Common Issues in Due Diligence from an Accounting and Tax Perspective

Due diligence is a vital process in mergers and acquisitions (M&A), designed to validate the target company’s financial, legal, and operational standing before a deal is finalized. From an accounting and tax perspective, this review can uncover critical issues that may influence transaction value, deal structure, and post-deal obligations.

In this article, we highlight the most frequently encountered accounting and tax issues during due diligence, along with key points for evaluation.

1. Working Capital Fluctuations

Analyzing historical trends in accounts receivable (AR), accounts payable (AP), and inventory is essential.

• Sudden changes in working capital may reflect inefficiencies in cash flow management, revenue recognition, or inventory controls.
• In some cases, poor working capital management may lead to the need for additional funding post-acquisition.
• Buyers should also assess how working capital trends may affect future cash flows.

2. Government-Related Contingencies

Some companies, especially those in regulated sectors (e.g., broadcasting or infrastructure), carry government commitments, such as product distribution or infrastructure rollout.

• Verify whether these obligations have been properly provisioned in the financials.
• Ensure the company has documented its progress and compliance with these commitments.

3. Long Outstanding Accounts Receivable

Long overdue AR can be misleadingly recorded as collectible, increasing the risk of overvaluation.

• Assess the sufficiency of allowance for doubtful accounts.
• Conduct subsequent collection testing to evaluate whether AR balances are still realizable.

4. Shareholder Distributions and Equity Movements

Unrecorded or undocumented shareholder distributions, such as dividends, share buybacks, or equity restructuring, may expose the company to tax risks.

• Watch for transactions that reduce equity without proper documentation.
• Undisclosed related-party transactions could result in deemed interest tax implications.

5. Unrecorded Expenses

Delays in recording expenses may inflate monthly net income, distorting profitability.

• This misrepresentation could affect earnings quality and valuation during a transaction.
• Ensure that all recurring and nonrecurring expenses are recognized on an accrual basis.

6. Prepaid and Other Deferred Expenses

Review accounts such as prepaid expenses, advanced vendor payments, and other assets to confirm whether the balances should still be capitalized or expensed.

• Examine underlying agreements and vendor conditions.
• Consider the vendor’s ability to fulfill obligations, especially when deposits are at risk.

7. Borrowings and Collateralization Risks

Review all loan agreements to identify:

• Covenant breaches (e.g., financial ratios, change of control).
• Collateralized assets, including pledged shares of the target company that may impact deal structure.

8. Tax Compliance and Exposure

Tax due diligence should cover:

• VAT, corporate income tax, and withholding tax filings and payments.
• Documentation of related-party transactions and transfer pricing policies.
• Review of tax dispute history, which may affect post-deal obligations or indemnity clauses.

Final Thoughts: A Risk-Aware Approach

Every due diligence exercise should be tailored to the industry and transaction structure. Accounting and tax issues often carry hidden risks that can significantly affect deal terms.

An effective due diligence process goes beyond surface-level compliance—it should aim to uncover latent liabilities, clarify cash flow realities, and ensure transparent financial reporting.

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This article was originally published in the May 2024 edition of GGI Insider – General Articles, a publication by Geneva Group International (GGI) featuring insights from professionals across the globe.

Protemus Capital is proud to contribute to this global platform, sharing practical insights from our due diligence experience. In M&A transactions, uncovering key issues through rigorous accounting and tax review is essential to safeguarding deal value and ensuring informed decision-making.