The Fraud Risk in Mergers & Acquisitions

A friend of mine unwrapped a Christmas present and was excited to open the box to discover her new gift. Her excitement turned to disappointment when she found a used candle inside the box. This was not a prank; someone had previously purchased the item, replaced it with a large used candle of approximately the same weight and returned it for a full refund. The store then restocked the deceptive box where it was repurchased again as a gift for my friend.

In my career, I have helped assist a number of companies through mergers or acquisitions that subsequently led to disputes or discovered fraud. These companies had, in their own way, discovered a used candle. Below are five mergers & acquisitions fraud risks I have seen while conducting investigations involving mergers and acquisitions.

Employee Background Checks

Hopefully your company has a rigorous on-boarding process that includes an employee background check to prevent fraud and abuse. Unfortunately, what we see all too often in an acquisition is that the acquiring company doesn’t perform a background check on employees at the company it is acquiring. As a result, fraudulent employees may be acquired along with the assets of the target company.These new employees gain access to new opportunities to commit fraud once a merger or acquisition is complete.

Adopting fraud

While the due diligence process is intended to provide a comprehensive appraisal of a business, establish its assets and liabilities and evaluate its commercial potential, it typically doesn’t go deep enough to uncover employee procurement fraud or payroll fraud. This process isn’t designed to identify these types of issues and as a result, you may end up adopting a fraud.

Systems integrations

After a merger or acquisition, often a decision has to be made to migrate one data system (general ledger system, payroll system, accounts payable system, etc.) to another or to run them in parallel. In one investigation, after a company had acquired a smaller competitor, the new parent intentionally migrated revenue and accounts receivable to its system platform and intentionally continued to run the legacy system in parallel so as to double count the revenue for the final quarter of the year. This was done in an effort to show that the acquisition was indeed a good business decision.

Layoffs

Often mergers or acquisitions result in layoffs, whether it’s in an effort to make the organization more attractive or reduce expense. On paper they make sense. Practically speaking though, there is inherent fraud risk associated with layoffs, particularly if they occur in the accounting or finance group. Employees often have specific knowledge that isn’t documented in SOPs and it can take months or years to replace. These gaps, if left unaddressed, result in an environment that’s susceptible to fraud.

Accounting fraud

One area where investors and analysts must spend extra time is in navigating the post-transaction financials. Benchmarking, competitor analysis, year-over-year, quarter-over-quarter and analyzing same-store sales are all types of comparative analyses. One thing that makes comparison difficult is if the organization changes. Imagine if a company acquired another company every month for 16 consecutive months. How would you compare the performance to any other period, or to any other company? It would be extremely difficult. This can create an opportunity for a company to hide revenue to investors or skew the numbers on performance.

4 Steps To Avoiding M&A Fraud

So what can you do to help ensure you’re not buying the proverbial used candle?

  1. Adhere to the standard due diligence process. Request audited financial statements and look for identified control weaknesses.
  2. Perform background checks on key personnel, and be sure that they go back a sufficient amount of time (background checks are subject to state and federal laws).
  3. Look for evidence of a robust anti-fraud program. Determine if there are whistleblower hotlines and codes of ethics and check if the organization has identified and mitigated its fraud risks. Obtain investigative reports of prior allegations of fraud, waste and abuse
    and understand the report findings.
  4. Evaluate the organization’s third parties including accountants, attorneys and other advisors. Have they been screened by the organization? Are they reputable? Are they in good standing with professional societies?

Better Together

Are you considering a merger or acquisition? Bennett Thrasher can partner with you to achieve the best outcome while mitigating risk. For more information about fraud in mergers and acquisitions, please contact Justin Snell by calling 770.396.2200.

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