The July issue of Accounting Today makes important points about accounting risk for failure to detect and report fraud. Sarah Ference, Risk Control Director for CNA, notes that while CPA engagements are not typically designed to detect or report fraud, most clients, and perhaps most jurors, think CPAs should always be on the lookout for fraud. 25% of claims arising from audit and attest engagements allege that the CPA failed to detect and report fraud. 6% of tax service claims also allege a failure to detect and report fraud. Ms. Ference notes the importance of engagement letters to manage expectations and, where appropriate, disclaim reliance. Mission creep, of course, can render the best engagement letter ineffective. Finally, the article suggests that anything sinister or unusual observed during the engagement should be reported in writing to the client. The disconnect between client/juror expectations and an accountant’s scope of engagement will apparently always be with us. Paying attention to potential fraud and reporting it may help your accounting firm avoid becoming a data point in the claims statistics.
Today the CPA Dailey Letter (citing CBS News and the IRS) warned against phishing attacks on accounting firm computer networks resulting in stolen data and fraudulent tax returns. We helped an unfortunate client facing this problem last year. They merged in a smaller firm in the middle of busy season and didn’t get the small firm converted to the large firm’s computer system quickly enough. Imagine a hacker getting copies of all your clients’ 2016 returns and then using your clients’ data to file fraudulent 2017 returns seeking big refunds. You and your clients learn about the problem when notices start drifting in from the IRS rejecting returns that seek 7 figure refunds. Eventually you get such a notice for every one of your tax return clients. You have to call each and every one of them to tell them that fraudsters have all their personal information from the return. Fraudulent tax returns may just be the beginning of their identity theft problems. This problem could really ruin your quarter and your year. Keep your software updates current and do some simulated attacks to protect your clients and your firm.
Earlier this week the Wall Street Journal and others reported that KPMG had hired former PCAOB staffers to reveal the secret list of KPMG audits that the PCAOB would examine. The article reported that the SEC had indicted 5 former KPMG employees including 3 former partners for fraud. KPMG apparently discovered the scheme in March of 2017 and self-reported. Allegedly almost half the 2013 KPMG audits reviewed by the PCAOB in 2014 had been found deficient and the firm felt pressure to improve its audit quality. The partners charged included those formerly in charge of national audit quality and another responsible for inspections.
A few days later GE announced an SEC probe of its accounting practices along with a restatement of its 2016 and 2017 financial results. At least part of the problem arises from revenue recognition issues in its jet engine and power turbine business. Other problems stem from charges in its long term care insurance business. Together the adjustments may total over 21 Billion dollars. KPMG has served as GE’s auditor since 1909.
These articles highlight the challenges even the largest audit firms face in detecting material misstatements in a client’s financials. We face increasing complexity in public company financials and auditors are struggling to keep up with the standards in a difficult environment.
1. Cyber Insurance is cheap and important to protect against risks not covered by E&O. Work with a knowledgeable broker and insurer and buy the coverage because the risk is real and growing.
2. Make sure your engagement letter includes:
• a specific description of the work you will do;
• limitation of damages provision where not precluded by standards;
• indemnification where not prohibited by standards;
• disclaimers where appropriate ( i.e. AUP’s);
• jurisdiction, venue and choice of law provisions; and
• a provision for the client to pay for time and expense you incur for subpoena compliance.
Watch out for client changes including cyber representations and indemnifications of any kind.
3. Evaluate the risk to your firm before responding to subpoenas or document requests. Consultation with your insurer or outside counsel may be time well spent. The risk runs from minimal to existential and different risks require different responses.
4. You save money by not engaging with bad clients. Red flags include:
• financially stressed or unprofitable clients;
• clients whose work you are not really equipped to handle;
• clients whose interests conflict with other clients; and
• clients who lack management integrity.
These all should be evaluated for disengagement. Consider firing your bottom 5 or 10% and investing those resources into developing better opportunities.
5. All of us have clients who present some special risk. Do what you can to mitigate that risk with:
• thorough client acceptance procedures;
• engagement letters;
• robust conflict analysis; and
• continuous reevaluation.
Employ detailed financial management including precise billing entries, timely billing and early AR follow-up in order to spot problems quickly.
Takeaways from State of the LPL Market Panel Presentation at ABA National Legal Malpractice Conference – Boston 2017
- Big Data is changing Underwriting, Broking and Claims Handling and helps to keep the LPL and APL markets highly competitive and insurance reasonably priced.
- P & C events, such as Hurricanes in the Caribbean, no longer drive rates up for Lawyers and Accountants because carriers now distinguish between Casualty and Professional Liability risks.
- The Great Recession, the largest economic crisis in 70 years, created a hard market that only lasted about six weeks.
- Capital to insure professionals keeps pouring into the market, despite an increase in huge claims individually exceeding hundreds of millions of dollars.
- Despite all the positive developments, premiums have increased between 2 and 4% on average for Lawyers E and O insurance in 2017. While 20 years ago this would have been classified as an annual inflation adjustment, now it may be the closest thing we will see to a hard market for some time.
Billy Newcomb and I recently won summary judgment for a top 100 accounting firm. A publicly traded company had sued in a Florida court, alleging negligent failure to detect fraud and claiming damages well into eight figures. Six other defendants, including a top 10 accounting firm, settled with the Plaintiff just after suit was filed, leaving our clients as the sole defendants. At court-ordered mediation, the Plaintiff, perhaps a little too confident in its home court advantage, refused to lower its demand under $5 million. Immediately after the mediation failed, the trial court granted summary judgment to CCS’ clients and dismissed all of the Plaintiff’s claims with prejudice.
Billy practiced law in Florida for five years and regularly litigates Florida cases, and he and I have done well in Florida over the years. We felt strongly about our liability and damages defenses and didn’t want to waste our clients’ money on an excessive settlement. Our clients agreed and had the confidence to stand up to the Plaintiff. If early summary judgment had not been granted, Billy and I planned to prevail on another dispositive motion or at trial.
When a Plaintiff makes a reasonable demand, we often recommend settlement to our clients. But, when the plaintiffs are unreasonable, we know how to get a better result at the courthouse.
As Churchill announced:
we shall fight on the beaches,
we shall fight on the landing grounds,
we shall fight in the fields and in the streets,
we shall fight in the hills;
we shall never surrender…
There are no sure things in litigation, but if you want to know what a case is worth, sometimes you must have the courage to fight. We are both very grateful to our clients for their courage in letting us go forward.
Last Saturday I was, once again, Player Coach for the Lawyers in the Jawbones v. Sawbones Charity Basketball Game. This is the 6th year of the Event and I have played, and Carlock Copeland has been a sponsor, every year. The event usually raises about $80,000 for the Side By Side Brain Injury Clubhouse and this year the Lawyers won again in a relatively close game. While our team was once again stacked with some pretty good ex-college talent, that was not what I thought about while leaving the Mercer University gym. The game started when a young woman was given a microphone in the middle of the Court and welcomed us all to the event. She only spoke about 20 brave but halting words to the assembled multitude. She had worked at the Clubhouse for five years trying to regain the powers of speech following a stroke. Her welcome was just a step along the way of recovery. Other brain damage victims happily passed out towels or worked the concession stand. After six years I have seen many of the same family members again and again.
Many of us are blessed to practice law or medicine or accounting. The joy of counseling clients and handling sophisticated work is something that we hopefully grow to value more and more over the years. I was reminded on Saturday night that many are not so blessed and we should appreciate all that we have. Link to learn more or support The Clubhouse: http://www.sidebysideclubhouse.org/giving-volunteering/donate/.
Takeaways from Professional Liability Underwriting Society (PLUS) International Conference 2016:
1. Law firms fail because of: too much debt, rapid expansion, guaranteed salaries, and/or cultural divides.
2. We are all expecting a U.S. law or accounting firm to get hit with a Panama Papers style data breach which brings down the firm and probably yields management liability claims as well.
3. The IRS will continue its attack on captive insurance companies utilized to avoid tax with no real risk transfer.
4. Mary Jo White will be missed and you might expect the SEC to focus less on Wall Street and more on Main Street in the next four years.
Just last week the ABA’s Standing Committee on Lawyers’ Professional Liability (LPL) released its Survey of Legal Malpractice Claims 2012-2015. Items of note include:
1. Total legal malpractice claims increased by 20% from the 2012 survey. This might appear to be a big increase but it looks small when you read on.
2. There was a huge increase in the number of claims in which claimants received over $1 million. There were only 52 such claims reported in the 2011 study but there were 440 such claims reported in the 2015 study for more than a 700% increase. Perhaps you should check my math, as a lawyer with a calculator is a scary thing; nonetheless, we should all check our limits and make sure we have enough coverage in a world of big dollar claims.
3. Total real estate claims dropped 21% when 2015 is compared to 2012. This is true despite the fact that commercial real estate transactions have increased during that time and many commercial real estate lawyers are experiencing the best of times. Not many real estate deals are failing and that helps keep the pressure off the lawyers who do the deals.
4. 46% of the claims arose from administrative errors, client relations or intentional wrongs. While this is a slight reduction from prior surveys, it still emphasizes the importance of basic blocking and tackling.
- Keep your administrative machine running smoothly, return client calls, be nice, don’t intentionally hurt your client, and your E & O risk is cut in half.
- The seamless web of the law is vast and can’t be perfectly understood by any of us. Let’s all do the easy stuff and reduce our risk dramatically.
5. Claims against bankruptcy and collection lawyers have only dropped off about 4% from the 2011 study to the 2015 study. Despite the precipitous decline in consumer bankruptcy filings, commercial bankruptcy filings are said to be on the rise and so are claims against the lawyers involved.
The Standing Committee puts out the Profile on Claims every third year and also sponsors two great conferences annually. If you are interested in getting involved in our work feel free to reach out to Joe Kingma or just say hello at our spring meeting in Boston.
I was fortunate to prevail in a bench trial for a great CPA firm in August and was reminded of these takeaways:
1) A CPA’s work product will seldom be perfect but good workpapers can save you from many apparent sins.
2) Identify sources of data in your work product or you may end up as guarantor of data you should not be responsible for.
3) Smart and highly educated Plaintiffs who exaggerate their claims can be systematically destroyed, but only with a light touch.
4) Credibility and likeability are critical in a factually complex case and lawyers and CPAs need to begin to establish both on day one of their engagement.
5) Our trial system is not perfect, but it often yields the right result so defendants should not despair.