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| July 2004 | The
Monthly Newspaper of the NYSSCPA |
Vol.
7, No.10 |
A War Story: Client Acceptance
By Hunter Colby
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.
Mark Spencer, CPA, was the principal of an accounting firm that specialized primarily in attest work for community savings and loans and mortgage companies and brokers. At a time when he was feeling a little bored with the lending industry and restless to try something new, one of Spencer’s mortgage broker clients referred a wealthy property developer, Gilbert Baker, to the CPA for accounting and attest work. Baker had fired his previous accountant and was anxious to find another one quickly.
Baker had a reputation as a hard-nosed businessman who had made a fortune from buying and rehabilitating distressed commercial properties and selling them for substantial profits. Spencer attempted to communicate with the predecessor CPA firm and found that the firm partners had dissolved the firm and ceased operations. Furthermore, Baker was suing the previous accountant, a member of the dissolved firm, who was unwilling to communicate with Spencer because of the pending lawsuit. Spencer obtained a copy of the complaint on file with the court and learned from it that Baker was alleging negligence in an audit of a small company he had purchased.
Spencer made inquiries about Baker among other CPAs and business associates. Based on those inquiries, Spencer surmised that the developer had a constant need for complex work to be performed, which would result in a steady stream of large accounting and auditing fees. Spencer had experience in property development accounting from several years earlier but would need to invest some time into getting back up to speed in the area. He was the only CPA in the firm with that type of experience, but he figured he could delegate his other work to his associates while concentrating on Baker. Spencer then spent several days, and a few sleepless nights, trying to weigh the risks of doing business with Baker against the opportunities and fees the business would generate. He ultimately decided to accept the developer as a client.
Spencer began auditing Baker’s financial statements but was handicapped by the lack of information he was able to receive from the predecessor CPA, and Baker was much too busy to be of any help to Spencer. The CPA nevertheless managed to complete work on his first audit of Baker’s business financial statements.
A few months later, Baker signed an agreement to sell a large office complex to Professional Properties. Before the agreement was signed, Spencer issued Baker’s financial statements to the developer and several other entities, including Professional Properties. Soon after the agreement was signed, a large retaining wall holding back the hillside behind the complex failed during a heavy rainstorm, allowing a massive mudslide to damage and disrupt business in an entire wing of offices.
Professional Properties then refused to honor its agreement to buy the complex, claiming that Baker’s failure to disclose the faulty retaining wall rendered its agreement null and void. Baker then sued Professional Properties for a breach of contract. During the discovery phase of the litigation, attorneys for Professional Properties learned that Baker’s audited financial statements failed to disclose two cases of pending litigation against him, as well as another lawsuit Baker had brought against another party (in addition to his suit against the prior CPA).
Professional Properties then claimed that the flawed financial statements further nullified its agreement to purchase property from Baker, and the jury agreed, thereby voiding the agreement. Baker then sued Spencer for negligence in his audit work.
Loss Prevention Tips
A background investigation of Baker would have provided the CPA with a history of litigation by the developer against auditors and others in his attempts to recoup unexpected business losses. In this case, an investigation would have also shown that Baker’s lawsuit against the predecessor CPA was without merit.
The CPA’s knowledge of the lawsuit against the predecessor CPA, and his difficulties in communicating with the predecessor, should have led him to the conclusion that the engagement risks were not worth the potential rewards derived from it.
“Dabbling” outside a firm’s areas of expertise has been shown to produce unusually high loss ratios. Furthermore, the construction, real estate and financial industries are notorious for disputes being settled by litigation. Other high-risk engagements include:
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limited partnerships;
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public offerings, IPOs and SEC work;
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audits;
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financial services;
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trustee work;
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buy/sell transactions;
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valuations;
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computer consulting; and
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any deals that look too good to be true.
Camico has long recommended client screening policies and procedures, now standard practice in the accounting profession, as the first steps to an effective loss control program. AICPA Practice Alert 2003-03, “Acceptance and Continuance of Clients and Engagements,” describes in detail the rationale and components of client and engagement screening processes. The full text of the alert can be found online at www.aicpa.org/download/cpaltr/2004_01/supps/pajan04.pdf.
Hunter Colby, J.D., is a claims specialist with Camico Mutual Insurance Co. and has more than 17 years of experience in claims. He earned his bachelor’s degree from State University of New York at Stony Brook and his law degree from Peninsula University in Mountain View, Calif. Colby is a member of the California State Bar Association.
