Accounting Due Diligence (#397)
/Accounting Due Diligence
The number of accounting due diligence activities is practically endless, so let’s be very clear about the goal here. You’re not concerned about business strategy, or customer churn rates, or the quality of the other party’s products. All you care about is making sure that the financial statements they show you are accurate, and to evaluate the quality of the underlying accounting processes. That’s it.
I’m going to focus on the accounting issues that are most likely to trip you up. In other words, these are the activities that could really cause problems if you don’t prioritize them.
Revenue Recognition
No question, the first item is revenue recognition. The best way to describe this one is with an example. You might remember the Hewlett Packard acquisition of Autonomy, back in 2011. HP ending up writing off most of the acquisition cost almost immediately, because it claimed that Autonomy had done all kinds of things to artificially boost its revenue. Some of the items HP found included channel stuffing, backdated contracts, and disguising low-margin hardware resales as higher-margin software licensing agreements.
A major consideration here is that an acquiree could potentially be jacking up its reported revenues by multiples of what they actually are, so this is prime territory for a deep analysis of how revenue is recognized, the terms of the underlying revenue contracts, and how robust the recognition controls really are.
Expense Analysis
Next up, dig into the largest expenses. This is usually the cost of goods sold, but it depends on the business. What you’re trying to figure out is whether the company’s reported gross margin is accurate. To do this, take the approach of an auditor who’s conducting a review, rather than an audit. You’re judging the reported expense based on a higher-level evaluation of the trend of reported expenses, and whether the cost as a proportion of revenue seems reasonable.
A major point here is that you don’t conduct the analysis at the level of the entire company – you conduct it at the product line level, or, for a smaller business, even at the individual product level.
Doing so makes it easier to spot anomalies. Keep in mind that it isn’t that difficult to fudge the reported amount for an entire expense category, but it’s much more difficult to fudge the results at the level of individual products and product lines.
Another major expense is going to be compensation. Look for areas in which compensation is being undercounted. This could be stock option agreements for which no expense has been reported, or maybe bonus plans for which there haven’t been any expense accruals. If there are a lot of hourly staff, make inquiries about whether overtime is being recognized correctly. In short, you don’t want to be faced with unexpected expenses after the acquisition has closed.
Next up, look for any expenses that could blow up on you. This does not mean subscriptions expense or office supplies expense. You can ignore that stuff. Instead, focus on whether there are any big, unrecorded or under-recorded expenses. For example, has the company recorded any asset retirement obligations? What about environmental liabilities? How about pending litigation? As an example, the German company Bayer bought Monsanto, and took on all of its legal liabilities related to the weedkiller Roundup. At the moment, Bayer is on the hook for $17 billion in legal settlements. In short, yes, looking for unrecorded liabilities is way more important than digging through utility bills.
Asset Analysis
Next, verify the assets. For example, remember Parmalat? This was a European dairy company that falsified $5 billion of cash holdings. Falsifying cash is rare, but it can happen. In addition, conduct a review of the highest-value inventory items, preferably with advice from an expert. Ask to see the detail for the highest-dollar receivables, and look really closely at the bad debt reserve. On top of that, conduct a walkthrough with a knowledgeable person to see if you can spot their highest-cost fixed assets, and verify their condition.
This is a tough area, because evaluating assets takes time, and due diligence operations are usually conducted very quickly. Given the time constraints, focus on the highest-value items and only explore lower-value items if you have time.
Those are the main issues. If the CEO wants to close a deal fast, before you’ve had time to look at these main issues, then explain the risks of going into a deal without full knowledge. With any luck, you can buy a few more days to dig further, which reduces the risk.
Process Analysis
Next is the question of whether there are any specific processes or procedures that I recommend reviewing. Absolutely, review the process flow for revenue recognition. If it’s a complex process, then maybe even go into full audit mode and sample a couple of large-dollar transactions. It makes a lot of sense to get a feel for whether there are any gray areas that could lead to revenue recognition problems.
If you have time, it’s useful to poke around in the accounting department and get a sense for how well it’s being run. For example, where are the bottlenecks? Are there piles of paperwork anywhere? If so, the department is probably understaffed, which you’re going to need to fix if the acquisition goes through.
What type of accounting software do they use? If it’s a lower-end system, then you may have to convert it over to something more robust, which is expensive and takes a lot of time.
Ask about best practices. You could use my Accounting Best Practices book as a checklist, and see what they’ve installed. If they’re up to date, that’s a really good sign. If not, then you have some ready-made efficiencies just waiting to be implemented.
If you actually have a few days for this analysis, then invite different staff out to lunch or dinner, and make inquiries. Let’s face it, you can’t dig up very much about processes in a few days, so just ask. Lower-level staff can be remarkably informative if you’re nice about it.
A final thought. Due diligence is frequently rushed much more than it should be. CEOs seem to think that it’s just a formality, so they may only give you a couple of days – which is ludicrous. At a minimum, push back and try to get more time. If not, then make a prioritized list of the riskiest to least risky areas, and start at the top. It’s quite likely that you’ll run out of time before you can even address the processes in the accounting department.