What Is Due Diligence Report?

2015-09-14 10:26:42

The process of due diligence essentially comprises of a thorough investigation of the business or individual before a contract is signed. It can be treated as a cautious act following a standard of care. The due diligence reports can be a legal obligation as well. However it is generally applied to investigations of voluntary nature. A typical example of due diligence being performed in a variety of industries is the process of evaluation of a target company by a potential acquirer. The acquirer basically looks at the company’s assets and other dealings before carrying out the acquisition. The concept behind due diligence is that this particular process serves as a necessary checklist of investigation which contributes rather significantly to the decision making processes. The decisions are definitely more informed in this manner and enhanced. The generally information gathered allows enhancement in the overall quality and amount of information available to the managers or other decision making bodies. This information is to be used in the most reflexive manner for decision making along with consideration of everything from the costs and benefits to the risks involved.

Etymology

The term of due diligence was first used in the United States’ Securities Act of 1933. It has been observed to be commonly used in the corporate world since then. The act offers defense in the section 11 which is termed as the “due diligence” defense which can be utilized by the broker-dealers on being accused of any kind of inadequate disclosure to their investors of information relating security purchases. The broker-dealers are not to be held liable if the due diligence act is followed to the dot. If both parties ensure that the investigation is carried out with due diligence about the company selling the equity and that particular piece of information is shared to the investors then there will be no case of non-disclosure of information which was not found in that process.

After the terminology was introduced it didn’t take time for institutionalization of the broker-dealer community to take place which is now considered as standard practice. Conduction of due diligence investigations of any offerings of stock by a company in which the broker-dealer are involved is a necessity. This term was previously limited to public offerings and that too only of the equity investments. However with time this is now associated with private mergers and related investments as well.

Business transactions and corporate finance

You must have heard about customer due diligence cases. These are the ones which allow customers the right to know about the ingredients and processes used for the creation of any given produce. The companies are required to follow a particular standard set by the government. Similar is the case with corporate finance and business transactions. Following is the framework for the diligence process. It can basically be divided into nine different areas:

Compatibility audit.

Financial audit.

Macro-environment audit.

Legal/environmental audit.

Marketing audit.

Production audit.

Management audit.

Information systems audit.

Reconciliation audit

The idea of valuations which basically revolves around value analysis of shareholders is essentially associated with the due diligence process. This is done to create reduction in the total number of failed acquisitions and mergers. Keeping this in consideration two new audit sections have now been included in to the framework of due diligence. The two are stated as:

The compatibility audit is the first one. It is necessary for the compatibility audit to ensure adding of shareholder value. The compatibility audit is the one dealing with the different strategic components of a given transaction.

The reconciliation audit is the second addition to the framework. It is essentially used for linking and consolidating other audit sections together by using a formal valuation. The process basically ensures a thorough testing process of the value added by the shareholders.

Other areas relevant to this include the following:

Environment

IT

Tax

Labor

Legal

Financial

Market or the commercial position and situation of the company.

Other areas to be included in this are:

Real and personal property

Liability coverage

Insurance coverage

Intellectual property

Labor matters

Employee benefits

Immigration

International transactions

Debt instrument review

The areas to be focused in the process of due diligence are still in the process of evolution. These are still being developed as the emerging issues relating to cyber security are definitely an area of concern for the acquirers of any business. The findings from due diligence have a direct impact on multiple aspects of a particular transaction which includes the following:

Purchase price

Representations

Warranties negotiated

Indemnification offered by the sellers.

These are generally agreed upon in the transaction agreement. Due diligence has now emerged as an entirely different profession for the experts of audit and accounting.

Foreign Corrupt Practices Act

The Foreign Corrupt Practices Act generally abbreviated as FCPA has asked many of the institutions in the United States to look in the process of evaluation of their overseas relationships. The increased number of penalties along with the enhancement in their size has led to this suggestion. In case of lack of due diligence on the part of any organization’s suppliers, vendors and agents along with the partners in mergers and acquisitions in overseas countries, it could possibly lead to conduction of business with a certain organization associated with the foreign official. Other options include their executives and state owned enterprises. A link or association of such can easily be perceived as an incentive of bribe for the foreign officials which typically leads to the non-compliance with the FCPA. The due diligence is required in two aspects in this particular case:

The first case is the initial due diligence. This is regarded as a rather necessary step in terms of evaluation of the kind of risk involved in carrying out a particular business with an entity before the establishment of a relationship. It is used to assess the current risk at that point of time.

The second one is known as the ongoing due diligence. This is different from the first one and is carried out in a periodic manner. This particular process of evaluation of the overseas relationship is done to discover association between the current relationships with the foreign company and a foreign official. The second thing to check in this manner is any corruption or illicit activities linked with the overseas business. The process of such is to be performed in an indefinite manner till the relationship seizes to exist.  It generally comprises of a comparison between the companies and the executives to a foreign official database. The process is required to be performed on all kinds of relationships without keeping the location as a consideration.

Human rights

The member countries of the OECD agreed upon revision of the guidelines for the promotion of a tougher set of standards in terms of human rights and the general corporate behavior. This was passed on 25th May in the year 2011. A new aspect of due diligence was introduced as an integral of this new terminology and definition. It required the corporations to carry out an investigation of third party partners for any kind of potential abuse or violation of human rights.

This new term was basically put forth by the Special Representative for Human Rights and Business of the United Nations, John Ruggie. He uses the term as an umbrella term to cover all the processes and involved steps through which a company strives to understand, mitigate and monitor all the impacts of the human rights. The guidelines for the Human Rights Due Diligence were formalized by the United Nations on June 16th owing to the endorsement of the guiding principles for business and human rights by Ruggie.

Civil litigation

The idea of due diligence in civil procedure basically involves the necessary processes of investigation which is to be conducted prior to a certain kind of requested reliefs. Take the example of bankruptcy for instance. The areas of laws involved in this particular process make use of civil litigation. Generally an attorney is hired to represent anyone filing the petition for bankruptcy. The attorney is required to engage in due diligence in order to ensure the factual accuracy of the representations made in the petition. It is also a typical prerequisite of a request in terms of reliefs in many states. These are the states which permit civil litigants for the conduction of pre-litigation discovery of any required and necessary facts in order to determine whether or not there is existence of factual basis for any action.

In terms of civil actions being sought for the seizure of a particular property; the party which requests the relief is asked frequently to be engaged in the process of due diligence. This is done to determine the interest claimants in the property after thorough review of public records concerned with the property.