Due Diligence
Due Diligence: Is Fraud Part of the Financial Due Diligence Puzzle?
September 9th, 2010 9:42 AM
The financial due diligence process for a buyer considering a merger or acquisition includes the completion of procedures selected by the buyer. These procedures commonly focus on the quality of earnings, assets and liabilities. They often consist of inquiries, process review, data and document analysis and other investigate actions to assist in evaluating the reliability and completeness of information obtained.Frequently, financial due diligence consultants discover facts and circumstances that look and feel irregular….like fraud. Should these findings be considered when planning financial due diligence projects? How are the finding reported in a due diligence report?
The Association of Certified Fraud Examiners (ACFE) 2010 Report to the Nations on Occupational Fraud and Abuse found that the typical organization loses 5% of its annual revenue to fraud and that the median loss caused by occupational fraud is $160,000, with one-quarter over $1 million . Using the 5% benchmark and an 18 month detection period, we can assume that these amounts are representative of companies generating revenue in the range of $3 to $15 million. If we go one step further and assume that a hypothetical acquisition enterprise value is roughly 5 times earnings before interest, depreciation, taxes, and amoritzation (EBITDA), the implied impact on value could be significant.
The type of fraud identifiied could result in a variety of findings having a negative or positive impact on value. For example, a tax fraud where an owner commingles personal and business expenses in the business causing an overstatement of expenses may result in a positive buyer adjustment to EBITDA indicating a possible understatement of value. In this situation the personal expenses will likely not continue under new ownersip. One the other hand, an upcoding fraud in a healthcare organization may result in a negative buyer adjustment to EBITDA and an analysis of potential penalties. In this situation the revenue collected may have to be repaid, and unrecorded penalty liabilities could exist indicating a possible overstatement of value.
For due diligence planning purpose, the potential for fraud and the impact fraud may have on a propsed transaction can be alarming and warrants consideration by the financial due diligence team and buyer management representatives. According to the ACFE the primary fraud detection method is a tip (40.2% of cases). A financial due diligence process often includes on-site interviews. These interviews sometimes lead to “tips” , and in some cases, findings related to unnormal business practices. These findings, without opinion expressed regarding legal guilt or innocence of any person or party, should be considered by the buyer and their legal counsel.
1. Key Findings and Highlights of the 2010 Report to the Nations http://www.acfe.com/rttn/2010-highlights.asp
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