march 2011 www.greaterchar lot teb iz .com

Rick HewittCPA, Transaction Advisory

Services

Accounting, Tax and Consulting Solutions

Elliott Davis, PLLC [accountingbiz]

Whether you are buying or selling a busi-

ness, both transactions involve both risk

and opportunity to the parties. Your goal,

as a buyer or seller, is to avoid surprises, while having

high confi dence in your decisions.

›Importance of due diligenceAs the buyer, by conducting the proper due dili-

gence before a merger or acquisition, you gain critical

insights and assurances that the business is what it

appears to be before moving the deal forward. As the

seller, by properly preparing for due diligence, you can

identify and address upfront issues that could other-

wise lead to purchase price disputes, closing delays,

buyer uncertainty and even post-transaction litigation.

Financial due diligence, when fully executed,

assesses not just the valid-

ity of historical results, but

also what the past perfor-

mance indicates about the

future prospects of the business. Financial due

diligence focuses attention on the critical success

factors including identifying risks and opportuni-

ties, potential contingencies, commitments and

exposures, and evaluating the quality of histori-

cal and projected earnings and cash fl ow, and the

internal controls, employees and systems sup-

porting the presented results. Findings from due

diligence procedures can usually be quantifi ed and translated into purchase

price adjustments, often based on a multiple of EBITDA (earnings before

interest, taxes, depreciation and amortization) or modifi cations to the terms

and conditions of the transaction.

As either the buyer or the seller, if you understand what needs to be accom-

plished in the due diligence process and prepare accordingly, you are likely to

achieve a more effi cient and effective outcome. The following addresses some

of the base-level expectations of the buyer and seller.

›Quality of earningsAn audit provides an opinion that the fi nan-

cial statements present fairly, in all material respects,

the fi nancial position and results of a company in conformity

with Generally Accepted Accounting Principles (GAAP).

However, GAAP allows for subjectivity, judgment and estimates

in a company’s accounting policies that can have a material effect

on the operating results and fi nancial position, and thus a trans-

action purchase price.

If audited, a buyer should look at the audit work papers to gain

an overview and understanding of the target’s accounting policies

and potential issues. For a company that is not audited, the

possibility of adjustments to price is even greater. Understandably, the seller

wants to present fi nancial results that may lead to the highest selling price.

Quality of earnings is typically the key focus area. This exercise begins

with the target’s reported EBITDA and adjusts or normalizes earnings to

refl ect what the buyer would expect on a pro forma basis. The seller may often

provide management adjustments for expenses it believes will not continue,

such as excess owner’s compensation, benefi ts

and extravagant expenses, one-time or unusual

expenses or expenses that may change as a result

of the transaction, such as rent, insurance or

professional fees.

In addition to evaluating management’s pro-

posed adjustments, the buyer may identify and

propose certain due diligence adjustments to

earnings. Related to the income statement, the

buyer will analyze revenue trends, compare

revenue to cash receipts (generally called a

proof of revenue) and look for early revenue

recognition or revenue that may be reversed, aggressive use of estimates, one-

time or unusual revenue transactions and revenue not related to the company’s

ordinary course of business.

The buyer should look at general and administrative

expense trends where certain discretionary accounts such as

marketing, repairs and maintenance, research and develop-

ment, and personnel costs may not be indicative of necessary

spending post-transaction.

Related to the balance sheet, a buyer should examine the methodol-

ogy applied to provision accounts, including sales returns and chargeback

allowances, reserves for doubtful accounts, inventory obsolescence reserves,

and warranty obligations and related reserves. The buyer should inquire

about capitalization policies, verifying that operating expenses are not being

improperly capitalized. Understanding these policies is critical to determin-

ing the impact on quality of earnings, to assess whether earnings have been

impacted by subjective accounting entries rather than business operations.

The buyer should also analyze key accrued expenses, searching for unre-

corded liabilities and assessing proper cut-off procedures, especially for interim

fi nancial statements. The seller should ensure that the most recent period

end balance sheet contains adjustments similar to those included at year end.

inancial Due Diligence: Meeting expectations of the buyer and seller

Scott HendersonCPA, Transaction Advisory

Services

Financial due diligence, when fully executed, assesses not just the validity of historical results, but also what the past performance indicates about the future

prospects of the business.

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Understanding the methodology for accruing

expenses and changes in these accounts during the

trailing 12 months may identify potential quality

of earnings issues.

A buyer and seller will likely view material-

ity differently. While the seller may conclude the

cumulative adjustments to EBITDA are not mate-

rial to the overall results of the presented fi nancial

statements, the buyer will likely consider the

adjustments very material if the purchase price is

calculated using a multiple of EBITDA.

›Further InvestigationConcurrent with its quality of earnings analy-

sis, the buyer should inquire about and examine

data that may shed additional light on the future

direction of the company and risk exposure to

the buyer. Key areas may include seasonality

issues, price versus volume impact on

revenue, trends of gross margins over-

all, by product and revenue line and

an understanding of the components

of cost of goods sold including

inventory valuation, allocation

of labor and overhead and fi xed

versus variable cost mixes.

Regarding customers, a buyer

should want to understand

terms of any customer contracts,

extent of customer concentration, reasons for lost

customers and variances in major customer activity.

Further, the buyer should inquire about

working capital trends (generally defi ned as

current assets less current liabilities) and cash

management issues including any apparent

receivable collection risks, trends in receivable

and inventory turnover and accounts payable

management. A buyer should also assess his-

torical capital expenditures and future capital

expenditure needs and capacity issues.

These areas, among others, should help the

buyer understand how cash is generated and

used, specifi cally distinguishing cash fl ow from

operating activities versus fi nancing and invest-

ing activities. A seller should anticipate and be

prepared to answer questions not only about the

company but comparisons to competitors and

industry benchmarks.

Through due diligence by the buyer, looking

beneath the surface of the fi nancial statements, and

proper preparation by the seller, providing quality

fi nancial statements, supporting documentation,

and meaningful responses to questions, an effi cient

transaction process should ensue.

Since each deal is unique, consider involving

your team of advisors (accountants, attorneys,

consultants etc.) who have experience with due

diligence engagements early in the process to

tailor and assist with procedures appropriate to

your transaction.

Content contributed by the Charlotte offi ce of Elliott Davis, PLLC, an accounting, tax and consulting services fi rm providing clients the solutions needed to achieve their objectives in 10 offi ces throughout the Southeast. For more information, contact Scott Henderson at shenderson@elliottdavis.com or Rick Hewitt at rhewitt@elliottdavis.com or visit www.elliottdavis.com.

Through due diligence by the buyer, looking beneath the surface of the fi nancial statements, and proper

preparation by the seller, providing quality fi nancial statements, supporting documentation,

and meaningful responses to questions, an effi cient transaction

process should ensue.