Financial Due Diligence
Due diligence is an investigation of a business or person prior to signing a contract, or an act with a certain standard of care.
Due diligence, often known by the acronym ‘DD’, usually refers to within the context of mergers and acquisitions when after reaching an initial agreement of cooperation with the target firm (in addition to the signing of a letter of intent, generally both parties will also sign a confidentiality agreement), the acquiring party is permitted through mutual agreement to conduct an investigation into the operational situation of the target firm.
Financial Due Diligence – Determining whether or not company accounts are consistent, evaluating the real situation of assets, liabilities and tax risks.
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The Importance and Purpose of Financial Due Diligence
Financial due diligence refers to financial professionals, according to the acquiring party’s objectives and commissioned scope, conducting investigation into the target firm’s financial circumstances and various other related factors. Financial due diligence ordinarily employs methods such as document review, conducting discussion and interviews with senior management and key employees, comparing historical financial data and trend analysis, and finally the reporting of financial and tax risks along with the actual operational situation of the target firm in written form to the acquiring party.
Conducting financial due diligence is not only related to proposed acquisitions or mergers, it can also be directed against joint ventures, financing or other deals and transactions. Principal work usually centres on people related or interest related business activities and relevant financial data, the ultimate goal being to provide assistance to the acquiring party in eliminating asymmetric information, and allowing the acquiring party to obtain a greater depth of understanding with regards to the target firm. Due to the differing characteristics of various industries, the knowledge and understanding of a certain industry on the side of an acquiring party might also differ from an equitable level with that of the target firm. Therefore financial due diligence process should be modified or adjusted so as to meet the acquiring party’s specific needs and expectations.
Fundamental Principles of Financial Due Diligence
Even though financial due diligence differs from general audit work, staff participating in a due diligence investigation, acting as third party independent financial consultants in the merger and acquisition group, must adhere to the following principles:
1. Independence Principle
– The independence principle typically covers two elements, the first is that of the financial consultancy firm, the second is the group of financial professionals that work on an investigation. For instance, before the aforementioned financial consultancy firm accepts the engagement it must not have provided the target firm in question with any service that could possibly conflict with that project of financial due diligence, and any financial professionals concerned with the project must not hold any direct or indirect economic interest concerning the firms involved, in order to guarantee said financial consultancy and project group members’ independence.
– Upholding an objective approach, establishing that any determination should be devised rationally and only according to already acquired and well understood information.
2. Prudence Principle
The prudence principle manifests itself in the following elements:
– Upholding a prudent and professionally skeptical approach, from beginning to end, through the process of due diligence.
– Review of work plans, staff allocation, working papers and financial due diligence report.
3. Comprehensiveness Principle
Financial due diligence should cover all aspects of the target firm’s relevant financial management and accounting.
In light of differing industries and differing firms, investigations must be conducted according to levels of risk after sufficiently considering client requirements.
Financial Due Diligence’s Operational Nature and Characteristics
Financial due diligence operations belong amongst related services, in comparison to assurance services (for instance the familiar service of auditing) they do not provide any level of assurance (they do not have an audit report or opinion paragraph). However, the ultimate result of this form of service, the financial due diligence report, possesses the characteristic of verifiability. From the thorough conduct of the merger and acquisition related activities, to the final transaction accomplishment and post-acquisition integration, the due diligence report undergoes examination and appraisal. Therefore, a financial due diligence engagement is really a challenge to the professional competency of the accounting or consulting firm.
China’s current system of practicing standards for certified public accountants has yet to establish any specialised standards pertaining to financial due diligence. Completing this engagement efficiently and to a high standard, displaying a firm’s professional competency, and promoting a high level of customer satisfaction are a firm’s predominant concerns when receiving requests for financial due diligence engagement. Through a comparison with the auditing of financial statements within assurance services, and through analysing the differences and similarities, suitable working methods and procedures can be identified and referenced.
Methods of Financial Due Diligence
During the investigative process, financial personnel usually will employ the following fundamental methods:
Review – through review of financial statements and other financial materials, identify critical and material financial factors;
Analytical procedures – includes procedures such as performance analysis, trend analysis, structural analysis etc. analysis of materials acquired through all channels-then through collating the results of this analysis discovering abnormalities and important issues.
Interview – sufficient communication with every level of the internal hierarchy, employees of different positions and roles, as well as intermediary institutions.
Internal communication – due to investigative group personnel coming from different backgrounds and specialisations, mutual communication and timely sharing of work results creates an effective method of accomplishing investigative targets.
In this comparison we have indicated that there are some key differences in the objectives of financial due diligence and financial statement auditing. In addition, the duration of a financial due diligence is comparably short, and therefore in the place of auditing methods such as confirmations, physical inventory observation and the re-calculation of financial figures, methods such as trend analysis, structural analysis and other such analytical tools are more often utilised.
Common Issues Seen in Financial Due Diligence
1. Application of Accounting Standards
During due diligence investigations, it is frequently revealed that the target company fails to some extent, and for various reasons, to comply with accounting standards. A typical and recurring example being that the target company recognises income on cash basis in place of accrual basis with a view to underpaying or avoiding paying relevant taxes.
There can also be differences resulting from a need to use the accounting standards adopted by the acquirer other than that of Chinese accounting standards, for example United States accounting standards. An example is that China’s companies are not allowed to calculate income tax after offsetting profits and losses among different units under the same corporate group, but the US allows income tax to be paid on the level of corporate group after the compensation of profits and losses.
2. Contingent Liabilities
During the course of the due diligence process, target companies are often found to have contingent or improperly recorded liabilities. Examples of such are guarantees or assurances provided by a third party or an affiliated company, unused annual leave of employees, insufficient or non-payment of employee social insurance and taxes, and possible litigation risks caused by violation of the laws and regulations relating to the businesses of the target company.
3. Related Party Transactions
During the due diligence process, problems regarding related party transactions are often found. For instance, the terms of trade are not compatible with the principle of independence; the target company provides off balance sheet guarantees for the transactions or liabilities of its affiliated companies for the overall interests of the corporate body instead of business objectives.
4. Mortgaged or Defective Assets
Particular attention should be paid to the fact that assets of the target company may well have been mortgaged or used as guarantees for other liabilities, or its factory or office premises might not have valid planning or construction permits, or some premises might not provide certification of ownership for their operating and available properties, all of which could severely distort records of income and expenditure.
5. Income Tax Payments
Through understatement of turnover or overstatement of operating expenditure, the target company might (willfully or inadvertently) underpay or not paying corporate and individual income taxes.
Follow-Up Work after Financial Due Diligence
1. Specialist Assistance for Investment Program
– Proposed resolutions for corporate financial risk (discovered in the course of financial investigation);
– Financial feasibility of investment model – Financial forecast of investment returns;
– Financial risk evaluation of investment program.
2. Integration Program and Specialist Assistance
– Evaluation of the professional competency of the target firm’s financial personnel and internal audit personnel;
– Recommending financial and internal audit personnel
– Assistance for financial management system and internal control system perfection or establishment;
3. Pre-transaction Asset Valuation Review
– Cooperate with assets valuation work;
– Connecting with valuation firms, ensuring favourable asset evaluation results;
– Constructive suggestion regarding important issues of asset valuation
4. Post-transaction Financial Audit and Internal Audit
The Importance of Financial Due Diligence for Target Firms
Prior to this chapter, all that has been discussed pertaining to the importance of financial due diligence has been from the perspective of the acquiring party, yet is this the only party that requires the service of financial due diligence? The answer to this question is that it is not. Along with the steadily increasing number of merger and acquisition cases (some which are successful, and some which end in failure), firms on the selling side (target firms), are also conscious of the importance of conducting financial due diligence beforehand.
From the perspective of the selling side, the importance of financial due diligence is embodied in the following aspects;
1. Effectively Preparing for Impending Merger and Acquisition Negotiations
Financial report forms act as a mirror, what presents itself in this mirror is the overall capacity of the enterprise. Through financial due diligence the selling firm can take a step towards understanding its own key strengths and shortcomings. This lets the selling party whilst conducting negotiations with the acquiring party to have greater confidence, to be able to understand and play to its strengths. Even if confronted with unavoidable questions, because sufficient preparation has been carried out in advance, the selling side is more than capable of putting forward the appropriate responses.
2. Raising the Firms Value
A single good financial due diligence report can make known a firms various issues, for instance questions of operation and internal control. Constructive suggestions from relevant financial specialists can still assist the firm in further perfecting or correcting issues that are discovered. This contributes to the firms raising operational efficiency, and ultimately the value of the firm itself.
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