If you’re considering buying a company, fraud may be the last thing on your mind. Unfortunately, you can’t afford to ignore the possibility that your acquisition target is hiding something — possibly something that will have negative financial and legal implications after the deal is complete. To ensure the transaction is what it appears to be, acquaint yourself with the issues and include a forensic accounting expert on your deal team.

Look at the numbers

During the due diligence process of a merger or acquisition, forensic experts review financial statements 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 as well as 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.

Watch for red flags

To determine whether unusual income figures indicate systematic manipulation, experts often consider whether insiders had the opportunity to commit fraud. A lack of solid internal controls usually raises red flags. Regulatory disapproval, customer complaints and suspicious supplier relationships can also indicate fraud. If warranted, an expert may perform background checks on your target company’s principals.

It’s important to note that some accounting practices adopted to present a selling 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.

Manage risk

There’s a way to help protect your transaction even if a seller successfully hides financial manipulation and other illegal activities: Include an indemnification clause in the purchase agreement. Your advisors may have to wrangle with the seller over such details as the definition of “fraud” and liability limits, but such clauses can help you manage the significant risk most acquisitions involve.

(This is Blog Post #1406)