Third-Party Review Can Be ‘Ounce of Prevention’
Investigation May Uncover Fraud, Other Problems

by Bob Ferguson, Sheryl E. Seigel

Jun 1, 2004

(TMA Global)

Although everyone in the business world is likely to agree that an ounce of prevention — otherwise known as due diligence — is well worth a pound of cure, many major acquisitions are completed following little more than superficial examinations of existing data.

That may be because it’s human nature to assume that terrible things happen only to other people or that it is too costly or time-consuming to conduct an independent investigation and verification of the financial and business information provided. Whatever the justification, many purchasers painfully discover information after the fact that, had they known it in advance, could have significantly altered the terms of a particular deal or prompted them to walk away from it.

Purchasers have for years focused their attention on previous years’ annual audited financial statements of an acquisition target as a principal source of key financial data about the business. However, given the increased complexity of modern business enterprises, the current legal environment, and the real-time flow of paperless electronic commerce, there are now both practical and legal reasons to include a forensic financial investigation as part of any pre-acquisition due diligence exercise.

Since the 1997 decision of the Supreme Court of Canada in Hercules Management v. Ernst & Young, [1997] 2 S.C.R. 165, it has been clear that a prospective purchaser of a business does not come within the ambit of persons to whom the acquisition target’s external auditor owes a duty of care in the preparation of annual financial statements. As such, any reliance by a purchaser on past years’ audited financial statements is not actionable against an auditor who turns out to be incorrect. In other words, as well as being historical, existing audited statements may contain interesting information, but, (a) they were not prepared with a buyer’s transaction in mind, and (b) if they are inaccurate in any respect, there is nothing a buyer can do about it.

In addition, a purchaser must also be aware that audited financial statements are prepared by accountants who are trained to audit, not to conduct forensic accounting. What is the difference? To begin with, annual audited financial statements are prepared to enable shareholders as a group to assess management’s performance over the past year and to provide guidance to management for the upcoming year. Annual audited financial statements are generally based on a sampling of a company’s financial data. They focus on recording those assets in accordance with generally accepted accounting principles (GAAP) for purposes of consistent and statutorily compliant reporting.

To a prospective purchaser of a company or its assets, the information contained in annual financial statements may be a helpful place to start. But a review of financial statements should not be the only information gathering process that the prospective purchaser engages in, particularly if one desires to ensure that there has been no manipulation of financial data by persons inside the target corporation.

In contrast, a professional forensic accountant retained as part of a pre-transaction due diligence team can perform a review that is specifically designed to test data and assumptions, with a view toward protecting a prospective buyer. A purchaser should be able to rely on this review when deciding whether to proceed with the intended acquisition and when finalizing pricing issues.

Forensic due diligence involves a critical review by a third party of a company’s major financial assets and principal customer relationships, and a detailed qualitative, rather than quantitative, analysis. A forensic accountant looks at patterns of activity, such as significant customer relationships, the frequency of turnover of major customer receivables, lawsuits that may have been settled out of court, patterns of major disbursements, and circumstances surrounding points of contact with a company’s major financial partners, including its external auditors.

Gauging Risks

The following disguised case study shows how one major company’s after-the-fact experience convinced it that forensic accounting could serve as an ounce of prevention for its future acquisitions.

Suspecting that the inventory listed in the assets of a recent acquisition had been substantially overstated, Company A engaged forensic financial investigators several months after it purchased majority ownership of a medium-sized company. The investigation proved that the company’s concerns were well founded. The acquired company’s vice president of finance was discovered to be stealing inventory, selling it to one of Company A’s competitors, and then covering it up by falsifying inventory figures.

Although Company A, which had valued the acquisition based on assets and earnings, greatly benefited by getting a true picture of its new acquisition’s financial worth, it did so at the cost of significant lost time and energy. That experience, however, convinced the company to retain forensic financial investigators a few weeks later to perform a due diligence investigation on a supplier that Company A was eager to purchase.

The supplier manufactured a specialized component for one of Company A’s most profitable products. It wanted to purchase the supplier both to earn a return and to ensure that the component it needed would always be available at a reasonable price. The company had tried to acquire the supplier for years, but its sole owner had always declined the overtures. However, due to sudden health problems in his family, the owner decided to sell his company.

Preliminary negotiations ensued and an agreement was worked out that would give Company A complete ownership of the supplier in return for 25 percent of the purchase price in cash and the other 75 percent in shares of Company A, which would be determined by their stock market value at the time of closing.

The purchase price was based on a five times multiple of the supplier’s pretax earnings as reported in their audited financial statements for the most recent year-end. Those statements showed pretax earnings of $5 million for the supplier, which established a purchase price of $25 million. As always, the deal was subject to due diligence, which in this case involved a review by forensic investigators.

The forensic team recommended — and Company A agreed — that its overall mandate would be to determine key business, financial, and accounting risks associated with the proposed purchase. That meant not only analyzing key financial and accounting information relevant to the supplier’s operations, but also investigating the marketplace, the supplier’s present and future position within it, and any previously unforeseen factors that could weaken or endanger the supplier’s profitability and viability.

The investigation produced three major findings. The first centered on the supplier’s customer list. The investigation determined that nine main customers, including Company A, accounted for 80 percent of the supplier’s $30 million in annual sales. Detailed background searches of the other eight companies revealed that three were owned, either directly or indirectly, by the same international parent.

Further research, including an analysis of public documentation and interviews with sources familiar with the parent, revealed that although the customers were financially healthy, their parent was undergoing major restructuring of its debts, including real estate and plant financing. The restructuring was significant enough to call into question the stability of the parent and, consequently, the future of a major portion of the supplier’s customer base.

The second major finding grew out of an assessment of the overall business risk involved in the acquisition, with specific exploration of how the supplier might be vulnerable to a loss or decline in its existing dominant position in the marketplace. Research indicated that the supplier had succeeded over the years because it manufactured, in conjunction with two other products, the part that Company A required. The cost of the part that Company A required was low because it was manufactured primarily from the by-product of materials from the other two parts. This meant that any change in the marketplace affecting the quantity of the other two products being manufactured and sold by supplier would impact the cost of producing the part for Company A.

Further investigation revealed that the supplier’s patent on one of the other two products was set to expire in the near future. In all likelihood, the supplier’s market share for the product would decrease because the loss of patent rights would open the market to greater competition. The lower market share could result in higher costs to produce the part for Company A because insufficient by-product availability would require the supplier to purchase raw material at a substantially higher cost.

The third finding resulted from background investigations of the supplier’s key officers. One revealed that the supplier’s comptroller had recently acquired a second mortgage on his home, which brought the total financing to more than 90 percent of its value. The mortgage was arranged through a broker at close to double the going interest rates, which meant that the comptroller’s house payments alone accounted for roughly 80 percent of his annual salary.

A lifestyle review further revealed that the comptroller spent lavishly on clothing, entertainment, travel, and material possessions to a degree far in excess of his apparent income. The principals in the proposed purchase requested further investigation. The seller recommended starting with inventory, for in his view, the comptroller spent more time on that area of the business than anywhere else.

Selected purchase transactions were investigated and analyzed. That process exposed a scheme that had been in place for almost two years. Unknown to his superiors, the comptroller had been rerouting raw materials before they were delivered to the supplier to another company registered to his wife and located in a nearby municipality. The comptroller doctored the supplier’s books, including bills of lading, to show that his employer received the goods.

Although the inventory had been audited twice during the relevant period, the comptroller on both occasions was able to direct the young audit staff to test-check inventory that he knew existed in accurate amounts. As a result, test checks of book to physical inventory agreed. The comptroller then falsified the physical count sheets to match the inventory recorded in the books. Investigators estimated that the scheme had cost the supplier about $750,000 in lost inventory. This information was turned over to the supplier, and the comptroller was dismissed immediately.

Reassessment

Following the presentation of findings, Company A had to assess whether these were deal-breaker or pricing issues. From its research, the company concluded that the offshore parent of the three customers would survive its restructuring, although Company A vowed to maintain a vigilant watch on the parent’s progress. The company also determined that the supplier would remain viable, despite the loss of patent rights on one of its products, although profitability would definitely decline. Another factor under consideration was the $750,000 in lost inventory. Although a bad apple had been removed, the comptroller had almost no assets, making any meaningful recovery from him impossible. Further, the fidelity coverage was uncertain.

Company A decided that purchasing the supplier was still a good business decision but that the deal had to be repriced in view of the new information. As a result of the $750,000 in overstated inventory, Company A insisted that the pretax earnings from the previous year-end financial statements be reduced from $5 million to $4.25 million. In addition, based on the expected impact of the lost patent rights, the company proposed that the purchase price be reduced from a five times multiple of earnings to a four times multiple of earnings. Consequently, it lowered its offer to $17 million ($4.25 million x 4) from $25 million ($5 mil-lion x 5). The supplier accepted the offer, and the purchase was completed.

It often takes a bad experience to convince someone that common wisdom everyone agrees with in theory — such as the benefit of preventive medicine — should also be followed in practice. Although the businesses in the case study were Canadian, fraud and other problems affecting the value of companies do not recognize international boundaries. Today more than ever, buyers in any corporate arena are well advised to be especially thorough in their pre-acquisition due diligence.

 

Bob Ferguson CA•IFA
Principal
Kroll Lindquist Avey
Ferguson’s practice focuses on forensic accounting, corporate investigations, and litigation support. Kroll Lindquist Avey is part of Kroll Inc., an international risk consulting firm providing a broad range of investigative, intelligence, financial, security, and technology services to help clients reduce risks, solve problems, and capitalize on opportunities.
Sheryl E. Seigel
Partner
Fasken Martineau DuMoulin LLP
Seigel works in her Canada-based company’s insolvency and restructuring group, which advises foreign and domestic businesses, lenders, creditors, institutional and distressed debt investors, insolvency professionals, and other stakeholders in financial restructurings.

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