Financial Due Diligence: Why an Audit is Not Enough?
There is a line of thinking that if a company is audited, what is the value of performing financial due diligence in the context of a purchase transaction. While an audit has many merits and does provide some comfort with respect to controls and reported numbers, investors need to consider a large number of other metrics that an audit is not designed to report on. Below are some key benefits to financial due diligence that an audit cannot provide:
An audit’s mandate is to give an opinion on whether management has presented a true and fair view of the company’s financial position and performance at a specific period of time and is not designed to address transaction specific interests such as quality of earnings, quality of working capital, quality of management or systems, etc. Audits are designed and report based on GAAP and GAAS. Financial due diligence, if done correctly, is designed and scoped based on the specific transaction objectives of the investor.
In most cases, a purchase transaction purchase price will be based on EBITDA (Earnings Before Interest, Taxes, Depreciation or Amortization) or include EBITDA as a variable factor in the purchase price or earn out calculation. Recurring EBITDA or normalized EBITDA is not an accounting measure and is not considered in an audit. Determining the quality of recurring EBITDA, normalizing adjustments, pro-forma impact of business changes, over / understated assets and liabilities, post-closing cost structure changes and inconsistent application of accounting policies, etc. are all part of financial due diligence and will in most cases have a direct impact on the purchase price of a transaction.
An audit will consider factors that impact revenues and expenses during an audit period; however, generally do not comment on the market drivers underlying the trends of a company’s operations. These trends are a critical part of understanding the sustainability of a company’s operating levels and expected changes thereto. Audits will report on historical periods while financial due diligence will focus on understanding the historical trends with a view on sustainability into the forecast and future periods.
Working capital is reported and analyzed in audit at single points in time. While informative, this does little to assist buyers to understand the relationship between operations, working capital and most importantly, cash flows. Looking at all of these relationships to understand if and when an investor may need to further invest in operations is critical in making the decision to close a transaction. Understanding the underlying drivers and relationships of working capital such as growth trends, industry movements, seasonality of the business, and conversion rates are all part of financial due diligence and are not part of the audit process.
Audits report on historical periods and generally stay away from commenting on future periods. Investors however, are interested in the forecast period and need to understand the future cash flows of the company because that is what they are buying. History is relevant to a buyer only to the extent it leads to insight on future operations. Financial due diligence analyzes forecast assumptions, expected cash flows, expected recurring earnings and expected cash flows from operations. Audit’s historical mandate does not provide insight into any of these key needs of investors.
An audit report is prepared based on well-defined rules and procedures for the general user of the financial statements. It has to be because the audit report is not addressed to any particular investor, rather the general shareholder of the company. A financial due diligence report is not a general report. It is a specific report designed with the needs of the investor and specific to transaction and target company. It is common that different potential investors of the same company will all have different due diligence reports on the same target company as the needs of each of the investors may be different. An audit has many uses; however, to an investor, a financial due diligence report will be more relevant and useful in the context of a transaction.
Rohit Prajapati is a Partner at BGD LLP and leads the Transaction Advisory Services Group.
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