Why our feet get muddy exercising financial due diligence
Some time ago I got a call from a friend who is an Emmy award-winning documentary film editor and producer asking if I had believed the rumors that footage of Palestinians dancing in the streets after September 11th was actually from some earlier occasion. I said that I neither believed nor disbelieved them, and was then chastised for not understanding that there were rules about such things that would prevent such incidents from happening except by accident.
I am certainly delighted that the entertainment industry has rules, but assume that, in fact, they need to be taken with the same grain of salt associated with financial reporting, and transactions. Most financial reporting and transactions are verified via paperwork. And it is not uncommon for the paperwork to be believed. Indeed, financial auditing revolves around paperwork, and most financial due diligence revolves around paperwork, and much verification is in fact checking one piece of paper against another.
While we don’t wish to give the appearance of being suspicious or paranoid (We are, in fact, both suspicious and paranoid: We merely don’t wish to give that impression), we don’t trust paperwork all that much, and, as a rule of thumb, want to see the goods and services being described. If someone says they are building a house, we want to see the house. If someone says their money is coming from construction, we want to see the buildings. If someone says they are selling herring, we want to open a few casks. Or, even better, all the casks. This jaundiced view is one of the separators between an audit, which verifies that the accounting procedures are correct, and due diligence, in which we verify (among other things) that the audited figures are real. As chance would have it, a surprising amount of stuff we look at turns out to be a trifle less real than we would like, and a surprising number of the people we look at are a bit less real than we would like. As an example, roughly one out of seven doctors we look at are not people we’d like treating us.
We also find a depressing number of cases in which what is listed on web sites doesn’t match what we find: It is not uncommon to have an address and a picture of a facility, with the implication being that the facility shown is at the address shown. Sometimes we discover that the building at the address is not the one shown in the picture. Sometimes we discover that the goods listed in inventory are, how can we put it? Not there.
While this occurs in the U.S., it is even more prevalent in Central and Eastern Europe, China, and Latin America, where we do much of our work. Different customs, different economies, different laws, and if you ignore this, you do so at your own peril.
The bottom line here is that when financial due diligence is exercised, the paperwork is a starting point, not an end in and of itself. When we look at the paperwork on a cattle operation, if we don’t come back with mud – and cow dung – on our boots, the job was not done. The good news is that when due diligence is exercised appropriately, you minimize your chance of a loss and looking like a fool.
