6 Pitfalls to Avoid When Merging Your CPA Firm
You canâ€™t hold back the demographic tide. In the U.S., another baby boomer turns 60 every eight seconds. This translates into a leadership change in the near future at many CPA firms. In anÂ important articleÂ in theÂ Journal of AccountancyÂ last year,Â John F. Raspante, CPA, and Joseph A. Tarasco, CPA explain:Â
Thousands of partners are at or reaching retirement age now and in the next five years, putting a tremendous strain on even the best succession plans. But age isnâ€™t the only factor affecting the profession. Factors such as increased globalization and turmoil in the general economy causing greater competition have been analyzed previously in theÂ JofAÂ (see â€śAccounting Firm M&As: A Market Update,â€ť Nov. 2010, page 30).Â
Â For many firms, an M&A strategy will be the solution to these problems.Â A thoughtful merger with another firm can solve lots of problems.Â It may help a firm increase revenues and grow at a faster pace to maintain a competitive edge within the marketplace. Â It helps obtain niche and industry experts as the marketplace moves more toward specialists and away from generalists. Â It can overcome succession-planning issues by merging in partners who have leadership and practice development skills. Â And it can expand the firmâ€™s geographic market; improve the chances of attracting better quality staff; and spread the cost of marketing, human resource and IT professionals over a larger base.
But there are pitfalls facing any firm as it plans growth and exit strategies. Â Here are six to beware: Â
Our experience in advising firms has revealed several specific M&A traps, which are highlighted in this article, that are often overlookedâ€”and that unwary firms can fall into amid time constraints and pressure to finalize a merger.
TRAP: RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS
The discovery of possible misstatements in financial statements reported on by a predecessor auditor has historically created challenges for the successor auditor. Firm mergers and acquisitions complicate those challenges.
Scenario: Predecessor firm P audited the financial statements of XYZ Corp. and issued an audit report for the year ended Dec. 31, 2009. Successor firm S audits XYZ for the year 2010 and expects to issue an audit report on comparative financial statements for the years ending Dec. 31, 2009, and Dec. 31, 2010. During the audit of XYZ, S becomes aware of information that leads the firm to believe that the financial statements of XYZ issued by P in 2009 require revision.
The P partners disagree with the need to revise the financial statements and object to any restatement. The merger agreement is silent as to which firmâ€™s professional judgment governs this dilemma. In addition, the merger agreement includes a one-year de-merger period, which has not elapsed and is creating additional pressure during the discussions on how best to resolve this problem.
Possible ramifications and considerations for S and P:
- S can resign from the engagement if it is not satisfied with the technical resolution to the potential financial statement revisions. This could be a significant problem, as XYZ is a major client of P and its loss as a client may lead to a de-merger of the firms. A more comprehensive and detailed due diligenceâ€”evaluations and inquiries made before a merger or acquisitionâ€”may have detected this problem early on and resulted in a simple resolution. Greater due diligence is recommended when merging firms have as clients startup companies, shell companies, larger companies, companies with liquidity and cash flow problems, and companies in nontraditional industries and other businesses that could be considered high-risk. For example, the due diligence might be extended to review more closely the potential merged firmâ€™s workpapers dealing with going concern or other emphasis-of-a-matter disclosures and the engagement teamâ€™s adherence to AICPA audit guides relating to nontraditional and higher-risk industries, as well as the firmâ€™s competency capabilities and realistic basis for completing higher-audit-risk engagements.
- Since the merger agreement doesnâ€™t address this issue, S should refer to the AICPA professional standards and use professional judgment regarding the need to restate.
- If S and P agree no restatement is necessary, they could issue comparative financial statements and make reference to Pâ€™s audit in the auditorâ€™s opinion paragraph of S. Alternatively, S could issue comparative financial statements that donâ€™t refer to Pâ€™s audit in the auditorâ€™s opinion paragraph.
It should be noted that similar risks apply to compilation and review engagements. The firms must balance the clientâ€™s needs, professional standards and the ultimate success of the merger.
TRAP: POST-TRANSITION ENGAGEMENT LETTERS
Scenario: P merges with S after P has issued and received signed engagement letters from its clients. S now must decide if and how it should issue updated or initial engagement letters to Pâ€™s clients.
Possible ramifications and considerations for S and P:
- One option might be to do nothing and wait until the next year to obtain new signed engagement letters. This may appear to be a practical solution, but itâ€™s risky. If a client of Pâ€™s believes S subsequently performed unauthorized or unexpected work beyond the scope agreed upon, there could be a breach-of-contract claim, particularly if P failed to make the client aware of the merger.
- They might instead issue new engagement letters to every client under the name S. For large firms, this could involve sending out hundreds or thousands of letters, which can be costly and time-consuming to oversee.
- Perhaps the most satisfactory outcome is if P had the foresight to include successor-and-assigns language in its engagement letters. This language allows S to service acquired clients with reduced fear of liability or contractual breaches. The required language varies by state, but the general content usually contains language such as, â€śAny rights which inure to the benefit of [the predecessor firm] pursuant to this engagement letter shall inure to its committed successors an interest by way of merger, acquisition or otherwise in their committed assigns.â€ť Inserting this language in engagement letters in contemplation of a merger makes the transition smoother for S and P and their clients.
TRAP: BREACHES OF CLIENT CONFIDENTIALITY
Scenario: Your firm is considering merging with or being acquired by another firm, which will conduct a due-diligence process of your firmâ€™s financials, agreements and other records. State accountancy boards, regulatory agencies and professional membership organizations have detailed rules regarding protecting clientsâ€™ confidential information. How can you avoid violating those rules if the merger transaction is not finalized?
Rule 301-3 of the AICPAâ€™s Code of Professional Conduct, â€śConfidential information and the purchase, sale, or merger of a practice,â€ť provides guidance in these circumstances:
Rule 301 prohibits a member in public practice from disclosing any confidential client information without the specific consent of the client. The rule provides that it shall not be construed to prohibit the review of a memberâ€™s professional practice under AICPA or state CPA society authorization.
For purposes of rule 301, a review of a memberâ€™s professional practice is hereby authorized to include a review in conjunction with a prospective purchase, sale, or merger of all or part of a memberâ€™s practice. The member must take appropriate precautions (for example, through a written confidentiality agreement) so that the prospective purchaser does not disclose any information obtained in the course of the review, since such information is deemed to be confidential client information.
Members reviewing a practice in connection with a prospective purchase or merger shall not use to their advantage nor disclose any memberâ€™s confidential client information that comes to their attention.
Possible solution for S and P:
- Require potential buyers or merger candidates to sign a separate confidentiality agreement that protects each party from client infringement and use of client information outside the due diligence process.
TRAP: OVERLOOKED PARTNERSHIP AND EMPLOYMENT AGREEMENTS
Scenario: As the merger documents are about to be finalized, a retired partner from the firm being acquired unveils an agreement stating he is entitled to receive an accelerated retirement payout when the merger is consummated due to a â€śclawback agreementâ€ť he has signed.
The potential exposure for overlooked written and verbal supplementary agreements extends to current partners and employees, as well. In many of these cases, the arrangement may have been made years before the deal discussions, and everyone except the partner or employee affected was ignorant of the agreement or its terms.
- Pre-M&A due diligence is the best defense against unexpected problems with overlooked agreements. Ask current and retired partners if they are aware of any additional partner-level agreements or if any agreements have been made with nonequity partners or staff.
TRAP: DISGRUNTLED PARTNER LEAVES WITH CLIENTS
Scenario: A partner in the acquired firm decides she doesnâ€™t like the merger deal terms and leaves the firm, taking clients with her.
Thereâ€™s always a chance that one or more partnersâ€”equity or contractâ€”will be dissatisfied with the M&A terms. If that partner or partners leave during the negotiations and take a significant amount of business, it could change the value of the deal and potentially kill it.
- Include an enforceable noncompete provision in an amendment to your partnership agreement prior to the M&A negotiations. State laws on noncompete agreements vary, so check to make sure the terms are enforceable.
- Meet with disgruntled partners early in the M&A discussions to negotiate fair withdrawal terms that will avoid the necessity of killing the deal months after negotiations commence.
TRAP: POST-ACQUISITION LIABILITY EXPOSURE FOR PRIOR WORK
Scenario: Your firm merges or acquires another firm. You inform your carrier about the acquisition and cancel the acquired firmâ€™s professional liability insurance because the combined successor firm doesnâ€™t need two policies.
Consequently, P has no coverage for past work. Statutes of limitation against CPA firms for general negligence and breach of contract vary among statesâ€”New Yorkâ€™s is three years and New Jerseyâ€™s is six years, for example. Failing to consider Pâ€™s potential liabilities for past work creates a major exposure for S.
- Have P obtain the longest tail policy available. Tail insurance, formally known as extended reporting period, continues your ability to defend claims after the claims-made policy is out of force. This covers the risk of a claim made against the acquired firm for work before the acquisition and is the preferred solution. Tail policies typically cover three to five years. The coverage is expensive because the policyâ€™s full cost is due upfront, but consider getting three-year coverage for maximum protection.
- If the same insurance company covers both parties to the merger, ask the insurer to use the earlier of the two firmsâ€™ retroactive (â€śretroâ€ť) dates. For example, if the acquiring firm has a retro date of 2005 and the acquired firmâ€™s retro date is 2000, ask the insurer to approve a retro date for the acquiring firm of 2000. This eliminates the need for a tail policy, but it has a drawback: The acquiring firmâ€™s liability limit now applies to claims against both firms. It creates a potentially unlimited exposure for claims above the acquiring firmâ€™s policy limit, particularly if the combined firms encounter multiple claims.
Read the whole piece here.Â
Advance Planning Makes Transitions Easier