Pre-transaction Financial Due Diligence: Differences from an Audit and its Limitations

In the U.S., CPAs provide both assurance services, including financial statement audits, and consultation services, such as pre-transaction financial due diligence. The purpose, nature, procedures and results of audits and financial due diligence engagement are sometimes confused with one another because some of the procedures performed in audits and financial due diligence engagements are similar – such as management inquiries, financial ratio analysis, reading of company documents, and evaluation of certain accounting policies used.

Buyers and sellers of businesses and transaction lenders should understand and appreciate the:

● Differences between an audit (or other assurance services) and financial due diligence

● Limitations on the scope of pre-transaction financial due diligence services.

First, consider several of the key differences between a financial statement audit and financial due diligence:

The culmination of a financial statement audit is the CPA’s opinion on a company’s financial statements (and, if the financial statements are those of a public company, an opinion on management’s assessment of internal controls). Those financial statements include balance sheets, statements of operations, statements of cash flows, and extensive footnote disclosures.

However, upon completing financial due diligence, the CPA expresses no opinion or other form of assurance on any matter. Further, the object of the CPA’s financial due diligence is specified matters the CPA and client have agreed to, such as normalized EBITDA, working capital’s composition and trends, and customer retention – rather than financial statements. And, audited financial statements alone are usually not sufficient financial information for buyers and transaction lenders, leading them to obtain financial due diligence services.

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The CPA’s audit work is governed by voluminous US Generally Accepted Auditing Standards (US GAAS) (and, in the case of public companies, also governed by SEC regulations and PCAOB standards). The CPA relies on detailed audit programs, checklists, statistical sampling, formally determined materiality thresholds for evaluating financial statement misstatements, and independently obtained evidence provided by third parties (such as customer confirmations of accounts receivable).

In contrast, the CPA’s financial due diligence work is governed by the AICPA’s (brief) Statement on Standards for Consultation Services (SSCS) No. 1, which only broadly requires that the CPA exercise due professional care, adequately plan and supervise subordinates’ work, gather sufficient relevant data (determined in the CPA’s professional judgment), and have the professional competence necessary to perform the services (which standards are also part of US GAAS). Also, the CPA’s analyses (such as financial ratio analysis, management inquiries, and reading of company documents) are based on the CPA’s judgment regarding the scope of the engagement and the kind of evidence that is relevant and sufficient to meet the engagement’s objectives. Management’s assertions are often sufficient for this purpose.

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US GAAS requires the CPA to design the audit to detect any material fraud affecting the financial statements.

However, while financial due diligence might disclose certain kinds of fraud, its purpose is not primarily “forensic.”

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In an audit, US GAAS requires that the CPA’s work include tests of internal controls (as well as substantive tests of financial transactions and financial statement balances).

In contrast, financial due diligence usually involves only high-level inquires of management regarding the company’s control environment and internal control procedures, in order to help the CPA evaluate the company’s earnings quality generally.

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In an audit, while the CPA’s client is the company whose financial statements are audited, the CPA’s opinion is relied upon by unidentified third-parties, such as lenders, trade creditors, and current or prospective equity investors. (In the case of public companies, the SEC also reviews public company filings, including the auditor’s opinion.)

In financial due diligence, however, the only user of the CPA’s work product is the CPA’s client – the prospective buyer (and any co-equity investors), the seller, or transaction lender that engages the CPA.

Next, consider several of the important limitations on the scope of pre-transaction financial due diligence:

First, as a result of performing financial due diligence, the CPA does not express an opinion, assurance or recommendations about the merits of the proposed transaction or its financing; the fairness of the transaction’s pricing, terms, or form of consideration; or the future operations of or achievability of financial forecasts for the target company.

Second, in performing financial due diligence, the CPA depends heavily on the client-buyer, target company, and their advisors having provided the CPA with complete and accurate information, and all relevant information, requested and answering the CPA’s questions fully and accurately.

Finally, as the label implies, financial due diligence does not include other areas of due diligence (such as regulatory compliance or IT due diligence).