For any transaction to be successful, the acquirer will have completed a thorough due diligence investigation. It is helpful to know some of the more common financial and accounting problems that are frequently arise so they can be avoided in advance.

Inventory Distortions

Undervaluation of inventory by private companies minimizes taxes but can lead to distorted earnings trends.

Overvaluation of Inventory

A key source of overvalued inventory is unrecorded inventory obsolescence caused by product overruns, changing technology, new product development and maturing or discontinued products. The overvaluation usually results from excessive obsolescence or failure to count inventory on hand accurately.

Litigation

Few companies are free of litigation, the most common resulting from product liability. This type of liability often surfaces well after the acquisition.

“Dressing Up” of Financial Statements before the Sale

“Dressing Up” tactics can include deferral of Research & Development expenses, and repairs and maintenance, “release” of inventory reserves, unduly low reserves, or estimates for such things as bad debts, pension accounting, sales returns and allowances, warranties, slow-moving and excess inventories, and undisclosed changes in accounting principles and methods.

Receivables Not Collectible at Recorded Amounts

Doubtful accounts, cash and trade discounts, dated receivables, and sales returns and allowances may not be adequately reserved for.

Credibility and Integrity of Management

A private investigation may be needed to obtain sufficient information and background on target management to determine if it is right for the job and trustworthy.

Personal Expenses in the Financial Statements

Personal expenses usually reduce reported net income. But such costs also can be used to affect trends and produce a favorable appearance that is misleading if not recast accurately. Proforma adjustments by the seller to eliminate such expenses often are overstated.

Tax Contingencies

Tax contingencies represent one of the biggest problem areas in an acquisition, because most companies tend to be very aggressive when preparing their tax returns.

Unrecorded Liabilities

Unrecorded liabilities may include vacation pay, sales returns, allowances, and discounts (volume and cash), pension and insurance liabilities, loss contracts and warranties, among others.

Related Party Transactions

Related party deals can have a material effect on the company under new ownership or on the historical trends presented during negotiations.

Poor Financial Controls

Included in poor financial controls are poor pricing and costing policies, and deficient budgeting systems and controls.

Regulatory Problems

Lack of compliance with environmental laws has become a significant problem. Other regulatory problems may exist in the area of safety, taxes, labor and so on.

Reliance on a Few Major Customers or Contracts

Loss of a major customer can have a material effect on operations.

Need for Significant Future Expenditures

Significant future expenditures needed might include relocation or expansion, replacement of aging equipment, or new product development requirements to remain competitive.

Unusual Transactions

Extraordinary actions such as sales of assets often improve the trend presented by the selling company.