A big mistake while doing everything right.

This article is written for fellow CPAs who may be making the same mistake I made by operating their firms without professional liability insurance. My mistake cost me $50,000 in out-of-pocket costs and many unpaid hours of work toward my defense, as well as worry and immeasurable anxieties. Given the uncertainty of jury decisions and the lack of accounting knowledge in our court systems, I feel I was fortunate. It could have been more.

As have most CPAs, I had read and heard many war stories about meritless court cases against practitioners. I also had read professional journal articles about plaintiffs who sue the people with the perceived deepest pockets. But I believed my firm exceeded the profession's recommended standards--and I found I was not immune to litigation anyway.

TOO HIGH A PREMIUM

After a friendly separation from my partner in June 1988, I took $150,000 worth of business and started my practice as a sole practitioner. The malpractice insurance that we had purchased through the American Institute of CPAs program followed me to my new practice. When it came time to renew the policy I was astonished at the large increase in the premium rate: The renewal premium was quoted at $2,500. Spending approximately 2% of my gross revenue on mal-practice insurance didn't seem like a good step for my new business, so I made a decision that came back to haunt me several years later.

We had never come close to any type of litigation or disagreement with our clients, so I saw it as $2,500 in the bank when I decided not to renew my malpractice insurance. And, instead of pocketing the money, I invested in a quality control program, a decision I thought would have a long-term positive impact on my firm and the quality of service I was providing to my clients.

SETTING HIGH STANDARDS

As an important part of my quality control program, I began to prepare for my first peer review under the American Institute of CPAs private companies practice section, which was scheduled to be completed in May 1990. To prepare for the review, I enrolled in a one-day, eight-hour AICPA course on quality control and took away many ideas and written materials. I then consulted with CPAs in larger firms who had had peer reviews and had quality control systems in place and used what I learned to write a quality control document for my firm.

The implementation process for our quality control system using the firm's quality control document, which began in 1989, involved a series of nine in-house seminars that I taught, each covering one quality control element. During the summer months, after the seminars, we conducted an internal inspection involving all professional and paraprofessional staff, who each reviewed three engagements on which they had not worked. Deficiencies were documented in writing and discussed with all staff members. As a result of the inspection we revised our quality control document and system to pin-point the areas that were most important to our firm and its needs.

Also, the firm engaged an experienced CPA peer reviewer to perform a one-day consulting review in December 1989 in which he looked at engagements and discussed quality control issues with professional staff members. We were pleased with his assessment and, after more than a year's work, with our quality control system.

Our peer review was completed in May 1990. We received an unqualified report, but we were issued a letter of comments. We immediately undertook additional education in accounting disclosure an area spotlighted by the comments letter.

At this point we as a firm felt very confident in our quality control system, which had been tested internally by our inspection program and externally by the peer review. We believed the money to implement the quality control system (including seminars, in-house training, quality control materials and the consulting and peer reviews), funds we might have paid for malpractice insurance premiums, had been well spent. We thought we were immune from lawsuits because of our quality control system and because, except for two audits and two reviews, all our engagements were compilations.

To be safe, we gave additional attention to those audits and reviews. And, on all compilation engagements we used an engagement letter, as well as an engagement checklist, to ensure we complied with all of the professional standards.

THE TROUBLE BEGINS

It was in 1990, just after the completion of our peer review, that our firm lost a compilation engagement client after we had worked for several weeks on the compilation. Unbeknownst to us, the work-in-process figures given to our firm had been padded. My many inquiries to the president and majority stockholder into the increasing work-in-process amounts had satisfied me and the compilation standards. We also had written memos to the file on the time, date and content of our discussions with the client. At its banker's request, in the summer of 1990, the client changed CPA firms. The new firm performed what amounted to auditing procedures on the work-in-process account that revealed a substantial overstatement. The former client kept us informed of what was found and even allowed us to review the workpapers.

It turned out that just before and during 1990, $250,000 was embezzled from this client. The embezzlement was discovered in 1991 when the client was experiencing severe cash flow problems. The client's former office manager was convicted of the crime and sentenced to prison, but the client's cash flow problems persisted. In December 1991, our firm was served with a lawsuit for accounting malpractice.

The day I was served with these papers was the bleakest in my accounting career. I had an outstanding quality control system, and I believe to this day that we followed and exceeded the professional standards in the performance of all our engagements. But we now had to prove all that to a jury.

The case went on for about two years and we spent approximately $25,000 on legal fees and other expenses. We finally decided it was cheaper to settle than to continue paying for the trial and risk the possibility of an unfavorable conclusion. The plaintiff was seeking in excess of $500,000. Mediation suggested that the case be settled for $10,000. In December 1993, we settled for $25,000 to be paid over eight years. The total cost to the firm was $50,000--all because we had decided to save some money.

QUALITY IS NOT ENOUGH

The lesson to be learned is that even when a firm has an outstanding quality control system--including a quality control document, annual inspections, an unqualified report on peer review--and even if work is performed with due professional care and exceeds the recommended professional standards, it's still possible to be sued, even on a compilation engagement. It cost me $50,000 to learn that all CPAs and firms need--in addition to excellent quality--the extra protection offered by accounting malpractice insurance.

EXECUTIVE SUMMARY

* ONE CPA LEARNED that even the best-implemented quality control program does not insure against malpractice lawsuits and unfavorable outcomes.

* IN SETTING UP A NEW FIRM, the practitioner decided to drop his malpractice insurance and spend the $2,500 premium money instead on a quality control program. He invested in seminars, conducted an internal inspection involving all professional and paraprofessional staff, created a quality control document and system and hired another experienced practitioner to perform a consulting review. The firm also underwent a peer review.

* DESPITE ITS EFFORTS, the firm was sued for malpractice when a compilation client became the victim of an embezzler. The firm spent $25,000 for legal and other fees and finally settled outside of court for another $25,000. The practitioner now believes that malpractice insurance would have saved his firm a lot of expense and anguish--and that it should be mandatory for every CPA firm.

EDWARD S. KISSCORNI, CPA, is president and chief executive of Kisscorni & Company, a four-person firm in Grandville, Michigan. DONALD J. KLEIN, CPA, is professor of accounting at Grand Valley State University, Grand Rapids, Michigan.