CPAs can protect against malpractice claims by
being prepared…and putting it in a letter.

A Nice Niche—If You
Minimize Liability Risk

BY JOSEPH WOLFE AND SHERRY ANDERSON

hen opportunity knocks, a CPA may want to check what’s out there before answering the door. The good news is that increased activity in estate planning, succession planning and mergers or acquisitions involving small to midsize businesses has fueled client demand for business valuation (BV) services in recent years. A small number of CPA firms specialize in performing BV engagements, and for the many firms considering the risks and rewards of tackling this niche as a new practice area others’ missteps can provide valuable life lessons.

Data on malpractice claims made against CPA firms arising from disputed valuations offer a roadmap for avoiding trouble spots. Culled from 1995–1999 claims for more than 22,000 firms insured with Continental Casualty Co. (CNA—underwriters of the AICPA’s professional liability insurance program), the data highlight a scenario that’s easy to avoid. Most of those claims arose from a tax planning, management advisory or other consulting engagement that had morphed into business valuation in mid-transaction at the client’s request.

In such cases, business owners ready to sell their companies—and comfortable with their CPAs—had pressed the firms for BV assistance, regardless of whether the CPA was experienced in valuation. Firms with insufficient training to perform the BV let themselves be coaxed into it by the client’s assurances the CPA’s knowledge of the business was the ideal qualification for the job. In instances involving the valuation of a closely held business, CPAs said they were caught unexpectedly, with no sense of a problem during the engagement. In other claims, the CPA accepted his or her first BV engagement because the client insisted the valuation was only a formality for a simple transaction already agreed on by buyer and seller.

WHERE IS THE RISK?

The data show malpractice claims arise from disputed valuations of service-based businesses more often than from manufacturing or retail businesses (see exhibit 1, below). Because service-related businesses have more intangible assets that contribute to goodwill, valuing them appropriately is critical to avoiding post-transaction disputes.

Key employees, an established client base or a proven track record of providing high-quality service are the basis of goodwill for all business sectors. How to factor such intangibles into the overall valuation is a point of contention in a number of claims. In many businesses, goodwill is tied directly to the owner’s involvement in managing the company as well as his or her relationships with the business’s clients and vendors. When the owner leaves the business the relationships exit too, and the nature of the company changes. It’s then that disputes between buyers and sellers can crop up.

The predominant allegations in BV claims are over- or undervaluation of assets or liabilities directly affecting the dollars paid or received (see exhibit 2, above). Other disputes may be categorized as

Communication problems. These relate to engagement-scope disputes, primarily over the extent of the CPA’s role in negotiations between buyer and seller.

Conflicts of interest. Problems typically arise when a CPA neglects to disclose up front that both parties to the prospective transaction are the CPA’s clients. In such situations the claimant may allege that, based on previously rendered tax or accounting services, the CPA had enhanced knowledge of the business being valued and purposely omitted relevant information to benefit the other client.

Alleged fraud. These usually assert the CPA had an undisclosed financial interest in a business and benefited from a sale based on the CPA’s valuation.

THIRD-PARTY CLAIMS

Surprisingly, third parties rather than clients filed 30% of the BV engagement claims in our data sample. (Only audit engagements trigger an equally high proportion of claims from nonclients.) Such claims generally originated with one of two types of third parties:

A nonclient party to a business sale. For instance, prior to the sale of a family business the children of a client were paid for their minority stock holdings based on a BV report prepared for the client. When the new owner turned around and sold the company based on a significantly higher per share stock price, they sued, claiming the BV had undervalued the stock.

Lenders and investors. In many other claims nonclient parties alleged reliance on the CPA’s work when making an investment decision. In such cases, the nonclients performed no due diligence and had no professional advisers to assist them. In other claims, the nonclient alleged the CPA either had an undisclosed indirect conflict of interest (such as partial ownership of a business that subcontracted with the client) or had communicated opinions or conclusions to the third party inappropriately.

Third parties also claimed that businesses were overvalued or undervalued based on goodwill intangibles. Other claims focused on the practitioner’s failure to consider key employees in the BV, alleging that when key employees left after the sale there were operational problems, mismanagement and lost client relationships. Some buyers claimed the CPA had failed to properly investigate and comment on ownership of patents, copyrights or technology under development.

LETTER OF THE LAW

A review of claims shows that many CPAs failed to use engagement letters. Because disputes about scope or methodology used to value intangibles are common in such assignments, a CPA is wise to protect himself or herself—and the client—by issuing a letter defining the scope of the project, briefly explaining that different approaches and methods can be applied to a BV, and identifying and explaining those being used. The absence of engagement letters can compromise the defense of a claim if a dispute develops.

Accounting principles and tax codes set the standards for traditional accounting and tax services, but BV precedents for standard valuation methods have been established through common usage and case law. Case law pertinent to valuations prepared by actuaries, claims adjusters, real estate agents and real estate appraisers can affect the acceptance of valuation methodology by judges and juries when hearing a BV controversy.

The AICPA Statement on Standards for Consulting Services (SSCS) identifies valuation as a consulting service, and both SSCS and the AICPA Code of Professional Conduct apply to CPAs and firms rendering BV. However, these standards do not include technical standards and rules of practice. Although the IRS and the Appraisal Standards Board of the Appraisal Foundation provide regulations, revenue rulings and professional standards that CPAs must adhere to when they value businesses in circumstances such as estate and gift tax return preparation and reporting to federal regulatory agencies, there are no universally applicable standards for performing BV services.

Accordingly, engagement letters for this practice area are essential, and each business valuation should have an engagement letter specifically drafted for it with the assistance of legal counsel. It should:

Outline the roles and responsibilities of the CPA, the client and other professionals involved in a prospective business sale.

Detail the scope and objective of the engagement and any key terms used in the letter, such as fair value.

Include appropriate disclosures regarding the scope of services performed, the approach and methods used in performing the BV, and the information supplied by others that will be relied upon by the BV practitioner.

Establish that use of the CPA’s report is restricted to specified parties or an intended class of parties, such as prospective purchasers of the business.

Include disclosures regarding the risk that taxing authorities or third parties could challenge the valuation method.

Include provisions for withdrawal.

RISK MANAGEMENT BASICS

A CPA who wants to meet a high standard of care when performing a business valuation has to apply appropriate methodology (see “Tips for the Valuator,” JofA, March00, page 35). Several basic practice management techniques can help CPAs avoid malpractice claims in this specialty.

Obtain solid training. Before accepting an engagement, CPAs need formal training in performing BV services—a client’s reassurance to the contrary notwithstanding. A number of organizations offer training and credentials in this specialty area (see “Where to Learn More,” below).

Perform client screening. A CPA should not accept a BV engagement unless he or she first has information on a number of issues, such as:

The reason for the engagement. Early in the client interview, find out why the client wants a business valuation, and when, how and by whom the valuation report will be used; consider the liability implications of those factors. For instance, if investors or lenders will use the valuation as a basis for determining the value of equity shares in a closely held business, recognize that in most states these parties will likely have the right to sue the firm that prepared the BV if a subsequent valuation dispute arises.

If the BV is intended solely for the use of a particular party, both the engagement letter and the BV report should include a paragraph restricting the use of the report. Consider adapting the example in AU 532.19 of the AICPA professional standards, which reads: “This report is intended solely for the information and use of [the specified parties] and is not intended to be and should not be used by anyone other than these specified parties.”

The client’s reputation and ethics. If the engagement is for a new client, a practitioner should inquire about the client’s prior experience in his or her industry and whether other professionals will be providing services relevant to the prospective transaction. Use your business contacts to verify the information provided and determine the client’s reputation for integrity and prompt payment. If the business or client is from outside your firm’s conventional geographic practice area, thorough scrutiny is called for. Request references such as lenders, attorneys, vendors or clients; verify the existence of the parties supplied as references; and contact them by telephone to obtain background information. In addition, consider investigating the prospective client’s credit rating and performing background checks on officers or owners of the business. Always disclose to the prospective client that you’ll be performing background or credit checks.

Conflicts of interest. Conflicts may arise from a request to perform a valuation of a family business in connection with a divorce when the CPA firm has provided tax advice to both spouses in the past and intends to continue rendering services to the business and the spouse controlling the business after the divorce. Avoid engagements where a conflict of interest exists; although disclosure and consent make the engagement acceptable under the AICPA’s Code of Professional Conduct, conflicts increase liability risk. It’s safer to decline in such instances.

The client’s level of sophistication. Is a potential client experienced in interpreting financial data? If the client enters into negotiations based on the requested valuation, can he or she compare the relative value of offers made, especially if buyers make offers based on their own due diligence? An unsophisticated client considering a merger or acquisition presents greater risk, as he or she places a high level of reliance on professional advisers and may have limited experience in managing a business similar to the one being evaluated. Mergers or acquisitions involving unsophisticated clients are more likely to be unsuccessful and result in malpractice claims against the BV practitioner. As in all areas of practice, clients with unrealistic expectations are more likely to sue when their expectations are not met.

Industry type and size of the business. Lack of related experience within an industry can lead to valuation errors. Consider hiring an expert to assist, if warranted.

Use engagement letters. The client should sign a customized letter for each BV engagement before any services are rendered. Preferably, the provisions of the engagement letter should be discussed in a face-to-face client meeting to address any client questions or concerns. Document this discussion in the client workpaper file.

Document thoroughly. Track all client communications in the workpaper file. In many cases, a client will make tax planning decisions based in part on a valuation report. Statements on Standards for Tax Services no. 8, Form and Content of Advice to Taxpayers, says that “written communications are recommended in important, unusual or complicated transactions.” Similarly, document discussions about valuation methodology in a letter to the client to avoid any possible misunderstandings.

BV services can be a rewarding and profitable practice niche if you adopt some basic risk management techniques to minimize exposure. BV methodology is constantly evolving, so stay current through training. Screen prospective clients thoroughly, issue engagement letters and document all client communications. If problems arise during an engagement, consult an attorney specializing in the defense of CPAs and ask your professional liability insurer for additional guidance. Be safe, not sorry.