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What is due diligence?

Due diligence is an investigation or audit of a potential investment or product to confirm all facts, that might include the review of financial records. Due diligence refers to the research done before entering into an agreement or a financial transaction with another party.

Investors perform due diligence before buying a security from a company. Due diligence can also refer to the investigation a seller performs on a buyer that might include whether the buyer has adequate resources to complete the purchase.

Stages of due diligence

Planning

As with any assurance engagement, sufficient planning is crucial to enable the reporting accountant to carry out the procedures necessary and to carry out the assignment to the highest standards.

Gathering information

Once instructions have been taken from the client, the terms of the engagement have been agreed and sufficient planning has taken place, information can be gathered to enable the reporting accountant to report back to the client.

The gathering of the information for the due diligence assignment has to be carried out systematically and carefully having regard to the size, complexity and degree of risk associated with the target.  The reporting accountant will have carried out the planning in such a way as to identify the areas of the target entity which are material and those areas which can be safely ignored.

Types of information the reporting accountant would need in order to gather information is given as follows:

  • Accounting records.
  • Interim financial statements/management accounts.
  • Latest set of audited/unaudited financial statements, together with supporting analysis.
  • Tax computations.
  • Employee files.
  • Minute books.
  • Correspondence files.
  • Statutory information such as the Articles of Association, Annual Returns, List of Directors/Shareholders.
  • Details of the group structure (where applicable).
  • Access to management to hold discussions and to corroborate any issues flagged up during the planning.

Working Papers

Work undertaken during the due diligence should be documented in accordance with the firm’s procedures.  Again, whilst the due diligence exercise is not an audit, compliance with ISA 230 (revised) ‘Audit Documentation’ may be considered appropriate by the reporting accountant.

Indeed, a working paper file relevant to a due diligence assignment should be structured in such a way that it facilitates cross-referencing of material items.  It also facilitates the cross-referencing of the planning memorandum to the detailed working papers (especially where certain areas identified at the planning stage of the assignment are judged critical).

Finally, a well-structured due diligence file will help answers questions asked by the client swiftly, especially in face-to-face meetings.

Reporting

The form of reporting should be agreed at the outset of the assignment. The purpose of the due diligence exercise is to provide the potential investor with the information and professional commentary they need in order to be able to make informed decisions about the target entity.

Typically such reports would consist of:

  • Scope of the engagement.
  • Executive summary.
  • History of the target.
  • Nature of the target including its business, group structure, internal processes, principal activities etc.
  • Statutory information held with (say) the Registrar of Companies.
  • Details of the internal structure of the target.
  • Financial reporting and accounting controls.
  • Critical accounting policies.
  • Summary of the latest approved financial statements and a summary of any available up-to-date management/interim accounts.
  • Review of the financial position of the target (balance sheet).
  • Details of any fixed and/or floating charges or preferential creditors.
  • Details of mortgages and financing.
  • Commentary relating to the entity’s cash flow.
  • Taxation issues.
  • Reviews of budgeted information and projections.
  • Future plans for the business.
  • Other relevant matters.
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