Due Diligence is a comprehensive appraisal and evaluation of a target company undertaken by a potential acquirer, especially to establish its assets and liabilities and evaluate its commercial potential.
It involves overview of a business to be undertaken by a prospective buyer, with a due diligence and evaluate its commercial potential. The duty of the person performing the due diligence on a company is to confirm the expectations, commitment, strengths and keen understandings of that business sector. It is also called reasonable diligence.
The due diligence is mostly used in mergers and acquisitions where one company wants to merge or acquire another company after evaluating each other’s potential. But it can be implemented in case of Partnership, Joint ventures and collaborations too. In case of mergers where a business considering a merger with another company, make sure that the company they are considering for merging with is financially sound.
The Due diligence report can help you to establish the true value or cost of a business transaction and the right information can contribute in how the terms of your agreement are drafted. It helps you to decide whether it is a promising decision or not.
For example, due diligence in a property transaction may refer to an assessment made to discover and evaluate any environmental liabilities that could impact the future of the property. It may include researching real estate records to determine any liens on the property, providing an itemized list of needed repairs and deferred maintenance items, or determining compliance with local building code provisions etc.
Types of Due Diligence
Financial Due Diligence – It determines whether or not company accounts are consistent over the years, evaluates the real situation of assets, liabilities as on date and risks and benefits involved with the company. The conclusion of the financial due diligence review should provide an overall evaluation of the viability of the target business following the proposed acquisition.
Legal Due Diligence – It involves analyzing all the contracts and any other document containing rules and regulations or bye-laws, evaluating whether or not any hidden legal hazards, lawsuits exist or any other legal compliance to be fulfilled by the company. It would involve studying Corporate documents, Agreement, licenses and permits, Liens etc.
Human Resources Due Diligence – It is concerned with identifying the qualifications, working experience, technical ability, working initiative, communication skills and other qualities of the target firm’s senior management personnel and key staff as well as their procedure of appointing personnel. There will be analysis of Employment terms, Retention agreements, retirement benefits, healthcare benefits etc.
Operational Due Diligence – It involves evaluating a target firm’s business model, structures and prospects, including identifying the existence of a market conditions and assessing their competitive situation and overall industry attractiveness.
Role of Chartered Accountant in Due Diligence
Historically, Chartered Accountants were not retained till the closure of business deals and problems began to emerge. The due diligence was conducted by traditional accountants, either in-house or external. Nowadays accountants are often brought in as soon as the agreement is signed for due diligence, usually at the same time as the lawyers.
The Chartered Accountants are required to give report on Due Diligence done by them of a particular firm known to be ‘due diligence report’. This involves investigative process to be carried out on the target firm. Basically they have the following roles to be performed in this regarding:
To provide reasonable assurance on the reliability of the financial statements and compliance with accounting standards and provisions.
Analysing the sustainability of business, competition, business plan, future prospects, corporate & management structure, technology, tax structure to reduce tax burden, synergy of target business to company’s business apart from researching regulatory compliances , legal issues and other financial data.
To give an opinion and if on the basis of that due diligence unearths information that makes the investment, loan or participation risky or undesirable and which cannot be adequately resolved then to not invest or continue with the same company.
Discussions with the staff of any matter which they consider material for the report, either formal or informal and physically attending the entity’s place to observe their routines.
To adopt various methods for reviewing the firm like Analytical procedures, Review, Interview, Internal and external communication etc.
The above Analysis done by the Accountant may often lead to purchase price adjustments both before and after the closing of the transaction. Sometimes the biggest adjustments come after the transaction closes and a more complete review is performed by the buyer and their internal and external accountants. The Accountant provides the report on the analysis done by him about the financial position about the company.
Why is due diligence important before a company acquisition?
To investigate into the affairs of Business as a prudent business person.
To confirm all material facts related to the Business and their truthfulness.
To assess the Risks, Opportunities, Strengths and weaknesses of a proposed transaction and evaluating them.
To reduce the Risk of post-transaction unpleasant surprises and to avoid a bad business transaction.
To confirm that the business from inside is the same what it appears from outside.
To Create a Trust and mutual understanding between two Unrelated Parties.
For Negotiating Price Concessions and revoking the agreement altogether if the information found or discussions made are not acceptable to the potential buyer.
To verify that the transaction satisfies with investment or acquisition criteria and fulfills all the conditions.
This analysis carried out before acquiring a controlling interest in a company or investing in a company helps to take a better decision.
Broad topics to be reviewed
Organizational Status
Contractual Obligations
Labor
Insurance
Tax
Accounting
Employee Benefits
Litigation and Product Liability
Environmental Liability
Valuation of Acquisition
Antitrust
Foreign Regulations
Intellectual Property
Document Retention
Corporate Books and records
Contingent liabilities
Customer Information
Competition
Marketing, Sales and Distribution
Research and Development
Advantages of due diligence
Due diligence activities can help uncover and prevent corruption, bribery, and other ‘white collar crime’.
Due diligence can act as an enabler of ethical procurement and is a way to improve an organisation’s goodwill and its relationships with stakeholders, including the general public.
Due diligence investigations into investments can help determine whether to proceed with the transaction and how much it is worth to invest.
Disadvantages of due diligence
Due diligence measures can be seen by some as burdensome and expensive.
There are countries and cultures in which due diligence is still very difficult to implement due to cultural and language barriers and the problems they pose in documentation, or due to some historical factors that may lead to a reluctance to disclose information.
Logistics and supply chain issues can be difficult to identify in due diligence checklists.
Ratio Analysis
Analyzing trends in various ratios is important to understand characteristics of the business and to estimate a scope for the business. Ratio analysis helps to pinpoint strengths and weaknesses of the target firm, which may help all over due diligence process. Combining the result of ratio analysis with the strategic goals of the bidder company is important in success of M&A. Finance team should analyze the target company and its industry with profitability, liquidity, activity, and leverage ratios.
Difference between Due Diligence and Audit
The next point that might come into the mind is that due diligence has all the features related to audit. The requirements of Audit and due diligence is same. So, what does make the difference between them? Answer to this question is shown below.
Due DIligence
Audit
1.
The Due Diligence is done by accountants, typically those experienced in Mergers & Acquisitions.
The Audit is mandatorily required to be conducted by independent accountants/ auditors as per section 139 of Companies Act, 2013
2.
The objectives are:
● Quality of earning assessment
● Historical working capital needs
● Sales and operating expense trends
● Assessment of assumptions in management’s forecast
● Assessment of key accounting personnel and accounting information systems
● Identification of deal issues specific to the transaction.
The audit objective is to provide professional opinion on whether the financial statements fairly reflect financial performance and position in accordance with GAAP.
3.
The scope of work is determined by the buyers. It focuses on dealing issues.
The audit is dictated by Generally Accepted Auditing Standards(GAAS.
The scope of audit involves detailed verification testing and typically covers results as of fiscal year end.
4.
Formal written report is required, but may be a brief summary of key deal points or a verbal communication.
Audit opinion is required.
5.
Buyers, Lenders and secondary investors are the users.
Wide range of stakeholders, including investors, banks, suppliers and customers are the users.
6.
The time period can range from one day desk review to several weeks of on site due diligence.
The timing of audit depends upon the stakeholders requirements.
Due Diligence important for banks
Nowadays, the banks are conducting due diligence as per the guidelines of RBI. Reserve Bank of India has asked private sector banks to conduct due diligence to determine suitability of candidates for appointment and continuation as a director on board.
This due diligence should be conducted on qualification, expertise, track record, integrity and other fit and proper criteria, RBI said in a notification.
Banks should obtain necessary information and declaration from the proposed and existing directors for the purpose, it said.
The board of the bank should ensure, in public interest, that nominated and elected directors execute the deeds of covenants every year.
(Author is a student pursuing CA Final in Chandigarh)
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