accounting, tax and consulting solutions inancial due ...through due diligence by the buyer, looking...
TRANSCRIPT
march 2011 www.greaterchar lot teb iz .com
Rick HewittCPA, Transaction Advisory
Services
Accounting, Tax and Consulting Solutions
Elliott Davis, PLLC [accountingbiz]
Whether you are buying or selling a busi-
ness, both transactions involve both risk
and opportunity to the parties. Your goal,
as a buyer or seller, is to avoid surprises, while having
high confi dence in your decisions.
›Importance of due diligenceAs the buyer, by conducting the proper due dili-
gence 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 other-
wise lead to purchase price disputes, closing delays,
buyer uncertainty and even post-transaction litigation.
Financial due diligence, when fully executed,
assesses not just the valid-
ity of historical results, but
also what the past perfor-
mance indicates about the
future prospects of the business. Financial due
diligence focuses attention on the critical success
factors including identifying risks and opportuni-
ties, potential contingencies, commitments and
exposures, and evaluating the quality of histori-
cal and projected earnings and cash fl ow, and the
internal controls, employees and systems sup-
porting the presented results. Findings from due
diligence procedures can usually be quantifi ed and translated into purchase
price adjustments, often based on a multiple of EBITDA (earnings before
interest, taxes, depreciation and amortization) or modifi cations to the terms
and conditions of the transaction.
As either the buyer or the seller, if you understand what needs to be accom-
plished in the due diligence process and prepare accordingly, you are likely to
achieve a more effi cient and effective outcome. The following addresses some
of the base-level expectations of the buyer and seller.
›Quality of earningsAn audit provides an opinion that the fi nan-
cial statements present fairly, in all material respects,
the fi nancial 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 fi nancial position, and thus a trans-
action 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 fi nancial 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
refl ect 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, benefi ts
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 pro-
posed 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 develop-
ment, and personnel costs may not be indicative of necessary
spending post-transaction.
Related to the balance sheet, a buyer should examine the methodol-
ogy 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 determin-
ing 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 unre-
corded liabilities and assessing proper cut-off procedures, especially for interim
fi nancial statements. The seller should ensure that the most recent period
end balance sheet contains adjustments similar to those included at year end.
inancial Due Diligence: Meeting expectations of the buyer and seller
Scott HendersonCPA, Transaction Advisory
Services
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.
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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 material-
ity differently. While the seller may conclude the
cumulative adjustments to EBITDA are not mate-
rial to the overall results of the presented fi nancial
statements, the buyer will likely consider the
adjustments very material if the purchase price is
calculated using a multiple of EBITDA.
›Further InvestigationConcurrent with its quality of earnings analy-
sis, 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 over-
all, 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 fi xed
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 defi ned 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 his-
torical 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, specifi cally distinguishing cash fl ow from
operating activities versus fi nancing and invest-
ing 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 fi nancial statements, and
proper preparation by the seller, providing quality
fi nancial statements, supporting documentation,
and meaningful responses to questions, an effi cient
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 offi ce of Elliott Davis, PLLC, an accounting, tax and consulting services fi rm providing clients the solutions needed to achieve their objectives in 10 offi ces throughout the Southeast. For more information, contact Scott Henderson at [email protected] or Rick Hewitt at [email protected] or visit www.elliottdavis.com.
Through due diligence by the buyer, looking beneath the surface of the fi nancial statements, and proper
preparation by the seller, providing quality fi nancial statements, supporting documentation,
and meaningful responses to questions, an effi cient transaction
process should ensue.