11/22/2021
The strain on deal teams due to the unprecedented merger and acquisition activity volume of 2021 could result in increased risk of financial statement errors, misrepresentations, or fraud going undetected, particularly in private and unaudited companies. Prospective buyers and insurers should be alert to accounts easily managed by sellers for potential fraud. Financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP) and the accrual basis of accounting utilize subjective estimates for certain types of accounts that may allow a seller to manage earnings leading up to a transaction. Intentional seller misrepresentation to increase reported earnings could result in buyers paying a purchase price in excess of the enterprise value that would have been calculated for the target company absent misrepresentation. If discovered, buyers and/or representations and warranties insurers may try to recover resulting losses from sellers. Post-transaction fraud claims are difficult to prove and costly, and they take a considerable amount of time to resolve.
M&A Fraud Claims and Litigation
Fourteen percent (14%) of 50 senior executives from corporate development teams, private equity firms, and investment banks surveyed in a 2020 study reported they have been involved in fraud-related claim litigation within the past 24 months.1
Fraud claims are by far the largest and the only claim category for which the median claim size exceeds the escrow, according to SRS Acquiom’s 2020 M&A Claims Insight Report.2
Fraud claims, on median, take 8.7 months to resolve, according to the same SRS Acquiom report.2
Buyers and insurers should understand which accounts of the target company rely on management’s judgment to determine an estimate and therefore may be used as a means to manage earnings. Buyers and insurers should also understand the frequency of management’s determination of these estimates and whether the financial statements relied upon are based on a current estimate. Some example financial statement risk areas that involve estimates are provided below.
Revenue. Revenue recognition policies and procedures may vary based on a company’s industry. Accounting for revenue recognition in certain industries may have increased risk of inappropriate recognition of revenue due to the nature of the product, service, and/or customer contract. Additionally, the recent implementation of the Financial Accounting Standards Board’s ASU 2019-09, Revenue from Contracts with Customers (TOPIC 606 or “ASC 606”), may further complicate revenue recognition for some companies. For example, when customer contracts require that a product or service be delivered over a period of time rather than all at one time, management may manage earning milestones in order to prematurely increase earnings prior to deal close. Some industries susceptible to such judgments include construction, project-based manufacturing, and professional services. Other potential revenue risk subject to management estimate include gross to net revenue adjustments, including discounts, returns and allowances, chargebacks, rebates, and coupons.
Inventory Reserves and Cost of Goods Sold. An inventory reserve is a contra asset account used to write down the value of inventory for causes such as obsolescence, spoilage, or theft of inventory. Inventory reserve expense charged to cost of goods sold should be recorded on a periodic basis and can be estimated based on historical experience or by using an inventory aging tracking system. In addition to this procedure, a company should continually consider changes in its business operations, the industry it operates in, its customers, and any other factors that impact held inventory to determine if changes to the accounting for slow-moving and obsolete inventory are necessary. Sellers may manage earnings prior to deal close by not recording specific inventory reserves for known obsolete or spoiled inventory leading up to deal close or by not following typical period review procedures for the reserve account.
Allowance for Doubtful Accounts/Allowance for Credit Losses and Bad Debt Expense. An allowance for doubtful accounts or allowance for credit losses is a contra asset account used to write down the value of accounts or trades receivable for those receivables that are estimated to be uncollectible. Management may estimate amounts predicted to be uncollectible and charged to bad debt expense in various manners, including a percentage-of-sales method or by basing it on an accounts receivable aging. Sellers may manage earnings prior to deal close by changing their criteria for which they recognize bad debt expense or by failing to record bad debt expense for known customer contract issues.3
Warranty Reserves and Warranty Expense. A warranty reserve is an accrued liability account for which a company records estimated future expenses to repair or replace products within a certain period of time based on an estimated number of product returns. Warranty expense and the related accrual should be recognized in the period in which the related product sales are recorded. Management may estimate the anticipated expense based on its own historical experience or industry experience. Sellers can manage earnings prior to deal close by changing their criteria for which they recognize warranty expense or by failing to change their estimate based on known product deficiencies or warranty policy changes.
Buyers and insurers may be able to decrease transaction fraud risk by performing financial due diligence procedures, such as the below listed procedures. Financial due diligence, either performed on behalf of the seller or the buyer, often focuses on determining the target company’s quality of earnings or assessing the portion of income attributable to the core operating activities of a target company in order to determine a stream of predictable future earnings potential. Financial due diligence providers, with limited time and resources, generally do not focus on investigating for seller fraud. Buyers and insurers may decrease transaction fraud risk by performing the below activities.
Look Back Analysis. Buyers and insurers should compare prior period forward looking assumptions (i.e., estimate) to actual results. For example, lookback analysis may be performed on percentage of completion, sales returns, a detailed sell through analysis of inventory for the trailing twelve months (“TTM”) on a part number basis, or a waterfall analysis of warranty claims to understand historical experience of claims versus accrual.
Perform Month-to-Month Variance Analysis. In addition to assessing annual trends, performing monthly variance analysis for the TTM leading up to the transaction close may help identify unusual trends that may indicate a change in accounting estimates leading up to the transaction. This may be particularly important if the seller represents and warrants and the buyer relies on financial statements for unaudited periods, financial statements where robust month-end financial statement close procedures are not performed, and financial statements with a large gap between themselves and the most recently audited financial statements. Variance analyses should compare current periods to historical periods predating the seller’s decision to sell the company.
Obtain Evidence for Variances. Buyers and insurers should not solely rely on discussions with the target company’s management, especially for items which are not represented by the seller in the transaction agreement or excluded from indemnification. Buyers and insurers should obtain evidence for explanations of unusual variances or transactions.
Review Significant Manual Financial Reporting Processes. Financial due diligence procedures should identify manual processes which feed into significant financial accounts. Obtain and review documentation of the manual processes for a sample of periods, particularly for periods which are unaudited, and compare the process to the process used for audited periods.
Rely on Hard Close Financial Statements. Transactions often involve target companies that do not perform all financial reporting procedures on a monthly basis (often referred to as a soft close) to include procedures related to financial estimates. The lack of scrutiny on an accounting estimate during a soft close may, at best, lead to a material financial reporting misstatement. At worst, the lack of procedures could lead to fraudulent activity going undetected. Buyers and insurers should understand the difference between the target company’s soft and hard close procedures and place additional scrutiny on those accounts receiving limited treatment by the company during interim financial statements.
Close All Open Diligence Items. Due to time and data limitations, due diligence items may remain open at the close of financial due diligence. In Stout’s experience investigating post-transaction disputes, these items are often the subject matter of disputes. Buyers and insurers should continue to pursue items the target company delays providing answers for, or when it claims that data cannot be easily provided. Buyers and insurers should perform a risk analysis of open items to determine which items they should continue to pursue. In addition, buyers and insurers should assess risk and consider excluding these items from indemnification.
1 “Risk in Review 2020-21, Global M&A and Transaction Solution,” Mergermarket, Aon, 2021.
2 “2020 SRS Acquiom M&A Claims Insights Report,” SRS Acquiom, January 2021.
3 This article does not address changes to the measurement of trade receivables under the Financial Accounting Standards Board Accounting Standards Update No. 2016-13, “Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” (ASU 2016-13), which is effective for public business entities that meet the definition of U.S. Securities and Exchange (SEC) files, excluding entities eligible to be smaller reporting companies as defined by the SEC, beginning after December 15, 2019, and all other entities beginning after December 15, 2022. Buyers and insurers should gain an understanding of the impact of ASU 2016-13 on target companies during the due diligence period and whether the target company’s financial statements properly report required changes under the new GAAP standard.
