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What's Behind the Curtain? Recognize the Importance of M&A Due Diligence

Posted by Meaden & Moore on Jan 3, 2017 8:00:00 AM

What's Behind The Curtain? Recognize The Importance of M&A Due Diligence In the rough-and-tumble world of mergers and acquisitions (M&As), it’s critical that buyers get to know sellers and their top executives, test their representations about asset condition and financial performance, and ferret out common fraud schemes. Fortunately, a fraud expert can help you avoid investing in a losing venture.This article offers tips on how to know if a seller is truly an ally and whether certain “creative” accounting or financial misstatements are misleading.

Is the Seller Really on Your Side?

The majority of occupational fraud is perpetrated by rank-and-file workers and lower-level managers. But fraud committed by owners and executives can be the most financially damaging, according to the Association of Certified Fraud Examiners’ biennial Report to the Nations on Occupational Fraud and Abuse. Without adequate M&A due diligence, unwary buyers could fall victim to false representations by sellers that never pan out after the deal closes — or they may inherit a hornet’s nest of white collar crime and embezzlement by employees.

Even if a company has fraud policies and internal controls in place, owners and executives can override them. These individuals also have access to financial statements, as well as incentives — such as bonuses for exceeding certain growth targets, or to inflate the company selling price — to falsify them.

So, it’s essential to perform background checks on, at the very least, your target’s owners and C-suite executives. A thorough check can uncover past involvement in criminal embezzlement, theft, forgery and other types of fraud, as well as involvement in civil litigation. It could also reveal falsified items on their resumés and other pertinent personal claims.

Are These Scams “Creative” Accounting or Financial Misstatement?

Owners and managers can use “creative” accounting techniques to artificially inflate a company’s value, such as prebooking revenues, leaving stale receivables on the books, recording phantom inventory or deferring expense recognition.

For example, a company might record sales early — and expenses late — in order to create the illusion of increased profits. Or a business might provide loans to major customers so that they can make large product purchases and give the appearance that the company’s sales are booming. Fraudsters might even hide liabilities, falsify transactions with related parties, overvalue receivables and securities, and overstate inventories to boost the selling price. All of these scams either artificially boost profits or asset values (or downplay liabilities) to maximize the selling price.

What Else Should You Watch Out For?

In other cases, your acquisition target might be rife with dishonest employees, who could be engaged in any number of fraud schemes — from stealing IT equipment and colluding with suppliers to skimming from petty cash and falsifying their expense reports. Fraud schemes are complex and varied, so they can be hard to expose. To prevent yourself from inheriting the seller’s problems, it’s important to tour the company’s facilities and interview management.

Looking beyond the financial statements might offer insight into business practices that provide motives to perpetrate fraud and cultural conditions that enable fraud to thrive. For example, domineering executives may feel entitled to break accounting rules and coerce other employees to participate in such activities.

Similarly, businesses that offer financial incentives for employees to meet high, even unrealistic, sales growth numbers — particularly if employees are meeting them — merit a closer look. High employee turnover and worker, customer and vendor complaints are also strong indicators that something is amiss. Finally, if the seller tries to restrict your due diligence team’s access to financial data or prevent them from speaking with key employees, be wary.

How Fraud Experts Can Help You

With any acquisition, fraud is almost always a deal breaker. A forensic accountant can be a useful addition to the due diligence team. These experts use their accounting, auditing and investigative skills to detect signs that an M&A target is cooking the books — or the seller itself is a victim of fraud.


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Topics: Investigative and Forensic Accounting

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