Evaluating Acquisition Targets and the Increasing Need to Focus on the Gray Areas

For U.S. companies applying Generally Accepted Accounting Principles (GAAP), the guidance is often not black and white, but can involve interpretation and judgment. And for international companies applying International Financial Reporting Standards (IFRS), there may be even greater subjectivity, given that IFRS is more principles-based. Application of these accounting standards inevitably involves some gray areas, and they should be an integral part of the buyer’s due diligence process in every M&A transaction.

Even where the financial statements have already been audited by a reputable firm, focusing on the gray areas can be exceptionally beneficial: it can highlight areas of financial risk; it can provide greater insights in vetting forecasted financial results; and it can identify areas where the target’s accounting policies differ from your own.

More often than not, the financial due diligence process is focused on quantifying the net assets of the business (aka “scrubbing the balance sheet”) and understanding the assumptions underlying the company’s financial projections.

However, attention should also be given to those accounting policies for which judgment and/or material estimates are required. SEC registrants often refer to such policies as “critical accounting estimates” and include required disclosures in the management discussion and analysis (MD&A) section of their periodic filings. Private companies are not required to provide such disclosures, and they may only touch on general accounting policies in the footnotes.

Critical accounting estimates often include areas such as revenue recognition, asset impairment analysis, contingent liabilities, income taxes and reserve accounting, including warranty provisions, bad debt allowance and reserves for excess and obsolete inventory.

Understanding your target’s policies with regard to these areas is critical, not only to assess the judgments applied, but also because certain accounting rules (especially those that are principles-based) can provide leniency in interpretation, and different companies arguably have different risk profiles.

Of course, no deal is ever black and white. The more time you spend understanding the gray areas in your acquisition, the better your chances are for understanding and correctly valuing what you’re buying. For an M&A due diligence checklist, see my firm’s report, M&A: Get What You Bargained For. You can download it here: http://www.roseryan.com/reports/manda.php