What is Due diligence?

Due diligence (DD) is research (comprehensive survey) or fact-finding of the Acquiring company for a targeted company. When the Acquiring company plans to buy the target company, the acquiring company will do DD to the target company.

DD can be done internally (internal audit team or the acquiring company recruit a team for specially perform DD) or externally (hire the external audit firm to perform).

The external audit firm can provide DD service to their existing client either as there was no conflict or against the code of ethics.

DD team will go to the target company to perform DD in the purpose of identifying good points and bad points of the target company in providing more information to Acquiring company to make a decision whether to buy the target company or not (because buying the wrong company can be a costly mistake).

In order to do DD, the Acquiring company needs to seek permission from the target company to do DD. If the target company really wants to sell, they will allow the Acquiring company to do DD because if the DD report discloses many good points, the cost of acquiring will be higher either.  

The purpose of DD is:

  • Information gathering

The acquired company would like to gather as much information as possible in making a decision for purchase. That information can be positive and negative.

  • Verify target company representations.

DD team can verify on behalf of Acquiring company on the information that management provided. For example, if the management mentioned that the company has a profit of 20% each year then the DD team has to verify this for Acquiring a company in order to prove what the management is true or not or is it just a fake statement made by management to make the company looks healthy.  

  • Identification of assets and liabilities of the company.
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DD is also the identification of assets and liabilities of the target company. It is not much related to IFRS but it focuses on the one that beyond IFRS. For example, if the target company has competent management personnel then it is an asset of the company.

After acquiring the company, if the Acquiring company can persuade CEO to stay and make the profit for the company then CEO is an asset of the company, but if they leave then it is the liability of the company as the Acquiring company needs to recruit new CEO and train them about the target company. A demotivated employees can be a liability of the company in DD.

  • Identification of any Operational issues.

DD team need to visit target company, conducting research on the background of the target company. If it is too many negative operational issues can reduce the value of the company.

  • Post acquiring planning

After acquiring, the Acquiring company can start planning on what should they do to the target company.

Benefits of conducting DD by external audit

There are some benefits of conducting DD by external audit compare to Internally such as:

  1. More independent facts and views can be share because the firm doesn’t have an emotional attachment to the decision.
  2. The audit firm has more competent and skillful since the firm could have done DD for its clients.
  3. Management will have more time to concentrate on its core business while hiring DD task to external audit.

III. What are the differences between DD and external audit?

Due DiligenceExternal audit
– It is a non-assurance engagement that has no opinion expression on the report.– It is an assurance engagement that needs to have an opinion on the financial statements.  
– DD Report is about the factual finding which is the result of doing research and survey on the target company.  – External audit report is a positive assurance which is about the opinion of an auditor whether the financial statements prepared by management are true and fair.  
– DD is focus on the past and future equally– External audit report is focused more on the past and little on the future (assessing ongoing concern of the business)  
– DD looks like much more documents and evidence though it is not just related to the financial statements. For example, forecasting, press release, operation document.  –  External audit focus on the current financial statement and its related evidence only.  

IV. Scope and procedure of DD (as compare to audit)

  • The audit is an assurance engagement (giving an opinion) while DD is a non-assurance engagement.
  • DD focuses on factual findings. And the investigation will draw in a much wider range of sources of information, including several years’ financial statements (prior years), management accounts, profit, cash flow, business plan. In summary, the firm will look at a wider range of evidence.
  • There was no detailed audit procedure been performed for DD unless it is requested by management.
  • DD will do a lot of Analytical procedures and a lot of inspections.
  • DD is more forward-looking than an audit
  • DD will not really look at the effectiveness of the internal control system, but the External audit will determine whether the internal control system whether is realizable.
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V. Content of DD report:

  1. Identification of the acquiring company and target company
  2. The objective of DD for example factual finding and research.
  3. There is no opinion on the DD report
  4. All the fats that were found the need to disclose whether it is positives or negative.
  5. Scopes of work. For example, the type of the procedures that were performed and evidence that were collected.