Financial records Inconsistencies: A Hidden Risk to Closing Your Deal

In most M&A and capital-raising transactions, buyers and investors often hire some of the most sophisticated professionals to carry out rigorous investigations with the aim of uncovering areas of potential risk exposures that suggest that ”a business is not worth as much as quoted”. Buyers and Investors (collectively known as the “Buy-side”), organize an exercise, called “due diligence”, to bridge information asymmetry, justify purchase price and uncover hidden liabilities.

Like many other buyers, the buy-side in transactions such as M&A and capital-raising aggressively seek to minimize purchase price to get the most out of the deal. As a result, they investigate areas of business including legal and incorporation, financials, tax, Information Technology and so on to obtain evidences that discount the proposed purchase price resulting in sellers’ value erosion, or worse, closure of the deal.

The deal process is usually hectic for the sellers. They would often need conduct rigorous preparations for transaction readiness including audit and other reconciliations, attend to countless information request in very professional manner without divulging sensitive business information, manage buy-side expectations, provide timely response in Q&A sessions, manage the data room and the entire deal process, all while engaging in normal business activities. As such, it is easy to overlook tiny details that could erode value for sellers, negatively shape buy-side narrative or halt deal entirely. One of the most famous culprits we would be delving into in this article is financial records inconsistencies.

What are financial records inconsistencies and why do they matter in a deal

It is noteworthy that business records are not limited to management accounts, general ledgers, trial balances and annual financial statements (audited accounts). Broadly, they constitute any document in which transactions or financial data could be captured, obtained, reproduced or reconciled. As such, financial records cut across contracts, invoices, sources documents, compliance documents etc.

Inconsistencies arise when financial items in a particular document do not reconcile or largely differ from the equivalent in another document. For example, the management accounts, audited financial statements and the company income tax filings are meant to disclose highly similar amounts of profits. The profit before tax in the financial statements should align closely with the amount reflected as “profit” in both statutory CIT filings and supporting documents leveraged for CIT payment.

Why does it matter if they reconcile or not?

• Narratives matter: When preparing for transaction readiness, it is important that the narrative, story and numbers tie together. This ensures coherence, transparency and trust, leaving the seller in a better position to negotiate.
• Purchase price: Discrepancies identified, especially when the numbers reported for compliance are lower than those reported for stakeholders, create massive exposures to liabilities to the full extent of non-compliance (principal), interest and penalties. Buyers would typically consider the worst-case exposure and adjust the purchase price downwards, or worse, halt the deal entirely.

Areas where record inconsistencies can create exposure and how they affect the deal

Inconsistencies in different financial records are problematic because they affect the value sellers can get from the deal. When potential exposures are uncovered, they either affect the deal in entirety (due to trust erosion), or they reduce the price buyers are willing to pay for the deal. As a result, here are the following areas where financial record inconsistencies can give rise to liabilities:

• Corporate Income Tax – Management accounts vs CIT computation vs CIT returns: Company income tax (CIT) assesses the profit of a company and charges taxes on the assessable profit. If there is material difference between the profits reported for tax purposes (evidenced by tax return and computation) and for stakeholders, given that the profit for tax purposes has been understated, exposure arises for the buyer in terms of the full cumulative unpaid tax amount (principal), the accrued interest at a rate subject to the discretion of the Nigerian Revenue Service (NRS) and other financial penalties according to the NRS act.
• Value added tax – Revenue records vs Invoices vs VAT returns: Businesses are required to collect and remit VAT on behalf of the NRS. Records like the invoices and revenue schedule evidence VAT receipt to be remitted. When these records show material discrepancies against those filed for VAT compliance, then the buyer risks exposure to the fully unremitted VAT receipts, interests and penalties subject to the VAT act.
• Withholding tax – Expense ledger & supplier invoices vs WHT filings: Businesses are also required to retain a certain portion of their expenses and remit them to the NRS on behalf of the vendor to foster tax compliance. Similarly, discrepancies or inconsistencies between these expenses data and the invoices evidencing the transactions against the filings for WHT purposes could raise unremitted WHT obligations and penalties for the buyer.
• Payroll taxes – Payroll records & General ledger vs PAYE filings: Businesses employ staff and are required to make monthly remittances on behalf of their staff. If the PAYE filings materially fall short of the internal records, there is further exposure to tax liabilities post-acquisition.
• Purchase commitments & Lease commitments – Purchase contract & Lease agreements vs Account payable records: Discrepancies arising from contractual obligations such as minimum order obligation with suppliers could create liabilities exposures if unfulfilled. However, they do not directly result in adjustment of purchase price, unless such purchase is considered uneconomical or above normal levels of working capital.

A practical guide to harmonize records and resolve inconsistencies

Every discrepancy uncovered by the buy-side during due diligence could result in purchase price discount, valuation adjustment, or worse a halt in discussions, depending on the materiality. As a result, it is important that sellers follow these frameworks that help minimize purchase price discount:

• Conduct investor readiness before formally opening discussions with the buy-side: The purpose of investor readiness is to ensure that a single, common source of truth and narrative is established for the transaction.
• Appoint a trusted advisor to navigate vendor due diligence: See the services of an advisor that will help identify discrepancies that could result in value erosion during due diligence.
• Identify areas of material concern and trace them back to source documents:Trace items of material discrepancies back to source to see if they explain the causes of discrepancies.
• Investigate unexplained discrepancies and quantify potential impact on the transaction: Discrepancies that cannot be resolved or explained need to be investigated. The cause needs to be identified and controls set in place.
• Create a control framework: After the cause has been identified, say for example due to alteration in figures, set-up a control framework to ensure future compliance is in place.
• Rectify the position: Correct the discrepancy, update the records and ensure disclosure to the appropriate authorities where compliance is required. Also, discuss with the appropriate parties the agreements on how the additional liabilities would be settled if required.
• Document the reconciliation: To ensure transparency with buyers and other concerned parties, ensure reconciliation is appropriately documented and disclosed if required.
• Perform transaction-readiness review: Before entering serious negotiations, perform a final cross-check across the records most likely to be examined. Check if every record agrees and discrepancies arising therein can be addressed as immaterial.

Conclusion

Ultimately, inconsistencies across financial information are not necessarily a problem, but unexplained differences can expose liabilities and create uncertainty during a transaction. What may appear immaterial in the ordinary course of business can affect valuation, purchase price and the buyer's willingness to proceed once it is subjected to due diligence. Before entering a transaction, businesses should ensure that their financial information is consistent, reconcilable and capable of supporting the value they are asking a buyer to pay.