[FAQs] on Due Diligence, Investigation & Forensic Accounting – Procedure | Differences

1. Studying the Business History: Accountant should make relevant enquiries about history of target’s business products, markets, suppliers, expenses, operations.
2. Significant Accounting Policies: Study accounting policies followed and ascertain whether any accounting policy is inappropriate.
3. Review of F.S.: Examine whether F.S. of target company have been prepared in accordance with the Statute governing the target entity, Framework for Preparation and Presentation of the F.S. and the relevant ASs. Review operating results of the target entity in great detail.
4. Taxation: Check whether business is regular in payment of taxes to Govt. Also look at the tax effects of the merger or acquisition.
5. Cash Flow: Review historical cash flows and their pattern to determine cash generating abilities. Check whether entity is able to honour its commitments to its trade payables, to the banks, to government and other stakeholders.
6. Financial Projections: Evaluate projections for the next 5 years with detailed assumptions and workings and the appropriateness of assumption used in the preparation and presentation of financial projections. If assumption used by the company appears to be are unrealistic, consider its impact on the overall valuation of the company.
7. Management and Employees: Examine status of work force, staff and employees and their retention. Match the job profile of the administrative and managerial staff with the requirements of the new incumbents.
8. Statutory Compliance: Make a list of laws that are applicable to the entity as well as to make a checklist of compliance required under those laws.

• Audit is an independent examination and evaluation of F.S. on an organization with a view to express an opinion thereon.
• Due diligence refers to an examination of a potential investment to confirms all material facts of prospective business opportunity. It involves review of financial and non-financial records as deemed relevant and material. It aims to take the care that a reasonable person should take before entering into an agreement or a transaction with another party.

Regularly Overvalued assets: Examine the following areas:

• Uncollectible receivables.
• Obsolete, slow and non-moving inventories and inventories valued above NRV, if any.
• Obsolete and unused plant and machinery and their spares.
• Assets value of which have impaired due to sudden fall in market value.
• Assets shown in books above market value due to capitalization of expenditure/foreign exchange fluctuation or capitalisation of revenue expenditure.
• Assets under litigation.
• Investment shown at cost whose market value is much lower.
• Investment carrying very low rate of return.
• Infructuous project expenditure.
• Intangibles of no value.

In order to ensure that the manufacturing unit will be able to meet the cash requirements internally, one is required to verify:

• Is the company able to honour its commitments to its trade payables, to the banks, to the government and other stakeholders?
• How well is the company able to convert its trade receivables and inventories?
• How well the Company deploys its funds?
• Are there any funds lying idle or is the company able to reap maximum benefits out of the available funds?
• What is the investment pattern of the company and are they easily realizable?

In order to investigate hidden liabilities, following areas need to be examined:

• Any show cause notice, which have not matured into demands but may be material and important.
• Contingent liabilities not shown in books.
• Company may have sold some subsidiaries/businesses and may have agreed to take over and indemnify all liabilities and contingent liabilities of the same prior to the date of transfer.
• Product and warranty liabilities, product returns & discounts, liquidated damages, etc.
• Tax liability under direct and indirect taxes.
• Long pending sales tax assessment.
• Cases of custom duty where only provisional assessment has been made and final assessment is yet to completed.
• Agreement to buy back shares at a stated price.
• Future lease liabilities.
• Claims against the company including third party claims.
• Unfunded retirement benefit of employees.
• Labour claims under negotiations.

1. Executive summary
2. Introduction
3. Objective of due diligence
4. Terms of reference and scope of verification
5. Brief history of the company
6. Summary on capital structure and group structure of company
7. Shareholding pattern
8. Observations on the review
9. Assessment of Management structure
10. Assessment of financial liabilities
11. Assessment of valuation of assets
12. Assessment of operating results
13. Assessment of taxation and statutory liabilities
14. Assessment of possible liabilities on account of litigation
15. Assessment of net worth
16. Any liabilities not provided for in the books
17. SWOT analysis comments on future projections
18. Status on charges, liens, mortgages and assets of the company
19. Ways and means to cover unforeseen contingent liabilities
20. Aspects to be taken care of before/after merger
21. Interlocking investments and financial obligations with group/associate companies amounts receivable subject to litigation.

• Auditing involves examination of financial information contained in financial statements to express an opinion whether or not the same have been prepared properly. In essence, auditing involves independent examination of financial information prepared by the management of an entity.
• Investigation implies systematic, critical and special examination of the records of a business for a specific purpose.
• Difference between audit and investigation are given below:

In assessing the turnover which the business would be able to maintain in the future, the following factors should be taken into account:

1. Trend: Whether in the past, sales have been increasing consistently or they have been fluctuating. A proper study of this phenomenon should be made.
2. Marketability: Is it possible to extend the sales into new markets or that these have been fully exploited? Product wise estimation should be made.
3. Political and economic considerations: Are the policies pursued by the Government likely to promote the extension of the market for goods to other countries? Whether the sales in the home market are likely to increase or decrease as a result of various emerging economic trends?
4. Competition: What is the likely effect on the business if other manufacturers enter the same field or if products which would sell in competition are placed on the market at cheaper price? Is the demand for competing products increasing? Is the company’s share in the total trade constant or has it been fluctuating?

1. The report should not contain anything which is not relevant.
2. Expressions used should be properly considered so that the possibility of arriving at a different meaning or interpretation other than the one intended by the investigator can be minimized.
3. Relevant facts and conclusions should be properly linked.
4. Bases and assumptions made should be explicitly stated.
5. Report should clearly spell out the nature and objective of the assignment, its scope and limitations, if any.
6. Report should be made in paragraph form with headings for the paragraphs.
7. Report should also state restrictions or limitations, if any, imposed on the instructions given by the client.
8. Opinion of the investigator should appear in the final paragraph of the report.

1. If the statements of account produced before the investigator were not audited by a qualified accountant, then of course there arises a natural duty to get the figures in the accounts properly checked and verified.
2. However, when the accounts produced to the investigator have been specially prepared by a professional accountant, who knows or ought to have known that these were prepared for purposes of the investigation, he could accept them as correct relying on the principle of liability to third parties.
3. Nevertheless, it would be prudent to see first that such accounts were prepared with objectivity and that no bias has crept in to give advantage to the person on whose behalf these were prepared.

Reliance on Audited Statement of Accounts:
If the investigation has been launched because of some doubt in the audited statement of account, no question of reliance on the audited statement of account arises. However, if the investigator has been requested to establish value of a business or a share or the amount of goodwill payable by an incoming partner, ordinarily the investigator would be entitled to put reliance on audited materials made available to him unless, in the course of his test verification, he finds the audit to have been carried on very casually or unless his terms of appointment clearly require to test everything afresh.

1. The adequacy or otherwise of fixed and working capital. Are these sufficient for the growth of the business?
2. What will be the trend of the sales and profits in the future? Establishing the trend of sales, product-wise and area-wise will ordinarily help in drawing a conclusion on whether the trend will be maintained in the future.
3. Whether the profit which the business could be expected to maintain in the future would yield an adequate return on the capital employed?
4. Whether the business is operating at its 100 percent capacity or improvements can be made to reach at full productivity?

Investigation on behalf of incoming partner is carried out so as to ascertain whether the terms offered to him are reasonable having regard to the nature of the business, profit records, capital distribution, personal capability of existing partners, etc. Steps involved in investigation includes the following:

• Ascertaining the history of the firm since inception and growth of the firm.
• Studies of the provisions of the Deed of Partnership, particularly for composition of partners, their capital contribution, drawing rights, retirement benefits, job allocation, etc.
• Scrutiny of the record of profitability of the firm’s business over a suitable number of years.
• Examination of the asset and liability position to determine the tangible asset, investment, appraisal of the value of intangibles like goodwill, know-how, patents, etc. including contingent liabilities and those for pending tax assessment.
• Assess position of order at hand and the range and quality of clientele should be thoroughly examined under which the firm is presently operating.
• Scrutinize terms of loan finance to assess its usefulness and the implication for the overall financial position.
• Study important contractual and legal obligations. It may be the case that the firm has standing agreement with the employees as regards salary and wages, bonus, gratuity and other incidental benefits.
• Study the composition and quality of key personnel employed by the firm and any likelihood of their leaving the organisation.
• Ascertain reasons for the offer of admission to a new partner and it should be determined whether the same synchronizes with the retirement of any senior partner whose association may have had considerable impact having on the firm’s successes.
• Appraisal of the record of capital employed and the rate of returns. It is necessary to have a comparison with alternative business avenues for investments.
• Ascertain manner of computation of goodwill on admission as also on retirement, if any.
• Examine whether any special clause exist in the Deed of Partnership to allow admission in future a new partner.

A bank is primarily interested in knowing the purpose for which a loan is required, the sources from which it would be repaid and the security that would be available to it, if the borrower fails to pay back the loan. On these considerations, the investigating accountant, in the course of his enquiry, should attempt to collect information on the under-mentioned points:

• Purpose for which the loan is required.
• Manner in which the borrower proposed to invest the amount of the loan.
• Schedule of repayment of loan submitted by the borrower, particularly, the assumptions made therein as regards amounts of profits that will be earned in cash and the amount of cash that would be available for the repayment of loan to confirm that they are reasonable and valid in the circumstances of the case.
• Financial standing and reputation for business integrity enjoyed by the directors and officers of the company.
• Authorisation under Memorandum or the Articles of Association to borrow money for the purpose for which the loan will be used.
• History of growth and development of company and its performance during past 5 years.
• How economic position of the company would be affected by economic, political and social changes that are likely to take place during the period of loan.
• Whether any loan application to any other Bank or Financial Institution was made, and if so, the reasons for rejection thereof.

• Fixed assets

1. 1. Investigating accountant should prepare schedules of full description of each item, its gross value, the rate at which depreciation has been charged and the total depreciation written off.
   2. In case rate at which depreciation has been adjusted is inadequate, the fact should be stated.
   3. In case any asset is encumbered, the amount of the charge and its nature should be disclosed.
   4. In case an asset has been revalued recently, amount by which the value of the asset has been decreased or increased on revaluation should be stated along with the date of revaluation.

• Inventory

1. 1. Investigating accountant should prepare schedules of the value of different types of inventories held and the basis on which these have been valued.
   2. Details as regards the nature and composition of finished goods should be disclosed.
   3. Slow-moving or obsolete items should be separately stated along with the amounts of allowances, if any, made in their valuation.
   4. If any inventory has been pledged as a security for a loan, amount of loan should be disclosed.

• Trade Receivables, including bills receivable: Composition of trade receivables should be disclosed to indicate the nature of different types of debts that are outstanding for recovery; also whether the debts were being collected within the period of credit as well as the fact whether any debts are considered bad or doubtful and the provision if any, that has been made against them.

• Investments: Investigating accountant should prepare schedule of investments which disclose the date of purchase, cost and the nominal and market value of each investment. If any investment is pledged as security for a loan, full particulars of the loan should be given.

• Secured Loans

1. 1. Investigating accountant is required to include debentures and other loans together in a separate schedule.
   2. Against the debentures and each secured loan, the amounts outstanding for payments along with due dates of payment should be shown.
   3. In case any debentures have been issued as a collateral security, the fact should be stated.
   4. Particulars of assets pledged or those on which a charge has been created for re-payment of a liability should be disclosed.

• Provision of Taxation

1. 1. Investigating accountant should ascertain the period up to which taxes have been assessed.
   2. If provision for taxes not assessed appears in be inadequate, the fact should be stated along with the extent of the shortfall.

• Other Liabilities: Investigating accountant should state whether all the liabilities, actual and contingent, are correctly disclosed.

• Insurance

1. 1. Investigating accountant should prepare schedule of insurance policies giving details of risks covered, the date of payment of last premiums and the sum assured.
   2. He should also make a report as to whether or not the insurance-cover appears to be adequate, having regard to the value of assets.

• Contingent Liabilities

1. 1. Investigating accountant should ascertain particulars of any contingent liabilities which have not been disclosed.
   2. For this purpose, he may conduct direct enquiries from the borrower company and members of its staff.

Areas of embezzlement of cash receipts:

1. Issuing a receipt for full amount collected, entering lesser amount on the counterfoil.
2. Showing a larger cash discount than actually allowed.
3. Adjusting a fictitious credit in the account of a customer for goods returned.
4. Cash sales entered as credit sales with debit to customer.
5. Writing off a good debt as bad & irrecoverable to cover up misappropriation of amount collected.
6. Short-debiting customer’s ledger account and withdrawing the difference on collection of full amount.
7. Under-casting the receipts side of cash book.
8. Over-casting the payment side of the cash book.

Investigation of frauds through supplier’s ledger:

1. Verify the adjustments in fictitious or duplicate invoices as purchases in the accounts of suppliers and subsequently misappropriating the amounts when payments are made to the suppliers in respect of these invoices.
2. Check whether any Credit Notes issued by suppliers are being suppressed and the corresponding amounts not claimed by them is subsequently withdrawn.
3. Check whether any amount unclaimed by suppliers, for one reason or another is being withdrawn by showing that the same have been paid to suppliers.
4. Verify whether purchase invoices are accepted at prices considerably higher than their market prices.
5. Verify the bought journal with reference to entries in the Goods Inward Book and the suppliers’ invoices to confirm that amounts credited to the accounts of suppliers were in respect of goods, which were duly received, and the suppliers’ accounts had been credited correctly.
6. Request all the suppliers to furnish statements of their accounts to see whether or not any balance is outstanding or due so as to confirm that allowances and rebates given by them have been correctly adjusted.