Understanding the Differences Between an Audit and Financial Due Diligence

In the context of mergers and acquisitions, potential investors often feel a level of comfort when their investment target is audited.  However, relying solely on a target’s audited financial statements when making an investment decision may be shortsighted.[1]  An audit’s purpose is to provide assurance that management has presented a true and fair view of a company’s financial performance and position [2], but audited financials often do not identify significant issues likely to be of interest to a buyer or seller.

The financial due diligence process typically covers a wide range of areas, including legal, information technology, operational, marketing and financial matters.  Financial due diligence (often referred to as “accounting” due diligence) focuses on providing potential investors with an understanding of a company’s (i) sustainable economic earnings,[3] (ii) historical sales and operating expense trends, (iii) historical working capital needs, (iv) key assumptions used in management’s forecast, and (v) key personnel and accounting information systems.  Although audits may provide a starting point for a potential investor’s evaluation of a company, they generally do not comment on the focus areas noted above.

As an analogy demonstrating the difference between an audit and financial due diligence, imagine a close friend entrusts you to buy him a used car.[4]  Having searched the classifieds, you find what appears to be the perfect car, and the seller provides you with a certificate from a reputable mechanic.  The purpose of the certificate is to provide a certain degree of comfort that the car is roadworthy.

Although the certificate verifying the car’s roadworthiness is nice, you may insist on performing your own “due diligence”.  Personally inspecting the car, kicking the tires, and taking a test drive might make you more comfortable about your friend’s potential purchase.  In fact, you may even want to hire another mechanic that you know and trust to perform a more thorough inspection.  Your mechanic knows more about your specific concerns and can delve deeper into the car’s history, operational features, and maintenance record to help you decide if it’s a lemon.

The financial due diligence provider is that second mechanic.  Based on the investor’s specific concerns, the financial due diligence provider can alter the scope of the engagement to address specific key risks.  The diligence provider can “kick the tires” and delve deeper into deal breaker issues and other potential areas of concern.

Quality of earnings

For obvious reasons, investors are particularly concerned with the fair valuation of the business.  Because businesses are often valued based on a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization),[5] financial due diligence providers focus on the “quality,” or sustainability, of the company’s earnings.  Unusual or non-recurring income and expense items, over/understated assets and liabilities, post-closing cost structure changes, and the inconsistent application of accounting principles are all analyzed to adjust historical EBITDA to reflect sustainable earnings.  The sustainability of a company’s EBITDA is not reflected in a standard audit report. The transaction advisory services team at Maxwell Locke & Ritter has performed hundreds of Quality of Earnings (“QoE”) engagements on SaaS and other recurring revenue companies.

Trend analysis

Audit procedures may include analytics to understand trends and relationships over the historical period, but audit reports do not comment on the market drivers behind those trends.  Financial due diligence reports address key market drivers, sales strategies, customer relationships and customer churn, and attempt to understand whether the trends reflected in the financials are sustainable.  Financial due diligence providers may also analyze the target’s cost structure and vendor relationships to identify potential post-transaction synergies.

Working capital

Buyers and sellers typically negotiate a “target” working capital to be delivered at transaction close.  The negotiated amount is usually based on the average working capital balances over the previous twelve months, but a sophisticated buyer may also consider (i) recent growth trends, (ii) industry conditions, (iii) the seasonality of the business, and (iv) the specific composition of working capital balances.  An audit report does not provide insight into monthly working capital accounts, putting the buyer at a significant disadvantage when negotiating the working capital target.

Forecast

Audits are concerned with historical financial statements only.[6]  Investors, however, are more interested in the company’s ability to sustain and grow earnings.  For that reason, investors need to understand the key assumptions used by the company’s management team in assembling the forecast.  Financial due diligence providers often analyze the company’s forecast and document the key assumptions to enable the investor to assess the feasibility of that forecast.

Qualitative observations

Perhaps most importantly, the financial due diligence provider may provide the investor with key qualitative observations from discussions with management.  These observations may include key findings regarding the Company’s internal control structure, management and accounting team, and accounting information systems.  Qualitative observations rarely appear in audited financial statements, but may be just as important in helping a buyer make an investment decision.

Summary

An audit provides assurance that management has presented a true and fair view of a company’s financial performance and position in accordance with well-defined rules and procedures.  For a buyer to make a well-informed investment decision, however, he/she should understand that an audit is a complement to, rather than a substitute for, a specifically tailored financial due diligence investigation of the investment target.[7]

Footnotes:

[1] Jim Woods, Due Diligence or Audit: It’s All in a Name; 31 (February 2002); http://app1.hkicpa.org.hk/publications/society_journals/2002/2002-02/26-28.pdf.

[2] Understanding the Financial Statement Audit; 3 (January 2013); www.pwc.com/gx/en/audit-services/publications/understanding-financial-audit.jhtml.

[3] Baker Tilly, Ten Considerations in a Quality of Earnings Study; (September 12, 2013); available at www.bakertilly.com/ten-considerations-in-a-quality-of-earnings-study.

[4] Woods, supra note 1, at 31.

[5] Don Busby, What’s Your Business Worth? Start with Your Profitability and Go from There; Austin Business Journal, November 21, 2014, at page 12.

[6] Sherif Andrawes, Mergers and Acquisitions – Financial Due Diligence; www.bdo.com.au/resources/articles/advisory/mergers-and-acquisitions-financial-due-diligence.

[7] Woods, supra note 1, at 32.

About the Authors:

Brandon Lamb and Lathrop Smith of Maxwell Locke & Ritter LLP in Austin, Texas contributed to this article.  They can be reached at 512-370-3200 or blamb@mlrpc.com and lsmith@mlrpc.com