New Accountant Ethic Proposals Affect Use Of Your Client's Outside Accountant, And Their Liability Under Malpractice Claims

September 2006

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In September 2006, the American Institute of Certified Public Accountants (AICPA) issued proposed new ethics rulings. Because these are reissued proposals that incorporate comments from a prior proposal, the newly-issued guidelines are likely to be finalized without further major revision.

Under Article 9, Section 65 of the California Board of Accountancy Regulations, all CPA licensees must follow the AICPA's Code of Professional Conduct, so these rules are not voluntary.

Attorneys should avoid using the client's existing accountant for all investigations and expert testimony needs.

Revisions are proposed to AICPA Ethics Interpretation 101-3. The changes affect a number of interpretations and rulings under Rule 101 of the Code of Professional Conduct. The proposals clarify that a wide range of potential litigation-related and expert witness services impair the "independence" of a CPA. This means that an accounting firm providing such assistance will need to resign from the ongoing audit or review services, and would have to disclose the lack of independence in compilation reports.

These requirements are already explicit for public company audits, and actually also existed for other services outside the public company environment. However, some were uncertain as to the scope of the restrictions for litigation services and forensic accounting.

Interestingly, although perhaps unintended, Interpretation 101-3 might actually be stricter than the independence requirements for public companies contained in Section 201 of the Sarbanes-Oxley Act (SOX). SOX specified nine prohibited services if independence is to be maintained. All services over certain de minimus rules also require Audit Committee approval. However, unlike the SEC's provisions involving certain services that are not material to the financial statements, Interpretation 101-3 contains no such relief, as the new proposals do not have de minimus exceptions.

If "independence" is to be preserved for financial statement reporting, then the accountant will have to be under the control of the client when the accountant is performing the litigation consulting, investigatory, or forensic accounting services. At first, this would appear to be completely counter-intuitive, and the opposite of what should occur. However, the rule makers have the view that any decision-making on behalf of the client must be avoided if the accountant is also going to report on financial statements. Consequently, the client must have management personnel who are sufficiently competent in the matters covered by the outside accountant's work. The client representative must then make all decisions as to the accountant's efforts.

The accountant must document (read: make explicit in a writing) certain aspects of the engagement for litigation consulting, investigatory, or forensic accounting services, including:

The client's agreement to oversee the services
The engagement objectives and limitations
The client's and the CPA's responsibilities

Imagine the cross-examination of an expert witness that is your client's existing accountant. The accountant and client both want to maintain the existing relationship to perform audit, attest, or review services, or to avoid disqualification in a contractual setting such as the client's loan agreement that requires involvement by an "independent" CPA. Such an expert would need to acknowledge that the client (i) was in total control of the expert witness relationship and project, (ii) approved all decisions, and (iii) is responsible for the project's conclusions. In the event that this is not clear from oral testimony, this result must be in writing.

In this situation, far from appearing independent to a trier-of-fact, such a witness will appear like a clerical pawn of the client. The practical impact of this is that an accountant who is performing ongoing work for a client can NOT perform expert witness testimony.

Similarly, investigation efforts, forensic accounting, and fact gathering in support of litigation can only occur if a suitably-skilled client representative is in charge. This also applies to royalty audits, financial reviews of contractual compliance, or any other assistance that a lawyer might need to advance a client's interests. This means that an accountant that is assisting an independent investigation by an audit committee, board of directors, or anything else in which outside counsel is directing the efforts will be prevented from then reporting on that client's financial statements. This has become the predominant practice already, but those prior exceptions will no longer be advisable.

An outside accountant can provide lay, percipient, or sensory-witness testimony without triggering these rules.

The bottom line is that a separate accounting firm should be used whenever independent investigations or expert testimony is needed.

Engagements that report on financial statements can not be covered by liability-limiting contracts

Contract-based limitations of liability have become more common with the large accounting firms. This trend will stop if the proposed guidelines become final.

An indemnification or limitation of liability provision is prohibited on a project that requires the accountant to be "independent". As with the rules described above, "independence" is a specifically defined term covering all audit, review, or attest engagements. In addition, accountants preparing compilation reports who are not "independent" have to specifically disclose this in their report. Consequently, even clients that obtain only the most basic accounting services are affected.

Consulting, tax projects, and other non-attest projects do not have "independence" requirements, and so are not affected by these contractual restrictions.

Other contractual provisions involving limitations or dispute resolution are allowable, including:

Punitive damages limitations
Clauses allowing the prevailing party to recover attorneys fees and costs
Waivers of jury trials
Use of arbitration or other ADR proceedings

Fulcrum Financial Inquiry is an accounting, valuation and financial advisory firm with significant experience in helping clients and their lawyers resolve disputes.