Due Diligence Red Flags When Evaluating Outsourcing Vendors

Many CPA and accounting firms now rely on outsourcing as a key business model. Firms often use outsourcing to handle tax prep, audit help, accounting tasks, or back-office work. Third-party providers play an essential part in getting these services done. When planned well, outsourcing helps firms grow, save time, and maintain steady performance. 

But outsourcing also brings responsibilities that firms cannot avoid or pass to others. Rules like IRS Section 7216, the AICPA Code of Professional Conduct, and the FTC Safeguards Rule set clear standards for how firms must choose, review, and manage these external providers. 

Due diligence does not work as a single, one-time task. Firms need to treat it as a continuous approach to show they provide proper care, oversight, and safeguarding of client data.  

This guide highlights key warning signs CPA firms should watch out for when reviewing outsourcing vendors. It also discusses how these issues can lead to compliance risks. 

Lack of Security Documentation 

A big and early warning sign is when a vendor does not have clear and written security policies. 

The FTC Safeguards Rule requires firms to have a written program to protect information and to choose service providers that can protect customer data. When checking a vendor, firms should request proof showing how they keep data secure. 

Watch out for these warning signs: 

1. No documented information security plan 
2. Security practices explained through conversations 
3. Policies are outdated or don’t match real-world operations 
4. Lack of clarity on how access to data is managed 

Without proper documentation, firms cannot check if safeguards are suitable or effective. More importantly, they fail to provide evidence to regulators, insurers, or reviewers showing that necessary precautions were taken. 

Security documentation is not about collecting stacks of papers or earning certifications. It’s about ensuring everything is clear and aligns with actual workflows. 

Missing Clear Confidentiality Rules 

Confidentiality is essential under IRS Section 7216 and the AICPA Code of Professional Conduct. When vendors handle client information, their confidentiality responsibilities need to be outlined and enforceable. 

A big warning is when there are no clear terms about keeping client information private, how it's accessed, used, or shared. 

Things to look out for: 

1. Missing confidentiality clauses in agreements 
2. Vague terms that ignore client data specifics 
3. No rules stopping extra use of the information 
4. No requirement to give back or delete data after a project ends 

When confidentiality rules are unclear, companies risk leaking tax records or financial details of clients without permission. AICPA ethics make it clear that the company is always responsible for protecting confidentiality, even if a vendor is involved. 

If a firm cannot explain how a vendor is required to safeguard client data, it has failed its duty to check things out. 

No Defined Confidentiality Obligations 

Proper oversight depends on having clear visibility. Firms need to watch how vendors use client data and manage their tasks. 

A major warning sign is when a vendor refuses or fails to support monitoring or audits. 

Some examples are: 

1. Missing system monitoring or access logs 
2. No way to see who accessed client data 
3. Refusal to cooperate with audits 
4. Lacking internal review systems 

The FTC Safeguards Rule says companies must check on service providers and evaluate risks. The AICPA standards also require businesses to oversee and review the work done by professionals. 

If audits aren’t possible, companies can’t confirm if they follow rules, spot problems, or handle inquiries. Oversight becomes an idea rather than an actual practice. 

No Incident Response Plan 

Security incidents are real and not just theoretical. Regulators require companies and their vendors to stay ready to handle security events. 

Not having a written plan to handle incidents is a major warning sign during due diligence. 

Signs of this include: 

1. Lacking a clear method to deal with data breaches 

2. Failing to establish how to escalate or notify parties 

3. Confusion about who does what during an incident 

4. Skipping reviews or tests of response plans 

The FTC Safeguards Rule says companies need to find, manage, and bounce back from security issues. Vendors are essential in this process when they access client data. 

If a vendor cannot describe how they handle incidents, the firm cannot fulfill its own response duties. 

Inability to Support Client or Regulator Inquiries 

Firms need to handle questions from regulators, clients, insurers, and professional organizations. Providers help firms respond. 

A major red flag arises when vendors cannot support inquiries related to: 

1. Data access and handling 
2. Security controls 
3. Incident history 
4. Compliance practices 

 Common warning signs include:

1. No designated compliance contact 
2. Incomplete or inconsistent responses 
3. Lack of documentation supporting claims 
4. Reliance on assurances rather than evidence 

In these cases, the firm carries the risk, not the vendor. Authorities and professional bodies will not accept the vendor's shortcomings as an excuse. Firms are responsible for picking vendors that can meet compliance demands. 

Why These Warning Signs Are Important 

Every warning sign points to a bigger issue - lack of structure. 

Regulations do not ban outsourcing. They require firms to prove they handle third-party partnerships with oversight, rules, and security. When vendors fail to meet even the most basic checks, they create risks, no matter how good their intentions or work quality may seem. 

Lower costs, ease of use, or long-term connections cannot erase regulatory risks. Firms need to show they have carefully reviewed vendors and keep a close eye on them. 

Documented due diligence around confidentiality, data security, contractual controls, and oversight is a common part of outsourcing governance for CPA firms. MYCPE ONE is an offshore services organization with over a decade of experience working with CPA and accounting firms, including engagements across more than one thousand firms, and has compliance resources available aligned with IRS, AICPA, and FTC requirements. 

Check Resources: 

A Complete Guide to IRS 7216, AICPA, and FTC Requirements	View here
Due Diligence Checklist	View here
Virtual Event: Update on IRS 7216, AICPA and FTC Requirements	View here

Conclusion 

Due diligence does not mean removing every risk. It means identifying and managing the risks that can be controlled. 

Things like missing documents, weak confidentiality agreements, inadequate monitoring, or failure to prepare for incidents are serious problems. These issues indicate that a vendor may fail to meet a firm's ethical and regulatory obligations. 

Firms spotting these warning signs early can form compliant outsourcing partnerships. These partnerships can withstand scrutiny and support steady, long-term growth.  

Key Points 

• Performing due diligence requires ongoing effort rather than treating it as a one-time activity. 
• Not having proper security documentation poses significant risks. 
• Confidentiality rules need to be clear and enforceable. 
• Firms need reliable ways to audit and monitor systems. 
• Being prepared to handle incidents is mandatory, not optional. 
• Vendors should assist clients and regulators with their questions or requests. 
• Organized frameworks help limit compliance risk. 

FAQs 

1. Do all outsourcing vendors have to follow identical due diligence rules? 

The level of due diligence depends on the type of work and the sensitivity of data being handled. Vendors handling confidential client information or tax return data must meet the basic standards of security, confidentiality, and proper oversight. Firms need to evaluate risks instead of making assumptions. 

2. Can a firm trust vendor certifications alone? 

Vendor certifications might help, but they do not take the place of a thorough investigation. A firm should confirm how controls are applied in real scenarios and see if they meet requirements from the IRS, AICPA, and FTC guidelines. Keeping records and monitoring processes is still very important. 

3. Does missing documentation always point to compliance issues? 

Although rules for documentation can differ, failing to show proof of protections, monitoring, or readiness for incidents can bring serious risks. Authorities and insurers focus on what a firm can prove rather than just what it says. 

4. How should firms reassess vendors? 

Firms need to treat due diligence as a continuous process. They should check vendors again if services shift, data access grows, or regulations change. A single evaluation often does not meet the requirements. 

5. Do these warning signs apply to vendors within the country, too? 

Yes, they do. Regulations emphasize third-party access and security measures, not location. Vendors within the country lacking strong protections can present the same compliance risks as those located abroad.