Know what you're getting into. (Due Diligence).

Whether your firm is acquiring another accounting practice, merging into another firm, merging the practice of another accounting firm into your firm--or even if you are becoming a partner in a firm--it is imperative that you conduct due diligence to ensure that the transaction will not expose you or your firm to significant liability or that you're not doomed from the beginning.

Even as a seller of an accounting practice, you should prepare for the due diligence that the buyer will conduct on your practice, as well as consider conducting due diligence on the buyer to ensure he or she will be able to make all future payments.

Some key due diligence issues that emerge as accounting firms enter into transactions include the following:

MALPRACTICE ISSUES

All parties involved in a transaction should review the malpractice insurance policies of each other and the claims history. As a seller, you want to ensure that your "prior acts" will be covered under the buyer's policy. If not, you may need to acquire a "tail policy," which is an expense that should be factored into the transaction.

A review of claims history will determine whether or not:

* The other party has been sued;

* There have been judgments against the firm or its partners;

* Claims are pending against the firm; or

* Payments on claims have been made.

The reputation of the firms that are parties in the transaction will be combined, so each will be tainted by any problems or malpractice claims that have been filed against the other. The surviving firm, depending upon the structure of the transaction, may be liable for malpractice acts committed by the other firm.

CONTRACTS

Many advantageous contracts have clauses that will be affected by the transaction. For example, the lease for office space may be subject to termination by the landlord, if the lease contains a provision treating a change of ownership or sale of the assets as an assignment, subject to the landlord's consent. Thus, two firms looking to consolidate into one office following the transaction may discover that the landlord has a right to either terminate the lease or increase rent to fair market value, which may significantly impact the economic benefit of the transaction.

Other contracts, such as equipment leases, maintenance contracts and the like, may also contain clauses providing for their termination upon assignment, or may not be assumable or assignable. Contracts that should be reviewed include shareholders or partnership agreements, buy-sell agreements, deferred compensation agreements for existing partners and unfunded retirement plans, which can create a significant liability for the combined entity.

Carefully review compensation agreements both to ensure how your own compensation will be calculated, as well as to determine whether or not there are any unfunded buyouts or retirements for partners of the surviving firm. Such arrangements may create a significant financial obligation and severely effect the firm's survival or profitability.

The firm's qualified retirement plans and their funding also should be examined carefully. For example, is there an under-funded defined benefit plan, which may require significant contributions in the future? Is there a defined benefit plan that, based upon participants' ages and the plan's performance, will require significant ongoing contributions? Is the plan current and in compliance with the law or is the plan subject to potential disqualification based upon various violations of the law?

CLIENT ENGAGEMENT LETTERS

Each party to the transaction should review the client engagement letters entered into by the other party. If there are no engagement letters, it's a red flag. Even if engagement letters do exist, they may contain terms that are economically detrimental to the acquiring party.

At a minimum, the engagement letters may need to be rewritten with the name of the new combined entity. Fee schedules and hourly rates, together with fixed-fee contracts, may impact the combined entity's economic viability.

FINANCIAL STATEMENTS

CPAs who enter into transactions should carefully review the other party's financial statements and tax returns for the last several years. Partners joining a firm also should conduct the same examination and due diligence of the financial statements and tax returns of the firm. Review the profitability and individual expenses, which may shed light on how the firm actually operates, as well as the balance sheet, which will disclose liabilities.

Various clues to the firm's culture can be discovered on the tax returns and financial statements, including expenditures for meals and entertainment, season tickets to sporting or culture events, automobiles and reimbursement of automobile expenses, travel and the firm's policy for continuing education reimbursements.

Different approaches to the treatment of these items, including, for example, whether the firm owns or pays for partners' automobiles, may reveal areas of potential disagreement between the partners.

If the firm's revenues have remained flat for several years or are declining, particularly if coupled with increasing expenses, this may be a sign that the proposed combination is necessary for one firm's survival and may effect the survival of the soon-to-be combined firm.

EMPLOYMENT MATTERS

Review personnel files for all staff members. If files are not maintained, this may give rise to claims for wrongful termination if the grounds for that termination are not adequately documented. A key issue facing many firms is whether non-exempt employees, such as non-certified accountants or bookkeepers, are being paid overtime. Failure to adequately comply with wage and hour laws may expose the firm to significant liability.

Similar to the review of potential claims in the malpractice area, attention should be paid to potential, pending or actual claims filed by employees. Have there been any claims for wrongful termination, discrimination or harassment?

The existence of such claims, or more important, the practices that underlie them, are warnings of potential problems and monetary exposure.

Similarly, the firm's employee policy manual should be reviewed. If there is no manual, it is a red flag.

While these are only some of the potential items that should be reviewed during your due diligence, it is apparent that no matter what the structure of the transaction is--a stock purchase, merger, asset acquisition or simply the joinder of new partners--due diligence can be crucial to avoiding potential liabilities.

Jonathan A. Karp, Esq., CPA, heads the corporate practice for Reish Luftman McDaniel & Reicher in West Los Angeles. He will teach the Education Foundation course on Succession Planning for the CPA Firm this year. You can reach him at [phone] or [e-mail].