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Top 5 Common Issues in Financial Due Diligence

 1. Accounting Standards

During the due diligence process, it often becomes apparent that the Target has failed to comply with at least some accounting standards (for various reasons). Typical examples include the Target recognizing income on a cash basis (rather than an accruals basis) or recognizing revenue incorrectly (this is more likely if the Target has multiple revenue streams and/or long-term contracts with stage payments spanning accounting years). From an M&A perspective, it is very likely that there will be differences between the accounting standards adopted by the acquirer and those of the Target (such differences may be more pronounced if the transaction is cross-border and where there are two (or more) accounting conventions being considered (for instance, US versus UK GAAP).

2. Contingent & Unrecorded Liabilities

It is not uncommon for contingent liabilities (a potential liability that may occur, depending on the outcome of an uncertain future event) or incorrectly recorded/disclosed liabilities to be found within a Target. At the more severe end of the spectrum, examples include litigation risks relating to the violation of laws and regulations (either specific to the industry in which the Target operates or on a national level), non-payment of taxes, warranty claims and breach of contract(s). Less severe contingent and unrecorded liabilities, but nonetheless potentially constituting “deal breakers,” include:

  • redundancy payments to be incurred in the future;
  • deferred tax (crystallizing on sale of an asset which has appreciated in value);
  • the incorrect categorization and accounting treatment of operating and finance leases;
  • and dilapidation provisions in respect of leased real estate. 

3. Related Party Transactions 

Problematic related party transactions are often uncovered during the due diligence process – the crux of the matter here is non-commercial transactions. The financial statements of the Target should be carefully examined. For instance, it should be determined whether the Target makes sales to other entities within a group. If intra-group sales are made, are these at higher margins than usual? Conversely, if intra-group purchases are made, are these at lower rates (therefore improving margins)? The balance sheet of the Target may show loans due to/from related parties. A review of payables and receivables will reveal the parties these amounts are due to/from and whether the balance sheet is “inflated” due to related party transactions.

4. Quality of Earnings

An acquirer will typically base their offer for a Target on a multiple of its Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) or a similar profit metric. Therefore, as part of the due diligence processes it is imperative that the “quality” and sustainability of the Target’s earnings is reviewed. When considering the Target’s normalized EBITDA or "run rate," the acquirer should exclude non-recurring, non-cash items such as gains or losses from acquisitions, divestitures, discontinued business operations or fixed asset sales (all of which have a distortionary affect on earnings). Other items to consider include any unusual or non-recurring revenue and expense items. Furthermore, changes in historical versus potential management remuneration and major customers being gained or lost should be considered.

5. Historical Results Versus Budget/Forecast

Once the due diligence team has grasped any historical trends/norms, they should consider the connection between actual historical results and budget/forecast to gauge the accuracy and reasonableness of the Target’s budgets/forecasts. For instance, if the Target has forecast for revenue growth and/or margin increases, how successful has it been at achieving this performance in the past? A review of the constituents of any projected revenue growth should be carried out to ascertain if growth is dependent on key customers, as an example. The acquirer should also analyze gross margins and any customer loyalty assumptions, in addition to forecasts relating to operating expenses (such as employee numbers).

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