The demise of Laventhal & Horwath, the many suits against CPA firms over failed S&Ls, and the recently publicized jury verdict against a CPA firm of $200 million in damages where the loss to investors was $13 million, may cause CPAs to ask, "How do I and my firm protect ourselves from the potential of financial ruin because of that one bad client?" "How do I protect against the financial catastrophe that one 'audit failure' can trigger?" The answer clearly rests with an understanding of your client and the business risks you are taking by becoming and remaining associated with that client.

Since 1978 the profession has implemented a comprehensive program of self-regulation including peer and quality review, audit failure inquiries, and oversight by professional associations such as the AICPA. Nine quality control standards were established to provide reasonable assurance that audits are conducted in conformity with generally accepted auditing standards (GAAS).

The second of the nine standards of quality control relates to acceptance and continuance of clients. All other control procedures are fruitless if a CPA chooses to serve an undesirable client. Consequently, client acceptance and continuance decisions should be made with care and should precede any significant professional services.

This article discusses the critical issues that CPAs should consider in making a decision to accept a new client. The recommendations made are based on interviews with executives of accounting firms and an examination of client acceptance documents employed by these firms and additional firms. Client acceptance procedures are of great importance to practitioners in firms of all sizes and for engagements of all types, both attest and non-attest.

THE MAJOR ISSUES

Some CPAs considering the acceptance of a new client may choose to prepare a very detailed checklist of items to consider in the process. Other practice units choose to prepare general guidelines, leaving the details of matters to be considered to the professional judgment of the CPAs directly involved in the decision. All practice units should establish a policy as to how the acceptance decision is to be made and documented.

Another area of concern is whether to apply client acceptance procedures for audit clients only or for clients seeking tax or management consulting assistance. Some CPAs use client acceptance procedures for audit clients only, whereas others conduct a review for all new clients using any service the CPA offers. Observers of the profession and its litigation problems point out that many local practitioners' biggest exposures are in their tax preparation and consulting activities.

One CPA interviewed reasoned that all new clients should be reviewed to avoid having the CPA "splattered" like a dye-pack explosion. Banks place dye packs in a stack of bills with an explosive device that is triggered when the dye pack leaves the bank. Each teller has one in the cash drawer in the event of robbery. The explosion splatters red dye on the money and the robber. The CPA was pointing out that when a client problem becomes public, both the CPA involved and all associates are discredited, even though audit services may not have been involved.

Regardless of the approach chosen, a definite consensus exists among the CPAs contacted on at least five major issues that must be addressed in the client acceptance decision. The five issues are as follows:

1. Management Integrity. Can the CPA rely on the management of the prospective client to provide meaningful disclosures and representations during the engagement?

2. Relationships with Other Professionals. What is the relationship of the prospective client with current and former lawyers and bankers and with the predecessor accountant?

3. Risk of Association. What is the risk to the CPA of becoming associated with the client, particularly as regards professional reputation and profitability?

4. Technical Competence. Does the CPA possess the technical competence to perform the necessary services, particularly when functional or industry specialization is a factor?

5. Professional Fees. Is the fee to be charged reasonable given the level of risk assumed, and is the prospective client capable of paying the fee?

Each of these issues will be considered in more detail. It is important to remember, however, that many of them are interrelated and no one issue can be considered in isolation.

MANAGEMENT INTEGRITY

Management assertions are a critical factor in both attest and non- attest engagements. The management environment can create business and audit risks that should be squarely addressed. The independent auditor, for example, examines financial statements that are based upon assertions of management ranging from the existence of an element in the financial statements to disclosures of information regarding that element. No responsible practitioner would knowingly place reliance on assertions of a client's management which had questionable integrity.

A number of conditions relative to key management integrity may present unusual risks. Key management personnel include the chief executive, operating, financial, and accounting officers. In addition, members of the board of directors play a role in management integrity. Among the most obvious risks is the situation in which there is a previous conviction of a key member of management for a criminal offense. Suspension or sanctions made by an administrative body at any time against a prospective client's management is of great concern.

One CPA expressed the opinion, "Once a crook, always a crook." This expression resulted when a prospective client was rejected because of its president's involvement in questionable behavior that the SEC took action upon. Some five years later, the same company sought to use the CPA who had rejected the company earlier. The decision was made to accept the company with its president. Within a few months, matters surfaced that indicated the president lacked integrity and that questionable transactions within the company were occurring. The CPA resigned as auditor. The philosophy that management exhibits in its conduct of the enterprise's business also may reveal much about its integrity. Care should be exercised when CPAs are considering a prospective client whose management is willing to accept unusually high risks in making decisions concerning key determinants of financial position, such as credit policies, accounting for major research and development projects, or compliance with laws and regulations. Overly aggressive tax positions also might signal problems with management integrity.

The willingness of a prospective client's management team to take unwarranted risks also may be indicative of a less-than-enthusiastic attitude toward the matter of internal control generally. A CPA's suspicions of such an attitude might be confirmed if management fails to address or to implement significant internal control suggestions made in prior audits. The lack of effective budgetary, cash flow, and costing systems may reflect both a lack of management's integrity and competence.

A company that has a strong information system may still pose a threat to itself and to the CPA considering the company as a prospective client if information generated by the system is not communicated to management and the board of directors. The chief financial officer has a major responsibility to keep board members and management aware of the economic, technological, political, and social challenges confronting the entity. An ineffective chief financial officer may not only leave the board uninformed but also may leave a vacuum of leadership that permits autocratic rule by one dominant individual.

Beware the Know It All

The autocratic manager poses a special threat to the CPA. Such a strong-willed individual may take unnecessary risks to fulfill ambitions. The autocrat neither seeks nor desires the counsel of colleagues and, by such behavior, may make poor decisions that increase the risk for the CPA who is considering association with the entity.

Passive boards of directors who are not aware of and do not participate in decisions regarding business affairs of the enterprise are often characteristic of the regimes of autocratic managers. The CPA should determine the role of the board in the management of the business. The changing nature of shareholders from relatively unsophisticated and uninterested to institutional and more sophisticated private investors suggests that boards of directors are being held more responsible for their actions. Recent trends have been away from "inside" directors toward "outside" directors who bring valuable expertise to their directorship duties.

CPAs considering a prospective client should examine current duties of key management personnel as well as their prior work experience. The number of years the manager has held his or her position and the total number of years the individual has been with the company are matters of interest. Prior experience is of particular interest in a situation in which management has acquired another business operating in an industry different from that of the prospective client. The background and experience of the board of directors also should be examined.

CPAs may find it useful to retain an outside investigative agency to obtain further information about individual reputations and finances. This assistance may be especially important with respect to senior management having personal financial difficulties or maintaining a lifestyle inconsistent with their earnings.

Newspapers and other publications are useful sources of information on a key executive of a prospective client. The LEXIS/NEXIS legal and news information service can be used to obtain immediate responses to inquiries regarding client and management litigation and published news items.

No CPA can afford the risk to reputation and profitability associated with accepting an engagement where management's integrity is an issue. Questionable management actions could lead to litigation. As the client acceptance document of one CPA suggests, a CPA's professional reputation is lessened each time the CPA is associated with litigation, regardless of the merits of the CPA's case.

The importance of management integrity is evidenced by an experience cited by one of the CPAs interviewed. The integrity of the chairman of the board of a recently acquired client was questionable. Prior to acceptance, the CPA had received a commitment from the prospective client that the chairman would resign (voluntarily or involuntarily) shortly after the engagement began. When the chairman was still in place three months after the engagement began, the CPA resigned ! RELATIONSHIP WITH OTHER PROFESSIONALS

GAAS require that a successor auditor communicate with the predecessor auditor prior to committing to provide audit services to a new client. Matters of interest include the opinions issued by the predecessor auditor, resignation of the prior auditor or the refusal to stand for reelection, disagreements between the prior auditor and management regarding accounting principles or auditing procedures, and any "opinion shopping" issues. Inquiry of other professionals having dealings with the client should, however, not be limited to the predecessor auditors.

Bankers, lawyers, and other professionals can provide important information about a prospective client and its management. They can be a valuable sources of information regarding the prospective client's litigation. history and the potential for future litigation, the financial stability of the prospective-client, the industry in which the prospective client operates, and integrity of management.

In making these inquiries, CPAs should keep in mind the old adage, "you are judged by the company you keep." CPAs should be interested in the reputations of the prospective client's advisors as well as that of the prospective client. If possible, inquiries should be made as to client 'acceptance pr6cedures' of these other professionals. The selectivity of these other professionals may be able to provide insights into the desirability of

A decision regarding the acceptance of a client should never be based solely on social contacts with the client's principals. These contacts generally do not provide sufficient knowledge of individuals' integrity or the business situation of a company to allow a reasoned decision to be made.

RISK OF ASSOCIATION

A CPA should avoid accepting a client who could damage the reputation or profitability of the practice. Client acceptance decisions are difficult. According to one CPA, a natural conflict of interest exists in the decision between screening a new client for rejection or acceptance versus obtaining new clients and making a profit. The increase in competition for new clients among CPAs in recent years only sharpens this conflict.

A prospective client involved in or about to be involved in litigation can be very dangerous. This is particularly true if the work to be performed by the CPA may be involved in the litigation or in some other form of claim. Worse still would be a lawsuit between the prospective client and another client of the CPA.

The prospective client's dealings with regulatory authorities is also of concern. An entity embroiled in a dispute with a regulatory agency can lead to litigation and negative public attention directed toward the CPA. The CPA should be particularly wary of situations where the relationship between the prospective client and the regulatory agency seems to be deteriorating.

A prospective client should be engaged in legitimate business activities that do not violate the laws of the jurisdiction where the company is headquartered or carries on its business. If the prospective client deals in a product or service with which the CPA is not comfortable, the CPA may wish to avoid associating with the client to avoid embarrassment.

Financial stability and liquidity of the prospective client also are important. Stability and liquidity can affect the CPA's choice of auditing procedures and the report ultimately rendered. A prospective client with liquidity problems, an inability to meet its financial obligations when they are due, large numbers of transactions with related parties, and dependence upon a single customer or a small group of customers should be carefully considered prior to acceptance.

Does all of this mean that a CPA should avoid associating with a company in a high-risk venture? Clearly, the answer is no. A well- managed organization engaging in high-risk ventures could prove to have a very positive effect on the CPA's reputation and profitability. The key to success is that the CPA should clearly understand the circumstances surrounding the operations of a prospective client before promising to provide services.

TECHNICAL COMPETENCE

A basic tenet of auditing is that the work is to be performed by persons having adequate technical training and proficiency. Complexities of the modern business world add a dimension to this requirement that goes far beyond the technical aspects of auditing. Obviously, the CPA must have the necessary technical competence to perform the required work or risk potential liability or damage to reputation.

Industry expertise is a key factor in many engagements. Many industries present challenges in terms of understanding the processes and economics of the goods or services produced. Specific risks may surface that are unique to a given industry and these risks may require special technical procedures.

Many prospective clients may be subject to complex laws and regulations of several governments in different countries. These regulations may require knowledge in specific technical areas if the rules are to be understood.

CPAs in smaller firms should be particularly careful to ensure that they possess the necessary skills to provide the services needed by a prospective client and thereby to complete the engagement successfully. Nothing can be more damaging to profitability and reputation than the failure to consider some specialized industry or regulatory matter that has a material effect on a client's financial statements.

PROFESSIONAL FEES

No engagement should be undertaken if a prospective client cannot pax, the fee for the work. Similarly, a CPA should be wary of a prospective client who still owes a fee to a predecessor. There is absolutely no reason to believe you wilt be treated any differentIX,. Fees charged a client should be commensurate with the risks to the CPA of providing the services requested. The fees should cover adequately the cost of the services provided. An entity should be approached cautiously if it suggests that it might pressure the CPA to modify the fee charged should business conditions deteriorate. For example, payment of fees should not be contingent upon the success of a future securities offering by the prospective client.

Adequate fees must be charged if a CPA is to attract and retain competent personnel. Although profitability cannot be allowed to overshadow integrity, profitability most assuredly must be considered if the CPA is to be successful.

IMPLEMENTING CLIENT ACCEPTANCE PROCEDURES

The identification of the five key issues in the decision to accept or reject a client is the first step in the process of developing policy in this area. While the firms interviewed were in general agreement as to what these issues are, they exhibited less agreement as to what methods should be used to obtain information about these issues. Two general approaches used are:

1. An extremely detailed checklist listing all of the matters relevant to the client acceptance decision, and

2. A more generalized form in which information regarding the client's circumstances for each of the five areas is documented in memoranda.

This last approach does not utilize a detailed checklist, although the instructions for the memoranda may contain a brief list of some issues that might be addressed therein. A third possible approach would be a combination of checklists and memoranda.

The Advantages...

Use of a detailed checklist has several advantagesl:

1. The checklist may prove to be more efficient since the critical issues to be considered are specified in the document. A carefully developed document should contain only the procedures necessay to a sound decision in order to avoid the cost associated with performing unnecessary procedures.

2. Avoiding costly and unnecessary procedures will allow the firm to control fees and compete more effectively in the current market for audit services.

3. The detailed listing of necessary procedures provided on the checklist will help to ensure that the procedures deemed vital to the client acceptance decision are considered for every client. Careful screening of each client can help the firm avoid clients that would damage the reputation and financial stability of the firm, particularly as regards litigation.

4. A carefully constructed client acceptance document could prove to be valuable evidence should any legal action arise.

... And the Disadvantages

The advantages claimed for a derailed checklist also can be viewed as disadvantages:

1. No single checklist (no matter how carefully developed) can be applicable to every client. Some procedures on the form may be unnecessary for certain clients while other necessary procedures are omitted from the list.

2. Performing unnecessary procedures will prove inefficient and costly.

3. Failure to perform omitted procedures could be costly and embarrassing, particularly if litigation results.

4. Completion of a checklist can become a mechanical process that may result in an unthinking practitioner completing the specified procedures while ignoring a major warning sign of impending disaster.

5. Legal counsel for a plaintiff may seize upon the apparent lack of completeness of a detailed document or upon the failure of an auditor to adhere to the procedures prescribed in the document.

6. Developing and maintaining a derailed checklist may prove to be costly.

7. Some bright individuals may find the completion of a detailed document to be limiting. These people may become so disenchanted with the rigidity of the form and the process that they leave the firm. The loss of an employee capable of becoming a valued member of the professional staff is significant in itself, but such a loss also results in costs to the firm associated with recruiting and training an adequate replacement.

DEVELOPING A CLIENT ACCEPTANCE DOCUMENT

Table 1 presents a basic guide to preparing a client acceptance checklist or memoranda. The questions listed in Table 1, and the means of finding answers to these questions should be addressed by practitioners in determining whether to accept or reject a client. Table 1 represents a synthesis of the client acceptance documents of the firms interviewed that should provide a basis for the development of client acceptance policies and procedures.

CPAs should seek clients who will enhance, not detract from their professional reputation and whose businesses afford a long-term relationship. In addition, CPAs should have the technical competence to perform the appropriate service and should assess the ability of the client to pay for such services.

1 Cushing and Loebbecke provide an expanded discussion of the advantages and disadvantages of audit structure generally in Comparison of Audit Methodologies of Large Accounting Firms: Accounting Research Study, No. 26 (American Accounting Association, 1986). Many of their thoughts on audit structure generally are applicable to client acceptance procedures specifically and are included in this discussion.

John W. Hardy, PhD, CPA, is a Professor at Brigham Young University. He is the author of numerous articles published in professional journals and he is a consultant to several corporations. Professor Hardy is currently the editor of Management Accounting News and Views and is active in the Management Accounting Section of the AAA.

Larry A. Deppe, PhD, CMA, CPA, is an Assistant Professor at Brigham Young University. Professor Deppe is a member of the AAA AICP, Institute of Management Accounting and Utah Association of CPAs. He recently has completed studies identifying the competencies required for the practice of accounting as well as salary, promotion and other employment issues relating to bachelors and masters degree graduates.

TABLE I

GUIDE TO PREPARING

A CLIENT ACCEPTANCE CHECKLIST OR MEMORANDA

Issue

* Management Integrity. Can the CPA rely on the management of the prospective client to provide meaningful disclosures andrepresentations during. the engagement.

* Relalionships with Other Professionals. What is the relationship of the prospective client with current and Former lawyers and banks and with predecessor accountants.?

* Association. What is the risk to the CPA of being associated wilh the client, particularly as regards professional reputation and profitability.?

* Technical Competence. Does the CPA possess the technical competence to perform the necessary services for the prospective client, particularly when functional or industry specialization is a factor?

* Professional Fees. Is the fee to be charged reasonable given the level of risk assumed, and is the prospective client capable of paying the fee.?

Questions to be Raised

* Who are the key members of management and what is their background and experience?.

* Has a key member of management been convicted of a criminal offense or been suspended or sanctioned by an administrative body.?

* Does management accept unusually high risks or take extremely aggressive positions inlhe conduct OF the business?

* What is the attitude of management toward creating and maintaining an effective system of internal control?

* Does a single member of management dominate other key managers and the beard of directors?

* What attention has the general and financial press given to the prospective client and managers.?

* Did the prior auditors refuse to stand for re-election or disagree with the prospective client regarding accounting principles or auditing procedures?

* What is the reputation in the business community of the prospective client's current and former legal counsel, commercial banker, and investment banker?

* How do these other professionals choose their client and does the level of selectivity reflect on the character of the prospective client.t?

* Has the predecessor auditor's fees been, paid in full, and if not, why?

* What is the nature of the most recent aucht opinion.?

* Is the prospective client involved in, or about to be involved in litigation? If so, with whom.? And why.?

* Is the prospective client embroiled in a dispute with a regulatory agency that mightlead to litigation and negative public attention tot both the prospective client and the accountant.?

* What is the business of the prospective client and is the accountant comfortable with the products or services provided by the prospective client?

* Does the prospective client pose a "going-concern" question?

* Has the prospective client performed better or worse than other firms in its industry?

* Does a major portion of the prospective client's revenue depend upon a single customer or group of customers? Is the continued existence of these customers questionable?

* What are the peculiarities of the industry in which the prospective client operates?

* What are the qualifications of the CPA in the industry of the prospective client?

* How will the acceptance of this client affect the staffing of other engagements and the work schedules of personnel involved?

* How much training will be needed to properly serve this client?

* Does the prospective client still owe a fee to a predecessor accountant?

* Is the prospective client's value of the CPA's services commensurate with the accountant's assessment of the risk associated with the potential client relationship?

* Has the client given any indication of an opinion that the fee should be modified based on the outcome of some future event?

* Does the fee cover the cost of the services provided?

* Is the fee commensurate with the level of risk to the accounting firm of providing the services requested?

Approaches to Answering Questions

* Prepare a list of key managers consisting of the name and title of each executive, the individual's holdings in the.p. rospective client, any current affiliations in addition to that with prospective client, number oF years of association with the prospective client, and prior affiliations and experience.

* Make inquiries of a litigation/government regulatory database such as LEXIS and a database of newspaper and magazine articles such as NEXIS.

* Consider the use of an outside investigative agency.

* Determine if members of your own professional accounting staff have any knowledge of the client regarding any oF these matters.

* Contact the predecessor auditor and obtain the predecessor' s view of any disagreements with the prospective client and compare the predecessor's account of the situation with that of the prospective client.

* Obtain access to the predecessor auditor's workpapers.

* Note and investigate any limitation of the responses of the predecessor auditors to inquiries concerning the integrity of management, disagreement with management on accounting principles, auditing procedures, or other significant matters, and the reason for the change of auditors.

* Contact bankers, lawyers, and other professionals who have served the prospective client and inquire of them regarding their opinion of the prospective client, the nature and length of their association with the prospective client, and their procedures for accepting and rejecting prospective clients.

* Access the NAARS database and obtain financial reports of the prospective client and any major customers as well as other firms in the industry.

* Access the NEXIS database and note any articles in newspapers or magazines regarding the prospective client, its customers, products or industry.

* Access the LEXIS database and note any prior or current litigation.

* Review the background and experience of professional staff through examination of resumes in file and personnel interviews.

* Review journals, magazines, and other publications relating to the industry to determine any significant issues or complexities associated with the industry.

* Assign professional staff members with expertise in the client industry to conduct office seminars to instruct other professionals regarding the client industry and its peculiarities.

* Consult experts in the prospective client's industry to identify issues relating to the industry.

* Estimate the fees for the first two years and determine if the fees are in accordance with the CPA's established fee structure.

* Make inquiries of the predecessor auditor regarding any unpaid fees.