The 5 Differences Between Normal Accounting and Due Diligence Accounting
Author: Elliott Holland
Performing an in-depth analysis is critical when acquiring a business. That's where due diligence accounting comes in.
Key Takeaways
A financial audit is typical for normal accounting
Due diligence covers much more, including marketing and operations reviews
Five critical differences and why due diligence is important when buying a business
When looking to invest in a merger or acquisition, you have two options for evaluating the target company's standing. You can rely solely on the target's audited records or go for due diligence accounting.
An audit ensures the financial performance and position the company gives you is accurate and fair. Unfortunately, it doesn't identify other significant issues that might interest you.
On the other hand, due diligence accounting goes a step further. It covers a wide range of areas and provides a bigger picture of the company. That's why it's critical to understand the differences between normal accounting and due diligence accounting. This post delves into the details.
What does due diligence mean?
Due diligence is a more comprehensive investigation of the business you're interested in buying. The process happens before finalizing the transaction to verify if the acquisition is worth it. It covers a wide range of areas, like:
Information technology
Legal documents
Operational processes and paperwork
Financials
Marketing
Once complete, due diligence accounting provides investors with an understanding of the company's:
Key personnel and accounting information systems
Historical working capital needs
Historical sales and operating expenses trends
Key assumptions used in management's forecast
Sustainable economic earnings
Normal accounting procedures don't provide insights into these areas.
Who does due diligence accounting?
The team responsible for due diligence accounting includes merger and acquisition (M&A) professionals, corporate finance experts, and accountants. The team could also be people from the prospective investor's corporate development, finance, or accounting department if the process happens in-house.
Sometimes, the investor may outsource the process to accounting firms, M&A firms, or boutique corporate finance companies. Individuals working on a regular audit are usually independent public accountants not attached to the company being audited.
How long is the due diligence accounting process?
Due diligence auditing usually takes one or two months to complete. The time is usually enough for the investor to evaluate the business in depth, including the financial aspects. It’s a good idea to avoid getting into the process unprepared, as it can be extremely time-consuming.
Key differences between normal audits and due diligence reports
Many investors think an audit is the same as financial due diligence, but that couldn't be further from the truth. The best way to clarify the confusion is to compare the two processes and identify the most notable differences. Here are five differences to consider.
1. Quality of Earnings
Investors are often interested in the fair valuation of a business, hence the reason they go for routine audits. However, they fail to gain deeper insights into the company's earnings before interest, depreciation, and amortization (EBITDA).
Financial due diligence focuses on the sustainability and quality of the company's earnings. It also analyzes usual and nonrecurring expenses, post-closing cost structure changes, and over- or underused assets and liabilities to adjust the historical EBITDA to reflect sustainable earnings.
Through due diligence accounting, it's possible to evaluate the inconsistent application of accounting principles for a more comprehensive report.
2. Regulatory requirements
Due diligence accounting typically doesn't have regulatory requirements, especially if the company is under private ownership. Nonetheless, due diligence is often a good idea because it helps an investor make a more informed decision.
That said, directors have fiduciary duties to ensure they act diligently. A regular audit is usually conducted annually unless the company qualifies for an audit exemption.
3. Period covered
A financial due diligence report typically covers two financial years, including the interim period. The review period varies based on the nature of the target company, resources available, the industry in which it operates, and the proposed transaction terms.
The review period could also capture an appraisal of all the financial forecasts prepared by the company's management. On the other hand, an audit only covers 1 financial year or 12 months unless there's a change in the company's financial year.
4. Working capital
Buyers and sellers will often negotiate a target working capital to be delivered at the close of the transaction. This amount often depends on the average working capital balances over the past 12 months. A well-informed buyer will consider other factors like:
The specific composition of working capital balances
The seasonality of the business
Industry conditions
Recent growth trends
An audit report doesn't capture all these insights, especially monthly working capital accounts. The lack of this information puts the buyer at a disadvantage as they negotiate the working capital target.
5. Deliverables
Due diligence usually results in a written report or memorandum that includes a commentary on the findings, along with analysis, conclusions, and recommendations. So, it's not uncommon for due diligence accounting reports to be 25 pages long.
With the report, a prospective investor can make a go or no-go decision. If they decide to proceed with the transaction, the due diligence will:
Identify financial risks and insecurity: Risks might include indemnity for past tax exposure or inclusion of an earned-out consideration. These can then be removed or alleviated during the negotiation process.
Validate the valuation model and inputs: This can include quantifying normalized EBITDA, identifying company-related risks like customer absorption, or providing an accurate estimate of working capital requirements.
Facilitate the integration phase: Due diligence can help prepare for the implementation of internal controls and financial reporting protocols.
An audit report is less informative, often indicating the auditor's opinion whether the financial statements meet international financial reporting standards (a respected global standard for financial statements). The information is usually not more than three pages.
Invest wisely with due diligence accounting
Failing to do your due diligence puts you at risk of making a costly purchasing mistake. The seller may conceal crucial details or fudge figures in the audit report to get you hooked. If you don't verify the details, you might buy a business or product that isn't a sound financial investment.
Get a professional to do due diligence before closing the deal to help prevent you from getting stuck with a bad business. At Guardian Due Diligence, we can help you complete the due diligence process before buying a business. Our team has evaluated over 1,500 deals and can help you, too. Contact us to schedule a call with our team to get started.