The Greatest Malpractice Risks and How to Mitigate Them

By Lauren Pitonyak

Many accountants don’t realize how everyday tasks can open themselves to malpractice litigation. Becoming aware of risks, mitigation techniques and the role of insurance can help to keep you safe.

Accountants work hard at collecting client financial information and then analyzing and reporting it to answer questions, prepare government filings and craft statements. It’s complicated, time-intensive work that must accurately hit the mark every time. When it doesn’t, malpractice lawsuits can ensue, saddling you with expensive settlements or judgments, punishing legal fees and a tarnished professional reputation. Fortunately, the causes of litigation are well known, as are the mitigation techniques that prevent it. Read on to learn more about keeping your practice safe in a lawsuit-happy age.

Sources of Litigation

Accounting is a risky business. But why is that exactly? Here are three factors that combine to make it so:

• Some mistakes, though highly predictable, are easy to make
• The accounting business by its nature encourages litigation
• Certain accounting practice areas serve as litigation magnets

Let’s consider each of these factors in turn.

Predictable Accounting Errors

Some mistakes happen frequently despite your best efforts to prevent them. These are mistakes such as:

• Generating a tax-return error: Tax-return work can be risky for several reasons. Forms can be difficult to prepare, especially when clients haven’t done their homework. Clients also pay a lot of attention to the financial impact of their tax filings. If they get less money back than they expected or face a large tax bill, they can be quick to file complaints and lawsuits.
• Straddling both sides of a transaction: When you agree to work for multiple firm owners or partners or for two spouses, you might receive conflicting instructions from each client. When disputes arise during such situations, tempers can flare and an accountant trying to serve multiple parties can become a target of abuse and eventually litigation. When both sides of a transaction feel their accountant has betrayed them, nasty litigation often results.
• Teaming up with clients to do business or investment deals: Partnering with clients on outside deals while also providing accounting services is a risky gambit. If the deal goes bad, clients might accuse you of sabotage or self-dealing and take you to court.
• Not documenting accounting engagements: Not documenting the terms of an engagement or failing to confirm key client decisions during a project can lead to costly malpractice litigation. Problem is, failing to explain and document terms can lead to incorrect client expectations. When your performance takes them by surprise, even though it’s totally appropriate, you may be on the receiving end of a malpractice action. Similarly, when an engagement takes a new turn that isn’t confirmed in writing and has a bad outcome for the client, guess who may get blamed for it? Having written confirmation of revised instructions is a powerful tool for nipping such litigation in the bud.
• Suing a client who has past-due invoices: Of course, it’s important to get paid. But realize that hiring an attorney to take legal action against a late-paying client may be asking for trouble. The client on the receiving end of such efforts will often retaliate with a malpractice lawsuit. The better alternative: avoid hard-nosed legal tactics and continue pointed, yet polite, efforts to receive what you’re owed.
• Dabbling in a practice area in which you lack experience: The temptation to chase revenue in a new area is hard to resist. But resist you must because lack of knowledge is a recipe for making mistakes. And if your work product is flawed and harms a client financially, you will be a sitting duck for a malpractice suit.

The Nature of the Business

Lawsuits often arise not because of a specific mistake, but because of the nature of the accounting business. Here are three examples of what we mean:

• Working with a financially deteriorating client. When clients are having financial trouble, seeking a scapegoat is a common human tendency. Their frustration might focus on you simply because you’re there. If their anger and resentment become acute enough, they might initiate a lawsuit against you. Even though you did nothing wrong, you will have to mount a legal defense.
• Getting blamed for fraud. When clients fall prey to fraud, scapegoating is a common outcome. Their attorney might seek to prove the accountant involved—you—should have detected and prevented the problem. If you didn’t, you might be accused of—and sued for—malpractice. This is yet another example of how accountants can get trapped in a legal dispute despite having done nothing wrong.
• Becoming a magnet for opportunistic third parties. When clients experience a crisis, outsiders often emerge to take advantage of the situation. For example, bankruptcies can lead shareholders, banks, business partners or customers to sue a failing company’s accountant, arguing that person (or firm) should have prevented the problem in the first place.

Practice-Area Litigation Magnets

Working in a litigation-prone practice area is the third factor that creates malpractice risk. For example, it’s well known that tax planning and compliance services account for a large share of malpractice claims, followed by audit and attest services, consulting services, bookkeeping and fiduciary services. Failing to implement quality-control systems may also result in mistakes that spark legal liability and eventually expensive malpractice settlements or judgments.

Auditing is a risky practice area, as well. Audit malpractice suits may not be common. But when they do occur, they can be high profile, disruptive and damaging to an accounting firm’s professional reputation. They often arise when accountants fail to do their due diligence on client statements and materials or when a client is a bad-faith actor manipulating data to make financial statements come out better than they should or to hide embezzlement.

Trustee-related work can be dangerous, too. Accountants often get such assignments from long-term clients with whom they’ve had trusting relationships. But they can run into trouble when the assignment puts them into conflict with third parties who believe the accountant’s decision financially harmed them. For example, mismanaging trust affairs or mishandling assets might put an accountant and trust beneficiary at loggerheads. If negotiation fails to resolve the dispute, a courtroom may be the next stop.

Given the many risks just discussed, two risk-mitigation steps are essential: practicing defensively and transferring risks to an insurance company by purchasing professional liability insurance.

Tips for Practicing Defensively

The best way to avoid accounting malpractice litigation is by doing business defensively. This requires adopting a loss-prevention mindset in every aspect of your practice. Here are some strategies for accomplishing that.

• Become a student of your clients’ businesses. This allows you to understand the difference between normal and aberrant business practices in their world. Plus, always stay current on their financial results and business initiatives. If a client is showing weak financials and entering new business arenas, that should set off warning bells. Also, document all client conversations and decisions, especially when a client fails to accept your accounting advice.
• Beware the non-payment trap. We mentioned this earlier, but the significance of non- or late-paying clients bears repeating. Due to the high risk of payment-tardy clients filing counter-suits, it’s best to pursue non-litigation measures to collect the funds you’re owed. If you’re not sure how to do that, consult with an experienced debt-collection attorney.
• Carefully research all prospective clients. The goal here is to avoid doing business with financially tenuous clients. Firms that are on the edge of bankruptcy will be more likely to commit fraud—and ensnare you in their crimes—than those who are in solid financial shape. Also, try to determine a prospective client’s litigation history. Companies that have sued a prior accountant may be more likely to sue you than those who’ve avoided legal disputes in the past.
• Read up on accounting ethics. Mastering ethical standards in accounting will make it easier for you to avoid conflicts of interests and other practice errors that may land you in court. We highly recommend you study the AICPA’s Professional Code of Conduct. This document lays down the bright lines that distinguish ethically acceptable behavior from unacceptable behavior. Staying within the lines of appropriate professional conduct will largely inoculate your practice against malpractice lawsuits.

Transfer Risk to an Insurance Company

Even if you do everything right—practicing defensively and staying within the bright lines of ethics—you still might get sued. That’s because no one’s perfect, and you might make a mistake that puts you in hot water. Furthermore, since human nature is a mystery, your best efforts to screen out litigious clients might still allow a difficult client to slip through the cracks. Enter accountant malpractice insurance.

How does it work? First, it provides you with a vetted defense attorney, as well as covers other legal expenses such as court and expert-witness fees. If you lose your case, your accountant malpractice insurance policy will then pay for settlements or court-imposed settlements. Finally, your policy will protect you against frivolous lawsuits. Even though such lawsuits are without merit, they can be expensive to get dismissed. Having an accountant malpractice insurance policy means you can continue doing what you do best—accounting engagements—and delegate nuisance lawsuits to your insurer-provided attorney.

If you don’t have accountant malpractice insurance, consider purchasing coverage from a reputable provider serving the accounting industry. If you already have such a policy, make sure it provides enough protection. Ask yourself:

• Are your limits of liability large enough to adequately cover your current risk exposures?
• Do your practice activities fall within the professional duties the policy covers?
• Can you accept the types of losses excluded under the policy?
• Does your policy cover emerging risks such as cybercrime and data breaches?
• Are you paying too much for your current coverage?

If you’re not happy with the answers to any of these questions, it’s time to compare your current policy against those from other providers.

Once you have a comprehensive and affordable policy in place, invest the time to understand how it works. Study your policy document, especially its insuring clause, so you know when and how your protection gets activated. Also, focus on key terms such as prior acts, predecessor firm coverage and extended reporting periods.

• Prior acts protection, also known as “nose coverage,” covers your mistakes when you had claims-made insurance from another insurer. It’s important because it means you can switch carriers or jobs and still maintain coverage for your prior work. The only caveat is that you must avoid going uninsured at any point in your career. The minute you create a coverage gap by lapsing your policy, your prior acts provision will only extend back to the last period of continuous coverage. Any mistake you make before that date will be uninsured.
• Predecessor firm coverage applies when one or more accountants in your firm used to work for another practice your firm acquired. As long as you have predecessor firm coverage, your current insurance policy will cover mistakes arising from the acquired accountant’s prior work. This provision applies as long as the named insured acquired a majority of the predecessor’s firm’s assets.
• An extended reporting period, also known as “tail” coverage, gives you the right to file a claim for your prior accounting work even though you cancelled your malpractice policy. Because claims-made insurance doesn’t pay for claims filed after policy cancellation and before you’ve lined up replacement insurance, arranging for tail protection is the only way to make sure your prior accounting work doesn’t blindside you legally.

In conclusion, understanding and mitigating your accounting malpractice risks takes time and costs money. But those investments will pale compared with the potentially catastrophic outcomes of losing a malpractice lawsuit. If you haven’t yet taken the steps recommended in this article, consider doing so as soon as possible. There’s nothing quite like sleeping soundly at night in these highly litigious times.

Paying too much for your accounting malpractice insurance? Then consider the insurance coverage available from 360 Coverage Pros.