Due diligence is key when buying or merging with another business. Today, many M&A deals involve companies that were disrupted by the pandemic, as well as those that have been adversely affected by recent supply chain shortages and geopolitical issues. Not only is it important to vet the seller’s financial statements, projections and representations for errors and exaggerations, but buyers need to look for potential signs of fraud.
Reviewing the financials
In today’s volatile marketplace, a seller who’s under duress may be tempted to make a distressed company appear healthier than it truly is. For example, the seller could:
- Report revenue prematurely (or fictitiously),
- Postpone expense recognition,
- Project unrealistic post-pandemic growth rates, and
- Fail to write off uncollectible receivables, obsolete inventory or impaired goodwill.
Creative accounting tactics, errors and other anomalies are especially common in smaller companies that don’t have their statements audited by outside experts or that may not have adequate internal financial expertise. A forensic accounting expert can help evaluate the seller’s financial statements for warning signs of fraud and review the assumptions underlying projections to determine whether they’re supported by historical trends and current market data.
Evaluating management
In addition to evaluating the target company’s control environment for opportunities to commit fraud, due diligence procedures should include background checks on the company’s principals. It’s also important to watch for behavioral warning signs of fraud. People who exaggerate results or commit fraud may exhibit control issues, such as an unwillingness to share duties, files or billing records. They also may become irritable or defensive when confronted about irregularities or potential conflicts of interest.
Although it’s better to detect fraud before a deal closes, a buyer might consider having an indemnification clause written into the purchase agreement. This measure can help protect the buyer against any lies that affect the purchase.
Researching external sources
During due diligence, buyers should look beyond the information provided by sellers. For example, regulatory disapproval, pending lawsuits, customer complaints and suspicious supplier relationships could forewarn of potential issues.
This information may be found through online searches of the company and members of its management team. A forensic accountant might suggest additional procedures — similar to those done during an audit — to help validate account balances and search for unreported liabilities and risk factors.
What’s a deal breaker?
Evidence of fraud and other anomalies cause some potential buyers to rescind their offers — but not always. In less-serious situations, it may be appropriate to adjust the purchase price or change the deal’s structure. A forensic expert can help determine what’s appropriate based on the circumstances.
Speak with a Meaden & Moore expert today to learn more.
