due diligence report

[thehawk]

Dear members,

Could any one of you tell me the contents of a due diligance report prepared by buyer of a comoany? What are the assets and liabilities which are required to be excluded while preparing the said report?

Regards,

SOHAIL KASHIF

[kamranACA]

Typically, due diligence assignments are awarded on the basis of a clear terms of reference (TOR). So, if this is the case, one has to follow the TOR.

For buy side advisory, Due diligence is a very detailed evaluation of an entity covering all financial, technical, commercial, environmental, and legal aspects. Due to the depth it typically carry, this is usually not carried out by a single specialist consultants. Rather, in big deals, such exercise is conducted through consortium of advisors and consultants having expertise in different aspects. However, in majority of such exercises the focal point for all consortia teams are the Financial Advisors who have to sum up the findings of other consortia team members in the advisable pricing models and adjusted balance sheet break-up values.

If you are raising this question with financial perspective, please be advised to elaborate all major assets, liabilities, differnt processes, SOPs regarding various processes, incomes, expenses, cash flows, future projections, going concern ability, condition and quality of assets, litigations, contingencies and taxation matters and pending disputes (specially off balance sheet ones) and the impact of expected resolution of all litigations and tax issues (taxation include all taxes), future capex plans and resultant operational improvements having impacts on future cash flows, product specificaions, product design and innovations, product pricing structures, revenue generation networks (such as distribution network for food industries), required compliances in connection with buyout decisions, post acquisition challenges and expansion/advertisement requirements etc etc. You can design various chapters of your report controlled through an index and headed by a cover letter. The conclusions drawn in each chapter can be summed up in the executive summary.

Please be advised that due diligence is a significant exercise which encompass very deep evaluations to surface the hidden skeletons which normally are not uncovered under routine assurance assignments and audits. The buy or sell decisions have to be based upon due diligence work, so margin of errors and omissions is NIL in case of such professional work.

Regards,

[thehawk]

Thank you very much sir for your detailed reply to my querry. I have a little further question that for calculation of book value of a share of the company could we take all assets such as deferred tax asset, tax refunds due from govt. etc or exclude them generally what kind of assets and liabilities are excluded for calculation of book value?

Regards,

[kamranACA]

There is no hard and fast rule to include or exclude any assets or liabilities when you wish to base your valuation on adjusted balance sheet based break up values.

To be more precise, none of the liabilities or assets are excluded without any reason or demonstrable justification. What you have to do is, analyze each liability and asset heads in such depth that you either tend to agree with the basis adopted for recognition and measurement or have concrete basis to object on such liability or asset. Objections can interalia be altogether on the existence/recognition of such liability or asset or on precision of its measurement etc. These objections can lead to due diligence adjustments regarding any head of liability or asset.

These adjustments are not to be recorded in the books of account compulsorily; rather, these are used only by the evaluator for reaching the adjusted balances of liabilities and assets with respect to his valuation.

If you surface a number of such adjustments and wish to incorporate them in the historical balance sheet of a cutoff date, you can add/deduct such adjustments from the reported balances to arrive at the adjusted balance sheet figures for your break-up valuation purpose.

Remember one thing; if you intend to reach adjusted breakup values, you should try your maximum to reach the fair value based justified figures of reported assets. For example, with respect to fixed assets, you can get a revaluation done on the basis of observable market data and use the expertise of some expert independent engineers (Technical consultants). You can take values of investments with respect to mark to market pricing with an analytical look of the trends in the period after the cutoff date agreed for due diligence, as well. You may have to very closely analyze the receivable to see if appropriate provisions exist for doubtful balances. You may have to inspect inventories and based upon your analysis conclude if some obsolescence provision is required for valuation. Similarly, you have to see if all legal evidence (challans, invoices, bills, statements etc) are available against tax refundable amounts and whether it is expected to be recovered in full. These principles have to be applied on all balances. You must agree and circularize balance confirmations to judge the quality of bank balances, investments, receivables etc. You should adopt some procedures to confirm the amounts due from statutory authorities as well.

With respect to liabilities, you have to take into account all off balance sheet liabilities as well which in your best judgment have remote chances to arise e.g. liabilities which may arise as a result of unfavorable decisions on pending litigation. For this purpose, the evaluators may need independent sub-evaluations by legal consultants as well. You may also have to get valuations of employees’ benefits from independent actuaries, if the nature of such benefits requires it. You must supplement your work by having confirmation from financers for the amounts due to them as of the cutoff date. You must agree and circularize balance confirmations to judge the adequacy of payables as of the cutoff date. You should adopt some procedures to confirm the amounts due to statutory authorities as well.

So these are a few tips; as I said earlier, this is a very detailed and skillful exercise and unless one has the appropriate skills, training, vision and knowledge, he/she may not be well suited to conduct such exercise. Because the margin of errors is NIL in this professional work.

I hope the above would be sufficient to make out a base point for the race.

One last point, keep in mind adjusted balance sheet based break-up value may not be a valid measure of concluding the pricing to be offered. One has to go to DCF valuation techniques and sophisticated financial modelling as well to substantiate his values. After having different valuations, the pricing range should be concluded.

Regards,