Business

Tuesday September 15, 2009

Due diligence probe is a must in current uncertain economic situation

RSM EYE - By Annie Look


AS an investor or a buyer embarking on a merger and acquisition exercise, one of the first steps he will invariably be advised to do is to carry out a due diligence investigation on the target entity.

This exercise becomes more important during uncertain economic times like this.

Due diligence is a process undertaken to investigate the affairs of an entity or a business, i.e. the target, to enable the investor or buyer to make an informed judgment as to the risks and opportunities he is going to take.

Although due diligence is usually commissioned by prospective buyers, it is not uncommon to see vendors appointing an independent party to undertake this exercise with the view of presenting business and financial information as transparently as possible to buyers.

The due diligence process, when properly conducted, attempts to ensure that the deal is consummated expediently and on terms that are fair to both sides.

Due diligence can typically be carried out from the financial, tax, legal and commercial aspects, including even environmental, if that be a case for concern.

Financial due diligence

When carrying out a financial due diligence, the buyer should inspect the target’s books and records to assess whether the financial statements properly reflect its financial performance.

Financial statements for the current and the past years, preferably three to four years, supported by listings of the assets that it owns and liabilities that it carries, including contingent liabilities, should be requested.

Depending on the circumstances surrounding the acquisition, the target’s management may not cooperate or may be reluctant to release such information, especially when they feel threatened by the impending takeover.

It is therefore important that the buyer secures adequate access to information such as accounting records and management reports and to people who are key to the investigation.

This pre-requisite should be agreed upon with the vendor right at the beginning of the process.

Financial performance

Focus on the quality of the target’s earnings for the possibility of window dressing and whether it is affected by one-time items such as impairment loss or gain or the sale of a capital item which should be adjusted to normalised earnings since it is non-recurring.

Financial ratios such as profit margins, receivables and inventory turnover and current and debt ratios should be used to analyse trends and performance in assessing its competitiveness.

These checks are particularly relevant in the current economic climate.

Recoverability of assets

Review the carrying values of fixed assets to assess their recoverable amounts.

In addition to checking their physical existence and ownership, review encumbrances and/or restriction to transfer or usage and existing maintenance contracts which the target may have locked itself into.

It is usually necessary to review the recoverability of assets such as trade receivables and inventories.

Slow moving assets serve as a red flag of a potential cash flow issue that could have a consequential effect on earnings leading to a possible adjustment to the purchase consideration.

Take note of related party transactions which may not be at arm’s length and rigorously test the collectability of these debts.

Liabilities and commitments

Unrecorded and contingent liabilities are often overlooked as they are off balance sheet. An inspection of the minutes of the board and internal management meetings may reveal some of these obligations.

Look for clauses in agreements where the target may have committed itself to a future sale or purchase, including those with recourse.

This will forestall unwanted surprises such as legal lawsuits and guarantees which may surface after the deal is sealed.

Take time to review terms of borrowings and their collateral to determine the extent of encumbrances on the target’s assets and the presence of covenants.

Look for bankers’ correspondences to detect breaches of contract and unrecorded liabilities such as unpaid interest and other finance charges.

As off balance sheet financing activities may not be fully disclosed in the accounts, review operating lease agreements for non-cancellable commitments and for capital commitments and hire-purchase contracts entered into.

Perform financial projections of profit and cash flows and a sensitivity analysis for the next two to three years to look at the viability of the business, in addition to understanding the critical success factors to the deal and the potential deal breakers.

Although the quality and reliability of the accounts prepared by management can be assessed by reviewing the adjustments made by the auditors in the audited accounts, a properly conducted financial due diligence requires a good understanding of accounting standards and relevant rules and regulations such as revenue recognition, appropriateness of the carrying values of assets and the adequacy and completeness of provisions and liabilities.

Other due diligence

A tax due diligence involves looking at local and cross border tax issues and the target’s compliance with tax laws, rules and regulations on, say, withholding taxes and transfer pricing.

Next is the need for a legal due diligence.

Typically it will cover corporate statutory matters, contractual arrangements, guarantees and indemnities and litigation.

A commercial due diligence will involve a review of the target’s market, competitive position and its management while an environmental due diligence deals with the compliance with environmental laws which can be complex.

Take note of implications on the financial statements or financial projections, of rectification costs and penalties that may be imposed should the target run foul of those laws.

Tight timeline

Because of the urgency entailed in most mergers and acquisitions, the buyer should insist that sufficient time be given to complete the due diligence.

Conducting the exercise in haste can be an expensive mistake, particularly in times like this earnings management is likely.

He should satisfy himself with the financial health of the business and that the financial return he is going to get is worth the price paid.

In addition, the buyer should insist on a contingency provision which grants him the right to adjust the purchase price based on the results of the due diligence.

l Annie Look is technical director of RSM Robert Teo, Kuan & Co. She is of the view that due diligence is a necessary precautionary measure. As the scope of due diligence can be very wide, it is important that the buyer has a clear idea of where he wants the work to be directed at. This is best decided by consulting an investigative accountant.

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