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Death in the firm - a cautionary tale.

What happens to a small firm when a partner dies and practice continuation planning is inadequate? Warren G. Nogle, CPA, partner, McLoughlin, Briese, Yip & Nogle, 100 Spear Street, Suite 1630, San Francisco, 94105, shares his experience.

I became the junior partner of a two-partner accounting firm in San Francisco in 1988. On joining the firm, I was placed in charge of new clients and those gained through acquisitions of smaller firms as well as management and computer consulting engagements. In addition, I was responsible for staff supervision in accounting work and tax preparation.

The senior partner was responsible for the old-line clients who were the firm's financial backbone. He specialized in personal financial planning and performed some management and administrative duties. The client base was composed primarily of doctors and attorneys. The firm's service mix and revenue were distributed equally among small business accounting services and individual and corporate tax returns. Computer and management consulting substantially contributed during the off-season.

On March 2, 1991, the senior partner died suddenly of a massive stroke. Although we had taken some precautions in case of death or disability, our firm essentially was unprepared to cope with a partner's death. The lessons we learned may prompt other CPAs to create policies that help see them through unforeseen tragedies.

BUY-SELL AGREEMENT

The existence of a buy-sell agreement and two related life insurance policies was my single greatest comfort after my partner's death. However, I wasn't aware they had problems until I needed them.

Our buy-sell agreement called for the firm to purchase life insurance policies for each partner, with the firm the beneficiary and the proceeds to be used to purchase part of the deceased partner's shares in the corporation. In addition, it called for an additional payout to the deceased partner's estate of up to 75% of the prior year's billings divided by the number of shares outstanding less the insurance proceeds.

In retrospect, although the agreement's terms were good for my partners' heirs, they were not very favorable to me because they

* Assumed retention of most of the clients.

* Assumed billing increases.

* Did not anticipate the recession and actual billing declines.

* Assumed expansion based on current clients and referrals.

In essence, the agreement looked backward rather than forward. In retrospect, I recommend using an average of the next two years' billings as 100%, with 50% credited to each partner as a favorable price to pay. This gives a better approximation of practice value and does not effectively penalize the surviving partner for surviving.

Because of the agreement's flaws, the firm's financial prognosis was not very good. I strongly recommend that all firms have buy-sell agreements with insurance coverage to fund a portion, if not all, of the buyout of the deceased partner's interest in the organization, but objective third-party assistance should be used to negotiate all such agreements. The exhibit at right covers some pitfalls of forging these agreements.

PRACTICE CRISES

After the senior partner's death, I faced a number of problems that needed to be solved if the corporation was to survive as a viable entity.

* Loss of clients. Client attrition was approximately 20% of total billings in the first six months after my partner's death and another 10% in the second six months. His clients were located throughout the San Francisco Bay area and many had been with the firm for 15 years.

The senior partner had established long-term personal and professional relationships with most of his clients. Unfortunately, they still viewed me not as their accountant but, rather, as another technician on the staff. There had been no comprehensive marketing plan to introduce me when I joined the firm. This failure caused a drop in clients after my partner's death that might have been avoided.

At the same time, my business development efforts were effectively stalemated. The firm had experienced solid growth after I came on board and since the purchase of a small accounting firm. It also had embarked on an organized marketing plan directed by a company specializing in developing new business for CPA firms.

While this growth benefited the firm, it created problems when I was left to handle the expanded work load alone. The addition of multiple responsibilities left me no time for new practice development to counter client attrition. I strongly suggest that firms create a marketing plan to be used in the midst of a crisis.

* One partner burdened with overseeing all administrative and professional concerns. The most immediate effect of my partner's death was that I suddenly was in charge of everything: three staff members, five professional software systems, eight computers (software and hardware maintenance) and all firm administrative functions, including such mundane items as writing checks to purchase office supplies. I immediately assigned to staff accountants and the secretary some administrative tasks that normally would have been performed by either partner because of their sensitivity.

To prevent this kind of chaos, partners should identify the administrative tasks for which they are responsible, describe them in writing and train the other partners to complete them. The written instructions could become the core of a firm operating manual.

For example, our firm used a time and billing system to track work for each client. The data were then edited and an invoice was prepared on a separate word processing system. Both systems were maintained by the deceased partner. The senior accountant and I spent hours trying to understand how the system worked. In the meantime, I developed a spreadsheet database to be used as a time-task capturing tool to load the time and billing system. A better option is to identify the primary firm systems and to train each partner to maintain and use them.

* Doubling the remaining partner's expense responsibilities. The financial burden of paying rent for a two-partner office with space for six, paying down equipment loans and for supplies and insurance was a heavy one.

As with most small firms, after staff expenses rent is the most costly item. Fortunately, only one year remained on our lease when my partner died, and as soon as it expired we moved the firm to smaller, less expensive quarters. Firms should try to pick a lease anniversary date that falls outside of tax season.

Two years after my partner's death, the task of downsizing to match revenues and expenses still required some very determined cost cutting. The intense pressure to maintain our client base while providing fast and competent service continued. Firms should prepare a short- and long-range business plan to identify service and cost levels and a contingency plan for emergencies.

* Unresolved problems with clients and third parties. In any firm, there is a limit on the amount of communication among partners regarding their clients. This was as true at our firm as anywhere else. During the months after my partner's death, I received calls about various tax matters from clients or representatives of the Internal Revenue Service or the California Franchise Tax Board. I found my partner did not always document the basis for his actions in tax cases. Additionally, some of the audits concerned tax issues at least three years old.

Under such conditions, adequate documentation becomes critical. Firms must enforce adequate documentation standards and ensure the staff - and partners - are following them. A firm's liability for a deceased partner's actions does not cease with his death. Consequently, proper documentation - and professional liability insurance - is a must.

I also recommend weekly or bi-weekly meetings of all partners so they can discuss the status of all their audits or projects. Partners also should insert documents in the files describing actions taken and the reasons for them.

After the senior partner's death, it was my responsibility to notify clients immediately through letters and telephone calls that the prior level of service would continue, to inform them that the partners had worked closely in preparing the client's tax returns and accounting and that business would continue as usual. The fact that the senior partner died at the beginning of tax season forced clients to stay with the firm because they didn't want to select a new accountant on such short notice.

However, one client, a partnership, immediately abandoned the firm, owing a substantial bill. Further examination revealed the senior partner had consistently undercharged the partnership for accounting services by 30% to 50%. This demonstrates why each partner must clearly identify his or her relationship with each client so the financial impact of these relationships can be evaluated by all the partners. Firms must implement management strategies for each client.

* Loss of knowledge and experience in technical areas and client relationships. Partners rely on each others' expertise and knowledge of clients' business. It is very difficult to switch to running a one-person shop when one is used to daily communication about accounting and tax matters. Even with contacts in other CPA firms, the time involved in describing an accounting or tax problem and obtaining a solution becomes extensive; it takes much longer than walking to the next office and asking for help.

* Previous short-term goals and long-term strategic plans that become obsolete. Each firm, no matter the number of partners, has a position in the marketplace. In our firm, we had had a specialty in service to the health care industry, primarily doctors and nurses. Our short- and long-range plans had been to increase our accounting services to this group and to develop new products, such as general financial consulting for medical practices, internal controls and implementation of proper billing procedures. These plans had been based on my partner's relationship to a host of doctors who were willing to provide consulting contracts to the firm or provide new business leads for health maintenance organizations.

Without these key relationships, I was faced with developing a whole new view of the surviving company, its personality, service levels and the desirable types of clients to seek out. In addition, for continued survival, it was crucial to identify ways to replace the clients we were likely to lose. I found I needed to reassess the firm's direction and develop a diversified client base.

SELL, MERGE OR

CONTINUE ALONE?

By September 1991, I had reached a turning point. I felt my options were to sell, merge or remain a sole practitioner. Each had its pitfalls. If I sold, I still had to earn a living. Most people wanted to merge - they were particularly interested in my focus on marketing. The last choice, remaining a sole practitioner, was an unacceptable option based on my experience so far.

As my wife wanted to leave the San Francisco area, I tried selling first. I engaged a professional sales company experienced in selling accounting practices to sell the firm to the right buyer at the right price.

The results of this exercise were spectacularly dismal. Potential buyers, recognizing the difficulties I faced, made distress-sale offers. I received no satisfactory bids.

When selling a practice under duress, CPAs should follow these rules:

* Find a reputable broker who will represent the firm owner and not the buyers.

* Do not sign an exclusive contract with the broker.

* Come up with an independent practice valuation.

* Do nothing to give the impression it is a distress sale.

I ultimately decided a merger was the most attractive option despite my bad experiences in trying to sell the firm. A well-crafted merger combines each firm's strengths and permits more diversity. In the current marketplace, diversity is preferable, if not crucial.

I have since merged with three CPAs from whom I rented space after I moved out of my former offices. This arrangement offers economies of scale, diversity of specialization and less risk for the individual.

PREVENTIVE MAINTENANCE

After my experience, I urge CPAs in firms with five or fewer partners to adopt at least these policies to avoid crises when a partner dies:

1. Regular partnership meetings to discuss the details of important engagements.

2. Better communication with other partners' clients.

Firms that implement these and other preventive maintenance measures will be glad they did if tragedy strikes.
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Title Annotation:small accounting firm
Author:Nogle, Warren G.
Publication:Journal of Accountancy
Date:Oct 1, 1993
Words:2007
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