Mike Costello
Today, CPAs are playing a major role on the due diligence team that advises buyers in an acquisition. Why? The buyer needs insight into the financial picture of the target as well as access to knowledge of tax laws and accounting rules for business combinations.
A CPA can also help buyers discover little-known landmines that can kill a deal, such as significant pension plan liabilities, hidden workers’ compensation costs and past tax problems.
Developing a List of Target Companies
A CPA can provide valuable input even in the earliest stages of an acquisition. A CPA can make a list of target companies based on the buyer’s goals and financial situation. This target list can help the buyer narrow the field and eliminate targets that don’t meet the acquisition objectives.
After an attractive target has been identified and the target’s owners have indicated a willingness to discuss a sale, the CPA can do a preliminary review of the company. Using new research or information you already have about the company, the CPA can determine whether synergy exists with the buyer’s company. Their goals, style of management and ways of doing business must be similar enough to make a productive combination.
At the same time, the target company’s price must fit the buyer’s financial situation and plans for the new organization.
The Financial Statements Don’t Tell All
Historical financial statements disclose a target’s financial position, results of operations and cash flows in accordance with generally accepted accounting principles. However, GAAP offers preparers several accounting alternatives that can affect the company’s earnings picture.
Depreciation, inventory valuation methods, the choice of revenue and expense recognition and other variables can affect the bottom line. For example, how aggressively is the company recognizing obsolete and slow-moving inventory?
Buyers may want to have a CPA look at a company’s sales figures by customer to track selling patterns. This may reveal whether the company keeps its good customers or merely has good salespeople. Also, a CPA can track sales by product to reveal where products are in their lifecycles.
Dealing with Unrecorded Liabilities
A CPA can assist in making sure that the target’s financial statements are fairly stated. As part of that process, he or she may identify unrecorded liabilities.
For example, underpayment of workers’ compensation insurance can be a substantial unrecorded liability. If the insurance company auditor then makes an adjustment at year end, the acquirer could be liable, unless protection is built into a purchase agreement.
A CPA can also help acquirers answer other important questions such as:
Has the target been subject to an IRS audit? If so, what were the issues?
Are there any product warranty claims because of defective merchandise, recalls, etc.?
Does the company have copyrights or patents that are nearing the end of their protection?
Are there any long-term commitments and contracts that will present potential financial obligations for the buyer?
Recasting Financial Statements
Recasting a target’s financial statements will, in some cases, give the acquirer a better picture of a company’s earnings as well as its potential. It can also provide a basis for determining a potential purchase price.
An acquirer will want to get an appraisal of the company’s assets to determine their fair market value or value in use. Many assets, like real estate, are undervalued on the balance sheet. Most intangible assets won’t appear on the balance sheet at all.
The CPA can also determine if the target’s management has taken steps to make the company appear more attractive by reducing discretionary spending such as advertising, research and development, new product introduction or repair and maintenance.
Reviewing Projected Financial Statements
Usually, the seller will prepare projections of operating results and cash flows. A CPA on the due diligence team can review the appropriateness of the assumptions used in the projections and help assist with their accuracy.
Buyers may want their CPA to review the target’s annual projections and compare it to the company’s multiyear strategic pan, if available, to determine any differences in assumptions or business strategy. If possible, the due diligence team should review old business plans to see if past objectives were accomplished.
Due Diligence is Just the Start
The CPA can play an important role on a buyer’s due diligence team, providing an independent perspective that the company’s financial statements and disclosures are in order, perhaps discovering unrecorded liabilities and assessing the reasonableness of projections. But the CPA’s role doesn’t end there.
A CPA can help the buyer structure a purchase agreement that will maximize potential earnings while minimizing negative tax consequences. He or she can also help the acquirer after the purchase to assist in a smooth integration of the two organizations.
If you have any questions about how a CPA can benefit the due diligence process for an acquisition you are involved in, please call.
Local Case Study
Over the years we’ve been involved in a significant number of due diligence projects that have helped our clients to enhance their business investments, and in some cases, to minimize losses.
In one such case, we “looked behind the numbers” in a situation involving the purchase of a manufacturing company that had a concentration of its revenues with one large customer.
We advised the buyer to obtain assurance that this sizeable customer would continue to buy products from the company after the purchase of the business.
Unfortunately, the seller would not allow the buyer to do anything to ascertain that the company’s largest customer would maintain its relationship after the sale, so we advised the buyer to “walk away” from the transaction. In our opinion, the risk of losing the customer that contributed the most to the cash flows and bottom line of the company was too great to result in a reasonable and justifiable transaction for the buyer.
This result was emotionally difficult for the buyer at first, but after the passage of time, he thanked us for helping him avoid a high-risk situation that could have potentially resulted in substantial losses.
(Mike Costello, CPA/ABV, CFE is a Certified Public Accountant, Certified Fraud Examiner, business appraiser and consultant with more than 20 years of training and experience in business valuations and appraisals, business acquisitions and divestitures, and forensic accounting.
He has written several articles for the Tennessee CPA and the AICPA’s Management Consultant newsletter.
He was the Managing Director and President of Costello, Strain & Company, PC, a CPA firm he established in May 1984. The firm was merged with Joseph Decosimo and Company, LLP, CPA’s in September 2003. Joseph Decosimo and Company, LLP was founded in 1972 and today is one of the top 100 CPA firms in the nation.)