Thorough Due Diligence Can Protect Your Acquisition From Fraud

In today’s rough-and-tumble world of mergers and acquisitions (M&As), buyers need to get to know business sellers and their executives, test their representations about asset condition and financial performance, and screen for common fraud schemes. Here’s why.

Whose side are they on?

Without adequate M&A due diligence, unwary buyers could fall victim to false representations by sellers that never pan out after the deal closes. Or they may inherit a hornet’s nest of white collar crime and embezzlement by employees.

Even if a company has internal controls in place, owners and executives can override them. These individuals have access to financial statements, and may have incentives — such as to receive bonuses for exceeding certain growth targets — to falsify them.

So it’s essential to perform background checks on your acquisition target’s owners and C-suite executives. A thorough check can uncover past involvement in criminal embezzlement, theft, forgery and other types of fraud, as well as involvement in civil litigation. It could also reveal falsified items on their resumés and other pertinent personal claims.

How “creative” is the business?

Financial statements should also be scoured for misstatements. Some owners may use “creative” accounting techniques to artificially inflate a company’s value. They might, for example:

• Prebook revenues,
• Leave stale receivables on the books,
• Record phantom inventory,
• Defer expense recognition, or
• Lend money to major customers so they can make large purchases that will inflate sales numbers.

Owners might also hide liabilities, falsify transactions with related parties, overvalue receivables and securities, and overstate inventories to boost the selling price.

Tip of the iceberg

Unfortunately, this is just the tip of the iceberg when it comes to fraud schemes that could diminish the value of your acquisition. In addition to performing financial and legal due diligence, be sure to tour your target’s facilities and interview management for insight into the company’s culture. For help conducting due diligence, please contact us.

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