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January 19, 2011

The economic forecast for 2011 predicts continued recovery, and many corporations that have amassed significant cash balances are stepping up the search for savvy investments. As a result, merger and acquisition (M&A) activity, as well as funding available to private equity funds and other investors, is expected to increase. Although, this is great news for many reasons, buyers still need to beware. Even though the economy was struggling, investment spending was down, and M&A activity had decreased – inherent risks of fraud, corruption and regulatory compliance violations did not decrease over the last few years. Accordingly, the role of forensic accounting professionals in the due diligence process has become critical to reducing potential losses.

Here are some important issues to consider in M&A activities:

Why conduct forensic accounting due diligence pre-transaction?

Addressing business and legal concerns, as well as the potential for negative reputational impact on an organization after a transaction closes, becomes increasingly expensive. The identification of potential fraud, corruption, and regulatory compliance violations during transactional due diligence is vital. While surfacing such issues may prove difficult during financial / tax / commercial due diligence, there are many risk factors that are readily discernable and may require in-depth forensic accounting due diligence procedures before closing a transaction, including:

  • “Off-balance sheet” or intercompany transactions appearing outside of the normal course of business
  • Excessive pressure by management to achieve financial goals / budgets
  • Industry sectors with a history of corruption and / or significant regulatory risks (e.g., construction, telecommunications, manufacturing, healthcare, and government contractors)
  • The reputation for corruption in a given country where the target operates (e.g., India, Russia and China)
  • Unusual business relationships including those with foreign government officials and third-party intermediaries (e.g., brokers, agents, and / or consultants)
  • Past compliance issues reported or rumored
  • Excessive travel, gift, entertainment, or miscellaneous expenses related to the awarding or retention of certain contracts
  • Excessive sales commissions contingent on obtaining certain contracts.

Furthermore, corporate development transactions often involve the purchase of or investment in small or medium-sized enterprises (SMEs) ranging from a sole proprietorship to an entity employing hundreds of people. The risk of potential fraud, corruption and regulatory compliance violations in these types of organizations is much greater for several reasons:

  • Many SMEs lack or have severely under-resourced internal audit, legal, and corporate compliance functions, resulting in a higher risk of a weak corporate culture ignorant of or complacent about the risk of fraud, corruption and regulatory violations. In some contexts, unscrupulous business practices may be seen as just another business device and a necessary evil that can be overwhelming challenges for an SME to overcome;
  • SMEs may not recognize or understand the complexities or “gray” areas of fraud, corruption, and regulatory compliance; and
  • SMEs often feel they have little support when dealing with extortion – demands for money, goods or services – and, as a result, are often unable to offer much resistance and become entangled in potential illegal activities.

There are numerous benefits to performing pre-transaction forensic accounting due diligence procedures – perhaps most notably, the ability to obtain (a) an increased understanding of obligations or liabilities the acquirer / investor may assume post-transaction, and (b) an acceptable level of comfort that certain potential risks associated with the target’s financial statements have been contemplated before a transaction closes.

An integrated financial / tax / commercial / forensic accounting due diligence team can assist with the identification of potential risk indicators that can alert both the buyer / investor and the target to potential issues that can affect the intent to move forward with a transaction, the need to expand the scope of due diligence, and / or the agreed-upon closing price – before it is too late.

What are some best practices in performing pre-transaction forensic accounting due diligence?

While the acquirer / investor may be concerned with additional time and costs associated with assessing a target’s exposure to potential fraud, corruption or regulatory violations, the creation of a strategic and tailored approach that fully complements the financial / tax / commercial due diligence procedures will help mitigate the risk of significantly more costly post-transaction outcomes such as internal or government investigations, compliance audits, financial restatements and litigation. To reduce the risk of costly post-acquisition measures, forensic accounting due diligence procedures often involve:

  • Conducting informational interviews of select target personnel to obtain an understanding of historical financial reporting / sales / marketing processes and procedures, corporate culture, internal controls and potential financial reporting risks;
  • Obtaining an understanding of the following documentation and relevant information from: compliance surveys, ethics (“whistleblower”) hotline procedures / reports, internal and external complaints / issue management procedures and remediation efforts, ethics and compliance / code of conduct training and communications, compliance monitoring and reporting, and employee disciplinary policies and procedures, including any related to allegations of fraud, corruption, and regulatory violations;
  • Analyzing significant contractual arrangements to identify terms or conditions known to be associated with higher risk of unscrupulous business transactions;
  • Studying the design and stated effectiveness of internal controls related to areas such as cash disbursement, cash receipts, segregation of duties, signatory authorizations, and journal entry approval, among others;
  • Obtaining an understanding of the target’s order-to-pay and procure-to-pay, as well as other transaction cycles;
  • Reviewing historical financial data for select general ledger accounts of interest such as those related to reserves and accruals, intercompany and related-party transactions, travel and entertainment expenses, and consulting expenses, among others; and
  • Examining select transactional data resident in the target’s vendor database, payroll database, and accounts payable database, among others, to identify potential indicators of bid-rigging, ghost payroll, false billing schemes, bribery, and vendor kickbacks.

Based on the nature and potential severity of any findings resulting from the performance of the select forensic accounting due diligence procedures above, the acquirer / investor and its advisers may deem further forensic due diligence procedures necessary. Common additional procedures may include more in-depth interviews of target personnel, further forensic accounting procedures, and background / integrity investigations of target principals or those with significant management and financial reporting responsibilities and key suppliers / customers. Remember, more often than not, where there is smoke, there is fire.

Conclusion
As you begin making M&A or investment spend decisions in 2011, remember that a pre-transaction due diligence strategy that includes some scope of forensic accounting procedures will, at a bare minimum, arm you with specialized knowledge about the potential risks associated with your investment. This resulting specialized knowledge will not only better position you in transaction negotiations, but also minimize the need for costly post-closing corrective measures.

About Alvarez & Marsal Dispute Analysis & Forensic Services
Since 1983, Alvarez & Marsal (A&M), a leading global professional services firm, has set the standard for working with organizations to solve complex problems, improve performance, drive critical change and maximize value for stakeholders. Our more than 1,700 professionals in offices across North America, Europe, the Middle East, Asia and Latin America, constitute a diverse group of seasoned professionals in major markets and financial centers throughout the world who bring deep financial, accounting, economic, regulatory, industry and technical expertise. Our team includes forensic accountants; certified public accountants and chartered accountants; certified fraud examiners; former executives; former SEC, Financial Services Authority and Office of the Comptroller of the Currency professionals; PhD economists; banking and securities professionals; chartered financial analysts; forensic technology specialists; former Federal Special Agents; and former Big Four partners and staff.

Alvarez & Marsal has been recognized as one of the Best Firms to Work For by Consulting magazine and has ranked as one of the Top 50 Consulting Firms by Vault.

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