An ethics quiz: the rules are there. These case studies look at some of them.

EXECUTIVE SUMMARY

* CPAs NEED TO BE MINDFUL of ethical issues in performing client services. They must be sensitive to public perceptions and expectations and must use informed judgment as well as adhere to professional standards.

* THREE OF THE MOST COMMON COMPLAINTS made against small to midsize CPA firms involve failure to return client records on a timely basis, failure to exercise due professional care and conflicts of interest.

* "DABBLING" IS DANGEROUS. Camico records show that engagements performed without adequate professional experience produce larger losses.

* THE CPA SHOULD NOT RELY ON disclosure as a form of protection against conflict of interest, as an aggrieved client can argue later that the client's consent was not "informed" by a third party such as an attorney. Prepare a properly drafted engagement letter and obtain all relevant signatures.

* A CPA WHO PROVIDES SERVICES to a limited partnership has duties to the partnership and to the limited and general partners. The CPA should not be biased because the general partners pay the CPA's fees.

* A SIGNIFICANT NUMBER OF TAX CLAIMS against CPAs results when clients are given only oral advice. CPAs should put all tax planning advice in writing--specifically, an "informed consent" letter outlining the pros, cons and options (in terms the clients will understand).

* WHEN IN DOUBT, CPAs SHOULD SEEK assistance early from legal counsel or a risk adviser to help clarify professional standards and prevent potential problems.

The professional image of CPAs currently is under siege. Long esteemed as trusted advisers possessing high standards for independence and ethics, practitioners--large and small, good and (in rare cases) bad--will be negatively affected by the Enron scandal for some time to come. In this climate of increased scrutiny, all CPAs need to be mindful of the everyday ethical issues that are part of performing client services. A CPA particularly needs to exercise informed judgment when making a decision about whether he or she is fully qualified--that is, capable of exercising professional due care--for an engagement.

LOOK THEM UP

Professional liability claims involve ethical violations or complaints that result when a CPA doesn't comply with, or appears not to comply with, professional, regulatory or legal standards. The practice standards are there, however. Most are set forth in the AICPA Code of Professional Conduct; Statements on Standards for Tax Services (SSTSs); GAAS; GAAP; regulations of the various state boards of accountancy; regulatory agencies such as the SEC, the GAO and the U.S. Department of Labor; and legal standards for diligence and negligence. When in doubt, refresh your memory by looking them up.

SHOULD YOU OR SHOULDN'T YOU?

Three of the most common complaints made against small to midsize CPA firms involve

* Failure to return client records on a timely basis.

* Failure to exercise due professional care.

* Conflicts of interest.

The nine question-and-answer scenarios in this article illustrate these and other common problems. They are mini case studies drawn from professional liability claims filed with Camico Mutual Insurance Co. (All names have been changed.) Camico's risk management advisers have provided the answers. How would you handle these situations?

1. Records transfer. A former tax client of yours demands you provide copies of all his records to his new accountant. The former client has not yet paid you for preparing last year's tax returns.

How would you respond to this request? Would your response be different if the engagement had been terminated before it was completed? How would state board of accountancy rules affect your response?

AICPA Professional Standards, ET section 501, says holding back client records after they're requested is an act discreditable to the profession. In most states, holding such records hostage for fees would be considered a violation of state board of accountancy rules, subject to a citation, a fine--or worse. From a loss-prevention standpoint, it's usually unwise to add fuel to the fire by not cooperating with former clients' transition to another CPA.

Much of this issue's risk exposure stems from confusion over what constitutes client records. According to ET section 501.01, client records are any accounting or other records belonging to the client and provided to the CPA by, or on behalf of, the client. If an engagement isn't completed, the CPA is required to return all records provided, regardless of whether or not fees have been paid.

If the CPA completed the engagement, she should be ready to provide workpapers demonstrating information not otherwise reflected in the client's books and records to assure the client's financial information is complete. The CPA can require payment before releasing her work.

Note: Many state boards of accountancy have expanded the AICPA's definition of client records to include workpapers such as adjusting journal entries, depreciation schedules and bank reconciliations, for example, that would not otherwise be available to the client. Under state board rules, the CPA must turn over all client records and cannot hold this information hostage for fees--even though the AICPA doesn't designate these workpapers as client records. In such instances the state board rule supersedes the AICPA rules.

2. Business valuation. Your client, ABC Pest Control, for whom you've prepared corporate tax returns only, has asked you to perform a business valuation for the purpose of a buy-sell insurance contract for the two stockholders. You have never formally performed a business valuation and possess no ABV or CVA designations.

Would you provide this service to your client?

The fifth article of the "Principles of Professional Conduct," on due care, requires the following: "A member should observe the profession's technical and ethical standards, strive continually to improve competence and the quality of services, and discharge professional responsibility to the best of the member's ability."

The code also covers professional competence. ET section 201, "General Standards," provides that members perform only those services they are competent to complete, and that due care be exercised in the performance of all professional services. ET section 202, "Compliance With Standards" provides that members must comply with all professional/technical standards which, in the case of business valuation, fall under the Statement on Standards for Consulting Services. ET section 102, "Integrity and Objectivity," has guidelines for member integrity and objectivity.

Falling short of the above standards can be construed as negligence. Some state laws consider it unprofessional to accept responsibilities that the licensee knows he or she is not competent to perform. In this scenario a CPA accepts the engagement in jeopardy of potential ethics violations and malpractice allegations if his or her competence is called into question. The CPA's competency is of utmost importance in specialized engagements. Juries and judges have a high expectation of CPAs and an even higher expectation of specialists.

Camico claims history shows that engagements performed without an adequate basis in experience produce larger losses--"dabbling" can be dangerous. The exhibit at right, "Loss Ratios by Service Concentration," shows that engagements outside a CPA firm's main areas of expertise (less than 15% of service concentration) generate the highest loss ratios: The higher the percentage of service concentration (specialization), the smaller the loss ratio is.

3. Conflict of interest--divorce. Your longtime clients Robert and Cathy are entering into divorce proceedings, and Robert, whom you've never met (because Cathy handles all the financial affairs of the couple, including taxes) has requested that you provide tax services to him as well as to Cathy during and after the divorce process.

How would you handle this request?

If your own clients are in dispute with each other, you may be brought into the dispute via conflict-of-interest charges. Divorcing couples (and partners in litigation with each other) will sometimes assert their CPA benefited the other spouse/partner to their own detriment. Marriages and partnerships require the CPA to treat each partner equally, regardless of who owns more assets or who pays the fees.

Divorcing spouses often present a potential conflict of interest when they ask their CPA to provide advice and services to both. Although representing both spouses is not prohibited, it's not really a good idea. However, if both cooperate with the CPA, the engagement can work. Start by having both spouses sign consent forms waiving any potential conflict of interest (refer to ethics Interpretation 102-2).

Note: The CPA should not get too comfortable with disclosure--informing each party of your relationship with the other--as a form of protection. It can be argued later the client's consent was not "informed" by a third party such as an attorney. Prepare a properly drafted engagement letter and obtain the signatures of both partners/spouses. A comprehensive resource for engagement letter language is the CPA's Guide to Effective Engagement Letters (Aspen Publishers, www.aspenpublisher.com).

It may be appropriate to disengage from one or both parties, even though that creates challenges, too. Disengage after completing work for the client. When the CPA disengages before completing work, a successor CPA may be unable to finish by the deadline. This type of delay can cause a client to miss an opportunity or seriously damage the client's business. CPAs should be aware of this exposure and shouldn't wait until the last minute to disengage.

When assisting in a divorce settlement, be prepared to

* Address the issue of deeds, IRA beneficiary designations and life insurance beneficiary designations.

* Provide records and possible witness testimony regarding matrimonial lifestyles and spendable income calculations.

* Deal with possible hidden clients and potential adverse interests (such as attorneys, children, family members and new spouses).

4. Client confidentiality. You specialize in accounting for fish processors. Your client, Best Fish, requires an audited financial statement. You are currently engaged to audit Top Fish, a competitor of Best Fish. In the audit of Top Fish, you learn that a customer of both businesses is about to file for bankruptcy.

Can the CPA perform the audit for both clients, and can the information learned in the Top Fish engagement be used in the Best Fish engagement?

A CPA is not prohibited from performing engagements for competing clients. In fact, specializing in specific industries for competing companies can increase professional competence and expertise. The problem that can develop is in disclosure of information learned in audits of competitors. Rule 301.01--"Confidential Client Information"--states: "A member in public practice shall not disclose any confidential client information without the specific consent of the client." This rule prohibits the CPA from disclosing this information without the specific consent of the client, unless the information is a matter of public record and is acquired independently of the Top Fish engagement.

The CPA firm should disclose the competing client relationships to each client prior to undertaking the engagements. This will help protect the firm from impairments of independence in appearance (as might be perceived by an aggrieved client if things go bad). Different partners at the firm should handle each engagement.

5. Error rectification. In preparing your client's 2001 form 1040, you notice that there's an error in the 2000 form 1040.

What are your professional responsibilities to your client? Would they differ if another CPA had prepared the year 2000 1040?

This issue is addressed in SSTS no. 6, "Knowledge of Error: Return Preparation." If a CPA becomes aware of errors in previously filed returns, or nonfiling of returns, he or she should inform the client and recommend corrective action. The CPA is prohibited from informing the taxing authority without the client's consent. The standard applies whether or not the CPA prepared the return. It should be noted the SSTSs are enforceable under Rules 201--"General Standards"--and 202--"Compliance With Standards"--and apply to all tax engagements (not just federal).

ET section 391, Ethics Ruling no. 3, provides guidance on communications between successor and predecessor tax preparers. The prior preparer cannot discuss issues with the new preparer without the client's agreement. The new CPA should obtain the written consent of the client to discuss issues with the former CPA. If the client balks, it may be an indication of problems.

6. Disclosure conflict. A general partnership owned by two partners engages you to provide services to the partnership and each of the partners. One partner has a 70% share and the other 30%. Two years into the engagement, the majority partner solicits you to provide confidential advice on how to creatively finance some large debts he has accumulated.

What are the issues in this request?

A general partnership requires equal treatment of each partner by the CPA regardless of the percentages of ownership. Both partners have a right to the same information. If you are refraining from disclosing information to one partner because of the confidentiality considerations of another partner, you're already caught in the middle. It's time to talk with your risk adviser or legal counsel. A minority partner who perceives unequal treatment from the CPA may have grounds for suing for conflict of interest and lack of disclosure. Representing both partners should begin with consent forms signed by both, waiving any potential conflict of interest (refer to ethics Interpretation 102-2).

7. Fiduciary duty. You have been doing tax work for a limited partnership as well as for the general partners of the partnership. After three years, you notice the general partners are paying themselves fees larger than those that were specified in the limited partnership agreement.

How would you address this situation?

A CPA who provides services to a limited partnership has duties to the partnership and to the limited and general partners. The CPA should avoid being on one side or the other, particularly that of the general partners, who pay the CPA's fees. When something looks amiss, it's better to be on "the side of the angels"--usually the passive limited partners.

The CPA should verify the information or evidence of wrongdoing is correct and insist the general partners notify the limited partners of the excess management fees. If the general partners refuse to disclose to the limited partners, the CPA should disclose. Even if the general partners fire the CPA in an attempt to avoid disclosure, the CPA still has a duty to disclose. Consult your risk adviser or legal counsel for guidance in such instances.

8. Conflict of interest--business. Your client owns Designer Chic, a highly successful women's clothing boutique. The owner is approached by two outside investors with the idea of opening two more boutiques. The owner incorporates and goes public, bringing in the outside investors and asking you to sit on the corporation's board of directors. You accept, buy stock in the corporation and--applying avoidance of conflict-of-interest guidelines--disclose your lack of independence to appropriate parties. Another client asks you to recommend a good investment.

Would you recommend Designer Chic?

Referring Designer Chic to another client would be imprudent from the standpoint of integrity and objectivity per ET section 102-3, which provides among other things that "a member shall maintain objectivity and integrity in the performance of any professional service." Investing in business deals with clients is often a mistake, especially when you also provide professional services to the business. Everyone is usually happy as long as the deal performs well and the client perceives you as a competent adviser with the client's best interests at heart.

When such a deal goes down the tubes, the client's perception of you can change quickly. To the client you appear to no longer have his or her best interests at heart, and juries tend to sympathize with clients, especially with the benefit of hindsight and all the facts laid out by a skilled attorney. In court the CPA is portrayed as having sacrificed the best interests of the client to self-interest.

In addition, disclosing a conflict of interest to the client looking for a good investment, while helpful, doesn't solve the problem. It later can be argued the client's consent was not "informed" by a third party such as an attorney. Don't get too comfortable with disclosure as a form of protection. In the end, the question is whether there is a perception the CPA no longer has unfettered loyalty to his or her clients.

9. Tax. Two business partners, your clients, are both interested in retiring. They wish to sell the assets of the several S corporations they own if the gain on the sales can be deferred for income tax purposes and if estate tax savings can be realized. Their attorney devises a complex plan that involves the partners' children forming a limited liability corporation (LLC) to buy the businesses' assets on an installment basis and then sell the newly acquired assets to a third party.

The attorney drafts a research memorandum for you and the client, covering the plan's technical aspects. You review the memo and present your arguments to the attorney that the LLC may be deemed a related party or controlled group by the IRS, thereby negating any tax advantages of the plan. You also acknowledge the IRS may apply different rules that supersede some aspects of the plan but still yield a positive result.

Can you recommend the attorney's tax position to your client? If so, how can you manage the clients' expectations about, potential penalties that may result from it?

You can recommend a gray or aggressive tax return position to a client, as long as

* You have a "good faith belief that the position has a realistic possibility of being sustained administratively or judicially on its merits if challenged" (SSTS no. 1.02a).

* The position "is not frivolous" (SSTS no. 1.02c).

SSTS no. 1.02d states: "When recommending tax return positions and when preparing or signing a return on which a tax return position is taken, a member should, when relevant, advise the taxpayer regarding potential penalty consequences of such tax return position, and the opportunity, if any, to avoid such penalties through disclosure."

SSTS no. 1.11 essentially states: "If particular facts and circumstances lead the CPA to believe that a taxpayer penalty might be asserted, CPAs should so advise the client and should discuss with the client issues related to disclosure on the tax return."

The IRS has forms for making such disclosures: 8275 and 8275-R. Instructions for using the forms are on them.

You can manage your own risk by educating the client about potential consequences. Do this in conversations and in your documentation. A significant number of tax claims against CPAs result when they give clients oral advice only. Put all tax planning advice in writing--specifically, an "informed consent" letter outlining the pros, cons and options (in terms the clients will understand). Obtain the clients' consent to the risks before filing the return. The client's attorney should see the letter. The informed consent letter clarifies that you, the professional, advise and inform, and the client decides. Without this letter, it is easier for claimants to make it appear that you made the decisions.

Disclosures can be useful on returns that stand a good chance of being penalized for "frivolous" positions or substantial underpayments, but they may also throw up red flags to auditors. If your client takes a gray position without disclosing it on a tax return, confirm the client's decision (and that the client shall bear responsibility for all tax, penalty or interest exposure) in a letter. It is sometimes advisable to insist on a defense and indemnity agreement built into an engagement letter with respect to the gray position.

After completing your due diligence, if you're still uncertain whether the position the client wants you to take is reasonable, have the client provide you with an opinion from tax counsel confirming the position has a realistic possibility of being sustained on its merits if challenged.

If a taxing authority audits your client, and the auditor challenges a tax return decision that you told your client would pass muster, call your risk adviser or tax counsel. You may need help presenting your position. If the audit is going south and the client is grumbling that this is your fault, take the client seriously, no matter how baseless it may sound, and call your advisers.

When in doubt, seek assistance early from your legal counsel or risk adviser to help clarify professional standards and prevent potential problems.

Tread Softly

About 57% of all claims
involve tax malpractice

Source: Camico Mutual Insurance Co., New York City.

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JOHN F. RASPANTE, CPA, is manager of Camico's New York office and leads Camico's new business efforts in the state of New York and the Northeast. He was at American International Group (AIG) and Lehman Brothers, before starting his own practice in 1982. He's a member of the AICPA, the NYSSCPA, the New Jersey Society of CPAs and the National Society of Tax Professionals.