Common issues in due diligence from an accounting and tax perspective

Understanding the target’s business model and industry nuances is essential for anticipating future contingencies. This is especially crucial in regulated sectors like financial services where adherence to industry regulation can impact operational and key performance indicators. Having a clear understanding of the transaction structure is essential before delving into analysis of contingencies or noteworthy elements that may affect the deal. This includes assessing factors such as the need for additional working capital, potential tax implications, and other relevant considerations that could impact the transaction's outcome.

Issues encountered during the accounting and tax due diligence process include:

1. Working capital
   
   A historical trends analysis of the target company's working capital is paramount. Look for significant fluctuations in accounts receivable (AR), accounts payable (AP), and inventory. Rapid changes may indicate potential underlying issues such as ineffective cash flow management, revenue recognition problems, anomalies in collection from customers or payment to suppliers, and inefficiency in inventory processes.
   
   Assessing these trends and potential issues can provide insights into the company's financial health and its ability to sustain operations. Moreover, understanding the potential impact of working capital requirements on future cash flows is essential for identifying any contingencies that may necessitate additional capital infusion post-acquisition. By analysing working capital dynamics, buyers can better assess the overall financial health and viability of the target company.
   
   
2. Contingencies related to the government
   
   Assess the target company’s ongoing government commitments, for example, like distributing set-top boxes in Indonesia's television industry. Confirm if the company has already accrued and set aside provisions for these contingencies, as well as monitoring the progress and commitment of the company in fulfilling them.
   
   
3. Accounts receivable
   
   Assess long outstanding AR that are likely uncollectible and whether the allowance is sufficient. In most cases, the company does not factor in allowances for long outstanding AR, assuming that customers will eventually settle the AR provided they are not insolvent. It is necessary to check subsequent collections as supporting evidence to justify whether AR allowance is needed for those long outstanding AR.
   
   
4. Share capital and dividend
   
   One common issue that arises is undisclosed distributions to shareholders which may include cash dividends, share buybacks, or other transactions aimed at reducing the company's equity base without proper documentation or transparency. The absence of proper documentation may also result in potential tax exposure of deemed interest due to it being considered as a related party transaction. 
   
   
5. Unrecorded expense
   
   When monthly expenses are not recorded promptly, monthly financial statements may present an inaccurate view of the company's performance. This delay in recognising critical expenses can inflate net income and affect the quality of earnings. This is particularly crucial during ongoing due diligence or M&A processes.
   
   
6. Prepaid expense, advanced expense, and other assets
   
   Understand the nature of the target company’s accounts, review agreements underlying transactions, and assess the validity of the accounts whether the treatment is still on the asset side or has already been expensed. For instance, in the event of a vendor deposit, where the underlying contract mandates a refund to the company, the potential inability of the vendor to fulfil this obligation due to financial hardship necessitates the pre-emptive recognition of the deposit as an expense.
   
   
7. Other borrowing
   
   Review accounts for breaches of the company's covenants, like financial ratio maintenance or ownership changes without creditor consent. Also, assess significant assets pledged to others – for instance, target company shares pledged as loan collateral, potentially impacting M&A transactions.
   
   
8. Taxation
   
   Ensuring compliance and accurate reporting is crucial. This involves scrutinising filings, payments, and returns for VAT, corporate income tax, and withholding tax. Evaluating related-party transactions and documenting transfer pricing is essential to address potential tax issues, including deemed interest risks. Assessing the company's tax dispute history helps anticipate disruptions and informs negotiation strategies.

There may be other issues and contingencies which may arise depending on the target's conditions, in terms of both industry and transaction structure. It is important to think critically so that all issues can be identified properly.

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Wulan leads the corporate finance team at Protemus Capital as a Manager. Leveraging her expertise in due diligence, valuation, and debt restructuring, Wulan's proven track record in these areas empowers her to guide clients through critical financial decisions.