Assisting Troubled Business Clients: A Midsize Dilemma for CPAs

BY WILLIAM Y. CULBERTSON

  

 

EXECUTIVE SUMMARY

Experienced CPAs will often recognize early signs of financial distress when performing routine audits, accounting or tax services for a midsize business.

A turnaround requires decisive and confident leadership and a willingness to change. Top management is usually under stress at this point, requiring outside assistance to interpret the meaning behind the numbers, regain its bearings, restore confidence and execute a turnaround. CPAs may be the best qualified to offer assistance.

CPAs have specialized training and education, practical experience in examining business operations and assessing control environments, and have established relationships with their clients. These are intrinsic skills necessary to helping with a turnaround.

Follow this five-step process to conduct a turnaround: (1) Initial Assessment; (2) Planning; (3) Execution; (4) Stabilization; and (5) Fresh Start.

CPAs have a duty to protect the public interest when they attest to financial statements. If a CPA’s independence has been impaired by helping a client in a turnaround, future attestation engagements must be performed by others. The client may still be an important source of referrals.

William Y. Culbertson, Esq., CPA, MBA, is an associate professor at Northern Kentucky University’s College of Business. His e-mail address is culbertsonw@nku.edu.

Certain identifiable traits of financial distress are common to every troubled business, regardless of its industry or size. A thorough understanding of those traits is helpful in choosing a course of action. This article examines the anatomy of a turnaround from the perspective of practicing CPAs and explains why a privately held midsize company has the best chance of surviving when its outside CPAs actively participate in the solutions to its problems, even if the CPAs need to abandon their independence.

Often, when a Fortune 500 company gets into trouble and its stock price tanks, an investment banker is hired to “explore strategic alternatives,” the CEO is replaced, and the rest of the story is on public display. When a “mom and pop” business gets into trouble, the choices are much more limited—sophisticated outside help is too expensive, the CEO is the business, and the end result usually gets buried in annual statistics about small business failures.

But when a midsize business gets into trouble and fails to take corrective action, eventually its bankers lose confidence in management and often require a turnaround specialist as a condition for credit renewal. Chances are that the company’s independent accountants recognized the warning signs of financial distress more than a year earlier and, following the guidelines of Statement on Auditing Standards no. 59, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern, addressed the “substantial doubt” question using the same intrinsic skills and business analysis techniques that are essential to a turnaround.

Yet, in my experience, CPAs rarely offer to assist a troubled business client for two reasons: Either they aren’t familiar with how a turnaround works, or they are reluctant to abandon their independence. However, whether they realize it or not, CPAs speak the language of turnarounds and are frequently more qualified to assist a midsize business in financial distress, especially if the only alternative is a bank-recommended turnaround specialist. This article provides CPAs with the tools they need to understand and possibly assist clients with the turnaround process.

THE TURNAROUND CAMPAIGN—A COMMON-SENSE APPROACH
Turning around a troubled business takes more than reducing costs, increasing sales or restructuring debts, although CPAs already play a significant role in defining or assessing these problems. The classic management consulting approach to problem-solving is a three-phase process: Analyze the problem; plan a solution; implement the plan.

Modifying this approach to a turnaround campaign includes considering the common traits of financial distress discussed above and adding two more phases to the process. The five phases of the process, presented below, each carry a suggested role for the CPA. There is overlap between them in terms of goals and timing. Therefore, the solutions, like the problems they address, must also be interrelated.

Common Traits of Financial Distress

Individual warning signs usually appear in the numbers well before conditions reach a crisis stage, and an effective leader will recognize those that threaten the business. But, by the time a trend has developed or when warning signs appear in combinations, rather than isolation, chances are that financial distress has already arrived and brought with it questions about leadership.

There are two common categories of financial distress:

1. Early warning signs. Look beyond the numbers, whenever a warning sign appears, to properly identify the underlying cause-and-effect relationships. For example:

A revenue decline could indicate a tough new competitor has taken away market share, a major customer relationship has been damaged or the overall market has declined.

Aggressive price-cutting could cause a squeeze on margins but could also be due to supplier cost increases, operating inefficiencies or a high ratio of fixed-to-variable costs.

Deterioration of receivables aging could reflect late deliveries, customer cash flow problems, or delivered quality faults.

Experienced CPAs, whether performing routine audit, accounting or tax services for a midsize business, will recognize these and other indicators. Of course, each sign could be an aberration and would not be significant standing alone. However, the longer the numbers are ignored and underlying conditions deteriorate, the worse the odds are for achieving a successful turnaround.

2. The leadership question. A turnaround may be the most difficult transition a company goes through. It requires decisive and confident leadership and a willingness to change. These attributes are often noticeably absent under distress. Instead, the following traits are consistently found:

Management has lost sight of the company’s core strengths or lost touch with changing times.

Incumbent managers tend to resist change or underestimate how bad things can get.

Management loses key stakeholders’ confidence, both externally (bankers, customers and suppliers) and internally (employees, shareholders and management itself).

Management time is in short supply when it is most in demand, leaving important matters unattended.

These two categories of common traits are interrelated and an important insight into the anatomy of a turnaround. Top management is usually part of the problem and needs outside assistance to interpret the meaning behind the numbers, regain its bearings, restore confidence, and execute a turnaround.


PHASE 1: INITIAL ASSESSMENT (IA)
The first step is a blunt analysis of the company’s business model, assumptions underlying it, current conditions, and top management’s effectiveness, which defines the problems and serves as a benchmark for future corrective action. The primary goals of this phase are to determine whether management is able to articulate a clear, well-conceived business strategy that works for the company regularly, and to answer the threshold question: Can the company survive? This step typically takes two to four weeks.

The CPA’s role. This is similar to the requirements of SAS no. 59, but looks closely at management as part of the assessment process, much like the new going-concern standard currently under development by FASB. This is the most important service the CPA can first perform in assisting a troubled client. The threshold question is objective and not based on the subjective view of any single stakeholder, owner or banker.

If the CPA believes that top management is ineffective or that liquidation is likely, then do not expend resources on a lost cause. It is unlikely that assisting a client in this phase will impair the CPA’s independence since the CPA will only be providing the client with his or her recommendations and not making the ultimate decision to expend the resources to turn the company around.

 »  Practice Tip 1  

The CPA’s viewpoint is the most objective. This is important during an Initial Assessment. Banks want to get repaid and owners tend to be desperate.

One of my biggest mistakes in a turnaround engagement with a nonattest client was to allow a wealthy owner, who had financed a $20 million disaster with subordinated notes and personal guarantees, to postpone badly needed debt restructuring until after the turnaround had taken hold.

Although we were successful in attracting significant amounts of new capital and new business, the owner had privately hatched a “self-help” plan with the bank that derailed the entire process and ultimately spawned a number of lawsuits. CPAs should never subordinate their judgment about the feasibility of a turnaround.


PHASE 2: PLANNING
If the threshold analysis concludes the company has a fighting chance for survival, develop a detailed corrective action plan based on the IA findings and form a turnaround team to oversee its implementation. Keep plans simple to establish a clear sense of direction and begin to restore confidence in leadership. This step typically takes one to three months.

The CPA’s role. I believe the best turnaround teams are composed of the CPA, top management and legal counsel. Once this team is formed, they should satisfy themselves that the turnaround team has the knowledge and insight to address critical issues and the commitment to see the process through.

At this point it should be determined what the CPA’s role will be. Will the CPA continue as an adviser or become part of the decision-making team? Of course, whenever CPAs become part of the decision-making team (my preference), their independence will be impaired from that point forward.

Once the team has been formed, its initial focus is to develop corrective action plans and to select the best metrics for measuring performance. For example, the turnaround team will set targets for fixed-, variable- and hybrid-cost components that must be achieved for the company to operate above its break-even point. The same holds true in setting goals for debt restructuring based on underlying collateral values and debt-service capability. Assisting in developing the corrective action plan and recommending metrics should not impair the CPA’s independence unless he or she becomes part of the decision-making team.

 »  Practice Tip 2  

Legal counsel may be your greatest ally. CPAs are usually surprised to learn that lawyers have a professional responsibility to approach management of a troubled business and to make recommendations beyond narrow legal terms, perhaps even where advice is unwanted.

Not only do their ethics rules suggest that lawyers should try to overcome management’s resistance to change in such circumstances, they also state that lawyers should recommend consultation with accounting professionals or financial specialists when business matters involve problems within their domain. (ABA Model Rules of Professional Conduct, Rule 2.1, Comment 4.)


PHASE 3: EXECUTION

This phase employs two concepts:

(a) Divide-and-Conquer, accomplished by outsourcing extraordinary problem resolution so management can concentrate on controlling ordinary ongoing operations. The goal is to restore internal confidence by overcoming the critical shortage of management’s time and assuring that things don’t get worse.

(b) Before-and-After, meaning that the bottom line must be sacrificed to improve the company’s cash position (the “before”) in order to reach the targets established during the planning phase (the “after”). This allows the company to walk a tightrope from short-term survival to long-term viability without reaching the tipping point, by overcoming the other critical shortage (cash). This step can take one to 12 months.

The CPA’s role. The CPA should remain involved throughout the Execution phase. Whether the CPA chooses to be hands-on in helping to resolve extraordinary problems, or oversees a specialist brought in for that purpose, will likely depend on the precise problems and the client’s wishes. For example, while management is tending to major customers, supply chain issues and labor relations, the CPA (or specialist) can fend off threats, carve out non-essential assets, resolve disputes and/or negotiate standstill agreements.

On an ongoing basis, the CPA can help top management stay focused on what works, avoid what doesn’t, and fine-tune the performance metrics as needed, based on the insight gained during the IA phase. The key to solid execution and restoring confidence is being available to assist where needed and staying sincerely committed to the process. It is most likely that any involvement by CPAs in the Execution phase will compromise their independence.

 »  Practice Tip 3  

First, do no more harm. If top management is unable to maintain important daily activities without matters getting worse, in spite of the fact that additional outside resources have been brought to bear in the Execution phase, then either the threshold question was answered incorrectly in the IA phase, or top management is not up to the task or does not represent the best interests of the company.

Although it’s possible to turn around a troubled business while replacing top management, it’s more difficult, requires a different approach, and is beyond the scope of this article.


PHASE 4: STABILIZATION
This phase demonstrates that progress must be steady and sustainable. The primary goal is to restore confidence of external stakeholders, which means that internal stakeholders shouldn’t attempt to undertake growth strategies before stability has been established. A turnaround takes time, and bankers won’t believe it until they’ve seen it twice. This step takes one to two years.

The CPA’s role. Most CPAs have extensive experience acting as liaisons between business clients and important creditors or investors. This role is important after the turnaround has taken hold. The CPA can keep communication channels open and hopefully avoid “lender fatigue” that often affects relationships between a troubled business and its bankers. If the independence line was crossed earlier in the process, there is no going back at this phase; if not, CPAs should limit their communication with creditors during a turnaround campaign that is being executed by others, so as not to appear to be reporting on behalf of management.

 »  Practice Tip 4  

Get paid for such extraordinary work. CPAs who are willing to step forward and assist clients in dis­tress should require a replenishing retainer, just like a turnaround specialist would.

Of course, troubled businesses are already strapped for cash in most cases, but this objection should be easy to overcome by discussing priorities and pointing out that administra­tive fees are always paid near the top of the list of every Chapter 11 proceeding. Administrative costs associated with an informal restructuring like a turnaround are almost always less than a formal reorganization, but are just as important.

Moreover, the prospect of becoming a substantial unsecured creditor is hardly conducive to maintaining objectivity. CPAs who perform such a valuable service for their clients under demanding circumstances should expect to get paid for it in the ordinary course of business or, without exception, they should decline the engagement.


PHASE 5: FRESH START

This phase recognizes that money follows solutions. A turnaround is about retrenchment, not growth, because it’s hard for a business to grow its way out of trouble. Once the turnaround is complete and confidence is restored internally and externally, revisit business strategy based on lessons learned from the past. This step is typically reached after about two years.

The CPA’s role. Who better to help thecompany chart a new course than the CPAwho participated in the turnaround? Clients typically discover that the ingredients of a successful turnaround campaign provide valuable insights into the strategic direction and guidance needed for long-term prosperity. Moreover, in establishing a new business model, that client is likelyto need help finding new sources of capital and the CPA should be able to tell a compelling story.

The CPA can do many things in a turnaround campaign to assist a client-company without stepping into management’s shoes. In those cases where the CPA’s independence has been impaired due to the role played in a successful turnaround, future attestation engagements must be performed by others.

But when should CPAs be willing to abandon their independence by assisting troubled business clients? Why not leave it to the turnaround specialist instead?

 »  Practice Tip 5  

Beware of predators. I have learned from experience that some turnaround specialists may look for opportunities to liquidate for profit, perhaps because their interests don’t truly lie in saving the business.

In addition, private equity groups may be willing to provide fresh money at a steep price, which could result in a backdoor takeover. I encountered one specialist who put these two approaches together and managed to take over a midsize business without putting any capital at risk, while charging a management fee for the privilege.


WHY CPAs SHOULD HELP

One of the worst things that could happen to a client-company with a fighting chance for a turnaround and who recognizes the need for change is to be forced to choose a specialist from a banker-provided list. The bank will expect to be kept informed by the specialist; management may distrust them; and some turnaround specialists who work for banks tend to “tee-up” assets for bulk sale. That’s a liquidation, not a turnaround.

In fairness, a variety of professionals offer this kind of service. An Internet search turns up management consultants whose Web sites display impressive resources and credentials.

However, turning around a troubled business requires a level of commitment based on some degree of loyalty to the company. Moreover, many of these professionals are no match for the reputation, experience or competence of CPAs, plus CPAs already have an established relationship with, and insight into, the business.

Nevertheless, a major issue for CPAs tends to be the appearance of independence, which is best understood as a CPA’s duty to the public. CPAs must balance their duty to protect the public interest, whenever they have attested to financial statements, with their duty to the established client relationship.

Concerns about maintaining independence for the sake of rendering future opinions should be set aside in favor of the exigencies of the day, because saving the company and losing an audit client is better than the alternative. Moreover, the client that is saved today but relinquished tomorrow to another firm might prove to be an important source of referrals.

CONCLUSION
In my 30 years working with a number of companies in financial distress, I have often heard clients express frustration that their outside accountants raised the going-concern question but never offered to assist. CPAs don’t need to be experts in business turnarounds, but before their client’s fate is sealed, they should at least understand the process and offer to consult with a troubled business client whenever a turnaround specialist is brought in for that purpose. Hopefully, this overview of a turnaround campaign will give CPAs greater insight into what to do when they find that a valued client has been engulfed by this predicament. The general public and clients, in particular, will benefit if CPAs use their intrinsic advantages vital to the moment.

AICPA RESOURCES

JofA articles
Deepening Insolvency,” Feb. 08, page 40
Ethics Rules Get Tighter,” Dec. 06, page 59
CFOs for Hire,” April 03, page 35

OTHER RESOURCES
Association of Certified Turnaround Professionals, www.actp.org
Association of Insolvency & Restructuring Advisors, www.airacira.org
American Management Association, www.amanet.org
Turnaround Management Association, www.turnaround.org
Reorganizing Failing Businesses , Volumes 1 & 2, Weil, Gotshal & Manges LLP ( http://www.amazon.com/Reorganizing-Failing-Businesses-Volumes-2/dp/1590317149 )

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