Caveat emptor: Forensic investigations and due diligence

Jim Martin and John Alfonsi are managing directors at Cendrowski Corporate Advisors.

In August 2011, Hewlett-Packard acquired the British software company Autonomy for $11.1 billion, a 58 percent premium over the target company’s share price. HP believed the acquisition of Autonomy would be the perfect complement to its existing technology. 

However, less than 15 months later, HP announced an $8.8 billion write-down. HP claimed it discovered accounting improprieties, misrepresentations and disclosure failures which inflated the value of Autonomy. These irregularities were allegedly undetected during HP’s due diligence phase of the acquisition.

Given the current challenging economic environment, mergers and acquisitions are seen as a means by which companies can achieve faster top and bottom-line growth as well as increased shareholder value. M&A activity and the heightened scrutiny of the marketplace have created a need to incorporate forensic investigative tools into the due diligence process.

Forensic tools should be incorporated into both the negotiation and examination phases to detect potential management misrepresentations and fraudulent activities. These forensic tools consist of applying professional skepticism, performing risk assessments and applying various financial analytical tools – among other forensic techniques – to verify and corroborate information obtained during the due diligence process. 

The negotiation process itself is somewhat arbitrary and can place the acquirer at a disadvantage. A seller can attempt to “polish the apple” when presenting its offer, and an acquirer is often forced to rely on financial statements or information prepared by, or under, the direction of the seller.

Therefore, a prudent acquirer needs to approach a potential transaction with a certain sense of “professional skepticism” to mitigate the risk of distortions.  This forensic technique consists of relentlessly asking questions, making critical assessments, and challenging all assumptions, especially with regards to the veracity of the seller.  

Not only should a buyer incorporate forensic tools during the negotiation phase, but they should also incorporate such skills during the examination phase of the company.  According to a Association of Certified Fraud Examiners report, the typical organization looses 5 percent of its revenue to fraud each year. By a wide margin, the ACFE report identified strong internal controls as the most effective measure for the prevention of fraud. Thus, as part of the due diligence process, the acquirer should forensically examine the in-place controls and identify any weaknesses that could allow erroneous or unauthorized transactions. A common method to identify potential internal control weaknesses is to perform an internal risk assessment, which helps to recognize and understand risks that might not appear obvious. 

An acquirer should also perform forensic analytics on the company’s financial statements.  There are a number of different analytical tests that can be performed in conjunction with financial due diligence procedures. When developing analytical tests, the acquirer should note current and past events within the organization and the industry in order to isolate anomalies from known events.   

Incorporating forensic techniques in the due diligence process will help expose or isolate areas of potential fraud, misrepresentation and/or irregular activities and ensure confidence before the acquirer consummates a deal.

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