In Brief
The current upward trend of CPA firm merger and acquisition activity shows no signs of slowing down. CPA firms and individual professionals must be aware of the ethical implications of such transactions and combinations. The authors identify eight common areas where ethical concerns can occur and provide advice for navigating these treacherous waters.
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Much has been written in the last few years regarding the merger of accounting practices, and much has likewise been written about professional ethics. Little, however, has been written regarding the relationship and interplay between the two topics. According to many consultants in the profession, the surge in CPA firm mergers and acquisitions, fueled by succession gaps, unfunded retirement plans, and intense competition, is expected to continue at an unprecedented rate. The profession will undoubtedly experience many more accounting practice mergers, and firms need to be mindful of the various provisions of codes of conduct that may apply. (While this article uses the phrase “mergers and acquisitions,” the authors feel the sale and purchase of an accounting practice equally apply.)
The authors feel that many of the principles in the codes of conduct apply in mergers and acquisitions of accounting practices. The parties to a merger transaction must ensure that the principles of the code of conduct are not overlooked in merger and sale transactions. This article will focus on the following eight ethical issues:
- Independence and objectivity
- Competency and due professional care
- Conflicts of interest (COI)
- Confidentiality
- Requests for client records
- Statements on Standards for Tax Services (SSTS) and U.S. Treasury Circular 230
- Commissions, referral fees, and contingent fees
- Advertising and solicitations.
While there are additional areas that may apply, the authors believe that these eight are the most common.
Independence and Objectivity
While both firms involved in a merger may be diligent about independence beforehand, the successor firm will still have to review whether independence standards have been satisfied afterward. Independence impairments can occur if a sound process is not followed.
Example. Firm A merges its accounting practice with Firm B. Firm A represents a large manufacturer who sells furniture across the country, while Firm B represents a retail furniture store that purchases furniture from this manufacturer. While representing manufacturers and retailers in the same supply chain does not necessarily cause independence impairments for an accounting firm, the relationship should be analyzed to ensure that independence is maintained. What if financial statements are prepared for both companies and the firm realizes that the controller from the manufacturer will be resigning to obtain a position at the retailer? How can the firm be objective (and free of conflicts of interest) in this scenario?
Example. Firm C, the acquiree in another merger, provides bookkeeping and outsourced payroll services to a large distributor who is the attest client of firm D, the acquirer in the merger. After the merger, can the successor firm maintain independence? The answer is anything but clear; however, guidance is provided in the AICPA Code of Professional Conduct section 1.140.010:
1.140.010 Client Advocacy
.01 An advocacy threat to compliance with the “Integrity and Objectivity Rule” [1.100.001] may exist when a member or the member’s firm is engaged to perform nonattest services, such as tax and consulting services, that involves acting as an advocate for the client or to support a client’s position on accounting or financial reporting issues either within the firm or outside the firm with standard setters, regulators, or others.
.02 The code governs these types of professional services, and the member shall perform such services in compliance with the “General Standards Rule” [1.300.001], the “Compliance with Standards Rule” [1.310.001], the “Accounting Principles Rule” [1.320.001], and any interpretations thereof. The member shall also comply with the “Integrity and Objectivity Rule” [1.100.001] that requires maintaining objectivity and integrity and prohibits subordinating one’s judgment to others.
.03 Some professional services involving client advocacy may stretch the bounds of performance standards, go beyond sound and reasonable professional practice, or compromise credibility, thereby creating threats to the member’s compliance with the rules and damaging the reputation of the member and the member’s firm. If such circumstances exist, the member and member’s firm should determine whether it is appropriate to perform the professional services.
.04 When performing professional services requiring independence, a member shall also comply with the “Independence Rule” [1.200.001]. [Prior reference: paragraph .07 of ET section 102]
Competency and Due Professional Care
CPA firms must determine whether they have the required skills and knowledge to complete an engagement. Furthermore, a determination must be made whether the industry in which a client operates is one in which the firm has familiarization, required skills, and knowledge to complete the engagement. Anything short of the above may be considered a breach of competency. The general standards rule of the AICPA code section ET1.300.001 provides detailed guidance.
Both sides to a merger should exercise due diligence regarding the firms’ similarities and differences and the types of clients and industries serviced. Even the most stringent due diligence efforts may fail at detecting possible future competency issues.
Example. Firm E merges with Firm F, which has a niche in litigation support services. Many of Firm F’s staff who specialize in litigation support services will not, however, be employed by the successor firm after the merger. Firm E has little, if any, experience in the litigation support practice sector. While many options are available, such as joint ventures with other professionals, obtaining the skills to perform litigation support services, hiring new staff, and training existing staff, the firm needs to ascertain whether it has the competencies to complete the services prospectively.
Example. Firm G is an industry leader in providing services to clients in the shipping industry. The staff assigned to shipping companies has been servicing these clients for decades. Firm G merges into a large regional firm, which has little, if any, knowledge of the tax issues of this industry. The staff who historically serviced these clients are repositioned by the managing partner of the successor firm in an effort to reduce labor costs. This is a classic case of exposure for the successor firm, both from a professional liability standpoint and as a violation of the competency section of the codes of conduct.
Conflicts of Interest
Firm mergers add to the challenges and complexities surrounding COI. Many conflicts, such as (but not limited to) divorced or divorcing spouses, buyers and sellers of businesses, and trusts and beneficiaries, may arise subsequent to a merger. While even the best screening processes may not reveal all conflicts, such screening still should take place during the due diligence phase of the merger, and indeed throughout the firm’s existence; the merger simply adds another strong reason to exercise due care. The authors strongly recommend that CPAs consider COI waivers in any case where actual, apparent, and or potential COI exist. Moreover, a solid client termination process should be in place.
Confidentiality
During the due diligence phase of a potential merger, both parties reveal significant confidential client information, such as clients under audit, Social Security numbers, net worth, and medical information. Does this sharing of confidential information result in confidentiality breaches by the parties to a merger? The general rule under the confidentiality principles of the AICPA Code of Professional Conduct states, “A member in public practice shall not disclose any confidential client information without the specific consent of the client” (section 1.700.001.01). There are, however, many exceptions and interpretations to the general rule; one such exception (section 1.700.050.03) states the following:
1.700.050 Disclosing Client Information in Connection with a Review of the Member’s Practice
.01 For purposes of the “Confidential Client Information Rule” [1.700.001], a review of a member’s professional practice includes a review performed in conjunction with a prospective purchase, sale, or merger of all or part of a member’s practice. Such reviews may threaten a member’s compliance with the “Confidential Client Information Rule.” To reduce the threat to an acceptable level, a member must take appropriate precautions (for example, through a written confidentiality agreement with the prospective purchaser) to help ensure that the prospective purchaser does not disclose any confidential client informationobtained in the course of the review.
.02 Members who perform such reviews should not use to their advantage or disclose any confidential client information that comes to their attention during the review. [Prior reference: paragraph .04 of ET section 301]
.03 Members who obtain client files as the result of acquiring all or part of another member’s professional practice should not disclose any confidential client information contained in such files. Members should refer to the “Transfer of Files and Return of Client Records in Sale, Transfer Discontinuance or Acquisition of a Practice” interpretation under the Acts Discreditable Rule [section 1.400.205] for guidance related to client files obtained through acquiring a practice. Ethics interpretations 1.200.040, 1.700.050, and 1.400.205 should be explored, but are effective June 17th 2017.
Both sides to a merger should exercise due diligence regarding the firms’ similarities and differences and the types of clients and industries serviced.
Regardless of the exception cited above, the authors urge both parties to any merger to exercise extreme caution and to understand the limitations imposed by this exception.
Requests for Client Records
While much guidance is provided in the AICPA code regarding requests for client records, the authors strongly recommend that CPAs also review the various state board rules that may apply, as they may have stricter provisions than the AICPA and other regulatory bodies.
The general rule essentially states that CPAs must return client records to the client after a demand for such records is made and regardless of whether the CPA has been paid for such services. The merger of an accounting practice muddies this scenario, as the two firms may have offices in different states, certain clients may not be part of the merger, clients may have outstanding accounting fees, and the individual firms’ engagement letters may differ regarding retention of record policies. The authors caution both parties to review their respective engagement letters, refer to the various state board rules regarding retention of client records, and consider their responsibility to clients or former clients regarding the retention of records.
Statements on Standards for Tax Services and U.S. Treasury Circular 230
There are eight statements on standards for tax services (SSTSs), and many of them are similar to the rules outlined in Circular 230. Of special interest is SSTS 6, Knowledge of Error: Return Preparation and Administrative Proceedings, as it has significant applicability to mergers of accounting practices (http://bit.ly/2BUwxlE). The other seven SSTSs and Circular 230 should also be reviewed, as they may impact a given merger.
Example. Firm H acquires the tax practice of firm I. During the first tax season subsequent to the merger, the staff realizes there are errors in prior tax filings of the clients of firm I. Once any error in a prior tax return is detected, the preparer must inform the client of the necessary corrective action and cite the consequences if the error is not corrected. Additional challenges arise if the client does not heed the preparer’s advice, or if the error affects multiple years. The ethical requirement for the firms is to strictly comply with the SSTS guidance and not the success of the merger or client retention; many practioners have failed this test and continued to service clients who fail to heed their advice regarding corrective action that must take place. In addition, the successor firm should expand its due diligence and evaluate the quality of the tax preparation services; this may reveal a “tone-at-the-top” problem.
It should be noted that the answer to this dilemma is not unique to mergers. It should also be noted that Circular 230 pertains to federal tax issues, whereas the SSTSs pertain to all areas of taxation.
Commissions, Referral Fees, and Contingent Fees
This is another area where the rules differ amongst the various state boards of accountancy. Most states prohibit these types of fee arrangements for attest clients, and require some level of disclosure if they are allowed; the authors are aware of many states that require written disclosure and some that use prescribed forms. The ethical challenge for merging firms encountered here is that one firm may offer financial planning services where such fees are common, and the other firm may not. This can present issues with the merger and potentially breach the relevant codes of conduct.
Example. Various consultants and financial planning professionals have paid referral fees to Firm J for clients who opened IRAs with their organizations. After Firm J merges with Firm L, the same financial planning professionals make a similar offer to the partners of the successor firm, which begins to accept these fees. The firm must immediately review whether such an arrangement is consistent with the applicable codes of conduct, review the types of services offered to each client, and ascertain the method of disclosure.
The peer review process may reveal many ethical issues associated with firm mergers.
Contingent fees have some additional conditions that should be followed and, as mentioned, may be state specific.
Advertising and Solicitations
As a general rule, advertising and solicitations for CPA firms and services cannot be false, misleading, and or deceptive. Furthermore, in some states the firm must maintain copies of the advertisement for a period of time. It should be noted these provisions apply equally to advertising and affirmations contained in firm websites.
One of the challenges that may develop involves the integration of two firms’ web-sites; care must be exercised in ensuring that the combined website is consistent with the applicable codes of conduct. Furthermore, an assessment of employees that were not part of the merger also should be undertaken. It is possible that an employee who provided specialized services, such as litigation support, business valuations, and expert witness services, may no longer be with the firm. These specialists typically have accreditations that draw prospective clients to a firm’s website; if they still appear on the website, but are not employed by the firm, an ethics violation may exist. In addition, all firm brochures, advertisements in trade publications, and firm alliances and associations must be kept current to satisfy ethical requirements.
The peer review process may reveal many ethical issues associated with firm mergers. While the list below is not all-inclusive, these issues are relevant to firm mergers and ethics:
- Proper firm registration in states where the firm practices
- Individual partner license registrations post-merger
- Merger and acquisition candidates who have yet to receive a peer review pass result
- Incomplete peer review cases prior to the merger.
Due Diligence Is More than Just a Phrase
The current surge in CPA firm mergers and acquisitions will likely continue for years to come. Much time and focus should be afforded in such a transaction, as it may be the most important transaction the firm will undertake. Focusing on the ethical considerations should be an integral part of this process and a cornerstone of the combine firm’s future success.
