Professional liability risk stemming from CPA firm acquisitions – part 2

Editor’s note: This is the second in a two-part series.

Part 1 of this series (see “Professional Liability Risk Stemming From CPA Firm Acquisitions — Part 1) discussed the hot CPA firm merger-and-acquisition (hereinafter, “Transaction”) market and how failure to perform sufficient due diligence could lead to professional liability claims. In part 2, we cover negotiating the purchase agreement (hereinafter, “Contract”), post-acquisition integration, and how risk can arise during these important Transaction phases.

Negotiating the deal

Negotiating any deal is often about the numbers. While financial metrics are important, there are other, sometimes underappreciated, aspects to be addressed before inking the deal.

Seek professional advice

Firms making acquisitions (hereinafter, “Survivor”) of another entity (hereinafter, “Target”) are advised to seek their own attorney to help navigate legal complexities, negotiate the deal, and draft the purchase agreement.

Evaluate professional liability insurance coverage

If coverage for future claims is not addressed during negotiations and a claim subsequently arises, differences in the Survivor’s and the Target’s coverages can lead to significant disputes between the parties, coverage gaps, or uninsured exposures for firm owners.

During negotiations, the Survivor should review the Target’s professional liability coverage with its own insurance agent or broker and modify the Contract to include, among other items:

• How coverage for the Target’s acts prior to the Transaction date will be addressed;
• The Target’s responsibility to purchase extended claims reporting period coverage, also known as a “tail,” if prior acts are not assumed by the Survivor;
• Required policy limits and terms;
• Deductibles and the party responsible for their payment; and
• Considerations in the event of death, disability, or retirement of any of the owners, or the dissolution of the combined business entity.

Address work-in-process

Unless responsibility for completion of pending engagements is specifically addressed in the Contract, the Survivor is typically responsible for finalization of incomplete engagements and issuance of work products post-Transaction.

The Survivor should review work-in-progress on all audit engagements, significant tax engagements, and other high-risk engagements. Ideally, this process is performed sufficiently in advance of the Transaction date to address any relevant issues and determine how to proceed.

Integration

One might think a sigh of relief is warranted when the Transaction is finally closed, but the real work has only just begun. Effort is not only required to reap the financial benefits of a transaction, but also to manage the professional liability risks of the Survivor, which may have grown exponentially overnight.

As Warren Buffett said, “An idiot with a plan can beat a genius without a plan,” so have a plan for integration.

There’s no ‘I’ in team — operating as one firm

Claim: Due to the Target’s remote location, the Survivor hosted a series of virtual “onboarding” sessions after the Transaction, but for only a month. After that, the Target was largely left on its own. The Target reverted to its old practices and siloed approach to client service. A Target’s client asked about the recommended structure for its foreign expansion, but the Target did not consult the Survivor’s international tax expert. If so, a different structure may have been recommended. Instead, the client sued the Survivor when it changed firms and the new CPA identified issues with the current structure.

Risks: Failure to properly integrate personnel into the Survivor is likely to result in confusion and turnover and may lead to errors or omissions.

In the absence of clear communication and timely training, Target personnel may continue delivering services in accordance with the Target’s policies. If quality management gaps were identified during due diligence, these gaps may remain and create exposure for the Survivor.

Recommendations: Remember to address these four factors:

• Communication: Communicate the Transaction to staff of both firms simultaneously. Meet with key members of the Target’s staff to support retention and explain new opportunities available to them.
• Culture: How will the Survivor integrate the Target into its culture? If separate offices will be maintained, consider having experienced partners of the Survivor relocate to the Target’s office(s). Include Target staff in team–building exercises. Assign Target staff a “buddy” from the Survivor who emulates the Survivor’s culture. Incorporate Survivor personnel into Target engagements and vice versa.
• Training: Conduct mandatory training sessions, including training to address concerns identified during due diligence, for Target personnel on the quality management policies of the Survivor. The greater the differences in policies and procedures between firms, the more training and time it will take for Target personnel to adopt new practices.
• Compliance: Monitor adherence to quality management policies more frequently in the first two years of the integration.

What else is important? Proper integration of clients into the Survivor firm

Claim: The Survivor did not subject the Target’s audit clients to its full client acceptance procedures because of the Transaction’s January date and proceeded to finalize in-process engagements. Unfortunately, an independence issue was subsequently discovered, and a previously completed audit engagement had to be reperformed by another firm. The client sued the Survivor for the costs of re-audit.

Risks: Proper client and engagement acceptance is one of the best protocols for keeping risks out of the firm. While some evaluation of the Target’s client portfolio was likely performed during due diligence, the analysis may not have been deep enough, and the Survivor may not have properly identified risks outside their tolerance level.

Recommendations: Be sure to consider the following four areas:

• Communication: Work with the Target to communicate the Transaction to its clients, including any required consents to transfer client information to the Survivor.
• Acceptance: Subject all the Target’s clients and engagements to the Survivor’s acceptance protocols. Just because the client was a fit for the Target doesn’t mean that it’s a fit for the Survivor. If a client does not meet the Survivor’s acceptance requirements or poses an unmitigable risk, terminate the engagement. If an engagement must be completed due to an impending deadline, consider additional risk management protocols, such as a supplemental review. If the Survivor cannot review acquired clients individually, consider starting with higher–risk clients, at a minimum.
• Engagement letters: For any engagements that will be performed or completed by the Survivor, obtain new engagement letters. If the Transaction is imminent, consider having the Target adopt the Survivor’s engagement letters, including a provision that the Terms and Conditions of that engagement letter may be assigned to any successors of the Target.
• Onboarding: Onboard the Target’s clients using the Survivor’s onboarding process (see “Help Reduce Risk With Formal Client Onboarding,” JofA, April 2024). To follow the new “rules of the road,” clients first need to know them. For key clients, consider having Target and Survivor partners jointly onboard the client.

It isn’t just people — systems integration

Claim: The Target’s client was assessed a large penalty because the IRS did not receive the paper-filed tax return. The Survivor was unable to access the Target’s legacy system to obtain documentation to substantiate when the tax returns were provided to the client for mailing. A claim against the Survivor followed.

Risk: The longer the Target and Survivor use separate systems, the more likely conversion issues may occur. Additionally, separate systems create confusion and may create the illusion that the Target does not need to adopt the Survivor’s procedures and can operate “business as usual.”

Recommendations: Identify which systems will be used by the Surviving firm going forward and convert data as soon as practical. Prioritize systems used for client services.

The key to success

The lessons in this article can be applied to any size or type of transaction — from an acquisition of another firm’s client portfolio or niche practice to a merger of equal-size firms.

Take a lesson from Warren Buffett, someone considered to be one of the most successful investors ever, and “invest in companies you believe in.”

139: Number of mergers and acquisitions among the top 500 firms in the U.S. during 2024.
 
Source: Based on AICPA Private Companies Practice Section (PCPS) tracking.

Deborah K. Rood, CPA, MST, is a risk control consulting director at CNA. For more information about this article, contact [email protected].
 
A version of this article originally appeared in the Journal of Accountancy.