Forensic Accounting in Transaction Services​

Specialist Expertise For Merger And Acquisitions

Mergers and acquisitions require a large amount of company resources, both money and time.

While typically businesses conduct a detailed assessment of the target company’s financial statements, systems and accounting processes, when undertaking due diligence an often overlooked area – but highly valuable one – is assessing whether the target company was involved in financial statement fraud.

This type of due diligence requires special expertise that is not normally possessed by staff accountants and external auditors. This is where forensic accounting plays an important role in mergers or acquisitions.

WHAT IS FORENSIC ACCOUNTING?

Forensic accounting is a specialized field of accounting that mainly focuses on exposing fraud, in particular, financial statement fraud. Forensic accounting engagements usually involve a detailed assessment of the company’s accounting systems and processes to determine the accuracy of the target company’s financial statements and provide an accurate analysis of these reports, including but not limited to identifying undocumented and understated liabilities, assets that are overstated or excessive sales and costs that are too low. In addition, forensic accounting also conducts background checks on key executives and managers.

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

Engaging in a forensic accountant should start when the prospective buyers and sellers gain general understanding and agree to the terms of the initial financial transaction. Prospective buyers will conduct a comprehensive financial due diligence of the business subject. This due diligence refers to the prudence that a reasonable company will take before making an acquisition, which focuses on investigating and analysing material facts that can influence acquisition decisions.

Furthermore, financial due diligence also ensures that the representation made by the seller is correct and accurate, which leads to answering some critical questions such as, should we buy? And at what price? And are there risk factors that can affect its value?

HOW DOES A FORENSIC REPORT DIFFER TO A REGULAR TRANSACTIONAL DUE DILIGENCE REPORT?

While the Corporate Finance team will examine abnormalities in finance based on account management trends and other underlying data, when conducting Transaction Services, they do not look at journal entries specifically for fraud. Their analysis and conclusions are based on financial data provided by the target company and does not make a statement as to whether the financial information is accurate or reliable.

WHAT WILL A FORENSIC ACCOUNTANT LOOK FOR?

• Fictitious sales/revenues
• Improper revenue recognition
• Improper asset valuations
• Concealed liabilities and expenses
• Improper disclosures.

WHAT IF FRAUD IS IDENTIFIED?

Depending on the fraud that is uncovered, prospective buyers have three options. They can:

• Withdraw the acquisition without consequence;
• Reduce the valuation to fair market value;
• Change the deal structure.

ARE THERE HIGH-RISK INDUSTRIES?

While all businesses can be suspect to fraud, in our experience, there are high-risk industries, due to the nature of their business. This includes manufacturing, software/IT, financial services and real estate and construction.

A CASE STUDY

A high-profile case was observed from Hewlett-Packard after they purchased Autonomy, a British software company, in 2011 for $11.1 billion. It was reported that HP thought Autonomy has a 64% premium for a company with nearly $1 billion of 2010 revenues, and possessing “a consistent track record of double-digit revenue growth, with 87 percent gross margins and 43 percent operating margins.” Little more than a year later, HP recorded an $8.8 billion impairment charge, citing Autonomy’s accounting improprieties as the reason. Investors wondered how could HP have gotten it so wrong before they plunked down $11.1 billion in cash?

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

It should be noted that Autonomy’s financial statements were audited by one of the Big 4. Even more, target companies that are not audited may pose a higher risk that investors/companies should place more of their attention.

Acquiring another business takes a large amount of money and time; again it is very important to conduct a detailed assessment of the target company’s financial statements, and this including financial statement fraud assessment. Hiring a forensic accountant during the merger or acquisition process can produce several benefits for the buyers.

The work of forensic accountants on due diligence issues provides information that enables buyers to make more informed decisions, ensure transparency and thus limit potential pitfalls and conflicts. Most importantly, forensic accountant analysis can provide additional negotiating leverage to adjust business purchase prices to reflect fair market value.

If you would like to know more about how forensic accounting helped clients around this high-risk matters involving financial statement fraud, accounting irregularities, and data recovery, please feel free to reach out to me.

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