Forensic Accounting in Transaction Services

20 Sept 2011

Specialized Expertise For Mergers And Acquisitions

Mergers and acquisitions require significant company resources, both money and time.

While businesses usually conduct a detailed assessment of the target company's financial reports, systems, and accounting processes during due diligence, an often-overlooked but highly valuable area is assessing whether the target company is involved in financial statement fraud.

This type of due diligence requires specialized expertise that is typically not possessed by staff accountants and external auditors. This is where forensic accounting plays a crucial role in mergers or acquisitions.

WHAT IS FORENSIC ACCOUNTING?

Forensic accounting is a specialized field of accounting that primarily focuses on uncovering fraud, particularly financial statement fraud. Forensic accounting assignments typically involve a detailed assessment of a company's accounting systems and processes to determine the accuracy of the target company's financial statements and provide an accurate analysis of these statements, including but not limited to identifying undocumented and underreported liabilities, overstated assets, or understated sales and expenses. Additionally, forensic accounting also conducts background checks on senior executives, officers, and managers.

AT WHAT STAGE OF M&A SHOULD YOU INVOLVE FORENSIC INVESTIGATION?

Involving forensic accountants for investigation should begin when the potential buyer and seller have a general understanding and agree on the initial financial terms of the transaction. The potential buyer will conduct a comprehensive financial due diligence of the business subject. This due diligence refers to the caution that a reasonable company would take before making an acquisition, focusing on investigating and analyzing material facts that could influence the acquisition decision.

Furthermore, financial due diligence also ensures that the representations made by the seller are true and accurate, leading to answers to critical questions such as, should we buy? And at what price? And are there risk factors that could affect its value?

HOW DOES A FORENSIC REPORT DIFFER FROM A TRANSACTIONAL DUE DILIGENCE REPORT?

Although the company's finance team will examine financial irregularities based on management account trends and other basic data, when conducting Transaction Services, they do not specifically look for fraud entries. Their analysis and conclusions are based on the financial data provided by the target company and do not make a statement as to whether the financial information is accurate or reliable.

WHAT WILL FORENSIC ACCOUNTANTS LOOK FOR?

• Fictitious sales/revenue

• Improper revenue recognition

• Incorrect asset valuation

• Hidden liabilities and expenses

• Inadequate disclosure.

WHAT IF FRAUD IS IDENTIFIED?

Depending on the fraud uncovered, the potential buyer has three options. They can:

• Withdraw the acquisition without consequences;

• Reduce the valuation to fair market value;

• Alter the deal structure.

ARE THERE HIGH-RISK INDUSTRIES?

Although all businesses can be suspected of fraud, according to our experience, there are high-risk industries due to the nature of their business. These include manufacturing, software/IT, financial services, as well as real estate and construction.

CASE STUDY

A high-profile case was observed from Hewlett-Packard after they bought Autonomy, a British software company, in 2011 for $11.1 billion. It was reported that HP thought Autonomy had a 64% premium for a company with 2010 revenue of nearly $1 billion, and had a “track record of consistent double-digit revenue growth, with a gross margin of 87 percent and an operating margin of 43 percent.” Less than a year later, HP recorded an $8.8 billion impairment charge, citing Autonomy's accounting irregularities as the reason. Investors wondered how HP could have made such a massive mistake before they shelled out $11.1 billion in cash?

HP sued Autonomy's founder, Mike Lynch, and its finance director, Sushovan Hussain, in the high court in London, accusing them of being involved in improper transactions with software resellers and questionable accounting practices. HP launched a $5 billion (£3.3 billion) fraud lawsuit against Mike Lynch, claiming that he had inflated his business's revenue by around $700 million over a two-and-a-half-year period.

It is worth noting that Autonomy's financial statements were audited by one of the Big 4. Moreover, non-audited target companies may pose a higher risk, so investors/companies should be more cautious.

Acquiring another business requires a lot of money and time; once again, it is crucial to conduct a detailed assessment of the target company's financial reports, including an assessment of financial statement fraud. Hiring forensic accountants during the merger or acquisition process can yield several benefits for the buyer.

The work of forensic accountants on due diligence issues provides information that enables the buyer to make more informed decisions, ensures transparency, and thus limits potential pitfalls and conflicts. Most importantly, the forensic accountant's analysis can provide additional negotiating leverage to adjust the business purchase price to reflect the fair market value.

DO YOU WANT TO KNOW MORE?

If you want to know more about how forensic accounting helps clients with high-risk issues involving financial statement fraud, accounting irregularities, and data recovery, do not hesitate to contact me.

DID YOU KNOW? “Private companies and small businesses rank highest in the frequency of job fraud at 42% compared to large companies, government, and non-profit organizations. Lack of internal controls is a precursor, or signal that financial statements are incorrect or intentionally fraudulent.”