Accountant Malpractice: When CPAs Make Costly Errors FAQ

The standard of care in accountant malpractice cases is that of a reasonably competent CPA practicing in the same or similar circumstances. This standard is derived from professional negligence principles and requires the accountant to possess and apply the knowledge and skill that a reasonably competent member of the profession would use.

The standard is not perfection; errors in judgment do not automatically constitute malpractice if a reasonable accountant could have made the same decision.

Courts look to several sources to establish the standard of care:

• Generally Accepted Accounting Principles (GAAP)
• Generally Accepted Auditing Standards (GAAS)
• AICPA Professional Standards
• State board of accountancy rules
• IRS regulations and guidance for tax matters
• Industry custom and practice

Expert testimony is typically required to establish what a reasonable CPA would have done in similar circumstances. The standard may be elevated for specialists, such as certified fraud examiners or those holding themselves out as experts in particular areas. Importantly, the standard is judged as of the time the services were rendered, not with the benefit of hindsight.

To prevail on an accountant malpractice claim, the plaintiff must prove four essential elements by a preponderance of the evidence:

1. Duty: The plaintiff must establish that the accountant owed a professional duty of care. This typically arises from the accountant-client relationship established through an engagement letter or course of conduct. Third parties may also be owed duties under certain circumstances depending on jurisdiction.

2. Breach: The plaintiff must prove that the accountant failed to meet the applicable standard of care by demonstrating what a reasonably competent CPA would have done differently. This element almost always requires expert testimony.

3. Causation: The plaintiff must establish both:

• Cause-in-fact (but-for causation): The harm would not have occurred without the breach
• Proximate cause: The harm was a foreseeable consequence of the breach

This often requires proving what the outcome would have been had the accountant performed properly, known as the "case within a case."

4. Damages: The plaintiff must prove actual, quantifiable damages resulting from the breach. Speculative or theoretical damages are insufficient.

These elements parallel other professional malpractice claims but require accounting-specific expertise to prove.

Damages in accountant malpractice cases aim to put the plaintiff in the position they would have been in had the accountant not been negligent. Calculation methods vary depending on the type of error and resulting harm.

For tax malpractice, damages typically include:

• Additional taxes paid due to the error
• Interest and penalties assessed by taxing authorities
• Costs of amended returns or IRS representation
• Lost tax benefits or credits that could have been claimed

For audit failures, damages may include:

• Investment losses incurred in reliance on negligent audit opinions
• Losses from undetected fraud or embezzlement
• Business losses from impaired financial statements

For business advisory failures, damages can include:

• Lost business opportunities
• Increased costs from poor advice
• Transaction damages from negligent due diligence

General damage principles apply: Recovery is limited to actual provable damages; speculative or contingent damages are not recoverable; the plaintiff has a duty to mitigate damages; and collateral source payments may reduce recovery. Expert testimony from forensic accountants or economists is typically required to calculate damages.

Statutes of limitations for accountant malpractice claims vary by state and by the legal theory under which the claim is brought. Most states apply a two to four year limitations period for professional negligence claims, but the key issue is determining when that period begins to run.

Accrual rules include:

• Traditional rule: The clock starts when the negligent act occurs
• Discovery rule: Many jurisdictions delay accrual until the plaintiff knew or reasonably should have known of the malpractice
• Continuous representation doctrine: Some states toll the statute while the accountant-client relationship continues for the same matter

For tax-related claims, the limitations period often begins:

• When the tax return is filed
• When the IRS issues an assessment
• When the client discovers or should have discovered the error

California, for example, applies a one-year discovery rule with a four-year outside limit for professional negligence under Code of Civil Procedure Section 340.6 (though this specifically applies to attorneys; accountant cases may be governed by the general negligence statute).

Given the complexity of limitations analysis, clients should consult with an attorney immediately upon discovering a potential claim to preserve their rights.

Expert witness testimony is almost always required in accountant malpractice cases to establish the standard of care and whether the defendant's conduct breached that standard. Unlike some negligence cases where a lay jury can apply common knowledge, accounting malpractice involves technical professional standards that require expert explanation.

Expert qualifications: The expert must be qualified by education, training, and experience in the relevant area of accounting practice. For tax malpractice, the expert should have substantial tax practice experience; for audit failures, the expert should be experienced in auditing and GAAS.

Experts typically testify regarding:

• The applicable standard of care for the services at issue
• How the defendant's conduct deviated from that standard
• Whether the deviation caused the plaintiff's damages
• The amount of damages attributable to the malpractice

Courts may exclude expert testimony that is not based on reliable methodology or sufficient facts, following Daubert v. Merrell Dow Pharmaceuticals in federal courts and similar standards in state courts.

Common knowledge exception: In rare cases involving egregious errors, the case may proceed without expert testimony if the negligence is so obvious that laypeople can determine it without technical assistance. However, relying on this exception is risky.

Accountant malpractice claims typically fall into several common categories:

Tax Preparation Errors (most frequent):

• Failure to claim available deductions or credits
• Mathematical errors resulting in underpayment or overpayment
• Missed filing deadlines causing penalties and interest
• Improper tax position advice resulting in penalties
• Failure to advise on estimated tax payments
• Errors in business entity tax elections

Audit Failures:

• Failure to detect material misstatements
• Failure to identify fraud indicators
• Inadequate audit procedures
• Improper reliance on management representations

Financial Statement Errors:

• Misapplication of GAAP
• Failure to disclose material information
• Compilation and review service failures

Business Advisory Failures:

• Due diligence failures in transactions
• Improper business valuation
• Negligent advice on entity structure

Breach of Fiduciary Duty: Conflicts of interest, failure to maintain confidentiality, and self-dealing.

Tax errors by CPAs create malpractice liability when the error results from a breach of the professional standard of care and causes quantifiable damages to the client. Tax malpractice claims require the same elements as other professional negligence claims but involve tax-specific analysis.

Common tax errors giving rise to liability:

• Missed deadlines for filing returns, elections, or claims for refund
• Failure to advise on or properly execute tax elections (S-corp elections, like-kind exchanges)
• Incorrect calculation of taxable income, deductions, or credits
• Failure to advise on estimated tax payment requirements
• Improper advice on tax positions later challenged by the IRS
• Failure to identify and claim available deductions
• Errors in complex transactions (mergers, acquisitions, retirement plan distributions)

Damages in tax malpractice typically include:

• Additional taxes owed that could have been avoided
• IRS penalties and interest (though accuracy-related penalties may require showing the position was not substantially justified)
• Costs of amended returns and IRS representation
• Lost opportunity costs for planning strategies no longer available

CPA defenses: The position taken was reasonable and supported by substantial authority, the error was within professional judgment, the client provided inaccurate information, or the client failed to follow advice.

Audit failure malpractice occurs when an auditor fails to follow Generally Accepted Auditing Standards (GAAS) and issues an inappropriate opinion on financial statements, causing damage to the client or third parties.

Types of audit failures:

Failure to Detect Material Misstatements: The auditor did not identify errors or fraud that a reasonable auditor following GAAS would have detected.

Audit Procedures Failures:

• Inadequate sampling
• Failure to test internal controls
• Insufficient substantive testing
• Over-reliance on management representations
• Failure to obtain sufficient appropriate audit evidence

Fraud Detection Failures:

• Ignoring red flags
• Failing to apply professional skepticism
• Not testing journal entries for fraud indicators
• Inadequate inquiry of personnel

Reporting Failures: Issuing an unqualified opinion when a qualified or adverse opinion was warranted, failing to disclose material uncertainties, and not communicating significant deficiencies to management.

Damages from audit failures can be substantial, including investment losses, undetected embezzlement losses, business losses, and regulatory penalties. The auditor may face claims from both the client and third-party users of the financial statements.

Third-party liability for accountant malpractice varies significantly by jurisdiction, with courts applying different tests to determine when non-clients can sue.

Ultramares Doctrine (New York approach): Accountants are liable to third parties only for fraud or gross negligence, not ordinary negligence. This strict approach limits liability to those in privity or near-privity with the accountant.

Restatement Approach (followed by many states including California): Imposes liability to third parties if:

• The accountant knows the client intends to supply the information to a specific third party
• The accountant knows the information will be used for a particular transaction
• The third party actually relies on the information for that purpose

Foreseeability Approach (minority of jurisdictions): Extends liability to any third party whose reliance was reasonably foreseeable.

Factors courts consider:

• Whether the accountant knew the third party would rely
• Whether the third party was specifically identified
• The purpose for which the information was prepared
• The extent to which the accountant's work was intended for third-party use

Engagement letters can limit third-party exposure by restricting who may rely on the work product.

Accountants facing malpractice claims have several potential defenses available:

No Breach of Standard of Care: The accountant performed according to professional standards and the claimed error was within the range of reasonable professional judgment.

Lack of Causation: Even if the accountant erred, the error did not cause the claimed damages. The plaintiff must prove "but for" causation and proximate cause.

No Damages: The plaintiff cannot prove actual quantifiable damages, or the claimed damages are speculative.

Comparative or Contributory Negligence: The client's own negligence contributed to the harm, such as:

• Providing inaccurate information
• Failing to review returns before signing
• Ignoring advice

Statute of Limitations: The claim was filed beyond the applicable limitations period and does not qualify for tolling.

Contractual Limitations: The engagement letter contains enforceable liability caps, damage limitations, or arbitration provisions.

No Duty to Third Parties: Third-party claims can be defeated by showing no duty was owed under the applicable jurisdictional test.

Reasonable Reliance: For audit cases, the auditor reasonably relied on management representations or internal controls after appropriate testing.

Professional Judgment: The position taken was a reasonable interpretation of ambiguous law or facts.

Failure to Mitigate: The plaintiff failed to take reasonable steps to reduce damages after discovering the error.