18

DUE DILIGENCE, INVESTIGATION

& FORENSIC AUDIT
LEARNING OUTCOMES

After studying this chapter, you will be able to:

 Know the concept of Due Diligence, Investigation and Forensic Audit.

 Differentiate between Audit and Investigation.

 Know the steps to be taken at the time of Investigation.

 Understand the purpose of Due diligence and content of its report

 Gain knowledge of Forensic Audit Techniques and content of its report.

CHAPTER OVERVIEW

Unit 1 : Due Diligence Unit 2 : Investigation Unit 3 : Forensic Audit

• Purpose • Steps in Investigation • Meaning

• Classification • Special Issues in • Fraud and Procedures
• Content of Due Investigations • Forensic Audit
Diligence Report • Audit V/s. Investigation Techniques

© The Institute of Chartered Accountants of India

 18.2 ADVANCED AUDITING AND PROFESSIONAL ETHICS

UNIT 1 : DUE DILIGENCE

1. OVERVIEW
Due Diligence is used to investigate and evaluate a business
opportunity. It implies a general duty to exercise care in any
transaction. Most legal definition of due diligence describe it
as a measure of prudence activity, or assiduity, as is properly
to be expected from, and ordinarily exercised by, a
reasonable and prudent person under the particular
circumstance, not measure by any absolute standard but
depends on the relative facts of the special case. Image: Due Diligence File 
Due diligence is a process of investigation, performed by investors, into the details of a potential
investment such as an examination of operations and management and the verification of material
facts. It entails conducting inquiries for the purpose of timely, sufficient and accurate dis closure of
all material statements/information or documents, which may influence the outcome of the
transaction.
Due diligence involves an analysis carried out before acquiring a controlling interest in a company
to determine that the determine that the conditions of the business conform with what has been
presented about the target business. Also due diligence can apply to recommendation for an
investment or advancing a loan/credit.
Due Diligence may also required to be performed in cases of corporate restructuring, venture capital
financing, lending, leveraged buyouts, public offerings, disinvestment, corporatisation, etc.
Sometimes, in a restructuring exercise, while the unit may remain within a group, it may pass from
under the charge of one management team to that of another team. This situation also gives rise to
the need for a due diligence review.

2. DIFFERENCE BETWEEN DUE DILIGENCE AND AUDIT

It needs be underlined that due diligence is different from audit. Audit is an independent examination
and evaluation of the financial statements on an organization with a view to express an opinion
thereon. Whereas, due diligence refers to an examination of a potential investment to confirms all


Source: www.lyagency.co.ke

© The Institute of Chartered Accountants of India

 DUE DILIGENCE, INVESTIGATION & FORENSIC AUDIT 18.3

material facts of the prospective business opportunity. It involves review of financial and non -
financial records as deemed relevant and material. Simply put, due diligence aims to take the care
that a reasonable person should take before entering into an agreement or a transaction with another
party.

3. IMPORTANCE OF DUE DILIGENCE

When a business opportunity first arises, it continues throughout the talks, initial data collection and
evaluation commence. Thorough detailed due diligence is typically conducted after the parties
involved in a proposed transaction have agreed in principle that a deal should be pursued and after
a preliminary understanding has been reached, but prior to the signing of a binding contra ct.
There are many reasons for carrying out due diligence including:
To confirm that the business is what it appears to be;
To identify potential ‘deal killer’ defects in the target and avoid a bad business transaction;
To gain information that will be useful for valuing assets, defining representations and
warranties, and/or negotiating price concessions; and
To verify that the transaction complies with investment or acquisition criteria.

4. CLASSIFICATION OF DUE-DILIGENCE
The purpose of due diligence is to assist the purchaser or the investor in finding out all the
reasonably can about the business he is acquiring or investing in prior to completion of the
transaction including its critical
Commercial or success factors as well as its
Operational Due Diligence
strength and weaknesses.
Financial Due Diligence
In addition, it may expose problems
Tax Due Diligence or potential problems that can be
addressed in the price negotiations
Legal Due Diligence
or by dealing suitable clauses in the
Environmental Due
Diligence contractual documentation, in
particular, warranty and or
Personnel Due Diligence
indemnity provisions.
Due Diligence can be sub-classified into discipline-wise exercises in following manner:
(i) Commercial/Operational Due Diligence: It is generally performed by the concerned acquire
enterprise involving an evaluation from commercial, strategic and operational perspectives. For
example, whether proposed merger would create operational synergies.

© The Institute of Chartered Accountants of India

 18.4 ADVANCED AUDITING AND PROFESSIONAL ETHICS

(ii) Financial Due Diligence: It involves analysis of the books of accounts and other information
pertaining to financial matters of the entity. It should be performed after completion of
commercial due diligence.
(iii) Tax Due Diligence: It is a separate due diligence exercise but since it is an integral component
of the financial status of a company, it is generally included in the financial due diligence. The
accountant has to look at the tax effect of the merger or acquisition.
(iv) Information Systems Due Diligence: It pertains to all computer systems and related matter
of the entity.
(v) Legal Due Diligence: This may be required where legal aspects of functioning of the entity
are reviewed.
The legal aspects of property owned by the entity or compliance with various
statutory requirements under various laws.
(vi) Environmental Due Diligence: It is carried out in order to study the entity’s environment, its
flexibility and adaptiveness to the acquirer entity.
(vii) Personnel Due Diligence: It is carried out to ascertain that the entity’s personnel policies
are in line or can be changed to suit the requirements of the restructuring.

Financial Due Diligence

At times, the financial due diligence review is interpreted as complete due diligence review since it
is supposed to ascertain the financial implications of all the other due diligence reviews. This is,
however, not appropriate. The term 'financial due diligence' should be used with caution. Unless the
scope of financial due diligence to be performed is wide enough to cover all the aspects, it should
not be confused with overall due diligence review.
It can be understood from the foregoing that the role of financial due dilig ence commences after a
price has been agreed for the business. The initial price and other decisions are taken on the basis
of net worth as well as trend of profitability of the target company, with an assumption that all
contingent liabilities that may impact the future of the business have been recorded. The principal
objective of financial due diligence, therefore, is usually to look behind the veil of initial information
provided by the company and to assess the benefits and costs of the proposed acquis ition/merger
by inquiring into all relevant aspects of the past, present and future of the business to be
acquired/merged with.
In order to achieve its objective, the due diligence process can include any or all of the following
objectives for individual areas of the verification:
 Brief description of the history of business
 The background of promoters
 Accounting policies and practices

© The Institute of Chartered Accountants of India

 DUE DILIGENCE, INVESTIGATION & FORENSIC AUDIT 18.5

 Management information systems

 Details of management structure
 Trading results both past and the recent past
 Assets and liabilities as per latest balance sheet
 Current status of Income tax assessments including appeals pending against tax liabilities
assessed by tax authority.
 Cash flow patterns
 The projection of future profitability
If a full fledged financial due diligence is conducted, it would include the following matters, inter alia,
in its scope:
(a) Brief history of the target and background of its promoter; (b) Accounting policies;
(c) Review of financial statements; (d) Taxation;
(e) Cash flow; (f) Financial Projection;
(g) Management and employees; (h) Statutory Compliance.

(a) Brief history of the target and background of its promoters - The accountant should begin
the financial due diligence review by looking into the history of the company and the backgr ound of
the promoters.
The details of how the company was set up and who were the original promoters has to be gone
into, before verification of financial data in detail. An eye into the history of the target may reveal its
turning points, survival strategies adopted by the target from time to time, the market share enjoyed
by the target and changes therein, product life cycle and adequacy of resources. It could also help
the accountant in determining whether, in the past, any regulatory requirements have had an impact
on the business of the target. Broadly, the accountant should make relevant enquiries about the
history of target's business products, markets, suppliers, expenses, operations. This could, inter
alia, include the following:
 Nature of business(es)
Manufacturer, wholesaler,
financial services, import/export.
 Location of production facilities, warehouses, offices.
 Employment
By location, supply, wage levels, union contracts, pension commitments, government
regulation.
 Products or services and markets

© The Institute of Chartered Accountants of India

 18.6 ADVANCED AUDITING AND PROFESSIONAL ETHICS

Major customers and contracts, terms of payment, profit margins, market share,
competitors, exports, pricing policies, reputation of products, warranties, order book,
trends, marketing strategy and objectives, manufacturing processes.
 History of the business with important suppliers of goods and services
Long-term contracts, stability of supply, terms of payment, imports, methods of
delivery such as "just-in-time".
 Inventories
Locations,
Quantities.
 Franchises, licenses, patents.
 Important expense categories.
 Research and development.
 Foreign currency assets, liabilities and transactions.
 Legislation and regulation that significantly affect the entity.
 Information systems.
(b) Accounting policies - The accountant should study the accounting policies being followed
by the target and ascertain whether any accounting policy is inappropriate.
The accountant should also see the effects of the recent changes in the accounting policies. The
target might have changed its accounting policies in the recent past keeping in view its intention of
offering itself for sale.
The overall scope has to be based on the accounting policies adopted by the management. The
accountant has to look at the main effect of accounting policies on the overall profitability and their
correctness. It is reiterated that the accountant should mainly look at all material changes in
Accounting Policies in the period subjected to review very carefully.
The accountant's report should include a summary of significant accounting policies used by the
target, that changes that have been made to the accounting policies in the recent past, the areas in
which accounting policies followed by the target are different from those adopted by the acquiring
enterprise, the effect of such differences.
(c) Review of Financial Statements - Before commencing the review of each of the aspect
covered by the financial statements, the accountant should examine whether the financial
statements of the target have been prepared in accordance with the Statute governing the target,
Framework for Preparation and Presentation of the Financial Statements and the relevant
Accounting Standards. If not the accountant should record the deviations from the above and
consider whether it warrant an inclusion in the final report on due diligence.

© The Institute of Chartered Accountants of India

 DUE DILIGENCE, INVESTIGATION & FORENSIC AUDIT 18.7

After having an overall view of the financial statements, as mentioned in the above paragraphs, the
accountant should review the operating results of the target in great detail. It is important to make
an evaluation of the profit reported by the target. The reason being that the price of the target would
be largely based upon its operating results.
The accountant should consider the presence of an extraordinary item of income or expense that
might have affected the operating results of the target.
It is advisable to compare the actual figures with the budgeted figures for the period under review
and those of the previous accounting period. This comparison could lead the accountant to the
reasons behind the variations. It is important that the trading results for the past four to five years
are compared and the trend of normal operating profit arrived at.
The normal operating profits should further be benchmarked against other similar companies.
Besides the above, and based on the trend of operating results, the accountant has to advise the
acquiring enterprise, through due diligence report, on the indicative valuation of the business.
In the case of many enterprises, the valuation is mainly based on the value of net assets only. For
valuation of immovable properties and plant, if required, the assistance of expert valuers could also
to be taken. The exercise to evaluate the balance sheet of the target company has to take into
consideration the basis upon which assets have been valued and liabilities have been recognised.
The net worth of the business has to be arrived at by taking into account the impact of over/under
valuation of assets and liabilities. The accountant should pay particular attention to the valuation o f
intangible assets.
The objective of the Due Diligence exercise will be to look specifically for any hidden
liabilities or over-valued assets.
Hidden Liabilities:

The company may not show any show cause notices which have not matured into demands,
as contingent liabilities. These may be material and important.
The company may have given “Letters of Comfort” to banks and Financial Institutions. Since
these are not “guarantees”, these may not be disclosed in the Balance sheet of the target
company.
The 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. These may not be reflected in the books of accounts of the company.
Product and other liability claims; warranty liabilities; product returns/discounts; liquidated
damages for late deliveries etc. and all litigation.
Tax liabilities under direct and indirect taxes.
Long pending sales tax assessments.

© The Institute of Chartered Accountants of India

 18.8 ADVANCED AUDITING AND PROFESSIONAL ETHICS

Pending final assessments of customs duty where provisional assessment only has been
completed.
Agreement to buy back shares sold at a stated price.
Future lease liabilities.
Environmental problems/claims/third party claims.
Unfunded gratuity/superannuation/leave salary liabilities; incorrect gratuity valuations.
Huge labour claims under negotiation when the labour wage agreement has already expired.

Over-Valued Assets :

Uncollected/uncollectable receivables.
Obsolete, slow non-moving inventories or inventories valued above NRV; huge inventories of
packing materials etc. with name of company.
Underused or obsolete Plant and Machinery and their spares; asset values which have been
impaired due to sudden fall in market value etc.
Assets carried at much more than current market value due to capitalization of
expenditure/foreign exchange fluctuation, or capitalization of expenditure mainly in the nature
of revenue.
Litigated assets and property.
Investments carried at cost though realizable value is much lower.
Investments carrying a very low rate of income / return.
Infructuous project expenditure/deferred revenue expenditure etc.
Group Company balances under reconciliation etc.
Intangibles of no value.
(d) Taxation - Tax due diligence is a separate due diligence exercise but since it is an integral
component of the financial status of a company, it is generally included in the financial due diligence.
It is important to check if the company is regular in paying various taxes to the Government. The
accountant has to also look at the tax effects of the merger or acquisition.
(e) Cash Flow - A review of historical cash flows and their pattern would reflect the cash
generating abilities of the target company and should highlight the major trends. It is important to
know if the company is able to meet its cash requirements through internal accruals or does it have
to seek external help from time to time.
It is necessary to check that:
(a) Is the company able to honour its commitments to its trade payables, to the banks, to

© The Institute of Chartered Accountants of India

 DUE DILIGENCE, INVESTIGATION & FORENSIC AUDIT 18.9

government and other stakeholders

(b) How well is the company able to turn its trade receivables and inventories
(c) How well does it deploy its funds
(d) Are there any funds lying idle or is the company able to reap maximum benefits out of the
available funds?

(f) Financial Projections - The accountant should obtain from the target company the
projections for the next five years with detailed assumptions and workings. He should ask the target
to give projections on optimistic, pessimistic and most likely bases.
The accountant evaluates the appropriateness of assumption used in the preparation and
presentation of financial projections. If, the accountant is of the opinion that as assumption
used by the target is unrealistic, the accountant should consider its impact on the overall
valuation of the company. He should offer his comments on all the assumption, highlighting those
which, in his opinion are not inappropriate. In case he feels the projections provided by the target
are not achievable or aggressive he has to mention this in his report. He should thoroughly check
the arithmetic of the calculations made for financial projections.
(g) Management and Employees - In most of the companies which are available for take over
the problem of excess work force is often witnessed. It is important to work out how much of the
labour force has to be retained. It is also important to judge the job profile of the administrative and
managerial staff to gauge which of these match the requirements of the new incumb ents. Due to
complex set of labour laws applicable to them, companies often have to face protracted litigation
from its workforce and it is important to gauge the likely impact of such litigation.
It is important to see if all employee benefits like Provident Fund (P.F.), Employees State
Insurance (E.S.I.), Gratuity, leave and Superannuation have been properly paid/ provided
for/funded. In case of un-funded Gratuity, an actuarial valuation of the liability has to be
obtained from a reputed actuary.
The assumptions regarding increase in salaries, interest rate, retirement etc. have to be gone into
to see if they are reasonable. It is also necessary to see if the basic salary /wage considered for the
valuation is correct and includes all elements subject to payment of Gratuity. In the case of PF, ESI
etc. the accountant has to see if all eligible employees have been covered.
It is very important to consider the pay packages of the key employees as this can be a crucial factor
in future costs. One has to carefully look at Employees Stock Option Plans; deferred compensation
plans; Economic Value Addition and other performance linked pay; sales incentives that have been
promised etc. It is also important to identify the key employees who will not continue after the
acquisition either because they are not willing to continue or because they are to be transferred to
another company within the 'group' of the target company.
(h) Statutory Compliance - During a due diligence this is one aspect that has to be investigated
in detail. It is important therefore, to make a list of laws that are applicable to the entity as well as to

© The Institute of Chartered Accountants of India

 18.10 ADVANCED AUDITING AND PROFESSIONAL ETHICS

make a checklist of compliance required from the company under those laws. If the comp any has
not been regular in its legal compliance it could lead to punitive charges under the law. These may
have to be quantified and factored into the financial results of the company.

5. WORK APPROACH TO DUE DILIGENCE

The purchase of business in many instances is the largest and most expensive assets purchase in
life time and therefore some caution should be exercised through the due diligence process.
Therefore, assessing the businesses fair value passes through.

Reviewing and reporting on the Assessing the business first

financials submitted by the hand by a site visit (if
target company. applicable).

Working through the

Helping prepare an
due diligence process
offer based on
with the acquisitioning
completion of due
company or investor by
diligence.
defining the key areas.

Discovering the correct strategy is always challenging, and even more so during challenging
economic circumstances. Each situation is unique. The variables are numerous, including factors
such as company age, markets, geography, price levels, competitive dynamics, to name but a few.
But when a company and its products are turned to match market needs and expectations -that is,
the decision markers and influencers involved in purchase decision-exceptional changes in
performance can occur. However, comprehensive model that describes this approach to the work
is illustrated in the figure below:

Diagnose

Define Defend
Discover Delivery

Design

Figure : Six Dimensional Process Framework

© The Institute of Chartered Accountants of India

 DUE DILIGENCE, INVESTIGATION & FORENSIC AUDIT 18.11

6. HOW TO CONDUCT DUE DILIGENCE

Image : Due Diligence Process 

Start with an open mind. Do not assume that anything wrong will be found and look for it. What
needs to be done is to identify trouble spots and ask for explanations.
Get the best team of people. If you do not have a group of people inside your firm that can do
the task (e.g. lack of staff, lack of people who know the new business because you are acquiring
a business in an unrelated areas, etc.), there are due diligence experts that you can hire. When
hiring such professionals, look for their experience record in the industry.
Get help in all areas like finance, tax accounting, legal, marketing, technology, and any others
relevant to the assignment so that you get a 36-degree view of the acquisition candidate.
Talk to customers, suppliers, business partners, and employees are great resources.
Take a risk management approach. So, while you want to do your research, you also want to
make sure that you do not antagonise the team of people of the target company by bogging
them down with loads of questions.
Prepare a comprehensive report detailing the compliances and substantive risks/issues.


Source: Mazars.sg

© The Institute of Chartered Accountants of India

 18.12 ADVANCED AUDITING AND PROFESSIONAL ETHICS

7. CONTENTS OF A DUE DILIGENCE REPORT

The contents of a due diligence report will always vary with individual circumstances. Following
headings are illustrative:
Example of Headings of a Due Diligence Report
 Executive Summary
 Introduction
 Background of Target
 Objective of due diligence
 Terms of reference and scope of verification
 Brief history of the company
 Share holding pattern
 Observations on the review
 Assessment of management structure
 Assessment of financial liabilities
 Assessment of valuation of assets
 Comments on properties, terms of leases, lien and encumbrances.
 Assessment of operating results
 Assessment of taxation and statutory liabilities
 Assessment of possible liabilities on account of litigation and legal proceedings against the
company
 Assessment of net worth
 Interlocking investments and financial obligations with group / associates companies,
amounts receivables subject to litigation, any other likely liability which is not provided for in
the books of account
 SWOT Analysis
 Comments on future projections
 Status of charges, liens, mortgages, assets and properties of the company
 Suggestion on ways and means including affidavits, indemnities, to be executed to cover
unforeseen and undetected contingent liabilities
 Suggestions on various aspects to be taken care of before and after the proposed
merger/acquisition.

© The Institute of Chartered Accountants of India