Financial Due Diligence

| April 23, 2010 | 0 Comments

Students of auditing papers will often come across the concept of 'financial due diligence' and may be asked to compare and contrast due diligence with that of statutory audit.

This article looks at the basics of due diligence and discusses how it differs from statutory audit.

Due Diligence

Due diligence is the investigation of the affairs of an entity by, or on behalf of, a potential investor or purchaser before the transaction is completed.  The primary purpose of due diligence is to enable the potential investor to make informed decisions concerning the balance of risks present and the opportunities available should the transaction complete. 

Financial due diligence is completed prior to the transaction being completed and the amount of financial due diligence to be completed will often vary according to the knowledge of the purchaser or investor, the size and complexity of the target and the degree of risk involved.

Financial due diligence is often undertaken by a reporting accountant who will undertake the work on behalf of the purchaser.

Regulatory environment

Due diligence is primarily an assurance engagement and the reporting accountant will be required to have an understanding of both accounting and auditing standards.  Whilst the reporting accountant, carrying out a due diligence assignment, is not expected to an express an opinion as to the truth and fairness of the financial statements in terms of audit, the reporting accountant may undertake a certain degree of the financial due diligence by applying International Standards on Auditing (ISAs). 

Knowledge of accounting standards is required to ensure that transactions and events have been properly accounted for in annual financial statements and any interim financial statements that the reporting accountant may use in his/her review.

Planning

As with any assurance engagement, sufficient planning is crucial to enable the reporting accountant to carry out the procedures necessary and to carry out the assignment to the highest standards. 

In many cases, the reporting accountant may be required to undertake a due diligence exercise on an entity which they may not necessarily have any past experience or dealings.  In such circumstances it is vital that the reporting accountant plans the due diligence carefully and obtains an understanding of the target entity and the environment in which it operates.  The reporting accountant may, therefore, consult the provisions in ISA 315 (redrafted) 'Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement'

Information Gathering

Once instructions have been taken from the client, the terms of the engagement have been agreed and sufficient planning has taken place, information can be gathered to enable the reporting accountant to report back to the client. 

The gathering of the information for the due diligence assignment has to be carried out systematically and carefully having regard to the size, complexity and degree of risk associated with the target.  The reporting accountant will have carried out the planning in such a way as to identify the areas of the target entity which are material and those areas which can be safely ignored. 

The reporting accountant is not expected to express an opinion on the financial statements, unlike an auditor, and therefore the extent of verification of information will largely depend on the requirements of the client and the scope of the engagement.  However, examples of the types of information the reporting accountant would need in order to gather information is given as follows:

·         Accounting records.

·         Interim financial statements/management accounts.

·         Latest set of audited/unaudited financial statements, together with supporting analysis.

·         Tax computations.

·         Employee files.

·         Minute books.

·         Correspondence files.

·         Statutory information such as the Articles of Association, Annual Returns, List of Directors/Shareholders.

·         Details of the group structure (where applicable).

·         Access to management to hold discussions and to corroborate any issues flagged up during the planning.

Working Papers

Work undertaken during the due diligence should be documented in accordance with the firm's procedures.  Again, whilst the due diligence exercise is not an audit, compliance with ISA 230 (revised) 'Audit Documentation' may be considered appropriate by the reporting accountant. 

Indeed, a working paper file relevant to a due diligence assignment should be structured in such a way that it facilitates cross-referencing of material items.  It also facilitates the cross-referencing of the planning memorandum to the detailed working papers (especially where certain areas identified at the planning stage of the assignment are judged critical).

Finally, a well-structured due diligence file will help answers questions asked by the client swiftly, especially in face-to-face meetings.

Reporting

The form of reporting should be agreed at the outset of the assignment. The purpose of the due diligence exercise is to provide the potential investor with the information and professional commentary they need in order to be able to make informed decisions about the target entity.

Many due diligence assignments will be biased towards negative reporting.  In other words, the client will require the reporting accountant to provide assurance that nothing has come to the reporting accountant's attention which would cast doubt on the credibility of the information reviewed by the reporting accountant during the due diligence assignment, which may result in the abandonment of the potential investment.

In most cases, the form of report will be written and generally most firms have an 'in-house' style and the contents of the report may have been agreed at the outset of the engagement.  However, reports should be professionally written and concise and the information contained within the report should not be ambiguous or contradictory.  Conclusions should also be made in the report.

In some, more simple due diligence assignments, it may be appropriate to simply restrict a report to just reporting by exception where problems, shortcomings or other matters which may be of particular relevance to the potential investor may be documented in the report. 

However, where the client is looking for a broad range of information, then a more fuller and more comprehensive report may be required which may be quite lengthy.  Many firms have standard templates which may cross-reference various points within the report (such as the executive summary and conclusions sections) to appendices.  Typically such reports would consist of:

·         Scope of the engagement.

·         Executive summary.

·         History of the target.

·         Nature of the target including its business, group structure, internal processes, principal activities etc.

·         Statutory information held with (say) the Registrar of Companies.

·         Details of the internal structure of the target.

·         Financial reporting and accounting controls.

·         Critical accounting policies.

·         Summary of the latest approved financial statements and a summary of any available up-to-date management/interim accounts.

·         Review of the financial position of the target (balance sheet).

·         Details of any fixed and/or floating charges or preferential creditors.

·         Details of mortgages and financing.

·         Commentary relating to the entity's cash flow.

·         Taxation issues.

·         Reviews of budgeted information and projections.

·         Future plans for the business.

·         Other relevant matters.

Due Diligence versus Audit

As mentioned above, the primary objective of the due diligence assignment is not to express an opinion on the truth and fairness of a target's financial statements; it is merely to provide a potential investor with crucial information, gathered as a result of the due diligence assignment, to enable the potential investor to make informed decisions about the potential investment/acquisition of a target entity.

Reporting accountants may perform certain aspects of the due diligence assignment in accordance with ISAs, but in contrast to statutory audit, the scope of the due diligence assignment is very much driven by the nature, size, complexity and client-requirements.

Statutory audit is concerned with expressing an opinion as to whether an entity's financial statements give a true and fair view and must be undertaken in accordance with ISAs.  The outcome of the statutory audit is the expression as to whether the financial statements give a true and fair view and the auditor's opinion is expressed as:

·         Unqualified.

·         Qualified.

·         Adverse.

·         Disclaimer.

Conclusion

It is important that a clear distinction is made between the objectives of a due diligence assignment and audit because there is a vast difference between the objectives of the two.

Due diligence may apply certain aspects of auditing standards, but an audit assignment must apply all applicable auditing standards.

Steve Collings FMAAT FCCA DipIFRS is the Audit and Technical Manager at LWA Ltd and a partner in AccountancyStudents.co.uk.  He is also the author of 'The Core Aspects of IFRS and IAS' and lectures on financial reporting and auditing issues.

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