Leading Buyers Down The Primrose Path: Auditors Face Pressure After Post-Deal Detections of Serious Accounting Flaws

Figures can lie. The painful reality that the ancient art of cooking the books still is going strong has been reinforced by the eruption of post-deal accounting scandals in the wake of two high-profile deals in the last two years. While the discoveries of accounting irregularities by targets in the two megadeals, as well firms in some non-merger cases, have rocked the accounting and dealmaking professions, an open question is whether they will drastically change m&a auditing and due diligence techniques. There have been rumblings about doing a more thorough auditing job in general or more vigorously challenging figures proffered by management. But there appears to be no magic bullet for getting to the truth, especially when fraud is involved. Mark McDade, partner at PricewaterhouseCoopers, says that accounting and financial discrepancies may fall through the cracks simply because auditors are under the gun to complete their work and let the deal proceed. The shortage of time is especially acute, he adds, when “two public companies are coming together.” Moreover, McDade notes that when preacquisition due diligence is launched, “they are not expecting a fraud.” But Larry Ross, president of Ross Financial Services Inc., Washington-based investigations firm, says that savvy acquirers may have to supplement standard auditing approaches with investigative techniques to uncover the most damaging warts. Ross asserts that accountants often are not geared to ferret out fraud, while investigators tend to zero in on anything suspicious. “They are not looking for the same things I’m looking for,” he said. The most recent m&a accounting storms exploded after the 1997 merger of HFS Inc. and CUC International Inc. to form Cendant Corp., valued at $11 billion, and the February 1999 acquisition of HBO & Co. by McKesson Corp. for $14.3 billion. In the fallout from both cases, heads rolled, a barrage of lawsuits were filed, earnings were restated, strategic implementation of the deals was snagged, and, in Cendant’s case, the controversy helped scuttle a deal to acquire American Business Insurance. Among the eye-popping allegations was that CUC and HBO had been using questionable accounting techniques for some time before their transactions, presumably to put the best face on the numbers they served up to investors. An auditor’s report in the Cendant investigation maintained that CUC had inflated revenues by $500 million over a three-year period through a variety of techniques, including discordant treatment of revenues and expenses. McKesson accused HBO of overstating software sales and holding back information on contracts with contingencies. Although there is a long history of mergers plagued by target accounting machinations, these cases have drawn attention because of their size and the expectation that auditing skills have been honed through the two-decades-long m&a boom. McDade said that the two deals are “probably individual situations.” But in general, he added, “it runs back to how much due diligence a company can do” given the time constraints. “The due diligence may not be as complete as one would like,” he stated. He also noted that the auditors have to work with “what the management team is telling you.” Ross, a tax lawyer before going into investigations, said that his approach to sniffing out flaws is based as much on art as on science. “I can look at a document, and something may lift off the page,” he said. “I can pull on that little thread and everything comes unraveled.” Unlike accountants who zero in material financial entries, investigators may find the triggering discrepancy to be minor at first blush. “It’s small fraud early on, a little bigger fraud later, and a little bigger fraud even later,” he said. “Pretty soon, you’ve got something material.” In the Summer 1998 issue of the M&A Insider newsletter, Ross described this telling discovery about a merger target that turned off a client considering a deal: “When the target’s financial records were obtained, investigators immediately noticed a peculiarity accounts receivable were increasing while sales were falling. The company’s SEC reporting made it appear as if it sold products in a broad retail market, but the target was really at the mercy of distributors. The target had developed a misleading account practice of reporting income at the time the distributor was contractually obligated to pay the target for the products. Regardless of their contracts’ stipulations, the distributors did not pay the target until they themselves had been paid by the retailers. “The target was unable to force the distributors to honor the terms of the contract. Although the target knew that the distributors did not pay the invoices until the retailers sold the products, often months after the distributors were contractually obligated to pay, the target continued to accrue sales at the time the distributors were supposed to pay the company. “We also noticed that concentration of customers was increasing, and discovered that the target was involved in litigation over a substantial amount of the accounts receivable with a distributor. Most importantly, it was determined that the target had lost that distributor as a customer and was relying on a smaller group of distributors for its business. Obviously, aspects of the target were revealed that made it considerably less attractive as an investment, and the client decided to look for another business opportunity.” Despite tighter financial disclosure requirements and stiffer enforcement, Ross said, they haven’t done away with all manipulators or clearly crooked operatives in the corporate sphere. He identified three tiers of dishonest people that confront the investigator with different challenges. The “congenitally dishonest” have a long pattern of fraudulent or suspicious conduct. “They are not that hard to investigate,” he maintained. The “situationally dishonest,” people who generally have clean records but go off the mark in special cases, are “harder to investigate,” he said. “Then there is the guy who is lying to himself. He believes things that aren’t true. He’s kidding himself. Those cases are the hardest to prove.”