Many CPAs don’t purchase professional liability insurance coverage because they think their clients will never sue them, but they forget about third-party claims. If a client goes bankrupt, their lenders, shareholders, and business partners could file a lawsuit against a CPA to recover their losses.
Unfortunately, accounting firms, CPAs, and professional service firms frequently get targeted for lawsuits unnervingly. You can’t avoid lawsuits, but you can mitigate your risk of third-party litigation. The reality is CPAs are vulnerable to several third-party claims that can land them in a courtroom.
Types of third-party claims against CPAs
Depending on the jurisdiction, CPAs can be held liable for damages based on common law, statutory law, or both. Liabilities from common law arise from negligence, breach of contract, and fraud. Statutory law liability is an obligation originating from a particular statute or law.
- Privity — CPAs and their clients enter into a contract with an agreement to perform specific services. If a CPA does not accomplish what they stated in the engagement letter, and the client suffers damages, they can be held liable. The same is true if a third-party can establish privity with a CPA.
- Professional negligence — Clients and third parties can sue accounting professionals for the tort of negligence – a wrongful act, injury, or damages in which civil action can be brought. Negligence is classified as ordinary or gross negligence.
- Fraud — Accounting professionals can be exposed to litigation under the fraud claim if they are suspected of being aware of misrepresenting a material fact, misleading another party, and injury resulting from the act.
Due to the risk of liability, CPAs, accounting professionals, accounting firms, and professional service firms are wise to carry professional liability insurance to protect from these types of legal claims and lawsuits.
Liability to third-parties
Being sued for fraud is the biggest risk CPAs face. In this case, a contract (privity) is necessary. For the third-party to win the case, they must prove several things.
- The auditor had a duty to exercise due care.
- The auditor knowingly breached that duty.
- The breach was the direct reason for their loss.
- The third-party suffered the claimed loss.
When does a third-party privity relationship exist?
To successfully file a claim against a CPA, a third-party must prove that a privity relationship exists. To establish that privity (a contract) exists, the third-party must show three things:
- The CPA was aware that his or her representations were to be used for a particular purpose or purpose.
- The CPA intended for the representations to be relied upon by the third-party.
- The CPA engaged in conduct linking him or her to the intended third-party, revealing the CPA’s understanding of the third-party’s reliance.
How E&O insurance protects professionals
E&O (Errors & Omission) insurance protects professionals against claims if a mistake occurs in a professional capacity. E&O coverage protects when a claim of negligence arises or when obligations are not met under a contract (privy). Even when third-party claims are found to be without merit, CPAs and accounting professionals may still end up owing a significant amount of legal fees.
An E&O insurance policy will cover legal fees and the cost of any settlement or judgment.
Any professional, including accountants, should carry E&O insurance. At McGowan, we have more than 50 years in the insurance industry. Learn more about our Errors and Omissions (E) Insurance Policies for Accountants and contact us today to answer your insurance questions.