A War Storyn

A War Story

By Ric Rosario

Editor’s Note: “War Stories,” drawn from Camico claims files, illustrate some of the dangers and pitfalls in the accounting profession. All names have been changed.

Subject: Buy-Sell Transactions

Ernest Brier was looking for a business to purchase in the $5 million to $10 million range. He consulted with his accountant, Sylvia Locke, CPA, who began to network among her clients and other contacts for businesses that might be interested in selling in that price range.

Locke found that one of her other clients, High Tech Publishers, is interested in selling. High Tech produces CDs, user manuals and product packaging for computer software companies. It also has a wholly owned subsidiary, Net Load, which helps customers download software via the Internet.

Brier asks Locke to prepare audited financial statements and a balance sheet for High Tech before negotiations for a sales price begin. High Tech also has a lot at stake in the transaction, so Locke is retained by both Brier and High Tech to perform the work. Locke determines the net cash flow of High Tech for the just-ended fiscal year, and Brier and High Tech agree to a sales price of seven times the net cash flow, a sum of $8.4 million.

Some of the High Tech’s accounts receivable are somewhat in doubt, so part of the agreement negotiated between Brier and High Tech is that High Tech will pay Brier the amount on an account receivable if and when it goes bad. Almost as soon as the purchase is finalized, High Tech accounts receivable begin to go unpaid at a much faster rate than anticipated. While High Tech makes good on its payments to Brier, he realizes that he paid seven times the price of those bad debts in the sales price he negotiated.

Now unhappy about the deal, he begins to look for other things in the financials that might be wrong. He finds that a number of sales between High Tech and its subsidiary, Net Load, were included in the net cash flow figure when they should have been excluded. This error was also multiplied by seven in the sales agreement. By now Brier is truly upset. He files a lawsuit against High Tech and Locke, alleging that the financial statements contain material misstatements.

High Tech is now having to spend money to defend itself against a lawsuit, and the company officers are worried about having to forfeit some of the money paid to High Tech by Brier if they lose the suit. They also sue Locke, alleging that her lack of due care is damaging their company.

Loss Prevention Tips

Following are six areas to consider in buy-sell transactions:

1.) Some of the first questions CPAs need to ask themselves in situations with potential for conflicts of interest are:

Who is the client?
Where does my duty flow?
Are there conflicting duties?

CPAs need to make sure that all parties involved are clear on who the client is (“clear” means putting it in writing).

2.) If there are possible conflicts:

Will a signed consent form waiving any conflict of interest help? (Remember not to get too comfortable with disclosure as a form of protection, as it can be argued later that the client’s consent was not “informed” by a third party, such as an attorney.)
Would it help if all parties got a second, independent opinion?
Are you walking into a snake pit?
Should you disengage before it becomes a mess?
Discuss your situation with your risk advisor or attorney.

3.) Have you evaluated what you are being paid to do? Are the few chargeable hours and the initial pat on the back worth the risks associated with the deal if it falls apart? Do a risk/benefit analysis.

4.) Are you qualified to perform the services the parties are requesting? Have you used the necessary precautionary language in writing that forewarns all parties? If something goes wrong and it ends up in court, CPAs who are qualified will evaluate your work. You should be comfortable that your work will stand up to this test. Even if the client would prefer to do something simple, cheap and quick, this does not replace your responsibility to follow standards.

5.) Have you considered how your work product will be used by all parties? Extra attention needs to be paid to the parts of the work that are going to be relied on for critical or high-risk transactions.

6.) How familiar are you with all the parties involved? Are they litigious? Are they “push the envelope” type personalities? Understand them well.

Ric Rosario, CPA, CFE, is vice president of risk management services with Camico Mutual Insurance Co. A certified fraud examiner, Rosario advises Camico’s policyholders and other CPAs on loss prevention principles and techniques.