The COVID-19 pandemic has often made the due diligence process for business acquisitions more complex and time-consuming. But if you’re buying a company, it’s critical to dedicate your full attention to this part of the M&A process — not only to confirm that the selling business is as valuable as you believe it to be, but to protect against fraud. Plan early to engage a fraud expert to review financial statements and other documents for signs that you could be dealing with a dishonest seller.

Subtle warning signs

When reviewing a seller’s financial statements, forensic experts look for subtle warning signs of fraud. These include excess inventory, a large number of write-offs, an unusually high number of voided discounts for returns, insufficient documentation of sales and increased purchases from new vendors. Another suspicious sign is increased accounts payable and receivable combined with dropping or stagnant revenues and income.

Fishy revenue, cash flow and expense numbers and unreasonable-seeming growth projections warrant further investigation to determine whether financial statements represent fraud or they’re evidence of unintentional errors or mismanagement. The latter is common in smaller companies that don’t have their statements audited by outside experts or that may not have adequate internal financial expertise.

Systematic manipulation

To determine whether unusual income numbers indicate systematic manipulation, experts often consider whether owners or executives had the opportunity to commit fraud. A lack of solid internal controls makes financial statement fraud more likely. Regulatory disapproval, customer complaints and suspicious supplier relationships can also raise red flags. If warranted, a forensic expert may perform background checks on your target company’s principals.

It’s important to note that some accounting practices adopted to present a business in the best light may be perfectly legal. However, if your expert finds evidence of intentional fraud — particularly at the executive level — you’ll probably want to rescind your acquisition offer. In less serious cases, you may simply need to make purchase price adjustments or even change the deal’s structure.

Negotiating protection

An indemnification clause written into the purchase agreement can protect you if a seller lies about matters that affect your acquisition, such as fraud. But negotiating these clauses can be tricky since sellers tend to push for a narrow definition of “fraud” and for limits on liability. The fact remains that if a seller has committed fraud, it’s better to uncover it before the M&A transaction goes through.

(This is Blog Post #992)