Less than 60 days after Company A made a commitment to purchase Company B, Company B reported lower-than-expected, first-quarter earnings. After closer scrutiny it was discovered that a substantial portion of Company B s historical revenue had been generated by selling off existing investments to accelerate income recognition “a practice called securitization" rather than recognizing income over time as the financial investments matured. Earnings dropped precipitously once Company B adopted Company A s funding policies, which didn't include much securitization.

By applying their forensic accounting, analytical, and legal skills, fraud examiners can help clients identify potential issues before they commit to purchase a company, preventing unfortunate surprises after the deal has closed.

Merger and acquisition activity escalated to unprecedented levels in the 1990s. The total value of mergers and acquisitions increased from $178 billion in 1990 to more than $1.7 trillion in 1998. With the continuing consolidation of such major industries as banking, insurance, and telecommunications, mergers and acquisitions should grow at an even faster rate in the new millennium. A fraud examiner can play an essential role in these transactions acting either as an independent consultant for the buyer or as a full-time employee on the company s acquisition team.

The Acquisition Process 

Every acquisition process is slightly different depending on which investment banker, if any, the seller has engaged to market the company. However, the process generally can be divided into these phases “ preliminary bidding, due diligence, final bid submission, contract negotiation/documentation, deal closing, and business integration.

Preliminary Bidding

In this phase, the seller issues to potential bidders an offering memorandum, which contains a description of the target company s operations, key management profiles, historical and projected financial information, and copies of audited financial statements. As part of the acquisition team, fraud examiners can assess the reasonableness of financial projections contained in the offering memorandum and identify trends in company performance. For example, does the target company plan to grow revenue and profit at levels higher than were historically achievable? If so, what change in business fundamentals is driving this growth? If revenues and volume are increasing rapidly, will the target be able to sustain the historical margin levels, or will margins suffer as market penetration improves?

Based on this limited review of data, bidders are asked to submit a non-binding preliminary range of purchase prices for the target company. The seller uses these values to determine which of the potential buyers will be invited to visit the target company for due diligence. Fraud examiners can help determine a proper range of purchase prices by reviewing market data and comparing those values to similar companies in the industry.

Due Diligence

The primary financial investigation surrounding mergers and acquisitions is referred to as "due diligence." Due diligence generally is conducted for three to five days at the target company s location. Potential buyers are provided with access to company records, interviews with key operating personnel, a review of the company s strategies, and its forecasted financial performance. The extent to which a seller makes information available depends on a number of factors including the size of the target, whether the target is publicly or privately held, and the marketability of the company (i.e. how many buyers are interested in purchasing the company). A large, publicly held company that has many interested buyers may not need to reveal large amounts of internal company data to bring about a sale. However, a small, private firm that is not well known may need to generate more data to influence potential buyers to make a bid. Regardless of how much data is provided, a fraud examiner s forensic accounting skills can be invaluable in the due diligence process, which includes examining data room materials, financial records, and revenue forecasts.

Data Room Materials

In each due diligence, the seller provides a "data room," containing all relevant financial books and records, a sampling of customer files, and copies of all material contracts the buyers need to evaluate the transaction. Fraud examiners can determine whether any documents were removed or altered to present a more positive view of company operations. When a sampling of data is provided, fraud examiners can evaluate the statistical methodology the seller used to produce the documents, and verify whether the sampling is representative of the entire population.

There are numerous cases in which management fraudulently altered documentation to improve financial results. On June 30, The Wall Street Journal published an article on the continuing accounting problems at McKesson HBOC, Inc., a healthcare software and services provider. Problems at McKesson date all the way back to 1937 when the Securities and Exchange Commission (SEC) found nearly $19 million in misrepresented assets, which were created through false inventories and accounts receivable. The company had been pretending to sell merchandise to Canadian dealers by drawing up elaborate, fake invoices and stationing secretaries in empty offices in Canada to re-route mail with Canadian postmarks. New allegations of revenue padding were made against McKesson in 1998. In both cases, the public accountants were unable to discover the fraud and gave "clean opinions" on the company s financial statements. By having a fraud examiner on the due diligence team, buyers do not have to rely solely on the seller s financial statements to make their decisions.

In addition, a target company s financial statements, even if prepared in accordance with General Auditing and Accounting Principles (GAAP), may not disclose all contractual commitments relevant to the buyer. Fraud examiners should assess whether any documents included in the data room present undisclosed commitments to the purchaser to perform certain duties after closing. For example, what is the target company s lease term on the existing facilities? In many cases buyers consolidate company operations by closing down existing facilities. If there are penalties associated with breaking the lease, then significant additional costs could be required to complete the acquisition. Another example is the inventory on hand at the target company s facilities. Fraud examiners should work with third-party appraisers to assess the fair market value of the inventory to ensure that the buyer is not paying a premium for slow-moving or obsolete stock.

Financial Records

Fraud examiners should compare interim financial statements from the most recent periods to annual audited statements, and then obtain explanations for any significant changes in balances or performance. Through this analysis and discussions with management, fraud examiners can ensure that the unaudited interim financial statements accurately reflect the results of company operations for the current year-to-date. This can be extremely important in determining current operating trends in the business since the last set of audited financials was prepared. It also may provide an early detection of adverse changes in financial condition that could impact the value of the target company and the ultimate purchase price offered.

Revenue Forecasts

Obviously, sellers often are aggressive in reporting revenue and income forecasts in their offering memorandas because they re trying to get the best price for their companies. In these instances, if a buyer goes ahead and acquires the company without carefully examining the forecasts, it'll be too late to go back to the seller for recourse once the buyer realizes the projected revenues won t be met.

Contract Negotiation/Documentation

After final bids have been submitted and a buyer selected, then the contract negotiations begin. This is typically the most lengthy and frustrating phase in a merger and acquisition. Negotiations oftentimes are drawn out sessions involving in-house and independent legal counsel for both the buyer and the seller. Discussions focus on contractual term issues, such as if an environmental condition surfaces shortly after close, which party has the liability for the exposure associated with penalties and cleanup? In some cases, the contractual terms that the seller is willing “or not willing“ to make will affect the purchase price offered by the buyer. A fraud examiner s unique mix of financial and legal perspectives can protect the buyer s interests and ensure solid contract negotiations.

Most larger acquisitions include a 90-day grace period after closing for the buyer to complete an audit of the company as of the acquisition date. Fraud examiners can help establish the scope of audit procedures and assist the auditors in their analysis. A particularly sensitive issue is who incurs the revenue and expenses between pre-closing and post-closing periods. The general theory is that all revenues and expenses prior to the sale date go to the seller, and all post-closing revenues and expenses go to the buyer. However, the official "cut-off date" still remains a hot issue.

For example, on July 1, The Wall Street Journal reported that Microsoft had been charged with "hiding" earnings from previous boom periods by recording excess reserves. These reserves would be released when needed to smooth earnings in slower periods. Such a manipulation of revenues and earnings between pre- and post-closing periods in an acquisition could affect the value of the property purchased.

Deal Closing and Business Integration

Deal integration is perhaps the most important step of the acquisition process. However, it is often overlooked by the buyer. Fraud examiners who were on the acquisition team can use their knowledge of the acquired company s operations during the integration. They can highlight and address problems identified during due diligence, as well as track and monitor for compliance all contractual commitments uncovered in the data room. Fraud examiners also can apply their knowledge of operating plans and strategic focus to ensure company financial projections are fulfilled. Fraud examiners can make the integration of financial reporting between the two companies much easier because they already are familiar with the acquired company s reporting methods. All of these aspects can be facilitated by fraud examiners to ensure a smooth integration.

The goal of all fraud examiners whether they are employees of large organizations or sole practitioners should be to expand their scope of services and provide added value to their employers. The trend toward mergers and acquisitions and the increasing complexity of these transactions provide an ideal opportunity for fraud examiners to use their accounting, investigative, and legal skills. By becoming an integral member of the acquisition team, fraud examiners can increase their exposure to senior management in their organization and help their companies and clients to succeed.

Bob Stefanowski, CFE, CPA, CMA, is senior vice president at Capital Funding Inc. His prior experience includes five years of public accounting with Price Waterhouse (now PricewaterhouseCoopers). He also is an adjunct faculty member, specializing in financial topics, at New York University. He has been a Member of the Association of Certified Fraud Examiners since 1990. 

References

1. Frank, Peter B., Michael J. Wagner, and Roman L. Weil, Litigation Services Handbook: John Wiley & Sons, 1990.
2. Gomes, Lee, "Microsoft Says SEC Probes its Accounting," The Wall Street Journal, July 1, 1999, A3.
3. MacDonald, Elizabeth, "The Ghost of Scandal Past," The Wall Street Journal, June 30, 1999, B1.
4. Pollak, David W., John F. Seegal, "Acquiring or Selling the Privately Held Company," Practicing Law Institute, 1999.