customer makes up 75 per cent of sales, you can focus your work
on how quickly that customer pays, calculate the percentage his
purchases have increased or decreased, determine how vulnerable
the company is to their existing orders, etc. and perform a cursory
review on the rest.
Uncovering The Truth
Every quality of earnings investigation turns up something the
buyer is better off knowing. If it impacts the value of the business,
the buyer and vendor are usually able to renegotiate the deal in
the buyer’s favour.
The buyer can benefit even when information is uncovered
that would raise the price of the business. “On one file, we found
a $150,000 error to the seller’s advantage,” says Vic. “If the seller
knew about it, he could have increased the price by the five times
multiple totalling $750,000.” But the seller didn’t get to read the
report the buyer had engaged MNP to complete. “That meant the
buyer knew they were getting a deal and had $750,000 in their
pocket to negotiate with,” says Vic.
Even serious issues can be resolved if they are brought to
light before the deal is finalized. In one case, the vendor’s General
and Office category in the financial statements jumped from
$5,000 one year to $30,000 the next. Delving in, MNP discovered
that overtime was being put into General and Office because the
company was paying cash.
Had the buyer purchased the business unaware of this fact,
potential tax issues, issues with the union, or even a lawsuit in the
future could have been costly. Such serious issues often cause
a deal to fall apart, but in this case, a solution was found. “The
vendor left more money on the table, in the form of a take-back
note, just in case there was future exposure,” says Vic.
In some cases, information about quality of earnings is
uncovered that drastically reduces the value of the company. John
offers the example of a seller claiming $1 million of normalized
earnings; the buyer agreed to pay $5 million based on those
earnings. But due diligence uncovered a significant cut-off problem:
the vendor was pre-reporting revenue, entering sales into the year
on which the price of the business was based instead of in the year
when the revenue was actually earned. Taking out the prerecorded
revenue resulted in a 40 per cent decrease in earnings.
The deal didn’t go through, but the buyer avoided a host of
problems. “If we didn’t go in, the buyer already had assumed that
the accounting records were being reported properly, and would
have done the deal. And next year, when the financial statements
were done properly, there would have been a big surprise that
would have put him offside on all his financial covenants with his
lenders,” says John. “He could have lost the business.”
While it’s possible to have your internal accounting team
check the quality of earnings, John warns that there are certain
instances when it’s important to have an independent third party
specializing in transaction advisory do the work for you. This is
especially important when you are seeking financing.
Using a third party is also an efficient way to get a labour-intensive process completed without draining your internal
resources. Performing due diligence often takes two to three
weeks to complete and involves working long days. Buyers also
need to consider what they will do if a serious issue is uncovered,
as they will want to access the right advice to renegotiate as
quickly as possible.
Done properly, due diligence to check quality of earnings is like
insurance for buyers. Accurate information in hand, they can understand
the issues ahead of time, renegotiate the deal based on the earnings
that are really there and complete the transaction successfully.
For more information contact:
firstname.lastname@example.org | 416.513.4177
email@example.com | 403.298.8479
Potential Issues in Target Businesses and How to Find Them
Pre-recording sales and deferred recording of expenses Cut-off testing and predictive analytical tests
Identified issues of changing margin patterns and incorrect
costing of goods
Analyzing gross margins to source documents
Identified obsolete inventory never written off which reduced
Analyze accounts inherent to management estimation
Ratios have identified weaknesses in financial management of
the enterprise and inaccuracies in reporting of results
Analyze trends in ratios