5 Ways to Define Due Diligence – and How It Differs From an Audit
Due diligence goes beyond an audit and can guide you to the best decisions when you're investing in a business
Key Takeaways
Audits focus on accounting records while due diligence looks at much more
Audits are often required, while due diligence is recommended
Audits look at one year, and due diligence examines longer time frames
Audits have a standard process; due diligence is customized around an investor's objectives
Audit reports are generally much shorter than due diligence reports
Financial audits and due diligence overlap in many ways. They both allow potential investors or stakeholders to learn more about a company, but beyond that, these processes are very different.
An audit is an independent examination of a company's financial records for accuracy. On the other hand, we can define due diligence as the process investors or buyers use to learn more about an acquisition target. If you're considering investing in a company, you should look at its audited financial records, but you also need to engage in due diligence to ensure you know exactly what you're buying.
To help you understand the differences between audits and due diligence, take a look at these five key differences.
1. Scope of analysis
An audit focuses exclusively on the financial documents of a business. An independent third party examines the accounting records of the business and compares them to sales reports, expense records, and other documents to ensure they are accurate.
Due diligence accounting also looks at a company's financial records, and, in fact, this aspect of the due diligence process may involve getting records audited for accuracy. However, due diligence doesn't stop there. It also examines the company's operations, assets, environmental issues, legal affairs, and personnel.
2. Regulatory requirements
There are all kinds of situations in which companies are legally required to submit to audits. For instance, the IRS randomly audits companies to ensure their tax returns are accurate. By law, public companies must undergo annual audits by independent auditors. In other cases, an audit may not be statutorily required, but an investor or a lender may request an audit before investing in the company or lending it funds.
Due diligence is never legally required. You don't have to undergo due diligence before investing in or buying a company. If you want to go into a deal blind, you have that right. But this is never a wise idea. You should always commit to due diligence before making a significant investment.
3. The period of time covered
An audit always covers a single year. It can cover a calendar year, but if the company uses a different 12-month period from its fiscal year, the audit will cover that time period. In some cases, an auditor will want to look at multiple years, but each individual audit only looks at a year's worth of details.
In contrast, due diligence usually takes a longer time period into account. Typically, before buying a business, you should expect to do due diligence into the company's operation and performance over the last two years, but in some cases, you may need to look at a longer time frame. You should never look at just one year as this is too small of a time period. Many scenarios could cause a company to excel during one year, and if you only look at that single year, you may have a distorted view of a business’s reality.
4. Customization
Audits generally have a standard process. An audit examines your accounting records for accuracy. The process is based on a methodology outlined by the International Standards of Auditing.
In contrast, due diligence can take a range of forms. There's no one-size-fits-all approach to due diligence. Instead, the process should vary based on the buyer’s needs. Consider what you need to know about the company's risks, its practices, and its financials. What unique elements do you need to consider based on your investment objectives? When you hire someone to perform due diligence on a company you are considering buying, these are the types of questions you will cover as you decide how to approach due diligence.
5. Results and deliverables
An audit report covers the accuracy of the company's financial statements. It explains if inaccuracies are small issues or material misstatements, and it's usually only about three pages long.
In contrast, a due diligence report is much more informative and often provides an in-depth Quality of Earnings report. These reports can be 25 pages or more, but the length depends on the objective of the investor and the complexity of the acquisition target.
A due diligence report may include information on the model used to evaluate the company's value. Generally, valuation is centered around the company's earnings before interest, tax, depreciation, and amortization (EBITDA). The due diligence report should explain what amounts need to be added into or subtracted from this number to create an accurate valuation for the company.
The report will also cover how to mitigate risks during the negotiation process. For instance, if the company doesn't look like it could run without the founder, you may need to negotiate an earn-out deal. Or you may need to negotiate an agreement that includes adjustments for a working capital minimum threshold.
Finally, different teams create these reports. Certified public accountants (CPAs) can audit accounting records. In contrast, when you're doing due diligence, you rely on a team of people that could include CPAs, lawyers, and mergers and acquisitions specialists. Before investing in a business, you should always look at its accounting records and ensure they've been audited for accuracy, but this should never be your final step. Due diligence helps you know what you're buying, and beyond that, it provides the insight you need to successfully negotiate the best deal.
At Guardian Due Diligence, we help investors go into deals with their eyes wide open. The due diligence process is an investment that will make you more informed and confident in your decision to buy a company. Don't go into a deal blind. Instead, contact us to talk about our due diligence services, which are customized for investors in your situation.