If you are thinking of buying or selling a company, you have probably heard the term “due diligence.” What does this term actually mean? Although due diligence can essentially mean validating certain claims that have been made in any context (qualitative or quantitative), we will explain the term as it pertains to a business transaction (i.e., a merger or acquisition).
During an asset purchase or business combination, a due diligence team would test and review the assets being acquired (cash, accounts receivable, inventory, fixed assets, etc.) and the liabilities being assumed. This normally begins with audited or reviewed financial statements of the acquiree, followed by additional analysis of the acquireeʼ s tax returns, insurance, and lease contracts, including employment agreements and outstanding litigation claims, etc. Similarly, as due diligence is being performed on behalf of the buyer, due diligence is also performed by the seller.
Seller due diligence is often overlooked during a merger or acquisition. Some factors that should be considered are the buyerʼ s ability to meet the financial commitments and whether the company is compatible or synergistic. Sellers should also perform due diligence related to potential “claw back” provisions or other deal points which could potentially result in a reduction of the purchase price.
During the due diligence process, both parties will usually obtain a quality of earnings (or Q of E) study. While an acquiree may already have a financial statement audit, a Q of E is different and viewed as critical and complementary to audited financial statements. A Q of E specifically focuses on a companyʼ s ability to generate income and free cash flows.
The typical quality of earnings starts with reported net income or earnings before interest, tax, depreciation, and amortization (EBITDA), and adjusts that figure for non-recurring events or transactions that are not executed at fair market value. For example, excessive or discretionary wages and bonuses are added back to arrive at a “normalized” net income figure. Other adjustments would include personal expenses in the business, eliminating non-recurring revenues and margins on lost customers, adding back of non-cash compensation (stock options, etc.), passed audit adjustments, and adjustments for related-party transactions.
It is important to note that Q of E engagements are not financial statement audits. While the engagements may have similar procedures performed, the major objectives and deliverables are quite different.
If you are considering buying or selling your business, consider working with an accounting firm to help address the potential situations outlined above.
About RJI CPAs
Established in 1980, RJI specializes in audit, accounting, corporate and international tax issues for publicly traded and privately held companies. RJI is PCAOB
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