UK: Risk Management For Accountants

Last Updated: 16 November 2012
Article by Alex Ktorides

It is true that accountants are well ahead of most other professions when it comes to risk management and certainly, the "big four" have had in place risk management processes and dedicated resources far earlier than solicitors, IFA's and surveyors to name but a few. However, this is no time to rest. Clients are running out of money, as the slow asphyxiation of the credit crunch finally chokes their life blood, and liquidators, litigation funds, irate investors and shareholders are starting to see litigation as a viable business plan. It seems a good time to re-visit the touchstones of risk management for accountants.

The risks facing accountants are varied: damage to reputation from bad clients or from losing data, claims from third parties as well as clients; failing to plan to detect fraud in the audit process; claims for missed time limits and challenges to (not so) "brilliant" tax schemes by HMRC. Modern day accountancy firms also offer investment management and financial services too, as the next "AIG" glut of claim cannot be far away. Add to this the complex issues involved when the various regulators come calling and the risk picture becomes complete.

Dealing with these topics fully is beyond the scope of this article but some of these measures if adopted will see off a number of these threats and otherwise bring down the risk to an acceptable level with which to do business.

Accountants are perhaps unique because of the way that their work can be expected to be of interest to parties not even being asked to pay their bills: the investor carrying out due diligence or the bank deciding whether to continue support. Clients can and do expect great service but there is so much that can go wrong with tax advice, or corporate finance activities or audit, that the terms on which clients are retained can define whether a claim will get off the ground or not.

Risk management for accountants should therefore start with the engagement letter. This is a must and should contain a number of key elements: the scope of work to be carried out; a reasonable and negotiated liability cap; terms of business and use of data; confidentiality; and how the work can be used or relied upon. These matters can be incredibly important. For example, in BP v Aon, the liability cap Aon had placed in its engagement with BP for the Texas part of the retainer was found to bite, but because some of the work had been carried out in London but the Aon office here had no engagement letter with BP, BP was able to bring a claim in the UK for all the loss thus avoiding the only (UK) liability cap that had been agreed. The mistake cost Aon £45 million. This highlights the need for engagement letters and that care must be taken over the identity of contracting parties and binding all those that the accountant considers might be relying on his or her work.

Turning to third parties. That duties to third parties can be owed by accountants is something that is now accepted and though there does have to be some extra element of "foreseeability", this can be a surprisingly easy duty to trigger. There are various tests but it seems clear that if the accountant knew his or her work was to be relied upon by a particular party for a given purpose and that party did so rely, a duty can well arise. It is easy to see how this may happen in practice. Client A is selling part of its business to B. B's advisors ask to see the draft accounts prepared by accountant C as well as reports that C have recently prepared on cash flow for its lenders. Accountant C has clear duties to A and the lenders and these duties are regulated by the terms of engagement agreed between them (including a liability cap) but B is looking to rely on accountant C's work. If B, in these circumstances, relies on the draft accounts or the report and suffers a loss because something in those documents is incorrect, accountant C faces the prospect of an unlimited claim. The ICAEW, in its technical releases sensibly recommends that when receiving such requests, accountants like C should ask B and its advisors to enter into an agreement which "holds harmless" C from any damage that may be sustained by B should it rely on the information C is providing. It is suggested that a prudent accountant would also seek an indemnity from A in providing the information and include a disclaimer in its work before handing this over. This is useful when other parties may see the work further down the line as often happens in cases of syndicated lending.

There are also steps that can be taken to mitigate the risks when the regulator seeks information and documentation from the accountant. In the case of the SFO, its powers should be carefully monitored and only once the accountant is satisfied that the powers are being exercised correctly should information about a client be handed over. The duty of confidentiality will give rise to an action in damages against the accountant unless the accountant is properly "compelled" to hand over the information in question. In practice, the accountant should demand a "Section 2" notice from the SFO, after discussing the scope of such request, which will then provide a defence to a confidence claim later down the line. It is also a good idea to negotiate, as a matter of time management and cost reduction, the amount of information to be provided and the method. The regulator, such as the SFO, may not be using the same electronic document system as the accountant and a discussion over IT, no matter mundane this may seem, can save a great deal of disagreement and money.

Turning to audit, the auditing standards issued by the Auditing Practices Board of the Financial Reporting Counsel are to be observed. Compliance with the auditing standards will be cited by claimants seeking to show that an audit was deficient and therefore the standards take on high significance in disputed claims. Training and proper planning are therefore key. The relationship with the entity being audited, via its directors and shareholders, can be a reason why an audit fails to detect serious issues and accountants should be training to pick up the warning signs (lack of risk management processes, controlling shareholder or charismatic chairman, unexplained debts, avoidance of the auditor and late provision of information).

In addition, the use of outside "member firms" or other outsourcing can be the source of error and claims. Audit work should be done centrally with proper and proportional partner supervision. Audit software packages, often designed in-house, should be refined and improved each year. A level of professional scepticism throughout is healthy when audits are being carried out.

There are a number of other ways for the accountant to limit the risks of being in business. The treatment of indemnities and warranties, which potential and existing clients seek, can be significant. In the rush to get on with new and exciting work, these terms of business are often left but a sensible discussion with the client at the contracting stage can save pain later. An indemnity, for example, for the negligence of a secondee sent to work for 6 months at a merchant bank could lead to a catastrophic claim against the accountant unless that indemnity is carefully worded and "capped" with a financial limit. Similarly, the incorrect selling of tax schemes which are "100% safe" can be mitigated by more circumspect language.

A note for modern day accountants who join a network of firms. Care needs to be taken here, as claimants look for the firm with the largest professional indemnity insurance policy to enforce against. There are a number of cases on the issue of cross-border liability and the legal position, it is submitted, may still evolve, but cases involving BDO in the US and PwC in India for example, highlight the fact that claimants will try to bring novel claims. The risks for accountants who are member firms lie in claims being brought in other jurisdictions, which are unpredictable and expensive to fight. Proper control of each network firm and clear separation of legal personality is key, as is the introduction for all members of contractual arrangements with each client. So, if you are about to join an international network, think about adding a clause to your terms of business which states that clients are not able to bring claims against other member firms, even where those members are acting jointly on a particular job, even as sub-contractor.

Finally, insolvency office holders will continue to appear on the scene, seeking access to the accountant's papers. A careful approach is needed if the request is to be controlled. The difficulty is that the rules are complex, with case law on ownership of papers differing slightly from the recommended practice from the ICAEW (see Chantrey Martin v Martin as a starter) and insolvency office holders themselves either not entirely aware of the subtle differences in the rules or choosing to ignore these. A rule of thumb is that liquidators are rarely entitled to either the entire file or to ask unlimited questions of the former accountant or auditor. The ownership of papers turns on the capacity of acting, with auditors owning almost all originals and copies and tax advisors owning little, aside from original letters it receives or notes it makes entirely for its own purposes. As long as the liquidator is kept in check and the powers under the insolvency act used responsibly and proportionately, a sensible deal should be done as soon as possible when an access request comes in.

In summary, whilst none of the above steps are a panacea for loss or future claims, they are sensible and occasionally vital. Just having an engagement letter, signed by the client, with defined terms and a clear scope of the work to be done, a reasonable liability cap that will withstand challenge and the correct approach to confidentiality and how the use of the accountants work is limited and must be agreed in writing, will all be huge steps towards keeping the risks to a sensible level for doing business.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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