February 20, 2019

MBAF's Juan C. Pena published an article on Auto Buy Sell Report discussing tips for avoiding fraudulent numbers in M&A transactions

There are only a few dealers out there that will say that “2018 was our best year ever.” Clearly we are in the downward portion of the cycle with regard to buy-sell. But if the old adage, “sell high & buy-low” holds true, then there is no need to give up on plans for expansion and acquisitions. Reviewing and looking for the next deal still makes sense, as long as you keep in mind that that negotiations could be a bit more difficult in this new environment. Which is why due diligence is more important now than ever.

Unfortunately, the typical due diligence processes may not go “deep enough” to detect fraud in the numbers that can impact the income multipliers. In general, the procedures performed during a typical due diligence evaluation are not designed to identify misconduct or misrepresentations, – either intentional, or not.

Looking Deeper for Fraud

Follow these steps to take a deeper look at the acquisition target’s operations so that you can avoid paying more than you should for an over-valued dealership:

  1. Inquire whether there have been any recent warranty audits. If there were a lot of adjustments resulting in large chargebacks, it could be an indication that warranty income is overstated if the dealer is putting through warranty work that does not qualify to be reimbursed by the manufacturer.
  2. Similarly, inquire about customer incentive audits. If there are many instances of customer incentives being kicked back, it may indicate trouble ahead on trying to keep your sales numbers up once you acquire the dealership. Pay attention to receivables due from the manufacturer for incentives. If the incentives are very aged, it could be an indication that the amounts recorded in other income are overstated.
  3. Aside from management fees, closely analyze any transactions that may be with individuals or companies associated with the owner or key dealership personnel, as relationships with such related parties won’t typically be at “arms-length.” Examples include advertising, legal services and porter and car washing services and other such outside services.
  4. One particular risk to be aware of is if the dealership has one or more rental car companies that appear to be mostly used to “punch” cars to meet manufacturer stair-step incentive goals, particularly if this has been happening recently. Often, the losses from selling those units after the units have been used or have sat on a lot are taken on the books of the rental car company and as such, it never hits the dealership’s books. It is always a good idea to check on your state’s corporate registration website and look for companies that are also owned by the dealership’s principals.
  5. If a dealership has significant vehicle wholesale income, inquire as to who the wholesalers are as they may be related dealerships or other related parties. Likewise, if wholesale parts sales are significant, review the list of parts wholesale customers to verify if these customers are third parties and not related to the owner(s). You don’t want to count on wholesale business that goes away once you own the store.

Other Tips to Avoid Fraud

In addition to the steps above, as we presented in an earlier article, here are some basic procedures to always follow in any M&A transaction:

  • If the dealership to be acquired is being audited, read all financial statements carefully. Do not forget to look for and read all footnotes on any unusual, or “one-time only” items.
  • Look at their accountant’s year-end adjustments to see if the books are clean. In addition, look at their internal control letter and see if any deficiencies exist. Pay close attention to the seller’s schedules for aging of receivables, and for new & used vehicles. Review the seller’s parts pad, for parts without sales in 12 months, or that have over a 12 month supply on hand.
  • Determine if the seller has performed a fixed asset physical inventory, and make sure all equipment, special tools, computers, furniture and signs on the fixed asset register are indeed there and in working condition.
  • Compare unit sales to manufacturer sales reports and DMV sales numbers. See how gross per unit compares to the industry average particularly in that market.
  • Meet with employees to determine that employees who are noted in add back schedule do not in fact contribute to the operations of the entity. In addition, if there are management fees determine what activities they provide as in most cases not all fees should be added back.
  • In regard to real estate purchases, have your experts perform building inspections, zoning and other possible encumbrances to property, and any potential environmental issues. In addition, did seller receive program money for image upgrades or new facilities that buyer will not receive going forward, that needs to be adjusted in buy-sell multiples?

Fraud isn’t always intentional; sometimes it is a matter of honest accounting errors. However, as a buyer who could be paying an income multiplier on earnings, it is easy to see why a seller may not be forthright in providing the whole story, and why it falls on you to find what may be the truth behind the numbers.

Juan C. Pena, CPA, CGMA, is a director in the Audit Department and Risk Advisory Practice at MBAF. His primary responsibilities include automobile dealership auditing and consulting, including operational efficiency and internal control consulting. He can be reached at jpena@mbafcpa.com 1- 305-377-9203

Click here to read the article on Auto Buy Sell Report.