Why Accounting for Your Liability Risks is Essential
By Irene Walton
Have you accounted for the various liability risks your accounting firm faces? If not, this article helps you get started by explaining the essential role of professional liability insurance.
Accountants spend the vast majority of their time gathering client financial information and then analyzing and reporting it for various purposes. It’s precise work that requires immense attention to detail. However, sometimes they get so wrapped up in their client engagements they may overlook their finances, especially their professional liability risks. This can lead to client malpractice lawsuits that produce large legal judgments or settlements, which can jeopardize an accountant’s financial future.
Take the case of the New York accountant who was sued after a hacking incident cost entertainment giant Warner Bros. $1.3 million. According to paperwork filed early in 2020, Warner Bros. hired a New York accountant to manage the accounts of a recent business acquisition. The accountant had been working with the acquired firm for many years. The engagement involved continuing to manage the firm’s books—paying its bills, payroll and taxes—during the transition period. For this the accountant received compensation of $2,000 per month. After the merger was complete, the engagement and $2,000 payments would end.
For a month, Warner Bros. and the accountant communicated by email without incident. Then Warner emailed the accountant saying it would soon need him to transfer the firm’s cash to Warner’s accounts. Shortly after, the entertainment firm emailed wire-transfer instructions to the accountant. But then another email arrived canceling the first one and redirecting the money to Wells Fargo instead of Bank of America. The second email appeared to come from the same Warner Bros. employee, except the email address was spoofed and there were numerous typos in the message.
The New York accountant followed the instructions in the second email, wired the money to the hacker’s bank account. He did this without contacting Warner Bros. for confirmation. When it became clear the money had disappeared, Warner Bros. attempted to recover the funds, but the accountant didn’t have enough cash available to comply.
In a related incident, the hacker altered an invoice from one of the acquired firm’s vendors, again substituting a phony bank for the real one. Together, the two incidents cost Warner Bros. $1.3 million. Unable to recover the stolen funds, Warner Bros. sued the accountant for malpractice and breach of contract. “Schwartz failed to ensure that its network or email systems were sufficiently secure or protected against unauthorized access and hacking,” the complaint stated, “which left (the accountant’s) emails—and therefore Warner Bros.’ confidential business and financial information—vulnerable to unauthorized access and manipulation by a hacker.”
The accountant, who received only one $2,000 retainer payment, was now on the hook for the full $1.3 million. Why did he fail to confirm the wire instructions with his client? It’s hard to know. Maybe he was busy or distracted by another project. Or maybe he was just having a bad day. In any event, the person did not focus on the task at hand and made a costly mistake. One hopes he had professional liability coverage to cover his legal expenses. An uninsured $1.3 million legal judgment against a small accounting firm could easily put it out of business—and wreck the personal finances of the owner.
Focus on risks
The case just described illustrates the need for accounting firms of all sizes to focus on their liability exposures and to mitigate them by purchasing professional liability insurance. The fact that potential litigation can emerge from many directions, not just cyber crime, means going uninsured or underinsured exposes your firm to many liability risks. If you’re not fully protected against litigation, now’s the time to strengthen your defenses. 360 Coverage Pros is a major online provider of such coverage.
What is Accountant Professional Liability Insurance? It’s a policy that shields your firm against the financial implications of being sued for malpractice. It provides cash to mount your legal defense, as well as pay for other expenses such as court and expert-witnesses fees. Most importantly, it will pay for judge- or jury-imposed judgments or settlements if you’re found guilty. And don’t forget...professional liability insurance doesn’t just protect you against legitimate legal claims. It also pays for an attorney to get frivolous lawsuits dismissed so you can get back to business.
It’s a truism that business professionals such as accountants or lawyers need liability protection. It simply comes with the territory. But let’s examine in greater detail why this need is so acute. It’s the result of three separate factors that heighten accountant risks:
- Their tendency to make certain predictable mistakes
- Several unique features of the accounting profession
- Risk-laden areas of the business that often generate litigation
Common accountant mistakes
Accounting risk-management experts point to several recurring themes when it comes to malpractice litigation. For some reason, accountants seem prone to making errors such as these:
- Making a tax-return error: Tax-return work can be problematic for two reasons. First, the returns themselves can be fiendishly difficult to prepare, especially if clients lack appropriate documentation. Second, returns are a high-profile engagement, meaning that clients pay close attention to the financial impact of their filings. If they receive a smaller tax refund or pay more than expected, they will be quick to blame their accountant. If they don’t receive satisfaction, they often sue.
- Working for both sides of a transaction or dispute. For example, agreeing to do accounting work for multiple firm owners or partners or spouses can become a lawsuit generator. In such cases, people’s feelings get inflamed and an accountant sitting between the parties can spark litigation.
- Doing business or investment deals with clients: When you provide professional services to clients and then also partner with them in an outside investment, you set yourself up for disputes. If the deal turns sour, clients will often suspect self-dealing on the accountant’s part and take you to court.
- Failure to document an accounting engagement. Not documenting the engagement upfront or failing to confirm key client decisions along the way are common causes of damaging litigation. That’s because the failure to communicate leads to incorrect expectations that when dashed can lead to bad feelings and ultimately litigation.
Aspects of the business
As if these problems weren’t enough, accountants must deal with certain aspects of their profession that seem to incubate lawsuits. These include:
- Having a client with deteriorating business or personal finances. Because you’re working closely with clients on their financial matters, a sudden change for the worse in those situations often leads them to blame you for their misfortune.
- Being a scapegoat for fraud. When clients become fraud victims—perhaps employees embezzled money from them—their attorney will often come after their accountant, alleging that the person or firm should have detected and prevented the crime before the fact.
- Having third parties come after you to capitalize on bad situations. Whenever a company faces a crisis, third parties emerge to take advantage of their misfortune. For example, when a firm files for bankruptcy, its shareholders, banks, business partners or customers often sue the firm’s accountant, arguing that it should have detected the fraud or other problem that caused the company to fail.
- Other parties who believe accountants should guarantee their clients’ success. This is especially true in auditing situations (which we will discuss in a moment).
Risk-laden practice areas
Operating in a risky practice area is the third reason why accountants need professional liability insurance. According to a professional liability insurer, 66% of accounting malpractice litigation originates from tax planning and services, while 13% and 11% of claims originate from audit and attest services and consulting services, respectively. The insurer found that bookkeeping was a relatively low-risk activity
Tax planning and compliance services breed countless malpractice errors. But three of the most common are failing to advise the client or providing the wrong advice, filing incorrect returns and failing to uncover fraud or theft. Lawsuits relating to consulting services arise most frequently from missing or flawed advice, not detecting theft or fraud or breaching one’s fiduciary duty. Finally, auditing and attest engagements were most likely to founder on the rocky shoals of misstatement or disclosure problems, as well as on failure to detect theft or fraud or not giving advice or giving the wrong advice.
Auditing is an especially risky area. Audit-related malpractice suits may not be an every-day occurrence. But when they happen, especially regarding large public-firm engagements, they can be highly disruptive and financially punishing. Although malpractice litigation around flawed audits can be highly complex, they frequently involve four common problems:
- Taking everything the client says at face value without doing adequate due diligence. This also applies to information the client submits to the auditor.
- Dealing with a bad-faith actor who may be cooking data to make their financials look better than they really are in order to not run afoul of credits. Similarly, an insider might twist data in order to sweeten their pay or cover up embezzlement.
- Being given exaggerated asset values, especially relating to intangible items such as customer lists or goodwill.
- Not properly planning the audit process, either due to lack of experience in the client’s business or using the wrong auditing methodology.
In addition, when auditors fail to do their work according to Generally Accepted Accounting Principles (GAAP) or Generally Accepted Auditing Standards (GAAS), they can get into hot water. These break down into violations of:
- General standards
- Field work standards
- Reporting standards
Auditing risks are the least of your worries. Accountants also run into trouble when they accept trustee assignments. They often get this work from long-term clients with whom they have friendly and trusting relationships. According to Stanley D. Sterna, J.D. and Deborah K. Rood, CPA, malpractice claims often arise from third parties who don’t know the accountant and vice versa. So the good will the accountant assumed would continue can suddenly dissipate when an accountant makes a trust grantor asset decision that third parties disagree with.
Sterna and Rood point to three common professional liability claims that arise from trustee work:
- The trustee distributed assets in such a manner that one or more of the beneficiaries believe they’ve been harmed.
- The trustee mismanaged trust affairs or mishandled its assets.
- The trustee invested trust assets imprudently or rendered poor advice regarding those assets.
Result? Third parties believe they didn’t receive their fair share of the trust’s assets and thus suffered a financial loss. Since they don’t know the accountant and have no loyalty toward that person, the barriers to litigation are relatively low. This can spell trouble for accountants who undertake this kind of work.
Accountants are cybercrime targets
Just as accounting firms become litigation targets because of the work they do for clients, they can also become cybercrime targets. That’s because they collect and store sensitive client financial information, but may offer less secure cyber defenses than their clients do. As a result, hackers view accounting firms as a chink in the armor of corporate cyber defense. Making matters more ominous, accounting practices are liable for both first-party and third-party cyber risks. The former refers to the direct costs to the accounting firm of a data breach or theft. These can range from payments to IT vendors to assess and repair computer systems to the cost of mandated data-breach disclosures, which can amount to several hundred dollars per record. Third-party risks occur when a data breach affects a customer or other party, which, if it suffers a financial loss as a result of a breach, may seek compensation from the accounting firm.
In addition to broad first- and third-party risks, accounting firms are vulnerable to specific technology-driven cyber threats. One of the most common is ransomware, This is a form of malware that takes control of all of your computers, files and networks so that you can no longer operate your business. Once hackers encrypt your computers and data, they offer to release them if you pay a sizable ransom, to be transmitted via a cryptocurrency such as bitcoin.
Although ransomware has been around for years, giving businesses ample time to prepare their defenses, it increased by 131% in 2019 compared with the prior year, according to an insurance-company study. Ransom amounts have moved into the seven- or eight-figure range. When you consider these payments along with the risk of malpractice claims due to the accountant not being able to deliver on his professional duties, the ransomware risk can be immense.
Meet professional liability insurance
In conclusion, no matter how you view your accounting firm risks—either as the product of your own mistakes, of certain features of the industry or of your involvement in high-risk practice areas—your exposures are significant. Not protecting yourself against them is foolhardy, especially now that buying professional liability insurance online is so easy.
You can purchase malpractice coverage that will protect your assets against client litigation, including nuisance lawsuits. It will provide you with access to a defense attorney, along with funds to cover legal judgments, settlements, court expenses and expert witness fees. Bottom line: protecting yourself against legal disputes means you will do business with less stress and worry, knowing that your business and personal assets will be safe.
360 Coverage Pros, a professional insurance source, stands ready to provide you with the professional liability coverage you need today. Major features include:
- Designed exclusively for those in the accounting profession
- Issued by an A+ rated insurance company
- Includes a broad definition of professional services
- Available for accounting firms of all sizes: solo, mid-sized, and large firms
- Provides post-firm protection (extended reporting period)
- Covers lawsuits arising from your previous work (prior acts coverage)
- Supported by a superior customer-service team
In short, now that you understand the many risks your accounting firm faces, are you confident you have properly accounted for them? If not, visit 360 Coverage Pros now to learn about your professional liability insurance options.
360 Coverage Pros provides accountants, Certified Public Accountants, bookkeepers, and tax preparers with affordable, A+ rated, professional liability insurance designed specifically for financial accounting professionals. Request an indication in minutes.
Irene Walton, Area Vice President, Affinity Manager
Irene is a U.S. benefits consultant with over 40 years of experience in analyzing and pricing professional liability and health and welfare risks. Irene began her career in 1980 with Mather & Co., Philadelphia, Pennsylvania in the Life benefits department. She began working with Associations in 1980 and was promoted from Account Executive to Department Manager of the Association Department in 1989. In her role as Department Manager, Irene helped to develop a third-party billing system to manage enrollments for associations. Irene was named Assistant Vice President, Association Operations in 2005. Mather & Co. merged with Bollinger Insurance in 2006 where Irene continued to manage the Association/Affinity clients. In 2013, Irene was named Area Vice President of the Affinity Division. In 2013, Irene became an employee of Arthur J. Gallagher & Co. through acquisition. During Irene’s 40+ years in the industry, she has focused on developing programs for associations and affinity groups to meet the needs of their members and by offering coverage for sole proprietors and firms.