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 recruiting a team to perform DD especially) or externally (hiring the external audit firm to perform).
The external audit firm can provide DD service to their existing client as there was no conflict or against the code of ethics.
DD team will go to the target company to perform DD to identify the target company’s good points and bad points in providing more information to Acquiring company to decide whether to buy the target company or not (because buying the wrong company can be a costly mistake).
To do DD, the Acquiring company needs to seek permission from the target company to do DD. If the target company wants to sell, they will allow the Acquiring company to do DD because if the DD report discloses many good points, the acquisition cost will be higher.
The purpose of DD is:
- Information gathering
The acquired company would like to gather as much information as possible in deciding on a purchase. That information can be positive and negative.
- Verify target company representations.
DD team can verify on behalf of Acquiring company the information that management provided. For example, suppose the management mentioned that the company has a profit of 20% each year.
In that case, the DD team has to verify this for Acquiring a company to prove whether the management is true or if it is just a fake statement made by management to make the company look healthy.
- Identification of assets and liabilities of the company.
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 is beyond IFRS.
For example, if the target company has competent management personnel, then it is an asset to the company.
After acquiring the company, if the Acquiring company can persuade the CEO to stay and make a profit, then the CEO is an asset to the company.
Still, if they leave, it is the company’s liability as the Acquiring company needs to recruit new CEOs and train them about the target company. A demotivated employee can be a liability to the company in DD.
- Identification of any Operational issues.
DD team needs to visit the target company and research the background of the target company. If there are too many, negative operational issues can reduce the company’s value.
- Post acquiring planning
After acquiring, the Acquiring company can start planning on what they should do to the target company.
Benefits of conducting DD by external audit
There are some benefits of conducting DD by external audit compared to Internally such as:
- More independent facts and views can be shared because the firm doesn’t have an emotional attachment to the decision.
- The audit firm is more competent and skillful since it could have done DD for its clients.
- Management will have more time to concentrate on its core business while hiring DD tasks to external audit.
III. What are the differences between DD and external audit?
|Due Diligence||External audit|
|It is a non-assurance engagement with no opinion expression on the report.||It is an assurance engagement that needs an opinion on the financial statements.|
|DD Report is about the factual findings from research and survey on the target company.||The external audit report is a positive assurance about an auditor’s opinion on whether the financial statements prepared by management are true and fair.|
|DD is focused on the past and future equally||The external audit report is focused more on the past and little on the future (assessing ongoing concerns 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, and operation document.||External audit focus on the current financial statement and its related evidence only.|
IV. Scope and procedure of DD (as Compared 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, and business plan. In summary, the firm will look at a wider range of evidence.
- No detailed audit procedure has 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 look at the effectiveness of the internal control system, but the External audit will determine whether the internal control system is realizable.
V. Content of DD report:
- Identification of the acquiring company and target company
- The objective of DD for example factual findings and research.
- There is no opinion on the DD report
- All the fats found need to disclose whether it is positive or negative.
- Scopes of work. For example, the type of procedures that were performed and evidence that was collected.