Dr. Epstein is the author of The Handbook of Accounting and Auditing, published by RIA, the tax and accounting business of Thomson Reuters.

He has been associated with this comprehensive reference work, and its semi-annual updates, for over 18 years.

Dr. Epstein served as the lead author of 26 annual editions of Wiley GAAP (1985 through 2010), 14 annual editions of Wiley IFRS (1997 through 2010), and several other works on U.S. GAAP and international accounting standards, all published by John Wiley & Sons.

Buyers Beware: Relaxing Due Diligence in M&A Transactions Could Be Fatal

By Elaine Vullmahn, CPA, CIA and
Barry Jay Epstein, Ph.D., CPA

Reliance on representations, warranties, or other contractual provisions as a substitute for due diligence in a merger or acquisition can be fatal. Under the current economic circumstances, continued - if not even greater - scrutiny should be applied, as motivated sellers may push the limits in order to maximize proceeds from such transactions.

Prudent buyers, and their attorneys, should ensure a due diligence review of a target company includes a thorough assessment of the following six areas.

Assessment of the Internal Audit Function

Is the target company’s internal audit function staffed with the right personnel, independent from management, and in regular communication with the audit committee of the board? The internal audit function should be manned by individuals who possess the knowledge and skills necessary to execute regular operational audits. In order to be effective and conduct unrestricted evaluations of management activities, the internal audit function must maintain its independence from management. The internal audit function also needs to maintain a good reporting relationship with the audit committee, so that operational risks can be assessed and acted upon in a timely manner.

Review the Role of the Audit Committee

Is the target company’s audit committee properly structured, consisting of members who are suitably qualified, and independent of management? The role, scope, and reporting structure of the audit committee should be detailed in a charter. In order for the committee to understand the intricacies of the company’s accounts, the members of the audit committee should be knowledgeable about financial reporting and auditing matters, and at least one should be qualified as a financial reporting expert. Ideally, the audit committee members should not have previously held executive positions at the target company.

Evaluate the Target Company’s Relationship with Its Outside Auditors

What type of relationship does the target company have with its outside auditor? The process by which the target company’s audit committee selected its outside auditors may raise a red flag regarding a lack of independence. This evaluation should also include an analysis of the costs incurred by the target company for non-audit services provided by its external auditors, the magnitude of which could possibly affect the level of scrutiny given to the entity’s financial statements.

Analyze Consistency in U.S. GAAP Compliance

Does the target company follow accounting practices similar to those of the buyer? Generally accepted accounting principles (U.S. GAAP) often allow for substantial management discretion, and arguably IFRS provides for even more applications of judgment. For example, management makes accounting estimates regarding the collectability of debts, the useful lives of depreciable assets, and the future economic benefits of intangible assets including goodwill. It may be necessary to harmonize the buyer’s and the target company’s practices to the extent that one is more aggressive or conservative than the other, in order to make meaningful comparisons and projections of post-combination results.

Examine the Target Company’s Internal Controls

Has the target company adequately developed, documented, and tested its system of internal controls? This is a critical question as the target company’s internal controls will have to be integrated with the buyer’s internal controls and procedures. In addition, acquirers’ CEOs and CFOs will eventually have to certify the effectiveness of the internal control over financial reporting by the combined entity. A careful review, therefore, should also be conducted on the target company’s previous public filings and related officer certifications in order to determine whether there have been any reported compliance issues or defects in the internal control system. Ideally, during due diligence the management comment letters provided by targets’ outside accountants over recent years, setting forth controls and other observations and recommendations, will also be obtained and perused.

Appraise the Target Company’s IFRS Readiness

Has the target company voluntarily decided - or might it be required in the near future - to adopt IFRS? If appropriate, a comprehensive appraisal should be made of the efforts the target company has in place to transition from U.S. GAAP to IFRS. This would include the training conducted to prepare accounting personal to understand the differences between the rules-based and principles-based approaches. Information technology infrastructure may need to be upgraded to run dual accounting systems or create consolidated financial statements. In addition, certain operating procedures may need to be modified.

A report, recently released by Audit Analytics, indicates that the incidence of financial restatements continued to decline over the three year time period from 2007 through 2009, compared to the base year 2006. The research firm ventured to surmise that “the Sarbanes-Oxley Act and the Securities and Exchange Commission are behind the decline.”

It certainly sounds reasonable that the combination of improved internal controls, CEO/CFO certifications, and severe penalties for failure to comply with the Act contributed to the trend. These results, however, should not lead buyers to assume that a seller’s representations and warranties regarding its financial statements deserve any less scrutiny when considering a business acquisition.

In addition, some companies are voluntarily transitioning to International Financial Reporting Standards (IFRS) in advance of the widely-expected requirement to do so, possibly in the hopes of better communicating with investors, customers and suppliers in the over-110 nations already mandating IFRS. Given concerns over adequacy of training on, and potential misapplication of, these principles-based accounting standards, buyers should have heightened concern over the soundness of internal controls and accuracy of a target company’s financial statements.

Note: This article first appeared in Law360.com on April 23, 2010.

About the Authors: Barry Jay Epstein, Ph.D., CPA, (email) is a litigation director in the Chicago, Illinois office of SS&G Financial Services, Inc., where his practice is concentrated on technical consultations on GAAP and IFRS, and as a consulting and testifying expert on civil and white collar criminal litigation matters. Dr. Epstein is the co-author of Wiley GAAP 2010, Wiley IFRS 2010, Wiley IFRS Policies and Procedures, and other books. At the time of this article Elaine Vullmahn, MBA, CPA, CIA was a Senior Litigation Accountant with Russell Novak & Company, LLP, specializing in internal control matters and litigation consulting. Ms. Vullmahn received her J.D. from the John Marshall School of Law, class of 2011.