How to undertake accounting and legal diligence?

To understand the health of a company or investment opportunity, it is imperative to undertake detailed accounting and legal due-diligence. Given the need for specific knowledge and the intricate nature of the work, it is often undertaken by external auditors and lawyers to provide an impartial assessment. 

Accounting diligence with management and the company’s auditors

In order to undertake the diligence, it will be necessary for the management and auditors of the company to be present to address any questions. Accounting diligence with management and auditors enables access to various aspects of a Company’s operations which may not be obvious from the outside. A team of auditors will ensure, via audited financials, that the management has reported correct financials of the Company and per the prescribed rules and procedures. Undertaking a due diligence exercise with management tends to identify from an investor’s perspective the following issues:

1. Working capital needs
2. Assets and liabilities status
3. Sales and operating expense trends
4. Sustainable economic earnings
5. Forecasting assumptions
6. Hiring, compensation and retention policies
7. Accounting information systems
8. Risk management procedures

Understand cash/non-cash reconciliation

Reconciliation ensures completeness of a transaction across the financial system of the company. Acting as a form of internal control of the balance sheet accounts, it gives the net income, deterring material misstatement. In the cash reconciliation process, the register’s cash balance is verified at the closure of the business. Identify via cash reconciliation the incorrect accounting records, if any. Cash reconciliation tests the authenticity of the financial records by comparing two-sets in double-entry accounting. It confirms general ledger accounts’ consistency, accuracy, and completion, ensuring quality bookkeeping. Adjustments to net income or loss’ aggregate amount also includes non-cash expenses and income items that impact net income. Non-cash reconciliation items need to be added or subtracted upon calculating cash made available by or utilized in operating activities. Understand non-cash reconciliation items like capital depreciation, amortization, alterations in accounts payable, accrued liabilities, unrealized gains or losses, asset write-downs, and prepaid expenses.

Understand management budgeting process (is it cash or GAAP)

Cash budgeting is the estimation of cash inflows and outflows over a period of time. It helps in ascertaining cash sufficiency (surpluses or otherwise) for operational continuity. The Company might need to raise capital via stock issuance or accessing debt options if cash is insufficient. Check if the cash budgeting process is for short-term or long-term cash budgets. The Company should be able to manage its sales and expenditures in a way that allows maintaining optimal cash flows. Investors’ demand for more complex performance reports encourages companies to adopt accrual accounting from the beginning itself. It also demands avoidance of an intensive task of transitioning from the cash to the accrual system in future. But a lack of visibility into the liquidity status (cash flow) creates a problem of tracking unearned revenue and expenses, making the Company’s cash flows confusing. Address this inefficiency by maintaining periodic cash-flow statements projecting the quantum of inflows and outflows, along with the GAAP system.

Accounting diligence

Due diligence is essential for reviewing and investigating business and financial processes of any company. Investors generally use it for assessing the financial health and the growth potential of small businesses. Management budgeting deals with the analyses of financial information for managing company processes. Beyond this, the accounting (financial) diligence concerns itself with understanding EBITDA sustainability, historical operating trends, accounting policies and procedures, and working capital requirements of a Company. It identifies risks activated as a result of incorrect accounting of misstatements in the balance sheet, whereas tax diligence examines tax compliance and appropriate applications of the tax laws. Accounting diligence helps in understanding a company’s:

1. Economic earnings’ quality and sustainability
2. Historical sales and patterns of operating expense
3. Historical working capital requirements
4. Prime assumptions used in management’s forecast
5. Accounting information systems

Areas of evaluation missed by audit exercises are duly covered by accounting diligence as it addresses key risks in particular, altering the scope of engagement.

Tax diligence

Tax due diligence comprises reviewing all taxes to be paid by the Company. It helps examine the tax liabilities and measure the quantum of tax exposure. The process involves precisely computing the payable taxes and refraining from tax misreporting, in addition to checking with the tax authorities the current status of any tax-related pending cases.

Vet and review the following tax compliance documents:

1. Last three to five years’ copies of income tax, withholding tax, and sales tax
2. Information pertaining to the Company’s previous or yet to be paid tax audits
3. Net operating loss or credit carryforwards of deductions (or tax credits) that aren’t used

Evaluate tax consequences of transactions by doing the following:

1. Get familiar with the historical tax risks of the business
2. Unused tax avenues
3. Tax policy, tax risk, and declaration function
4. Impact of risk and opportunities on transaction pricing
5. Develop a robust representation and warranty of the sale and purchase agreement

Legal diligence, litigation review

Legal due diligence (investigation) seeks crucial facts, liabilities, and obligations of the business. The process involves documentation review and interviewing for extracting specific knowledge, helping in making an informed investment decision. The legal diligence tries to understand the legal responsibilities of the Company (if any):

1. Debts
2. Leases
3. Lawsuits
4. Warranties
5. Contracts
6. Distribution agreements
7. Compensation

Legal due diligence is vital since it examines and reviews the following copies:

1. Memorandum of Association (MoA) and Articles of Association (AoA)
2. Board and shareholders’ Meetings’ Minutes (last three years)
3. Key Management Personnel-issued share certificates
4. All guarantees having the Company as a party
5. All material contracts (JVs or partnership agreements, LLC agreements)
6. Licensing or franchise agreements
7. Loan and bank financing agreements, and lines of credit having the Company as a party
8. Communications with government agencies
9. Litigation or governmental investigations
10. Environmental liability inspections and compliance audits

Legal diligence assists in better understanding the target Company’s value, drafting, negotiations, potential issues in deal-closing, etc.

Legal and accounting review, review of all legal accruals

Asymmetries exist between legal services and approaches of accounting accruals. Eliminating them requires prudent management of legal fees and accounting accruals. Legal services that are incurred but aren’t yet paid accrue legal fees (including billed for and pre-billed legal services). Purchasers of legal services generally tend to operate as per the accrual accounting method. Access accrual information of the Company (the legal and finance departments) to know what invoices are issued and paid for to know invoice stages. Legal accruals include costs that are incurred but not invoiced, unpaid invoices, and invoices that are rejected. Ensure timely, accurate, effective and compliant reporting.

Plan due diligence exercises to understand the status quo of the Company. The exercise involves defining its approaches, methods, and protocols; conducting it and compiling its findings for analyses. Recording of the positive and negative qualities of the business is vital for assessing the associated risks. The objective should be to identify if any future legal problems would arise from the management decisions being taken today. Understand a firm and its operations at the micro level via accounting and legal diligence prior to making investments.