Investigations and Due Diligence

Paper – 3 / Volume II: Advanced Auditing And Professional Ethics

Chapter 20 CA Sunil S Kothari BBM, CPA (USA), FCA

Learning Objectives

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Understand what is investigation & due diligence?

How these engagements are different from Audit?

Introduction to Investigation

• Background • Concept

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What is Investigation?

A systematic and in-depth examination to establish a fact or to evaluate a specific situation.

It is inquiry into facts

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When is it undertaken?

To enable financing / investment decisions

Senior management / Government get an indication / primary evidence of fraud

Fraud / profitability / cost determination

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Audit Vs Investigation

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Audit Vs Investigation - Objective

• Limited to a particular scenario or areas where effort is to establish a certain fact

Investigation:

• Largely revolves around financial statements - true and fair view of the state of affairs and working results of the entity

Audit:

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Audit Vs Investigation - Scope

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• Coverage can be situation specific. May be governed by the statute Investigation:

• External / Internal audits are generally undertaken pursuant to requirements of specific statutes

Audit:

Audit Vs Investigation - Periodicity

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• Can be one time / less frequent than audit. Actual work may exceed period of a financial year.

Investigation:

• Frequency is determined by the statute / management Audit:

Audit Vs Investigation - Nature

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• Requires going beyond obvious evidence i.e. a detailed study Investigation:

• Mainly involves sampling / judgment. It is more of a persuasive nature than conclusive

Audit:

Audit Vs Investigation – Inherent Limitations

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• May relate to information not received / access not given to particular information. Otherwise no apparent limitation is assumed.

Investigation:

• Audit involves inherent limitation of sampling / reliance on management / expert etc.

Audit:

Audit Vs Investigation - Evidence

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• Conclusive evidence about the matter being examined Investigation:

• Prima facie evidence about the account balances / class of transactions

Audit:

Audit Vs Investigation - Standards

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• Is a skillful activity where what should happen is not generally available through standards

Investigation:

• Governed by the applicable statutes and reporting framework Audit:

Audit Vs Investigation - Reporting

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• Outcome is reported to a person who has initiated the engagement Investigation:

• External audit reports are addressed to the shareholders while internal and other audits are reported to senior management / board of directors / committees of board

Audit:

How usually an investigation is carried out?

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Stages in Investigation

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Stage 2 Collection of Evidence

a. Focus on conclusive evidence

b. Important to retain evidence

Stage 1 Investigation preparation

a. Identify the purpose of investigation

b. Identify resources required

Stage 3 Analysis of evidence

a. Identify tools and techniques to use

b. Process data

c. Interpret analysis results

Stage 4 Results dissemination

a. Report findings

b. Present findings

Defining objectives and scopes

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After the objective is clear, then it should be further fragmented into action level sub-components

This helps in achieving engagement objectives in effective manner

Defining objectives and scopes

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End objective should be very clear as the conclusion of the investigation may have significant implications on important business decisions or human resource positions

Formulation of investigation program

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The actionable investigation steps are to be essentially derived from the investigation objective

The nature / timing and extent of investigation procedures may vary according to the investigation objective

Collection of evidence

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Since the purpose of the investigation is to go beyond obvious, getting conclusive evidence may be complex

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Sub-steps in evidence collection

Collection of evidence

In order to be effective, the evidence collection process should include all fact finding techniques like: • Inquiry – Direct / Corroborative • Walkthrough • Record searching / examination • Re-performance • Analytical procedures

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Analysis and interpretation of findings

Critical evaluation of series of evidences gathered for a particular event / class of transactions is needed

This is to avoid lopsided conclusion or inappropriate reporting of the fact

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Analysis and interpretation of findings

Inferences resulting from various evidences are to be studied and a common inference is required to be derived

The conclusion / inference is to be evaluated against the investigation objective

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Reporting of findings

Careful use of words to correctly convey the conclusion

Facts noted should have logical flow to enable the reader to comprehend the conclusion

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Reporting of findings

Sources of information / facts gathered should be clearly mentioned

Skeleton of the report to contain headings / sub-headings and annexures should be given as required to improve the readability

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Reporting of findings

Restriction / limitation on scope should be clearly mentioned

Bases and assumptions made should be explicitly stated

The final opinion of the investigator should appear in the final paragraph of the report

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Reporting of findings

Since there cannot be a standard developed for the investigations and end outcomes are important for the entities, the investigation report should be carefully drafted

Independent review of the report shall help to achieve the objective of the engagement and avoid further complications

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Special Issues in Investigation

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Special Issues in Investigation

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1.Coverage- 100% or selective

2. Reliance on Audited Financial Statements

Coverage – 100% or selective

It is dependent on the objective of the investigation

In respect of investigation to conclude on the total quantum of the transaction, 100% verification may be needed

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Coverage – 100% or selective

In case of conclusion on the qualitative aspects like appropriateness of particular method / process, scientific / statistical sampling methods may be used.

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Reliance on audited statements

It is a matter of judgment

When investigation specifically relates to the amounts in financial statements, it is appropriate not to put reliance on the previously audited financial statements

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Reliance on audited statements

Amounts in previously audited financial statements can be referred to direct the flow of the investigation engagement

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Reliance on audited statements

Careful reading of financial statements including notes to accounts may provide peculiar inputs to the investigator

If the investigator decides to rely on audited financial statements, he must -

- Obtain the consent of the client in writing - Mention this fact in the report

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Special Issues in Investigation

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3.Use of an expert

4. Investigation of disputes

Use of expert

There is no clear Yes / No in using the expert’s help

Investigations involving technical aspects such as ERP review, law matters can include use of expert’s opinion / view

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Use of expert

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Important to remember: Use of expert is agreeable to the person initiating investigation

Costs for expert services are estimated and approved

Confidentiality of the information exchanged with the expert needs to be ensured.

A written report or view is desired than the verbal or informal communication about the subject matter

Investigation of disputes etc.

Most challenging in nature

Experience, interpersonal skills and strong domain knowledge are key

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Investigation of disputes etc.

Need to understand the human influential forces impacting the engagement

Need to identify camouflaged evidence and real evidence

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Investigation of disputes etc.

Consistencies between verbal communications and records under review are to be established

Professional skepticism to be observed throughout the engagement

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Special Issues in Investigation

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5.Basis of opinion

Basis of opinion

Strictly confined to the investigation scope

Should avoid speculative aspects in the report

Investigator should mention limitation in fact gathering; if any

Like routine audit report, investigation report may be other than a non-qualified

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Business Investigations

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Factors to be considered in Business Investigations

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The overall context

Profit and Loss Account

Balance Sheet

Notes to Accounts

Other Sources

Understand the context

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Knowledge about the Entity

Profit and Loss A/c Balance Sheet

Notes to account / Directors’

Report

Annual Report / Financial Statements

Understanding of above aspects helps in taking the overall / larger view

Knowledge about entity

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Market share / Profitability / Competition

Diversification

Board of Directors / Senior management

Existing legal cases

Recent news

Profit & Loss Account

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Product-wise segments

Gross / Net margins

Geographies of operation

Usual / unusual events

Prior period / exception items

Balance Sheet

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Capital ratios

Leverage ratios

Working capital adequacy

Estimates / provisions

Suspense Accounts

Off balance sheet positions / contingent liabilities

Notes to Accounts

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Accounting policies adopted / consistency

Details about leases, related party transactions etc.

Basis for specific positions taken in the accounting certain transactions

Other Sources

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Directors’ Report

Corporate Governance Report

Management Discussion and Analysis

Types of Investigations

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Types of Investigations

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Statutory – pursuant to sections 235 to 251 of the Companies Act, 1956

Other

Statutory

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Investigation of the affairs of a Company

Investigation of ownership of Company

Statutory Investigation

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Investigation into affairs of the Company

U/s 234

• Initiated by the Registrar

U/s 235

• Initiated by members

U/s 237

• Initiated by the Company or Court

Statutory Investigation

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Investigation of ownership of the Company

Initiated by CG u/s 247

The objective is to determine the true persons who are interested in the company and are in control

Non-statutory – Business Scenarios

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On behalf of incoming partner

Valuation of shares in private limited entities

On behalf of bank – new loaning / corporate debt restructuring

Non-statutory – Business Scenarios

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Frauds

Review of profit / financial forecast

Non-statutory –Business Scenarios

On behalf of incoming partner History of the firm

Partnership deed and provisions therein

Business Analytics- Includes profitability and assessment of assets and liabilities

Composition and quality of key personnel

Reasons for offer of admission to a new partner

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Non-statutory –Business Scenarios

Valuation of shares Net-worth Basis - Specific focus on value in use than the carrying values

Yield Basis – Critical examination of the various assumptions made in determining the future maintainable profits / cost of capital etc.

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Non-statutory –Business Scenarios

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Investigation for financing/restructuring

Credit Worthiness

Evaluation of proposed end use of money

Valuation for assets for purpose of security

Authority of the directors to borrow

Requisite permissions for restructuring

Non-statutory –Business Scenarios

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Frauds

Cash Receipts

Cash Payments

Frauds through cooking the books – ledgers, suspense accounts etc.

Stock in hand

Non-statutory –Business Scenarios

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Financial forecast

Mainly done to decide acquisitions

Scope may include preparation/review of financial forecasts

ICAI has issued a standard on “Examination of prospective Financial information”

Testing time

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Investigation

MCQ1 :As compared to the financial audit the Investigation typically requires

A. More in-depth enquiry

B. Overview of the process

C. Interviews with the process owners

D. Samples and judgments

Answer: A. More in-depth enquiry

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MCQ .2 :Evidence required for financial audit is

A. Verbal

B. Prima-facie

C. Substantive & conclusive

D. Documented

Answer: B. Prima-facie

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MCQ.3 : Objective of the Investigation is not to

A. Review the fraud

B. Review the financing decision

C. Express true & fair opinion of financial statements

D. Determine profitability

Answer: C. Express true & fair opinion of financial statements

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MCQ.4:The scope of the investigation is generally governed by

A. The requester

B. Specific purpose

C. Auditing standards

D. Always by respective statues

Answer: B. Specific purpose

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MCQ.5:In case oral information is obtained in the investigation, A. Investigator can rely if the source is authentic B. This needs to be corroborated with other supporting evidence C. It can be supported by confirmation from other person D. Investigator can conclude based on this information Answer: B. This needs to be corroborated with other supporting evidence

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MCQ.6:The Investigation report should be submitted to the

A. Shareholders

B. Person who has requested it

C. Referred employees

D. CEO / MD

Answer: B. Person who has requested it

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MCQ.7:In investigation involvement of expert is required

A. Each Time

B. Never

C. Only in case of technology related investigation

D. Depending on the subject matter

Answer: D. Depending on the subject matter

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MCQ .8 :Conclusion of the investigation should include

A. Details of the transactions tested

B. Clear Opinion establishing the fact

C. Futuristic statements

D. Interview transcripts

Answer: B. Clear Opinion establishing the fact

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Introduction to Due Diligence

• Background • Concept

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Background

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Globalization

Economic conditions

Inorganic growth strategies – Mergers & Acquisitions

Risk Management – diversification

Electronic advancements – e-commerce, internet, cloud computing

What is due diligence?

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Due Diligence is a term that is often heard in the corporate world these days in relation to corporate restructuring.

It includes internal reconstruction, amalgamations, spin-offs, divestiture, mergers, joint ventures, split-off, etc.

A measure of prudence or assiduity, as is properly to be expected from, and ordinarily exercised by, a reasonable and prudent man under the particular circumstance. …Blacks law dictionary

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Purpose

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To assist the purchaser or the investor - - in his decision making - through use of professional skills - before the transaction is complete

Sometimes due diligence may be carried out post the transaction. E.g. Due diligence to identify post acquisition synergies

WHY DUE DILIGENCE? 78

Types of due diligence (DD)

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Due Diligence

Financial/ Accounting

Tax

Operational

Information Technology

Human Capital

Environmental

Legal

Commercial or operational DD

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Involves on-site understanding and analysis of: > Daily/routine processes > Business operations > Analysis of key employees/contractors

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Commercial or operational DD

Involves gathering information on: • New products/service creation • Markets • Competition • People/Organizational matters

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Need for Commercial or operational DD

Financial DD

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Defined as “an investigation into the affairs of anentity prior to its acquisition, flotation,restructuring or other similar transaction.” • Objective is to ensure that prospective investor makes an

informed investment decision. • It is not just-Checking the facts/reciting them

Its about- Evaluation, Interpretation, communication

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Financial DD-Focus Areas Quality of

earnings, gross margin & cash

flows

Quality of assets and working

capital

Potential liabilities and commitments Net Debt

Separation/ structuring/

integration issues

Tax DD

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Ensuring that organization is in compliance with tax laws.

Identifying and quantifying contingent liabilities

Information Systems DD

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Involves scrutiny of IT systems and processes in use and ascertaining better ways of deriving value from IT Assets.

Since most controls today are automated, information system DD gives a fair idea about the control environment too.

Legal DD

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Scrutiny of all, or specific parts, of the legal affairs of the target company with a view of uncovering and legal risks and provide an insight into company’s legal matters.

Environmental DD

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Environmental Due Diligence (EDD) is the collection and assessment of data relative to environmental conditions or impacts prior to a transaction to identify and quantify environment-related financial, legal, and reputational risks.

Personnel DD

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Involves analysis of workforce composition; assessment of top management; analysis of economic and legal relationships with employees; C&B system, employment agreements, etc.; review of HR records, employment litigation and investigations; and review of the compliance of HR policies and procedures with the applicable legislation.

Testing time

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Due Diligence

MCQ.1:Due diligence is A. always relating to review of financial statements B. Meant to assist the decision of the purchaser / investor C. Nothing but in-depth analysis of financial statements D. generally carried out by the Chartered Accountants Answer: B. Meant to assist the decision of the purchaser / investor

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MCQ.2:Most important aspect in any financial due diligence engagement is A. Understanding overall financial reporting structure

B. Review notes to account

C. Review of audit report for immediate preceding year

D. Documentation

Answer: A. Understanding overall financial reporting structure32

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MCQ.3:Due diligence engagement involves:

A. Selection of statistical samples

B. Selecting and evaluating samples based on judgment

C. Selection of random samples

D. 100% verification of the selected account balance Answer: B. Selecting and evaluating samples based on judgment

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MCQ.4: The due diligence engagement is carried out A. Always before completion of the related transaction B. Usually before the related transaction is completed

C. After completion of the transaction

D. None of the above

Answer: B. Usually before the related transaction is completed

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MCQ.5:Following may not be a covered as a part of financial due diligence

A. Review of inventory valuation

B. Review of related party transactions

C. Review of provisions for employee benefits D. Review of patent litigation filed against the target entity Answer: D. Review of patent litigation filed against the target entity

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Previous Examination Questions

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Previous Examination Question 1 Nov 2012 – You have been appointed to investigate a suspected embezzlement of cash receipts in a departmental store. What are the steps you would take in this regard? (6 marks)

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Answer Planning: • Understand people, process and technology aspects involved in the cash

receipts • Determine the period for which the transactions are to be checked. Execution: • Identify cash receipt points • Identify how these are recorded. • Ask probing questions like what happens if the cash received is not

recorded, recorded short etc. • Compare cash sales against the cash received for a particular period • Identify whether maker-checker controls exist to avoid scenario of one

person having full control over all transactions • Compare cash received against cash deposited into bank or transferred

to head office. • Identify is any limits to hold cash in hand is determined to avoid excess

cash in hand. • Check the frequency of cash verification, who carries out that?, is it

documented?, what were the reasons for differences between cash as per books and cash in hand.

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Previous Examination Question 2 May 2013 – J Ltd. is interested in acquiring S Ltd. The valuation of S Ltd. is dependent on future maintainable sales. As the person entrusted to value S Ltd. what factors would you consider in assessing the future maintainable turnover? (4 marks)

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Answer Factors relating to senior management / entity level: - How the sales/marketing force is comprised off. - Policies and approval mechanism for prices, discounts. - Analysis of customer base / geographical spread Factors relating to maintainability of sales - Present market share - Threats to product obsolescence / level of research on new product

development - Present gross margins, cost pressures, supply chain effectiveness - Competitive advantage - Important assumptions in sales projections like volumes, price increases,

pricing strategies, schemes, cash / credit sale ratio, average collection period etc.

- Product / Service mix - Distribution channels - Committed sales

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Lesson Summary- Investigation

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As compared to the financial audit the Investigation typically requires more in-depth enquiry.

Objective of investigation is not to express true and fair opinion on financial statements.

The scope of investigation is governed by specific purpose.

Assumptions/restrictions/limitations in an investigation assignment should be clearly communicated in the report. The investigator must first confirm the extent of checking required, use of an expert and reliance on audited financials.

Lesson Summary- Due Diligence

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Due diligence provides understanding or risks and hazards and strengths and opportunities related to investment decisions. Due diligence ensures informed decision making, helps build synergy and increases negotiation leverage. It requires selection and evaluation of samples based on judgment.

Out of audit, investigation and due diligence, due diligence is more directly related to decision making.

Thank You

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