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March 2011
Financial Due Diligence: Meeting expectations of the buyer and seller
By Rick Hewitt and Scott Henderson

     Whether you are buying or selling a business, both transactions involve both risk and opportunity to the parties. Your goal, as a buyer or seller, is to avoid surprises, while having high confidence in your decisions.

 

Importance of due diligence

     As the buyer, by conducting the proper due diligence before a merger or acquisition, you gain critical insights and assurances that the business is what it appears to be before moving the deal forward. As the seller, by properly preparing for due diligence, you can identify and address upfront issues that could otherwise lead to purchase price disputes, closing delays, buyer uncertainty and even post-transaction litigation.

     Financial due diligence, when fully executed, assesses not just the validity of historical results, but also what the past performance indicates about the future prospects of the business. Financial due diligence focuses attention on the critical success factors including identifying risks and opportunities, potential contingencies, commitments and exposures, and evaluating the quality of historical and projected earnings and cash flow, and the internal controls, employees and systems supporting the presented results. Findings from due diligence procedures can usually be quantified and translated into purchase price adjustments, often based on a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization) or modifications to the terms and conditions of the transaction.

     As either the buyer or the seller, if you understand what needs to be accomplished in the due diligence process and prepare accordingly, you are likely to achieve a more efficient and effective outcome. The following addresses some of the base-level expectations of the buyer and seller.

 

Quality of earnings

     An audit provides an opinion that the financial statements present fairly, in all material respects, the financial position and results of a company in conformity with Generally Accepted Accounting Principles (GAAP). However, GAAP allows for subjectivity, judgment and estimates in a company’s accounting policies that can have a material effect on the operating results and financial position, and thus a transaction purchase price.

     If audited, a buyer should look at the audit work papers to gain an overview and understanding of the target’s accounting policies and potential issues. For a company that is not audited, the possibility of adjustments to price is even greater. Understandably, the seller wants to present financial results that may lead to the highest selling price.

     Quality of earnings is typically the key focus area. This exercise begins with the target’s reported EBITDA and adjusts or normalizes earnings to reflect what the buyer would expect on a pro forma basis. The seller may often provide management adjustments for expenses it believes will not continue, such as excess owner’s compensation, benefits and extravagant expenses, one-time or unusual expenses or expenses that may change as a result of the transaction, such as rent, insurance or professional fees.

     In addition to evaluating management’s proposed adjustments, the buyer may identify and propose certain due diligence adjustments to earnings. Related to the income statement, the buyer will analyze revenue trends, compare revenue to cash receipts (generally called a proof of revenue) and look for early revenue recognition or revenue that may be reversed, aggressive use of estimates, one-time or unusual revenue transactions and revenue not related to the company’s ordinary course of business.

     The buyer should look at general and administrative expense trends where certain discretionary accounts such as marketing, repairs and maintenance, research and development, and personnel costs may not be indicative of necessary spending post-transaction.

     Related to the balance sheet, a buyer should examine the methodology applied to provision accounts, including sales returns and chargeback allowances, reserves for doubtful accounts, inventory obsolescence reserves, and warranty obligations and related reserves. The buyer should inquire about capitalization policies, verifying that operating expenses are not being improperly capitalized. Understanding these policies is critical to determining the impact on quality of earnings, to assess whether earnings have been impacted by subjective accounting entries rather than business operations.

     The buyer should also analyze key accrued expenses, searching for unrecorded liabilities and assessing proper cut-off procedures, especially for interim financial statements. The seller should ensure that the most recent period end balance sheet contains adjustments similar to those included at year end. Understanding the methodology for accruing expenses and changes in these accounts during the trailing 12 months may identify potential quality of earnings issues.

     A buyer and seller will likely view materiality differently. While the seller may conclude the cumulative adjustments to EBITDA are not material to the overall results of the presented financial statements, the buyer will likely consider the adjustments very material if the purchase price is calculated using a multiple of EBITDA.

 

Further Investigation

     Concurrent with its quality of earnings analysis, the buyer should inquire about and examine data that may shed additional light on the future direction of the company and risk exposure to the buyer. Key areas may include seasonality issues, price versus volume impact on revenue, trends of gross margins overall, by product and revenue line and an understanding of the components of cost of goods sold including inventory valuation, allocation of labor and overhead and fixed versus variable cost mixes.

     Regarding customers, a buyer should want to understand terms of any customer contracts, extent of customer concentration, reasons for lost customers and variances in major customer activity.

     Further, the buyer should inquire about working capital trends (generally defined as current assets less current liabilities) and cash management issues including any apparent receivable collection risks, trends in receivable and inventory turnover and accounts payable management. A buyer should also assess historical capital expenditures and future capital expenditure needs and capacity issues.

     These areas, among others, should help the buyer understand how cash is generated and used, specifically distinguishing cash flow from operating activities versus financing and investing activities. A seller should anticipate and be prepared to answer questions not only about the company but comparisons to competitors and industry benchmarks.

     Through due diligence by the buyer, looking beneath the surface of the financial statements, and proper preparation by the seller, providing quality financial statements, supporting documentation, and meaningful responses to questions, an efficient transaction process should ensue.

     Since each deal is unique, consider involving your team of advisors (accountants, attorneys, consultants etc.) who have experience with due diligence engagements early in the process to tailor and assist with procedures appropriate to your transaction.

     Content contributed by the Charlotte office of Elliott Davis, PLLC, an accounting, tax and consulting services firm providing clients the solutions needed to achieve their objectives in 10 offices throughout the Southeast. For more information, contact Scott Henderson at shenderson@elliottdavis.com or Rick Hewitt at rhewitt@elliottdavis.com or visit www.elliottdavis.com.

Rick Hewitt and Scott Henderson are CPA, Transaction Advisory Services at Elliott Davis, PLLC
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