Time to Refocus on Loss Prevention

By John F. Raspante

CPA firms currently are facing the dual prospect of rising insurance premiums and shrinking availability of the coverage they need—known as a “hard market” in insurance jargon. It also appears that the larger the CPA firm, the more trouble it will have finding necessary coverage at affordable premiums.

The causes are not hard to identify: Enron, WorldCom and other corporate scandals have made insurance companies extra wary of CPA firms. Also, the losses from Sept. 11 have depleted insurance company surplus, and the stock market downturn has cut company investment income to the point where rates are being raised in order to rebuild surplus. As insurance companies perceive increased risk to their capital, it is important for CPA firms to give even higher priority to their loss prevention and risk management processes.

Client Screening

For starters, Camico has long advocated thorough client screening processes for new and existing clients, including:

• credit checks and/or background checks,
• examination of previous financial statements,
• examination of the prior CPA’s management letters,
• interviews with the client,
• interviews with the client’s key personnel,
• discussions with the client’s banker,
• discussions with the client’s legal counsel, and
• discussions with the client’s prior accountants and auditors.

Camico recommends that client screening be done regardless of the nature of the services being performed. See the sidebar for a sample checklist for individual clients. A more extensive checklist for corporate clients, and other client screening tools, can be found on the policyholder-only section of the Camico website at www.camico.com.

Due Care

Just as critical is the need for CPAs to understand their clients’ businesses and industries. Accepting engagements the firm is not competent to perform, and falling short of the professional standards for due care, can be construed as negligence. This can put the firm in jeopardy of ethics violations and malpractice allegations.

Camico claims history shows that engagements performed without an adequate basis in experience produce larger losses. In other words, “dabbling” can be dangerous. The above chart on “Loss Ratios by Service Concentration” shows that engagements outside a CPA firm’s main areas of expertise (less than 15 percent of service concentration) generate the highest loss ratios. The higher the percentage of service concentration (specialization), the smaller the loss ratio is.

Engagement Letters/Documentation

A lack of written communication about the scope of the firm’s services, advice given or other interactions can lead to an expectation gap between what the client wants and what the CPA can reasonably be expected to provide. The best way to establish an understanding with the client is by putting it in an engagement letter, along with the terms of the engagement. Camico recommends engagement letters for every type of engagement.

Language in the letter should be limiting in its descriptions of services, objectives and responsibilities. The engagement letter is not the place to embellish or market the firm’s capabilities. The CPA firm wants to limit, not expand, its risk exposure in the letter. For more information, consult the Fourth Edition of the CPA’s Guide to Effective Engagement Letters, recently updated by Camico and published by Aspen Publishers at www.aspenpublishers.com.

Finally, proper documentation is essential to a risk management program. Without documentation, the CPA is at a disadvantage in a dispute. Juries expect CPAs to retain comprehensive documentation. If a critical event is not documented, and is remembered differently by other witnesses, usually the jury will not give the CPA the benefit of the doubt. Instead, it will take the view that the CPA had a duty to document but failed to do so. The failure to document conversations, decisions and actions is a grave mistake many CPAs make.

When in doubt, always seek assistance early from your legal counsel or risk advisor—before a small problem becomes a big one.