Claims Against Accountants and Advisors Who Missed or Hid Fraud

Start with the engagement letter

Liability for missed fraud begins and ends with what the accountant agreed to do. The engagement letter defines it, and the professional standards attach duties to each level of service.

• Audit. The accountant expresses an opinion that the financial statements are fairly presented. Auditing standards require the auditor to plan and perform the audit to obtain reasonable assurance that the statements are free of material misstatement, whether caused by error or fraud, and to assess fraud risk. An audit does not promise to find every fraud, but a fraud that distorted the statements materially and that reasonable procedures would have caught is within the audit's scope.
• Review. Limited assurance based on inquiry and analytical procedures. Reviews are not designed to detect fraud, and a review engagement letter says so.
• Compilation, bookkeeping, tax preparation. No assurance. The accountant assembles management's numbers. These engagements carry no duty to detect fraud, though they can carry a duty to act on red flags the accountant actually saw.
• Advisory, CFO services, fractional controller. The duty is whatever the contract says, and a professional who took on controls, approvals or reconciliations may have assumed a duty to notice what those tasks would reveal.

A company that paid for a compilation and expected an audit has a hard claim. A company whose auditor signed off on statements inflated by a controller's four-year scheme has a real one.

The client's claims: negligence and breach of contract

The client who engaged the accountant may sue for professional negligence, sometimes called accounting malpractice. The elements are a duty arising from the engagement, breach of the standard of care of a reasonably prudent accountant under the same circumstances, and damages proximately caused. The standard is proven by expert testimony from another CPA about what the applicable professional standards required and where the work fell short. A breach of contract claim for failing to perform the engagement as promised is usually pleaded alongside it, which matters because the contract claim may carry attorney's fees and has a four-year period.

Damages are the loss the negligence caused: typically the amounts stolen after the point at which competent work would have detected the scheme, plus investigation costs. The defense will argue that the loss before that point is not recoverable, and that some of the loss would have occurred anyway.

Third parties who relied on the work

Investors, lenders and acquirers often relied on audited or reviewed statements and want to sue the accountant who issued them. Texas law is narrower here. Negligent misrepresentation under section 552 of the Restatement (Second) of Torts, which Texas follows, makes a professional who supplies false information in the course of business liable to a limited group of persons for whose benefit and guidance the professional intended to supply it, or knew the recipient intended to supply it, in a transaction the professional intended to influence or knew the recipient so intended.

In Grant Thornton LLP v. Prospect High Income Fund (Tex. 2010) the Texas Supreme Court applied that limit strictly. Investors who bought bonds in reliance on an audit report could not recover for negligent misrepresentation because the auditor did not know its report would be used for their specific transactions; general knowledge that investors might rely on a public audit was not enough. The court also required actual reliance for the fraud claim, which failed where the plaintiffs had not read the audit before buying. A third party therefore needs evidence that the accountant knew its work was going to this recipient, for this deal: a reliance letter, a comfort letter, correspondence with the lender, or an engagement scoped for the transaction. The general claim is explained in negligent misrepresentation in Texas.

When the accountant helped

An accountant who knew of the fraud and helped conceal it, by booking the entries management dictated, backdating documents, or signing an opinion they knew was false, faces fraud liability with its four-year period and exemplary damages, and liability for knowing participation in the insider's breach of fiduciary duty. Proving knowledge is the hurdle. Workpapers, emails with management, and the accountant's own notes of unresolved discrepancies are the evidence. An accountant who flagged the problem in writing and was overruled by management is in a very different position from one who buried it. Those theories are developed in civil conspiracy and knowing participation in Texas.

Example

Suppose a Frisco medical practice engaged an accounting firm to audit its annual statements for three years while its office manager was diverting insurance reimbursements to a personal account, about $600,000 in all. The audit workpapers show that in year two the auditor noted that recorded insurance receipts were 9 percent below the practice management system's billings, requested a reconciliation, received a one-line explanation from the office manager and closed the point. Professional standards require an auditor who identifies such a variance to obtain sufficient evidence and to treat management's unsupported explanation with skepticism. The practice has a negligence claim for the losses from the date of that audit forward. The firm's defenses will be its engagement letter's limitation of liability, the practice's own failure to segregate duties, and the office manager's share of responsibility under chapter 33.

The defenses accountants raise

• Scope. The engagement did not include procedures that would have found this. Decisive in compilation and tax cases; contested in audits.
• Limitation of liability and shortened deadlines. Many engagement letters cap the firm's liability at the fees paid, exclude consequential damages, and shorten the time to sue. Texas generally enforces negotiated limitations between businesses, though not for fraud or gross negligence, and the clause is read against the drafter where ambiguous. Read it before assuming the claim is worth pursuing.
• Imputation and the company's own conduct. Where the fraud was committed by the company's own officer, the accountant will argue that the officer's knowledge and conduct are imputed to the company, so the company cannot complain that the accountant failed to catch what the company itself was doing. Texas courts limit imputation where the officer acted entirely for personal benefit and against the company's interest, which describes most embezzlement, but the argument is made in every case.
• Proportionate responsibility. Under chapter 33 of the Civil Practice and Remedies Code the accountant may designate the embezzler as a responsible third party and ask the jury to assign percentages of responsibility. A jury that puts most of the fault on the thief reduces the accountant's share, and a defendant found less than 51 percent responsible pays only its percentage.
• Causation. The company would have lost the money anyway, or management ignored warnings the accountant did give.

Deadlines

Professional negligence and negligent misrepresentation claims against accountants carry the two-year period in section 16.003 of the Civil Practice and Remedies Code. Texas courts apply the discovery rule to accounting malpractice where the negligence was inherently undiscoverable, so the clock may start when the client learned or should have learned of the error, and fraudulent concealment by the accountant tolls it further. Fraud, knowing participation and breach of contract carry four years under section 16.004. Engagement letters often shorten these by agreement. Because the discovery of an embezzlement is itself the event that starts the two years running against the accountant, the decision whether to pursue the professional has to be made early, often while the claims against the thief are still being developed. A tolling agreement can buy time; see what a tolling agreement is and when it helps.

Other advisors

The same framework applies to outside CFOs, bookkeeping services, payroll providers, investment advisors and attorneys, with the standard of care set by each profession and the duty set by each engagement. Payroll and bookkeeping vendors usually have service agreements with tight limitation clauses. Investment advisors who missed fraud in a fund they recommended are covered by securities law and FINRA or SEC rules; that question is addressed in whether you can sue an investment advisor for fraud. Attorneys who missed or facilitated a fraud are subject to legal malpractice and fiduciary claims, with their own two-year period.

Should you pursue the accountant?

The question is practical. The accountant is often the only solvent, insured defendant, since CPA firms carry professional liability coverage and the embezzler does not. Against that, the claim requires an expert, confronts a limitation clause and an imputation defense, and will spend most of its energy on the percentage of responsibility between the professional and the thief. A litigator's evaluation starts with three documents: the engagement letter, the workpapers or deliverables for the years in question, and the professional's correspondence with the person who committed the fraud. Tina Wysk represents businesses and investors in fraud and professional negligence disputes in Dallas state and federal courts.