Due diligence is an investigation or examination of a business or person prior to signing a contract, or an act with a certain standard of care.
The investigation or examination could be carried out for a potential objective for merger, acquisition, privatization, or similar corporate finance transaction normally by a buyer.
It can be a legal obligation, but the term will more commonly apply to voluntary investigations. A common example of due diligence in various industries is the process through which a potential acquirer evaluates a company which he has targeted or its assets for an acquisition.
The theory behind due diligence holds that performing this type of investigation contributes significantly to informed decision making by enhancing the amount and quality of information available to decision makers and by ensuring that this information is systematically used to deliberate in a reflexive manner on the decision at hand and all its costs, benefits, and risks.
Due diligence takes different forms depending on its purpose:
This can include self due diligence or “reverse due diligence”, i.e. an assessment of a company, usually by a third party on behalf of the company, prior to taking the company to market.
A reasonable investigation focusing on material future matters.
An examination being achieved by asking certain key questions, including, how do we buy, how do we structure an acquisition, and how much do we pay?
An investigation of current practices of process and policies.
The due diligence process (framework) can be divided into nine distinct areas.
Compatibility audit – which deals with the strategic components of the transaction and which links/consolidates other audit areas together via a formal valuation in particular to test whether shareholder value will be added.
Financial audit – where due diligence is required to validate financial statements. The goal of the process is to ensure that all stakeholders associated with a financial endeavor have the information they need to assess risk accurately.
Macro-environment audit– major external and uncontrollable factors that influence an organization’s decision making, and affect its performance and strategies.
Legal/environmental audit – evaluations intended to identify environmental compliance and management system implementation gaps, along with related corrective actions
Marketing audit – is a fundamental part of the marketing planning process. It is conducted at various points during the implementation of the plan. The marketing audit considers both internal and external influences on marketing planning, as well as a review of the plan itself.
Production audit – Verify the production records such as production slips / memos to ensure that the records are properly maintained. Also verify the log books of machinery to check the details of production.
Management audit – is a systematic examination of decisions and actions of the management to analyze the performance. Management audit involves the review of managerial aspects like organizational objective, policies, procedures, structure, control and system in order to check the efficiency or performance of the management over the activities of the Company
Information systems audit – is an examination of the management controls within an Information technology (IT) infrastructure. The evaluation of obtained evidence determines if the information systems are safeguarding assets, maintaining data integrity, and operating effectively to achieve the organization’s goals or objectives. These reviews may be performed in conjunction with a financial statement audit, internal audit, or other form of attestation engagement.
Reconciliation audit – relates to audit of various types of reconciliations which includes mainly bank reconciliation. In addition audit of other reconciliations like debtors and creditors reconciliations are also performed in conjunction with a financial statement audit, internal audit, etc.