Transaction Testing: Increase the Effectiveness of Pre-Acquisition Due Diligence

What is transaction testing?

Transaction testing is an informed and targeted analysis of higher-risk business activity recorded in the target entity’s books and records that are typically prone to misconduct. The objective of transaction testing during pre-acquisition due diligence is to enable an acquirer (as early as possible in the M&A transaction life cycle) to:

• • Identify potential instances of misconduct that may result in non-compliance with regulatory requirements and/or the target’s own internal policies regarding higher-risk business activities that may impact the overall M&A transaction; and
  • Prepare timely disclosure and remediation under DOJ Safe Harbor.

To achieve early identification and preparation, transactions are analyzed to identify the following attributes typically indicative of misconduct:

• • Lack of a valid business purpose of the transaction and/or the transaction is not in accordance with the target entity’s own internal policies;
  • Lack of complete and accurate documentation (e.g., purchase orders, contracts, invoices, bank statements) available to support the business purpose of the transaction;
  • Lack of documentation to evidence authorized review and approval of the transaction in accordance with the target entity’s internal policies, including delegation of authority; and,
  • Transaction is recorded in the target entity’s books and records in a manner that does not accurately reflect the substance of the transaction.

In addition to identifying potential instances of misconduct, transaction testing enables identification of weaknesses in a target entity’s processes and internal controls to prevent or detect potential instances of misconduct. Early detection of issues in both areas enhances the acquirer’s ability to comply with the DOJ Safe Harbor disclosure and remediation deadlines and provides a critical insight to be evaluated by the acquirer when making a “go” or “no go” decision.

How should transaction testing be conducted?

To ensure that transaction testing is efficient and effective (i.e., minimizes time and cost while maximizing results), the testing should be conducted on a targeted, risk-based approach. Specifically, a judgmental sample of transactions should be selected based on a target entity’s risk profile focused on higher-risk activities (i.e., transactions incurred in connection with activities typically prone to misconduct within a particular industry and/or business operating model) and higher-risk locations (i.e., transactions incurred in locations prone to misconduct).

For example, if conducting transaction testing to identify potential instances of non-compliance with applicable anti-corruption regulations, sampled transactions should include:

• • Sales to state-owned enterprises in locations known for corruption;
  • Payments to third-party intermediaries that interact with foreign government officials on behalf of the target entity in connection with sales and/or operational activities in locations known for corruption;
  • Payments to government agencies for licenses, permits, inspections, and customs clearance in locations known for corruption;
  • Gifts, travel, meals and entertainment provided to foreign government officials in locations known for corruption; and,
  • Petty cash held in locations known for corruption and other cash-based activities, generally.

Selecting a judgmental sample of transactions focused on these areas (as opposed to selecting transactions to achieve “coverage” across expense accounts) minimizes the potential for routine, lower-risk transactions being analyzed and avoids a “boil the ocean” approach and cost.

Higher-risk activities and locations should be identified in conjunction with document review and interviews conducted by external counsel, which highlights the inter-dependence of the two workstreams to increase the efficiency and effectiveness of pre-acquisition due diligence.

What are the benefits of transaction testing during pre-acquisition due diligence?

Transaction testing can not only validate certain aspects of external counsel’s findings, but also identify potential “red flags” that may impact other due diligence workstreams. Additionally, transaction testing demonstrates to regulators a commitment to “do the right thing.” In that sense, interviews and document review by external counsel and transaction testing by experienced forensic accountants should be considered two sides of the same coin, and pre-acquisition due diligence cannot be fully effective without both.

Pre-acquisition transaction testing enables an acquirer to make more informed decisions regarding the overall transaction, including:

• • Evaluate impact to acquisition (e.g., purchase price, assets to be acquired/divested, representations & warranties);
  • Identify further transaction testing to be conducted during the post-sign, pre-close phase;
  • Determine nature and extent of remediation and integration efforts;
  • Address potential successor liability concerns; and,
  • Consider potential disclosures to applicable regulators.

Further, the results from transaction testing can enable an acquirer to:

• • Demonstrate to the DOJ a good-faith effort to conduct an informed and robust pre-acquisition due diligence;
  • Enhance an acquirer’s ability to meet the DOJ Safe Harbor disclosure and remediation deadlines; and,
  • Devise and disclose to the DOJ an interim strategy to mitigate risk in the event the DOJ Safe Harbor remediation deadlines cannot be met. 

Conclusion

The unfortunate perception of transaction testing is that it “boils the ocean” and therefore, is inefficient from a cost and timing perspective. In reality, the opposite is true. When conducted on a targeted, risk-based approach by experienced forensic accountants in conjunction with interviews and document review by external counsel, transaction testing during pre-acquisition due diligence can be efficient and effective. As acquirers often struggle to balance limited time, resources, and budgets with the need to identify risks, transaction testing can be the best tool to achieve that balance in an efficient and cost-effective manner.

Acquirers need as much information as possible during the pre-acquisition due diligence phase. Transaction testing, when executed correctly by experienced forensic accountants during that phase, has proven to be the most cost-effective source of information to enable acquirers to make informed decisions throughout the M&A transaction life cycle.