Although audit and financial due diligence involve analysis of financial statements of a company, the purpose and method are quite different and it needs to be understood that both are different and one can’t replace the other. Following differences have been panned out to understand why the two aren’t the same.
Financial due diligence is a non-assurance service and therefore, it is not a part of the statutory services of certified public accountants. Rather, the role of a financial professional is more like a management consultant for financial advisory. Whereas, audit is a statutory service, which is part of assurance services to be provided by certified accountants.
The objective of financial due diligence is to provide an investor with the insight of the operations of the target company, be it for the purpose of investment or for acquisition. Thus, helping the investor in making an informed decision, so that they are aware about the risks involved. The purpose of auditing services is to check, whether the company is following the prescribed format for book keeping, adhering to the accounting standards and reporting the finances accordingly, including red flags, if any.
Financial due diligence is not just about analysing the company’s financial statements. While doing due diligence, several factors have to be taken into consideration such as the firm’s background, operating industry and the prospects for the industry as well as the firm; past, present & future earnings projections; contingencies; risk involved; etc. Financial due diligence highlights the risks in the company and / or the transaction; an acquirer or investor could then mitigate these risks either through legal clauses or earn out mechanisms. For example, the financial DD could highlight that major part of the company’s future revenue would be coming from a single contract; in this case, the revenue risk would be high in case the company loses the client; in such a case, the investor could either value the contract separately with its risks, or invest based on an earn-out with conditions to reduce exposure to the client; similarly, it would be a good idea to set up a meeting with the client to see if they have any negative feedback or reservations on the investor (esp. if it’s a majority) coming in.
During audit, confirmations are done for the inventories and other such investigative methods are employed, whereas during financial due diligence comprehensive methods of review such as observation, analysis and interviews are employed.
The duration for financial due diligence is much shorter than for audits as audits also include physical confirmation of inventories and recalculation of financial statements, whereas financial due diligence uses trend analysis, structural analysis and other tools for analysis.