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Financial Due Diligence
Corporate acquisitions/mergers/taking over have become a part of business strategy to grow rapidly and widely.The objective is to increase the local / global market share. Incentives given under the Income Tax Act for mergers and acquisitions have also given fillip to such activity.A key element in such an exercise, whether it involves the acquisitions of another entity, unit or assets of anentity, is the performance of a “due diligence” review. Due Diligence may also required to be performed incases of 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 duediligence review.Due diligence is a review of the enterprise, unit or assets, as the case may be, to be acquired.
Due Diligence : Sub-Classification
Due Diligence can be sub-classified into discipline-wise exercises. It may be mentioned here that these sub-classification should not be seen as totally mutually exclusive to each other. If considered mutually exclusive, itmight result into a less-than-effective evaluation of the entity. The sub-classification of due diligence exercisecould be as follows:
Commercial or Operational Due Diligence
Financial Due Diligence
Tax Due Diligence
Information System Due Diligence
Legal Due Diligence
Environmental Due Diligence
Personnel Due DiligenceOf all the sub-classification of due diligence exercises, Financial Due Diligence has the highest significancewith regard to a corporate restructuring exercise. The reason is quite simple to understand. For an investor, thefinal decision should necessarily be in the form of financial terms and information. It, therefore, becomesimperative that the results of all other kinds (sub-classification) of due diligence should be translated inmonetary terms.The financial due diligence is generally done by professional accountants. Professional accountants are alsohired to conduct tax due diligence because of their knowledge and expertise in the area of taxation laws. Theacquiring enterprise engages other professionals to conduct other aspects of the over all due diligence reviewexercise. For example, a lawyer or a Company Secretary may be engaged to carry out legal due diligence, an personnel professional may be engaged to conduct personnel due diligence, an engineer and a marketing professional may be engaged for conduct of operational due diligence. However, the implications of all the duediligence exercises should be ascertained by the professional accountants engaged to carry out financial duediligence review. Accordingly, accountants need to review the reports of the due diligence exercises performedfor other aspects of business to evaluate the financial implications.
Timing of due diligence review exercise
There are no rigid rules for determination of the stage of acquisition at which due diligence review is conducted.The timing of the review is very much a situation-specific issue. It depends upon a range of factors that beginning from the nature of the transaction (inter restructuring, acquisition), the relationship between the parties involved (related parties, first time negotiator), the regulatory frame work (for example, in a takeover of a listed company, the acquirer may not be able to perform such a review, given the time, constraints and as thetarget is under no obligation to allow one). The list is never ending. Its is at this point at which significantamount of professional fees, etc. are incurred for the services rendered by the various professionals attachedwith the process of acquisition. It has been mentioned that due diligence reviews can be sub-classified intodiscipline-wise exercises. Various kinds of due diligence reviews are undertaken depending upon the nature of target’s operations.
 
Objectives of Financial Due Diligence
There are certain inherent risks that increase significantly without due diligence. Where two parties are involvedin a deal, representations are made to transferee about the entity, unit or assets being transferred. Completing atransaction without adequate information, or half-truths, can lead to a significant financial loss. Basically, the performance of a due diligence review seeks to ensure that the transferee, at a later stage, does not faceunpleasant surprises when the acquisition is over. The due diligence seeks to provide assurance to the transfereethat the information available to him presents a true and fair view of the situation based on which negotiation isdone.Broadly, the review process would provide comfort on,
inter alia
, the following:
True and fair view presented by the financial statements
Systems and controls established are followed
Uniformity of accounting policies
Availability of records
Quality of record keeping
Existence of fixed assets, and ownership of those assets
Realisable value of business
Undisclosed liabilities
Possible exposure to future liabilities
Contingent liabilities, their nature and quantum of commitments made by the entity
Compliance with various laws and regulations applicable to the entityThe initial price and other decisions are taken on the basis of net worth as well as trend of profitability of thetarget 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 viel of initial information provided by the company and to assess the benefits and costs of the proposedacquisition/merger by inquiring into all relevant aspects of the past, present and future of the business to beacquired/merged with.
STATEMENT AND INFORMATION TO BE CALLED FOR FROM TARGET PRIOR TO STARTINGTHE DUE DILIGENCECorporate Documents
1.Memorandum and Articles of Association2.Board Minutes copies for last five years3.Financial Statements for say five years with complete schedules4.Tax accounts (if different) with Tax audit reports/returns5.Latest financial statements duly audited6.Quarterly published results for last say eight quarters7.Engineering Reports like report on environmental problems8.Market studies/reports on company products9.Details of patents, trade marks, and copyrights10.Details of Licenses11.Copies of all contracts
 
Supply and sales agreements
Employment and consulting agreements
Leases
License and franchise agreements
Loan agreements/Debenture trust deeds
Shareholders agreements
Agreements with labour and management
Pension and profit sharing plans
ESOPs / stock purchase plans /sweat equity agreements
Welfare benefit plans
Personnel handbook or policy manual
Deferred compensation plans
Insurance policies
Agreements giving right to acquire /use company assets
Tenancy rights/lease agreements
Sales and product warranty agreements
Subsidies like S.T subsidy, Central subsidy12.Details of MODVAT/CENVAT credit on capital goods13.The transferability and possibility of continuance of the above14.Acquisition agreements15.Title documents to real estate property16.Real property and asset identification with ownership/ lease details17.Survey maps/reports18.Mortgages19.Guarantees and letters of comfort20.Latest annual return
Key Information from Management
1.Analysis of Company’s past operating performance and projected change in operations2.Segment wise profitability statements3.Details of ownership of company’s securities4.Potential defaults under existing contracts or potential litigation5.All material correspondence with Govt. agencies6.Pending laws or regulation that may effect the company’s business7.Product backlogs, purchasing, inventory and pricing policies8.Pending negotiation for the purchase or disposition of assets or liens
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