Deals are hit by writedowns as due diligence focuses on current market conditions, writes Witold Sawin of accountancy firm Sawin & Edwards

The global financial turmoil has changed the face of deal-making. One of the many effects of the present crisis is the hard line being taken in the approach to due diligence work. The world has changed over the course of a the last few months and nothing can be taken for granted.

Twelve months ago, a company’s bank balance would have attracted limited attention in terms of verification: now the reporting accountant will seek further evidence of the stability of the bank holding the funds especially if it is offshore. Almost every area of a company’s financial and trading position is coming under much greater scrutiny.

Whereas previously historical information was given a high degree of importance and was supplemented by a CV of recent developments, the reliance placed on historical information has diminished. The past has never been a reliable guide to the future, but in present circumstances the question being asked is whether it’s any guide at all? Here are some of the more problematic areas in a present day due diligence scenario:

Defined benefit pension schemes have always been a problem in terms of the future funding requirements, but that is nothing compared to the current position. The last company accounts drawn up, say to 31 December 2007, might have reflected a modest pension fund deficit, but consider the position now some ten months later. The value of the pension fund investments will certainly have dropped by at least 30 per cent to 40 per cent depending on the investment policy and whether there were are substantial holdings of bank shares in the portfolio.

There may not be any up to date actuarial information or pension fund accounts since 31 December 2007, but clearly this would be a serious issue in any deal being negotiated. A substantial pension fund deficit could kill a deal on its own.

M&A hurdles
Foreign currency exposure could also be a deal breaker. A UK company with US dollars or euro creditors may find itself in serious difficulties given the recent collapse of sterling against both the other major currencies. The sterling exchange rate has gone from a high of 2.10 to a low of 1.47 within a 12-month period.

A company with material unhedged creditors in those currencies may well be heading for the rocks even if the historical fundamentals look good. A balance sheet that looked respectable 12 months ago might not look quite so rosy when converted at current rates.

The valuation of intangible assets might also be a serious stumbling block. As the recession deepens, the present values of future cash flows from certain brands, patents or other intangibles may well give rise to impairment writedowns.

Although such assets are usually subject to annual impairment tests these will not have been carried out in many cases since 31 December 2007. Companies preparing interim results to 30 June will not have fully addressed the issue in most cases, besides which things didn’t look quite so bad just a few months ago. A reporting accountant carrying out a due diligence now will insist on detailed evaluation of the likely future cash flows arising from such assets and in the absence of such evidence will be inclined to adjust their value substantially downwards.

Property valuations
Another area that will come under close scrutiny is the valuation of property, whether it is an investment property or the businesses own premises. A current day valuation will almost certainly be requested given the dramatic fall in all property prices.

The message is that any business looking for a sale based on its last set of year end accounts, which in many cases will be 31 December 2007, will need to think again and recast these based on today’s realities before anyone even picks up the phone.