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FORENSIC DUE DILIGENCE

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South Africa has recently seen a significant increase in mergers and acquisitions. Despite global market tumult and poor conditions in debt markets, transactional activity is continuing, where market players see the opportunity to get good deals done, and to restructure their entities to respond to the fast evolving environment.

As the cost of funds for such deals increases and it becomes even more important to ensure that acquisition values are sound, investors are increasingly aware of factors that diminish acquisition value after transactions. The unearthing of a fraud or a regulatory violation after closing a transaction, is probably the fastest way in which value can be lost after an acquisition. When such losses occur, they are significant and could even exceed the value of the original investment if, for example, there is a regulatory fine involved or the value of a company’s shares plummets.

Warranty clauses in purchase and sale agreements will not cover all aspects of losses that can be incurred, such as damaged reputation, loss of management time, operational inefficiencies and other indirect losses. The risks of fraud, corruption and failure of an acquired business to comply with regulations should be top of any investor’s agenda.

Both buyers and sellers should be sensitive to the risks of fraud and corruption. During pre-acquisition and pre-investment, a due diligence on a host of business risk areas should be reviewed in order to minimise potential loss of value to the acquirer after the transaction.

As an example, an acquired entity could have been involved in undisclosed price fixing and after a deal, the purchaser could be exposed to unforeseen action and fines from the Competition Commission. This could damage the reputation of the company or even jeopardise the transaction.

Exposure to threats arising from fraud and corruption, such as reduced revenues, increased costs, reputational damage, competitor or shareholder litigation, or even regulatory sanctions including criminal prosecution, should not be ignored by directors.

Conducting forensic due diligence requires a global knowledge of fraud and corruption trends together with highly specialised investigative and industry experience. The review’s primary objective must be to evaluate the potential future loss in value resulting from inappropriate or unethical business practices of the target.

Investigations are concentrated in specific areas that are prone to, or have been, targets of frauds within an organisation, such as related party transactions, consulting expenses and accounts with high levels of management discretion. Areas that are governed by specific laws and regulations also need to be looked at closely. It is also useful to review the organisation’s attitude towards anti-fraud mechanisms such as fraud hotlines and fraud awareness programmes.

The other angle that needs to be looked at in a forensic due diligence is where an acquiree seeks to manipulate financial statements so as to extract a higher price from the acquirer. This constitutes a deliberate misrepresentation of the financial condition of an entity through the intentional misstatement of amounts and disclosures in the financial statements so as to deceive users of the financial statements.

In some cases, the symptoms of financial statement manipulation, such as low quality of earnings, may be spotted by the prospective acquirer without realising that the root cause is actually fraudulent reporting. Despite the application of IFRS, two companies facing similar circumstances may choose different methods and practices to achieve different results. Prospective acquirers need to watch out for lack of consistency over time in accounting practices and instances where accounting practices selected are aggressive, so as to maximise net profitability and the balance sheet value.

A seller who is under financial pressure is likely to unethically massage his/her financial statements so as to ensure a quick sale at a high value. Where there are obvious opportunities to ‘easily unlock value’ with an acquisition – it is important to ask yourself why the current owners have not already done so. Where warning signs are spotted, it is useful to get the normal due diligence to be more forensic oriented.

The following are but a few examples of risks that such an exercise would cover to detect financial statement manipulation:

  • Critically examining contracts for completeness to ensure that clauses or documents that could indicate undisclosed commitments and penalties are not concealed. Often in a due diligence there are significant quantities of documents to be looked at where the sheer quantum of information makes it difficult to identify fraudulent trends. Forensic investigators can use relationship mapping and data mining tools to reveal patterns that an individual analysis of documents would not normally reveal.
  • Inspecting sales invoices to ensure that they represent genuine sales. Customer details, such as similar telephone numbers for different customers, could indicate outright manipulation of sales documentation. Sales to related parties (whose relationship may not be openly disclosed) can create a cash trail that seems to indicate a healthy, but unfortunately misleading, level of activity.
  • Provisions for doubtful debts may be artificially reduced by tampering with ageing through using credit notes to clear old invoices and re-issuing the same amounts with more current dates.
  • Engineering bank reconciliations to reflect higher cash balances by artificially increasing uncleared deposits and reducing uncleared cheques. Reconciliations that unnecessarily contain hundreds of old reconciling entries and numerous contra-entries may be a case of deliberate sloppiness so as to more easily conceal fraud.
  • Smoothing of profits between pre and post acquisition dates can play havoc when it comes to determining post acquisition profits accurately, especially where a sale agreement has a clause where parts of the purchase price are subject to certain profitability levels being achieved or continued after purchase of the business.
  • Use of journals to cover financial statement manipulation. In some cases, the overall profitability may not be changed but journal entries could be done between segments of a company to reinforce the buyer’s rationale in terms of a particular segment. An example of this would be where a business has low profitability but the buyer’s decision is premised on a perceived opportunity within a seemingly ‘growing’ segment and restructuring or weaning the other ‘non-performing’ segments.
  • There may be journal entries that are termed mis-allocations but do not make sense, such as a journal entry that reduces creditors and increases revenue.

With hindsight after things have gone wrong, the above examples may seem obvious and shareholders may question why management did not pick up the problems. During the urgency and excitement that an acquisition generates the indicators of fraud may fall between the cracks. The critical element that a forensic examination brings in such instances is the ability of the investigator to form a fraud hypothesis that guides the due diligence team in terms of where to look and where procedures should be extended.

A seasoned investigator may also have the ability to ask tough questions without offending. This is important given that, where there is suspected financial statement fraud, the CEO and CFO are often implicated, and one does not want to burn bridges and derail a transaction before there is concrete evidence of such manipulation.

The findings from a forensic due diligence can assist the acquirer when factored into the negotiations, and will help reduce risk and disruption from the transaction post-deal. The acquirer will have more information in terms of the obligations and operating issues that will be taken up over and above what a traditional financial due diligence focusing purely on financial statement risks, would reveal. Post-deal, the acquirer will have the benefit of starting off with an action plan for corrective measures and internal control enhancements.

The Corporate Laws Amendment Act, 2006 states that it is an offence to issue financial statements and circulars that are incomplete in terms of material information, and in finalising any transaction, directors should challenge whether there has been a rigorous exercise to unearth skeletons arising from fraud and corruption that may exist in their target’s closet.

Mandla Moyo CA(Z), BCompt (Hons), is a Certified Fraud Examiner and Certified Information Systems Auditor and the director for Risk Advisory Services at Ernst & Young.