01.03.09

Financial Due Diligence for M&A in Russia
Alexander Golovin, Auditor, Alinga Consulting Group

With the financial crisis raging outside, many companies are facing financial crises internally. For some, finding a strategic investor might be the only way to stay afloat. For those who have avoided the worst of the crisis and have the means, however, now can be a great time to become a strategic investor or even purchase competing companies while market prices are down.

In either case, properly evaluating the target company for purchase or investment with a financial due diligence investigation is an obvious and crucial first step to make. The bookkeeping and administrative information must be checked against reality, starting with the company's financials and paying close attention to the tax load and potential tax risks.

The basic stages of a financial due diligence are as follows:

1. Check to make sure that all fixed assets, materials, goods for resale, and/or finished goods match, in both condition and number, the data recorded in company accounts.

This requires running spot inventories of company assets. Fixed assets should be photographed for future reference. Assure that any real estate owned by the firm is properly registered with the state (it frequently isn't) and that all deeds and other ownership documents are in order.

Goods for resale, finished goods, and non-liquid assets should all be checked to make sure their number and value all correspond to what is recorded in the company's accounting.

2. Reconcile accounts receivable with customers; verify revenues with corresponding primary documentation.

Documentation for the sale of goods or services must be properly signed and stamped by the parties involved. Even when payment for the goods or services has already been received, the cash cannot be recognized as revenue until the relevant documentation is obtained. Otherwise the sale is not legally complete and the payment can be recalled at any moment.

3. Reconcile accounts payable with suppliers, verify expense recognition with the corresponding primary documentation.

Questions frequently arise in Russia about "economically unjustified" expenses. To prevent problems, transport expenditures, for example, should be documented with a delivery record containing detailed information about the goods carried in the shipment and the route taken. The bill of lading should also be present to confirm the shipment. Consulting services should also be accounted for with detailed documentation about the nature of and deliverables from the consulting work. The tax authorities will often not recognize these types of expenses as valid without such documentation.

4. Evaluate risks related to hard currency loans, verify interest rate calculations.

With the current drop in the value of the ruble, hard currency loans held by Russian companies operating primarily on the Russian market are especially risky and should be of special focus to any due diligence performed today.

5. Review salary recognition – both for operations and administration.

In part due to the prevalence of partially under-the-table salary payments, it is not unusual in Russia for the true cost of a company's work force to be greatly understated in official accounting.

6. Verify lease payments.

It is estimated that the average business understates its lease expenses by 20% in Russia. This can be due to a "mutually beneficial" arrangement between the business and landlord to help the landlord avoid taxes on the rental income. Lease expenses must be checked against market rates as well as the related primary documentation.

7. Review property for possible liens and encumbrances.

Property is often used as collateral for loans, or is pledged. Sometimes the property can be used to guarantee third party loans. The terms of the loan are generally not published in financial reporting, but indicated only in the agreement. There are risks that the same property could be offered for collateral on multiple loans and in this case, the obligation generally will not be reflected in the company's accounts.

Furthermore, leased property often is not recognized in off-balance sheet accounts.

8. Calculate net worth.

Occasionally, expenses are recognized on the balance sheet as assets, thereby artificially improving a company’s current financial status. Alternatively, current expenses are frequently overstated, so as to reduce tax burden.

It should also be noted that there is the risk of compulsory liquidation by law if the company has negative net worth.

9. Determine the company’s total tax burden and tax risk.

 

Calculations of tax burden must take into account the “basic” taxes: Unified Social Tax, VAT, Personal Income Tax, Profit Tax, and Property Tax.

Special attention must be given to checking the legality of any deductions or tax benefits the company has applied to its tax filings.

Any disputes the company might currently have with the tax authorities and what the chances are of the company winning the case must also be taken into account.

Before the final stage of the investigation an analysis of the business’s capital, reserves, and financial investments must be done with attention paid to cash flow between affiliated organizations and persons.

After this, the methodology used in determining the cost of goods sold is reviewed, any amortization recognized is checked for accuracy, and net profit calculations verified.

In addition, any contingencies and provisions for them should be identified.

10. Calculate the financial ratios.

The final stage of the financial due diligence is to calculate EBIT (Earnings before Interest and Taxes) and EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization). Short-term and long-term debt must be considered in light of the company’s working capital.

Based on all of this, we can then make a final and informed decision on a potential merger or acquisition.

This process, run by independent consulting companies, is often lengthy. In one recent case in Russia, it took an entire year for the company to gather and process all the necessary information. However, the wait was certainly worth it and in that particular case, the object of acquisition was determined to be overvalued by 30%. 

Misrepresented financials can be found in countries around the world. Recent examples such as Enron and Parmalat show that company data can be severely manipulated even when audits are being performed. Russia, for its part, must make significant efforts to improve legislation regulating financial reporting if it is to make cases of such abuses less frequent.

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