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:
Current issues affecting the company which could result in additional time and cost to resolve.
Prospects for the future to ascertain whether the investment is likely to generate the desired rate of return on investment.
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:
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.
Operational matters
Investigation of the operational risks, capex requirements, quality of information systems; key customers and suppliers.
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.
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.
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.
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:
an assurance assignment (where a professional conclusion is expressed), or
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
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.
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.
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.
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.
Gathering information
The external advisor will gather any other relevant information that could influence the decision of the client.
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.
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.
Claims made by the vendor can be substantiated
For example, future order levels and current finance agreements.
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 | ||||
| Objective | To provide the acquirer with | To form an opinion as to | |||
| sufficient information to make | whether the financial | ||||
| an informed decision about | statements are free from | ||||
| whether the acquisition is a | material misstatement | ||||
| worthwhile investment | |||||
| Scope of work | Past performance | Past performance | |||
| Current issues | Cash flow forecasts | ||||
| Future prospects | for going concern | ||||
| review | |||||
| Focus | Financial performance | Financial performance | |||
| and position | and position | ||||
| Operational matters | |||||
| Market position and | |||||
| commercial matters | |||||
| Legal matters | |||||
| Tax matters | |||||
| HR matters | |||||
| Level of assurance | Limited assurance or | Reasonable assurance | |||
| No assurance | |||||
2 Acceptance considerations
As with any assignment, the practitioner must only take on work of acceptable level of risk. The acceptance matters given in 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 .
Whether the acquisition is a hostile takeover. This may affect the ability to obtain sufficient appropriate 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.
3 Procedures
Due diligence procedures will involve:
Analytical review of past financial statements to assess the recent financial performance of the target company.
Review of forecasts including an assessment of the reasonableness of assumptions used in the forecast.
Review of existing contracts to identify when the contracts expire and whether the contracts will be affected by a change of owner.
Review of terms and conditions of related party transactions which may have affected the performance of the target company.
Inspection of asset registers and ledgers to identify possible overstatement which would affect the price paid.
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.
Review of board minutes to identify significant issues affecting the target company which may affect its value.
Correspondence between the company and its lawyers regarding any outstanding legal issues.
Correspondence from the tax authority regarding any tax investigations or issues.
Review of industry data to assess the status of the industry and industry specific risks.
Approach to exam questions: Due diligence
Exam questions will often ask for procedures to be performed for a due diligence engagement. These procedures need to identify the information relevant to the client’s investment decision. Based on this information, the client will decide whether to go ahead with the acquisition or it will help them decide what price they are willing to pay.
One way to approach the question is to put yourself in the position of the client.
What would affect your decision?
What would make you want to go ahead with the acquisition?
What would make you think it’s not such a good investment? Examples include:
Pending legal actions
Outstanding tax investigations
Declining market
Increasing competition
Damage to reputation
Old assets in need of replacing Declining financial performance
Quality issues
Reliability of asset valuations Completeness of liabilities
Human resource issues – e.g. strike action, low morale.
Test your understanding 1
Plaza, a limited liability company, is a major food retailer with a chain of national supermarkets. It has extended its operations throughout Europe and most recently to Asia, where it is expanding rapidly.
You are a manager in Andando, a firm of Chartered Certified Accountants. You have been approached by Duncan Seymour, the chief finance officer of Plaza, to advise on a bid that Plaza is proposing to make for the purchase of MCM. You have ascertained the following from a briefing note received from Duncan. MCM provides training in management, communications and marketing to a wide range of corporate clients, including multi-nationals. The ‘MCM’ name is well regarded in its areas of expertise. MCM is currently wholly-owned by Frontiers, an international publisher of textbooks, whose shares are quoted on a recognised stock exchange. MCM has a National and an International business.
The National business comprises 11 training centres. The audited financial statements show revenue of $12.5 million and profit before taxation of $1.3 million for this geographic segment for the year to
31 December 20X3. Most of the National business’s premises are owned or held on long leases. Trainers in the National business are mainly full-time employees.
The International business has five training centres in Europe and Asia. For these segments, revenue amounted to $6.3 million and profit before tax $2.4 million for the year to 31 December 20X3. Most of the International business premises are leased. International trade receivables at 31 December 20X3 amounted to $3.7 million. Although the International centres employ some full-time trainers, the majority of trainers provide their services as freelance consultants.
Required:
- Define ‘due diligence’ and describe the nature and purpose of a due
diligence review. (3 marks)
- Explain the matters you should consider before accepting an engagement to conduct a due diligence review of MCM. (5 marks)
- Describe the procedures that should be performed for the due
diligence review of MCM. (7 marks)
(Total: 15 marks)
Test your understanding 1
- Nature and purpose of a ‘due diligence’ review Definition
Due diligence may be defined as the process of systematically obtaining and assessing information in order to identify and contain the risks associated with a transaction (e.g. buying a business) to an acceptable level.
Nature
The nature of such a review is therefore that it involves:
– gathering about a company whose equity is to be sold to identify any information relevant to the investment decision.
– disclosure (e.g. to a potential investor) of findings.
Purpose
Its purpose is to find all the facts that would be of material interest to an investor or acquirer of a business. It may not uncover all such factors but should be designed with a reasonable expectation of so doing.
- Matters to be considered (before accepting the engagement) Tutorial note: Although candidates may approach this part from a rote-learned list of ‘matters to consider’ it is important to tailor answers to the specifics of Plaza and MCM. It is critical that answer points should not contradict the scenario (e.g. assuming that it is Plaza’s auditor who has been asked to undertake the assignment).
Information about Duncan Seymour
Consider the relationship of the chief finance officer to Plaza and whether he has authority to approach Andando to undertake this assignment.
Purpose of the assignment
The purpose must be clarified. Duncan’s approach to Andando is ‘to advise on a bid’. However, Andando cannot make executive decisions for a client but only provide the facts of material interest. Plaza’s management must decide whether or not to bid and, if so, how much to bid.
Scope of the due diligence review
It seems likely that Plaza will be interested in acquiring all of MCM’s business as its areas of operation coincide with Plaza’s. However it must be confirmed that Plaza is not merely interested in acquiring only the National or International business of MCM.
Andando’s competence and experience
Andando should not accept the engagement unless the firm has experience in undertaking due diligence assignments. Even then, the firm must have sufficient knowledge of the territories in which the businesses operate to evaluate whether all facts of material interest to Plaza have been identified.
Resources available
Whether the firm has sufficient resources available
(e.g. representative/associated offices) in Europe and Asia to investigate MCM’s International business.
Threats to objectivity and independence
For example, if Duncan is closely connected with a partner in
Andando or if Andando is the auditor of Frontiers.
Tutorial note: Candidates will not be awarded marks for going into ‘autopilot’ on independence issues. For example, this is a one-off assignment so size of fee is not relevant. Andando holding shares in MCM is not possible (since wholly owned).
Rationale for the acquisition
Presumably it is significant that MCM operates in the same territories as Plaza. Plaza may be intending to provide extensive training programs in management, communications and marketing to its workforce.
Relationship between Plaza and MCM
Plaza may be a major client of MCM. That is, Plaza is currently outsourcing training to MCM. Acquiring MCM would bring training in-house.
Tutorial note: Ascertaining what a purchaser hopes to gain from an acquisition before the assignment is accepted as important. The facts to be uncovered for a merger from which synergy is expected will be different from those relevant to acquiring an investment opportunity.
Time available
Andando must have sufficient time to find all facts that would be of material interest to Plaza before disclosing their findings.
Access to information
Whether there will be restrictions on Andando’s access to information held by MCM (e.g. if there will not be access to board minutes) and personnel.
Due diligence
Degree of secrecy required
This may go beyond the normal duties of confidentiality not to disclose information to outsiders (e.g. if unannounced staff redundancies could arise).
Plaza’s current auditors
Why have they not been asked to conduct the due diligence review, especially as they are responsible for (and therefore capable of undertaking) the group audit covering the relevant countries?
Communication with the current auditor
Andando should be allowed to communicate with Plaza’s current auditor:
– to inform them of the nature of the work they have been asked to undertake, and
– to enquire if there is any reason why they should not accept this assignment.
Other services that can be offered
In taking on Plaza as a new client Andando may have a later opportunity to offer external audit and other services to Plaza (e.g. internal audit).
- Procedures
Tutorial note: These should be focused on uncovering facts that may not be revealed by the audited financial statements (e.g. contingencies, commitments and contracts) especially where knowledge may be confined to management.
– Review management contracts to identify whether any members of MCM’s senior/executive management have contractual terms that will result in significant pay-outs to them on change of ownership of the company or their being made redundant.
– Enquire of management if there are there any major clients who are likely to be lost, or any contracts with clients that will lapse or be made void in the event that MCM is purchased by Plaza.
– Review lease agreements to identify the principal terms of the leases relating to the International business’s premises and whether penalties are likely to be incurred if leases are terminated.
– Enquire of management whether MCM has entered into any purchase commitments since the last audited financial statements (e.g. to buy or lease further premises).
– Enquire of management who the best trainers are that Plaza should seek to retain after the purchase of MCM.
– Review board minutes to identify if any events have occurred since the last audited financial statements were published that have made a significant impact on MCM’s assets, liabilities, operating capability and/or cash flows.
– Review correspondence with the tax authority to identify any outstanding tax issues, tax investigations or unpaid taxes which could result in additional costs.
– Review legal correspondence to identify any outstanding legal issues which could result in additional costs.
– Review the trend of MCM’s profit (gross and net) for the last five years (say). Similarly earnings per share and gearing.
– For both the National and International businesses compare:
– gross profit, net profit, and return on assets for the last five years
– actual monthly revenue against budget for the last 2 years
– actual monthly salary costs against budget for the last 2 years
– actual monthly freelance consultancy fees against budget for the last 2 years
– actual monthly premises costs (e.g. depreciation, lease rentals, maintenance, etc.) against budget for the last 2 years.
– Review projections of future profitability of MCM against net profit percentage for:
– the National business (10.4%)
– the International business (38.1 %)
– overall (19.9%).
– Review of disposal value of owned premises against carrying values.
– Compare actual cash balances with budget on a monthly basis and compare borrowings against loan and overdraft facilities.
– Compare the average collection period for International trade receivables month on month since 31 December (when it was nearly seven months, i.e. $3.7/$6.3 × 365 days) and compare with the National business.
– Compare key performance indicators by centre for the last two years, for example:
– number of corporate clients
– number of delegates
– number of training days
– average revenue per delegate per day
– average cost per consultancy day
– gross and net profit margins
– return on centre assets
– average collection period
– average payment period
– liquidity ratio.
