Here we go again.
Long time readers of Risk Management Resource may recall a Winter 2003 article entitled “Managing Risk in a Slow Economy.” That article discussed the importance of maintaining industry expertise and current training on changes in professional standards, considering the risks associated with performing a requested service under the circumstances, knowing market conditions affecting clients, and the importance of good file documentation.
In 2008, market conditions are again deteriorating. The slowdown in escalating real estate prices, followed by the collapse of the sub-prime mortgage market, started the ball rolling. The days of “easy credit” for both personal and commercial loans are over, at least for now.
Clients in financial distress are under pressure to reduce expenses and maintain their financing to make it through lean times. Clients who are both ethical and astute business managers are best equipped to weather the storm. Those who hesitate to make tough decisions regarding expense and staff reductions, and do not take a realistic approach to forecasting sales and income, are more likely to fail. Irrespective of the reasons, clients in financial distress present elevated risk to the CPA firms that serve them.
The most immediate risk to CPAs is collection of fees. Managing accounts receivable collection can help CPAs reduce the risk of experiencing both unpaid fees and malpractice claims. It is important to collect fees at the time of service, or when the report or tax return is delivered. CPAs need to be prepared to terminate clients that are unable or unwilling to pay their bills on time, but first consider the potential impact on the client. If a client is in danger of missing a governmental, regulatory compliance or tax deadline as a result of withdrawal or withholding of reports or tax returns, consultation with an attorney and the professional liability insurer should take place prior to taking action. Review Interpretation 501-1 of the AICPA Code of Professional Conduct, Response to Requests by Clients and Former Clients for Records, regulatory requirements, and state board of accountancy regulations prior to responding to demands for records from delinquent clients, as these may affect your ability to withhold records. Withholding client records due to unpaid fees is considered a disreputable act under some state board of accountancy regulations.
Additionally, take a look at your engagement letters. They should specify how you bill for services, your rates, and when payment is due, as well as the consequences of late payment or nonpayment of fees. For more information, see the practice aid included in the reference list.
If, after consulting with other owners in the firm, it is deemed appropriate to continue servicing a delinquent client for a period of time due to the seasonality of their business or some other factor, the CPA should consider meeting with the client and requiring them to sign a promissory note in the amount of the outstanding fees plus the firm’s customary financing charges prior to performing any additional services. Consultation with an attorney about the content of this legal document is necessary to ensure it is enforceable under applicable state laws. When performing attest work, the firm should also evaluate the effect of client delinquency on independence. Remember that the AICPA Code of Professional Conduct (ET Sections 191.103 -.104) provides that independence is impaired if billed or unbilled client fees remain unpaid more than one year prior to the date of any report issued in connection with an attest engagement.
Requiring a delinquent client to sign a promissory note can limit the risk that the client may later dispute the amount of fees owed. This, of course, does not eliminate the risk that this debt may not be collectible, but it does simplify collection proceedings if this becomes necessary, and helps minimize the risk of counterclaims alleging that the service was in some way defective. It’s harder for clients to support a claim alleging that previously rendered services were defective if they already signed a promissory note agreeing to the amounts owed for those services.
The other and more significant risk of association with clients who don’t manage their business effectively in tough times is the risk of exposure to malpractice claims from the client’s partners, shareholders, and lenders. Many CPAs mistakenly presume that in a closely held business or partnership, blame for the failure of a business will fall squarely on the managers or general partners. While it’s true they are directly in the line of fire from those parties who have suffered losses, CPAs who render attest or consulting services to clients can get caught in the crossfire, albeit for different reasons.
Risks to Auditors
When a business fails, auditors typically are sued under a theory that the client’s financial statements were not presented fairly in accordance with GAAP, and had the statements been correct, the stakeholders would have taken action at an earlier date to reduce or eliminate the losses they incurred. Often the allegation is that accounts receivable were overstated, and that write downs should have been taken or larger loss reserves established in an earlier year. Other times, there are allegations that certain assets were impaired but not written down on the financial statements, and that the auditor conducted insufficient procedures to independently verify their value. Another common allegation is that the footnotes to the financial statements did not adequately disclose related party transactions and that as a result, the financial statements were misleading.
Managing these risks in an audit engagement comes down to the basics of quality control and the application of professional judgment. Auditors “...must obtain sufficient appropriate audit evidence by performing audit procedures to afford a reasonable basis for an opinion regarding the financial statements under audit” (AICPA Professional Standards, SAS No. 105, Generally Accepted Auditing Standards). The risk assessment auditing standards (SAS No. 104 – 111) require auditors to assess a client’s business risks and develop an audit approach and strategy to reduce audit risks to an acceptable level. In an economic downturn, auditors should give special considerations to fraud risk factors that exist in the client’s business environment and how they could be triggered by market conditions.
While compliance with professional standards and quality control are always important, another key consideration for high-risk audit engagements is the need for concurring review. A thorough review of the audit program and working papers and discussion between the concurring reviewer and the auditor can help identify any potential problem areas, and assess compliance with the risk assessment standards, as well as the audit documentation requirements contained in SAS No. 103. If a firm does not have internal resources to perform quality review, the firm should consider engaging, after obtaining written consent from the client, another firm's auditor who is independent from the client and has the knowledge and experience in audit technical, industry practice, and regulatory requirements pertinent to the audit.
Risks to Consultants
Sustaining a cause of action against a consultant in connection with business advice provided occurs much less frequently than claims against auditors, but clients facing financial difficulties may attempt to blame their consultants for their problems. CPAs who are deeply involved in providing ongoing advice to clients who are attempting to manage a financial crisis sometimes unwittingly “cross the line” and expose themselves to third-party claims. Usually this occurs because the CPA is providing ongoing information to lenders and stakeholders about actions client management is taking to manage through the crisis. Often clients feel their actions will be viewed as more credible if these parties hear about them from the independent CPA. Contact with third parties erodes privity defenses available to CPAs in most states. Privity is generally defined as a connection or mutual interest between parties, established by contact or contracts between them. Avoiding third-party contact on behalf of clients helps avoid the unintentional establishment of privity.
The exposure associated with providing consulting advice to clients in financial distress is more easily managed than for auditors. First, consultants should always carefully consider why the client is asking them to talk to third parties about their business. Is the contact necessary, or could the information just as easily be conveyed by client management? Casual conversations with client’s lenders and other stakeholders can lead to claims alleging damages incurred due to reliance on the information provided by the consultant. If third parties are requesting copies of reports produced for clients, they should be redirected to the client for this information. Essentially, consultants provide advice to their clients, and clients determine whether to act on these recommendations. Consultants’ advice or recommendations are not intended for third-party use. And therefore, third parties should not be put in a position to claim reliance on the advice or recommendations. Consultants can also limit their risk by restricting the use and distribution of their consulting reports or other work products.
Additionally, unlike auditors who must contend with independence rules, consultants can use provisions in engagement letters to try to limit their liability and to have their clients hold them harmless in connection with claims made against them by third parties. A discussion of this subject, including sample engagement letter language, can be found in the practice aid Preparing and Using Engagement Letters, available to AICPA Professional Liability Insurance Program policyholders in the
In an economic downturn, CPAs typically face an increased risk of malpractice claims. The last significant economic downturn affecting CPAs occurred in the early 1980s. Initially, many real estate development and construction firms failed, and problems later spread to other types of businesses caught in a credit squeeze; in some cases, their CPA firms got caught in the crossfire. Clients rely on their CPAs for advice and service in good times and bad times. However, identifying clients in financial distress and closely monitoring how the client responds to the crisis, the services provided, and bill payment can help CPAs manage the risks attendant to an economic downturn.
References:
Preparing and Using Engagement Letters, published by Continental Casualty Company, June 2006, available to AICPA Program policyholders at www.cpai.com.
Assessing and Responding to Risks in a Financial Statement Audit (Parts I and II), by John A. Fogarty, Lynford Graham and Darrel R. Schubert, Journal of Accountancy, July 2006 and January 2007
Booms, Busts and Fraud, by Paul Povel, Rajdeep Singh, and Andrew Winton, The Review of Financial Studies, July 2007
How to Nab the Rogues: 10 Fraud Tips, by David M. Katz, CFO.com, January 30, 2008
February 2008
By Joseph Wolfe, Assistant Vice President, Risk Control, CNA,
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