Buyer Beware: How to Perform Proper Due Diligence

8/11/2016 - By Zachary Farrington

You think you’ve found it — the right company to buy. You’ve made a bid, signed a letter of intent and have the seller’s financial statements. They look good, but is the seller telling the whole story?

Caveat emptor. This where due diligence comes in.

Due diligence is perhaps the most important part of the deal. If done properly, due diligence provides you with an in-depth understanding of the quality of earnings of the target company. Armed with this knowledge, you are better equipped to establish pricing, determine the best deal structure and proceed with post-purchase planning.

What to Look For

Below are some typical areas on which to focus your due diligence:

Revenue recognition: Revenues should be recognized in the proper period, along with costs related to generating those revenues. Generally accepted accounting principles (GAAP) should be consistently applied.

Normalization adjustments: Non-recurring income and expenses must be normalized to reflect realistic earnings. These adjustments might include seller discretionary items that are not anticipated to impact future earnings, such as compensation in excess of fair market value, one-time legal fees, the loss of a big customer or a particularly large debt expense.

Quality of revenues: Due diligence in this area entails a comprehensive assessment of revenues and margins by customer, product line and channel. The goal is to assess the quality and sustainability of the revenue stream.

Accounting adjustments impacting earnings: It’s important to analyze the nature of activity within reserves and accruals, such as allowance for doubtful accounts, inventory reserves, warranty reserves and accrued liabilities.

Inventory valuation: Capitalization of costs into inventory should be closely assessed to determine the appropriateness of valuation.

Pro forma cost adjustments: Pro forma costs might include expenses such as restructuring or financing costs. These must be carefully analyzed, both qualitatively and quantitatively, to determine whether the adjustments were in an appropriate amount and manner.

In addition to these categories, due diligence should include a look at value drivers such as the scalability of the business, depth of the management team, adequacy of information systems and equipment, and the customer/supplier base.

Also, it’s wise to double-check the working capital requirements and thresholds established in the letter of intent or purchase agreement and assess capital expenditures, both past and future.

How to Proceed

Warning: Attempting to perform due diligence on your own is not prudent. This is an area in which the services and expertise of a trusted CPA can be extremely valuable.

Your CPA is likely to see areas of concern that you may not notice. He or she can then steer you away from questionable transactions or companies that aren’t as financially healthy as they might appear at first glance.

A CPA will typically issue a comprehensive report that analyzes and shares observations about the business. While the intent of the report is to confirm what the CPA has seen, the report can also be useful in negotiations moving forward.