Our Accounting Practice has been tracking accounting firm professional liability claims since 1999 for the Major Firms Group. We monitor both the frequency (the number of reports) and the monetary value of claims. We pay particular attention to claims that generate losses in excess of $4 million (“Severe Claims”) and emerging trends. While claims tend to come from similar sources each year, our data shows that the value of Severe Claims is increasing. In 2008, the average value of the Severe Claims in our data set since 1999 was $9.3 million. In 2019, the average of the Severe Claims was $14.3 million – an increase of 53.7%. The majority of Severe Claims continues to originate in the audit practice but other areas are catching up. In 2010, 77% of the Severe Claims arose from an audit engagement. In 2019, audit was the cause of only 62% of the Severe Claims in our database.
Below is a discussion of recent claims trends, factors driving severity and certain areas we are monitoring as emerging areas of concern.
Although by no means new, we continue to see Major Firms ensnared by Ponzi schemes and other client level fraud. Over 40% of the Severe Claims in our database involve fraud perpetrated by employees, management or business owners. In all of these claims the accounting firms and their employees did not commit any fraud. Rather, it was fraud perpetrated by employees/owners of the client who purposefully hid the wrongdoing.
A recent example of a fraud case trapping a Major Firms Group accounting firm (“MFG Firm”) is the Aequitas Fraud that has been reported in the media. The MFG Firm was a party to a $300 million settlement, along with Deloitte and others, including law firms and securities brokers. It is believed that Deloitte took the largest share of the settlement. This MFG Firm is by no means alone in the Major Firms Group arena to suffer a loss because of a client’s fraud. Not all of the others were publicly reported like the Aequitas matter. Unfortunately, when accounting firms provide services to clients that commit fraud they are often the target from plaintiffs, banks and investors, to recoup losses.
In looking at the recent fraud related claims in our data base there are some lessons learned that come out of these cases:
It is critical that firms continue to train partners and staff in fraud risk assessment, professional skepticism, and professional judgement. Plaintiffs’ look for evidence that the audit team did not exercise an appropriate level of professional skepticism or displayed poor judgement in the conduct of the audit. It is key to document their risk assessment and the audit response developed in the audit planning process to address significant risks of material misstatement due to fraud and error. In addition, auditors must also remain vigilant for new risks throughout the audit and modify their planned procedures in response to the identified risks.
Management Assertions and Representations
Firms also get in trouble when there is an impression that the audit team merely accepted significant assertions and representations made to them by management without performing enough work to test those assertions and corroborate management’s representations. In several Severe Claims, the appearance of a lack of due care or professional skepticism on the part of the auditor led to larger settlements.
In reporting on the Aequitas claim, a local publication, The Oregonian, wrote:
“Aequitas never gained the local reputation for integrity and savvy that its executives longed for. Co-founders Bob Jesenik and Brian Oliver had participated in too many sketchy deals for sophisticated Oregon investors to feel comfortable with them. But the faintly unsavory reputation wasn’t a problem in other parts of the country.”
“The founders of Aequitas came out of Portland’s banking community, where locals were wary of them. Etesian’s Lochrie, a 35-year wealth advisory veteran, says they had a “sordid” reputation in Portland financial circles. Lochrie acknowledges that might have been hard to detect for an outsider: … “From a national basis, it would be hard to see the little things going on in the background, the things you learn at the country club, but I talked to a number of people who had former dealings with these guys. They’d been around Portland for decades. Historically, he says, the men had been known locally as mini corporate raiders. “They bought something with leveraged money, bankrupted it, split it up, and took all the money. They had done pretty well. You just wouldn’t want to be involved with these guys.”
Knowledge of your local business communities is invaluable in client acceptance. In the Aequitas matter the Major Firm involved did not have a local presence. When firms’ are vetting clients from other geographies finding a way to tap into local knowledge and /or professional references is more challenging but should be sought if possible. Based on these news reports at least some people felt that the Aequitas management group did not have a sterling reputation. If the professionals heard this information it would be a client acceptance red flag, particularly for a business soliciting millions of dollars from investors.
Tax Advice on Transactions
Four matters have been reported in recent years from multiple firms with similar fact patterns. Each have potential damages greater than $2 million. In each case a client was involved in a significant transaction (purchasing or selling a significant asset). In each instance the client’s attorney took the lead in advising, documenting and negotiating the transaction documents. Typically the firm’s tax professionals were brought in for a telephone call with the client and the attorney to advise on the potential tax impacts of the transaction. They were provided draft deal documents and discussed the transaction and the tax impact over the phone. No or inadequate documentation of the facts and the tax impact occurred. Rather, the discussion was viewed by the firm as a casual conversation with the client. The plaintiffs’ attorneys viewed this as tax advice and in the absence of the firm’s own documentation, the client’s or their attorney’s notes became the record of the discussion and advice provided.
Accounting firm partners and professionals pride themselves on being responsive to the needs of their clients. While certainly appropriate to take a call from a client, discuss an issue or area of concern, and provide advice over the phone, it is critical, however, to document the substance of the discussion, documents reviewed, and any advice provided. It is just as critical to recognize when the subject matter deserves a more thorough analysis, and when a new engagement letter or scope of services description is warranted. With complex transactions in particular, the relationship partner must understand when to consult with other experts within (or outside of) the firm regarding the subject matter at hand.
Accountants need to recognize that transactions present complex issues and present higher than average liability risks. Any advice should be confirmed in writing. We suggest the writing include:
- the facts as presented to the accountant;
- reference any documents provided and reviewed;
- restate the question posed (scope of the engagement);
- detail the exact advice and any appropriate caveats; and
- close the writing by clearly stating that if any of the facts or documentation change it can change the tax impact of the transaction.
Transactions are significant events for a client. Informing the client you want to take the appropriate time to assess and review the transaction properly helps the professional to provide the correct advice which is beneficial to both the client and the professionals. [Pressure from the client or their attorney to provide an immediate answer or pushback on a request for more time should be a yellow flag for the accounting professional.] Documenting the assumptions, questions and advice will provide better communication and flush out the importance of keeping the accountant up to date on the details of the transaction.
We are seeing a slight uptick in claims related to IT implementation services. In addition, we have been keeping our eye on SOC for Cybersecurity services as a potential source of claims. In particular, we have been watchful for claims alleging that a firm performed a SOC engagement and subsequent to issuance of the report the client suffered a cyber breach and alleged the engagement team missed security exposures that contributed to the breach. To date, we have not seen claims arising out of this exact fact pattern. Recently, however, there is a claim related to IT Implementation services alleging that the accounting firm that led the system implementation is liable for damages arising out of a cyber breach at the client, alleging the system implementation did not include adequate security in the software and the administration of the IT system necessary to prevent or detect on an ongoing breach. This is a new and developing matter but we anticipate we will see more claims of this nature in the future as cyber breaches grow more common and more sophisticated. Given the increasing costs to remediate such breaches it is inevitable that a certain percentage of the clients harmed by breaches will look to third parties to try to recoup the damages from a breach.
It is important not to overpromise in marketing and proposal materials and communication and documentation is critical when engaging with a client for IT implementation and consulting services. Documentation should include:
- Clear description of the scope of the project including:
- Specific services and products provided and
- What is not included in the scope of the project;
- Appropriate disclaimers regarding the ability of a well-designed and implemented IT system’s defenses against a cybersecurity breach;
- Conversations with management and key IT personnel at the client regarding expectations on cybersecurity, remembering that management may not always be your primary point of contact;
- Limitation of liability provisions in engagement letters;
- Milestones and client sign-offs throughout the project; and
- Do not overpromise in marketing materials
In the claim at hand, the client hired a third party consultant to identify all of the weaknesses in the IT system implemented by the firm and how security could have been improved. While we do not know at this point if the client would have paid for the level of security described by the consultant, the client is treating the consultant’s report as the base line for what should have been provided as part of the firm’s implementation work.
Forecasted Financial Statements
Two matters of note have recently been reported related to financial forecasts. In both matters, the forecasts were used as part of bond offerings, and the bond principal subsequently defaulted on the bonds. While one matter appears to present no ultimate liability on the part of the accounting firm that performed the work, the second has already resulted in a multi-million dollar settlement. Some of the key distinguishing features between the two matters include:
|Multi-Million Settlement||No Liability Matter|
|Poor client due diligence and acceptance procedures. One of the principals at the client had a history of regulatory compliance issues.||Good Client Selection. Project principal had a history of successful projects that were operating and paying off bond holders timely|
|Alleged independence violations.||No allegations of independence issues.|
|Reality that actual cash flows did not match those described in the offering document. Allegation that the firm knew or should have known the intended use of funds did not match the offering documents.||No misrepresentations of cash flows or inappropriate use of bond proceeds. Shortfall in bond payments resulted from low sales and market price of units below estimates.|
|Reliance on appraiser alleged to have lacked requisite expertise and failure of firm to recognize the lack of appropriate expertise.||Estimates appeared reasonable and based on reputable sources.|
|Alleged improper diversion of funds impacted amount available to bond holders.||Underlying real estate and other collateral still had some value resulting in less than total loss to bondholders.|
Examinations of forecasted financials have generally been viewed by most firms as high risk work and many large firms have policies that prohibit or significantly limit acceptance of such engagements. Lenders are relying on the reasonableness of the forecasts to put up significant dollars. If the project does not perform as forecasted the forecast and the examination will be critically reviewed by the bond holders and other investors in a project. As illustrated above, when there are facts a plaintiff can raise to cast doubt on an accounting firm’s professional skepticism or judgments made in performing the work, the dollars involved in these engagements make settlement negotiations difficult and make the claim risky to take to trial.
Client acceptance on forecast engagements should be strict and include:
- Thorough due diligence regarding the professional reputation and strength of principals
- Inclusion of internal or external professionals, such as appraisers and valuation experts, with the requisite expertise and strong professional reputation with the subject matter being evaluated.
- Ensuring the forecast involves a market with sufficient comparables on which a third party may place reasonable reliance regarding future performance.
- Limiting engagement performance, supervision and review to professionals with appropriate industry and subject matter expertise and experience performing examinations of forecasts.
Conservation Easements (tax shelter abuse revisited)
Tax shelters in varying forms periodically rear their head to deliver professional liability claims to accounting, legal and other professional services firms. The claims hit the industry, firms vow not to fall for the tax shelter abuse again, then 5-10 years go by and several firms fall for the next iteration of abusive shelters.
Conservation easements have a long history and a noble purpose. Many conservation easements are valid transactions and fall within the intended scope of the tax code. Recently however, abusive conservation easement shelters have ensnared several accounting firms, primarily in the southeast United States. As Southeastern firms became embroiled and the word got out to avoid these shelters in that region, we noted a high number of inquiries from our clients in other regions who were contacted by the promoters looking for a firm to work with (dupe) in other regions of the country. The firms we talked to have wisely avoided these out-of-region engagements.
The IRS outlined its concerns in Notice 2017-10 (Listing Notice – Syndicated Easement Transactions). The first sentence of this notice states:
“The Department of the Treasury (Treasury Department) and the Internal Revenue Service (IRS) are aware that some promoters are syndicating conservation easement transactions that purport to give investors the opportunity to obtain charitable contribution deductions in amounts that significantly exceed the amount invested.”
On its face this simple statement screams abusive shelter. Yet there are clever people that can parse the facts and the code and convince themselves and others that these syndications comport with the tax code. Time will tell if the promoters or the IRS are vindicated. Our risk management tips:
- When the tax treatment seems too good to be true – beware.
- Just because “smart” people are involved does not make it right or safe.
- Just because “others are doing it” does not make it right or safe.
- Common sense is more important than a clever parsing of the tax code.
- Saying “no” to a client or perspective client is ok when you are presented with an “opportunity” in these situations.
We have remained open for business since the onset of the COVID-19 pandemic in the United States as we transitioned quickly to a 100% remote worker arrangement in early March. Please contact Jay Moroney and Owen Bailitz for assistance with risk management concerns or your account team with policy and coverage questions.
 The sordid tale of Aequitas Management holds lessons for RIAs. By Michelle Celarier, August 13, 2019
EPIC’s Accounting Firm Practice
The Accounting Firm Practice of Lemme, a division of EPIC Insurance Brokers & Consultants, specializes in assisting accounting firms worldwide with the procurement of insurance coverage. Our team provides personal, proactive, timely and exceptional service while being fully transparent and accountable to our clients. We do not believe in the status quo. Experienced, results driven brokers negotiate creative insurance solutions while also offering best practice advice, valuable insight and risk management services for our accounting firm clients.