
Average Claim Size
Exhibit 2
Frequency vs. Severity
One of Camico’s first objectives was to assist its policyholder firms with client acceptance processes and documentation, including engagement letters for all engagements. The thrift crisis prompted the insurer to develop a “Financial Institution” supplement in 1989 to help CPA firms assess risk exposures from work in that sector. By the 1990s, the thrift crisis led to a recession triggered by sinking real estate values; by then, many CPA firms had gained experience in assessing risk exposures and how to manage them.
Tax Reform Act of 1986
Several other factors played into the liability situation for CPAs during the 1980s. The Tax Reform Act of 1986 added complexities and penalty provisions to the Internal Revenue Code at a time when the IRS sought to place more of the responsibility for valid tax return information on tax preparers. CPA firms needed to clarify and document the firm’s responsibilities as well as the client’s responsibilities; engagement letters, which had been utilized in audit engagements for many years, were now being recommended by risk management experts for use in tax engagements. Tax engagement letters also secured authorization from clients to process tax returns through an outside computer service bureau, thereby proactively addressing confidentiality concerns, as well as clarifying fee billing and collection policies and practices, which had long troubled many CPAs who had not gained adequate control over fee collection issues.
Engagement letters became an essential tool for CPA firms to document their fee collection policies and their ability to stop work in the event the clients did not pay their bills on a timely basis. This prevented fees from building up to unacceptable levels and removed the need to sue clients for fees—a step that almost always resulted in legal fees outstripping the amounts owed. Stop-work and disengagement clauses, and the enforcement of them, effectively moved fee collection problems from a risk management issue to a practice management issue.
Expansion of Service Offerings
Many CPA firms sought to expand their practices in the 1980s by offering new services, such as financial planning, estate tax planning, and business management and consulting. The profession was generally becoming more complex, which expanded risk exposures, requiring more effective risk management approaches that would help prevent disputes with clients and third parties, and protect CPA firms from litigation. Firms needed fundamental loss prevention tools, such as client acceptance and continuance procedures, engagement letters, and ongoing documentation of advice to clients and warnings to them about adverse or negative conditions, such as inadequate internal controls and exposures to fraud. CPA firms also needed engagement letters for virtually every engagement they accepted, each with its own set of needs and variables.
Many CPA firms sought to expand their practices in the 1980s by offering new services, such as financial planning, estate tax planning, and business management and consulting.
Camico began the process of drafting a developing sample letter for each type of engagement. These sample letters then required advice to CPAs on how to use them to clarify engagements, document responsibilities, improve client communication, and reduce the risk of disputes. This led to advisory services on how to effectively use engagement and other letters, which in turn led to services on how to prevent losses in a variety of areas, such as responses to subpoenas, regulatory requests for information, lender and third-party requests for “comfort” letters, conflicts of interest, ethics, record retention, arbitration, mediation, disengagement—in short, the entire range of CPA risk management.
Flood of Subpoenas
By 1997, many CPA firms were struggling with a flood of subpoenas seeking numerous documents, many of which were confidential. This expanded the risks of potential claims for firms, especially if the firm tried to comply with a subpoena before obtaining written consent from the client and without undertaking measures to protect client confidentiality. In order to safely navigate the rules and regulations intended to protect clients, most CPA firms needed assistance from outside legal counsel or qualified risk advisors before producing documents or providing testimony. One prudent strategy, still used today, is to consider subpoenas as potential claims. Insurers can prevent more subpoenas from maturing into claims by helping CPAs interface with attorneys and prepare for pre-trial and pre–grand jury testimony.
Abusive Tax Shelters
In 2002, the IRS doubled the number of its criminal investigations of tax return preparers over the previous year, developing a “counter-marketing” campaign against abusive tax shelters. In early 2003, the IRS provided amnesty from penalties and prosecution, by disclosing foreign bank or other accounts and transactions to avoid taxes through the Offshore Voluntary Compliance Initiative.
CPA firms that were insured with Camico at the time reported to the insurer questionable tax strategies that they had encountered in the market. The firms provided detailed information about such strategies, enabling Camico to disseminate that information to policyholders through advisory articles that provided loss prevention steps to manage return preparer risks. The insurer also found that a significant number of tax claims resulted from clients providing oral tax planning advice without putting the advice in writing. “Informed consent” letters were recommended for improving client communications and managing the risks associated with complex tax strategies. The letters clarified that the professional advises and informs the client, while the client makes the decision and consents to the risks and consequences before filing the return. By outlining the pros, cons, and options—in terms clients understand—these letters helped obtain clients’ understanding and consent to the risks and consequences before a return is filed. Before the use of these letters, it was easier for claimants to argue that the professional made the decisions and should therefore bear all of the responsibility.
The Great Recession
The 2008 financial crisis brought economic turmoil the likes of which had not been seen since the Great Depression. Many of the largest firms on Wall Street, burdened with billions of dollars of bad assets and toxic mortgage securities stemming from the subprime market, required assistance from the federal government, which was able to help Fannie Mae, Freddie Mac, Bear Stearns, and AIG. But when Lehman Brothers could not find a buyer, the federal government allowed the firm to fail. At $639 billion, it became the largest bankruptcy in U.S. history. The stock market also crashed, and credit markets froze, cutting off loans to consumers, banks, and businesses, many of which had to seek bankruptcy protection.
Economic conditions have historically had a significant impact on CPA professional liability claims. In general, more claims and larger claims are filed during a downturn; the recession of 2008/09 was no exception. Public expectations and standards for the CPA profession (as opposed to CPA professional standards, or the profession’s standards for itself) again became a focal point, and clients asserted their expectation that CPAs should advise and warn clients of all risks and opportunities. When something goes wrong with their businesses, some clients will perceive the CPA as having failed to advise and warn about whatever went wrong. Hindsight also leads some clients, and their attorneys, to ask why the CPA did not send written warnings about potential losses.
Long-term Lessons
What we have learned since the mid-1980s has been repeated over and over: as the economy goes, so goes CPA risk exposure. When a positive economy is building, CPA claims are lower. But claims are also gestating, waiting for their moment to be born. Economic upswings tend to cause unbridled enthusiasm, which leads to unwise speculation. When the economy eventually sours—and it always does—unwise speculation turns into losses, and investors and creditors, especially banks, look for scapegoats. What better scapegoat than the CPA, who advised the client to invest, or who “validated” the investment?
Over the years, Camico has provided guidance on the steps CPAs can take to address economic exposures, including the following:
- Identifying and educating clients at high risk;
- Educating staff members who interact with clients;
- Heightening professional skepticism;
- Increasing scope, intensity, and fees for attest work;
- Insisting on current valuations;
- Identifying and understanding investment risk;
- Being attentive to disclosure of loan covenant violations;
- Examining risk to third parties;
- Risk-screening new and existing clients;
- Documenting the firm’s understanding with the client in an engagement letter; and
- Documenting all advice, warnings, and decisions.
The fundamental principles of risk management for CPAs have remained remarkably constant over the years, despite the variety and complexity of changes that have taken place in regulatory and professional standards for CPAs. This constancy is mainly due to the high expectations the public has for CPAs—expectations that affect the way CPAs are perceived in the world of professional liability, where CPAs are judged by jurors, judges, and arbitrators who generally have a limited understanding about what CPAs do.
Judgments and verdicts rendered in liability disputes then create what are sometimes referred to as jury or claims standards, which have almost always been higher than the standards the profession has established for itself. CPAs who pay proper attention to their professional liability exposures gear their risk management techniques not only to what the profession expects of them, but also to what the public expects of them.
Despite the growth in professional liability exposures over the past three decades, the growth in CPA firm revenues over the same period has generally kept pace: thus, the average CPA firm pays about 1% of its revenues for professional liability insurance. This is a much lower rate than what most other major professions pay—another reason why the CPA profession is still attractive and rewarding for those who pay attention to public expectations as well as professional expectations.
