Company owners might be surprised at the impact insufficient historical financial reporting can have on the potential sale of their business. When a seller’s financial reporting does not support its claims, the results can be costly, including buyers negotiating a lower purchase price. There are several accounting and financial reporting issues owners should consider at least two years in advance of offering their company for sale.
Audits Are What Matter
Owners often rely on external accountants for assurance and tax services but fail to understand the level of service they’ve engaged. Having an external accountant prepare a company’s annual tax returns is not much help in the financial due diligence process. The only service implied with tax return preparation is that the owner provided financial data that the accountant used to complete the tax return forms. While an accountant often provides other valuable accounting and consulting services to the owner, these are not as useful in the financial due diligence process.
It is not uncommon for an owner to be confused about the service he or she thinks is being performed. What many call audits are actually compilations or reviews. U.S. accounting rules have specific guidelines regarding what constitutes compilations, reviews, and audits. Compilations are the most basic level of service performed by accountants and generally help owners present the company’s financial data in the form of financial statements, but they do not provide any assurance regarding that financial data. Reviews are one step up from compilations in that the CPA performs primarily analytical procedures and inquiries in order to provide a reasonable basis for obtaining limited assurance regarding the financial data. But neither service implies a deeper dive into the financial data on par with an audit or with financial due diligence.
With audits, an accountant provides a high, but not absolute, level of assurance about whether the financial statements are free from material misstatement. Auditors obtain audit evidence in order to provide this level of assurance through a variety of steps, including inquiry, examination, observation, physical inspection, third-party confirmations and analytical procedures. An audit implies that an independent auditor was able to express an opinion in relation to the company’s financial statements.
Owners preparing a business for sale should obtain financial statement audits for at least two fiscal years prior to offering the company for sale. The audits indicate to potential buyers that the company’s financial information has already been examined by a third party, instilling confidence in the information. In addition, audits might help identify financial reporting issues earlier than during the financial due diligence process.
Understanding Financial Statements
Companies often are started by entrepreneurs who are amazing at generating revenue and earnings but not so amazing at understanding income statements and balance sheets. Potential buyers do not expect owners to be financial analysts, but they do expect them to understand their own financial statements. Although owners often manage the business in terms of cash, U.S. generally accepted accounting principles generally require companies to report on an accrual basis, reflecting revenues when earned and expenses when incurred.
During due diligence, potential buyers will expect an owner to provide financial statements reported on an accrual basis and to understand how the company recognizes revenue in the financial statements. There can be significant differences between financial statements on an accrual basis and those on a cash basis, and owners should take the time to understand the accounting methods the company uses.
Owners use various pieces of data to manage their business, and they should understand how any financial data maps to the financial statements. For example, owners might track sales by when a product or service is sold by their sales team, but the financial statements might reflect when that product is shipped or when that service is provided. Owners should be clear regarding any data that might eventually be provided to potential buyers. This will not only avoid confusion but also will help an owner appear well prepared.
The financial due diligence process most likely will occur at some time other than just after fiscal year-end, so owners also should understand whether interim financial reports are prepared consistently with annual financial reports. Companies often prepare monthly financial reports on a cash basis and annual financial reports on an accrual basis. While there technically is nothing wrong with this practice, potential buyers will want to compare annual information to interim reports on an apples-to-apples basis. Depending on the accounting methods the company uses, this could be a straightforward task or a very difficult one.
Consistent Accounting Methodology and Categorization
Nothing can clog up the financial due diligence process more than inconsistently prepared financial information. Potential buyers want to analyze trends, and these trends become less meaningful if owners change how transactions are reported. If potential buyers have to spend too much time cleaning up the financial data, they might begin doubting the integrity of the information. Sellers can avoid giving buyers cause for doubt by deciding up front on the proper accounting methods for the business and sticking to them.
Companies for sale should be prepared to provide historical financial information on a consistent basis. If the company provides the originally reported information and maps the pro forma adjustments to arrive at consistent reports, the potential buyers can focus on the trends instead of on their doubts.
Financial Reporting: Supporting the Owner’s Operational Claims
Often, one of the most frustrating issues for potential buyers during the financial due diligence process is when a company cannot adequately support financial claims. For example, owners might have included historical gross margin by product line in their offering memorandum, but those numbers might turn out to be broad estimates if the company’s direct costs are not tracked by product line. Without the details that can be reconciled with the financial statements, potential buyers cannot be expected to believe an owner’s claims regarding specific product lines.
Owners often have a set of data they use to manage the business. Potential buyers will want to see this data, understand the trends, and understand how they track back to the financial statements. Owners also should be aware of industry-specific financial information that potential buyers may expect, such as financial results by store for retail operations.
Managing the Financial Due Diligence Process
Potential buyers do not expect every company to have a CFO, director of accounting and controller. They do, however, expect a company to have at least one point of contact who understands the historical financial information. In fact, hiring a CFO two months before the financial due diligence process begins often just creates a bottleneck because the new employee has to first request the information from other people.
Companies need one person who understands how its transactions are recorded and what the accounting system is capable of reporting. If a company already relies heavily on an external accounting firm for other services, that third-party firm can help. Potential buyers will want interim financial statements on a consistent basis, and an external CPA can help the company’s internal accountant to determine the pro forma adjustments needed without auditing the interim period and can also explain the accounting methods applied.
Financial Due Diligence Equals Pain Management
Due diligence has astutely been described as “the business equivalent of a colonoscopy,” by Norm Brodsky in "The Long Road to Nirvana." Preparing and improving financial reporting at least two years in advance of a potential buyer’s examination will not only make the process a little less painful, it will also better support a company’s value.
Kim Fette is with Crowe Horwath LLP in the Chicago office. Mike Lux is a partner with Crowe in the Chicago office.