The Role of Internal Controls in a Due Diligence Process

The due diligence process for target acquisitions should extend beyond what’s evident — financial performance, sales strategy and revenue growth, legal and tax liabilities, operational performance metrics — and cover those elements of the business which present tangible implications for the pre-assessment of the business’s condition as well as ease of post-integration activity. The internal control environment, though often overlooked, is an area of significant risk to the success of an acquisition.

With significant focus on the evident areas above, the due diligence process for an acquisition often fails to identify internal control deficiencies which pose not only a risk to the overall purchase but also pose significant post integration risks.

Smaller, private or family owned companies are especially prone to shortcomings within their internal control environment. Sometimes it is as simple as a lack of resources, but also can include financial reporting systems access and established practices in procurement, sales and expense recording.

Internal control is a process affected by an entity’s board of directors, senior leadership, management and other personnel designed to provide reasonable assurance regarding the accuracy of financial reporting, compliance and achievement of objectives relating to sales and operations.

When conducting due diligence, the buyer will want to not only know that the numbers and activities of the business are truthful as presented but also that the integrity of the processes to generate those numbers and activities is intact. If the internal processes and controls are well documented, tested and operating effectively, presenting this to the buyer will provide the buyer more assurance of the accuracy of what the seller is presenting.

Establishing internal controls around Information System Access and Changes, Delegations of Authority, Vendor Selection, Procurement, Sales and Contracting will provide a buyer the insight necessary to assess the business’s current and ongoing operations and trends. These processes and controls support the presentation and story of the business by the seller.

During a financial review, the buyer will look at every element on the balance sheet, every account reconciliation and support including every process and control around the financial closing process and balance sheet account analysis. With a strong control environment of reviews and approvals and strong system access controls and analysis around financial reporting, a buyer will gain the necessary confidence in the financial statements to help the seller garner the best sales prices possible.

When preparing to sell a company, the strength of an internal control environment can not only be an asset at the negotiation table for the seller, but just as much an assuring benchmark for a buyer. With questions on this topic, contact us.