How CPAs Should Respond to a Malpractice Suit

That client appreciation curve suddenly takes an immediate decline and the questions then begin about the role of the CPA and whether he or she should have known about the wrongdoing.

Given the accounting malpractice stories that hit the news more and more often, now is the time for a discussion – and a forward look at how the role of a CPA has changed and will continue to change.

A Turning Point in Accounting Malpractice

When I look at accounting malpractice, I tend to point to one specific turning point.

“Consideration of Fraud in a Financial Statement Audit” is an audit standard for CPAs that was enacted in 1997. With that new standard I prognosticated there would be many more lawsuits against accountants for their failure to detect fraud. And how true my prediction has become!

Without fail, in almost all cases where a company suffers from a fraud, its CPA is sued (or at least, there is consideration to go after the CPA). This is true no matter what service the CPA provided (including simple compilation services).

My prediction was based upon many facts I knew at the time. To begin with, the 1997 standard was the first time I had ever seen the American Institute of CPAs use the word “fraud.” Furthermore, that terrible word was also not used in any accounting text books at the time. Up until then all CPAs had been taught that it was not their duty to look for fraud – only to let their clients know if they saw or suspected any “defalcations.” And many CPAs, especially the older ones still have this mistaken belief.

Accountants Take Note: Fraud Is Serious Business

Too many CPAs have not taken the fraud word seriously.

They have the mistaken belief that fraud only happens to other folks. According to a study by Camico Insurance Company, the public expects CPAs to detect fraud – and fraud drives the largest losses in terms of significant accounting malpractice claims.

This public expectation, arguably, has only intensified over the past 16 years since 1997. You do not have to go back to the days of Worldcom and Enron, either; the illicit activity conducted by former Dixon, IL comptroller Rita Crundwell to the tune of $53.7 million over 20 years was apparently missed by the city’s accounting firm. Charges were brought just last November – and this year, the city sued the firm.

Along with this trend (or perhaps because of it) regulators have stepped up their efforts. The Dodd-Frank act gave regulators a much lower legal bar to go after accounting firms for their failures. In April the CFTC filed its first ever case against an accounting firm for shoddy accounting work. Regulators are taking a close look at accounting firms who failed to detect red flags of fraud at Peregrine Financial Group, MF Global and many failed banks (see Wall Street Journal, April 29, 2013,”Brokerage Firm Ills Stir Auditor Scrutiny”.)

As Camico pointed out, the public expects CPAs to detect fraud and the legal bar for regulators has been lowered. Fraud will never go away, and neither will expectations for CPAs to not only detect but also help defend against it.

For experts and attorneys who work in the accounting malpractice field, my prediction remains true. Expect more cases against CPAs – accounting malpractice, after all, is a growth industry.

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Ralph Summerford is the President of Forensic Strategic Solutions, Inc., where he is a recognized financial investigator specializing in forensic accounting, business valuation, fraud examination and matters related to fraud and accounting malpractice. Mr. Summerford often testifies as an expert witness in federal and state courts on matters involving complicated financial transactions. He works closely with plaintiff and defense attorneys; corporate board and audit committees; bankruptcy trustees and creditors’ committees; insurance company special investigation units; government inspector generals and government agencies.