A tax practitioner's guide to risk management.

• Author: Hill, Lawrence M.

How do you decide whether to take on a now client? Ideally, by identifying whether the reward (fees, referrals) justifies the risk (potential future litigation). This article provides a blueprint of issues to be considered and making and implementing the now client decision, including obtaining client background information, drafting proposal and engagement letters, monitoring client communications and other issues.

The following observations regarding risk management and practice protection have been made over the course of the past decade, while defending tax professionals in hundreds of lawsuits, threatened litigations, disciplinary proceedings, criminal investigations, depositions, subpoena matters and other legal proceedings. This article is not intended to be all-inclusive, but merely serves to highlight some of the areas that the tax practitioner should be sensitive to in conducting actions to be taken when his practice.

The costs of practice protection continue to skyrocket and the number of lawsuits brought against tax accountants remains staggering. Litigation risk should always be in the back of the practitioner's mind during the course of an engagement.

Awareness of the potential threat of litigation and conscious efforts to manage the risk serve as powerful deterrents to lawsuits and enhance the overall quality and ultimate success of a practice.

Litigation exposure can arise at any stage of an engagement. The risk management process begins at the client evaluation stage, when the professional elects to become associated with a particular client and agrees to undertake a specific type of engagement. It continues throughout the course of engagement and, quite often, even after the engagement is concluded.

The Client Evaluation Process

Client evaluations are a critical feature of risk management. By entering into a relationship with a client, the practitioner benefits from the rewards of bringing on a new client or engagement, but also bears the potential risks associated with the new relationship. Appropriate evaluation of the risk-reward equation is a fundamental feature of practice protection.

The first question a practitioner should ask when considering a new client relationship is, "Do I want to become associated with this client?" The natural inclination is to answer this question in the affirmative. However, the answer is not as clear-cut as first appears, and should not be arrived at without first determining whether the new relationship makes sense from a risk-reward standpoint.

Engagement Risk

Every new client relationship involves some engagement risk. The ideal arrangement is one that entails a high degree of reward and a low degree of risk. An engagement that brings with it high risks and low rewards should be avoided. In the long term, such undertakings cause far more problems than they are worth.

There are several key elements of engagement risk, the most important of which is the prospective client's integrity. Clients who are honest and reputable are generally more likely to be open, accessible and cooperative. It is thus usually easier to obtain complete, accurate and truthful information from them because they have nothing to hide. As a result, work is more likely to be completed in a timely and efficient fashion. Targeted deadlines are easier to meet and there tend to be fewer cost overruns. Such clients are more likely to pay their bills timely and work out any potential differences with the professional in an amicable fashion. They are also less likely to engage in vexatious litigation and less likely to find themselves embroiled in controversies with regulators, shareholders, employees and creditors, all of which can consume the professional's time--often without reimbursement.

Honesty and integrity alone, however, do not the perfect client make; a number of other significant risk factors should be considered before undertaking an engagement. It is important to consider the potential negative publicity or harm to professional image that may arise from being associated with a particular client, industry or project. For example, one would want to carefully consider whether it would be in the firm's best interests to perform work for a corporation that is accused of widespread employment discrimination. Would it be in line with the firm's goals to provide assistance to an individual who is under indictment for tax evasion? Would it make sense to be engaged by a foreign entity that has mysterious origins and a dearth of records? While these questions might not necessarily be answered in the negative, depending on the facts and circumstances, and the firm's goals and philosophies, the key is to analyze any potential negative ramifications before accepting the engagement.

The prospective client's financial condition is yet another factor. If the client is on the verge of bankruptcy or in serious financial trouble, it may affect the practitioner's ability to get paid for work performed. The practitioner may even find himself being dragged into a lawsuit for allegedly causing the failure of the business, even though he had no role in its failure. It is not unusual for this type of lawsuit to be commenced simply because those harmed by the business's failure are looking to recoup their losses from those who have "deep pockets" or insurance coverage.

Other factors that should be considered in evaluating engagement risk are: the client's level of tax and business sophistication; business conflicts or other conflicts of interest that may arise; the level of cooperation anticipated from the client and the ease of obtaining necessary information; issues related to fee realization; and whether the practitioner possesses the adequate resources, skills and experience to service the client competently and efficiently.

Assuming the potential client has passed muster, the practitioner must then ask whether the engagement is worth taking on from a risk-reward standpoint. For example, many accounting firms no longer accept prospective reporting engagements. Experience has taught them that the litigation risks and costs associated with these engagements far outweigh the advantages of taking them.

Red Flags

The following warning signs may warrant declining an engagement or reevaluating an existing client relationship:

* The client has gone through numerous CPAs in recent years.

* The client is experiencing significant financial difficulties or has a history of nonpayment of fees to professionals or other service providers.

* The client has undergone a significant change in management or other personnel.

* The client is faced with significant regulatory difficulties.

* The client has demonstrated propensity to be litigious or is currently involved in litigation.

* The client imposes unreasonable time constraints or other unusual scope limitations on the engagement.

* The practitioner has a negative visceral reaction to the client (i.e., a "gut feeling" that something is wrong).

Conducting the Evaluation

Today's high-technology environment and easy access to the Internet and computer information services make conducting a client evaluation much easier than in the past. Computer databases can be used to obtain pertinent background information regarding prospective clients, including...