DUE DILIGENCE
Due diligence is a fact finding exercise and is usually conducted to reduce the risk of poor investment decisions.
Purpose of due diligence
An advisor is engaged by the acquirer of a company to gather information on the target company. This information may:
- Reveal potential problems before an acquisition decision is made and enable the potential acquirer to enter into the transaction with open eyes.
- Provide the client with the information they need to decide
– whether or not to go ahead with an acquisition
– when to go ahead with the acquisition
– how much should be paid for the target company.
- Increase stakeholder confidence in the acquisition decision, for example, if the acquisition is to be financed by a bank loan. The bank will have greater confidence that the investment is sound and the loan is more likely to be repaid.
The due diligence provider will need to look at:
(i) Current issues affecting the company which could result in additional time and cost to resolve.
(ii) Prospects for the future to ascertain whether the investment is likely to generate the desired rate of return on investment.
(iii) Past performance to establish how successful the company has been and may be able to continue that success into the future.
The main purpose of due diligence is to ensure the acquirer has full knowledge of the target company such as:
- a) Financial performance and position
Analysing and validating the target’s revenue, future cash flows and financial position including identification and valuation of contingent liabilities and key assets.
- b) Operational matters
Investigation of the operational risks, capex requirements, quality of information systems; key customers and suppliers.
- c) Market position and commercial matters
A comprehensive review of the target’s business plan in the context of the industry and market conditions; including the industry life cycle.
- d) Legal matters
Whether the company has been compliant with the relevant legal and regulatory framework, whether any legal cases are in progress and what the likely outcome might be.
- e) Tax matters
Whether the company is up to date with its tax returns and tax payments. Whether any tax investigations have been performed and whether any issues are still to be resolved.
- f) HR matters
Whether there are any HR issues affecting the company such as industrial action, staff on long term sick leave, low morale and productivity, contractual disputes, etc.
The acquiring company may decide the issues and risks identified are so significant they do not want to go ahead with the acquisition. They may use the issues to negotiate a reduced price, or require the vendor to resolve the issues before the acquisition completes.
Level of assurance
Depending on the client’s requirements, due diligence may either be conducted as:
- i) an assurance assignment (where a professional conclusion is expressed), or
- ii) an agreed upon procedures assignment (where the accountant presents the client with factual information they have requested about the target company).
Benefits of engaging an advisor to carry out due diligence
1) Decrease management time spent assessing the acquisition decision
Due diligence reviews can be performed internally, by the management of an acquiring company. However, this can be time consuming and the directors may lack the knowledge and experience necessary to perform the review adequately. Engaging an external advisor to carry out the review allows management to focus on strategic matters and running the existing group as well as ensuring an impartial review.
2) Identification of operational issues and risk assessment of the target company
For example:
– possible contractual disputes following a takeover
– potential breaches of covenants attached to any finance
– the adequacy of the skills and experience of key management within the target company
– operational issues such as high staff turnover; issues with supplies/suppliers, quality issues with products or the retention of key customers.
3) Liabilities evaluated and identified
It is particularly important that the potential acquirer identifies contingent liabilities that may crystallise in the future, and considers the likelihood of them crystallising and the potential financial consequences. These will affect the price the acquirer wishes to pay for the target.
4) Identify assets not capitalised
Internally generated intangibles, such as internal brands, will not be included on the statement of financial position but are vital to purchasing decisions as they increase the value of the business.
5) Gathering information
The external advisor will gather any other relevant information that could influence the decision of the client.
6) Enhance the credibility of the investment decision
Engaging an external advisor to carry out the due diligence will ensure an independent, objective view is obtained on the investment decision, including the price to be paid.
7) Planning the acquisition
The due diligence provider can advise on change management following the acquisition, including integrating the new company into the group, which key staff to retain, help with any restructuring as well as the more immediate issues of determining an appropriate price and reviewing the terms of the sale and purchase agreement.
8) Claims made by the vendor can be substantiated
For example, future order levels and current finance agreements.
9) Evaluation of possible post-acquisition synergies and economies of scale and potential further costs
The advisor will investigate and advise on post-acquisition issues such as consideration of staffing requirements, including identification of management and key personnel who should be retained post-acquisition.
The advisor should identify potential synergies. The combined entity may be able to utilise distributions systems, staff and noncurrent assets allowing for surplus assets to be sold and duplicate roles and processes to be made redundant.
Comparison of due diligence to external audit
| Due diligence | External audit
|
|
| 1. Objective | To provide the acquirer with
sufficient information to make an informed decision about whether the acquisition is a worthwhile investment
|
To form an opinion as to
whether the financial statements are free from material misstatement |
| 2. Scope of work | · Past performance
· Current issues · Future prospects
|
· Past performance
· Cash flow forecasts for going concern review
|
|
3. Focus |
· Financial performance
and position · Operational matters · Market position and commercial matters · Legal matters · Tax matters · HR matters |
Financial performance
and position
|
| 4. Level of assurance | · Limited assurance or
· No assurance |
Reasonable assurance
|
Acceptance considerations
As with any assignment, the practitioner must only take on work of acceptable level of risk. The acceptance matters given in chapter 6 must be considered.
In addition, the following matters should be considered:
- Why the company is not using their existing firm of accountants if they do not approach their current provider of services.
- Whether the target company’s employees know about the acquisition. If not, the firm will need to be careful not to disclose information to the employees when obtaining evidence.
- Whether the acquisition is a hostile takeover. This may affect the ability to obtain sufficient appropriate evidence from the target company.
- Exact scope of the due diligence, e.g. limited assurance or agreed upon procedures, financial due diligence only or consideration of commercial, legal, or operational matters. This will affect the time and resources required.
- The reason for the acquisition. This may affect the type of information that needs to be gathered.
- The deadline for the report. Some due diligence engagements may require the investigations to be performed at short notice.
- Any ethical threats which may be created. If the due diligence involves valuing the target company’s assets and liabilities, a self-review threat may be created later on if the audit firm then audits those assets and liabilities which have been purchased by the audit client. If the assets have been overvalued the audit firm may be reluctant to bring this to the client’s attention.
Procedures
Due diligence procedures will involve:
- i) Analytical review of past financial statements to assess the recent financial performance of the target company.
- ii) Review of forecasts including an assessment of the reasonableness of assumptions used in the forecast.
iii) Review of existing contracts to identify when the contracts expire and whether the contracts will be affected by a change of owner.
- iv) Review of terms and conditions of related party transactions which may have affected the performance of the target company.
- v) Inspection of asset registers and ledgers to identify possible overstatement which would affect the price paid.
- vi) Review of the accounting policies of the target company and how they compare with the acquiring company. The results of the target may be recalculated on the basis of the acquiring company’s policies to assess the difference arising from less prudent accounting policies.
vii) Review of board minutes to identify significant issues affecting the target company which may affect its value.
viii) Correspondence between the company and its lawyers regarding any outstanding legal issues.
- ix) Correspondence from the tax authority regarding any tax investigations or issues.
- x) Review of industry data to assess the status of the industry and industry specific risks.
