By Catherine T. Marchelletta, CPA, MST

Due diligence is the process of making sure every aspect of a transaction is in order and that all parties involved are well-informed before moving forward. When it comes to mergers and acquisitions (M&A), it involves the investigation of a company’s historical financial reporting, results of operations, tax filings, related-party transactions, sales, pending legal proceedings, and potential environmental problems. Many parties often are involved, including attorneys, CPAs, environmental experts, and labor consultants.

Due diligence helps the buyer and seller make informed decisions. Buyers need to understand the ramifications of acquiring a particular business:

• Is the purchase price warranted?
• What is the quality of earnings?
• Are there hidden liabilities?
• Are there hidden tax delinquencies or obligations?

The due diligence process increases the chances of a successful deal by identifying possible irregularities or confirming the accuracy of information provided.

The seller wants to ensure the buyer’s ability to pay the purchase price, determine the tax ramifications of the transaction as structured, and understand the post-sale arrangements such as earn-outs and continued equity arrangements.

Due diligence often uncovers information that leads to a purchase price adjustment, so the effort can result in more accurate pricing. Also, if problems arise that the buyer is not willing to accept, the due diligence process allows the buyer to back out of the deal with no penalty.

The CPA’s Role

CPAs are integral to the due diligence process as they have the ability to uncover the true financial position of a business and to discover any irregularities, misstatements, undisclosed liabilities, or other arrangements. CPAs work closely with the client, their attorneys, and other members of the due diligence team, but they will differ depending on whether the client is the buyer or the seller.

Generally, a CPA will get involved after the buyer and seller have executed a letter of intent. A letter of intent is a signed agreement that spells out the buyer’s and seller’s understanding of the deal, structure, and purchase price and sets a time limit for each side to perform due diligence procedures.

Before starting a due diligence engagement, a CPA must understand the scope of the work to be performed and clearly define the expectations and fees in an engagement letter. Scope can vary dramatically depending on the type of transaction. Due diligence that involves the sale of assets may be less in scope than a transaction involving the sale of stock or equity. In an asset deal, generally, the buyer assumes only agreed-upon liabilities of the business. In a stock deal, the buyer “steps into the shoes of the seller,” meaning that the buyer assumes all liabilities of the seller, whether disclosed or not.

Scope will also depend on the size and complexity of the transaction: cost, timing, level of confidence among the parties, and structure of payments (all cash or seller note) contribute to the determination of scope. Any procedures expected to be performed post-closing should be clearly defined in the engagement letter along with associated fees. Post-closing tasks could involve observing inventory counts as of the closing date, true-up of assets and liabilities assumed, purchase price adjustments for working capital thresholds, and more.

The CPA usually reviews historical financial statements, tax returns, performance ratios, and other relevant financial information for the preceding three- or five-year periods as well as current and projected results of operations. CPAs analyze accounts receivable for collectability, test and recalculate inventory, perform searches for unrecorded liabilities, review contracts and compensation arrangements, as well as review leases, repair and maintenance costs, capitalization policies, and more.

CPAs also may be asked to determine the tax ramifications of the transaction or prepare a formal quality of earnings report.

A quality of earnings report is an analysis of the business’s trends in earnings before interest, taxes, depreciation, and amortization (EBITDA), free cash flows, and working capital. The CPA generally adjusts for items that are nonrecurring, shareholder-related, or other discretionary items. The quality of earnings report is used by the buyer to determine if adequate cash flows and income can be generated to provide the desired return on investment and coverage of operational and acquisition related costs. The buyer’s bankers frequently request this report before finalizing the acquisition financing.

As part of the due diligence process, a CPA should review the purchase agreements to determine if it accurately defines the terms of the agreement, assets sold, liabilities assumed, calculations of purchase price adjustments, various indemnifications, payment terms, and escrow accounts, for example. Any concerns should be discussed with the client and their attorneys during the drafting process to avoid unintended consequences.

Challenges and Timing

Every deal is different: some may be the sale of stock, some the sale of assets, others may involve a continued equity stake for the seller or different levels of revenue sharing. Unique factors require the due diligence process to be customized so it addresses the specifics of the deal at hand.

Often the seller is not prepared to supply all the documents and information requested in a timely manner. Generally, most letters of intent provide for a due diligence period ranging between 30 and 90 days. If the relevant data is not made available to the buyer’s team as soon as requested, the buyer’s team may not have adequate time to fully investigate the deal. Also, delays in providing information or providing incomplete information may create a sense that the information provided leading up to the letter of intent is inaccurate or is suspect. This will often result in delays in closing the deal and perhaps even the buyer terminating the deal altogether.

Conclusion

Due diligence is critical to the deal process. It creates greater awareness of the full transaction and what is expected from the buyer and the seller to close the deal.

CPAs are an integral part of the due diligence team and can provide much needed guidance and analysis of the financial condition of the business being acquired or sold. To be effective, the CPA and the due diligence team must define scope and areas of responsibility among the team members.

It is also important that any prospective seller be prepared to provide all information and document requests as early as possible. Information and document requests can be lengthy and can take a great deal of time to compile. Best practices recommend that an electronic data room should be set up and populated with as much information as possible in advance of the signing a letter of intent. This data room will be made available to authorized members of the buyer’s and seller’s due diligence teams once the letter of intent is signed.

Most important is constant communication of findings and concerns among team members during the due diligence process. Everyone is working within tight time constraints while managing a lot of moving parts. Proper planning and coordination can help ensure the effectiveness of the due diligence process.

Catherine T. Marchelletta, CPA, MST, is a partner in the tax and consulting departments of Louis Plung & Company in Pittsburgh.

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