Uncovering Hidden Risks in a Business Acquisition

Uncovering Hidden Risks in a Business Acquisition

When contemplating the purchase of a company or new business unit, fraud usually isn’t top of mind. However, seasoned business professionals should understand that overlooking the possibility of hidden risks in your acquisition target could lead to serious financial and legal consequences both now and in the future. Including a forensic accountant on your acquisition team could help you move the transaction along smoothly, without unpleasant surprises.

Thorough Examination of Financials

During the due diligence process of an acquisition, a forensic accountant plays a crucial role in analyzing the target company’s financial statements for the subtle yet critical signs of fraud or foul play. Common red flags may include things such as excess inventory, significant write-offs, an unusually high volume of voided discounts, inadequate documentation, and an uptick in purchases from new vendors. Suspicion should also arise when account balances are not in sync, such as when accounts receivable is rising while revenue is declining or stagnant.

Unusual fluctuations in revenue and expense figures, as well as seemingly unrealistic growth projections, may warrant further scrutiny to determine if they are normal or perhaps a result of the nefarious acts of management. Unintentional discrepancies are not uncommon in smaller companies lacking sufficient internal financial expertise. This is why it is so important to engage with a forensic accountant who has the proper skillset to assess the true position of the target business. Without this guidance you may be flying blind directly into dangerous territory for your company.

Watchful for Warning Signs

Evaluating whether unusual income figures are indicative of manipulation involves assessing whether insiders had the opportunity to commit fraud. A lack of robust internal controls is often a red flag and leaves gaps in the proverbial armor. Additionally, regulatory infractions, customer complaints, and suspicious supplier relationships may suggest that there is more going on than the seller is indicating. To gain further insight, an expert may conduct background checks on the target company’s key personnel, perform data analysis, and even review key policies and procedures to evaluate their effectiveness.

While modifying accounting practices to present a business in a favorable light might be legal in most situations, evidence of deliberate fraud, especially at the executive level, could prompt you to reconsider your offer. In less severe cases, adjustments to the purchase price or changes in the deal structure might be necessary. Each situation requires specific attention and investigation, without this many times neither side of the transaction is happy with the results.

Mitigating Risks

Even if a seller successfully conceals financial manipulation or other illicit activities, there are ways to protect your transaction. Consider including an indemnification clause in the purchase agreement. Although this may involve negotiation with the seller on details such as the definition of “fraud” and liability limits, such clauses are invaluable in managing the significant risks inherent in most acquisitions.

How NAFA Can Help

At North American Forensic Accounting PC, we specialize in assisting clients from a variety of industries navigate the complexities of mergers and acquisitions. Our experts are often called upon to provide business valuations and quality of earnings assessments to help clients better understand their target. This independent assessment can go a long way in identifying risk and financial anomalies that could influence your final decision. We frequently remind clients about the Latin phrase Caveat Emptor or “let the buyer beware”. Remember that it is critical to always do your due diligence.

Our experts can help provide you with the peace of mind and confidence you are looking for as you evaluate your next transaction. Contact us today for more information on how we can support business acquisitions.