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Series 79 practice questionmediumDue Diligence Process

An investment banker is leading financial due diligence on a potential acquisition target. Which of the following findings would be the MOST significant red flag?

  1. AThe target's revenue has grown at 5% annually for the past three years
  2. BThe target has changed its revenue recognition policy twice in the past three years, each time resulting in higher reported revenue✓ Correct answer
  3. CThe target has a customer concentration of 15% with its largest client
  4. DThe target's effective tax rate is slightly below the statutory rate
Explanation

Why B — The target has changed its revenue recognition policy twice in the past three years, each time resulting in higher reported revenue

Repeated changes to revenue recognition policies that consistently boost reported revenue are a major red flag in due diligence, as they may indicate aggressive accounting practices or an attempt to inflate financial performance. This could mask deteriorating business fundamentals and exposes the acquirer to the risk of overpaying. Customer concentration of 15% and below-statutory tax rates are relatively common and not inherently concerning, while 5% steady growth is a neutral finding.

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