Mergers are like marriages. Success depends on any number of factors, but failure may be a result of one overriding flaw. In the case of mergers, that flaw often is lack of thorough due diligence.
You may be able to get some of the information you need about a potential acquisition from public documents and interviews with senior executives. When it comes to unearthing creative accounting practices and fraud, though, you may want to call in help. Forensic accountants know where and how to look for financial irregularities that could prove fatal down the road.
Pre-merger due diligence begins with your own assessment of a potential acquisition’s corporate culture. One warning sign is a company that hasn’t demonstrated a commitment to fraud prevention or implemented best practices for governance. It’s important that the organization have well-defined and regularly reinforced codes of ethics, as well as strong internal controls that are periodically reviewed and tested for compliance.
Another potential problem is a management team that doesn’t communicate well. A CFO with an intimidating or dictatorial management style, for example, might feel free to bend accounting rules because other employees are too fearful to question his or her actions.
Of course, any effective due diligence includes intensive scrutiny of corporate, financial, tax, loan and regulatory records. It should encompass short-term debt retirement capabilities, liquidity, profitability and the ability to meet long-term obligations. This is where an experienced forensic accountant can add value to the process.
Digging for Dirt
Experts look for documentation of any financial claims and are alert to signs of cleverly hidden shenanigans. If, for example, a company says it has brought its income recognition policies into compliance with new SEC standards, a forensic accountant will consider what effect the change has on previous figures. The expert also will examine earlier figures to see if they reflect any financial irregularities.
A forensic accountant may devote much of his or her attention to earnings that are subjective, too. Reserves, accruals and estimates all can be manipulated for income management purposes. If accruals, for example, have increased significantly in recent months, it’s important not to blindly accept the company’s assurance that these increases are due to normal fluctuations. Forensic experts insist on specifics: What causes the fluctuations? Why are they handled this way? Is there a better approach? If so, why isn’t it being followed?
Experts also look beyond the numbers and examine the opportunities and potential reasons for fraud or misstatement. Companies that demand unreasonable financial performance from their managers, for example, are more likely to be defrauded than are companies with realistic expectations.
No Hiding, Please
Forensic accountants can discover hidden liabilities, overvalued receivables or securities, understated liabilities, and overstated inventories — any or all of which might create an inaccurate picture of a company’s true value. Signs of potential fraudulent reporting include:
- Excessive restrictions on auditors,
- Material (more than 5% of market value) related-party transactions,
- Individuals or executive “cliques” dominating corporate management,
- High employee turnover, and
- Excessive tax-driven earnings reductions.
Any of these may be significant, but limiting auditors’ access to data, senior executives or operational personnel generally is considered a sign that something is amiss.
More Than Compatibility
When it comes to mergers, compatibility is, of course, important. As in a marriage, one party’s strengths can compensate for the other party’s weaknesses. But some weaknesses can be crippling, so it’s essential that you examine your potential partner for fraud before you make the leap.
Counter Negative Perceptions
One mistake many companies make during M&As is overlooking the importance of a good communications strategy. Employees — especially if they’re also shareholders — investors, lenders, customers and suppliers all want to know how a merger will affect them. Explain in as much detail as necessary why the deal makes sense and how it will benefit stakeholders.
Early on, determine how you’ll describe strategic goals, as well as how you’ll communicate, monitor and report progress toward them. Don’t be overly optimistic, but attempt to minimize uncertainties and avoid undue disruptions. Be honest about the affects you expect the merger to have on earnings and return on invested capital — and then let the world know whether you were right. If problems arise, address them openly.
If a merger begins with negative perceptions outside the inner circle of top executives, it can be difficult to turn those perceptions around. Mergers are complicated, but they’re not — or shouldn’t be — top secret. Communicating what you can as soon as you’re able will help you avoid undue pressure to turn in unreasonable numbers once you’ve signed the deal. And pressure to perform is the last thing you need if you want to avoid fraud.
About Scale Finance
Scale Finance LLC (www.scalefinance.com) provides flexible contract CFO & Controller services, business valuations, and support in raising capital, or executing M&A transactions, to entrepreneurial companies. The firm specializes in cost-effective financial reporting, budgeting & forecasting, implementing controls, complex modeling, valuing businesses, and other financial management, and provides strategic help for companies raising growth capital or considering M&A/recapitalization opportunities. Most of the firm’s clients are growing technology, healthcare, business services, consumer, and industrial companies at various stages of development from start-up to tens of millions in annual revenue. Scale Finance has a team of more than 45 professionals serving more than 120 companies in the Carolinas and beyond.