Due Diligence and the Role of Forensic Accounting

The value of forensic accounting isn’t limited to determining the extent of business fraud; a recent Arizona engagement shows how it can help business owners avoid bad decisions in mergers and acquisitions ... and help attorneys distinguish between business valuation and financial investigation

Andrew D. Pappas, CPA

Earlier this year we received a call from the attorney for a Kansas company, Flat Lands Manufacturing. The company’s owner, a Mr. Page, was considering the acquisition of a Phoenix company, Tapujo Distributing. The contemplated purchase was a strategic one, as he viewed the Tapujo acquisition as beneficial to the expansion of his existing business.

From Page’s point of view, Tapujo potentially offered many sources of value: an extensive list of regular customers who would be excellent prospects for Flat Lands; geographic proximity to even more prospective customers; and skilled and experienced managers and employees who could help sustain Tapujo’s historic profitability in the absence of the company’s founder.

Flat Lands’ attorney went on to say that he and Page had some concerns about the accuracy of the financial information that Tapujo’s owner and CFO had provided. He explained that the purpose of his call was to ask us to perform a business valuation to help alleviate their concerns.

Valuation premature. After asking him for some additional information, I advised him that Pappas & Company is not a valuation firm and that, if he was certain that the situation called for a business valuation, I would be happy to recommend two or three valuation professionals in whom we have confidence.

But I cautioned him that, if they were truly concerned about the reliability of Tapujo’s financial information, they should consider conducting a financial investigation before they asked someone to perform a business valuation.

I explained to him that a business valuation would produce a report of Tapujo’s market value – crucial information, for sure – but that the valuation study would be based on the very financial information that was troubling him and Page. A financial investigation either would affirm the accuracy of Tapujo’s financial information, thus providing the basis for a reliable valuation, or would confirm what they already suspected, that Tapujo’s information was unreliable.

I suggested that, if he truly doubted the financials they were getting from Tapujo, he had come to the right place.

“We approach every investigation,” I told him, “with the presumption that something is wrong, and someone is bad.” I pointed out that financial investigation and business valuation are two very different disciplines, and it’s not the valuation professional’s purpose to think like someone with an evil mind. “That’s our job,” I said.

That evidently made sense to the attorney, because within a few days Page engaged us to perform a financial investigation of Tapujo Distributing. The business valuation could wait.

Analysis. We found the management and financial staff at Tapujo Distributing to be generally cooperative. We enjoyed full access to the company’s financial records, and Tapujo’s accounting firm gave us the company’s audited financial statements and tax returns and the supporting work papers. In addition, we met with Tapujo’s corporate attorney and interviewed all members of the company’s management team and some of its middle managers and staff.

While we were going about our work, negotiations between the parties hit a snag. Tapujo Distributing was a C corporation, and, depending on how the deal was structured, the sellers could be stuck with a double-taxation problem. Their tax advisor suggested that, to alleviate that issue, they negotiate a stock transaction. Meanwhile, Page’s attorney was advising him to purchase Tapujo’s assets – not the corporation’s stock – so as not to inherit from Tapujo any potential liabilities and contingencies, and also because a purchase of assets was more advantageous from a tax perspective.

At the same time, Page’s vision for rapid sales growth and higher profits had lost none of its luster. He was formulating business plans that were based on the ability of his soon-to-be Arizona division to match and build on the sales levels reported by Tapujo. Thus, our examination of Tapujo’s sales records, and confirmation that their actual volume equaled the reported levels, took on extra importance.

Discoveries. Our investigation revealed that Tapujo’s financials, while generally accurate, were not indicative of future profitability. The problems that we discovered included the following:

• More than 25% of the company’s recent sales were to a customer that had just filed bankruptcy.

• A tour of the facilities revealed outdated computers and substantial deferred maintenance of the company’s production facility and equipment (I nearly fell through one of several patched holes in the roof). It was clear that the seller had not been reinvesting in the business and that Page would incur substantial and immediate expenses in bringing some of the assets up to date.

• We discovered a contract that obligated the seller to pay 15% of the sales price to each of his two key vice presidents. Those payments would allow them to retire and gut the company of top management.

• Finally, we found a recently filed (and undisclosed) lawsuit against the seller – a contingent liability the seller would be acquiring as part of the stock purchase.

Armed with our findings, Page reduced his offer and persuaded the sellers to make part of the purchase price contingent on the company’s ability to reach post-closing sales targets.

Aftermath. With our work completed in this M&A engagement, Page praised our report, thanked us for our service, and bought Tapujo Distributing, Inc. for the revised purchase price.

He never ordered a business valuation.

Time will tell if Page made the right move in purchasing Tapujo. But he made his decision, good or bad, with reasonably full knowledge of what he was getting for his money.

While the preceding account is based on an actual case, the facts have been simplified and the names of all parties have been changed.

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