An Elementary Introduction to Financial Reviews and Their Role in M&A

"No wind serves him who addresses his ship to no certain port." - Michel de Montaigne, French Renaissance philosopher

With the growing trend towards globalization, vertical and lateral consolidation has become the only viable way forward in many industries, as enterprises battle to expand their scales of operation and market share, cut costs and boost performance. And while the government of Taiwan has progressively loosened restraints on foreign investment - moving aggressively to revise legislation and draft a set of appropriate laws-the public's attitude towards corporate mergers has undergone a gradual transformation from opposition and resistance to openness and acceptance. This trend is evident when one looks at the steady increase over the past decade in the annual tally of domestic merger cases. The early part of that period saw the start of acquisitions by foreign buyers. In the middle part, there began a series of consolidations among domestic businesses, such as the five-company consolidation by chip-making giant UMC, or the merger between Unipac Optoelectronics and Picvue. The tail end of the period has featured M&A deals with foreign companies and the first batch of large consolidations in the financial sector, including the establishment of financial holding companies with cross-industry marketing among banking, insurance, securities and other sectors.

Hoping to launch yet another wave of mergers and acquisitions among domestic enterprises, and thus boost the operating efficiency of businesses, The Legislative Yuan's Economic Committee has passed a draft amendment to the Business Merger and Acquisition Law that further relaxes standards and simplifies merger procedures. How big an impact these changes will have remains to be seen, but as experience with M&A grows in Taiwan, financial reviews (due diligence and valuation), once viewed as mere formalities, are gradually gaining in importance.

Due diligence and valuation are two required steps in the M&A process. As to due diligence, it may be broken down into reviews of the enterprise's finances (including taxes), legal circumstances, operations, human resources and information systems, with decisions on the actual contents-the procedures to be carried out-depending on the particular characteristics of the industry in which the two parties operate, the respective form(s) of business organization involved, the methods used to effect the merger or acquisition, etc. Because Taiwan's businesses are predominantly small- and medium-scale enterprises, the above types of review are frequently folded into financial reviews and performed together. And as for engagement clients, these can be divided into buyers and sellers. In practice, buyers are more numerous, so in what follows we will illustrate using buyer's-side due diligence.

Financial due diligence extends to the company's operating situation, assets and liabilities, off-balance sheet transactions, and non-financial information related to business operations, such as organizational structure, significant resolutions and contracts, and the management team and personnel of the company. Based on one's understanding of the objectives of the assignment and the client's expectations, an in-depth review and analysis of the above information is performed, and face-to-face discussions and inquiries are conducted with the management of the target company. One then compiles and presents a report of significant findings along with explanations of the results of the review and analysis. The objective is to allow the client to quickly understand whether the target company meets its expectations, and to expose any significant issues that might impact either party in the prospective deal.

In earlier times, because Taiwan's financial accounting system was relatively undeveloped, the discovery process stressed accounting errors and potential tax risk. However, there have been constant additions and amendments to local accounting system standards and associated laws and regulations, and levels of education and overall accounting ability have risen a great deal. These trends, plus ever-more transparent information disclosures and the growing impact of globalization, have combined to shift the focus of financial reviews towards other issues, namely, business operations and personnel problems, transactions with related entities, potential risk exposure from overseas subsidiaries, and off-balance-sheet transactions.

In addition to the focus of financial reviews, there is also the question of timing. Financial revues are generally performed:

(a) when two parties in a potential M&A deal initiate contact;
(b) when a consensus has been reached on the price of the deal;
(c) when the price of the deal is already certain, but it is necessary to adjust actual operating value and net value.

A preliminary review (a) covers less ground and takes less time. Given that clients typically have pressing demands, no more than two weeks is spent on review procedures, as a rule, in a preliminary review.

Since most senior managers are not financial accounting experts, they are often relatively unfamiliar with the financial statement preparation process and the applicable accounting standards, laws and regulations, and they also may not grasp what the numbers in financial statements say in terms of potential contributions and risks. For this reason, and because information from financial reviews is often used in M&A price adjustment mechanisms, appropriate financial review procedures must be performed to clarify any outstanding questions. Usually, if significant obstacles to a deal are discovered in the course of a financial review, an M&A deal will be put on hold or called off, but for deals that do go through, the risk of failure will be lower.

To the general public, financial reviews are the same as financial statement audit certification, net value audits and other audit work. Of course, this is not so. Among the bigger differences are the needs of the client, the experience of the employees involved, the timeliness of tasks performed, and the amount of risk borne. Consider an analogy: If doing an M&A is like getting married, then a financial statement audit is more like going for a routine annual physical-the procedures are pretty much fixed and uncomplicated, but you can't get a very clear, detailed picture of how well or poorly your body and its components are doing. But a financial review is like the kind of comprehensive health examination that some people have before getting married: the results have to do with the happy and fruitful life a person hopes to create with someone special.

Looking back over the last ten years of M&A in Taiwan, it is clear that differences in attitude still separate local businesspeople from their counterparts abroad. Because of differences in language, culture, and educational environment, foreign businesspeople are more inclined to rely on, and put their faith in, various experts to help evaluate an M&A target in Taiwan. Local companies are more likely to emphasize high-level business talks, friendships and shared experiences. The opinion of an outside expert is, for the most part, merely one of the documents to be filed with the competent authority. However, as M&A deals and experience with them continue to accumulate in Taiwan, people's conception of M&A is gradually evolving, and differences in attitude are slowly diminishing.