Why Accounting Due Diligence Is Important Case Study

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accounting serves as a means of prioritizing business activities. In many instances, business has limited amounts of resources and a seemingly infinite amount of methods in which to deploy them. For large, multinational corporations the problem is compounded as various departments jockey to receive the maximum amount of funding for their own projects. By accounting properly, management can better ascertain which projects will be fully funded and which project will not be funded. This prioritizing ensures that the business enters markets or engages in activities in which it has relative competitive advantages in.

Accounting is therefore used to better assess the risks and behaviors embedded within these profit maximizing activities. Enron, Tyco, and WorldCom have proved that a profit motive without an audit or risk assessment can be detrimental to society. In fact, an independent audit assessment should be conducted to avoid conflicts of interest while protecting the public at large.

Cardinal and Coyote were correct in their approach to due diligence and risk assessment. Due to profit maximizing motives and misaligned incentives, management has incentive to portray the best (or sometimes worst) results it possibly can. These accounting tricks however do not accurately portray the economic reality of the underlying business. In many instances, aspects can be hidden from the view of an investor who does not conduct the proper due diligence. For example, companies currently uses off balance sheet financing through operating leases to hide leverage from investors. Companies may capitalize interest expense to portray a higher solvency ratio. Although less pertinent today, companies have used VIE's to store assets and liability off balance sheet to also appear better than they are. Some businesses will even go as far to tout pro forma earnings, as oppose to economic earnings within their quarterly results.

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Cardinal and Coyote must be aware of these potential hidden items when conducting their due diligence. Gabelli, for example, found a $1 million loan payable that has been overdue for months. This activity in isolation calls into question the company's ability to pay suppliers in a proper manner. This also calls into the question, management oversight and governance as it relates to financial activities. This is particularly true for Jost Furniture which has a business predicated on its current ratio. As a furniture business, the company may have a relatively high current ratio as it displays assets (furniture) within its stores to sale. It also may have large inventory amounts to help properly anticipate consumer demand for furniture. With such a high dependence on these elements, the company must be sure not to violate debt covenants that may allow banks to immediately call their loans. If this occurs the company's current ratio will immediately decline as the company must liquidate inventory, or deplete cash reserves to pay off creditors. Gabelli, through his due diligence was able to locate the overdue loan payable, the potential call from the bank, and helped the society eliminate a costly investment loss. Jost's lack of cooperation with the previous auditor is another red flag as it relates to the overall due diligence process. The fact that the company has had multiple auditors and refuses to cooperate….....

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