When a client is a liability.

Do some clients seem to be more trouble than they're worth? They might be.

A manufacturing company officer shows interest in retaining a CPA firm for an audit that could generate nearly $100,000 a year in fees. However, the firm's investigation reveals the client changed accountants twice over the last three years, its signature product is becoming obsolete and no replacement has been developed. The firm rejects the engagement solely because the malpractice risk presented by a client that is regularly dissatisfied with its accountant and that has impending fmandal problems far exceeds the potential financial reward.

Accountants once could accept almost every engagement without incurring malpractice risk. However, with the increasing prevalence of management fraud, clients' unwillingness or inability to pay for professional services and financial troubles affecting enterprises of all sizes, screening prospective and existing clients is becoming a valuable component of a malpractice defense program.

CLIENT PROBLEMS

CPAs should beware the following characteristics when choosing clients:

* Present or impending financial or organizational difficulty. Some warning signals are insufficient working capital, an industry experiencing many business failures, a company with high turnover in key positions and management responsibilities vested in one person when they should be shared by several. Other characteristics include poor credit, dependence on a few customers for products or services and companies that invest other people's money. If a financially troubled client files for bankruptcy, the CPA could be named as a defendant in any resulting litigation.

* Involvement in suspicious transactions. CPAs should be alert to any activity that is or appears to be illegal, such as bribery, kickbacks, unauthorized corporate transactions, illegal contributions or artificially improved financial statements.

* Unreasonableness and uncooperativeness. Accountants should be wary of clients that balk at providing necessary documents and records on time, fail to document underlying facts and have unrealistic expectations of the time needed to complete an engagement. Other signs of incompatibility include

1. Blaming the accountant for the company's financial problems.

2. Unfavorable tax laws and rulings that affect the company as well as other circumstances beyond the accountant's control.

3. Vague, guarded responses to inquiries.

4. Threats to take the company's business elsewhere.

5. Requests for changes in the engagement, such as a change from an audit to a compilation engagement before the work is completed.

* Fee pressures. Some clients demand to pay an unreasonably low fee for professional services and regularly dispute their bills, sometimes withholding fees for months. Such clients force CPAs to choose between losing money on an engagement and performing lower-quality services.

* Refusal to sign engagement and representation letters. Clients who will not sign these documents expand CPAs' potential liability to clients and third parties.

* Demand for risky services. A firm's partnership agreement should prohibit performance of specified high-risk engagements.

* Incompatible personality. CPAs should learn as much as possible about a prospect's corporate and individual style to determine if it's compatible with firm culture.

* Characteristics such as

1. Seeking an auditor toward yearend.

2. Weakness in or absence of internal controls. 3. Lack of organization.

4. Poorly maintained records and collection difficulties.

5. Failure to file income tax returns for several years.

6. Frequent involvement in litigation. It is particularly important not to rely too heavily on one client or a group of clients for billings. For example, when a client represents 25% of a practice or one publicly held client represents 10%, the client may be able to exert undue influence on the accountant's judgment. A diversified client base is best.

If a CPA decides to accept a high-risk client and engagement, absolute compliance with defensive practices, such as use of a clear engagement letter, is necessary. A practitioner may accept a client initially considered risky under the condition that its circumstances improve within a specified period of time. The increased risk should be taken into account when setting fees, and it may be prudent to collect fees in advance.

SIZING UP THE CLIENT

An effective screening process requires strict adherence to client-acceptance guidelines and documentation of all associated conversations and decisions. The following procedures are important steps in the screening process:

1. If the client approaches the practitioner, ask why the client is changing accountants.

2. Visit a potential client's business to determine the condition of its management, finances and internal controls. Some practitioners require an analysis of all new clients' internal controls.

3. Meet a prospect's accounting and tax personnel to determine financial needs and the condition of accounting records.

4. Check all potential clients' references to determine their reputation for honesty, credit history and rating, financial stability, cooperativeness and litigation history, possible conflicts of interest, management quality, personnel competency, personality and potential to be sources of new clients.

5. Be aware of high-risk industries. Those in which CPAs are especially vulnerable to litigation include savings and loans, health care, property and casualty insurance and not-for-profit organizations. High-risk engagements are described in the next section, below.

6. After receiving necessary client authorization, contact the prospect's former accountant, current attorney, bankers, credit bureaus and current and former business associates and employees. Inquiries to the Better Business Bureau, the Chamber of Commerce or trade associations can be especially productive. CPAs should document all communications.

Refusing an engagement with a questionable client is far less complicated than withdrawing once services have been provided. Should an accountant decline an engagement, the prospective client must be informed of the decision orally and in writing and be advised that no action will be taken on the engagement. In some cases, it may be appropriate to inform the potential client of any approaching deadlines or statutes of limitations and of the need to retain another accountant.

The same review procedures should be applied annually to existing clients, or whenever there are developments in a client's financial condition or management or changes in laws affecting a client--for example, Environmental Protection Agency regulations or hazardous-waste laws. Since a client's circumstances can change markedly over time, CPAs must keep track of new risks affecting clients.

If the screening process does not produce enough information to warrant rejection of a prospective client or termination of an existing one, at the very least it identifies engagements that require extra precautions.

HIGH-RISK ENGAGEMENTS

The sidebar on pages 57-58 provides a newclient checklist. In addition to targeting litigation-prone clients, CPAs can safeguard their practices by identifying engagements that produce a high percentage of claims (see the exhibit at left).

Specific transactions that tend to be most frequently associated with malpractice liability are

* New financings.

* Audits of clients raising capital for a new business.

* Buy-sell situations.

* Disputes between clients and third parties.

* Unusual or complex tax issues.

* Liquidations, bankruptcies, going-concern issues or receivership engagements.

* Tax returns, financial statements or tax opinion letters for limited partnerships.

* Divorce (specifically, valuations of community property).

* Valuations in which the CPA represents both the buyer and seller of stock.

* Related-party transactions.

* Determinations of a business sale price in accordance with book values or audited earnings.

* Absentee-investor transactions.

* Engagements to design and install computer systems.

STICK WITH THE PROGRAM

Although the list of possible grounds for a malpractice claim is long, practitioners can reduce their risk of losses greatly by recognizing high-risk clients, engagements and industries. Establishing and following strict client-acceptance and -retention guidelines help identify high-risk clients and engagements, thereby reducing the chance of possible malpractice litigation. Successful programs help create a relationship that is in the best interests of the client and the firm.