The number of malpractice claims filed against CPA firms dropped noticeably in 2004 and 2005, which may reduce 2006 premiums, say industry observers. However, risk managers from the profession's two largest malpractice insurers are watchful for an increase in claims."Accounting malpractice insurance is experiencing a rate drop in the small-and-medium-size market," said Dave Sukert, senior vice president of underwriting at Aon Insurance Services, the administrator for the AICPA's Professional Liability Insurance Program.

"This is born of many things, but the main reasons are the results on the client side," he said. "It's the results of risk management and practice management on the part of CPAs."

"The market has calmed down," agreed Ric Rosario, vice president of risk management at Redwood City, Calif.-based Camico. "Several carriers left the market and prices started rising in late 2003," he said. "It was clearly a classic hard market through the middle of 2005, where there were not a lot of carriers, and prices were going up. The reason for this is that, from a claims perspective, 2001 and 2002 were very nasty claim years. The spike either chased carriers out of the market, or put them under. And those that stayed in had to raise their rates."

"The good news is that 2003 and 2004 turned out to be pretty good claims years," he continued. "The market stabilized, and carriers no longer had pressure to raise their rates. In a soft market, there are too many people in the marketplace, and pricing tends to be based on trying to increase market share. It ultimately produces a negative spiral. Prices go down, but not necessarily because claims go down - companies cannibalize each other."

Rosario said that the market is more balanced now, and as a result, there's more rational behavior and less gouging.

Different firms, different risk

Risk management is different for firms of different sizes, according to Joe Wolfe, assistant vice president for risk control at CNA, the underwriter for the American Institute of CPAs' insurance program. "Because the profile is different, we do different things from a management perspective," he said. "Large multi-office operations are struggling to deal with firm integration issues and quality control issues that don't affect smaller firms in the same way."

To educate CPAs about their potential liability, CNA has hosted live Web seminars on CPA2Biz (the AICPA's marketing services Web site), published articles and provided sample engagement letters in 10 principal areas of practice.

"As far as claims go, things haven't changed much - tax is still the highest in volume and audit generates the most severe claims," said Wolfe. "We thought that as tax software became increasingly sophisticated, we might see a different mix of claims because practitioners had better tools than they did before. But that's not what is happening."

Wolfe said that last year, 58 percent of the total volume of claims stemmed from tax practice. He pointed out that at the same time that tax software was becoming more sophisticated, the Tax Code was becoming substantially more complex, citing the several major tax acts that have since passed. As a result, he opined, the need to maintain technical training is soaring and that might lead to an over-reliance on software to solve technical problems.

"On the audit side, we're seeing the same issues as in past years," Wolfe explained. "There are a lot of claims that arise out of the failure to detect financial statement fraud, and theft of assets. Quality control continues to be a really important issue in audit practice. In seminars, we talk about [the fact that] 70 percent of audit malpractice claims involve the audit of privately held companies."

He cautioned that firms that do Yellow Book audits might inaccurately tend to look at them as low risk. "We're seeing more liability claims as a percentage of total audits," he said. "These audits involve the same kind of issues as privately held clients, including financial statement fraud and theft of assets."

"A lot of these entities have weak or nonexistent internal controls," he explained. "Firms should do due diligence and understand what they're getting into before they accept the engagement. Some firms look for this kind of work as a means of keeping their staff busy. They look at it as low risk and even underbid the job. These are all risk factors."

"In an age of mergers and acquisitions, firms have to be vigilant and aware of the tail provisions in the policy," said Aon's Sukert. "For example, if a firm is acquired, how will prior acts of malpractice be handled? This needs to be examined from the perspective of five or 10 years down the road, not just one year."

Securities and Exchange Commission work remains a large concern for insurers, according to Camico's Rosario. "A lot of work is emerging across borders. Accountants seem to be reaching out and doing a lot more international work. It's spreading to non-Big Four firms, working its way down the scale."

Whose risk is it, anyway?

The proper handling of firms transitioning as Baby Boomer partners age is often overlooked, he said. "The leadership is aging, and as they transition their practice, there are all kinds of liability issues - who will carry on the business, what about semi-retirement, are they working for the firm or as a consultant on their own? The problem is to clarify retiring partners on their role, as well as their responsibility for liability."

For example, Rosario noted, many partners continue to do work at the firm with their own clients, and it can be vague as to whether they are working for the firm or are on their own. "If they take billings on the side and the firm lets them, but they use the firm's services, then the firm is not collecting any fees but it has the exposure to liability," he said.

"There are all kinds of pitfalls. A classic one involves a senior partner with the firm for 30 years. No one in the office will challenge him, but because his mental ability has diminished they bypass the quality control process. Even though the firm may have excellent quality control, when the partner bypasses it and makes a mistake, it can open the firm to unintended liability. And the worst thing is to have liability that you're not insured for."

Rosario sees outsourcing as a result of the profession's inability to develop its own talent to do the work that has become available.

"Historically, the profession has done outsourcing for a long time, but now it's political because it has gone offshore," he said. "The liability considerations are obvious. The quality of the work of the outsourcer and controls to ensure quality are vital. Moreover, the quality control of transmitting information is important. These are considerations that continue to grow, and we're watching them."

The cascade effect of work trickling down from Big Four firms to regional and midsized accounting firms is continuing, and presents another area of potential liability. "My advice to CPAs attracted by these opportunities is, 'Be honest with yourself,'" said Sukert. "When you consider a business opportunity, look at how you got the opportunity, why you got the opportunity, what are your competencies, and can you really do the job? Realize what your capabilities are, because the potential downside can be bigger than the dollars you might get."

"It's better to tell the client, 'We know people who can do this work,' and send them down the street," he said. "You'll make up in good will for any business you lose."

Wolfe agreed. "The cascade effect is very real, and it's not temporary," he said. "Some think that once [Sarbanes Oxley Section] 404 work slows down, things will go back to the way they were. In fact, there have been large-scale shifts. The Big Four have made decisions as to who their core clients are."

"Everyone is crying for additional staff, but training and planning for the future is critical with existing staff," Wolfe continued. "We think that firms need to think carefully about how to develop the staff they have. If you're trying to serve a new breed of client, it's better to have your staff ready to go when the opportunity arises than take it on the fly."

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