Contents of Financial Due Diligence

Project Preparation Stage

The intermediary institution, before accepting the engagement, needs to carry out initial operational activities and decide whether or not to accept the engagement. At the time of carrying out these initial operations, the principal questions it must consider are:

First, the professional competence of personnel, ascertain whether or not the personnel are familiar with the related industry and client, whether they possess experience of carrying out similar engagements, whether they are equipped with the necessary technical capacity and knowledge, and if the occasion requires whether they are capable of obtaining specialist help.

Second, consider the objectives of the prospective clients, confirming that there are no misunderstandings in the terms of the engagement. Due to the special features of merger and acquisition projects, when accepting an engagement, the confidentiality agreement, the usage of the report and terms of the disclaimer are all areas which warrant particular emphasis and attention.

Project Planning Stage

Initial Preparative Work

Includes explaining to the target firm the investigative objectives and the relationship with the client, compiling and issuing an investigation data manifest, and understanding the target firms historical evolution, organisational structure, primary operational scale, ownership and investment structure, as well as future development tendency etc. At the same time, estimating the target firm’s scale and degree of operations complexity, this would facilitate the determination of project personnel, work progress and key areas to focus on.

Compiling an Investigative Plan

After the initial preparation of the investigation, the project leader ought to begin the compilation of an overall work plan for the project. The project plan should comprise of project objectives, investigation procedures, key areas to focus on during the investigation, project personnel composition, project time and location arrangements etc. At the same time, within the framework of the overall work plan, the project manager should also compile and revise a detailed work program for the financial due diligence.

Risk Assessment Stage

In financial due diligence, the following elements constitute risk assessment:

a) The state of affairs in the industry, and the legal and regulatory environment, amongst other external factors;

b) The nature of the target company;

c) The target company’s objectives, strategies and relevant operational risks;

d) The target company’s financial statements and primary financial issues.

(e) Implementation Stage


(1) A few aspects that should be effectively grasped during investigative work:

a) Sustainable Operation

Operational cash flows are a useful indicator for understanding the sustainability of the target company’s operational situation. In comparison to accounting profits that can be subject to manipulation, cash flows can be more a more accurate representation of the going concern of the target company. Furthermore, taking into account the target company’s motives for accepting an acquisition, the difficulties it confronts relating to sustainable operation can be observed.

b) Internal Control

Documents related to internal control should be obtained and read through, and a walk-through test should be conducted, in an effort to understand and evaluate the rationality of the internal control design and its effectiveness in execution.

c) Financial Affairs

Information about the accounting policies, financial structure, credit worthiness, asset quality and profitability of the target company need to be obtained. The admissive degree of the target company’s financial standing is subject to the level of internal control, but procedures involving important issues must be conducted in a thorough manner, for instance the verification of the ownership of major assets and contingencies. For those cases already highlighted, for example mortgages and guarantees, contingencies, pending legal actions, etc. need to be followed up as they develop. For risk items not highlighted, they should become the major focus of the financial due diligence work.

d) Taxation Affairs

The current structure of the tax burden, tax treatment, and the fulfilment of paying and withholding tax in the target company should be studied. For enterprises enjoying tax preference, one should estimate their tax burdens after the end of the preferential period; for those who have not fulfilled their obligation to pay tax, one should perform a quantitative analysis of their tax risks.

e) Financial Forecasts

The forecasts involved in financial due diligence include: incomes, investment scales, capital requirement, changes in major accounting policies, etc. All these are finally reflected in the forecast of cash flows and earnings capacity. Certified public accountants must carry out appraisals of the industry outlook, policy orientation, interest rates, exchange rates, changes in taxation, etc. In addition, when dealing with primary facts involved in the forecasts, one must maintain a professionally sceptical attitude and verify them with utmost prudence.

(2) Contents of Investigative Work

a) Investigation of the overall financial data of the target company

In financial due diligence, some basic financial circumstances of the target company need to be understood. One can learn its time of establishment, history, registered capital, shareholders, modes of investing capital, properties and major businesses, etc. through obtaining the company’s business licence, capital verification report, constitution and organisational structure. A detailed understanding of the target company should also contain the head office and all the companies under its control, including the proper information of its related parties. Moreover, the target company’s tax policies should be covered, which comprise current tax types, tax rates, bases for calculation, the collecting departments, preferential tax policy, tax allowance and exemption, and settlement and payment of annual enterprise income tax.

b) Investigation of the Target Company’s Specific Financial Condition

The reliability of the financial statements of the target company, which is related to its own procedures of internal control, would affect that of financial due diligence. Consequently, when conducting financial due diligence, the internal control of the enterprise should be taken into account. After having developed an understanding of the system of the internal control of the company, one can probe into its financial position and profitability.

c) Investigation of Special Matters

Special matters refer to financial commitments, contingent liabilities, post balance sheet events, related party transactions, off-book assets and liabilities, etc. which exist in the target company. These items should be given high attention. More detailed primary source documents are needed in order to assess their legitimacy and fully disclose them in the financial due diligence report according to their materiality.

Completion Stage

The main contents of this stage are the preparation of work papers and drafting of the report.

Due to the particularity of each project and the uncertainty of information collection, it is not probable that the work papers of financial due diligence can be of the standards of financial statement audit. It is more likely to depend on the personal ability and the professional judgement of the executive staff. In the financial due diligence report, findings should be stressed. Under the circumstances of inadequate basis, excessively positive conclusions should be minimised. The incompleteness of obtained information and work scope needs special emphasis. When narrating the conclusion, firstly, one could make a general evaluation of the investment project, which is primarily a summary of the investment value of the company. Secondly, an overall estimation of the level of risk involved in the project should be given. Lastly, measures to avoid risk and suggestions regarding the steps of acquisition should be put forward to the acquiring party.