As Featured in the CPA Insider
When there is a large supply of available capital from small investors seeking higher returns, shady operators proliferate. Both business principals and promoters whose primary motivation is personal profit emerge to promote new ventures.
Retaining the services of respected professional firms is an important element in the success of all new ventures seeking capital, but it is critical to the success of businesses that are severely undercapitalized, offer products or services with limited market demand, or are simply frauds. These business principals and promoters actively seek out established professional service firms to prepare prospective financial statements and provide client referrals to invest in their ventures.
Persons promoting these ventures often display some common characteristics when approaching professionals whose services they seek to retain:
· Flash – Displays of personal wealth are used to bolster their image as successful entrepreneurs. In many fraudulent investment schemes, the central character involved in raising capital is charismatic, has strong sales skills, and maintains a lifestyle intended to display economic success.
· Contacts – The principal or promoter of a marginal or fraudulent new venture often takes care to mention a number of contacts in their industry or the financing community. Fraudfeasors also may use assistants to help them deceive professionals who don’t independently check references by providing the professional with phone numbers for their contacts and having the assistants pose as the contacts.
· Hottest new venture since... – The principal or promoter will compare the product or service of their venture to that of a highly visible and successful start-up company. They use this comparison to emphasize the market demand for their firm’s product or service, and suggest that the firm will need extensive professional services in the near future due to the anticipated rapid business growth.
· High Tech, Bio Tech, or “Fraud Tech”... – Highly technical products or services are favorites of shady promoters. Both investors and professionals who lack the technical knowledge to understand how the product or service is used and the market for it are targeted to invest in or provide service to the business. Medical research and information technology ventures are good examples of the kinds of businesses promoted by these individuals.
Persons promoting these ventures seek out established CPA firms to lend credibility to their business as they pursue investors. They may request a non-attest service such as the compilation of the company’s prospective financial statements and provide assurances about limiting the use and distribution of the compilation report. Certainly, while most start-up ventures are legitimate and have a need for such services, it behooves CPAs to approach such engagements with caution and to do their homework prior to accepting new clients under these circumstances.
Risk Management: Client Screening for “Start-Up” Companies
· Thoroughly investigate any principals and promoters of a “start-up” venture seeking financial statement services. Request references, and independently verify the reputation, experience, and contact information of the parties listed as references prior to contacting them. Verify the background, experience and credentials of the principals and promoters of the venture. Be especially cautious if one or more of the principals recently relocated from another state, and investigate the experience and reputation of their prior business ventures. If the identities of the owners or principals of the business venture are not disclosed to you, do not accept the venture as a prospective client.
· Contact the managing principals at any professional service firm which the prospective client indicates they have retained or will retain, and verify that the firm has agreed to perform services. Inquire about the extent of client screening that firm performed and the results.
· Investigate the business and its product or service. If the CPA firm lacks relevant industry experience, decline the proposed engagement. Many firms are lulled into a sense of complacency when compiling prospective financial statements for a start up venture because they view the level of service as “low risk”. Performing any level of financial statement service for a client in an industry in which the firm lacks experience presents elevated risk, and start-ups are especially risky due to the high rate of failure. If the CPA firm has relevant industry experience, use industry contacts to inquire about the business, its principals, and the market and competition for the product or service. Be especially cautious of businesses that are heavily dependent on products in the research and development stage or products with short life cycles. Service providers introducing a new and untested service should also be approached with caution, such as those providing Internet-based services.
· Consider the extent to which management representations must be relied upon to perform the requested service, even in non-attest engagements. Accept only those clients wherein background checks indicate client management has the requisite training and experience in that industry and has operated ethically in the past. Disclaimers and disclosures in engagement letters and reports aid in the defense of malpractice claims, but do not prevent claims from being made when substantial amounts of money are lost.
· Maintain professional skepticism, and “trust your gut”. CPAs who have experienced malpractice claims as a result of the unethical conduct of a short-term client often indicate they had a “funny feeling” about accepting the client based on the client’s behavior, but accepted the engagement anyway. If you have doubts about the integrity or ethics of client management or believe that the individual or venture may be engaged in illegal or potentially illegal activities, decline the engagement.
Most “start-up” companies are legitimate and can be excellent long-term clients for CPA firms. However, when supply exceeds the demand for private capital, there will be unscrupulous operators seeking investment capital for marginal businesses, and establishing an association with an established CPA firm is one of their first orders of business. Performing appropriate client screening is the most effective method to avoid becoming associated with such ventures.
November 2007
By Joseph Wolfe, Assistant Vice President, Risk Control, CNA,
The purpose of this article is to provide information, rather than advice or opinion. It is accurate to the best of the authors’ knowledge as of the date of the article. Accordingly, this article should not be viewed as a substitute for the guidance and recommendations of a retained professional. In addition, CNA does not endorse any coverages, systems, processes or protocols addressed herein unless they are produced or created by CNA. Although based on actual cases, the facts depicted herein are fictitious. Any similarity to real people or cases is unintentional and purely coincidental.
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