Contract breaches: Why it pays to know your business partners well and document, document!

In this blog post, Brad Sargent warns of the costs associated with contract breaches and the importance of sound business relationships and meticulous record keeping.

Have you ever told someone you’d do something and then were unable to follow through? Did you call the person to let them know, or wait to see how bad the damage was, then scrambled to repair it? Or perhaps you’re the type who tells people you’ll do something, with no intention of doing it, simply to gain favour. I could write at length about representations made in personal relationships, but let’s focus on commercial relationships.

Parties conducting business will often enter into contracts to document the terms of their relationship. Attorneys are engaged to ensure that legalities are considered and expectations are clearly spelled out. The participants agree to the terms, execute the contracts and go forward. Yet, we forensic accountants spend a huge percentage of time investigating breaches to these contracts.

I have seen contracts breached at every phase. Entities enter into agreements with no intent of honouring them, break the agreement in the midst of conforming to the terms, or fail to deliver at the very end. Consider the party that never intended to comply. My friend Fred Fresard of Dykema Gossett PLLC is a commercial litigation lawyer licensed in both the U.S. and Canada. Fred notes: “Over and over again, we see salespeople agree to a contract that their company cannot possibly comply with. The company has no choice but to breach and hope they can work it out, short of litigation and some hefty bills.” Fred’s advice? “Make sure your agreements have standard terms and conditions, and that your salespeople don’t vary from those terms without prior approval from your company’s lawyer.” Often times, we accountants are charged with “making the numbers work” — putting us in the frontline of possible accounting fraud.

In tough times, many businesses are willing to cross ethical lines just to make the sale. An overly ambitious salesperson not only breaks all the rules, but is allowed to because management can’t afford to lose a star performer. I also see cases involving the breach in the middle of the agreement. Sadly, it is how the underperforming party reacts to the potential breach that can lead to litigation. Instead of seeking an honest dialogue, they begin to mislead. Consider the underperforming business that relies on a line of credit. Sales are down and receivables begin to lag. The line of credit is based on the assets, so if the receivables fall below a certain figure, the credit could be jeopardized. Magical accounting to the rescue! Dummy invoices create dummy credit sales, which in turn create dummy receivables. The perpetrators tell themselves that somehow the lie is lessened if it is perceived to be temporary.

Breaching a contract at the end (think, at delivery) is usually a result of never intending to comply, and often involves failure to communicate the breach, leaving the business partner damaged and with no time to make repairs. In a supply chain, a minor failure to deliver can grow exponentially. In the automotive world, for example, it can involve millions of dollars in damages.

Over the years, I’ve seen countless signatures on contracts and thought that each one identified an individual’s commitment. Sadly, whether matters of the heart or commerce, lying has become a modus operandi. Make sure you know your business partners well and document, document, document!

About the Author

Brad Sargent, CPA, CFF