Going the 'extra mile' is okay, but beware of the risks
While client loyalty is an admirable characteristic, the economic downturn combined with the increasing focus on accountants' liability necessitates careful evaluation of decisions to "go the extra mile" for clients.
Losses often destroy relationships, and clients in difficult economic positions may be willing to sacrifice their relationships for even modest economic advantage.
As discovered by Andy Accountant, "going the extra mile" is only good business when it does not involve significant additional risk.
For the last 10 years, Andy had audited the financial statements of Parts-R-Us, Inc. (PRU), a regional auto parts sales and distribution company owned by Eric Entrepreneur. In 1997, Eric informed Andy of his plans to acquire Cycle Parts (Cycle), a smaller specialized parts distributor owned by Sid Sneaky.
Eric asked Andy to assist with PRU's due diligence investigation of Cycle, and Andy dutifully issued an engagement letter for the consulting work. Subsequently, however, Eric informed Andy that he and Sid had agreed that Andy would review Cycle's 1997 financial statements.
Andy accommodated Eric's request and agreed to perform the review. As the cost of the engagement was being borne by Cycle, Andy's engagement letter was issued to Cycle and its shareholders.
In early March, the merger was finalized and the parties executed a stock purchase agreement. PRU paid Cycle's shareholders $500,000 and delivered a promissory note for the remaining $500,000 of the purchase price. Several weeks later, Andy issued a review opinion on Cycle's 1997 financial statements.
Although the review opinion was unqualified, it did disclose that Cycle was only marginally profitable. As with the engagement letter, the review opinion was addressed to Cycle and its shareholders.
Unknown to Andy and Eric, Cycle had experienced economic difficulties for the last several years and, to keep the company going during the downturn, Sid had been engaging in creative accounts receivable and inventory practices.
Because Andy did not detect this during the review, Cycle's 1997 financial statements were overstated and showed a marginal profit when the company had in fact lost money, as it had for the last several years.
Cycle's results of operations proved no different in 1998 and it sustained its largest loss ever. By late 1999, PRU was facing additional economic problems and sued Andy.
Although Andy's review opinion had been issued after the merger agreement was signed, PRU claimed reliance on alleged pre-merger due diligence services. It also alleged reliance on Cycle's 1997 financial statements in connection with important post acquisition decisions.
While Andy felt betrayed by Eric, and the lawsuit cost him time, effort and money, he did learn some important lessons.
First, when the nature of the engagement changed, Andy should have revoked his original engagement letter or otherwise formally documented that the due diligence engagement had been terminated without any services having been provided.
Second, by issuing the engagement letter to Cycle, Andy placed himself in a position where he was performing attest services for both Cycle and PRU at a point in time when he had knowledge of the planned merger. Thus, both Cycle and PRU were in a position to raise conflict of interest allegations.
Aside from the professional standards issues, Andy doubled the risk of the engagement and impaired his ability to defend his work without any additional compensation. Instead of facing the risk of a claim by the buyer, Andy was at risk if either the buyer or seller was dissatisfied.
Third, Andy should have recognized that issuing the financial statements after the merger agreement was signed did not completely negate the risk of the engagement.
While this did significantly mitigate the risk and allowed Andy to resolve the lawsuit for a nominal amount, merger-related services carry significant risk and plaintiffs lawyers are very creative in developing theories of reliance.
With a little additional care, Andy could have avoided the lawsuit entirely.
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