1. Basis of preparation
Consider the basis on which the financial statements were prepared. For small and medium-sized businesses (SMEs), financial statements are often prepared with a focus on tax requirements rather than the needs of a broader audience, such as potential investors or other stakeholders. As a result, they often reflect tax-specific accounting policies or undisclosed accounting policies that may not accurately represent the company’s financial performance and position.
You should also consider the target’s wider internal controls. Strong processes and controls, such as standardised month-end closing procedures, improves the quality of reporting. This leads to more reliable data for decision-making. Assessing the consistency of monthly reporting is a crucial aspect of financial due diligence because monthly results are likely to be used in key aspects of the transaction such as setting earn-out targets or agreeing on a net working capital target.
2. Audit materiality
Audited financial statements offer an independent view of a company’s financial reporting and are generally more reliable than unaudited accounts. However, investors should remember the objectives and thresholds for materiality that apply to audits differ from those of financial due diligence. You should also consider the existence of any unadjusted misstatements in earnings because while these may not be material from an audit perspective, they may materially impact the price you pay due to the multiplication effect of the valuation multiple.
3. Adherence to fundamental principles
Accounting frameworks generally follow key principles, yet deviations from the following principles are common in financial statements of SME businesses:
- Fair presentation: This requires the faithful representation of the effects of all transactions, events and conditions impacting the business;
- Accrual accounting: Recording revenues and expenses when they are earned or incurred, not when cash is exchanged;
- Consistent presentation: Allows the comparison of financial performance and position between periods; and
- Limited offsetting (only when allowed) of assets and liabilities (or revenues and costs)
For example, SME businesses may simplify revenue and cost recognition by using a cash basis of accounting or by recording transactions on the invoicing date without considering the actual timing of underlying activities. Additionally, financial statements might not include necessary accruals for all expenses incurred at a balance date. This can result in timing errors, misinterpretation of performance, and unexpected impacts on valuation.
Often SMEs will not record all required provisions on their balance sheets. This might be the case when a property lease has a make good provision that will lead to a likely future cash out flow. If this obligation goes undetected, you might need to settle the full obligation post-acquisition although the seller would have received, at least partially, the benefit from the use of the property. SMEs might also only record obligations at year-end which means interim results should be interpreted with care.
4. Changes in accounting policies and estimates
Accounting policies and estimates play a crucial role in how a company’s earnings are reported, and ideally, they should be consistently applied. Changes should only be justified when they lead to a more faithful representation of economic results. However, when changes do occur, it’s essential that all necessary disclosures are made. This allows users of the financial statements to understand the impact of the changes.
SMEs often do not appropriately describe the specific accounting policies they have applied, let alone any changes to these accounting policies or estimates. For instance, a business might decrease their estimate of inventory obsolescence which can lead to a one-off gain in a reporting period. Investors must remain wary and critically assess any unexplained changes in earnings or the valuation of assets or liabilities on the balance sheet.
5. Classification
Accounting frameworks typically mandate disclosure in financial statements based on an item’s commercial substance. However, it’s not uncommon to find items that have been misclassified. For example, a business acting as an agent for a customer should only recognise the net revenue for the activities it performed. But, in some cases, SMEs following tax-based accounting might classify the gross receipts as revenue. This classification potentially distorts the scale of revenue of a business and its margins, leading to the wrong conclusions being reached when assessing growth expectations.
SMEs might also expense certain assets for tax reasons which would typically require capitalisation under standard accounting rules. The expensing of capital items leads to an overstatement of expenses and an understatement of earnings in the year the cost is recorded.
So, carefully consider the classification of transactions and balances in the financial statements and make the appropriate adjustments to earnings and working capital balances if there are indications of errors.
Always take a step back and look at the bigger picture
Before commencing financial due diligence, it is useful to take a step back and consider the quality of the overall financial reporting of a business. Not only will this highlight key risk areas which need to be addressed during diligence, it will also help avoid costly errors in valuation or unexpected subsequent adjustments to price which might remain undetected otherwise.
Accounting rules can be complex and errors hard to detect. However, a well-planned diligence approach that adequately considers reporting quality can significantly reduce risk and improve your chances of a favourable outcome.
