Many corporate executives consider risk assessment to be the most difficult component of diligence to address. The prevalence of fraud and Foreign Corrupt Practices Act (FCPA) violations in the media, coupled with the fact that deception may be the most critical element in these crimes, leads many executives to ask whether their third-party diligence is uncovering all of the skeletons that might be lurking within the company.
When engaging a third-party provider for due diligence, make sure that the services covered include analyses of:
Ensure that your diligence team has the expertise to perform income tax, franchise tax, and sales and use tax exposure analyses to identify potential successor liability issues. Buyers need to be aware of unknown and unpaid taxes, as voluntary disclosure remedies may significantly reduce exposure.
In addition to potential tax liability issues and common tax considerations such as entity structure and deal structure, make certain that your diligence team examines potential hidden tax savings opportunities. Many companies are finding increased cash flow through fixed asset depreciation studies, repair and maintenance capitalization analysis, research and development tax credits, and green building and development deductions to name a few.
As with many professional service offerings, the variety and quality of services differs between providers. For example, a fixed asset study done in a previous year by a reputable firm may leave potential savings unexamined. Ensure that your diligence team looks for unidentified opportunities and also examines the thoroughness of recently addressed items.
Your third-party diligence team should assess contractual obligations, including earnouts in process of being negotiated. Many companies use earnouts – which contractually provide for additional future compensation – to close coveted deals. A down side to earnouts is that they can be riddled with accounting and valuation implications that, if not examined by your diligence team, can result in surprises down the road.
Consider the terms of the earnout. Most of these contracts include specific definitions of accounting terms. For example, an earnout based upon revenue inherently rests upon revenue recognition and the underlying accounting standards, which can be complex to interpret and apply. Consider having your diligence team work with legal counsel to evaluate the contract language for thoroughness and accuracy from a financial and accounting perspective. Enough detail should be included to ensure clear interpretation and application of the earnout as to avoid future liability.
Earnouts also represent contingent considerations that can impact your company’s financial statements: 1) from the outset; 2) after additional adjustments are made to account for the business combination; 3) during the earnout period; and 4) following the earnout period. Make sure your diligence team examines the implications of the earnout and its potential outcomes on your financial statements. This assessment should involve relevant business valuation expertise to properly assess fair market value.
Engaging a diligence team that can perform data analytics as part of the diligence process is highly recommended. In this electronic age, data includes everything from financial transaction data to emails, building-access logs and phone records. Forensic analytic tools now offer the ability to analyze 100 percent of a company’s data, as opposed to sampling.
Consider this example: A buyer engaged a diligence team to conduct an analysis of the target’s customer base. The team examined 100 percent of the sales data and determined that one customer had three unique entries. None of the entries would have placed the customer in the top 10 customer list, but the three collectively did. In addition, the customer was located in a country in which the buyer did not know the target did business. The country presented a unique set of risks. These facts may not have been identified in a traditional analysis of customers.
Reputable firms that offer third-party diligence provide a variety of fairly standard options from which to choose. Discussions with these providers typically cover similar territory. This article summarizes a targeted selection of services that you will want to consider when engaging a third-party diligence provider.
The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, or tax advice or opinion provided by Clifton Gunderson LLP to the reader. The reader also is cautioned that this material may not be applicable to, or suitable for, the reader’s specific circumstances or needs, and may require consideration of non-tax and other tax factors if any action is to be contemplated. The reader should contact his or her Clifton Gunderson or other tax professional prior to taking any action based upon this information. Clifton Gunderson LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.
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About the Author
Yassir Karam, JD, CPA/ABV, ASA, MBA, is national managing partner of Clifton Gunderson LLP’s Advisory Services. He oversees valuation and forensic accounting services for the firm’s publicly traded and privately held companies. He can be reached at Yassir.Karam@cliftoncpa.com.