Lessons taught by the courts.
This article is not intended to provide legal advice on specific matters and readers are encouraged to consult their own legal counsel. Comments may be directed to Laurrence Wojcik at (312) 634-5110.
Although large-scale securities fraud schemes make the news, it's the garden-variety embezzlement cases that continue to haunt most firms. Whether they provide audit, review, compilation or monthly bookkeeping services, CPAs still face claims from their clients when a bookkeeper's defalcations are uncovered.
Last year, Maryland's highest court dealt with a typical embezzlement case. Wegad v. Howard Street Jewelers (326 Md. 409, [Md. 1992]) involved a malpractice claim brought by the jeweler against its CPA for his failure in a nonaudit engagement to detect embezzlement by the store's cashier. The jury found the jeweler contributorily negligent in causing the loss, thus the accountant prevailed, but the decision was reversed on appeal. (See Legal Scene, JofA, Mar.93, page 21.)
The CPA appealed to Maryland's court of appeals, the state's highest court, which reinstated the jury verdict in the CPA's favor. The court specifically pointed out that although in some cases aecountants might be engaged for the very purpose of detecting possible defalcations, there were other cases in which their engagement was more limited and did not necessarily include searching for misappropriations. The court found the scope of a CPA's undertaking had a direct bearing on how much reliance a client could place on his or her advice.
"The client," according to the court, "should not be permitted an...unqualified right to rely on the accountant's advice and thereby be completely insulated from responsibility for his or her own shortcomings. For example, we do not believe...an accountant's negligent failure to report shortages completely insulates the client who consistently leaves the company's cash...fully accessible to all employees and customers."
In its opinion, the Maryland high court cited the CPA's engagement letter, which warned that the engagement couldn't be relied on to detect fraud, defalcation or other irregularities. The letter specified only that the CPA would inform the business "of any matters that come to our attention [that] cause us to believe...the information furnished us is not correct."
The court found that under these circumstances, a client might be less justified in relying on a CPA than when he or she was engaged, for example, to perform a fraud audit to protect the possibility of embezzlement.
In addition to the engagement letter, the court cited the CPA's testimony that he told the store owners at two yearly meetings that employees might be stealing from the business. Although the court acknowledged the CPA might have failed to report suspicious discrepancies in the store's books and records, it held such a failure was not sufficient to excuse the store owners from looking out for their own interests.
"The fact that an accountant has not discovered or disclosed employee theft does not completely excuse the employer from taking reasonable measures and exercising reasonable vigilance to prevent theft," it said.
Wegad teaches important lessons. It underscores the need for engagement letters. The reference to the engagement letter demonstrates how a court can attach great legal significance to a CPA's disclaimer of any responsibility to detect fraud. Accordingly, statements that the CPA's services are not designed and cannot be relied on to disclose fraud, defalcations or other irregularities should be inserted in all engagement letters.
Such disclaimers should not be qualified with phrases such as, "if I see suspicious circumstances, I'll let you know" - disclaimers should be unequivocal and stand on their own terms. In audit engagements, the auditor should put in writing that although the audit is designed to provide reasonable assurance of detecting errors and irregularities that are material to the financial statements (a requirement under Statement on Auditing Standards no. 53, The Auditor's Responsibility to Detect and Report Errors and Irregularities), it is not designed and cannot be relied on to disclose all fraud, defalcations or other irregularities.
DEFINE THE ENGAGEMENT
Disclaimers also are critical in engagements that do not involve financial statement preparation. For example, CPAs routinely are retained to prepare annual corporate tax returns. In such engagements, they often are required to post the year's transactions to generate a general ledger and trial balance, which clearly involve more than just basic tax return preparation. As a result, clients often misinterpret the nature and scope of the accounting services provided.
Without documentation of engagement scope, it is virtually impossible for CPAs to protect themselves from future claims that more than tax preparation was involved. In Griffith Motors, Inc. v. Parker (633 S.W.2d 319 [Tenn. App. 19821]), the plaintiff, Griffith Motors, won a case against its CPA, Parker, for failing to detect one employee's false bookkeeping entries to cover a theft and cheekkiting scheme.
Although the CPA contended he was only preparing tax returns, the court pointed out that the client was under a different impression. After noting that the CPA had provided all the accounting services for the business as well as the business's owner, the court added there had never been any informal or written contract for these services. It cited the company owner's impression of the "straight audit" he believed the CPA was engaged to do: "The accounting firm comes in and generally takes a look at the important functions of the dealer,' looking at the cash and at postings, and generally |taking a look at the books.'"
This testimony was coupled with the fact that the CPA had evaluated the performance of accounting personnel and procedures. It was sufficient evidence to raise questions about the nature of his engagement, "notwithstanding the considerable . . . evidence that the contract contemplated only preparation of income tax returns [that] . . . entitled the accountant to rely exclusively upon the information furnished by the client."
Even if the engagement had been exclusively for tax preparation, the court said, an unusual yearend adjustment should have alerted the CPA to a problem and the CPA should have brought the matter to management's attention.
Although not even a written disclaimer in the engagement letter might have protected the CPA in this case, it certainly could have assisted his defense and his ability to place some of the blame on the business owner. Under the circumstances, the court faced contradictory statements on the scope of the CPA's services as well as expert testimony that professional standards required the CPA to speak up. The CPA lost.
Apart from the obvious lessons in these cases, CPAs should note that when it's necessary to tell the client about an event or condition that suggests an opportunity for embezzlement or defalcation, such disclosure or notice should be confirmed in writing. Once the management point has been made, the accountant must reiterate it as long as the condition exists. Although such repetition may seem a futile gesture with some clients, it is vital to the CPA's protection.
Some courts found management representation letters to be significant. In Begier v. Price Waterhouse (no. 87-6096, 1992 WL 236175 [E.D. Pa. Sept. 14, 1992]), a bankrupt client's trustee sought to hold the firm liable for breach of contract in performing its audits. The firm countered that the audit client had provided false and misleading information as part of a massive fraudulent scheme to inflate corporate value and hide the company's true financial position.
In granting summary judgment to Price Waterhouse, the court found the plaintiff had lied to the firm in its management representation letter. The court pointed out that the engagement letter between the parties required the engagement to be performed in accordance with generally accepted auditing standards. According to the court, "When performing an audit in accordance with GAAS, an auditor must obtain certain written statements from the audited company's management. In these statements,. . . management must acknowledge its responsibility to present the company's financial statements fairly, and it must affirm the truthfulness of the information it provides to the auditor during the examination."
The court determined that the client had provided false and misleading financial information to the accountant and therefore had breached a material provision of its contract with the CPA firm. The uncontested record showed top management deliberately had presented false and misleading financial information to Price, since the very people who were falsifying the books signed the letters to the CPA firm. As a result, the company had breached the agreement and any performance failure by Price was excused.
The case also is significant because it held the trustee in bankruptcy bound by the acts of corporate officers committed before the bankruptcy.
Practitioners should incorporate in their engagement letters a statement that the auditor will not release the report until he or she receives the management representation letter in which management specifically acknowledges it is responsible for fairly presenting the financial statements and that it must affirm the truthfulness of the information it provides to the auditor. Such a statement makes it clear at the outset of the engagement that the management representation letter itself is a material element of the contract.
READ THOSE DISCLAIMERS
There also is a trend by the courts to require investors to pay attention to disclaimers and warnings in offering statements and prospectuses. Last year, a federal district court judge in Chicago dismissed a $100 million class action based on warnings in a limited partnership offering statement that the investors acknowledged reading in their subscription documents (In the Matter of VMS Limited Partnership Securities Litigation, no. 90 CC 2412, slip op. [J. Zagel N.D. Ill., Sept. 23, 1993]).
In dismissing the plaintiffs' securities and RICO (Racketeer Influenced and Corrupt Organizations Act) claims, the court said that although the plaintiffs purported to understand the offering to be a "conservative tax-advantage investment," the offering materials explicitly described it as high-risk and speculative and served to "inform [them] of the very matters and risks that they claim were not disclosed."
THE IMPORTANCE OF DOCUMENTATION
Decisions like these underscore the importance of documentation and disclosure in defending malpractice claims. CPAs, through their working papers and related engagement documents, are afforded a unique opportunity to record history for courts to review in the future - an opportunity that should not be missed.
Practitioners must keep in mind that their own clients remain the most likely plaintiffs in a lawsuit. Although oral testimony can be persuasive, it's rarely as credible as a written document, especially one exchanged between parties at the time the discussions or events took place. Make the time to document.
* NUMEROUS COURT decisions reaffirmed the importance of documentation and disclaimers when CPAs face malpractice claims.
* AN ENGAGEMENT letter that defined the scope of one CPA's undertaking was sufficient evidence to prove the practitioner had not been at fault for failing to discover embezzlement. Lack of such documentation helped another practitioner lose a similar case.
* A MANAGEMENT representation letter specifically acknowledging that the company is responsible for fairly presenting the financial statements was important evidence for CPAs in another suit.
* THERE ALSO IS a trend in the courts to require investors to pay attention to disclaimers and warnings in offering statements or prospectuses.
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|Title Annotation:||malpractice claims against accountants|
|Author:||Wojcik, Lawrence A.|
|Publication:||Journal of Accountancy|
|Date:||Oct 1, 1993|
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