Liability Exposures in Providing Accounting Services to Contractors

John F. Raspante, CPA, MST, is the director of compliance and risk management as well as the director of education with Graf Repetti & Co., LLP. Material for this article comes from Camico Mutual Insurance Company (www.camico.com), where the author formerly served as national account advisor, with responsibility for supporting and strengthening Camico's relationships with state CPA societies, CPA alliances and associations, large CPA firms, and insurance agencies.

ABSTRACT

Many industries have the potential to expose accountants to unique liability risks. The contracting industry has traditionally been subject to the following conditions, which have created economic hardships for the contractor and liability exposure for the accountant. These are: 1. seasonality, 2. labor shortages and transient workers, and 3. erratic revenue patterns, and others. These conditions act as a catalyst in many professional liability claims against accountants. To help reduce the exposures inherent in this industry, accountants should understand the causes of claims and develop a loss prevention program designed to mitigate those risks. When professional standards require the percentage-of-completion method of accounting, there is a considerable reliance on the use of estimates by both management and the accountant. To mitigate this type of exposure and allegations by both third parties and clients, accountants should carefully document, and reiterate in their engagement letters, work papers, and management representation letters, that the estimates are based upon management's assumptions. FULL TEXT

Many industries have the potential to expose accountants to unique liability risks. The contracting industry has traditionally been subject to the following conditions, which have created economic hardships for the contractor and liability exposure for the accountant:

* Seasonality,

* Labor shortages and transient workers,

* Erratic revenue patterns,

* Fluctuations in the real estate market and economy,

* Regulatory oversight,

* Noncontemporaneous accounting systems,

* Use of estimates in accounting for revenue,

* Lack of segregation of incompatible duties, and

* Complexities of the tax code.

These conditions act as a catalyst in many professional liability claims against accountants. In addition, the contracting industry is prone to swings based on economic conditions that create "feast or famine" levels of demand for contracting services, with the famines sometimes forcing contractors to go out of business.

Contractors' financial statements are used heavily by third parties such as banks and bonding companies to make significant business decisions. If something goes wrong, the link to the accountants' financial statements is clear. This is especially true under New York law when the accountants are aware, and acknowledge their understanding, of the intended reliance.

To help reduce the exposures inherent in this industry, accountants should understand the causes of claims and develop a loss prevention program designed to mitigate those risks.

While this discussion is limited to contractors that are nonissuers as defined by the Sarbanes-Oxley Act of 2002, certain claims data have shown the following common areas of action against CPAs providing services to contractors:

* Use of estimates,

* Independent contractor reclassifications,

* Third-party users of financial statements,

* Internal control weaknesses in the accounting function, and

* Management fraud.

The causes of claims in the preceding list can be effectively managed by employing the loss prevention tools and techniques described below. Other causes of claims, such as problems with subcontractors and the noncompletion of jobs, can be addressed with a variety of loss prevention techniques, especially a thorough clientscreening process. (See AICPA Practice Alert 2003-03, Acceptance and Continuance of Clients and Engagements.)

Use of Estimates

When professional standards require the percentage-of-completion method of accounting, there is a considerable reliance on the use of estimates by both management and the accountant. Final results often differ sharply from these estimates. These discrepancies can result in substantial misstatements. When this happens, thirdparty users of financial statements are often skeptical about the reasons for the disparity. Accountants should be aware of the potential for management to overstate earnings by manipulating estimates. If such manipulations are not caught, rhe accountant's work Ls often questioned and a cause of action may follow.

For instance, "fade" describes the tendency of gross profit and gross profit percentages on jobs reported in process to not hit the estimates when the jobs are completed When this happens repeatedly, contractors are typically punished by the companies that provide their surety bonds. Those companies will often discount the reported results by even more than the fade would suggest.

Incidentally, accountants will find that developing good relationships with surety companies can help in their efforts to issue consistently accurate financial statements.

Loss prevention tools. To mitígate this type of exposure and allegations by both third parties and clients, accountants should carefully document, and reiterate in their engagement letters, work papers, and management representation letters, that the estimates are based upon management's assumptions. For example, an engagement letter for an assembly of a forecast may include the clause:

An assembly does not include evaluating the support for management's assumptions and, as such, we will not express a conclusion or any other form of assurance on the assumptions underlying such Statements.

An exception would be for audit engagement letters, which should state that an audit "includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation." An accountant's knowledge of the industry will be essential to assessing the reasonableness of significant estimates made by management. Before they are used, engagement letters should be reviewed by the accountant's risk adviser or legal counsel for possible modification. It should be noted that engagement letter provisions will have little, if any, effect on third parties.

Any third-party questions should be directed and answered by management. A sound client acceptance and retention policy should alert accountants to overly aggressive clients that might attempt to overstate earnings through the improper use of estimates. Effective screening should give accountants a good idea about their potential clients' integrity.

Independent Contractor Reclassifications

The tendency for contractors to hire independent subcontractors often results in examinations by the IRS, Department of Labor, and workers' compensation insurance carriers. These examinations often seek to reclassify independent contractors as employees and assess the client for payroll taxes, insurance premiums, penalties, and interest. To further compound the problem, each of these agencies has its own criteria for determining the status of independent contractors or employees, and the examinations often cover multiple periods.

Loss prevention tools. One of the most effective ways to resolve this type of dispute is to clearly delineate the accountant's responsibility or lack thereof regarding independent contractor or employee determinations. The following paragraph is recommended for engagement letters:

Our engagement is not designed to determine the status of your workers as employees or independent contractors, We are available under the terms of a separate engagement to provide this service.

This language will be of limited use with third parties. Additionally, if an accountant does provide services to determine the status of workers, the independence implications of providing such services should be considered. In providing any nonattest services to a client, an accountant should examine and follow Ethics Interpretation 101-3, Performance of Nonattest Services.

Another effective tool to reduce exposure is to provide me client with articles or governmental publications that recite the client's responsibility when hiring independent contractors and the conditions associated with successful government examinations. (IRS Publication 15- A, Employer's Supplemental Tax Guide, provides guidance on this decision process.)

Third-Party Users of Financial Statements

Professional liability claims against accountants are most frequently made by clients. Nevertheless, Exhibit 1 shows that the claims of third-party creditors (banks and bonding companies) form, in terms of dollar amount, the majority of claims against accountants. Exhibit 2 shows that financial statement audits and reviews, which are needed by third parties that provide financing to contractors, are often the cause of such claims. Therefore, accountants must carefully consider all of the parties that will be relying on its services. It helps to think about those who will be damaged if the business fails and to remember that an unsuccessful result is usually what drives a disappointed party to sue. Claims involve not just client business failures but failures by contractors or their subcontractors to perform as promised if the surety is unable to prevent nonperformance.

Although it is beyond the scope of this article, a review of the particular statutes regarding the privity defense is warranted. (For New York, as an example, an instructive article is "Recent Court Ruling Poses New Threat to Accounting Firms," by Dan L. Goldwasser, Esq., The Trusted Professional, August 15, 2007.) The advice below may also be helpful.

Loss prevention tools. If possible, accountants should limit the distribution and use of financial statements by employing the following language in engagement letters:

You must obtain our prior written permission before you distribute a copy of our financial report to anyone other than the specified parties.

If Client distributes a copy of our financial report to any person or entity other than internal management without having first obtained our prior written permission to do so, Client hereby agrees to indemnify and hold us harmless from and against any and all claims or causes of action for damages or loss against us by such person or entity as a result of said party's alleged reliance on said report. Client's obligation to indemnify includes, without limitation, the obligation to indemnify us for, and pay, all of the attorneys' fees and costs reasonably incurred by us in defending against such claims.

Accountants should also keep in mind the possibility of limitations on the use of indemnffication provisions in engagement letters (see Ethics Interpretation 501-8, Failure to Follow Requirements of Governmental Bodies, Commissions, or Other Regulatory Agencies on Indemnification and Limitation of Liability Provisions in Connection with Audit and Other Attest Services).

When feasible, accountants should 1) avoid direct communication with third parties requesting financial statements or explanations regarding financial statements; 2) explain the answers to management, who will then respond to the third party; and 3) avoid acknowledging, in words or conduct, that they know the third party will be relying on their work.

Internal Control Weaknesses

Internal control weaknesses resulting from the failure to separate responsibilities in the accounting function are the most common of all the exposures that confront accountants who serve contractors. Exhibit 3 shows that more tiian half of losses come from embezzlement and client fraud. Typically, an office manager pays the bills, computes payroll, reconciles the checkbook, and approves purchase orders. Without a separation of these critical functions, material defalcations and embezzlements can occur. The following language is recommended for use in the bank reconciliation service:

Each period we will reconcile Client's books and records of the following bank accounts: Bank names and account numbers with the bank statements for proper account balance and to identify reconciling items that may require adjustments to your books and records. We will not be analyzing cancelled checks to determine whether signatures or payments are authorized or for any other purpose, but we will briefly scan them to confirm the amounts match those recorded on the bank statement. By your signature below, you acknowledge that you understand and agree that our services are limited in scope and are not designed to detect employee embezzlement or other fraudulent activities involving your bank accounts. Should you wish us to expand our procedures to include additional work or investigations, we will arrange this with you in a separate engagement letter.

Again, the independence implications of such an additional engagement, as set forth by Ethics Interpretation 101-3, should be considered.

Loss prevention tools. Accountants should recommend the bonding of certain key employees in the accounting function. On a related note, an accountant should recommend that contractors obtain background checks on candidates considered for employment and periodically on existing employees. It is a good practice to suggest to clients the benefits of a forensic audit and to keep their response to this suggestion in the accounting firm's files.

Once an engagement is accepted, an accountant should discuss any internal control weaknesses with the client, use an internal control warning letter to document the discussion, and retain a copy of the letter.

Management Fraud

Associating with a client whose management lacks integrity can have disastrous consequences. Exhibit 4 shows that the size of the average claim due to client fraud is substantial. Client screening procedures, now standard practice, are the first steps in an effective risk and practice management program.

Loss prevention tools. An accounting firm should use an acceptance checklist, available from some professional liability insurance companies, to screen potential clients before taking them on. A firm should also communicate with predecessor CPAs, auditors, and third parties. Current clients should be reevaluated at least once a year. This will enable the firm to better monitor any changes that might affect the professional relationship and to avoid situations that could escalate into crises. Firms can also stipulate in their engagement letters that the engagement is not binding until client acceptance procedures have been completed. Firms would be wise to consider background investigations for key decision makers in all significant engagements.

Client acceptance procedures should include assessing management's commitment to implementing and maintaining effective internal control. AICPA Practice Alert 2003-03 recommends inquiring of management about the following topics:

* Antifraud programs and controls,

* Control environment,

* Risk assessment process,

* Information and communication systems relevant to financial reporting,

* Control and monitoring activities, and

* Any changes that management believes should be made to enhance the effectiveness of the entity's internal control.

Discussions with prior accountants and reviews of their reports on internal control-related matters are also helpful.

Regardless of the level of service being performed, accountants should familiarize themselves with Construction Contractors-AICPA Audit and Accounting Giade and the annual audit risk alert covering the industry. Accountants should also be familiar with the risk assessment guidance in Statements on Auditing Standards (SAS) 104-111. (See "Financial Statement Services: Watch Out for the Gaps," by Duncan Will, The Trusted Professional, September 2008.)

SAS 99, Consideration of Fraud in a Financial Statement Audit, directs auditors to do the following:

* Exercise professional skepticism when considering the possibility of a material misstatement due to fraud,

* Discuss the risks of material misstatement with engagement personnel,

* Obtain the information needed to identify the risks of material misstatement,

* Assess those risks,

* Design an audit in response to them,

* Evaluate audit evidence, and

* Communicate about fraud to management, the audit committee, and others.

While SAS 99 has significantly heightened the importance of exercising professional skepticism and identifying and assessing the risks of fraud, it does not come close to meeting a typical jury's expectations of what a CPA's responsibilities should be in fraud detection. Engagement letters should include an acknowledgment that the client is responsible for the following:

* The financial statements,

* Accuracy and completeness of the information that goes into the statements,

* Adjusting the financial statements to correct material misstatements, and

* Communicating any material changes to the statements.

Accountants should advise clients about their exposures to fraud in a letter that warns about the general risks, suggests steps clients can take to reduce the risks, and offers services to help reduce those risks.

Contractors provide tremendous opportunities for accountants, but also pose unique liability exposures. Careful client screening and acceptance, documentation, and specially crafted engagement letters are invaluable in protecting a practice from the exposures in serving contractors.

GRAPHIC: ChartsIMAGE CHART, EXHIBIT 1, Relative Dollar Value of Construction Claims by Plaintiff Category, 1986-2007, EXHIBIT 2, Relative Dollar Value of Construction Claims by Type of Service, 1986-2007IMAGE CHART, EXHIBIT 3, Relative Dollar Value of Construction Claims by Cause Loss, 1986-2007IMAGE TABLE, EXHIBIT 4, Average Construction Claim Size, 1986-2007