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The need for expanding organizational options for CPAs.

The current litigation crisis is doing more than causing some CPA firms to shut their doors. It's also preventing some firms from opening. Today, more than ever before, pursuing a career in public accountancy may mean risking your savings, your home and other personal assets for the possible negligence or actions of partners serving clients for whom you have never worked. For some, the risk is clearly too great. Although we are having some success at liability reforms, the accounting profession cannot reverse the effects of the litigation explosion. However, we should not stand in the way of CPAs seeking to minimize an unreasonable degree of personal liability exposure.

In November, members of the American Institute of CPAs will be asked to vote on proposed changes of Rule 505--Form of Organization and Name of the AICPA Code of Professional Conduct. The current rule and existing state accountancy laws and regulations limit Institute members to practicing in proprietorships, partnerships or professional corporations (PCs). The proposed rule change would allow members to practice in any form approved by state law or regulation, including a general corporation and a limited liability company (LLC). (An LLC is an entity that is treated similarly to a corporation for purposes of determining liability of shareholders, directors and officers but is treated as a partnership for tax purposes. Seven states currently permit their formation: Colorado, Florida, Kansas, Nevada, Utah, Virginia and Wyoming. However, in the state of Virginia, the statute does not permit professionals to form LLCs.)

This rule change may not seem monumental, yet, in reality, it could be a significant step in helping to ensure the profession's future viability.

CPA firms of all sizes need a structure that insulates them from unreasonable legal liability. They also need a structure that affords the flexibility to respond to the changing needs of the marketplace, to operate cost-effectively and to position themselves for future growth. Changing Rule 505 will provide AICPA members with expanded organizational options so they can better meet those needs.

At present, Rule 505 deprives members of the liability protection offered by practice as a general corporation, an LLC or any other organizational form that in the future may be permitted under state accountancy laws or regulations. Such an obstacle not only makes CPA owners who perform quality work and have not committed any wrongdoing vulnerable to excessive liablity exposure for mistakes made by those in practice with them but also may impeded the CPA profession from attracting and retaining the most talented individuals.

In The Litigation Explosion, published in April 1991, Walter Olson, a senior fellow at the Manhattan Institute, emphasizes accountants' vulnerability to litigious actions: "Litigation and its threat have begun to metastasize to virtually every sector of the economy. Retailers sue manufacturers, franchisees sue franchisers, commercial tenant sue office and mall developers, and everyone sues accountants."

In such a litigious environment, CPA firms deserve to be on a level playing field with other business enterprises, including their own clients, many of which are organized as corporations.

The AICPA is alone among national groups in restricting members' form of practice. Other associations, such as those for lawyers and doctors, do not dictate their members' form of practice and rely instead on state licensing regulations. I believe the AICPA should change its rules to reflect the public policy decisions made by the legislatures where its members practice. Our members should be given the right to practice in the same forms as other responsible enterprises.


We are all acutely aware that times have changed. The profession is changing and the proposed amendments to Rule 505 are, in part, a reflection of the changing times. Firms must be able to adapt their organizational structures to keep pace with shifts in the economic, regulatory and legal environments in which they are currently operating.

In the early days of the profession, accountancy corporations were fairly common, until the AICPA's predecessor organizations adopted a corporate practice ban. After that, practice units were proprietorships or partnerships in which each partner was, and still is, personally liable for claims against the partnership or against any other partner, regardless of the individual's involvement in the case that is being considered. This is known as vicarious liability.

In the late 1960s, the prohibition against practice in corporate form was dropped and Rule 505 of what was then called the AICPA Code of Professional Ethics was amended to permit practice as a PC. Yet even then members never envisioned that they would be subjected to such excessive legal liability costs or that a considerable percentage of their personal assets would be in jeopardy as a result of business failures, compounded by a recessionary period.

CPAs are now allowed to practice in PCs in all states. However, this corporate form does not necessarily restrict the personal liability exposure of CPA shareholders not directly involved in wrongful conduct. In fact, in some states, the statutes governing PCs have unlimited liability rules similar to those governing partnerships.

Additionally, CPAs who organize as PCs often face another obstacle: restrictions on interstate practice. Most states limit shareholders in a PC to professionals licensed within the state and prohibit practice by an out-of-state PC. As a result, an accounting firm seeking to help a client with business in another state may have to form another PC in that state, increasing its administrative and financial burden. This has become an increasing problem even for many small practitioners.

In the interest of addressing these practical and legal considerations, the AICPA special committee on accountants' legal liability sent a memorandum to each state CPA society in October 1986, recommending that existing PC statutes be modified to limit the degree to which CPA shareholders are exposed to vicarious personal liability and to permit multistate practice. Included with the memo was model statutory language to accomplish those goals. Since then, however, the AICPA has seen few, if any, improvements in PC laws.

Against this backdrop, the AICPA board of directors, with the full support and encouragement of the special committee, proposed removing the restriction against practice in general corporate forms under Rule 505. Under the general corporat laws of the states, there are no existing restrictions on interstate practice and shareholders are more fully and reliably protected from personal vicarious liability than are PC shareholders.


Given the current ligigious environment, even firms with single-state practices could, if given the option, structure themselves as LLCs or general corporations to increase liability protection. The PC, the LLC and the general corporate form will not insulate CPA shareholders from liability for their own wrongful acts. However, it's important not to underestimate the extent to which innocent shareholders (such as those not personally responsible for any wrongful conduct) of an LLC or commercial corporation are more fully and reliably protected from liability than those of a PC.

LLC or general corporate shareholders can be sued only under the ordinary principles of tort law, while PC shareholders may be sued under the language of the various PC statutes. Even when worded in a relatively neutral fashion, these statutes often provide plaintiffs with a more favorable standard than found in common law.

For example, in several states the PC statutes specially provide for personal liability not only for wrongful acts committed by the shareholder but also for those committed by "any person under his direct supervision or control." Such language invites lawsuits against the accountant responsible for the alleged wrongdoing and against every shareholder in the chain of command, including the accountant who may have secured the engagement.

Also at risk under such laws are PC shareholders who have general oversight of offices, regions, lines of business, functions or, indeed, of firms, even if they do not actively participate in the business in question. By contrast, under common law principles applicable to the LLC and commercial corporation, the potential plaintiff would more likely be required to show that each named defendant had an active role--or was responsible to the plaintiff to have an active role--in the transaction under consideration.

Even laws worded less explicitly may be construed to create a cause of action that would not exist under the LLC or general corporation laws, and some states, such as California, for example, impose the same liability on PC shareholders as that borne by partnership partners.

Regardless of wording, there also is a danger under PC laws that shareholders could be held personally liable for corporate debts unrelated to professional services--a liability from which shareholders are protected under LLC and general corporation laws. It was only in 1985 that the New York Court of Appeals concluded that PC shareholders in New York should be protected from such liability. The Ohio Supreme Court, however, reached the opposite conclusion. The risk of an interpretation of the PC laws similar to Ohio's exists in any state in which the highest court or the legislature has not already decided on the issue. This is a risk some firms cannot afford to take.


The move to change Rule 505 is driven by the need for greater flexibility and to provide innocent CPAs with protection against unwarranted legal liability. It is not about making firm assets exempt from claims by injured parties. It is not about avoiding public responsibility. It is not about avoiding public responsibility. It is not about compromising professional standards. On the contrary, changing this rule will enable CPAs to better meet their responsibilities t the public.

There are practical, legal and strategic advantages to be gained by the proposed amendment at a time when CPAs are faced with a litigation explosion and are bearing insurance costs that were inconceivable 10 years ago. The crippling liability exposure facing many accountants today may discourage practitioners from providing a full range of services to enterprises they regard as risky--the very enterprises that may benefit most from high-quality work. Indeed, the specter of accounting firms sinking under the weight of an overly demanding legal and economic environment has become a harsh reality with the bankruptcy filing of Laventhol & Horwath, formerly the nation's seventh largest accounting firm, and the demise of Spicer & Oppenheim, a highly regarded regional accounting firm.

Increasing client needs and government pressures are likely to compel future CPAs to assume even more accountability in rendering specific services. The profession is willing and able to assume greater responsibility to meet public needs. However, CPAs can do so most productively and most cost-effectively only after eliminating the threat of losing their life savings if another of their shareholders or partners makes a mistake or acts negligently.

The right to practice in a variety of organizational forms does not alter members' obligations to adhere to professional standards. CPA firms' auditing and accounting work is carefully monitored through the peer review program of the AICPA division for CPA firms or through the Institute's quality review program.

Some 30 years ago, when the profession first allowed its members to practice in PC form, there was no public backlash against the profession. In fact, the public did not perceive reduced liability exposure as tantamount to reduced standards of practice. Since the proposed change to Rule 505 represents only an opportunity for accountants to take advantage of local laws, it is unlikely to generate a negative reaction. Accountants still will be held responsible for their own work, and their reputations and financial assets will remain at risk.


A change in AICPA Rule 505 would be a first step toward obtaining more flexible practice provisions in state laws and regulations. If the rule is changed, the AICPA would work in concert with state societies to plan legislative efforts and petition state boards of accountancy for changes in laws and regulations.

In recommending revisions to Rule 505 and providing firms with greater choices in selecting the form of practice that best meets their needs, I am not rejecting the PC as an appropriate structure to meet firms' needs in today's environment. On the contrary, we owe it to ourselves and to those who will be entering the profession in the future to pursue every means available--PC, LLC and general corporation--to minimize personal liability for owners of CPA organizations.

The AICPA will continue to encourage state societies to press for the improvement of the PC statutes in their states. Plans for a renewed campaign organized to gain reform of state PC laws are already under way. The initiative to allow practice in other business forms would supplement these efforts.

The liability crisis certainly will worsen before it improves. But as Olson points out in The Litigation Explosion, we can do something about it: "As individuals and in our larger associations, we are most of us terribly vulnearable to the perils of litigation. Yet as a society, was are in no sense helpless to remove its evils. All it takes is the will."

If the CPA profession is to keep pace with the times and meet its challenges head on, we need to exert our will; we need to work toward changed. The urgent need for greater flexibility in choice of organizational form for CPAs in public practice and improved liability protection during these times certainly supports the proposed amendment of Rule 505.

CPA firms, like other American enterprises, need and deserve the right to choose the organizational structure that will enable them not only to survive but also to operate effectively in the years ahead. We must commandeer every possible resource available to us in seeking legislative relief from unwarranted and excessive legal liability. Difficult? Yes. Impossible? No. Necessary? Absolutely.

I have been a strong supporter of changing Rule 505 from the moment the change was first proposed. As we approach the vote, I urge all AICPA members to vote in favor of this change. Future generations of CPAs will be grateful.

THOMAS W. RIMERMAN, CPA, the outgoing chairman of the board of the American Institute of CPAs, in managing partner of Frank, Rimerman & Co., Menlo Park, California.
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Author:Rimerman, Thomas W.
Publication:Journal of Accountancy
Date:Oct 1, 1991
Previous Article:Schools of accounting.
Next Article:Practice continuation agreements; no sole practitioner or small firm should be without one.

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