Forensic accounting in mergers, acquisitions

In the fast-paced world of mergers and acquisitions (M&A), companies are constantly seeking opportunities to expand their market presence, acquire new technologies, or gain a competitive edge.

While M&A deals can offer exciting growth prospects, they also come with inherent risks, including financial irregularities, fraud and other potential pitfalls that can impact the success of the transaction.

This is where forensic accounting plays a critical role in helping companies navigate the complexities of the M&A process and ensure the financial integrity of the deal.

Forensic accounting is a specialised field that combines accounting, auditing and investigative skills to uncover financial fraud, misconduct or other irregularities. In the context of M&A, forensic accountants are tasked with conducting due diligence and post-transaction investigations to identify and mitigate risks associated with the target company’s financial health and integrity.

Due diligence: Assessing the target company’s financial health

Due diligence is a crucial step in the M&A process, where the acquirer conducts a comprehensive review of the target company’s financial statements, accounting records, internal controls and other relevant information to assess the risks and opportunities associated with the transaction. Forensic accountants play a key role in due diligence by analysing financial data, identifying potential red flags and providing valuable insights to the acquirer.

During due diligence, forensic accountants focus on several key areas to assess the financial health of the target company, including;

Examining the accuracy and reliability of financial statements

Assessing the adequacy of internal controls

Evaluating the target company’s compliance with regulatory requirements

Here are some examples of the key areas they focus on and the specific red flags they may uncover:

Revenue recognition

Unusual revenue recognition policies or practices

Significant revenue from one-time or non-recurring transactions

Unexplained discrepancies between reported revenue and industry benchmarks

Aggressive or inappropriate use of reserves or allowances to manage revenue

Expense management

Unusually high or increasing operating expenses relative to revenue

Significant expenses related to related-party transactions

Unexplained variances in expense categories or cost centres

Lack of supporting documentation for large or unusual expenses

Inventory valuation

Significant inventory write-downs or write-offs

Obsolete or slow-moving inventory not properly accounted for

Inaccurate inventory counts or valuation methods

Unexplained discrepancies between physical inventory and recorded amounts

Cash Management

Unusually high or low cash balances relative to industry peers

Significant related-party transactions or transfers of cash

Unexplained cash flow patterns or irregularities

Concerns about the target company’s banking relationships or access to capital

Accounting practices and internal controls

Lack of or inadequate internal controls over financial reporting

Frequent changes in accounting policies or practices

Unexplained or unusual journal entries or accounting adjustments

Lack of segregation of duties or appropriate oversight

Financial reporting

Inconsistencies or discrepancies in financial statements

Unexplained changes in key financial ratios or metrics

Significant off-balance-sheet transactions or arrangements

Unusual or unexplained related-party transactions

By conducting a thorough analysis of the target company’s financial data, forensic accountants can help the acquirer identify any potential risks or issues that may impact the success of the M&A deal.

Specific areas of focus for forensic accountants

One of the key areas of focus for forensic accountants during due diligence is the assessment of revenue recognition practices. Improper revenue recognition practices can lead to financial irregularities, overstated revenues, and misrepresentation of the target company’s financial performance.

Forensic accountants carefully review the target company’s revenue recognition policies and practices to ensure compliance with accounting standards and identify any potential issues.

In addition to revenue recognition practices, forensic accountants also examine the target company’s expense management and cost structure during due diligence.

By analysing the target company’s expense data, forensic accountants can identify any discrepancies, inefficiencies, or irregularities that may impact the financial health of the company.

Another critical aspect of due diligence for forensic accountants is the evaluation of inventory valuation practices.

Improper inventory valuation practices can lead to overvalued or undervalued inventory, which can distort the target company’s financial position and performance. Forensic accountants conduct a detailed analysis of the target company’s inventory valuation methods, procedures, and controls to ensure accuracy and compliance with accounting standards.

Post-transaction investigations

In addition to due diligence, forensic accountants also play a vital role in post-transaction investigations to uncover any potential fraud or misconduct that may have occurred during or after the M&A deal.

Post-transaction investigations involve analysing financial data, conducting forensic interviews, and reviewing documents to identify any irregularities or fraudulent activities that could impact the financial health and reputation of the merged entity.

Forensic accountants use a variety of techniques and tools to uncover financial misconduct during post-transaction investigations, including data analysis, forensic interviews, document reviews, and financial modelling.

By conducting a thorough investigation, forensic accountants can help the merged entity address any issues related to fraud, embezzlement, asset misappropriation, or other fraudulent activities that may impact the success of the M&A deal.

Conclusion

Forensic accounting plays a critical role in the context of mergers and acquisitions by helping companies identify and mitigate risks associated with financial irregularities, fraud, and other potential issues.

Through due diligence and post-transaction investigations, forensic accountants provide valuable insights and support to ensure the financial integrity of the M&A transaction. By conducting a thorough analysis of the target company’s financial data and uncovering any potential fraud or misconduct, forensic accountants help protect the interests of stakeholders and ensure the success of the M&A deal.

Dr Kudzanai Vere is forensic accounting expert with a proven track record and competencies in dealing with insurance claims in Zimbabwe. He is the Director in charge of Forensic Accounting, Investigation and Auditing at Kudfort Zimbabwe. He can be contacted on kudzanai@kudfort.co.zw or +263 771 592232-ebusinessweekly