Engagement letters often form the litmus test of Professional liability claims, where either the claims are accepted bona-fide or rejected altogether owing to the backend stress, time and effort and defense costs associated.
In such scenarios, adopting and practicing strong client acceptance procedures, which essentially get initiated with a prospective client evaluation, help prevent a claim. Basis successful client evaluation, a CPA firm can avoid the associated risks that come with a bad client by declining the servicing opportunity. Alternatively, the CPA firm can initiate a mutually conducive client relationship in awareness of the risks presented by the new client which can be tackled by appropriate risk mitigation tools.
3 Factors for Successful Prospect Evaluation
Below are 3 vital parameters to address and reduce a CPA firm’s professional liability risk:
Client integrity can be adjudged by the prospect’s representations and transparency of information provided, like tax return preparations. It often is the case that client representations are the only evidences to rely upon by a CPA firm and hence a client needs to be chosen wisely to avoid any integrity issue at a later stage.
2). Financial strength
The second most important criterion is the prospective client’s financial stability and creditworthiness. In case a client faces bankruptcy, often the associated CPA firms which had been providing attestation services face the fire and may be sued legally. Claims often arise from bad clients who manipulate their statements, tax returns or business bank accounts.
In such instances, the associated CPA firm lands chances of a financial risk specifically, like outstanding receivables. Clients having historical balances due create a trouble for CPA firms, where the latter, in good faith, keep servicing the clients in the hope of payment receipt in future against the CPA services provided in continuity. In cases where a client falls to pay huge amounts owing to negligence or deliberate avoidance may cause a CPA firm to sue the client or claim outstanding fees, although this may backfire on the CPA firm for professional negligence.
Lastly, it is very important to check if the CPA firm and its prospective client are having a mutually conducive professional culture, respect and courtesy. Absence of the same can lead to ill-treatment by the client, delay in deadlines, avoidance or delay in bill payments and even extending timely financial information. A lack of conducive culture can also visibly lead to lack of the client’s understanding and acceptance of each party’s roles and responsibilities and eventually cause a professional liability claim.
Important Checklist for Successful Client Evaluation
The AICPA Statements on Quality Control Standards (SQCS) require firms to establish policies and procedures for the acceptance and continuance of client relationships and specific engagements. These apply to a CPA firm’s accounting and auditing practice, as well as any other service. Acceptance process can vary from firm to firm where Solo practitioners can proceed with a single peer while Mid-size firms can discuss prospective clients as a partner group. Large-size firms normally use a client acceptance committee.
Professional liability risk is borne by the entire firm (not only by the partner) where consistency in client evaluation is required and is a critical parameter for firm’s level of risk tolerance. It is hence strongly advisable to document the firm’s client acceptance criteria and evaluation process, including additional approvals that may be required.
The checklist includes:
- Assessing background information, including those available on digital media, corresponding to the client and key members of client management.
- Verifying the referral source and/or the client’s other professional advisors.
- Understanding the client’s history with its former CPA(S) and reason for change.
- A discussion with the client’s former CPA(s) and check the client’s comfort level in facilitating the same (in case the client may display lack of interest, this could possibly indicate an integrity issue).
- Assessing management’s experience, financial knowledge, credentials, appreciation of internal control, and acceptance of their responsibilities that are applicable to the service to be rendered.
- Understanding any changes in ownership, management, and governance.
- Performing a credit check to assess the client’s ability or willingness to pay timely invoices.
- Ensuring personal with prospective clients for an upfront understanding and relationship building.
- Verifying pending or past lawsuits of a client and understanding its propensity to sue its professional advisors (supporting processes can be inquiries, internet searches, and review of public records).
- Reviewing the client’s financial ratings.
- Reviewing prior financial statements of the client to ascertain specific delays (if any) in issuance or restatements.
- Reviewing previous tax returns, recent tax return audit results, and other pending tax issues.
- Going by instinct in client validation.
Response Mechanism to Identified Risks
Efficient risk management practices are required to mitigate the risk to an acceptable level for the CPA firm. Such Risk management practices include:
- Retainer adaptation preceding servicing, billing and payment terms in the engagement letter
- Inclusion of risk allocation provisions, such as dispute resolution, limitation of liability and damages, and indemnification, in engagement letters wherever permissible
- Assigning an experienced engagement team for service delivery
- On-boarding a secondary-senior level reviewer on the engagement team
- Mutual review of the engagement letter contents with the client, including each party’s responsibilities and expectations of their role in the engagement
- Performing frequent and continuous evaluations to monitor client risk and ensure that it does not exceed the initially accepted risk level
In case of integrity concerns noted in above procedure, it is best advisable to decline the client opportunity as identification of an efficient risk management practice, or its combination becomes difficult for such clients at a later stage.
Economic Considerations Influencing Risk Acceptance
When the economy is lopsided, CPA firms may be more inclined to take up certain risks, which they would not ideally be considering in utopian conditions. This can cause accepting a client engagement out of the firm’s standard operating boundaries, expertise or acceptance criteria.
Continuing with Client Evaluation
Since definition of ‘Risk’ for the client and ‘Risk tolerance’ for a CPA firm may keep changing with times, consistent client evaluation is mandatory keeping the Client Acceptance criteria intact. In case issues are figured out at a later stage, it should be a best practice to cut the umbilical cord with such a client.