Engagement Risk Management

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By Eva Lang

Ron Klein, a vice president-claims counsel with CAMICO Mutual Insurance Company, spoke at the recent AICPA/ASA Business Valuation Conference on the topic of Engagement Risk Management. It was an eye-opening presentation for valuation analysts who may be a bit complacent about the risk of taking on certain engagements.

The following article "10 Ways to Manage Your Risk in This Economy" is an excellent primer for CPAs on managing engagement risk from the CAMICO website:

10 Ways to Manage Your Risk in This Economy

Economic conditions historically have a significant impact on CPA professional liability claims. In general, there are more claims filed in an economic downturn, and there are larger claims filed after an economic bubble bursts. The reasons for increases in claims frequency and severity are multiple:

* people and companies lose money,
* business decisions go awry more easily, and
* there is not as much business opportunity as before.

Economic downturns tend to have an impact on the credit availability, and this downturn is no exception. Credit crunches cause difficulties for some clients. Good borrowers may have trouble getting credit, and it may be next to impossible for not-so-good borrowers. This situation may cause them to pressure CPAs to go along with them on a particular issue so they can qualify for credit. Client difficulties might also show up as business problems for which the CPA is blamed.

What Can You Do About It?

1. Identify clients that are at high risk. If you have a specialty or a significant client in a certain industry, get together with other partners or associates and start extrapolating: what if the economic downturn causes the loss of a client's customers or a line of credit? What kind of services are we rendering? What will happen?

This process leads you to recognize risk stress points. If you're in an attest engagement, this will point you to where on the balance sheet or income statements the risk is going to show up. The likely culprits are inventory, accounts receivable, or revenue recognition. There may be valuation issues when it comes to certain assets.
CPAs will want to figure out which clients will be affected in order to warn them about their risks. Jury research shows that CPAs are expected to "advise and warn" - to advise clients of opportunities and to warn them about risks.

Identifying clients that are at high risk is a key point. No one solves a problem of which they are unaware. The CPA then needs to make sure that clients are getting good advice. The good news is that those clients who respond well may end up generating more revenue for you, which is as good as avoiding problems.

2. Educate clients through newsletters or targeted mailings. Identify which clients would benefit from a targeted mailing, and use it to emphasize issues such as the tax consequences of the forgiveness of indebtedness. Communicate that you are there to help them with their decisions. Such communications can be done in an effective way without creating additional exposure.

3. Educate your staff, because they are the ones who will interact with the clients and help you identify those at high risk. When clients call and ask about certain issues that you have pre-identified with your staff, you can use a cohesive, centralized approach to dealing with their issues.

4. Increase professional skepticism. Professional skepticism is a must: to protect yourself, to protect the readers of the financial statements, and to protect the client. Desperate times will cause some clients to take desperate measures that get by a CPA who has become complacent. Professional skepticism means you will think twice about something that doesn't make sense.

Another common but serious error for CPAs is to go along with the client on an issue such as the valuation of inventory or assets, which will satisfy the creditors or investors but also result in a significant material misstatement. Don't take on your client's problems and become a victim for the client. Loyalty to a client is not above the professional standards of integrity, independence and objectivity. It's not worth losing your reputation and your own financial security as the result of a disastrous engagement.

5. Increase scope, intensity, and fees for attest work. Increased professional skepticism and client identification may result in an increase in scope or intensity for attest work. If scope or intensity increases, fees had better increase as well, especially for audits.

6. Insist on current (90 days) real estate valuations. If you have a business client that relies in any way on real estate valuations, you must insist that those valuations are current. In this market, in certain geographic locations, valuations that are older than 90 days probably will not fly; 60-day valuations are better. Be sure that the valuations are authentic. If the appraiser is working out of Alaska but appraising California property, there may well be something wrong.

7. Identify and understand investment risk to subprime. You can identify investment risk generally and then try to isolate it into subprime and other categories.

8. Be attentive to disclosure of loan covenant violations, generally with audit and review engagements, but it is more important now than ever to be punctilious and exact about loan covenant violation disclosure. The third-party creditor or bank might claim that there were loan covenant violations that were not disclosed. In regular times, loan covenants are violated routinely and banks don't care about them. They don't care until they lose money; then it's critical.

9. Examine risk to third-party creditors. The creditor, bank, investor, or silent partner who is relying on the operating partner will become your risk, especially in attest work. If you don't examine the risk, you are essentially flying blind.

10. Risk-screen new and existing attest clients. Look at business failure risk and management risk (i.e., competence and integrity). The risk-screening process will also help you identify engagement risk and risk stress points. This process will help you more directly resource your audit personnel on the stress points in the engagement. It may allow you to re-price the engagement as well. One word about re-pricing, however: you cannot re-price a disastrous engagement to make it worthwhile.

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