Risk Management & Liability Guidebook

Table of Contents | Editorial Board

PART I - INSURANCE

1. THE MARKET

The accountants’ professional liability market has undergone continuous change, activity and growth since 1992 due to overwhelming competition among the various insurers. There are more companies than ever offering accountants’ professional liability insurance affording accounting firms a wide range of pricing and coverage options. While price is important, it is only one factor to consider. More important are the insurer's quality of service and claims handling. All too often, accountants who purchase insurance solely on the basis of premium find their savings illusory once they report a claim.

A. AVAILABLE POLICIES

The following list sets forth the majority of companies providing professional liability policies for the accounting profession:

• A/pls+
• Accountants Liability
• Assurance Corporation (ALAC)
• American Home Assurance Co.
• American Society of Accountants (ASA)
• AVRECO, Inc. (offering Lloyds of London policies)
• CAMICO Mutual Insurance Company
• CNA Insurance Company
• Coregis/Westport
• CPA Mutual Insurance Co.
• Garden State Indemnity Co.
• Golden Eagle Insurance Company
• Hartford Insurance Co.
• Interstate Insurance Company
• SAFECO Insurance
• Travelers Group
• Zurich-American Insurance Company

B. CRITIQUE OF AVAILABLE PROGRAMS

A/pls+ has proactive loss prevention and claims handling and is extremely selective in its underwriting. It also offers profit sharing distributions to its insureds. Accordingly, it can offer lower costs to its insured firms over the long-term. Rated "A" by A. M. Best

American Home, a subsidiary of AIG, has been offering accountants professional liability longer than any other insurance company, although it is no longer aggressive in pursuing this market. American Home currently offers coverage of up to $15 million. Rated "A++" by A. M. Best.

American Society of Accountants (ASA) targets CPA firm with one to five professionals. ASA is wholly committed to loss prevention. Its program is rated B++ by A.M. Best.

AVRECO, Inc. is an insurance agency that provides coverage through underwriters at Lloyds of London on a non-admitted basis. The policy is broadly written but contains a large number of exclusions. It is geared toward smaller firms. AVRECO provides no loss prevention services.

CAMICO Mutual Insurance Company offers a policy which is designed for a wide range of accounting firms. CAMICO targets small to mid-sized firms located in California and other western and mid-western states and actively promotes loss prevention activities including seminars and newsletters.

CNA is the AICPA-endorsed insurer and offers coverage on two levels: a basic policy for small firms and a broad policy for larger firms. CNA tends to price its policies aggressively and offers broad policy terms. Rated AA@ by A. M. Best.

Coregis/Westport was formerly the insurer for the AICPA endorsed program. It was recently purchased by G.E. Capital Corp. greatly enhancing its financial stability. A. M. Best AA++@ rated.

CPA Mutual is a risk retention group and, therefore, is not rated by A.M. Best. CPA Mutual has a program in which insureds may get lower premiums in the form of dividends. CPA Mutual, like A/pls+, advocates loss prevention.

Garden State Indemnity Co. only offers policies in New Jersey. Its policy has broadly written exclusions and is designed for smaller firms with limited practices. No loss prevention services are offered. Garden State has a NA-3 A.M. Best rating (not enough information to rate).

Golden Eagle Insurance Company offers its policies in California and Arizona. Although Golden Eagle offers no loss prevention services, it does provide discounts to firms that participate in loss prevention activities. It has an A.M. Best rating of C++.

Hartford Insurance Co. has only recently begun to offer accountants liability insurance and the parameters of its program are still unknown.

Interstate is a subsidiary of Fireman’s Fund and is A. M. Best AA@ rated. It is aggressive on pricing and offers many coverage enhancements.

SAFECO Insurance offers a policy which is designed for smaller accounting firms. Its target is firms having no more than twenty-five professionals. SAFECO publishes a loss prevention newsletter and provides hotline support. It is rated A++ by A.M. Best.

Travelers Group seeks to insure firms with up to fifty professionals. Its policy is well written and should appeal to small and mid-size firms. Travelers does not provide loss prevention services but it takes an applicant’s loss prevention efforts into account when underwriting and pricing.

Zurich American is a financially strong company which has taken over the professional liability program previously offered by Home Insurance Co. It is rated AA++@ by A. M. Best.

2. BUYING INSURANCE

A. WHAT LIMITS?

Deciding on what limits to obtain, more often than not, is an emotional decision, as opposed to a scientific one. There are generally two schools of thought that apply to this process:

Buy As Much Coverage As You Can Afford - When insurance premiums sky-rocketed in the late 1980s, most firms maintained relatively low limits of liability because the cost for higher limits coverage was prohibitive. In the current competitive climate, most firms are in a position to purchase higher limits since the premiums have decreased. In many instances, firms are obtaining more coverage for a lower premium than they paid in the early 1980s. Purchasing as much coverage as you can affords a greater comfort level and Asleep at night@ insurance.

Buy The Most You Have To - Many firms fear that high limits may attract lawsuits; they are afraid that if they have higher limits, plaintiff attorneys may automatically include them in suits in an attempt to obtain proceeds from the firm's policy. These firms tend to purchase what they determine to be the minimum that they need to protect themselves. Other factors that must be considered when deciding the appropriate limits of liability are as follows:

Split Limits - Some insurers offer a per claim limit with a larger limit as an aggregate for the policy period (i.e. $1,000,000/$3,000,000 provides $1,000,000 per claim, $3,000,000 in the aggregate for all claims pertaining to the policy period). When firms purchase an aggregate they are covered up to the Aper claim@ limit for each claim; however, they are also covered up to the maximum aggregate limit for more than a single claim. This coverage is more attractive for those firms who, in the past, have had more than one claim per policy year.

Defense Inside Limit - Defense costs are usually (but not always) within the limit of liability and, therefore, reduce the amount of available coverage. In New York, the extent to which defense costs may be charged against policy limits is limited by Regulation 107. A few insurers offer policies with defense costs in addition to the policy's limit of liability. This option is available at a higher premium than Defense Inside Limit. Defense costs include legal fees and associated expenses. They do not include indemnity (i.e. judgment or settlement) payments.

B. WHAT DEDUCTIBLE TO SELECT?

Deciding what deductible to select entails a philosophy similar to the decision to buy Aas much coverage as you can afford.@ Therefore, a firm should choose the highest possible deductible that allows its owners to still be able to "sleep at night." Of course, the choice of deductible is limited to an amount the insurer will authorize after a review of the firm profile. This is because insurer will frequently pay out claims in full with its own funds in order to expedite a settlement and then look to the firm to collect the deductible obligation; and no insurer wishes to be left Aholding the bag@ if the firm is not able to pay the deductible. In addition to selecting the amount of the deductible, there are three types of deductibles that are available:

Per Claim Deductible - the deductible applies to each and every claim. This is the most common form of deductible.

Annual Aggregate Deductible - The amount of the deductible is capped during the policy period and applies to single or multiple claims. Only a few insurers offer annual aggregate deductibles.

Loss Only Deductible/Dollar One Defense - The deductible only applies to indemnity payments. This is always provided with Defense Outside coverage (see above) and may be offered by some insurers for an additional premium with Defense Inside coverage.

C. FACTORS TO CONSIDER WHEN PURCHASING INSURANCE

There are many decisions that have to be made when purchasing professional liability insurance. The following items should be considered.

Claims Handling - It is important to ascertain the insurer's reputation for handling insureds’ claims. Does it have experienced claims representatives on staff? How much defense work does it do in-house? How closely does it work with the insured in defending claims? Companies vary in their attitudes towards claims. Some look at the terms and conditions of coverage and are quick to disclaim liability for claims that are excluded or outside of the scope of coverage. Other companies make great efforts to afford coverage with respect to claims falling in those gray areas in the policy language in an effort to avoid disputes with their own insureds. In recent years, some plaintiff's attorneys have taken what should have been regular malpractice claims and have purposely worded their complaints to allege fraud instead of negligence to entice insurers to disclaim both coverage and defense costs. The strategy is to force the defendant to settle a smaller case quickly rather than incur large legal bills. Some insurers will provide defense until fraud is proven, while others will not. Therefore, it is important to try to ascertain the coverage philosophy of the insurer before purchasing insurance.

Policy Coverage - How broad/comprehensive are the coverages offered? Remember, a policy is only valuable to the extent that it covers the scope of practice offered by the insured firm. The scope of coverage does differ significantly making it critical to review both the policy's definition of professional services and its exclusions.

Exclusions - Does the policy exclude a service offered by your firm? You may be able to modify the exclusion for an additional premium or find a competitor's policy of similar quality without the exclusion.

Insurers Financial Ratings - The financial strength of an insurer is important as insurance will only be valuable if the insurer is solvent when a claim arises. Moreover, insurers in a weak financial position may be prone to disclaim claims against their insureds. A.M. Best is a good guide but should not be the only benchmark. A knowledgeable insurance broker should be able to give you greater insight into the strength and stability of each company being considered.

Available Limits - Are the limits offered appropriate for the needs of the firm?

Price - Is the price reasonable vis-à-vis other carriers and the coverages offered? Price is often negotiable but beware of a deal too good to be true.

Responsiveness - Consideration must be given not only to the insurer selected, but also to the broker you are using. As a rule, you should work with a broker who specializes in professional liability.

Risk Management - Many companies offer loss prevention services. Some insurers place greater emphasis on this aspect of practice than others. In this regard, it should be remembered that only a portion of the cost of a claim is covered by insurance. Insurance policies do not cover lost time spent in defending a claim.

Over the past ten years, the number of insurers offering professional liability insurance to accounting firms has increased dramatically. Therefore, firms now have a wide selection of insurers to choose from. Firms should consider the above-listed factors in selecting their insurance coverage. Because of the large number of factors, accounting firms should consider utilizing the services of an independent broker who specializes in accountants= professional liability insurance and who is familiar with the markets and coverages available. While certain cost advantages may be achieved by purchasing insurance directly from the insurer, those choosing this route may not be able to discern the shortcomings of a particular policy and may sacrifice some bargaining power.

D. HOW TO COMPLETE THE APPLICATION

In most cases, the application is the only way for the insurance company to learn about your firm. It, therefore, behooves each firm to be as complete and as accurate as possible. Supplements should be included to explain any circumstances about the firm's practice that may warrant concern by the insurer. The application becomes part of the policy and, therefore, it is critical that the application be completed in full and reviewed by every partner/principal of the firm. Every effort should be made to be accurate, while putting the firm in the best possible light. Because applications usually take many hours to complete, some firms may be tempted to take shortcuts. Such temptations should be resisted. In addition, some firms may leave out requested information or exaggerate data in an attempt to depict themselves in a favorable manner. It is important that firms be as accurate and forthcoming as possible because insurers can rescind coverage under certain circumstances should a claim arise if representations in the application are not accurate or do not fully present the risks posed by their practices. Thus, the best policy is to disclose all adverse factors, but try to explain why those factors should not present an unacceptable risk. In this connection, firms should not hesitate to supplement their responses with additional information.

E. WHAT IS NEGOTIABLE?

Price, policy coverage, limits of liability and deductibles are all negotiable items. Keep in mind that all insurance companies must operate within certain guidelines; however, these guidelines do permit some degree of flexibility. Your broker, who should be knowledgeable about these issues, is the best person to assist you in your negotiations.

Price is one of the most negotiable features of a quote. All insurers utilize a formula to derive the price for their policies. Usually, there is a high degree of flexibility built into these formulae so that the underwriters can exercise discretion to alter their price depending on various characteristics of the firm and competitive factors. Therefore, firms seeking to lower their insurance costs should obtain quotes from several insurers as well as make every effort to present their firm as favorably as possible to the insurer.

Generally, insurers try to determine the inherent risks in the types of services offered by the firm, the level of training offered to the firm’s staff, the internal quality controls used by the firm, the quality of the firm’s clientele and the extent to which the firm uses engagement letters and other loss prevention measures. If the firm has had any claims, full explanations of the circumstances leading up to the claim and what efforts the firm has made to prevent similar claims in the future should be set forth. In today’s competitive market place, insurers are offering greater coverages than in the past. Your broker should be familiar with what is being offered and should advise you regarding additional coverages available to your firm. For example, most insurers will eliminate exclusions in the policy for an additional premium charge, or modify exclusions, depending on the nature of the firm’s practice. In addition, some insurers are willing to work with their insureds and to permit their insureds to select their own defense counsel.

3. UNDERWRITING CONSIDERATIONS

A. SCOPE OF PRACTICE

One of the primary areas of consideration by insurers on deciding whether to accept or decline a particular risk is the scope of practice of the applicant. Insurers in the last few years have become particularly sophisticated in asking firms to provide practice profile information. While most insurers are still primarily concerned with the delivery of audit services (particularly, to publicly traded companies), they are also concerned, as a result of recent litigation, with accounting services, tax services, fiduciary services, securities activities, personal financial planning, management advisory services, business investment advice and any other non-customary services provided by the firm. Of great concern to most insurers is a firm's position with respect to the Year 2,000 Issues. Firms that are trying to assist their client in becoming Year 2,000 Compliant may find few insurers willing to insure them. Becoming less of a concern are services performed for financial institutions.

Most of the insurer application forms and their many supplements create headaches for the majority of firms. However, the opportunity to differentiate your firm from a similar risk by utilizing the application form is critical to the underwriter's acceptance of your risk and the terms and cost of coverage. Accordingly, accounting firms should utilize the insurer's application form to explain their expertise in each area in which they practice. The liberal use of addenda to describe the firm's training, supervision and quality controls in each area will also enhance its insurability.

The two largest areas producing claims for insurers in terms of frequency and severity emanate from both audit and tax services. In fact, almost 70% of insurers' claims emanate from audit and tax services. One of the other areas which has continued to provide insurers with problems is the continually expanding scope of management advisory services performed by CPA firms. In the last ten years, this area has become a particularly dynamic growth area for accountants resulting in the creation of a plethora of services not before or historically offered by accounting firms. Traditionally, the insurance industry viewed management advisory services (MAS) as effectively relating only to the technology and computer area. However, MAS in the last ten years, has expanded to include litigation support services, personnel management and general management consulting.

One of the growing areas of concern in light of numerous losses, is the provision of services for a client in which the firm has an equity or financial interest. Insurers are naturally concerned that this will lead to conflicts and compromise the independence and objectivity required of a CPA firm. In addition, there is the potential risk of an increased moral hazard due to the direct financial rewards as a result of the equity interest. Accordingly, it is critical that CPA firms recognize the importance of analyzing the services that they provide and explaining these to insurers in the most concise way, as this will have a distinct impact on the insurer's desire and ability to provide coverage and provide it at an effective cost!

B. PRIOR CLAIMS

Another of the critical sections within the application form is the area of prior claims information. A prior claims history provides insurers with a benchmark against which they decide whether the risk being submitted falls within the highly desirable, moderately desirable or less desirable category. Statistically, insurers are able to prove that a firm which has a significant frequency exposure ( i.e. reports a number of claims within a defined time period) will ultimately experience a significant claim. The purpose of the underwriting exercise is to ensure that the rate being charged is commensurate with the risk being accepted. Clearly, a firm that has had either a number of claims or one or more serious claims will indicate to the insurer a less than desirable statistical probability that the firm will become a repeat offender. As a result, insurers scrutinize the prior claims history both from a reporting and payment standpoint.

From the prior claims history, an insurer is able to determine what kind of problems the firm has suffered in the past and whether the firm has made any attempt to correct these problems from an internal management standpoint. As an example, failure to utilize engagement letters where clear evidence would show that the utilization of engagement letters would have prevented the claim, will create, in the insurer's mind, a less than desirable exposure.  Insurers are not as concerned with a single paid claim, whether it be significant or not, as the reason for purchasing the insurance is to take care of this situation. However, insurers will carefully review any and all prior claims experience in order to ensure that the firm has:

• Learned from its experiences in the past and has taken steps to mitigate its future exposure;
• Does not continue to create a greater than acceptable risk level; and
• Is likely to continue to present a more desirable risk profile for the future.

C. QUALITY CONTROL SYSTEMS

Throughout the underwriting process, critical to an underwriter's review of the CPA firm will be its ability to mitigate and control risks. Throughout the application form, a number of questions will be asked concerning the utilization of engagement letters, independent internal review of audit work papers, the firm's submission to the peer review process and the results of such reviews, and internal procedures where client funds are managed. The insurer will be looking to identify whether the firm is complying with the elements of quality control recommended by the AICPA. As with any business, it is important that the CPA firm follow a work plan which has been devised and approved to ensure that work is being performed in a professional manner. Insurers view quality control as creating a standard against which they are capable of measuring risk. While the AICPA will continue to set standards, these standards are the minimum level at which insurers expect their insureds to perform.

The majority of claims emanate from the insured firm's failure to follow its own quality control procedures. Accordingly, utilization of internal reviews as a way of ensuring compliance with quality control procedures are critical to the mitigation of risk from the insurer's standpoint. As an external control, insurers are also extremely concerned with the results of a firm's peer review. Accordingly, firms that perform audit services for public companies and are required to undergo peer review every three years are requested to provide a copy of their peer review report, together with the recommendations made by the reviews. In this way, insurers are able to ascertain whether the recommendations contained in the report have been complied with, thus providing clear evidence of the firm's commitment to mitigate risk and to prevent potential claims from arising.

It should be noted that even firms with exceptional quality control procedures will occasionally be sued. However, it is critical to the CPA's firm's ability to defend itself that a proper recognizable procedure be in place and that the firm's work papers adequately reflect the work performed. The insurer's ability to verify the applicant's contention regarding its work product is contingent upon the work product adequately reflecting the implementation of quality control procedures. While quality control is not a panacea, the utilization of quality control, together with an active and well-supported risk management program, will have an impact on an insurer's view of the risk presented by an applicant.

D. SUITS FOR FEES

Insurers first became concerned with CPA firms' suing their clients for unpaid fees as early as the late 1970s. As anyone who has sued a client is aware, a suit for fees in almost all circumstances results in a counterclaim for failure to provide the professional service and advice the client expected or was entitled to. Ultimately, fee suits have the effect of creating a litigious situation - one in which the client has the upper hand -as the CPA firm must now defend itself and its work product against almost unrealistic standards. Accordingly, wherever possible, suits for fees should be avoided. In fact, some insurers recommend that suits for fees should be avoided altogether!

In order to do this, a CPA firm must institute strict control procedures regarding its billing and fee collection. In addition, the utilization of resignation letters can be critical with respect to potential ongoing liabilities. Where the application form reveals a history of fee suits, the insurer, if it decides to offer a quotation, will be looking to determine whether the CPA firm has policies in place regarding the payment of fees and the monitoring of overdue accounts. Such policies should cover - (a) engagement letter forms addressing the payment of fees; (b) collecting payments in advance; (c) suspending services for delinquent clients; (d) collecting interest on past due notices; and (e) obtaining promissory notes for unpaid balances.

Wherever possible, CPA firms should not sue their client for unpaid fees without analyzing the professional services performed for the client and the likelihood of a counterclaim being made and possibly being sustained. Where possible, before a suit is instituted, an independent party should review the file to ascertain the likelihood of whether the client could sustain a claim. No one likes to perform services for which they will not be reimbursed; however, past fees must be viewed in context of a lawsuit, particularly in light of the time and effort to be expanded by the firm in defending a counterclaim.

Evidence of frequent suits for fees will deter insurers from providing a competitive quote or, in most situations, any quote. Clearly, every insurer will be concerned with the applicant's ability to manage its practice, as insurers view the inability to control client receivables as an indication of the ability to control remainder of the firm's practice. Suits for fees are discussed more fully in Section II.12 hereof.

E. OTHER 

Throughout the application and underwriting process, the underwriter seeks to evaluate each applicant in terms of a list of risk factors which it has identified from its past claims experience to create a rating base (or pricing formula) based upon those criteria. As a result, every CPA firm must understand that most application forms seek to assess the firm's risk in terms of a number of factors that the insurer can evaluate and understand. Viewed in this context, it is not difficult to understand why an insurer may not be capable of evaluating and understanding the difference between the services performed by one CPA firm and those performed by another. Clearly, the mere completion of an application form does not provide this. As a result, CPA firms are encouraged to also provide a narrative explaining its internal auditing controls and how those controls are designed to minimize the firm's exposure to liability risks.

4. TAIL AND PRIOR ACTS COVERAGE

Because accountants professional liability policies are written on a "claims made" form, in the event a firm's policy were canceled, it would effectively be left with no coverage if a claim were subsequently asserted against it following the termination date of the policy. This contrasts with the traditional Aoccurrence@ policy form (traditionally used in general liability policies), which keys coverage to when the actual service which created the claim was performed. As an example, if a firm's policy was in force from January 1, 1996 to January 1, 1997 on a claims-made basis, then any claim which is reported during that policy period would be covered by that policy regardless of when the firm's services had been performed. Under an occurrence policy, the policy which was actually in force at the time the services were provided, (e.g., five years ago) would be the policy that would apply. To prevent a lack of coverage in the event of a cancellation or non-renewal, every claims-made policy provides for an extended reporting period option or tail coverage. This is critical, as it determines a firm's ability to protect itself in the event that the insurer either wishes to leave this particular line of coverage or does not renew the firm's policy.

Thus, professional liability coverage consists of two components - work in progress and prior acts exposures. The longer a firm is in practice, the larger the prior acts component becomes. Insurers promulgate their rates based upon a rate-step factor. Each year when the policy renews, the firm's rate moves up a step until it reaches the insurer's maximum rate. If a firm commenced practice on January 1, 1998, there would be no basis to bring a claim against the firm on the policy's inception date since the firm had not previously performed any work. Accordingly, an insurer would rate a firm newly commencing practice very differently from firms which had been in practice for a number of years. As the new firm continues to develop business, when it comes to renew its policy in January, 1999, the insurer would move the rate from a rate-step 1 (or $1.00) to a rate-step 2 (or $1.35). This recognizes that the new policy is not only picking up the work which will be performed in the next twelve months, but also the exposure emanating from the work which was performed in the previous twelve months. This is a significant component of the underwriting methodology utilized by insurers as it enables insurers to monitor which exposures they are actually insuring. As a result, insurers will appear to offer extremely attractive terms to firms that have newly entered practice versus those that have been in existence for a number of years. Thus, insurers merely move their rating methodology to coincide with the increased exposure which they are assuming. Ultimately (usually seven to eight years), the firm will reach the fully mature rate required by the insurer to take care of the prior acts exposure being assumed.

In short, whenever a firm receives a quotation from an insurer which appears highly attractive, it should determine whether:

• The coverage as presented provides full prior acts coverage and does not contain any limiting endorsements with respect to the time period within which the firm's professional services will be covered in the event of a claim (also known as a "retroactive limitation clause" endorsement).
• The tail or extended reporting period option under the coverage being offered provides a number of options - 1, 3, 6 years or even unlimited - thus ensuring that all prior acts exposure will be adequately covered in the event the policy is canceled or non-renewed. Wherever possible, this option should be available "both ways" (i.e. whether the firm or the insurer wish to cancel or non-renew the policy).

Finally, another area where prior acts and tail coverage is extremely important is in the event of a merger or acquisition. On such occasions, a CPA firm should consult with its insurance representative as to how and whether it can insure the liabilities of the entity it is acquiring.

5. DUTY TO NOTIFY

All accountants' professional liability policies include a requirement that the insured firm notify its insurer in the event that it receives (or is served with) a demand, notice, summons or other process. Most insurers require that this notice be given immediately (and in writing). The requirement for immediate notice permits two key services to be triggered by the insurer:

*The recording of the claim for the purpose of identifying the insurer's duty to cover the claim under the policy then in effect; and

*The appointment of legal counsel whose involvement may help to diffuse the volatility of the situation through an independent and detached review of the circumstances surrounding the claim.

For the purposes of most professional liability policies, a Aclaim@ may arise in two different ways:

*An actual demand, notice, summons or other process seeking compensation for the alleged failure of the firm to provide the professional services expected or required by the plaintiff; and

*The CPA firm becomes aware of circumstances which could reasonably be expected to give rise to a claim either because an error is discovered or because the client or a third-party has incurred damages which can be traced back to the firm's actions.

The reporting of such Acircumstances,@ in most policies, has the effect of assuring that if a subsequent demand is received by the firm, the insurer will consider notice to have been given under the policy which was in force at the time the circumstance was reported. As an example, the firm becomes aware that one of its clients may suffer a tax penalty as a result of its failure to list certain deductible items in a prior tax return. While there may be potential remedies to this problem (such as filing an amended return), in the event that such remedial efforts are unsuccessful, the client will suffer a loss for which the firm may be held liable. Although no "claim", i.e. demand, has been made, clearly the firm has a potential liability. By reporting this situation as a "circumstance" which may subsequently give rise to a claim, the insurer "assigns" this matter to the policy in force at the time the original notice was received.

This has two benefits:

*If a subsequent claim does arise, the firm has already provided notice; and

*Early involvement of the firm's insurer may help mitigate the potential exposure.

Before giving notice of a claim or circumstance, a CPA firm should review its policy carefully with respect to where notice should be sent. In the event of any confusion, the firm's insurance representative should be contacted. Not all insurers treat notice of Acircumstances@ as a notice of a claim. Because this feature is highly advantageous to the insured firm, it is prudent to inquire whether the insurer's policy includes an Aawareness provision@ before the policy is purchased.

6. DUTY TO COOPERATE

Every insured accounting firm has a duty to cooperate with its insurer. This duty arises out of specific provisions in the firm's policy (i.e., the "cooperation clause"), as well as from the legally implied duty to act in good faith. The duty to cooperate applies both to the defense of claims covered by the firm's insurance, as well as to assisting the insurer in determining whether, and to what extent, there is coverage for the claim.

The first of these duties requires that the insured firm work with defense counsel and provide that counsel with such information and documents as might be necessary or helpful in order to defend the firm against the claim. It also requires the members and employees of the firm to meet with defense counsel to convey and explain this information, and to prepare for oral examinations before trial (also referred to as "depositions" or "EBT's"), and for their trial testimony. It also requires that they attend their depositions and appear for trial. A failure to so cooperate would be a breach of the insurance contract, providing the insurer with a basis for disclaiming liability.

The insured firm's second duty of cooperation requires the insured firm to supply information to its insurer. This is to enable the insurer to evaluate the claim so that the insurer can effect an appropriate resolution of the claim. It also enables the insurer to determine whether, and to what extent, coverage pertains to the claim.

For the most part, information pertaining to the claim will be sent to the insurer by defense counsel who will periodically report developments relating to the claim. While such reports are customary, the insured firm not only has the right to receive copies of such reports, it also has the right to review those reports before they are transmitted, as defense counsel, while generally selected and paid by the insurer, owes his or her primary duty of loyalty to the firm.

In order to determine whether it has a duty to cover a given claim, the insurer may seek certain information from the insured firm. While much of the information that the insurer may need for this purpose may have already been supplied by the firm to defense counsel, the insurer should seek this information directly from the insured firm, as defense counsel will not normally get involved in coverage issues between the insurer and the insured firm. Nevertheless, the firm may simply authorize defense counsel to pass such information on to the insurer.

Although the insured firm has a duty to cooperate with the insurer in supplying this information, such requests for information should be handled with great care, as an inappropriate disclosure could prompt the insurer to disclaim liability. Accordingly, it is advisable for accounting firms to seek the advice of counsel before responding to such requests. Although nothing prohibits defense counsel designated by the insurer from supplying this advice, many attorneys asked to defend claims on behalf of insured firms will be reluctant to become involved in a dispute (or potential dispute) between an insured firm and its insurer.

7. COVERAGE DISPUTES

An accounting firm's insurer is only required to defend and indemnify an insured's firm with respect to those claims that are covered by its policy. Thus, an insurer would not be required to provide coverage for claims that were brought outside the policy period or were encompassed by one of the "exclusions" within the policy.

When a claim is brought to the attention of an insurer, it has a duty to investigate whether there is coverage for that claim under the policy. In a great many cases, the insurer will simply not be able to make this determination from a review of the complaint and, in some cases, this determination cannot even be made based upon information available to the insured firm. When the insurer's duty to cover a claim is not clear, the insurer has a duty to provide the insured firm with a defense until such time as the coverage issues become clear which, in many cases, may not happen until the case has been concluded.

A. RESERVATION OF RIGHTS LETTERS

Because an insurer who provides a defense to a claim may be deemed to have waived its right to later disclaim liability for the claims, insurers have adopted the practice of writing to their insureds immediately following the submission of a claim, advising the insured of certain provisions within the insurance policy which may form the basis of a later disclaimer of liability by the insurer. Such letters (commonly referred to as "reservation of rights" letters because the insurer reserves its right to disclaim liability) generally have an ominous tone, as they strongly imply that the insurer will not cover the claim. While they are clearly intended to convey that warning, only a small percentage of cases in which such letters are sent are actually disclaimed. In most cases, the insurer goes on to both provide a defense to the claim, and to pay the entire settlement amount other than the insured firm's deductible amount. Nevertheless, insured firms that receive such letters should discuss them with their counsel, as the very fact that the insurer sent the letter may provide the insured firm with additional rights to control the defense of the claim.

B. DISCLAIMER LETTERS

Occasionally, it will be clear at the outset that a claim is outside of the scope of the policy, in which event the insurer will decline to defend the claim and will notify the insured firm that it is disclaiming responsibility for the claim. Although such letters are relatively rare, they require immediate action, as the insured firm must make arrangements to defend the claim and must consider whether it wishes to contest the insurer's decision to disclaim. Thus, the insured firm must immediately contact its counsel and take action.

C. RESERVATION OF RIGHTS AGREEMENTS

Rather than simply send a "reservation of rights" letter, insurers will occasionally seek to enter into an agreement with the insured firm. In this agreement, the insurer will reserve its right to later disclaim on certain bases. In return, the insurer will agree to provide the insured with a defense of the matter. In this way, the insurer will seek to avoid having the insured take over the defense of the matter. From the insured firm's perspective, it secures the defense of its claim without having to resort to court action in order to compel the insurer to fund the defense of its claim.

D. SELECTION OF DEFENSE COUNSEL

Most insurance policies for small and mid-size accounting firms require the insurer to provide a defense to covered claims. This is in contrast to policies written for the large firms, which place the duty of defending claims in the hands of the insured firm. Even where the insurer has the duty to defend claims, the insured may have the right to select counsel and to control the defense of the claim if the insurer reserves its right to disclaim liability of the claim. Selection of defense counsel and control of the claim are important rights, especially where there is a serious possibility that the insured firm may be called upon to pay all or a significant part of any final resolution of the claim.

Because of the importance of controlling the defense of claims, certain insurers will permit some insured firms, principally those with large deductible obligations, to select defense counsel. In some cases, this right can be obtained through the payment of an additional premium.

E. DECLARATORY JUDGMENT ACTIONS

Because the law provides that the duty to defend is broader than the duty to indemnify, most insurers will provide a defense of a claim even though they believe that they have no responsibility to indemnify the insured against any resulting judgment or settlement (or major part thereof). Should an insurer wrongfully refuse to defend the claim, it could be held responsible not only for the defense costs, but also for any resulting liability incurred by the insured. It is for this reason that early disclaimers of liability are relatively rare.

An insurer that does choose to provide a defense to a claim believed to be outside of the scope of the insured firm's policy may seek to have a court rule as to its responsibility with respect to a claim as a means of limiting its defense and indemnity obligations. This is done through a "declaratory judgment" (or "DJ") action. A DJ action is a separate case from the plaintiff's claim against the insured firm. In fact, if there is a material overlap in the issues in the two cases, the court will not entertain the DJ action, so as not to prejudice the insured firm's position in the liability case.

In a DJ action, the insurer and the insured firms will employ their own separate coverage counsel. Although the defense counsel may serve as the insured firm's counsel in a DJ action, this is generally not done. Defense counsel, however, may not represent the insurer in the DJ action.

8. INSURANCE REGULATION

Insurance is a highly regulated industry for the simple reason that a purchaser of an insurance policy pays for the policy in advance, not knowing until much later whether and to what extent the insurer will provide coverage. As such, it is an industry designed for abuse. It is for this reason that it is highly regulated in every state. Such regulations concern which insurers shall be licensed (or admitted) to sell their policies within the state, the capital requirements of insurance companies (which is usually a function of volume of premiums collected), the terms of policies deemed to provide acceptable levels of coverage, and prohibitions against unethical practices and false advertising. Set forth below are some of the aspects of insurance regulation that impact the accountants= liability insurance market.

A. ADMITTED, NON-ADMITTED/SURPLUS LINES CARRIERS

Throughout the insurance industry, there are numerous operating formats which can be utilized by an insurer to underwrite risks. One of the available choices is whether they are prepared to provide coverage on an admitted or non-admitted surplus lines basis. Simplistically, admitted companies are those which have been authorized and licensed to do business in a given state and have been reviewed by the state's insurance department. Admitted insurers are required to file both their policy wordings and rates and act in compliance with their filings under the risk of financial or other penalties by the state insurance department. They are also subject to the state guaranty funds in the event of their insolvency or bankruptcy. Wherever possible, and where the risk permits, a CPA firm should seek to obtain coverage from an "admitted" insurer. In addition to the review and regulation by the state's insurance department, admitted companies are also reviewed by the many independent rating agencies, e.g. A.M. Best, Standard & Poor's and Moody's. In this way, a firm has a means of measuring the financial security of its insurer as promulgated by these rating agencies.

As an example, consider the following rating system utilized by A.M. Best. Insurers rated A++ (XV) by A.M. Best are considered financially superior. The class designation (XV) denotes that the insurer has $2 billion or more in reported policyholder surplus plus conditional reserves. By contrast, an insurer rated C- would be considered marginal.

To permit flexibility in underwriting risks, the insurance industry also utilizes "non-admitted" or "surplus lines" companies. Non-admitted companies are those which are not licensed to carry on business in a particular jurisdiction. However, many states publish Awhite lists@ which list non-admitted insurers whom the insurance department considers acceptable for difficult-to-place risks.

Surplus lines companies are utilized to provide coverage where there is no admitted insurer available to provide the coverage requested. As a result, surplus lines insurers can be more flexible; however, in most states, in order to place its business with a surplus lines insurer, a purchaser must obtain (a) declinations of coverage from a specified number of insurers and (b) an affidavit completed by the placing broker regarding those declarations of coverage. In addition, most insurance departments require the payment of a surplus lines tax where a surplus lines insurer is utilized. Since the market for professional liability coverage is very competitive for all but the very large CPA firms, there is little reason why most CPA firms should not obtain their coverage from an admitted insurer. A well-run risk retention group or similar entity owned by accountants themselves may also be a good alternative for some firms.

B. REGULATION OF POLICY TERMS

Most policy terms (certainly within the admitted market) are required to be filed and approved by the state's insurance department. The regulation of policy terms is an attempt to ensure that basic policy provisions are provided to a firm when purchasing a policy. While clearly there are numerous differences between the various policies offered, the provision and regulation of policy forms ensures that a CPA firm will obtain a minimum level of coverage which the insurer and the insurance department find necessary in order for an insurer to be able to provide its product to a particular client base.

C. REGULATION OF CAPITAL AND SURPLUS

Each year, insurers are required to file with the state insurance department a statement which outlines their capital and surplus position. It also identifies the placement of admitted and non-admitted reinsurance which has an effect upon the capital and surplus position of the company. In addition, these filings permit the various state insurance departments to monitor the financial health and solvency of the various insurance companies operating within their states. These annual filings are also utilized in independent reviews performed by the various independent rating agencies to monitor the ongoing health and success of the insurance companies.

D. REGULATION 107

Regulation 107 issued by the New York State Department of Insurance provides for defense offsets against the policy limit, which effectively has the result of providing additional coverage to the insured firm with respect to a claim made against it in the event that the stated limit of liability is eroded by defense costs. Thus, this regulation provides a measure of protection for the insured in the event that a claim is ultimately settled where a significant portion of the policy's limit has been utilized purely for defense and the insured could be faced with making the actual settlement payment personally.

In New York State, Regulation 107 provides:

• Where the policy is below $1,000,000, defense costs are provided in addition to the policy limit and the deductible is not subject to defense costs; and
• Where the policy limit is $1,000,000 or greater, then only 50% of the policy limit may be utilized for defense costs. This 50% rule also applies to the deductible.

 

PART II - RISK MANAGEMENT

1. CLIENT SELECTION

A. IMPORTANCE OF SCREENING

High risk clients and engagements increase the liability exposures of even the most careful accounting firms where an attempt will be made to (i) blame the firm for any misstatements which are found in a client's financial statements or (ii) hold the firm liable for substantial losses suffered by various persons who allegedly "relied" on the misstated financials, including the client itself, and the client's shareholders, lenders and trade creditors. In order to reduce these litigation exposures, it is imperative that accounting firms carefully screen out high risk clients and engagements which clearly "spell trouble" for the firm. Unfortunately, such clients and engagements cannot be "dealt with" by simply charging higher fees because, if litigation ensues, defense costs and damage exposure will almost certainly greatly (many times, by a factor of 100) exceed the fees (including any premium) previously charged the client.

Walking away from an engagement is not an easy decision, but taking on a high-risk engagement can lead not only to liability but to professional discipline and sometimes even to criminal indictment.

B. "PROBLEM" CLIENTS AND ENGAGEMENTS

While it is not possible to catalog all "problem" clients and engagements, the following are common examples of situations which should be avoided or, at least, approached with significant caution and a realistic assessment of the risks:

Unsavory Clients. Avoid clients that have previously engaged in improper or illegal activities. If caught, such clients often try to pin the blame on the accountant, especially where tax liability is involved. "My accountant told me to do it that way" is one of the more common refrains of clients who cannot be trusted. If other accounting firms have declined to service the prospective client, determine why those firms turned away the client.

Clients With Financial Problems. Firms should always be wary before taking on a client which is already in financial distress or has a "going concern" problem. Even if such a client was "doomed" to fail before the firm accepted the engagement, a significant possibility exists that the firm will be held responsible in future litigation for any failure by the client.

Clients With Poor Internal Controls. Be cautious when accepting an engagement for a client which has poor internal controls or where management is lax in enforcing internal controls in place. The likelihood that a client's financial statements will be materially misstated greatly increases if its books and records are unreliable, or its internal accounting group is poorly trained, unreliable or understaffed. Such clients are also vulnerable to client-employee thefts for which accounting firms are routinely blamed.

Clients Which Lack Internal Stability. Be cautious when accepting work for a client which lacks internal stability, especially if there is frequent turnover in its important managerial positions. Such firms have a high failure rate, leaving bank loans unpaid.

Clients With Uncertain Futures. Think twice before accepting an engagement if the prospective client's major products are either difficult to market or only in the "start-up" phase. Unfortunately, the financial outlook for such clients is highly uncertain and it is possible that the firm will be at least partially blamed for the client's ultimate failure.

Clients Which Frequently Change Or Sue Accountants. Prospective clients which have a history of changing accounting firms, refusing to pay professional fees or suing accountants obviously "spell trouble" from the beginning.

Clients Shopping For An Accountant. CPA firms should be suspicious when a prospective client seeks assurances concerning the proper accounting treatment for a material transaction prior to its engagement of the firm. The client may be improperly "shopping" for a firm willing to endorse a questionable approach in return for payment of fees.

Clients Involved In Substantial Litigation. Avoid clients which are already embroiled in significant litigation or government investigations, the outcome of which could have an adverse effect on their financial viability or ability to attract and retain new business and customers.

Clients Engaged in Material Related-Party Transactions. Be suspicious of clients which participate in material related-party transactions. By making appropriate inquiries, the firm should satisfy itself that the existence and terms of all such transactions have been fully disclosed and that such transactions are not a part of a series of illegal acts or a scheme to falsify financial data.

Clients Requiring Expertise Not Possessed By The Firm. A CPA firm should not accept engagements if it does not have the personnel or skills to properly perform the required work. Special consideration should be given to whether the firm is qualified to perform high risk engagements, such as audits of financial institutions and construction companies. Such consideration also applies to audits of pension plans and entities receiving government grants or contracts. Both of these areas have highly specialized accounting and auditing issues that come under regular scrutiny by Federal and State agencies. These agencies feed into the professional discipline apparatus of state CPA regulators, the AICPA and state CPA societies. At a minimum, their investigations can trigger the need to make damaging disclosures on insurance applications. While it is always difficult for a firm to turn away business, the risks associated with taking on work the firm is not qualified to handle are too great.

Clients That Are Unable Or Unwilling To Pay Fair Prices. Avoid engagements for unreasonably low fees. While it is sometimes tempting to initially perform services for a very low fee in order to attract an important new client, the temptation to cut back on procedures required by GAAS or other applicable standards to avoid losing money on the engagement is too great. If litigation arises from low budget engagements, disclosure of the firm's failure to perform all required procedures in order to save money may be devastating. Even if the firm complied with applicable professional standards, a jury may infer from the engagement's low fee that corners were cut by the firm.

Client Engagements that "Feel Wrong". Experienced CPAs commonly have the ability to sense when something is amiss with an existing or prospective client, even though the CPA cannot point to specific evidence. All too often, this professional intuition proves correct. If something about a prospective engagement feels wrong, it may be best to walk away.

C. CLIENT-IN-TAKE PROCEDURES

To avoid overly risky clients and engagements, CPA firms should establish formal screening procedures which must be followed before a new client or new engagement is accepted. Among other things, accounting firms should develop a written checklist which incorporates the risk factors listed above, as well as other risks identified by the firm. Using that checklist, the firm's management (or a committee appointed by management) should carefully review each prospective client or new engagement, and determine whether the litigation risks to the firm outweigh the expected financial benefits.

In order to make an informed decision concerning new client acceptance, the firm should obtain and review all available information. For example, the firm should read any public filings by the "client", check the public press and make inquiries of knowledgeable third parties to learn as much as possible about the prospective client and its management.

In addition, the firm should make detailed inquiries of the predecessor accountants before accepting a new client. Such inquiries should be specifically directed to such matters as management's integrity, any disagreements between the predecessor and management with respect to GAAP, GAAS or other significant matters, and the reasons why the prospective client is seeking to change accountants. As part of the foregoing, the firm should also review its predecessor's workpapers before taking on the new matter.

Absent unusual circumstances, an accounting firm should refuse to accept any new client which refuses to authorize the predecessor accountants to communicate with the new accountant or to make its work papers available to the successor accountant. Clients that have had disputes with their prior accountants will often make disparaging remarks about their prior accountants in an effort to discourage contact with the prior accountant. Such remarks should not dissuade a firm from communicating with the prior accountants and should be considered when evaluating the acceptability of the client.

D. CONFLICT OF INTEREST ISSUES

Before taking on a new client or engagement, a firm should make sure that no "conflict of interest" exists. This subject is discussed in detail in Section 10 below.

E.  INDEPENDENCE ISSUES

Before taking on new work which requires that it be "independent" of the client (e.g., auditing or other verification or attest services), a CPA firm should carefully consider whether any facts exist which would impair its independence or create an appearance that independence is lacking. Generally, questions involving "independence" can be resolved by consulting the AICPA's Code of Professional Conduct and related interpretations and ethics rulings.

Among other things, the AICPA's "independence" rulings provide that to be independent, an accountant must NOT:

Assume the role of employee or of management. For example, the accountant should not consummate transactions, have custody of client assets, or exercise authority on behalf of the client. The client must prepare the source documents for its transactions in sufficient detail to identify clearly the nature and amount of such transactions. The accountant should not make changes in such basic data without the concurrence of the client.

Have any loan to or from the client or any officer, director, or principal stockholder of the client, except for a limited number of "permitted" loans (e.g., certain loans from financial institution clients).

Be in threatened or actual positions of material adverse interests with the client or its management by reason of threatened or actual litigation. Because of the complexity and diversity of the situations of adverse interests which may arise (especially in cases of "threatened" litigation) CPA firms should obtain further guidance on this matter by consulting with legal counsel and reviewing applicable AICPA "guidelines" concerning the effect of litigation on "independence".

Allow an individual to participate in an engagement if during the period of the professional engagement or at the time of expressing an opinion a firm member or employee participating in the engagement has a close relative with a financial interest in the enterprise that was material to the close relative and of which the individual participating in the engagement has knowledge.

The AICPA has also addressed (among others) the following "independence" related issues: (i) former practitioners and firm independence, (ii) honorary directorships and trusteeship of not-for-profit organizations, (iii) the effect on independence of financial interests in non-clients having investor or investee relationships with an accountant's client, (iv) the meaning of certain independence terminology and the effect of family relationships on independence, (v) the effect on independence of relationships with entities included in the governmental financial statements, (vi) independence and attest engagements, (vii) contingent fees and (viii) commissions and referral fees.

The SEC has established its own "independence" requirements (see Rule 2-01 of Regulation S-X) which CPA firms must satisfy if their engagements are subject to the Commission's rules and regulations. In some instances, these rules are more stringent than those imposed by the AICPA or the various State Boards of Accountancy. Among other matters, the SEC rules address the effect on independence of:

The accountant's performance of EDP and bookkeeping services for the client;

Various financial interests held by the accountant in the client;

Failure by the client to pay the accountant's fees

Family relationships between the accountant and the client; and

Business relationships between the accountant and the client.

Although independence issues in the context of financial statements filed with the SEC have been assumed by the Independence Standards Board (AISB@), the ISB, as an interim measure, has adopted all of the SEC independence rulings and interpretations.

Since some regulatory agencies other than the SEC (e.g., the FDIC) also maintain their own independence rules, CPA firms should ascertain that all applicable independence standards have been complied with whenever a client is subject to an agency's jurisdiction.

F. CLIENT REFUSALS AND NON-ENGAGEMENT LETTERS

When a CPA firm decides not to accept a prospective client for any reason (e.g., excessive risk, conflict of interest or independence problem), it should consider sending the person or entity a formal rejection letter. Otherwise, if the contemplated service (e.g., the preparation of tax returns) is not performed by others on a timely basis, the "client" may attempt to hold the firm that refused the work liable for any damages or penalties which flowed from non-performance of the service in question. While the use of rejection letter is clearly a matter of judgment, they deserve serious consideration in cases in which the client is facing imminent financial statement or tax return filing deadlines.

G.  CLIENT PRUNING AND DISENGAGEMENT LETTERS

Occasionally, CPA firms should disengage existing clients if they begin to take on one or more of the risk characteristics set forth in Part B. above. To facilitate the identification of overly risky clients, firms should periodically review their client roster using a "checklist" similar to the list previously proposed for accepting new clients.

A CPA firm should also drop an existing client if an unreconcilable "conflict" or "independence" problem arises which did not exist when the client was initially accepted.

Whenever a CPA firm withdraws from an engagement, it should send the client a formal resignation letter. Among other things, this letter should apprise the client of all pending deadlines (e.g., tax filing dates) so that the client cannot blame the firm if required action is not taken on a timely basis.

2. ENGAGEMENT LETTERS

A. IMPORTANCE

Accounting firms are frequently sued for having failed to perform services or rendered advice which their client alleges they agreed (or were expected) to render. Accordingly, the profession has long encouraged its members to use engagement letters to establish a clear understanding of the services to be performed, and to define the responsibilities between them and the client.

The use of engagement letters by accountants is based on the premise, as noted in professional standards, that an accountant should reach an understanding with the client concerning the engagement and communicate this understanding orally or in writing. Various references to reaching such an understanding appear throughout professional standards and other professional literature. The AICPA Code of Professional Conduct, however, does not require written engagement letters.

Over the years, and especially in these litigious times, engagement letters have been used with greater frequency, and have evolved to include language addressing topics related to the engagement, such as statements about the limitations of the services provided, particularly in the case of audit, attestation, and accounting and review services. It is even more important to fix the terms of a firm's engagement where the services to be rendered are of a non-standardized nature, such as in consulting engagements. Engagement letters have also been used to establish an understanding of fee and billing arrangements.

(1) Fundamental Guidelines

According to a variety of commentators, each engagement letter should contain the following information, and address the following subjects:

• Addressee
• Identification of the financial statement and/or work to be performed
• A statement that no work other than that identified will be performed; and that work performed will be updated unless specifically agreed to in writing
• Description of principal services to be provided
• Additional services ancillary to the main purpose of the engagement
• Identification and explanation of unique terminology
• The limitations of the firm's services and responsibilities
• The responsibilities of the client, including the client's assistance
• The basis upon which the firm's fees are to be charged
• Resolution of disputes
• Client's acknowledgment of the terms of the engagement

(2) Descriptive Guidelines

At the outset, an engagement letter should specify the type of services to be performed by the accounting firm. For example, by setting out the parameters of an engagement as a compilation, an accounting firm may prevent the client from later establishing that the firm undertook to review or audit a set of financial statements, without an expressly identified step-up in service.

In addition, an engagement letter should also describe the nature of the services to be performed. This is particularly important in specialized engagements such as those in which the accountant performs agreed-upon procedures or consulting services. The specific procedures to be performed can either be listed in the engagement letter itself or set forth in an accompanying schedule. Some accounting firms even refer to the appropriate professional literature governing the engagement or the procedures to be performed. By so specifying what services will be performed, the firm can minimize potential litigation, and may prevent client disputes based upon a misunderstanding of the scope of services to be provided.

In order to avoid a misunderstanding with the client regarding the benefits to be derived from the firm's services, the engagement letter should mention the limitations of the specified services. These limitations generally should mirror the applicable professional standards and include the limited ability of the firm's services to unearth frauds and client employee defalcations. Of course, it is not practical to mention all items not covered by a firm's services in the engagement letter. But, if a client specifically identifies certain items it expects to be covered in an engagement, an accounting firm should consider language in the engagement letter identifying the limiting factors associated with its engagement.

It is also important that the engagement letters specify the client's responsibilities. If the client agrees to provide any workpapers, confirmations or other documents, locate documents selected for testing, or assist the firm in any other way, these responsibilities should also be itemized in the engagement letter. It is also useful to specify the timing of the client's responsibilities and a warning that the client's failure to adhere to that schedule will necessarily cause a delay in the firm's performance of its engagement.

Regardless whether an accounting firm's charges are based on the time expended in performing its engagement or upon a fixed-fee arrangement, the engagement letter should specifically set forth the fee arrangement, as well as any limitations or contingencies associated with the arrangement. All too often, firms encounter difficulties recovering uncollected fees when the fee arrangement is not explicitly articulated. In this regard, the engagement letter should specify when payments are due. If interim invoices are to be sent, the engagement letter should also specify that the firm reserves the right to suspend its services or terminate the engagement if the client does not pay its invoices on a timely basis. In addition, the engagement letter should provide that if the firm terminates its services due to nonpayment of its fees, it shall be deemed to have earned that portion of its total fees represented by its accrued time charges, irrespective of whether it has completed its engagement.

B. STANDARD ENGAGEMENT LETTER FORMATS

(1) Audit/Review/Compilation

Although there are several references to engagement letters in the authoritative literature of the accounting profession; neither the profession nor its regulators require that a firm enter into an engagement letter with its clients. Instead, engagement letters are only recommended for the protection of accounting firms so as to prevent misunderstandings with their clients. Nevertheless, the fact that the authoritative literature of the profession does encourage the use of engagement letters places a greater legal burden upon accounting firms to reach a clear understanding with their clients as to the scope of their services and assumed responsibilities.

The auditing section of the AICPA's Professional Standards is virtually silent on the subject of engagement letters, referring only to specified elements, accounts or items, reports on internal control and reviews of interim information. In fact, it offers no examples of engagement letters.

In contrast, the standards are explicit about the use of engagement letters for accounting and review services, perhaps because the risk of misunderstanding in this area is greater. Accounting and review ("AR") Section 100.08 says, "The accountant should establish an understanding with the entity, preferably in writing, regarding the services to be performed." Examples of engagement letters for both compilations and reviews services appear in AR Sections 100.53 and 100.54.

Although it is not an authoritative source, the AICPA Audit and Accounting Manual ("AAM") provides helpful advice on engagement letters. The AAM contains an excellent discussion of matters the engagement letter should address, as well as illustrative forms of letters appropriate for audits, compilations and reviews in various circumstances. The manual also suggests that an accounting firm need not issue the letter more than once a year and that one letter may cover a variety of services.

The key points to consider including in audit engagement letters are as follows:

Purpose of letter: This letter will confirm our understanding of the arrangements for our audit of the financial statements of [company name] for the year ended [date].

Engagement purpose: We will audit the company's balance sheet at [date], and the related statements of income, retained earnings and cash flows for the year then ended. In all circumstances, our responsibility for this engagement will be limited to this period. The purpose of our engagement will be to express an opinion on the fairness of presentation of these financial statements in conformity with generally accepted accounting principles [or other comprehensive bases of accounting].

This paragraph should limit the accountant's responsibility to a specified interval, a provision that may discourage a claim related to work allegedly or actually performed at another time. This paragraph also can describe the engagement's fundamental purpose. While this may seem elementary, it sets a logical stage for the contents to follow. Although a firm may undertake to perform an audit of its client's financial statements, it should not agree to issue an unqualified report as problems may subsequently be encountered which might preclude the issuance of a report, creating the possibility that the client might contend that the failure to issue a report (much less an unqualified report) constitutes a breach of contract and thereby precludes the firm from collecting its unpaid fees.

Responsibilities: The accuracy and completeness of the financial statements, including the related footnotes, are the responsibility of the company's management. Management also is responsible for selecting sound accounting principles, and for maintaining an adequate internal control structure. Our responsibility is to express an opinion on the financial statements based on our audit.

This section should explicitly recognize all the client's and auditor's major responsibilities. As the AAM manual points out, such definitions are especially important for write-up work leading to the preparation of financial statements for a small, non-public client. Should an accounting firm offer advice about a choice among alternative accounting principles, it is essential that the client acknowledge its responsibility for the selection decision.

Standards applicable to engagements: We will conduct our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. The term reasonable assurance implies a risk that material monetary misstatements may remain undetected and precludes our guaranteeing the accuracy and completeness of the financial statements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe our audit will provide a reasonable basis for our opinion.

The paragraph that concerns applicable standards is, of course, based on the standard auditor's report set forth in SAS No. 58. The additional reference to detection risk alerts the client to the possibility that material misstatements will not be discovered due to the audit process's inherent limitations. In this same regard, it may be helpful to point out that the "reasonable assurance" provided by an audit opinion is clearly less than a guarantee as to the material accuracy of the client's financial statements.

Audit procedures: Our procedures will include obtaining an understanding of the company's internal control structure and testing those controls to the extent we believe necessary. We also will physically examine the fixed assets and inventories [if applicable], and will confirm receivables, certain other assets and liabilities by corresponding with selected customers, suppliers, attorneys and banks. In addition, we will read the other information included in the annual report to stockholders and consider its consistency with the financial statements.

Management representations: At the conclusion of our audit, we will request from you a letter attesting to the completeness and truthfulness of representations and disclosures made to us during the course of our work.

The audit procedures sections address the firm's responsibility for obtaining an understanding of the internal control structure, underscoring for the client the importance of the controls for audit purposes. It also refers (albeit obliquely) to the management's discussion and analysis section and other financial information appearing in documents in which the audited financial statements are published. Once client personnel understand the requirements of AU Section 550, they may be particularly careful to avoid inconsistencies between the "other information" and the client's financial statements.

Scope restrictions: If you are aware of any restrictions that might limit the scope of our testing, we ask that you bring them to our attention as soon as possible. Such restrictions, if significant, may preclude us from issuing an unqualified opinion.

A paragraph on scope restrictions can impress on the client the importance of early notification to the auditor so the work can proceed smoothly without a significant fee increase. It also points out the seriousness of significant restrictions and may discourage the client from imposing any such limits.

Responsibility for detecting fraud: Generally accepted auditing standards require us to design our audit to detect errors and irregularities that would have a material effect on the financial statements. However, since we will not examine all the transactions that occurred during the preceding year, our audit cannot provide absolute assurance that such errors and irregularities, including frau