FEATURES
Due Diligence or Audit:
It’ s All in a Name
30
The Hong Kong
ACCOUNTANT
FEBRUARY 2002
FEATURES
I
t is often cited that the majority of
M&A transactions fail to achieve
the returns targeted in the original
investment/divestment proposal. Put
another way, as a buyer or seller, you
have a 50% likelihood, at best, that
you will succeed in realizing the value
that drove you to do the deal – and a
much greater chance that you will
not!
Are you willing to risk your
reputation, renege on your fiduciary
duty to your shareholders to exercise
due skill and care, and leave things
to c hance? How ca n you ma ke
success a reality – and leave failure
to others? Read on…
Due Diligence – A Value
Added Exercise
High quality due diligence would be
a good st a rt i ng point . Thi s i s
particularly important in the Asia
Pacific region where a host of issues
are commonly encountered that impact
upon the deal appraisal process:
corporate governance considerations,
restatement of financial information in
a c c orda nc e wi th i nt e rna ti ona l
accounting standards, related party and
“off balance sheet” transactions, poor
quality information, transactions based
on informal business arrangements
rather than contractually defined terms
and conditions, tax, regulatory and
legal issues, complex group structures,
antiquated IT systems, HR and related
cultural issues – the list goes on.
The importance of a thorough and
well planned due diligence
investigation is well understood in
developed markets such as the US and
Europe. In contrast, in Asia the quality
of the deal evaluation and execution
process varies considerably – this in
spite of the perceived much increased
transaction risk in undertaking M&A
in this region . Whilst more
sophisticated investment professionals
tend to understand the meaning and
objectives of proper due diligence and
the value it can add to the transaction
process, short cuts are common both
for corporate and private equity
investors alike.
By way of example, this often
manifests itself in investors requesting
and relying on the performance of an
audit rather than due diligence – or
sellers relying on audited accounts
rather than striving to maximize the
return on divestment through a well
managed sale, incorporating a tailored
vendor due diligence process.
So What’s the Difference –
Due Diligence and Audit?
They are both undertaken by
accountants. They both involve a
review of financial information. Does
the name really matter?
Yes. Yes. Yes.
Imagine a close friend entrusts you
with a blank, signed cheque to go and
buy them a second hand Ferrari.
Having found what looks like the
perfect model, the owner provides you
with a certificate of roadworthiness
from a reputable garage – dated last
week. This certificate is required by
law to be updated on an annual basis
for all cars more than three years old.
The procedures to be performed by a
garage in providing the certificate are
set out therein. The purpose is to
provide a degree of comfort that the
car is roadworthy.
have made and/or the price you are
prepared to pay – for example any
repair or maintenance work that
might need performing. Why? For a
start you know you cannot rely on
the certificate of road-worthiness for
your own assessment purposes. The
procedures performed by the garage
in that respect were defined by
specific legal requirements and with
a di ffe re nt obj e ct i ve i n m ind.
Secondly, you have an obligation to
your friend to obtain an independent
expert opinion. They have entrusted
you with a substantial sum of money
and you need to be able to
demonstrate that you have spent it
sensibly and with due care. The
special report that you yourself have
c o m m i ss i on e d wi l l se r ve t h i s
purpose well.
This scenario, whilst admittedly
rather artificial, is similar to an
investment decision taken by corporate
or private equity management. They
are acting on behalf of the shareholders
or fund i nvestors and ha ve a n
obligation to exercise due skill and
care in the performance of their
duties. This includes, inter alia,
undertaking an appropriate level of
due diligence as part of the deal
...in Asia the quality of the deal
evaluation and execution process
varies considerably...
Woul d t hi s “ce rt i fic a t e ” be
sufficient for your purposes? Would you
r e l y o n t h e c u r re n t o w n e r ’ s
representations that the car has been
well maintained? Or would you insist
upon performing your own “due
diligence” procedures: a test drive, a
look under the bonnet, a close
inspection of the paintwork and doors
to ensure everything is in order and
“as expected”?
In fact, in addition to your own
due diligence, you would probably
also commission a garage of your
own choosing to perform certain
specific procedures with a view to
highlighting any deficiencies that
might impact upon the decision you
evaluation process. To rely solely on
the audited accounts of the target
company would be foolish, not to
mention negligent. To commission a
special audit, in the place of a proper
due diligence exercise, would also in
most cases be inappropriate – an audit
seeks to provide a degree of assurance
on a set of financial statements in
accordance with well defined rules and
procedures (see table below), not to
identify issues likely to be of interest
to a buyer or seller.
No Second Chance
To fail to appreciate the differences
between an audit and a due diligence
exercise can be a costly mistake to
make. It may result in the payment of
The Hong Kong
FEBRUARY 2002
ACCOUNTANT 31
FEATURES
Area
Who
Audit
• Accountants specialising in audit.
Objective
• An assurance / attest function.
• Provides a degree of comfort on
historical financial information.
Scope
• Dictated by Generally Accepted
Auditing Standards (“GAAS”)
• Involves detailed verification work
including sample testing of
transactions and balances.
• An audit opinion.
Deliverable
Cost
• Largely fixed:
- Scope dictated by GAAS
- Less possibility for overruns
- Commodity product
Due Diligence
• Not restricted to accountants.
• Should involve experienced M & A professionals.
• Identification of “deal issues”, impacting
- price
- financing / structuring
- contractual terms and conditions
- operational considerations
• A flexible process dictated by scope of work
determined by buyer / seller.
• Focused on “deal issues”. Limited detailed testing
or verification procedures.
• Varies. Usually a formal written report,
but may be a presentation or brief bullet
point summary of major issues.
• More variable
- Scope can vary from a one day desk top review
exercise to several weeks’ full scope due diligence
- Unless well managed, more difficult to provide accurate
cost estimate upfront
- Premium priced product
Table 1: Differences: Audit versus Due Diligence
fees for a service/product that is not
what you intended. At worst, to the
extent deal breaker issues or areas of
upside are not identified – because you
requested an audit – you will have been
negligent in your duty to your
shareholders. Ignorance is not an
option.
Is There a Place for an
Audit in the M&A
Process at All?
The due diligence process is
completed, and no issues have been
identified of such magnitude that would
result in the deal being aborted.
However concerns have been raised
as to the quality of certain assets in
the balance sheet, and the full inclusion
of liabilities. You are also concerned
about cash being extracted from the
business between signing and closing
and the potential adverse impact on
working capital. How can you gain
additional comfort at closing that you
are getting what you think you are
paying for?
The performance of a completion
audit exercise is an increasingly
common phenomenon in Asia, usually
linked in with some form of purchase
price adjustment mechanism. This
adjustment mechanism would normally
make reference to a minimum net
asset or net working capital position
at completion, and sometimes to a
threshold earnings number as well. In
this regard the basis of preparation of
the completion accounts, and the
definition of key reference numbers in
the Sale and Purchase agreement, is
crucial. This will include, amongst
other things, Generally Accepted
Accounting Principles (GAAP) to be
applied, together with any specific
accounting policies to be adopted
instead of the target company’s normal
policies. This would typically apply to
provisioning policies such as those
relating to accounts receivable,
inve ntory, or employee rel ated
liabilities.
But the Vendor Has
Promised Comprehensive
Warranties and Indemnities….
It is not uncommon for a vendor to
promise comprehensive representations, warranties and indemnities at the
outset in return for a quick deal with
minimal due diligence. Do not be
fooled! What is promised at the outset
is usually very different to what is
encountered later on in the process
when it comes to negotiating the
detailed contractual terms. Also,
warranties and indemnities are not a
substitute for a thorough due diligence
proce ss – more ofte n t ha n not
recoveries left to this mechanism alone
are hard fought, time constrained and
costly in terms of management time,
effort and incremental legal fees.
In cases where pre-acquisition due
diligence is significantly restricted
however, as often happens in an auction
process, it is crucial that this is
factored into the strategic planning and
overall deal evaluation process.
Options available include a reduction
in the consideration offered to reflect
the increased uncertainty (and hence
risk) associated with having performed
only limited due diligence, a purchase
price adjustment mechanism (for
example by way of a completion audit
process or contingent payment terms),
or the performance of a detailed post
acquisition due diligence exercise
immediately after acquisition with a
view to identifying potential claims
under warranties and indemnities.
In Conclusion….
Buying or selling businesses is, by
its very nature, a risky business. To
succeed where others are, more likely
than not, to fail requires an appreciation as to the importance of a thorough
deal appraisal process – this includes
understanding what distinguishes good
due diligence from bad, and why an
audit can never be a substitute for a
specifically tailored investigation of
the target company. HKA
By Jim Woods
Partner
PricewaterhouseCoopers
The Hong Kong
32
ACCOUNTANT
FEBRUARY 2002