Due diligence is the research and analysis of a company done in preparation for a business transaction, such as a corporate merger or business acquisition. The due diligence activities performed prior to completing a merger or acquisition transaction vary based on the terms of the engagement agreed upon by the parties to the transaction. While there are many different types of activities performed during a due diligence examination, a critical activity is the financial due diligence. Financial due diligence includes procedures to analyze and validate the Company’s financial information which are dictated by the scope of the work determined by the buyer.
Common procedures for due diligence, or areas of focus, include analyses of:
- Major assets and liabilities
- The quality of earnings
- Trends and forecasting
- Working capital and will also include qualitative observations for areas such as accounting procedures, internal control structure and other significant findings.
1. Major Assets and Liabilities
The analysis of major assets and liabilities by an experienced accountant or financial due diligence professional can quickly determine if the target company has poor accounting and has failed to comply with prevailing accounting standards. Poor accounting records will be a significant roadblock in completing a merger or acquisition transaction. Utilizing company accounting personnel or outside CPAs to prepare in advance for the rigors of a financial due diligence examination will prevent unforeseen roadblocks that can put the seller at a significant disadvantage during the negotiation process.
2. Quality of Earnings
A quality of earnings study is performed to assist with the determination of the fair value of the business. Quality of earnings studies typically include revenue recognition testing and analysis, testing to determine if revenue and expenses are recorded in the proper period, a proof of cash, an analysis of earnings before interest, tax, depreciation, and amortization (EBITDA), and an analysis of customer concentrations or other risks. Preparing for a quality of earnings study in advance will provide owners with time to correct identified issues and better understand issues that may come up during the study.
3. Trends and Forecasting
Trend analysis and forecasting are also performed as part of financial due diligence. During this process, the following information is analyzed: Key historical revenue trends, historical margin trends (including product line margins) seasonality and customer and supplier concentrations, key customer and vendor relationships, and historical raw material cost trends, general administrative, advertising and R&D expenses. The trend analysis will provide insights into the key assumptions used by the company to determine the feasibility of forecasts.
4. Working Capital Observations
The working capital of a company is oftentimes analyzed as part of a buyer’s desire to purchase adequate working capital to initially fund ongoing operations. Merger and acquisition deals will often adjust the assets and liabilities that will be included in working capital based off which accounts are included in the deal. Further, other adjustments are typically made based off the nature of certain balances. It is important for company owners to know what is on their company’s balance sheet and to be confident the balances are correct in order to be prepared for negotiations with the acquirer.
Documenting the Accounting Procedures
Lastly, establishing documented accounting procedures and a strong internal control structure will help to ensure the organization has reliable financial reporting and is in compliance with laws, regulations, and policies. Owners and management should be actively involved in the design and ongoing implementation of accounting procedures and a sound control environment to ensure the objectives of the organization are met. Establishing accounting procedures and internal controls will mitigate problems that may be encountered during financial due diligence.
How DHJJ Can Help
Whether you are preparing your company for acquisition or seeking to acquire another company, DHJJ’s CPAs are available to help you with both the buyer and seller side merger and acquisition due diligence needs. DHJJ will assist with the analysis, provide recommendations and work closely with your legal and company accountant, creating a team whose focus is on you, the owner. If you are looking at merging or acquiring, please contact DHJJ at 630-420-1360.
