Professional liability risk stemming from CPA firm acquisitions – part 1

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

The CPA firm mergers-and-acquisitions market remains hot! Whether firms are flush with cash after a private-equity infusion, operating in a growth mode, willing to take on debt, or taking advantage of Baby Boomers retiring, this trend is likely to continue.

Firms making acquisitions (hereinafter, “Survivor”) may overlook or shortchange professional liability risk that can arise from acquiring another entity (hereinafter, “Target”). This is especially true if a Survivor lacks experience with mergers or acquisitions (hereinafter, “Transaction”) or faces pressure from investors to grow. The haste to close a deal may lead to confirmation bias and ignored red flags.

Warren Buffett said, “We don’t have to be smarter than the rest. We have to be more disciplined than the rest.” Discipline starts with due diligence. Failure to perform sufficient due diligence could lead to professional liability claims, as highlighted in the following scenarios.

A CPA FIRM’S MOST VALUABLE ASSET? PEOPLE

Claim: A CPA firm looking to broaden its services to individual tax clients acquired a practice with two principals who represented themselves as personal financial specialists (PFSs). The market took a downturn, and a disgruntled client with substantial losses sued the Survivor for malpractice. Discovery revealed that neither of the Target’s principals had the professed PFS credential. The plaintiff attorney was able to tie this misrepresentation to other misrepresentations allegedly made to the client, complicating claim defense.

Risks: Professional liability claims can arise from a Target’s niche services. If the Survivor relies upon the qualifications of the Target’s personnel and lacks sufficient knowledge to oversee services delivered by the Target itself, undetected errors may arise.

Recommendations: Follow Buffett’s advice and “go into business only with people whom I like, trust, and admire.” During due diligence, evaluate the skills and reputation of the Target. Even if the Survivor provides the same services to similar clients, it is important to understand the Target’s qualifications.

Verify relevant experience, educational backgrounds, required licenses, and professional designations of the Target’s key personnel. Inquire about regulatory or disciplinary investigation history. Check state accountancy boards and professional associations to verify good standing.

CLIENTS ARE IMPORTANT, TOO

Claim: A CPA firm acquired a lucrative practice that served professional athletes. The Survivor did not subject these clients to its normal client acceptance procedures, instead relying upon the Target’s previous assessments. A claim from a superstar receiver arose three years post-Transaction, and the Survivor learned that the client had previously sued a prior CPA and other professional advisers. After protracted and very public litigation, the Survivor acknowledged that had they fully understood the risks associated with “celebrity” clients, and this client in particular, they may have approached the continuance decision, and the Transaction, differently.

Risks: Client and engagement acceptance and continuance processes are always critical, but especially during a Transaction that brings with it a large book of “new” business. Claims may arise from the Target’s high-risk clients if the Survivor fails to properly understand, identify, and manage the risk.

Recommendations: Examine the Target’s client and engagement acceptance practices and compare them to the Survivor’s policies. Just because a client was ideal for the Target does not mean it’s the right fit for the Survivor. Identify differences in client acceptance protocols. Review client lists and consider whether any clients are too great a risk for the Survivor to continue serving post-Transaction.

QUALITY IS JOB NO. 1

Claim: Bad habits are hard to break, as evidenced by what happened when a Target’s client needed post-Transaction advice about a partnership investment. The partner provided the potential tax implications to the client orally, even though the Survivor’s protocols required documentation. The partnership investment went bust, and the client asserted that she had invested only because of the partner’s recommendation. Without any documentation of the advice’s limitations, the claim was difficult to defend.

Risks: Targets that do not integrate quality protocols into day-to-day decisions may be more likely to have professional liability claims. Large gaps in the value placed on quality and in risk tolerance between the Survivor and Target will likely create challenges during integration and beyond.

Recommendations: Survivors can identify risks by evaluating a Target’s quality protocols during due diligence. Assess the Target’s tone at the top. Most CPA firms say they value “quality,” but what does quality mean to the Target? Does it have the same definition of, and attitude toward, quality as the Survivor? Is the Target’s risk tolerance similar to the Survivor’s?

Read the Target’s most recent peer review report and quality documentation. Focus on policies related to client acceptance, engagement letters, engagement assignments, documentation standards, and supervision and review requirements. Assess adherence to established policies through an inspection of a sample of workpapers and results of the Target’s internal review processes.

If a practice area does not have documentation, quality assessment will largely be based upon discussion. Ask how the Target monitors quality. Can the Target articulate its client acceptance process? What is the Target’s engagement letter policy? How are engagements assigned? Do partners work with multiple staff, or do they have “their” people?

Red flags may exist if the Target has little or no documentation, cannot articulate its quality protocols, or if the Target’s principals operate with a high level of autonomy and little oversight.

EVALUATE CLAIM EXPERIENCE

Claim: A Target’s loss run report included many small claims, but it was brushed off by the Survivor, as none of the claims were material. What the Survivor missed was a pattern of undisciplined behavior and a failure to learn from previous mistakes. This pattern continued post-Transaction when that lack of discipline resulted in a multimillion-dollar claim asserted against the Survivor.

Risks: The Target’s professional liability claim experience should be considered from the perspectives of firm culture, practice management, and quality. Claim experience also affects the availability and cost of insurance coverage.

Recommendations: Discuss the Target’s process for identifying and elevating actual and potential claims. Request a 10-year loss run report, which is typically provided by the Target’s professional liability insurance carrier. Review the nature of services, responsible personnel, and claim investigation results for any trends. Ask about lessons learned and protocols implemented or modified as a result. Mistakes happen to everyone, but how the Target responded, or failed to respond, to a claim speaks volumes.

AT THE END OF THE DAY, CULTURE IS KEY

Claim: A traditional CPA firm acquired a Target with a niche insurance practice to help it prepare for the retirement of its key insurance partner. Unfortunately, the Target’s and Survivor’s cultures were very different, leading to the departure of a significant portion of the Target’s personnel post-Transaction. Remaining engagement team members had little or no insurance experience. When state insurance regulators reviewed the Survivor’s audit reports, many problems were discovered, resulting in a ban from performing insurance company audits for 10 years and a referral to the state board of accountancy for disciplinary review.

Risk: If the Survivor and Target do not have compatible cultures, problems are likely to arise. Some problems may be purely financial, but others could result in a professional liability claim.

Recommendations: To quote Buffett, “Culture, more than rule books, determines how an organization behaves.” Use your network to understand the Target’s culture. If possible, talk to former employees, retired partners, and clients. Do you like the people with whom you are negotiating? At the end of the day, you will need to work with them.

THE NEXT STEP AFTER DUE DILIGENCE

Buffett said, “the difference between successful people and really successful people is that really successful people say no to almost everything.” Sometimes the right answer after due diligence is to walk away, but sometimes it isn’t, and a Transaction follows. But, as we’ll learn next month, addressing professional liability risk doesn’t stop after the deal is done.

2.32%: Difference in total shareholder return between serial acquirers (+1.42%) and one-time acquirers (-0.90%).

Source: Is Your M&A Organization Built to Win? The 2024 M&A Report, Boston Consulting Group, Oct. 16, 2024.

Deborah K. Rood, CPA, MST, is a risk control consulting director at CNA. For more information about this article, contact specialtyriskcontrol@cna.com.

Continental Casualty Co., one of the CNA insurance companies, is the underwriter of the AICPA Professional Liability Insurance Program. Aon Insurance Services, the National Program Administrator for the AICPA Professional Liability Program, is available at 800-221-3023 or visit cpai.com.

This article provides information, rather than advice or opinion. It is accurate to the best of the author’s knowledge as of the article date. This article should not be viewed as a substitute for recommendations of a retained professional. Such consultation is recommended in applying this material in any particular factual situations.

Examples are for illustrative purposes only and not intended to establish any standards of care, serve as legal advice, or acknowledge any given factual situation is covered under any CNA insurance policy. The relevant insurance policy provides actual terms, coverages, amounts, conditions, and exclusions for an insured.