DUE DILIGENCE IN mergers & acquisitions.

By developing a template to guide business units in mergers and acquisitions, internal auditors at Ameritech took due diligence to a higher level. Management decision-making processes were strengthened, and the stock of internal auditing soared.

MERGER AND ACQUISITION (M&A) activity is booming in today's global environment. In the first half of 1999, the total value of all M&A transactions exceeded $891 billion in the U.S. and more than $1.5 trillion worldwide. Companies are turning to M&A deals for faster growth and aggressive expansion as an alternative or complement to organic growth.

Ameritech [*] is among the organizations that took the M&A route for long- and short-term opportunities in growing core phone services, expanding locally and nationally, and adding new products and services. Evaluating these activities to position Ameritech as the premier provider of communication services in the telecommunications industry represents the essence of due diligence.

DEFINING THE PROCESS

Due diligence is the process of identifying and confirming or disconfirming the business reasons for the proposed capital transaction. During my tenure at Ameritech's internal audit services (IAS), three factors--customer needs, strategic fit, and shareholder value--were at the core of every analysis.

Several functions were involved in due diligence related to potential acquisitions, including strategy, finance, legal, marketing, operations, human resources, and internal audit services. The direction of Ameritech's due diligence efforts depended on what the company expected to gain from the transaction: employees, customers, processes, products, or services.

(*.) Ameritech was acquired by SBC Communications, Inc. in October 1999.

INTERNAL AUDIT INVOLVEMENT

Traditionally, IAS hadn't always participated in the due diligence process; or if we did, our involvement began late in the process with a few specified tasks. The importance of M&A activity as an element in Ameritech's growth escalated, however, and we perceived that internal auditing's contributions were needed in this area and recognized that IAS staff should be involved in the review of the proposed capital transactions as early as possible.

To get management's attention, we looked for ways to demonstrate that the skills and competencies of our auditors would add value to all M&A deals at Ameritech. Our team performed extensive research--interviewing key Ameritech personnel, scrutinizing previous deals, reviewing periodicals, and obtaining due diligence templates from external consulting firms. We also identified several best practices and benchmarks used by world-class companies.

We learned that Ameritech employed various methods of due diligence depending on which business unit was performing the analysis. We identified the need for a uniform template that all business units could use to initiate the due diligence process and then tailor to each particular opportunity.

Our team developed the due diligence template, and it was subsequently adopted by senior management. The structure of the template allows business units to shape the due diligence process and adapt it to each unique transaction. It also addresses the needs of decision-makers by confirming support for the key benefits of the proposed transaction, identifying potential deal breakers, and evaluating integration issues.

Our research and follow-through confirmed that internal audit departments can play a major role both prior to and after a merger or acquisition. By performing due diligence internally, we took advantage of our internal auditors' in-depth knowledge of company operations and overall strategy. Internal auditors' skill sets in areas such as interviewing, analysis, and communication--attributes crucial to due diligence success--were also tapped. In addition, our contributions resulted in reduced consulting fees, improved response time, and knowledge retention throughout the company.

THE FIRST TEST

A month after senior management accepted the due diligence template, we were presented with our first chance to use it. Ameritech was completing the purchase of a relatively small, privately held company and needed a thorough pre- and post-review of the acquisition.

As part of the acquisition process, Ameritech was naming a new chief financial officer (CFO) who needed to learn quickly about the key risks related to the business and integration opportunities at hand. Together, our team and the CFO dissected the key processes within the business to pinpoint any real or potential control weaknesses and to compare the business practices and current operations.

We used the due diligence template to examine controls in the following processes:

1 Cash receipt, application, and management

2 Processing of accounts receivable

3 Processing of accounts payable

4 Processing of employee expense reimbursements

5 Inventory ordering, controls, and management

6 Customer billing systems

7 Employee payroll

8 Vendor and customer contract review and approval

9 Revenue recognition policies

For each process, we:

* Documented and process-mapped the newly acquired company's methods and procedures.

* Assessed the effectiveness of controls in place.

* Compared the processes and practices with Ameritech's and benchmarked key factors such as reserve balance, inventory turns, and other items.

* Provided recommendations on improving operations and taking advantage of synergies.

Using the due diligence template, we assessed risk by examining the key components of the acquired company's business. The critical processes were reviewed to determine integration issues and areas of immediate concern. Factors such as cycle time and capacity were analyzed and benchmarked to develop action plans that the new CFO could use immediately.

The template was also useful in quantifying synergistic opportunities for making the combined entity greater than the parts. We analyzed the key assumptions of performing the transaction to separate quick hits and long-term opportunities for the integration team. By confirming and classifying the benefits according to implementation ease or difficulty, the integration team was able to maximize the benefits of the acquisition in a shorter period of time.

In essence, our internal auditors were the first Ameritech employees that the newly acquired company's employees met. Our practices were highly effective in building trust and sharing knowledge between the two entities; and we were able to communicate through example our company's culture and commitment to professionalism, respect, and quality.

As a result of our active participation in the due diligence process, we formed strong partnerships with the new management team and continued to stay connected to the acquired organization by developing the annual audit plan. We became closely involved with the company's business to perform value-added work and identify additional synergies among the joint operations.

PROVING OURSELVES

In developing the template and offering the skills of our audit team, we earned a greater role in due diligence activities. We were invited to participate at earlier stages of the due diligence process for several other transactions. For a subsequent, larger acquisition, we became involved on the financial, operations, and purchasing due diligence teams early in the assessment. Using our template, we were able to identify risks quickly,

document the impact, and provide a concise written report to management. As a result, management was able to adjust valuations and assess resources in a more comprehensive and effective manner. Additionally, management began to rely on our team to confirm and disconfirm synergistic opportunities used in negotiation proceedings.

Working closely with management helped us to refine the template even further. By taking a more active role in the due diligence process, we became more knowledgeable about Ameritech's concerns, strategies, and methods of evaluating the business. Our auditors also became more forward thinking in assessing risks and opportunities. We eventually began reporting to the audit committee of Ameritech's board of directors on the quality of the acquisition process and the acquisition itself.

MOVING TO THE FRONT

An acquisition is a key event for any company, and internal auditors can and should take an active role in M&A activity. There is perhaps no better opportunity for auditors to demonstrate how they can add value and improve or maintain the company's bottom line. In the environment of change and uncertainty that exists during a merger, internal auditors' skills can help to reap the substantial rewards that M&As are intended to yield.

Expanding contacts and working as partners with senior management encourages internal auditors to apply their skills and knowledge to other projects, such as incorporating best practices and benchmarking. The M&A experience gives the auditor more credibility in identifying issues and management solutions. Thinking and working strategically assists the internal auditors in truly providing value for all stakeholders.

At Ameritech, our internal audit services were less costly than those that might have been provided by independent accountants or consultants. As a significant bonus, using the internal audit department to perform services routinely provided by independent accountants helped to retain knowledge within the business.

In addition, the due diligence template allowed management to understand more fully the skills and abilities of a very important internal resource--the internal audit department. Management's confidence in us soared, and we positioned ourselves at the front of the business in identifying future risks and opportunities to improve business performance, customer satisfaction, and shareholder value.

JOE BURKE, CIA, CPA, formerly a senior internal auditor at Ameritech in Chicago, is associate director-finance for SBC DataComm, Inc., a subsidiary of SBC Communications, Inc. in Chicago.

Sample From the Ameritech Checklist Template for Due Diligence in Capital Transactions

Each of the capital transactions entered into by Ameritech is unique. Every one of those opportunities -- mergers, acquisitions, joint ventures, alliances, and divestitures -- must be evaluated in terms of how it fits into Ameritech's strategies and vision: expand core business, offer new services, and enter global markets.

The overall goal of the due diligence review is to raise Ameritech's comfort level in executing the transaction. Our due diligence efforts address the following areas:

* Business climate or industry

* Cultural environment

* Marketing

* Financial

* Operations

* Legal

* Human resources

* Environment

In our organization, tightly organized teams are involved in due diligence. Clearly defined expectations, roles, and responsibilities, coupled with excellent communication, have been key success factors for these teams. The individuals involved in the due diligence effort are expected to:

1. Sign and adhere to confidentiality agreements.

2. Focus efforts on work steps that address high-risk issues. Some work steps are critical for certain types of transactions, while the relevance of others may depend on Ameritech's purpose in executing the transaction.

3. Tailor work steps to fit the transaction. If research leads to specific findings or critical observations, individuals continue to collect and analyze data until key assumptions have been verified.

4. Document the source of information either by individual or resource. All source materials and supporting documentation are linked to the appropriate work step.

5. Document the implications of the research and analysis. Initial and date each work step upon completion.

6. Communicate findings and concerns with the due diligence team as soon as they are known.

BUSINESS CLIMATE OR INDUSTRY

Understanding these issues will provide a big picture view of the target and can shape the direction of the due diligence effort.

Work Steps

1. Determine whether the business is public or private. If it is public, review all public records, such as Dun & Bradstreet, annual reports, and SEC filings, to gain an understanding of the history of the business. For privately held businesses, refer to legal resources. Highlight significant events and causes. Review long-term strategic plans.

2. Document industries, products, services, markets, facilities, principal customers, and subsidiaries involved in the transaction. Include the number and location of impacted employees.

3. Assess how employees, customers, competitors, and regulatory agencies will react to the transaction with Ameritech.

CULTURAL ENVIRONMENT

Understanding the impact of culture is critical, especially when people are key to the transaction. Culture encompasses the basic values, beliefs, and assumptions that the members of an organization share. It affects thoughts and behaviors. Key to understanding culture is determining how employees, stakeholders, customers, and suppliers might react to the impending change. Once the cultural assessment is complete, Ameritech should have a clear understanding of how all parties will respond to the change.

An organization's culture has many dimensions, some of which are addressed below. To conduct a thorough assessment of each dimension, determine the importance of the dimension and how much risk Ameritech is willing to take. Analyze and document the culture of both the target and the Ameritech business units involved. Determine what cultural gaps exist, their potential impact on the transaction or integration, and whether or not the gaps can be overcome.

Work Steps

1. Determine how decisions are made -- centralized vs. decentralized; employee empowerment; speed in making decisions; risk-reward sharing.

2. Describe risk orientation and entrepreneurial behavior in the target organization.

* How quick are they to recognize new opportunities?

* How flexible are they in reacting to changing conditions?

* How innovative are their products and methods?

3. Describe the degree of horizontal cooperation and coordination across functions, business units, and product lines.

Sample checklist items from each of the eight due diligence areas are shown. To view the entire checklist, visit www.theiia.org/InternalAuditor/current_issue.htm.

MARKETING

If the transaction is being executed to acquire best practices or maintain marketing channels and practices, the focus should be on Ameritech's ability to maintain or exceed existing service levels.

Work Steps

1. Document the functionality, uses, and customer demand for products and services involved in the transaction. List comparable goods and services.

2. Describe the major factors that affect the demand for products and services. Explain foreseeable changes to demand.

3. Describe basic customer buying considerations, such as price, quality, service, and availability. Review and document recent customer complaints.

FINANCIAL

The financial element of due diligence aids the team in understanding the controls surrounding financial reporting. This segment of the process validates the value of the transaction and ensures that forecasts are achievable and in line with industry and market levels.

Work Steps

1. Review and document results of the three previous years' audited financial statements, public registration statements, tax returns, and management letters. Understand unusual fluctuations, quality of financial information, and management turnover.

2. Develop appropriate financial ratios and growth rates for the target and benchmark to industry. Key for Ameritech are days sales outstanding, aging of receivables, inventory turnover, operating margins, earnings per share, and working capital. Develop additional measures as circumstances dictate.

3. Document sales history and forecasts, treatment of sales backlogs, customer credit policies, and customer churn rates.

OPERATIONS

Understand the target's resources and ability to provide goods and services at the current levels. Evaluating the locations, equipment, and employees is a useful strategy in understanding how the products and services are produced.

Work Steps

1. Document the annual operating costs and capacity of facilities included in the transaction. Determine how and to what degree assets are utilized.

2. Determine the real costs of running the business on a fully loaded basis. Document per-unit costs and break-even points for products and services.

3. Obtain documentation for all operations, inventory management, and distribution software and systems. Note compatibility issues with Ameritech systems.

LEGAL

Understand the target's past and current litigation and identify legal matters for the transaction. The key is to determine the legal risks to which Ameritech will be exposed.

Work Steps

1. Obtain a listing of all past and pending lawsuits. Document their impact on the transaction.

2. Obtain a listing of all related contracts, warranties, trust agreements, and similar documents. Assess the potential impact of each.

3. Obtain franchising and licensing agreements, line of credit agreements, loan agreements, lease agreements, outside contractor agreements, and sales representative and distributor agreements. Document their impact on the transaction.

HUMAN RESOURCES

If employees are acquired as a result of the transaction, benefit and retirement plans must be understood clearly. Recommendations should be made with regard to what employees and benefit programs should be retained.

Work Steps

1. Obtain copies of the target's employee plans for benefits, contracts, bonuses, incentives, insurance coverage, and stock option agreements. Document qualified retirement plans for current and retired employees.

2. Document key management functions, responsibilities, and job descriptions. Obtain succession plans.

3. Confirm that employment policies and practices are in compliance with local, state, and federal laws and regulations.

ENVIRONMENT

Document any risks posed by the target with respect to clean-up costs and potential litigation. Determine whether or not environmental experts are necessary to review the target and what kind of expertise should be used.

Work Steps

1. Review public filings for disclosure of environmental issues. Document public and legal reactions to environmental issues. What would be the impact on Ameritech?

2. Contract with the appropriate parties to inspect waste treatment facilities, off-site disposal facilities, and surrounding emissions.

3. Review and document past and pending litigation on environmental issues.