Avoiding Due Diligence Issues
For More Information:
Proactive Due Diligence
Navigating Transaction Pitfalls
For any transaction to be successful, the acquirer will have completed a thorough due diligence investigation. It is helpful to know some of the more common financial and accounting problems that are frequently arise so they can be avoided in advance.
Undervaluation of inventory by private companies minimizes taxes but can lead to distorted earnings trends.
A key source of overvalued inventory is unrecorded inventory obsolescence caused by product overruns, changing technology, new product development and maturing or discontinued products. The overvaluation usually results from excessive obsolescence or failure to count inventory on hand accurately.
The most common form of litigation in the lower middle and mid-market results from product liability. This type of liability often surfaces well after the acquisition.
"Dressing Up" tactics can include deferral of Research & Development expenses, and repairs and maintenance, “release” of inventory reserves, unduly low reserves, or estimates for such things as bad debts, pension accounting, sales returns and allowances, warranties, slow-moving and excess inventories, and undisclosed changes in accounting principles and methods.
Doubtful accounts, cash and trade discounts, dated receivables, and sales returns and allowances may not be adequately reserved for.
A private investigation may be needed to obtain sufficient information and background on target management to determine if it is right for the job and trustworthy.
Personal expenses usually reduce reported net income. But such costs also can be used to affect trends and produce a favorable appearance that is misleading if not recast accurately. Proforma adjustments by the seller to eliminate such expenses often are overstated.
Tax contingencies represent one of the biggest problem areas in an acquisition, because most companies tend to be very aggressive when preparing their tax returns.
Unrecorded liabilities may include vacation pay, sales returns, allowances, and discounts (volume and cash), pension and insurance liabilities, loss contracts and warranties, among others.
Related party deals can have a material effect on the company under new ownership or on the historical trends presented during negotiations.
Included in poor financial controls are poor pricing and costing policies, and deficient budgeting systems and controls.
Lack of compliance with environmental laws has become a significant problem. Other regulatory problems may exist in the area of safety, taxes, labor and so on.
Loss of a major customer can have a material effect on operations.
Significant future expenditures needed might include relocation or expansion, replacement of aging equipment, or new product development requirements to remain competitive.
Extraordinary actions such as sales of assets often improve the trend presented by the selling company.
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