The third part of due diligence is perhaps the most important, the easiest, and also, I’m sorry to say, the most boring.
I’m talking about accounting due diligence.
By this I am referring to the kind of due diligence that accountants frequently practice. That is, the assessment of the risks that a company’s accounting records present and the potential for inaccuracies within those records. This is why external auditors are required hires at publicly traded companies, and why they are legally and ethically bound to disclose their confidence in the accuracy of the books they are analyzing.
To understand this, let’s look at the concept of “going concern.” In accounting, this refers to the idea that a company, as it currently stands, can continue operating for the forseeable future and can make enough money to avoid bankruptcy or disrupt its product line. Obviously, in the case of unprofitable and fast-growing companies like Snapchat (SNAP) or Tesla (TSLA), defining this going concern will require different assumptions than with a large and very profitable company like Apple (AAPL). But the same general questions apply, which are:
- Is the company bringing in enough money (from profits or outside investors) to cover its obligations (debts, bills, payroll)?
- Is the company’s business model resulting in operating income that can be used to fund future operations?
These are not easy questions to answer. In reality, a variety of cash flows from various sources can obfuscate just how financially solvent a company is, which is why standards of what is a going concern change over time and there are disagreements among accountants about whether a firm is a going concern.
And that brings us to the first step of accounting due diligence: has an auditor signed off on the company as a going concern? If not, why not? If so, what assumptions led to that assertion?
The second step of accounting is much more quotidian and substantially more important. Simply put: are the accounting books accurate?
In the case of a big company like AT&T (T) or Apple, this is a pretty easy question to answer, because these companies have external accountants whose job is to ensure that they are. But that doesn’t mean that they are always right—as we saw with Enron or Bear Stearns, accountants can either be lying or wrong, because the books don’t actually reflect reality as a result of fraud (Enron) or exogenous factors that aren’t caught by GAAP (generally accepted accounting principles), as was the case with Bear Stearns.
A financial analyst’s job is to look for obvious errors or blind spots in the books, but an analyst cannot analyze every small detail of a company’s accounting records. For one, not all are made public to all analysts. Secondly, even if they were, there are too many records in most companies for one person to analyze. And, perhaps most importantly, accounting is a unique skill that includes knowledge and capabilities that are beyond competent and even very good financial analysts’ abilities—you can’t be an expert in finance and accounting, even if you’re an expert in one and know a lot about the other.
In other words, when doing accounting due diligence, an analyst needs to identify what the accountants have said, how reliable what they’ve said is, and what possible blind spots there could be. If the analyst finds no evidence of fraud, the next issue will be to find evidence that there are things that the accountants cannot account for.
That brings us to our last aspect of due diligence: the credit rating.