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Evaluating an acquisition target: pay attention to the gray areas

What’s more shocking: HP’s $8.8 billion (yes, billion!) impairment charge recorded in its recently completed fourth quarter, or the fact that it blames the charge on the “accounting improprieties and disclosure failures” of Autonomy, a UK-based company it acquired just last year? Clearly, investors were not pleased, as evinced by the immediate drop in stock price after the announcement was made. What lingers, though, is an aching question that haunts companies contemplating an acquisition: if HP, with its significant M&A experience and multiple Big Four audit teams, failed to see through Autonomy’s misrepresentations, then what hope is there for the rest of us?

Investigations by the Securities and Exchange Commission’s Division of Enforcement and the UK’s Serious Fraud Office are under way to determine whether evidence of fraud exists. I think it’s safe to say that detecting fraud at a target company is not typically engrained in the pre-acquisition due diligence process. However, consider this: what if the “improprieties” weren’t fraud per se, but instead liberal interpretations of principles-based international financial reporting standards?

Drawing focus to areas requiring extensive judgment and assumptions should be an integral part of the due diligence process. Even where the financial statements have already been audited by a reputable firm, focusing on the gray 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 & Analysis 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 rev rec, 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.

So the moral of the story is, no deal is ever black and white. The more time you spend understanding the gray, the better your chances are for understanding and valuing what you’re buying.

For an M&A due diligence checklist, see our report, M&A: Get What You Bargained For.