Our client bought 100% of a business (‘Company A’) for R 60 million. The purchase price was determined using a multiple of 3 times profits, and was based on an analysis of the 2005 audited financial statements which reflected an operating profit of R 19 million.

A financial due diligence was carried out before the deal was signed. However, the auditors who conducted the procedures failed to uncover significant financial statement fraud.

Although the deal was based on 2005 numbers, it was concluded just one month prior to the end of the 2006 financial year. Consequently, the auditors analysed the latest 2006 management accounts to verify the sustainability of revenue and profits. In 2005, total revenue was R 45 million, however, at the time of the due diligence fieldwork, 2006 sales were only R 23 million. When the auditors queried the significant drop in sales for 2006, management presented them with an invoice of approximately R 20 million in respect of sales of a new product, which had never before formed part of historical revenue.

In their report, the auditors noted that management had represented that 2006 revenue and profits were trending in line with 2005. Although significant red flags had been raised in this area, the due diligence report concluded that 2006 revenue and profits were in line with expectations and performed no further procedures in this area.

The deal went ahead.

It turns out that the R 20 million invoice was fraudulent in that it actually related to revenue earned in a related party company to the shareholders of Company A. This revenue was ‘shifted’ into Company A to overstate revenue in a scheme designed to boost the purchase price.

Actual 2006 revenue was only R 24 million (almost half of 2005) and the company incurred a loss of R 4 million, down from a profit of R 19 million in 2005. These and other factors resulted in the company being liquidated, less than a year after the deal had been concluded!

We were engaged to unravel the fraudulent scheme, quantify the losses and examine means of recovery. During our investigation, we were able to identify, through Business Intelligence procedures, that the sellers of the company (although locked into strict restraint of trade agreements) had opened a business directly in competition with Company A. This also contributed to the failure of the business that was sold.