Financial and Tax due diligence and its significance in practice

A widely-used term in M&A (transaction) consulting, “due diligence” means a legal, economic, financial or technical investigation of the company that is the subject of the transaction (often referred to as the “target”). The specifics of each transaction call for an accurate, detailed and tailored due diligence, which requires engaging competent advisors who keep abreast of the latest developments in this field. As a pre-arranged and in-depth investigation of the company being acquired, due diligence aims to obtain accounting and economic information necessary for the investment decision. While due diligence is typically commissioned by the buyer, it can also be conducted at the seller’s request, with its findings being presented to prospective buyers. Performing due diligence when buying or selling a company improves the client’s awareness and provides a more complete picture of the company’s assets, liabilities, trading partners and general affairs, facilitating the decision-making process and reducing the risk inherent in the transaction. Last but not least, due diligence findings may also identify potential improvements to be made after the takeover of the company, and thus help to improve its efficiency, eliminate potential risks or enhance competitiveness. Due diligence may cover the sale/acquisition of an entire company (“share deal”) or only the assets currently owned by a company (“asset deal”). Performing due diligence may also be one of the conditions that must be fulfilled in order for funds to be provided by banks/companies (for example when financing through loans or refinancing existing loans).

Financial due diligence

Unlike a statutory audit, financial due diligence focuses on areas that are relevant to the investor. For this reason, the scope (extent and areas of the investigation) is always agreed with the client before the process begins, which usually differs from a statutory audit in that it focuses on the future development, financial indicators (net working capital, EBITDA) and economic results of the company rather than on legislative requirements. As a rule, the last three completed fiscal years are examined.

Tax due diligence

Tax due diligence usually focuses on corporate income tax and VAT. Where real estate makes up a large portion of the company’s assets, real estate tax also plays an important role. Tax due diligence typically covers the last three tax periods or periods that may be inspected by the tax authorities.

The focus and scope of due diligence

The focus and scope of due diligence should always be appropriate to the sector in which the company operates. For example, if the buyer is acquiring a company that leases office space, due diligence should focus on examining the lease relations, their amount and the property occupancy rate in the following years, reviewing the related service costs and their transfer to the tenants, setting or assessing the refurbishment and investment plan in relation to the current condition of the property, etc. Where due diligence covers a manufacturing company, it is necessary to examine the order pipeline, product margin, customer portfolio, etc. As the client is kept informed of the ongoing due diligence process, the client may step in and require that particular aspects be examined in more detail or, on the other hand, that particular elements of the pre-arranged scope be modified or skipped.

The most common due diligence findings

Due diligence typically reveals risks (even in audited companies) that can be addressed before the acquisition takes place, or that are treated by providing the buyer with a discount on the purchase price or with the seller’s warranties. The most common findings of financial due diligence include, for example, a failure to disclose a (potential) liability (e.g. arising from litigation, unpaid liabilities), bad debts of significant value, failure to comply with legal obligations (e.g. when using subsidies, making mandatory payments, etc.), failure to comply with banking covenants, which may result in a significant deterioration of credit conditions, obsolete inventories or fixed assets that require significant investment in the future, etc. The most common findings of tax due diligence include incorrect differentiation between repairs and capital improvements, failure to tax time-barred liabilities or liabilities 30 months overdue, errors in depreciation and classification into depreciation groups, etc. In recent years, there has been a growing demand for the insurance of transaction-related risks, and it is high-quality due diligence that provides important information and documents that help identify and rate potential risks in the company. In practice, financial and tax due diligence is very often combined with legal and sometimes technical due diligence. Where these types of due diligence are conducted simultaneously, ensuring cooperation between the teams is important since the findings usually have an impact on multiple areas. Due diligence findings are compiled into a clear report (the scope and form of which are agreed with the client) that may be used in both negotiating the purchase price and obtaining a bank loan to finance the deal. Differences in the assessment of individual transactions give rise to the need for an accurate, detailed and tailored due diligence that provides the client with the information required to determine whether or not to go ahead with the acquisition. If the acquisition gets the green light, the due diligence findings should also provide information for the purchase price negotiations and mechanism, and, last but not least, important inputs for the drafting of the purchase agreement terms and warranties. Our tax and transaction team is ready to guide and assist you through the entire due diligence process.